Edgar Filing: HALLMARK FINANCIAL SERVICES INC

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.

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 - 20,808,954 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

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

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

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

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

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.

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”).

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.

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.

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.

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.

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.

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.

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	$	4.74		$	4.04		$	4.74		$	4.04

Expected term (in years)		6.4			6.4			6.4			6.4
Expected volatility		35.0	%		19.4	%		35.0	%		19.4	%
Risk free interest rate		3.4	%		4.5	%		3.4	%		4.5	%

8. Segment Information

The following is business segment information for the three and six months ended June 30, 2008 and 2007 (in thousands):

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2008			2007			2008			2007
Revenues:
Standard Commercial Segment	$	22,157		$	20,003		$	43,986		$	41,770
Specialty Commercial Segment		31,988			32,978			64,075			61,076
Personal Segment		16,498			14,696			32,224			28,469
Corporate		1,020			1,059			2,571			1,379
Consolidated	$	71,663		$	68,736		$	142,856		$	132,694

Pre-tax income (loss):
Standard Commercial Segment	$	3,984		$	2,664		$	7,865		$	5,423
Specialty Commercial Segment		6,265			9,441			11,558			14,127
Personal Segment		1,913			2,176			4,503			4,294
Corporate		(1,895	)		(1,349	)		(3,193	)		(3,199	)
Consolidated	$	10,267		$	12,932		$	20,733		$	20,645

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

	June 30,		December 31,
	2008		2007
Assets

Standard Commercial Segment	$	163,521	$	211,428
Specialty Commercial Segment		202,692		229,138
Personal Segment		75,710		100,986
Corporate		96,617		64,762
	$	538,540	$	606,314

9. 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 5 of our Annual Report on Form 10-K for the year ended December 31, 2007 for more discussion of our reinsurance.

The following table shows earned premiums ceded and reinsurance loss recoveries by period (in thousands):

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2008		2007		2008		2007

Ceded earned premiums	$	2,312	$	4,144	$	4,622	$	8,024
Reinsurance recoveries	$	1,156	$	2,349	$	1,263	$	3,433

10. Notes Payable

On June 21, 2005, an unconsolidated trust subsidiary 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. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity. As of June 30, 2008, 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 June 30, 2008, the balance on the revolving note was $2.8 million, which currently bears interest at 4.69% per annum. Also included in notes payable is $1.1 million outstanding as of June 30, 2008 under PAAC’s revolving credit sub-facility, which also currently bears interest at 4.69% per annum. (See Note 12, “Credit Facilities”).

On August 23, 2007, an unconsolidated trust subsidiary completed a private placement of $25.0 million of 30-year floating rate trust preferred securities. Simultaneously, we borrowed $25.8 million from the trust subsidiary for working capital and general corporate purposes. The note bears an initial interest rate at 8.28% until September 15, 2017, at which time interest will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage points. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity. As of June 30, 2008 the note balance was $25.8 million.

11. 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). As of June 30, 2008 we had fully repaid our obligation to the sellers.

12. 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. The credit facility was further amended effective May 31, 2007 to increase the revolving credit facility to $25.0 million and establish a new $5.0 million revolving credit sub-facility for the premium finance operations of PAAC. The credit agreement was again amended effective February 20, 2008 to extend the termination to January 27, 2010, revise various affirmative and negative covenants and decrease the interest rate in most instances to the three month Eurodollar rate plus 1.90 percentage points, 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. As of June 30, 2008, we were in compliance with all of our covenants. (See Note 10, “Notes Payable”).

13. Deferred Policy Acquisition Costs

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

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2008			2007			2008			2007

Deferred	$	(13,613	)	$	(12,606	)	$	(28,018	)	$	(24,966	)
Amortized		13,377			11,321			27,123			21,897

Net	$	(236	)	$	(1,285	)	$	(895	)	$	(3,069	)

14. Earnings per Share

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

	Three Months Ended				Six Months Ended
	June 30,				June 30,
	2008		2007		2008		2007

Weighted average shares - basic		20,806		20,768		20,794		20,768
Effect of dilutive securities		78		-		91		-
Weighted average shares - assuming dilution		20,884		20,768		20,885		20,768

For the three and six months ended June 30, 2008 , 899,167 shares of common stock potentially issuable upon the exercise of employee stock options were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such options would be anti-dilutive. For the three and six months ended June 30, 2007, 500,000 shares of common stock potentially issuable upon exercise of employee stock options were excluded from the weighted average number of shares outstanding on a diluted basis because the effect of such options would be anti-dilutive.

15. Net Periodic Pension Cost

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

	Three Months Ended						Six Months Ended
	June 30,						June 30,
	2008			2007			2008			2007
Interest cost	$	167		$	180		$	334		$	360
Amortization of net (gain) loss		(167	)		50			(335	)		100
Expected return on plan assets		16			(160	)		32			(321	)
Net periodic pension cost	$	16		$	70		$	31		$	139

We contributed $152 thousand and $196 thousand to our frozen defined benefit cash balance plan (“Cash Balance Plan”) during the three months ended June 30, 2008 and 2007, respectively. We contributed $236 thousand and $270 thousand to our Cash Balance Plan during the six months ended June 30, 2008 and 2007, respectively. Refer to Note 13 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2007 for more discussion of our retirement plans.

16. Contingencies

We are engaged in legal proceedings in the ordinary course of business, none of which, either individually or in the aggregate, are believed likely to have a material adverse effect on our consolidated financial position or results of operations, in the opinion of management. The various legal proceedings to which we are a party are routine in nature and incidental to our business.

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” for a discussion of some of the uncertainties, risks and assumptions associated with these statements.

Introduction

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 American Hallmark Insurance Services, 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 TGA Insurance Managers, Inc., Pan American Acceptance Corporation (“PAAC”) 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 solely of American Hallmark General Agency, Inc., which does business as Phoenix Indemnity Insurance Company.

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, retains a portion of the risks on the non-standard personal automobile policies marketed by our Phoenix Operating Unit, assumes a portion of the risks on the commercial property/casualty policies marketed by our TGA Operating Unit and assumes a portion of the risks on the aviation property/casualty products marketed by our Aerospace Operating Unit.

Hallmark Specialty Insurance Company (“HSIC”) presently assumes a portion of the risks on the commercial property/casualty policies marketed by our TGA Operating Unit.

Hallmark Insurance Company (“HIC”) (formerly known as Phoenix Indemnity Insurance Company) presently assumes a portion 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, HIC retains 34% of our total net premiums written and HSIC retains 20% of our total net premiums written. This pooling arrangement had no impact on our consolidated financial statements under GAAP.

Results of Operations

Management Overview. During the three and six months ended June 30, 2008, our total revenues were $71.7 and $142.9 million, representing a 4% and 8% increase over the $68.7 million and $132.7 in total revenues, respectively, for the same periods of 2007. Increased earned premium due to increased retention of business produced by our Specialty Commercial Segment, and increased production by our Personal Segment were the primary causes of the increase in revenue. Standard Commercial Segment revenues increased $2.2 million, or 11% and 5%, during the three and six months ended June 30, 2008 as compared to the same periods during 2007, due primarily to increased contingent commissions related to favorable loss development on prior accident years. Specialty Commercial Segment revenues decreased $1.0 million and increased $3.0 million, during the three months and six months ended June 30, 2008 as compared to the same periods of 2007, due to lower commission income primarily as a result of the continued shift from a third-party agency model to an underwriting model, partially offset by increased net premiums earned as a result of the increased retention of business. Revenues from our Personal Segment increased $1.8 million and $3.8 million, or 12% and 13%, during the three and six months ended June 30, 2008 as compared to the same periods during 2007, due largely to geographic expansion into new states. Corporate revenue of $1.0 million remained relatively unchanged for the second quarter of 2008 as compared to the same period in 2007. Corporate revenue increased $1.2 million for the six months ended June 30, 2008 primarily due to increased recognized gains on our investment portfolio of $0.2 million and increased investment income of $1.0 million due to changes in capital allocation.

We reported net income of $7.2 million and $14.3 million for the three and six months ended June 30, 2008, which was $1.6 million lower and $0.5 million higher than the $8.8 million and $13.8 million reported for the same periods in 2007. On a diluted basis per share, net income was $0.34 and $0.68 per share, respectively, for the three months and six months ended June 30, 2008 as compared to $0.42 and $0.66 per share for the same periods in 2007. The decrease in net income for the three months was primarily attributable to favorable loss development on prior accident years during the second quarter of 2008 of $0.3 million as compared to $1.9 million for the same period during 2007. The year to date increase in net income was primarily attributable to a lower effective tax rate from a higher amount of tax exempt bonds in our investment portfolio in 2008 than we held in 2007. Year to date 2008 pre tax income increased $0.1 million to $20.7 million from the prior year. Increased revenue, as discussed above, was partially offset by increased incurred loss and loss adjustment expense of $8.6 million, increased interest expense of $0.8 million from our issuance of trust preferred securities in the third quarter of 2007 and increased operating expense of $0.6 million.

Second Quarter 2008 as Compared to Second Quarter 2007

The following is additional business segment information for the three months ended June 30, 2008 and 2007 (in thousands):

Hallmark Financial Services, Inc.

Consolidated Segment Data

	Three Months Ended June 30, 2008
	Standard			Specialty
	Commercial			Commercial			Personal
	Segment			Segment			Segment			Corporate			Consolidated

Produced premium (1)	$	21,624		$	35,986		$	14,153		$	-		$	71,763

Gross premiums written		21,624			27,338			14,153			-			63,115
Ceded premiums written		(1,382	)		(945	)		-			-			(2,327	)
Net premiums written		20,242			26,393			14,153			-			60,788
Change in unearned premiums		36			(2,395	)		1,014			-			(1,345	)
Net premiums earned		20,278			23,998			15,167			-			59,443

Total revenues		22,157			31,988			16,498			1,020			71,663

Losses and loss adjustment expenses		11,669			13,976			10,384			-			36,029

Pre-tax income (loss)		3,984			6,265			1,913			(1,895	)		10,267

Net loss ratio (2)		57.5	%		58.2	%		68.5	%					60.6	%
Net expense ratio (2)		27.3	%		30.7	%		21.6	%					29.2	%
Net combined ratio (2)		84.8	%		88.9	%		90.1	%					89.8	%

	Three Months Ended June 30, 2007
	Standard			Specialty
	Commercial			Commercial			Personal
	Segment			Segment			Segment			Corporate			Consolidated

Produced premium (1)	$	24,751		$	40,956		$	13,298		$	-		$	79,005

Gross premiums written		24,740			28,540			13,297			-			66,577
Ceded premiums written		(2,804	)		(1,477	)		-			-			(4,281	)
Net premiums written		21,936			27,063			13,297			-			62,296
Change in unearned premiums		(1,731	)		(5,474	)		219			-			(6,986	)
Net premiums earned		20,205			21,589			13,516			-			55,310

Total revenues		20,003			32,978			14,696			1,059			68,736

Losses and loss adjustment expenses		11,267			10,635			8,813			(3	)		30,712

Pre-tax income (loss)		2,664			9,441			2,176			(1,349	)		12,932

Net loss ratio (2)		55.8	%		49.3	%		65.2	%					55.5	%
Net expense ratio (2)		27.0	%		32.0	%		22.8	%					27.9	%
Net combined ratio (2)		82.8	%		81.3	%		88.0	%					83.4	%

(1)

Produced premium is a non-GAAP measurement that management uses to track total controlled premium produced by our operations. We believe this is a useful tool for users of our financial statements to measure our premium production whether retained by our insurance company subsidiaries or retained by third party insurance carriers where we receive commission revenue.

(2)

The net loss ratio is calculated as incurred losses and loss adjustment expenses divided by net premiums earned, each determined in accordance with GAAP. The net expense ratio is calculated as total underwriting expenses of our insurance company subsidiaries, including allocated overhead expenses and offset by agency fee income, divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum of the net loss ratio and the net expense ratio.

Standard Commercial Segment

Gross premiums written for the Standard Commercial Segment were $21.6 million for the three months ended June 30, 2008, which was $3.1 million less than the $24.7 million for the three months ended June 30, 2007. Net premiums written were $20.2 million for the three months ended June 30, 2008 as compared to the $21.9 million reported for the same period in 2007. The primary reasons for the decline in premiums were increased competition and rate pressure in the standard commercial markets.

Total revenue for the Standard Commercial Segment was $22.2 million for the three months ended June 30, 2008 as compared to $20.0 million for the same period in 2007. This $2.2 million increase was due primarily to increased contingent commissions of $2.1 million related to favorable loss development on prior accident years during the second quarter of 2008 as compared to the same period for 2007. Net premiums earned increased $0.1 million for the quarter due to the upward trend of net premium written in 2007 as compared to the flat net written premium trend in 2008.

Pre-tax income for our Standard Commercial Segment of $4.0 million for the second quarter of 2008 increased $1.3 million from the $2.7 million reported for the second quarter of 2007. Increased revenue as discussed above was the primary reason for the increase in pre-tax income, partially offset by higher losses and loss adjustment expense of $0.4 million for the quarter and increased operating expenses of $0.5 million due to production related costs as well as new hires. The higher losses and loss adjustment expense is evidenced by a net loss ratio of 57.5% for the three months ended June 30, 2008 as compared to 55.8% for the same period of 2007.

The net loss ratio was unfavorably impacted by lower ceded losses of $0.9 for the three months ended June 30, 2008, as compared to $1.8 million for the same period the prior year. The gross loss ratio before reinsurance was 58.1% for the three months ended June 30, 2008 as compared to 57.3% for the same period the prior year. The gross loss results for the three months ended June 30, 2008 included $0.4 million of favorable prior year development as compared to favorable loss development on prior accident years of $0.6 million recognized during the same period of 2007. The Standard Commercial Segment reported net expense ratios of 27.3% and 27.0% for the second quarters of 2008 and 2007, respectively.

Specialty Commercial Segment

Gross premiums written for the Specialty Commercial Segment for the second quarter of 2008 were $27.3 million, which was $1.2 million less than the $28.5 million reported for the same period in 2007. Net premiums written for the second quarter of 2008 were $26.4 million, which was $0.7 million less than the $27.1 million reported for the same period in 2007. The decrease in premium volume was due to increased competition and rate pressure in both the excess and surplus and general aviation markets.

Total revenue for the Specialty Commercial Segment of $32.0 million for the second quarter of 2008 was $1.0 million less than the $33.0 million reported in the first quarter of 2007. This 3% decrease in revenue was largely due to lower commission income of $3.5 million for the quarter primarily as a result of the shift from a third party agency structure to an insurance underwriting structure partially offset by increased net premiums earned of $2.4 million for the quarter as a result of the increased retention of business and increased net investment income of $0.1 million.

Pre-tax income for the Specialty Commercial Segment of $6.3 million for the second quarter of 2008 decreased $3.1 million from the $9.4 million reported for the same period in 2007. Decreased revenue, discussed above, as well as increased losses and loss adjustment expenses of $3.3 million were the primary reasons for the decrease in pre-tax income, partially offset by lower other operating expenses of $1.1 million.

The Specialty Commercial Segment reported a net loss ratio of 58.2% for the second quarter of 2008 as compared to 49.3% for the second quarter of 2007. Unfavorable prior accident year development of $0.5 million for the second quarter of 2008 as compared to favorable prior accident year development of $1.4 million during the same period of 2007 were the primary cause for the increase in net loss ratio. Absent prior year development, the gross incurred losses and loss adjustment expense before reinsurance were higher by $1.2 million primarily due to increased pricing pressure reflected in our current accident year loss estimates. The Specialty Commercial Segment reported a net expense ratio of 30.7% for the second quarter of 2008, as compared to 32.0% for the second quarter of 2007. The decrease in the net expense ratio was primarily due to increased retention on our catastrophe reinsurance and commercial property per risk reinsurance programs during the second quarter of 2008 as compared to the second quarter of 2007.

Personal Segment

Net premium written for our Personal Segment increased $0.9 million during the second quarter of 2008 to $14.2 million compared to $13.3 million in the second quarter of 2007. The increase in net premium was due mostly to continued geographic expansion.

Total revenue for the Personal Segment increased 12% to $16.5 million for the second quarter of 2008 from $14.7 million for the same period in 2007. The primary reason for the increase was higher earned premium of $1.7 million.

Pre-tax income for the Personal Segment was $1.9 million for the three months ended June 30, 2008 as compared to $2.2 million for the same period in 2007. The increased revenue, as discussed above, was partially offset by increased losses and loss adjustment expenses of $1.6 million and increased operating expenses of $0.5 million due mostly to production related expenses attributable to the increased earned premium.

The Personal Segment reported a net loss ratio of 68.5% for the second quarter of 2008 as compared to 65.2% for the same period in 2007. A competitive pricing environment and the new business impact associated with geographic expansion were the primary reasons for the increase in net loss ratio. We recognized $0.3 million of favorable prior accident year development in the second quarter 2008 as compared to $0.1 million of unfavorable prior accident year development in the second quarter of 2007. The Personal Segment reported a net expense ratio of 21.6% for the second quarter of 2008 as compared to 22.8% for the second quarter of 2007. The decrease in the net expense ratio was mainly due to increased finance charges and fixed overhead allocations in relation to earned premium.

Corporate

Corporate revenue of $1.0 million for the three months ended June 30, 2008 remained relatively unchanged from the $1.1 million reported for the same period in 2007. Recognized gains on our investment portfolio decreased $0.6 million and investment income increased $0.6 million due to changes in capital allocation.

Corporate pre-tax loss was $1.9 million for the second quarter of 2008 as compared to $1.3 million for the same period in 2007. Contributing to the increased loss was increased interest expense of $0.4 million due primarily to the issuance of trust preferred securities in August 2007 and increased operating expense of $0.1 million.

Six Months Ended June 30, 2008 as Compared to Six Months Ended June 30, 2007

The following is additional business segment information for the six months ended June 30, 2008 and 2007 (in thousands):

Hallmark Financial Services, Inc.

Consolidated Segment Data

	Six Months Ended June 30, 2008
	Standard			Specialty
	Commercial			Commercial			Personal
	Segment			Segment			Segment			Corporate			Consolidated

Produced premium (1)		43,373			68,006			31,880			-			143,259

Gross premiums written		43,373			52,099			31,880			-			127,352
Ceded premiums written		(2,746	)		(1,913	)		-			-			(4,659	)
Net premiums written		40,627			50,186			31,880			-			122,693
Change in unearned premiums		440			(2,550	)		(2,224	)					(4,334	)
Net premiums earned		41,067			47,636			29,656			-			118,359

Total revenues		43,986			64,075			32,224			2,571			142,856

Losses and loss adjustment expenses		22,979			28,979			19,575			-			71,533

Pre-tax income (loss)		7,865			11,558			4,503			(3,193	)		20,733

Net loss ratio (2)		56.0	%		60.8	%		66.0	%					60.4	%
Net expense ratio (2)		27.3	%		30.7	%		22.0	%					29.1	%
Net combined ratio (2)		83.3	%		91.5	%		88.0	%					89.5	%

	Six Months Ended June 30, 2007
	Standard			Specialty
	Commercial			Commercial			Personal
	Segment			Segment			Segment			Corporate			Consolidated

Produced premium (1)		48,301			80,313			28,374			-			156,988

Gross premiums written		48,221			54,641			28,373			-			131,235
Ceded premiums written		(5,439	)		(2,729	)		-			-			(8,168	)
Net premiums written		42,782			51,912			28,373			-			123,067
Change in unearned premiums		(2,655	)		(11,230	)		(2,224	)		-			(16,109	)
Net premiums earned		40,127			40,682			26,149			-			106,958

Total revenues		41,770			61,076			28,469			1,379			132,694

Losses and loss adjustment expenses		24,108			21,716			17,080			(7	)		62,897

Pre-tax income (loss)		5,423			14,127			4,294			(3,199	)		20,645

Net loss ratio (2)		60.1	%		53.4	%		65.3	%					58.8	%
Net expense ratio (2)		27.5	%		31.8	%		23.2	%					28.1	%
Net combined ratio (2)		87.6	%		85.2	%		88.5	%					86.9	%

(1)

(2)

Standard Commercial Segment

Gross premiums written for the Standard Commercial Segment were $43.4 million for the six months ended June 30, 2008, or 10% less than the $48.2 million reported for the same period in 2007. Net premiums written were $40.6 million for the six months ended June 30, 2008 as compared to $42.8 million reported for the same period in 2007. Increased competition and rate pressure continue to challenge premium volume growth in the Standard Commercial Segment.

Total revenue for the Standard Commercial Segment of $44.0 million for the six months ended June 30, 2008 was $2.2 million more than the $41.8 million reported during the six months ended June 30, 2007. This 5% increase in total revenue was primarily due to increased contingent commissions of $1.4 million related to favorable loss development on prior accident years during 2008 compared to the same period for 2007. Also contributing to this increase in revenues was increased net premiums earned of $0.9 million and increased net investment income of $0.2 million. These increases in revenue were partially offset by lower processing and service fees of $0.3 million, due to the shift from a third party agency structure to an insurance underwriting structure.

Pre-tax income for our Standard Commercial Segment of $7.9 million for the six months ended June 30, 2008 increased $2.5 million, or 45%, from the $5.4 million reported for the same period of 2007. This increase in pre-tax income was primarily attributable to increased revenue discussed above as well as lower loss and loss adjustment expenses of $1.1 million. These increases were partially offset by higher operating expenses of $0.9 million primarily due to production related expenses related to higher earned premium and new hires.

The net loss ratio for the six months ended June 30, 2008 was 56.0% as compared to the 60.1% reported for the same period of 2007. The gross loss ratio before reinsurance was 54.2% for the six months ended June 30, 2008 as compared to 57.5% for the same period the prior year. The gross loss results for the six months ended June 30, 2008 included $2.2 million of favorable prior year development as compared to favorable prior year development of $0.6 million recognized during the same period of 2007. Absent prior year development, the gross incurred losses and loss adjustment expense before reinsurance for the Standard Commercial Segment were lower by $0.9 million due to better gross loss experience.

The Standard Commercial Segment reported net expense ratios of 27.3% and 27.5% for the six months ended June 30, 2008 and 2007, respectively.

Specialty Commercial Segment

Gross premiums written for the Specialty Commercial Segment for the first six months of 2008 were $52.1 million, or 5% less than the $54.6 million reported for the same period in 2007. Net premiums written for the first six months of 2008 were $50.2 million or 3% less than the $51.9 million reported for the same period in 2007. The decrease in premium volume was due to the increased competition and rate pressure in both the excess and surplus and general aviation markets.

Total revenue for the Specialty Commercial Segment of $64.1 million for the first six months of 2008 was $3.0 million more than the $61.1 million reported in the first six months of 2007. This 5% increase in revenue was largely due to increased net premiums earned of $7.0 million for the first six months of 2008 as a result of the increased retention of business. Increased net investment income contributed an additional $0.3 million to the increase in revenue for the quarter. These increases in revenue were partially offset by lower ceding commission and fee revenue of $4.2 million due primarily to the shift from a third party agency structure to an insurance underwriting structure.

Pre-tax income for the Specialty Commercial Segment of $11.6 million for the first six months of 2008 decreased $2.6 million, or 18%, from the $14.1 million reported for the same period in 2007. Increased losses and loss adjustment expenses of $7.3 million, partially offset by the increased revenue discussed above and lower operating expenses of $1.7 million due mostly to production related expenses.

The Specialty Commercial Segment reported a net loss ratio of 60.8% for the first six months of 2008 as compared to 53.4% for the first six months of 2007. Unfavorable prior year development of $1.0 million for the six months ended June 30, 2008 as compared to favorable prior year development of $1.4 million for the same period of 2007 was the primary cause for the increase in the net loss ratio. Absent prior year development, the gross incurred losses and loss adjustment expense before reinsurance were higher by $4.0 million primarily due to increased pricing pressure reflected in our current accident year loss estimates.

The Specialty Commercial Segment reported a net expense ratio of 30.7% for the first six months of 2008 as compared to 31.8% for the first six months of 2007. The decrease in the net expense ratio was primarily due to increased retention on our catastrophe reinsurance and commercial property per risk reinsurance programs during the first six months of 2008 as compared to the same period in 2007.

Personal Segment

Net premium written for our Personal Segment increased $3.5 million during the first six months of 2008 to $31.9 million compared to $28.4 million in the first six months of 2007. The increase in premium was due mostly to continued geographic expansion that began in 2007.

Total revenue for the Personal Segment increased 13% to $32.2 million for the first six months of 2008 from $28.5 million for the same period in 2007. Higher earned premium of $3.5 million was the primary reason for the increase in revenue for the period. Increased finance charges of $0.3 million were partially offset by lower third party commission revenue of $0.1 million.

Pre-tax income for the Personal Segment was $4.5 million for the six months ended June 30, 2008 as compared to $4.3 million for the same period in 2007. The increased revenue, as discussed above, was offset by increased losses and loss adjustment expenses of $2.5 million and increased operating expenses of $1.0 million due mostly to production related expenses attributable to the increased earned premium.

The Personal Segment reported a net loss ratio of 66.0% for the first six months of 2008 as compared to 65.3% for the same period in 2007. A competitive pricing environment and the new business impact associated with geographic expansion were the primary reasons for the increase in the net loss ratio. We recognized $0.6 million of favorable prior accident year development during the first six months 2008 as compared to $0.1 million of favorable prior year development during the first six months of 2007.

The Personal Segment reported a net expense ratio of 22.0% for the first six months of 2008 as compared to 23.2% for the first six months of 2007. The decrease in the net expense ratio was mainly due to increased finance charges in relation to earned premium, as well as fixed overhead allocations in relation to earned premium.

Corporate

Corporate revenue increased $1.2 million for the first six months of 2008 as compared to the same period in 2007. The increase was primarily due to increased investment income of $1.0 million due primarily to changes in capital allocation and $1.1 million of net gains recognized on our investment portfolio during the first six months of 2008 as compared to $0.9 million of net gains recognized during the same period of 2007.

Corporate pre-tax loss was $3.2 million for the first six months of 2008 and 2007. The increase in revenue discussed above was offset by increased interest expense of $0.8 million due primarily to the issuance of trust preferred securities in August 2007 and increased operating expenses of $0.4 million.

Financial Condition and Liquidity

Sources and Uses of Funds

Our sources of funds are from insurance-related operations, financing activities and investing activities. Major sources of funds from operations include premiums collected (net of policy cancellations and premiums ceded), commissions, and processing and service fees. As a holding company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to meet operating expenses and debt obligations. As of June 30, 2008, Hallmark had $26.6 million in unrestricted cash and invested assets at the holding company. Unrestricted cash and invested assets of our non-insurance subsidiaries were $3.5 million as of June 30, 2008.

AHIC, domiciled in Texas, is limited in the payment of dividends in any 12-month period, without the prior written consent of the Texas Department of Insurance, to the greater of statutory net income for the prior calendar year or 10% of statutory surplus as of the prior year end. Dividends may only be paid from unassigned surplus funds. HIC, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year surplus or prior year’s net investment income, without prior written approval from the Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in the payment of dividends to the greater of 10% of prior year surplus or prior year’s statutory net income, without prior written approval from the Oklahoma Insurance Department. During 2008, our insurance company subsidiaries’ ordinary dividend capacity is $16.3 million. None of our insurance company subsidiaries paid a dividend to Hallmark during the first six months of 2008 or the 2007 fiscal year.

Comparison of June 30, 2008 to December 31, 2007

On a consolidated basis, our cash and investments (excluding restricted cash) at June 30, 2008 were $370.9 million compared to $411.7 million at December 31, 2007. Settlement of receivables and payables for securities during the first quarter of 2008 as well as a decline in market value for the period, contributed to this decrease in our cash and investments. At June 30, 2008, 88% of the Company’s investments were rated investment grade and had an average duration of 2.9 years, including approximately 36% that were held in short-term investments. The Company classifies its bond securities as available for sale. The net unrealized loss associated with the investment portfolio was $4.7 million (net of tax effects) at June 30, 2008 (see Note 4 of Notes to Condensed Consolidated Financial Statements which appears in Item 1 of this Report).

Comparison of Six Months Ended June 30, 2008 and June 30, 2007

Net cash provided by our consolidated operating activities was $29.7 million for the first six months of 2008 compared to $44.6 million for the first six months of 2007. The decrease in operating cash flow was primarily due to increased paid losses from the maturing of retained business growth that began in late 2005.

Net cash used in investing activities during the first six months of 2008 was $132.0 million as compared to $68.6 million for the same period in 2007. Contributing to the increase in cash used in investing activities was an increase of $111.4 million in purchases of debt and equity securities, a $80.0 million increase in net purchases of short-term investments, and a $8.3 million reduction in restricted cash, partially offset by a $136.4 million increase in maturities and redemptions of investment securities.

Cash used in financing activities during the first six months of 2008 was $10.1 million as compared to $15.6 million used by financing activities for the same period of 2007. The cash used in both periods was primarily for the payment of deferred guaranteed consideration to the sellers of the subsidiaries comprising our TGA Operating Unit. As of June 30, 2008 we had fully repaid our obligation to the sellers.

Credit Facilities

Trust Preferred Securities

On June 21, 2005, an unconsolidated trust subsidiary 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 June 30, 2008, the note balance was $30.9 million. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity.

On August 23, 2007, an unconsolidated trust subsidiary completed a private placement of $25.0 million of 30-year floating rate trust preferred securities. Simultaneously, we borrowed $25.8 million from the trust subsidiary for working capital and general corporate purposes. The note bears an initial interest rate at 8.28% until September 15, 2017, at which time interest will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage points. As of June 30, 2008, the note balance was $25.8 million. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity.

Structured Settlements

In connection with our acquisition of the subsidiaries now comprising our TGA Operating Unit, we issued to the sellers promissory notes in the aggregate principal amount of $23.7 million, of which $14.2 million was paid on January 2, 2007, and $9.5 million was paid on January 2, 2008. We were also obligated to pay to the sellers an additional $1.3 million, of which $0.8 million was paid on January 2, 2007 and an additional $0.5 million was paid on January 2, 2008, in consideration of the sellers’ compliance with certain restrictive covenants, including a covenant not to compete for a period of five years after closing. We secured payment of these installments of purchase price and restrictive covenant consideration by depositing $25.0 million in a trust account for the benefit of the sellers. We recorded a payable for future guaranteed payments to the sellers of $25.0 million discounted at 4.4%, the rate of two-year U.S. Treasuries (the only permitted investment of the trust account). As of June 30, 2008 we had fully repaid our obligation to the sellers.

Conclusion

Based on budgeted and year-to-date cash flow information, we believe that we have sufficient liquidity to meet our projected insurance obligations, operational expenses and capital expenditure requirements for the next 12 months.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

As of June 30, 2008, there had been no material changes in the market risks described in our Annual Report on Form 10-K for the year ended December 31, 2007.

Item 4T. Controls and Procedures.

The principal executive officer and principal financial officer of Hallmark have evaluated our disclosure controls and procedures and have concluded that, as of the end of the period covered by this report, such disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is timely recorded, processed, summarized and reported. The principal executive officer and principal financial officer also concluded that such disclosure controls and procedures were effective in ensuring that information required to be disclosed by us in the reports that we file or submit under such Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure. During the most recent fiscal quarter, there have been no changes in our internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Risks Associated with Forward-Looking Statements Included in this Form 10-Q

This Form 10-Q contains certain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are intended to be covered by the safe harbors created thereby. These statements include the plans and objectives of management for future operations, including plans and objectives relating to future growth of our business activities and availability of funds. The forward-looking statements included herein are based on current expectations that involve numerous risks and uncertainties. Assumptions relating to the foregoing involve judgments with respect to, among other things, future economic, competitive and market conditions, regulatory framework, weather-related events and future business decisions, all of which are difficult or impossible to predict accurately and many of which are beyond our control. Although we believe that the assumptions underlying the forward-looking statements are reasonable, any of the assumptions could be inaccurate and, therefore, there can be no assurance that the forward-looking statements included in this Form 10-Q will prove to be accurate. In light of the significant uncertainties inherent in the forward-looking statements included herein, the inclusion of such information should not be regarded as a representation by us or any other person that our objectives and plans will be achieved.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings.

Item 1A. Risk Factors.

This Item is omitted, as permitted for a “smaller reporting company” (as defined by the Securities and Exchange Commission).

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

None.

Item 4. Submission of Matters to a Vote of Security Holders.

Hallmark’s Annual Meeting of Shareholders was held on May 22, 2008. Of the 20,801,587 shares of common stock of Hallmark entitled to vote at the meeting, 16,666,751 shares were present in person or by proxy.

At the Annual Meeting, the following individuals were elected to serve as directors of Hallmark and received the number of votes set forth opposite their respective names:

Director	Votes For		Votes Withheld

Mark E. Schwarz		15,212,726		281,287
Scott T. Berlin		16,258,362		281,287
James H. Graves		16,385,389		281,287
George R. Manser		16,169,427		281,287

At the Annual Meeting, Hallmark stockholders approved an increase in the number of shares of common stock authorized for issuance under the 2005 Long Term Incentive Plan. Votes were cast 14,443,821 in favor of such proposal, with 11,865 votes abstaining.

Item 5. Other Information.

None.

Item 6. Exhibits.

The following exhibits are filed herewith or incorporated herein by reference:

Exhibit Number		Description

3(a)		Restated Articles of Incorporation of the registrant, as amended (incorporated by reference to Exhibit 3.1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).

3(b)		Amended and Restated By-Laws of the registrant (incorporated by reference to Exhibit 3.1 to the registrant’s Current Report on Form 8-K filed October 1, 2007).

4(a)		Specimen certificate for Common Stock, $0.18 par value per share, of the registrant (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to the registrant’s Registration Statement on Form S-1 [Registration No. 333-136414] filed September 8, 2006).

4(b)		Indenture dated as of June 21, 2005, between Hallmark Financial Services, Inc. and JPMorgan Chase Bank, National Association (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27, 2005).

4(c)		Amended and Restated Declaration of Trust of Hallmark Statutory Trust I dated as of June 21, 2005, among Hallmark Financial Services, Inc., as sponsor, Chase Bank USA, National Association, as Delaware trustee, and JPMorgan Chase Bank, National Association, as institutional trustee, and Mark Schwarz and Mark Morrison, as administrators (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27, 2005).

4(d)		Form of Junior Subordinated Debt Security Due 2035 (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed June 27, 2005).

4(e)		Form of Capital Security Certificate (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed June 27, 2005).

4(f)		First Restated Credit Agreement dated January 27, 2006, between Hallmark Financial Services, Inc. and The Frost National Bank (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed February 2, 2006).

4(g)		Form of Registration Rights Agreement dated January 27, 2006, between Hallmark Financial Services, Inc. and Newcastle Special Opportunity Fund I, L.P. and Newcastle Special Opportunity Fund II, L.P. (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed February 2, 2006).

4(h)		Indenture dated as of August 23, 2007, between Hallmark Financial Services, Inc. and The Bank of New York Trust Company, National Association (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August 24, 2007).

4(i)		Amended and Restated Declaration of Trust of Hallmark Statutory Trust II dated as of August 23, 2007, among Hallmark Financial Services, Inc., as sponsor, The Bank of New York (Delaware), as Delaware trustee, and The Bank of New York Trust Company, National Association, as institutional trustee, and Mark Schwarz and Mark Morrison, as administrators (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed August 24, 2007).

Exhibit Number		Description

4(j)		Form of Junior Subordinated Debt Security Due 2037 (incorporated by reference to Exhibit 4.1 to the registrant’s Current Report on Form 8-K filed August 24, 2007).

4(k)		Form of Capital Security Certificate (incorporated by reference to Exhibit 4.2 to the registrant’s Current Report on Form 8-K filed August 24, 2007).

31(a)		Certification of principal executive officer required by Rule 13a-14(a) or Rule 15d-14(a).

31(b)		Certification of principal financial officer required by Rule 13a-14(a) or Rule 15d-14(a).

32(a)		Certification of principal executive officer Pursuant to 18 U.S.C. 1350.

32(b)		Certification of principal financial officer Pursuant to 18 U.S.C. 1350.

SIGNATURES

In accordance with the requirements of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

HALLMARK FINANCIAL SERVICES, INC.

(Registrant)

Date: August 11, 2008		/s/ Mark J. Morrison
		Mark J. Morrison, Chief Executive Officer and President (Principal Executive Officer)

Date: August 11, 2008		/s/ Jeffrey R. Passmore
		Jeffrey R. Passmore, Chief Accounting Officer and Senior Vice President
		(Principal Financial Officer)