HALLMARK FINANCIAL SERVICES INC - Quarter Report: 2007 September (Form 10-Q)

Unassociated Document

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, 2007

Commission file number 001-11252

Hallmark Financial Services, Inc.

(Exact name of registrant as specified in its charter)

Nevada		87-0447375
(State or other jurisdiction of		(I.R.S. Employer
Incorporation or organization)		Identification No.)

777 Main Street, Suite 1000, Fort Worth, Texas		76102
(Address of principal executive offices)		(Zip Code)

Registrant's telephone number, including area code: (817) 348-1600

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o Accelerated filer o Non-accelerated filer x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date: Common Stock, par value $.18 per share - 20,768,252 shares outstanding as of November 7, 2007.

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

INDEX TO FINANCIAL STATEMENTS

	Page Number

Consolidated Balance Sheets at September 30, 2007 (unaudited) and December 31, 2006	3

Consolidated Statements of Operations (unaudited) for the three months and nine months ended September 30, 2007 and September 30, 2006	4

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (unaudited) for the three months and nine months ended September 30, 2007 and September 30, 2006	5

Consolidated Statements of Cash Flows (unaudited) for the nine months ended September 30, 2007 and September 30, 2006	6

Notes to Consolidated Financial Statements (unaudited)	7

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Balance Sheets

($ in thousands)

	September 30			December 31
	2007			2006
	(unaudited)			(audited)
ASSETS
Investments:
Debt securities, available-for-sale, at market value	$	163,054		$	133,030
Equity securities, available-for-sale, at market value		41,988			4,580
Short-term investments, available-for-sale, at market value		56,311			25,275

Total investments		261,353			162,885

Cash and cash equivalents		61,681			81,474
Restricted cash and cash equivalents		15,646			24,569
Premiums receivable		53,136			44,644
Accounts receivable		18,503			13,223
Prepaid reinsurance premium		1,154			1,629
Reinsurance recoverable		5,781			5,930
Deferred policy acquisition costs		20,776			17,145
Excess of cost over fair value of net assets acquired		30,025			31,427
Intangible assets		24,354			26,074
Prepaid expenses		1,094			1,769
Other assets		12,131			5,184

Total assets	$	505,634		$	415,953

LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Notes payable	$	60,681		$	35,763
Structured settlements		9,897			24,587
Unpaid losses and loss adjustment expenses		116,136			77,564
Unearned premiums		108,365			91,606
Unearned revenue		3,356			5,734
Reinsurance balances payable		-			1,060
Accrued agent profit sharing		1,990			1,784
Accrued ceding commission payable		7,052			3,956
Pension liability		2,884			3,126
Deferred federal income taxes		115			2,310
Current federal income tax payable		336			2,132
Accounts payable and other accrued expenses		22,736			15,600

Total liabilities		333,548			265,222

Commitments and Contingencies

Stockholders' equity:
Common stock, $.18 par value (authorized 33,333,333 shares in 2007 and 2006; issued 20,776,080 shares in 2007 and 2006)		3,740			3,740
Additional paid in capital		118,283			117,932
Retained earnings		51,847			31,480
Accumulated other comprehensive loss		(1,707	)		(2,344	)
Treasury stock, at cost (7,828 shares in 2007 and 2006)		(77	)		(77	)

Total stockholders' equity		172,086			150,731

	$	505,634		$	415,953

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						Nine Months Ended
	September 30						September 30
	2007			2006			2007			2006

Gross premiums written	$	62,304		$	58,107		$	193,539		$	153,718
Ceded premiums written		(779	)		(3,102	)		(8,947	)		(7,542	)
Net premiums written		61,525			55,005			184,592			146,176
Change in unearned premiums		(2,100	)		(12,811	)		(18,209	)		(41,289	)
Net premiums earned		59,425			42,194			166,383			104,887

Investment income, net of expenses		3,774			2,912			9,811			7,505
Gain (loss) on investments		418			(135	)		1,299			(1,501	)
Finance charges		1,206			1,037			3,477			2,940
Commission and fees		7,280			9,943			23,344			32,223
Processing and service fees		111			410			586			1,994
Other income		4			4			12			24

Total revenues		72,218			56,365			204,912			148,072

Losses and loss adjustment expenses		36,723			23,589			99,620			60,478
Other operating expenses		24,087			23,044			70,511			64,097
Interest expense		1,026			1,527			2,608			4,774
Interest expense from amortization of discount on convertible notes		-			-			-			9,625
Amortization of intangible asset		573			573			1,719			1,719

Total expenses		62,409			48,733			174,458			140,693

Income before tax		9,809			7,632			30,454			7,379

Income tax expense		3,227			2,755			10,087			2,918

Net income	$	6,582		$	4,877		$	20,367		$	4,461

Common stockholders net income per share:
Basic	$	0.32		$	0.27		$	0.98		$	0.28
Diluted	$	0.32		$	0.27		$	0.98		$	0.28

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						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006

Common Stock
Balance, beginning of period	$	3,740		$	3,198		$	3,740		$	2,606
Conversion of note payable to common stock		-			-			-			589
Issuance of common stock upon option exercises		-			-			-			3
Balance, end of period		3,740			3,198			3,740			3,198

Additional Paid-In Capital
Balance, beginning of period		118,085			93,663			117,932			62,907
Discount on convertible notes, net of tax		-			-			-			6,066
Conversion of note payable to common stock		-			-			-			24,562
Equity based compensation		198			50			351			107
Exercise of stock options		-			(1	)		-			70
Balance, end of period		118,283			93,712			118,283			93,712

Retained Earnings
Balance, beginning of period		45,265			21,873			31,480			22,289
Net income		6,582			4,877			20,367			4,461
Balance, end of period		51,847			26,750			51,847			26,750

Accumulated Other Comprehensive Loss
Balance, beginning of period		(2,746	)		(3,668	)		(2,344	)		(2,597	)
Amortization of net actuarial loss, net of tax		33			-			97			32
Unrealized gains on securities, net of tax		1,006			1,438			540			335
Balance, end of period		(1,707	)		(2,230	)		(1,707	)		(2,230	)

Treasury Stock
Balance, beginning of period		(77	)		(77	)		(77	)		(17	)
Acquisition of treasury shares		-			-			-			(100	)
Exercise of stock options		-			-			-			40
Balance, end of period		(77	)		(77	)		(77	)		(77	)

Stockholders' Equity	$	172,086		$	121,353		$	172,086		$	121,353

Net income	$	6,582		$	4,877		$	20,367		$	4,461
Amortization of net actuarial loss, net of tax		33			-			97			32
Unrealized gains on securities, net of tax		1,006			1,438			540			335
Comprehensive Income	$	7,621		$	6,315		$	21,004		$	4,828

The accompanying notes are an integral part

of the consolidated financial statements

Hallmark Financial Services, Inc. and Subsidiaries

Consolidated Statement of Cash Flows

(Unaudited)

($ in thousands)

	Nine Months Ended
	September 30
	2007			2006
Cash flows from operating activities:
Net income	$	20,367		$	4,461

Adjustments to reconcile net income to cash provided by operating activities:
Depreciation and amortization expense		2,344			2,418
Amortization of beneficial conversion feature		-			9,625
Amortization of discount on structured settlement		310			784
Deferred federal income tax benefit		(1,170	)		(4,062	)
(Gain) loss on investments		(1,299	)		1,501
Change in prepaid reinsurance premiums		475			(808	)
Change in prepaid commissions		487			659
Change in premiums receivable		(8,492	)		(10,118	)
Change in accounts receivable		1,604			(8,725	)
Change in deferred policy acquisition costs		(3,631	)		(5,578	)
Change in unpaid losses and loss adjustment expenses		38,572			29,793
Change in unearned premiums		16,759			42,114
Change in unearned revenue		(2,378	)		(6,516	)
Change in accrued agent profit sharing		206			(319	)
Change in reinsurance recoverable		149			(3,396	)
Change in reinsurance balances payable		(1,060	)		(1,542	)
Change in current federal income tax payable		(1,796	)		(2,197	)
Change in accrued ceding commission payable		3,096			104
Change in all other liabilities		3,059			(3,556	)
Change in all other assets		(5,835	)		854

Net cash provided by operating activities		61,767			45,496

Cash flows from investing activities:
Purchases of property and equipment		(367	)		(487	)
Premium finance notes repaid, net of finance notes originated		(856	)		(2,184	)
Acquisition of subsidiaries, net of cash acquired		-			(25,964	)
Change in restricted cash		12,244			778
Purchases of debt and equity securities		(187,256	)		(67,795	)
Maturities and redemptions of investment securities		115,288			20,104
Net purchases of short-term investments		(30,713	)		(27,776	)

Net cash used in investing activities		(91,660	)		(103,324	)

Cash flows from financing activities:
Proceeds from exercise of employee stock options		-			40
Payment of structured settlement		(15,000	)		-
Proceeds from issuance of trust preferred securities		25,774			-
Debt issuance costs		(674	)		-
Proceeds from issuance of convertible debt		-			25,000
Proceeds from note payable to related party		-			12,500
Proceeds from revolving loan on credit facility		-			15,000

Net cash provided by financing activities		10,100			52,540

Decrease in cash and cash equivalents		(19,793	)		(5,288	)
Cash and cash equivalents at beginning of period		81,474			44,528

Cash and cash equivalents at end of period	$	61,681		$	39,240

Supplemental Cash Flow Information:
Interest paid	$	2,184		$	3,698
Taxes paid	$	13,053		$	9,084

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 Hallmark General Agency, Inc. (“Hallmark General Agency”) and Effective Claims Management, Inc. Our TGA Operating Unit handles primarily excess and surplus lines commercial insurance products and services and is comprised of Texas General Agency, Inc. (“Texas General Agency”), Pan American Acceptance Corporation (“PAAC”) and TGA Special Risk, Inc. (“TGASRI”). Our Aerospace Operating Unit handles general aviation insurance products and services and is comprised of Aerospace Insurance Managers, Inc. (“Aerospace Insurance Managers”), Aerospace Special Risk, Inc. (“ASRI”) and Aerospace Claims Management Group, Inc. (“ACMG”). Our Phoenix Operating Unit handles non-standard personal automobile insurance products and services and is comprised 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, 2006 included in our Annual Report on Form 10-K filed with the SEC.

The interim financial data as of September 30, 2007 and 2006 is unaudited. However, in the opinion of management, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods. The results of operations for the period ended September 30, 2007 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 current year presentation. Such reclassification had no effect on net income or stockholders’ equity. Investment balances that were previously reported in Restricted Cash and Investments on the balance sheet have been reclassified to debt securities, available-for-sale, at market value during the current period. The amount reclassified from the December 31, 2006 presentation is $7.2 million.

Redesignation of Segments

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

Reverse Stock Split

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

Use of Estimates in the Preparation of the Financial Statements

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

Recently Issued Accounting Standards

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

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

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

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

3. Business Combinations

We account for business combinations using the purchase method of accounting. The cost of an acquired entity is allocated to the assets acquired (including identified intangible assets) and liabilities assumed based on their estimated fair values. The excess of the cost of an acquired entity over the net of the amounts assigned to assets acquired and liabilities assumed is an asset referred to as “excess of cost over net assets acquired” or “goodwill.” Indirect and general expenses related to business combinations are expensed as incurred. While preparing our income tax return during the third quarter of 2007 we identified certain tax deductions that were not considered deductible when we initially recorded the purchase price allocation for the TGA and Aerospace Operating Units in 2006. This correction is considered immaterial to the purchase price allocation and was corrected on the September 30, 2007 balance sheet. The correction reduced total goodwill and total deferred federal income tax liability by $1.4 million.

4. Supplemental Cash Flow Information

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

	TGA			Aerospace
	Operating Unit			Operating Unit

Fair value of tangible assets excluding cash and cash equivalents	$	52,906		$	8,391
Fair value of intangible assets acquired		30,531			12,356
Capitalized direct expenses		232			36
Structured settlement		(23,542	)		-
Liabilities assumed		(47,468	)		(7,478	)

Cash and cash equivalents used in acquisitions	$	12,659		$	13,305

5. Pledged Investments

We have certain of our securities pledged for the benefit of various state insurance departments, reinsurers and the sellers of our TGA Operating Unit. These securities are included with our available-for-sale debt securities as we have the ability to trade these securities. We retain the interest earned on these securities. These securities had a carrying value of $23.3 million at September 30, 2007.

6. Share-Based Payment Arrangements

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

As of September 30, 2007, there were incentive stock options to purchase 677,499 shares of our common stock outstanding and non-qualified stock options to purchase 40,000 shares of our common stock outstanding under the 2005 LTIP, leaving 115,834 shares reserved for future issuance. As of September 30, 2007, there were incentive stock options to purchase 93,001 shares outstanding under the 1994 Employee Plan and non-qualified stock options to purchase 23,334 shares outstanding under the 1994 Director Plan. In addition, as of September 30, 2007, there were outstanding non-qualified stock options to purchase 16,666 shares of our common stock granted to certain non-employee directors outside the 1994 Director Plan in lieu of fees for service on our board of directors in 1999. The exercise price of all such outstanding stock options is equal to the fair market value of our common stock on the date of grant.

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

A summary of the status of our stock options as of and changes during the year-to-date ended September 30, 2007 is presented below:

				Average		Contractual		Intrinsic
	Number of			Exercise		Term		Value
	Shares			Price		(Years)		($000)

Outstanding at January 1, 2007		332,334		$	7.04
Granted		520,000		$	12.52
Exercised		-		$	-
Forfeited or expired		(1,834	)	$	5.05
Outstanding at September 30, 2007		850,500		$	10.40		8.1	$	3,108
Exercisable at September 30, 2007		138,751		$	4.79		3.6	$	1,285

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				Nine Months Ended
	September 30,				September 30,
	2007		2006		2007		2006

Intrinsic value of options exercised	$	-	$	-	$	-	$	103

Cost of share-based payments (non-cash)	$	198	$	50	$	351	$	107

Income tax benefit of share-based payments recognized in income	$	69	$	17	$	123	$	37

As of September 30, 2007 there was $2.7 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements granted under our plans, of which $0.2 million is expected to be recognized in the remainder of 2007, $0.6 million is expected to be recognized in 2008, $0.8 million is expected to be recognized in each of 2009 and 2010 and $0.3 million is expected to be recognized in 2011.

The fair value of each stock option granted is estimated on the date of grant using the Black-Scholes option pricing model. Expected volatilities are based on historical volatility of our common stock. The risk- free interest rates for periods within the contractual term of the options are based on rates for U.S. Treasury Notes with maturity dates corresponding to the options’ expected lives on the dates of grant.

The following table details the weighted average grant date fair value and related assumptions for the periods indicated (in thousands). There were no options granted in the third quarter of 2006.

	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2007			2006		2007			2006

Grant date fair value per share	$	4.14			n/a	$	4.04		$	6.26

Expected term (in years)		6.5			n/a		6.4			5.0
Expected volatility		19.0	%		n/a		19.4	%		59.1	%
Risk free interest rate		4.8	%		n/a		4.5	%		4.9	%

7. Segment Information

The following is business segment information for the three and nine months ended September 30, 2007 and 2006 (in thousands):

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2007			2006			2007			2006
Revenues:
Standard Commercial Segment	$	23,530		$	20,964		$	65,300		$	57,768
Specialty Commercial Segment		32,760			22,889			93,836			56,003
Personal Segment		15,185			12,257			43,654			34,944
Corporate		743			255			2,122			(643	)
Consolidated	$	72,218		$	56,365		$	204,912		$	148,072

Pre-tax income (loss):
Standard Commercial Segment	$	3,514		$	5,112		$	8,937		$	11,245
Specialty Commercial Segment		6,350			2,867			20,477			7,925
Personal Segment		1,854			2,316			6,148			6,760
Corporate		(1,909	)		(2,663	)		(5,108	)		(18,551	)
Consolidated	$	9,809		$	7,632		$	30,454		$	7,379

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

	September 30, 2007		December 31, 2006
Assets
Standard Commercial Segment	$	129,527	$	130,764
Specialty Commercial Segment		235,335		167,675
Personal Segment		96,401		85,391
Corporate		44,371		32,123
	$	505,634	$	415,953

8. 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.

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006

Ceded earned premiums	$	2,372	$	3,112	$	10,396	$	6,735
Reinsurance recoveries	$	537	$	3,130	$	3,973	$	4,024

Our insurance company subsidiaries presently retain 100% of the risk associated with all non-standard personal automobile policies marketed by our Phoenix Operating Unit. We currently reinsure the following exposures on business generated by our HGA Operating Unit, our TGA Operating Unit and our Aerospace Operating Unit:

Property catastrophe. Our property catastrophe reinsurance reduces the financial impact a catastrophe could have on our commercial property insurance lines. Catastrophes might include multiple claims and policyholders. Catastrophes include hurricanes, windstorms, earthquakes, hailstorms, explosions, severe winter weather and fires. Our property catastrophe reinsurance is excess-of-loss reinsurance, which provides us reinsurance coverage for losses in excess of an agreed-upon amount. We utilize catastrophe models to assist in determining appropriate retention and limits to purchase. The terms of our property catastrophe reinsurance, effective July 1, 2007, are:

We retain the first $2.0 million of property catastrophe losses; and

Our reinsurers reimburse us 100% for each $1.00 of loss in excess of our $2.0 million retention up to $28.0 million for each catastrophic occurrence, subject to a maximum of two events for the contractual term.

Commercial property. Our commercial property reinsurance is excess-of-loss coverage intended to reduce the financial impact a single-event or catastrophic loss may have on our results. The terms of the commercial property reinsurance, effective July 1, 2007, are:

We retain the first $1.0 million of loss for each commercial property risk;

Our reinsurers reimburse us for the next $5.0 million for each commercial property risk; and

Individual risk facultative reinsurance is purchased on any commercial property with limits above $6.0 million.

Commercial casualty. Our commercial casualty reinsurance is excess-of-loss coverage intended to reduce the financial impact a single-event loss may have on our results. The terms of our commercial casualty reinsurance, effective July 1, 2007, are:

We retain the first $1.0 million of loss for each commercial casualty risk; and

Our reinsurers reimburse us for the next $5.0 million for each commercial casualty risk.

Aviation. We purchase reinsurance specific to the aviation risks underwritten by our Aerospace Operating Unit. This reinsurance provides aircraft hull and liability coverage and airport liability coverage on a per occurrence basis on the following terms:

We retain the first $350,000 of each aircraft hull or liability or airport liability loss;

Our reinsurers reimburse us for the next $1.15 million of each aircraft hull or liability loss and for the next $650,000 of each airport liability loss; and

Our reinsurers provide additional reimbursement of $4.0 million for each airport liability loss and aircraft liability loss, excluding passenger liability.

Refer to Note 6 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2006, for reinsurance coverages in effect prior to the current treaties.

9. Notes Payable

On June 21, 2005, an unconsolidated trust subsidiary, Hallmark Statutory Trust I, 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 September 30, 2007, the note balance was $30.9 million.

On August 23, 2007, a newly formed unconsolidated trust subsidiary, Hallmark Statutory Trust II, 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 September 30, 2007 the note balance was $25.8 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 September 30, 2007, the balance on the revolving note was $2.8 million, which currently bears interest at 7.23% per annum. Also included in notes payable is $1.2 million outstanding under PAAC’s revolving credit sub-facility, which also currently bears interest at 7.23% per annum. (See Note 11, “Credit Facilities”).

10. 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 September 30, 2007, the balance of the structured settlements was $9.9 million.

11. 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. Principal outstanding under the revolving credit facility generally bears interest at the three month Eurodollar rate plus 2.00%, payable quarterly in arrears. We pay letter of credit fees at the rate of 1.00% per annum. Our obligations under the revolving credit facility are secured by a security interest in the capital stock of all of our subsidiaries, guaranties of all of our subsidiaries and the pledge of substantially all of our assets. The revolving credit facility contains covenants which, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. The amended and restated credit agreement terminates on January 27, 2008. The new premium finance sub-facility terminates May 31, 2009. As of September 30, 2007, we were in compliance with all of our covenants.

PAAC had a $5.0 million revolving credit facility with JPMorgan Chase Bank which terminated June 30, 2007. This facility was replaced with the new $5.0 million premium finance sub-facility with The Frost National Bank as discussed above.

11. Deferred Policy Acquisition Costs

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006

Deferred	$	(12,197	)	$	(10,709	)	$	(37,163	)	$	(28,299	)
Amortized		11,635			8,531			33,532			22,721

Net	$	(562	)	$	(2,178	)	$	(3,631	)	$	(5,578	)

12. Earnings per Share

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2007		2006		2007		2006

Weighted average shares - basic		20,768		17,760		20,768		16,019
Effect of dilutive securities		-		26		-		19
Weighted average shares - assuming dilution		20,768		17,786		20,768		16,038

For the three and nine months ended September 30, 2007, 520,000 shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than the average price of the common shares and, therefore, their inclusion would have been anti-dilutive. For the three and nine months ended September 30, 2006, 109,166 shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the exercise prices of the stock options were greater than the average price of the common shares and, therefore, their inclusion would have been anti-dilutive.

13. Net Periodic Pension Cost

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2007			2006			2007			2006
Interest cost	$	180		$	172		$	540		$	515
Amortization of net loss		50			40			150			121
Expected return on plan assets		(161	)		(157	)		(482	)		(472	)
Net periodic pension cost	$	69		$	55		$	208		$	164

We contributed $31 thousand and $0.2 million to our frozen defined benefit cash balance plan (“Cash Balance Plan”) during each of the three months ended September 30, 2007 and 2006, respectively. We contributed $0.3 million to our Cash Balance Plan during each of the nine months ended September 30, 2007 and 2006. Refer to Note 14 to the consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2006 for more discussion of our retirement plans.

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

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

Introduction

Our non-carrier insurance activities are segregated by operating units into the following reportable segments:

Standard Commercial Segment. Our Standard Commercial Segment includes the standard lines commercial property/casualty insurance products and services handled by our HGA Operating Unit which is comprised of our Hallmark General Agency, Inc. and Effective Claims Management, Inc. subsidiaries.

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

Personal Segment. Our Personal Segment includes the non-standard personal automobile insurance products and services handled by our Phoenix Operating Unit which is comprised 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, 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.

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

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

Effective January 1, 2006, our insurance company subsidiaries entered into a pooling arrangement, which was subsequently amended on December 15, 2006, pursuant to which AHIC retains 46% of the total net premiums written by all of our operating units, PIIC retains 34% of our total net premiums written and GSIC retains 20% of our total net premiums written.

All share and per share amounts have been adjusted to reflect a one-for-six reverse split of all issued and unissued shares of our authorized common stock effected July 31, 2006.

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

Results of Operations

Management Overview. During the three months and nine months ended September 30, 2007, our total revenues were $72.2 million and $204.9 million, respectively representing a 28% and 38% increase over the $56.4 million and $148.1 million in total revenues, respectively, for the same periods of 2006. 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. Specialty Commercial Segment revenues increased $9.9 million and $37.8 million, or 43% and 68%, during the three months and nine months ended September 30, 2007, respectively, as compared to the same periods of 2006. Revenues from our Personal Segment increased $2.9 million and $8.7 million, or 24% and 25%, during the three and nine months ended September 30, 2007, due largely to geographic expansion into new states. Increased retention of business was also the primary reason for the Standard Commercial Segment’s $2.6 million and $7.5 million increases in revenue for the three months and nine months ended September 30, 2007, respectively. Net gain on investments of $0.4 million and $1.3 million for the three months and nine months ended September 30, 2007, respectively, as compared to net losses on investments of $0.1 million and $1.5 million recognized for the same periods the prior year, were the primary reason for an increase in revenue for Corporate.

We reported net income of $6.6 million and $20.4 million for the three months and nine months ended September 30, 2007, respectively, as compared to net income of $4.9 million and $4.5 million reported for the three and nine months ended September 30, 2006, respectively. On a diluted per share basis, net income was $0.32 and $0.98 for the three months and nine months ended September 30, 2007, respectively, as compared to net income per share of $0.27 and $0.28 for the same periods in 2006. During the nine months ended September 30, 2006, we recorded $9.6 million of interest expense from amortization attributable to the deemed discount on convertible promissory notes issued in January, 2006 and subsequently converted to common stock during the second quarter of 2006. The increase in net income was also attributable to increased revenue as discussed above and to prior year favorable loss reserve development of $2.9 million for the nine months ended September 30, 2007 as compared to $2.0 million of prior year favorable development recognized during the same period of 2006. Lower interest expense and additional investment income from a larger investment portfolio resulting from increased retention of premiums also contributed to the increase in net income.

Third Quarter 2007 as Compared to Third Quarter 2006

The following is additional business segment information for the three months ended September 30, 2007 and 2006 (in thousands):

Hallmark Financial Services, Inc.

Consolidated Segment Data

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

Produced premium	$	21,945		$	37,919		$	14,854		$	-		$	74,718

Gross premiums written		21,918			25,531			14,855			-			62,304
Ceded premiums written		198			(977	)		-			-			(779	)
Net premiums written		22,116			24,554			14,855			-			61,525
Change in unearned premiums		(311	)		(870	)		(919	)		-			(2,100	)
Net premiums earned		21,805			23,684			13,936			-			59,425

Total revenues		23,530			32,760			15,185			743			72,218

Losses and loss adjustment expenses		13,513			13,682			9,532			(4	)		36,723

Pre-tax income (loss)		3,514			6,350			1,854			(1,909	)		9,809

Net loss ratio (1)		62.0	%		57.8	%		68.4	%					61.8	%
Net expense ratio (1)		27.3	%		30.8	%		22.9	%					27.7	%
Net combined ratio (1)		89.3	%		88.6	%		91.3	%					89.5	%

	Three Months Ended September 30, 2006
		Standard Commercial Segment			Specialty Commercial Segment			Personal Segment			Corporate			Consolidated

Produced premium	$	22,206		$	41,320		$	12,278		$	-		$	75,804

Gross premiums written		21,967			23,862			12,278			-			58,107
Ceded premiums written		(2,270	)		(832	)		-			-			(3,102	)
Net premiums written		19,697			23,030			12,278			-			55,005
Change in unearned premiums		(497	)		(11,256	)		(1,058	)		-			(12,811	)
Net premiums earned		19,200			11,774			11,220			-			42,194

Total revenues		20,964			22,889			12,257			255			56,365

Losses and loss adjustment expenses		9,347			7,450			6,800			(8	)		23,589

Pre-tax income (loss)		5,112			2,867			2,316			(2,663	)		7,632

Net loss ratio (1)		48.7	%		63.3	%		60.6	%					55.9	%
Net expense ratio (1)		28.1	%		30.7	%		24.3	%					27.8	%
Net combined ratio (1)		76.8	%		94.0	%		84.9	%					83.7	%

(1) 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 $21.9 million for the three months ended September 30, 2007 as compared to $22.0 million for the three months ended September 30, 2006. Net premiums written were $22.1 million for the three months ended September 30, 2007, or 12% more than the $19.7 million reported for the same period in 2006. Increased competition has kept premium produced by the Standard Commercial Segment relatively flat for the third quarter of 2007 compared to the same period in 2006. The increase in net written premium is primarily attributable to increased retention of business and a more cost-effective structure for reinsurance.

Total revenue for the Standard Commercial Segment of $23.5 million for the third quarter of 2007 was $2.5 million more than the $21.0 million reported in the third quarter of 2006. This 12% increase in total revenue was primarily due to increased net premiums earned of $2.6 million for the quarter due to increased retention of business and increased net investment income of $0.4 million. These increases in revenue were partially offset by lower ceding commission revenue and processing fees of $0.5 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 $3.5 million for the third quarter of 2007 decreased $1.6 million, or 31%, from the $5.1 million reported for the third quarter of 2006. This decrease in pre-tax income was primarily attributable to higher net loss results as evidenced by a net loss ratio of 62.0% for the three months ended September 30, 2007 as compared to 48.7% for the same period of 2006.

The higher net loss ratio was impacted by lower ceded losses of $0.3 million for the three months ended September 30, 2007 as compared to $3.2 million for the same period in 2006. The gross loss ratio before reinsurance was 59.6% for the three months ended September 30, 2007 as compared to 58.2% for the same period the prior year. The gross loss results for the three months ended September 30, 2007 included $0.1 million of favorable prior year development as compared to favorable prior year development of $0.5 million recognized during the same period of 2006. Absent prior year development, the gross incurred losses and loss adjustment expense before reinsurance for the Standard Commercial Segment were lower by $0.2 million.

The Standard Commercial Segment reported net expense ratios of 27.3% and 28.1% for the third quarters of 2007 and 2006, respectively. The net expense ratio for 2006 was higher primarily due to costs to assume from Clarendon National Insurance Company the unearned premium previously produced by the Standard Commercial Segment.

Specialty Commercial Segment

Gross premiums written for the Specialty Commercial Segment for the third quarter of 2007 were $25.5 million, or 7%, more than the $23.9 million reported for the same period in 2006. Net premiums written for the third quarter of 2007 were $24.6 million, or 7%, more than the $23.0 million reported for the same period in 2006. The increase in premium volume was due to the increased retention of business produced by our TGA Operating Unit from 50% in 2006 to 60% in 2007.

Total revenue for the Specialty Commercial Segment of $32.8 million for the third quarter of 2007 was $9.9 million more than the $22.9 million reported in the third quarter of 2006. This 43% increase in revenue was largely due to increased net premiums earned of $11.9 million for the quarter as a result of the increased retention of business. The Specialty Commercial Segment also recognized $1.1 million of contingent ceding commission under quota share agreements for treaties effective 2006 and prior, due to improved underwriting results. Increased net investment income contributed an additional $0.4 million to the increase in revenue for the quarter. These increases in revenue were partially offset by lower ceding commission revenue of $3.6 million due to the shift from a third party agency structure to an insurance underwriting structure.

Pre-tax income for the Specialty Commercial Segment of $6.4 million for the third quarter of 2007 increased $3.5 million, or 121%, from the $2.9 million reported for the same period in 2006. Increased revenue, discussed above, was the primary reason for the increase in pre-tax income, partially offset by increased losses and loss adjustment expenses of $6.2 million and increased operating expenses of $0.2 million due mostly to production related expenses that are directly related to increased earned premium.

The Specialty Commercial Segment reported a net loss ratio of 57.8% for the third quarter of 2007 as compared to 63.3% for the third quarter of 2006. The initial actuarial loss estimates at the time of the acquisition of the subsidiaries comprising the Specialty Commercial Segment have proven to be high as positive indicators have emerged in these operations. As a result, the Specialty Commercial Segment experienced favorable prior year development of $0.5 million for the three months ended September 30, 2007, as compared to no prior year development in the third quarter of 2006. The Specialty Commercial Segment reported a net expense ratio of 30.8% for the third quarter of 2007 as compared to 30.7% for the third quarter of 2006.

Personal Segment

Net premium written for our Personal Segment increased $2.6 million during the third quarter of 2007 to $14.9 million compared to $12.3 million in the third quarter of 2006. The increase in premium was due mostly to continued geographic expansion that began in 2006.

Total revenue for the Personal Segment increased 24% to $15.2 million for the third quarter of 2007 from $12.3 million for the same period in 2006. Higher earned premium of $2.7 million and increased finance charges of $0.2 million were the primary factors for the increase in revenue for the period.

Pre-tax income for the Personal Segment was $1.9 million for the three months ended September 30, 2007 as compared to $2.3 million for the same period in 2006. The increased revenue, as discussed above, was offset by increased losses and loss adjustment expenses of $2.7 million and increased operating expenses of $0.7 million due mostly to production related expenses attributable to the increased earned premium. The Personal Segment reported a net loss ratio of 68.4% for the third quarter of 2007 as compared to 60.6% for the same period in 2006. 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 $0.1 million of favorable prior accident year development in the third quarter 2007 as compared to $0.7 million of favorable prior year development in the third quarter of 2006. The Personal Segment reported a net expense ratio of 22.9% for the third quarter of 2007 as compared to 24.3% for the third quarter of 2006. 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 to PIIC in each period.

Corporate

Corporate revenue increased $0.5 million for the third quarter of 2007 as compared to the same period in 2006. The increase was primarily due to $0.4 million of net gains on our investment portfolio during the third quarter of 2007, as compared to $0.1 million of net losses recognized during the third quarter of 2006.

Corporate pre-tax loss was $1.9 million for the third quarter of 2007 as compared to $2.7 million for the same period in 2006. Contributing to the decreased loss were the gains discussed above and lower interest expense of $0.5 million due to the permanent financing of debt used to acquire the subsidiaries comprising the Specialty Commercial Segment in 2006. Most of this debt was either converted to equity in the second quarter of 2006 or repaid with proceeds from our public equity offering in the fourth quarter of 2006. Partially offsetting these improvements were increased operating expenses of $0.2 million for the third quarter 2007 due mostly to increased consulting costs related to compliance with Sarbanes-Oxley Section 404 requirements and new employees.

Nine Months Ended September 30, 2007 as Compared to Nine Months Ended September 30, 2006

The following is additional business segment information for the nine months ended September 30, 2007 and 2006 (in thousands):

Hallmark Financial Services, Inc.

Consolidated Segment Data

	Nine Months Ended September 30, 2007
	Standard Commercial Segment			Specialty Commercial Segment			Personal Segment			Corporate			Consolidated

Produced premium	$	70,246		$	118,232		$	43,228		$	-		$	231,706

Gross premiums written		70,139			80,172			43,228			-			193,539
Ceded premiums written		(5,241	)		(3,706	)		-			-			(8,947	)
Net premiums written		64,898			76,466			43,228			-			184,592
Change in unearned premiums		(2,966	)		(12,100	)		(3,143	)		-			(18,209	)
Net premiums earned		61,932			64,366			40,085			-			166,383

Total revenues		65,300			93,836			43,654			2,122			204,912

Losses and loss adjustment expenses		37,621			35,398			26,612			(11	)		99,620

Pre-tax income (loss)		8,937			20,477			6,148			(5,108	)		30,454

Net loss ratio (1)		60.7	%		55.0	%		66.4	%					59.9	%
Net expense ratio (1)		27.4	%		31.4	%		23.1	%					27.9	%
Net combined ratio (1)		88.1	%		86.4	%		89.5	%					87.8	%

	Nine Months Ended September 30, 2006
		Standard Commercial Segment			Specialty Commercial Segment			Personal Segment			Corporate			Consolidated

Produced premium	$	69,357		$	115,610		$	34,116		$	-		$	219,083

Gross premiums written		68,884			50,718			34,116			-			153,718
Ceded premiums written		(6,122	)		(1,420	)		-			-			(7,542	)
Net premiums written		62,762			49,298			34,116			-			146,176
Change in unearned premiums		(12,396	)		(26,136	)		(2,757	)		-			(41,289	)
Net premiums earned		50,366			23,162			31,359			-			104,887

Total revenues		57,768			56,003			34,944			(643	)		148,072

Losses and loss adjustment expenses		27,165			13,969			19,369			(25	)		60,478

Pre-tax income (loss)		11,245			7,925			6,760			(18,551	)		7,379

Net loss ratio (1)		53.9	%		60.3	%		61.8	%					57.7	%
Net expense ratio (1)		29.1	%		27.6	%		25.7	%					27.8	%
Net combined ratio (1)		83.0	%		87.9	%		87.5	%					85.5	%

Standard Commercial Segment

Gross premiums written for the Standard Commercial Segment were $70.1 million for the nine months ended September 30, 2007, or 2% more than the $68.9 million reported for the same period in 2006. Net premiums written were $64.9 million for the nine months ended September 30, 2007 as compared to $62.8 million reported for the same period in 2006. Increased competition and rate pressure have challenged premium volume growth by the Standard Commercial Segment throughout 2007.

Total revenue for the Standard Commercial Segment of $65.3 million for the nine months ended September 30, 2007 was $7.5 million more than the $57.8 million reported during the nine months ended September 30, 2006. This 13% increase in total revenue was primarily due to increased net premiums earned of $11.6 million and increased net investment income of $1.1 million. These increases in revenue were partially offset by contingent commission adjustments related to adverse development on prior accident years of $1.5 million, as well as lower ceding commission revenue of $2.4 million and lower processing and service fees of $1.3 million, in both cases due to the shift from a third party agency structure to an insurance underwriting structure.

Pre-tax income for our Standard Commercial Segment of $8.9 million for the nine months ended September 30, 2007 decreased $2.3 million, or 21%, from the $11.2 million reported for the same period of 2006. This decrease in pre-tax income was primarily attributable to the contingent commission adjustment discussed above, as well as higher net loss results.

The net loss ratio for the nine months ended September 30, 2007 was 60.7% as compared to the 53.9% reported for the same period of 2006. The net loss ratio was unfavorably impacted by lower ceded losses of $2.3 million for the nine months ended September 30, 2007 as compared to $3.8 million for the same period in 2006. The gross loss ratio before reinsurance was 58.2% for the nine months ended September 30, 2007 as compared to 55.6% for the same period the prior year. The gross loss results for the nine months ended September 30, 2007 and September 30, 2006 both included $0.8 million of favorable prior year development. Absent prior year development, the gross incurred losses and loss adjustment expense before reinsurance for the Standard Commercial Segment were higher by $2.7 million primarily due to competitive market conditions in the current accident year.

The Standard Commercial Segment reported net expense ratios of 27.4% and 29.1% for the nine months ended September 30, 2007 and 2006, respectively. The net expense ratio for 2006 was higher primarily due to costs to assume from Clarendon National Insurance Company the unearned premium previously produced by the Standard Commercial Segment.

Specialty Commercial Segment

Gross premiums written for the Specialty Commercial Segment for the first nine months of 2007 were $80.2 million or 58% more than the $50.7 million reported for the same period in 2006. Net premiums written for the first nine months of 2007 were $76.5 million or 55% more than the $49.3 million reported for the same period in 2006. The increase in premium volume was due to the increased retention of business produced by our TGA Operating Unit from 50% in 2006 to 60% in 2007, as well as the retention of the business produced by our Aerospace Operating Unit beginning in the third quarter of 2006.

Total revenue for the Specialty Commercial Segment of $93.8 million for the first nine months of 2007 was $37.8 million more than the $56.0 million reported in the first nine months of 2006. This 68% increase in revenue was largely due to increased net premiums earned of $41.2 million for the first nine months of 2007 as a result of the increased retention of business. The Specialty Commercial Segment recognized $4.4 million of contingent ceding commission under quota share agreements for treaties effective 2006 and prior due to improved underwriting results. Increased net investment income contributed an additional $1.8 million to the increase in revenue for the quarter. These increases in revenue were partially offset by lower ceding commission and fee revenue of $9.4 million due to the shift from a third party agency structure to an insurance underwriting structure.

Pre-tax income for the Specialty Commercial Segment of $20.5 million for the first nine months of 2007 increased $12.6 million, or 158%, from the $7.9 million reported for the same period in 2006. Increased revenue, discussed above, was the primary reason for the increase in pre-tax income, partially offset by increased losses and loss adjustment expenses of $21.4 million and increased operating expenses of $3.9 million due mostly to production related expenses that are directly related to increased earned premium.

The Specialty Commercial Segment reported a net loss ratio of 55.0% for the first nine months of 2007 as compared to 60.3% for the first six months of 2006. The initial actuarial loss estimates at the time of the acquisition of the subsidiaries comprising the Specialty Commercial Segment have proven to be high as positive indicators have emerged in these operations. As a result, the Specialty Commercial Segment experienced favorable prior year development of $1.9 million for the nine months ended September 30, 2007, as compared to favorable prior year development of $0.5 million for the same period of 2006, was the primary cause for the decrease in the net loss ratio. The Specialty Commercial Segment reported a net expense ratio of 31.4% for the first nine months of 2007 as compared to 27.6% for the first nine months of 2006. The increase in the net expense ratio was primarily due to the 2006 net expense ratio being depressed by the amortization of the fair value adjustment of the deferred policy acquisition cost asset, which was recognized in the application of SFAS No. 141 in the 2006 acquisition of the TGA Operating Unit. This favorably impacted the reported operating expenses during the first nine months of 2006. In addition, amortization of the fair value adjustment of the unearned premium reserve, also recognized pursuant to SFAS No. 141, reduced the reported net premiums earned during the first nine months of 2006.

Personal Segment

Net premium written for our Personal Segment increased $9.1 million during the first nine months of 2007 to $43.2 million compared to $34.1 million in the first nine months of 2006. The increase in premium was due mostly to continued geographic expansion that began in 2006.

Total revenue for the Personal Segment increased 25% to $43.7 million for the first nine months of 2007 from $34.9 million for the same period in 2006. Higher earned premium of $8.7 million was the primary reason for the increase in revenue for the period. Increased finance charges of $0.7 million were offset by lower investment income of $0.5 million due to the reallocation of capital to other segments for their increased retention of premium and lower third party commission revenue of $0.2 million.

Pre-tax income for the Personal Segment was $6.1 million for the nine months ended September 30, 2007 as compared to $6.8 million for the same period in 2006. The increased revenue, as discussed above, was offset by increased losses and loss adjustment expenses of $7.3 million and increased operating expenses of $2.1 million due mostly to production related expenses attributable to the increased earned premium. The Personal Segment reported a net loss ratio of 66.4% for the first nine months of 2007 as compared to 61.8% for the same period in 2006. 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 $0.3 million of favorable prior accident year development during the first nine months of 2007 as compared to $0.7 million of favorable prior year development during the first nine months of 2006. The Personal Segment reported a net expense ratio of 23.1% for the first nine months of 2007 as compared to 25.7% for the first nine months of 2006. 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 to PIIC in each period.

Corporate

Corporate revenue increased $2.8 million for the first nine months of 2007 as compared to the same period in 2006. The increase was primarily due to $1.3 million of net gains on our investment portfolio during the first nine months of 2007 as compared to $1.5 million of net losses recognized during the same period of 2006.

Corporate pre-tax loss was $5.1 million for the first nine months of 2007 as compared to $18.6 million for the same period in 2006. The decreased loss was mostly due to the absence of the $9.6 million of interest expense incurred in the first six months of 2006 from amortization attributable to the deemed discount on convertible promissory notes issued in January, 2006. These notes were converted to common stock during the second quarter of 2006. Also contributing to the decreased loss were the gains discussed above and lower interest expense of $2.1 million due to the permanent financing of debt used to acquire the subsidiaries comprising the Specialty Commercial Segment in 2006. Most of this debt was either converted to equity in the second quarter of 2006 or repaid with proceeds from our public equity offering in the fourth quarter of 2006. Partially offsetting these improvements were increased operating expenses of $1.0 million for the first nine months of 2007 due mostly to increased consulting costs related to compliance with Sarbanes-Oxley Section 404 requirements and new employees.

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 September 30, 2007, Hallmark had $36.6 million in unrestricted cash and invested assets. Unrestricted cash and invested assets of our non-insurance subsidiaries were $6.9 million as of September 30, 2007.

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. PIIC, 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. GSIC, 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 2007, our insurance company subsidiaries’ ordinary dividend capacity is $12.4 million. None of our insurance company subsidiaries paid a dividend to Hallmark during the first nine months of 2007 or the 2006 fiscal year.

Comparison of September 30, 2007 to December 31, 2006

On a consolidated basis, our cash and investments (excluding restricted cash) at September 30, 2007 were $323.0 million compared to $244.4 million at December 31, 2006. Net cash provided by our operating activities and the issuance of trust preferred securities during the third quarter of 2007 contributed to this increase in our cash and investments for the nine months ended September 30, 2007.

Comparison of Nine Months Ended September 30, 2007 and September 30, 2006

Net cash provided by our consolidated operating activities was $61.8 million for the first nine months of 2007 compared to $45.5 million for the first nine months of 2006. The increase in operating cash flow was primarily due to increased collected premiums resulting from increased retained premium volume, partially offset by additional retained paid losses and loss adjustment expenses and additional paid operating expenses.

Cash used in investing activities during the first nine months of 2007 was $91.7 million as compared to $103.3 million for the same period in 2006. The higher cash used in investing activities during the first nine months of 2006 was mostly due to the acquisitions of the subsidiaries comprising our Specialty Commercial Segment which used $26.0 million, net of cash acquired. The withdrawal of $15.0 million from a trust account securing the future guaranteed payments to the sellers of the subsidiaries comprising our TGA Operating Unit to make the first installment payment in the first quarter of 2007 contributed to the reduction in cash used by investing activities during the first nine months of 2007. Also contributing to the reduction in cash used by investing activities was an increase of $95.2 million from maturities and redemptions of investment securities. Net premium finance notes repaid of $0.9 million during the first nine months of 2007 versus net premium finance notes repaid of $2.2 million during the first nine months of 2006 also contributed to the reduction in cash used in investing activities. Partially offsetting these reductions was a $119.5 million increase in purchase of debt and equity securities and a $2.9 million increase in net purchase of short-term investments.

Cash provided in financing activities during the first nine months of 2007 was $10.1 million as compared to $52.5 million provided by financing activities for the same period of 2006. The cash provided in 2007 was from the issuance of trust preferred securities less debt issuance costs, offset by the payment of a portion of the structured settlement to the sellers of the subsidiaries comprising our TGA Operating Unit. The cash provided in 2006 was primarily from the issuance of three debt instruments in January. The first was a promissory note payable to Newcastle Partners, L.P. (“Newcastle Partners”) in the amount of $12.5 million to fund the cash required to close the acquisition of the subsidiaries now comprising our Aerospace Operating Unit. The second debt instrument was $25.0 million in subordinated convertible promissory notes to the Newcastle Special Opportunity Fund I, L.P. and Newcastle Special Opportunity Fund II, L.P. (the “Opportunity Funds”). The principal and accrued interest on the convertible notes was converted to 3.3 million shares of our common stock during the second quarter of 2006. The $25.0 million raised with these notes was used to fund a trust account securing future guaranteed payments to the sellers of the subsidiaries now comprising our TGA Operating Unit. The third debt instrument was $15.0 million borrowed under our revolving credit facility to fund the cash required to close the acquisition of the subsidiaries now comprising our TGA Operating Unit. In October 2006, we repaid the promissory note to Newcastle Partners and repaid $12.2 million of the outstanding principal balance of our revolving credit facility, in each case with proceeds received from our public equity offering. Newcastle Partners and the Opportunity Funds are each an affiliate of our Executive Chairman, Mark E. Schwarz.

Credit Facilities

Trust Preferred Securities

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 is due on or before January 1, 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 is due on or before January 1, 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 future 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 September 30, 2007, the balance of the structured settlements was $9.9 million.

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 September 30, 2007, 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, 2006.

Item 4T. Controls and Procedures.

The principal executive officer and principal financial officer of the Company have evaluated the Company’s 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 the Company in the reports that it files or submits 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 the Company in the reports that it files or submits under such Act is accumulated and communicated to the Company’s management, including its 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 the Company’s internal controls over financial reporting that have materially affected, or are reasonably likely to materially affect, the Company’s 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 the Company's 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 the control of the Company. Although the Company believes 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 the Company or any other person that the objectives and plans of the Company will be achieved.

PART II

OTHER INFORMATION

Item 1. Legal Proceedings.

The Company is 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 the consolidated financial position of the Company or the results of operations, in the opinion of management. The various legal proceedings to which the Company is a party are routine in nature and incidental to the Company’s business.

Item 1A. Risk Factors.

In addition to the other information set forth in this report, you should carefully consider the following risk factors:

Our success depends on our ability to price accurately the risks we underwrite.

Our results of operations and financial condition depend on our ability to underwrite and set premium rates accurately for a wide variety of risks. Adequate rates are necessary to generate premiums sufficient to pay losses, loss settlement expenses and underwriting expenses and to earn a profit. To price our products accurately, we must collect and properly analyze a substantial amount of data; develop, test and apply appropriate pricing techniques; closely monitor and timely recognize changes in trends; and project both severity and frequency of losses with reasonable accuracy. Our ability to undertake these efforts successfully, and as a result price our products accurately, is subject to a number of risks and uncertainties, some of which are outside our control, including:

Ÿ	the availability of sufficient reliable data and our ability to properly analyze available data;

Ÿ	the uncertainties that inherently characterize estimates and assumptions;

Ÿ	our selection and application of appropriate pricing techniques; and

Ÿ	changes in applicable legal liability standards and in the civil litigation system generally.

Consequently, we could under-price risks, which would adversely affect our profit margins, or we could overprice risks, which could reduce our sales volume and competitiveness. In either case, our profitability could be materially and adversely affected.

Our results may fluctuate as a result of cyclical changes in the property/casualty insurance industry.

Our revenue is primarily attributable to property/casualty insurance, which as an industry is cyclical in nature and has historically been characterized by soft markets followed by hard markets. A soft market is a period of relatively high levels of price competition, less restrictive underwriting standards and generally low premium rates. A hard market is a period of capital shortages resulting in lack of insurance availability, relatively low levels of competition, more selective underwriting of risks and relatively high premium rates. If we find it necessary to reduce premiums or limit premium increases due to competitive pressures on pricing in a softening market, we may experience a reduction in our premiums written and in our profit margins and revenues, which could adversely affect our financial results.

Estimating reserves is inherently uncertain. If our loss reserves are not adequate, it will have an unfavorable impact on our results.

We maintain loss reserves to cover our estimated ultimate liability for unpaid losses and loss adjustment expenses for reported and unreported claims incurred as of the end of each accounting period. Reserves represent management’s estimates of what the ultimate settlement and administration of claims will cost and are not reviewed by an independent actuary. These estimates, which generally involve actuarial projections, are based on management’s assessment of facts and circumstances then known, as well as estimates of future trends in claim severity and frequency, judicial theories of liability, and other factors. These variables are affected by both internal and external events, such as changes in claims handling procedures, inflation, judicial trends and legislative changes. Many of these factors are not quantifiable. Additionally, there may be a significant reporting lag between the occurrence of an event and the time it is reported to us. The inherent uncertainties of estimating reserves are greater for certain types of liabilities, particularly those in which the various considerations affecting the type of claim are subject to change and in which long periods of time may elapse before a definitive determination of liability is made. Reserve estimates are continually refined in a regular and ongoing process as experience develops and further claims are reported and settled. Adjustments to reserves are reflected in the results of the periods in which such estimates are changed. For example, a 1% change in September 30, 2007 unpaid losses and loss adjustment expenses would have produced a $1.2 million change to pretax earnings. Our gross loss and loss adjustment expense reserves totaled $116.1 million at September 30, 2007. Our loss and loss adjustment expense reserves, net of reinsurance recoverables, were $110.3 million at that date. Because setting reserves is inherently uncertain, there can be no assurance that the current reserves will prove adequate.

Our failure to maintain favorable financial strength ratings could negatively impact our ability to compete successfully.

Third-party rating agencies assess and rate the claims-paying ability of insurers based upon criteria established by the agencies. During 2005, A.M. Best, a nationally recognized insurance industry rating service and publisher, upgraded the financial strength rating of PIIC, from “B” (Fair) to “B+” (Very Good), and upgraded the financial strength rating of AHIC, from “B” (Fair) to “A-” (Excellent). Our insurance company subsidiaries have historically been rated on an individual basis. However, effective January 1, 2006, our insurance company subsidiaries entered into a pooling arrangement, which was subsequently amended December 15, 2006, whereby AHIC would retain 46% of the net premiums written, PIIC would retain 34% of the net premiums written and GSIC would retain 20% of the net premiums written. As a result, in June 2006, A.M. Best notified us that our insurance company subsidiaries would be rated on a pooled basis and assigned a rating of “A-” (Excellent) to each of our individual insurance company subsidiaries and to the pool formed by our insurance company subsidiaries.

These financial strength ratings are used by policyholders, insurers, reinsurers and insurance and reinsurance intermediaries as an important means of assessing the financial strength and quality of insurers. These ratings are not evaluations directed to potential purchasers of our common stock and are not recommendations to buy, sell or hold our common stock. Our ratings are subject to change at any time and could be revised downward or revoked at the sole discretion of the rating agencies. We believe that the ratings assigned by A.M. Best are an important factor in marketing our products. Our ability to retain our existing business and to attract new business in our insurance operations depends largely on these ratings. Our failure to maintain our ratings, or any other adverse development with respect to our ratings, could cause our current and future independent agents and insureds to choose to transact their business with more highly rated competitors. If A.M. Best downgrades our ratings or publicly indicates that our ratings are under review, it is likely that we would not be able to compete as effectively with our competitors, and our ability to sell insurance policies could decline. If that happens, our sales and earnings would decrease. For example, many of our agencies and insureds have guidelines that require us to have an A.M. Best financial strength rating of “A-” or higher. A reduction of our A.M. Best rating below “A-” would prevent us from issuing policies to insureds or potential insureds with such ratings requirements. Because lenders and reinsurers will use our A.M. Best ratings as a factor in deciding whether to transact business with us, the failure of our insurance company subsidiaries to maintain their current ratings could dissuade a lender or reinsurance company from conducting business with us or might increase our interest or reinsurance costs. In addition, a ratings downgrade by A.M. Best below “A-” would require us to post collateral in support of our obligations under certain of our reinsurance agreements pursuant to which we assume business.

The loss of key executives could disrupt our business.

Our success will depend in part upon the continued service of certain key executives. Our success will also depend on our ability to attract and retain additional executives and personnel. We do not have employment agreements with our Chief Executive Officer or any other of our executive officers other than employment agreements entered into in connection with the acquisitions of the subsidiaries now comprising our TGA Operating Unit and our Aerospace Operating Unit. The loss of key personnel, or our inability to recruit and retain additional qualified personnel, could cause disruption in our business and could prevent us from fully implementing our business strategies, which could materially and adversely affect our business, growth and profitability.

Our industry is very competitive, which may unfavorably impact our results of operations.

The property/casualty insurance market, our primary source of revenue, is highly competitive and, except for regulatory considerations, has very few barriers to entry. According to A.M. Best, there were 3,141 property/casualty insurance companies and 2,017 property/casualty insurance groups operating in North America as of July 23, 2007. Our HGA Operating Unit competes with a variety of large national standard commercial lines carriers such as The Hartford, Zurich North America, St. Paul Travelers and Safeco, as well as numerous smaller regional companies. The primary competition for our TGA Operating Unit’s excess and surplus lines products includes such carriers as Atlantic Casualty Insurance Company, Colony Insurance Company, Burlington Insurance Company, Penn America Insurance Group and, to a lesser extent, a number of national standard lines carriers such as Zurich North America and The Hartford. Our Aerospace Operating Unit considers its primary competitors to be Houston Casualty Corp., Phoenix Aviation, W. Brown & Company, AIG and London Aviation Underwriters. Although our Phoenix Operating Unit competes with large national insurers such as Allstate, State Farm and Progressive, as a participant in the non-standard personal automobile marketplace its competition is most directly associated with numerous regional companies and managing general agencies. Our competitors include entities which have, or are affiliated with entities which have, greater financial and other resources than we have. In addition, competitors may attempt to increase market share by lowering rates. In that case, we could experience reductions in our underwriting margins, or sales of our insurance policies could decline as customers purchase lower-priced products from our competitors. Losing business to competitors offering similar products at lower prices, or having other competitive advantages, could adversely affect our results of operations.

Our results may be unfavorably impacted if we are unable to obtain adequate reinsurance.

As part of our overall risk and capacity management strategy, we purchase reinsurance for significant amounts of risk, especially catastrophe risks that we and our insurance company subsidiaries underwrite. Our catastrophe and non-catastrophe reinsurance facilities are subject to annual renewal. We may be unable to maintain our current reinsurance facilities or to obtain other reinsurance facilities in adequate amounts and at favorable rates. The amount, availability and cost of reinsurance are subject to prevailing market conditions beyond our control and may affect our ability to write additional premiums as well as our profitability. If we are unable to obtain adequate reinsurance protection for the risks we have underwritten, we will either be exposed to greater losses from these risks or we will reduce the level of business that we underwrite, which will reduce our revenue.

If the companies that provide our reinsurance do not pay our claims in a timely manner, we could incur severe losses.

We purchase reinsurance by transferring, or ceding, part of the risk we have assumed to a reinsurance company in exchange for part of the premium we receive in connection with the risk. Although reinsurance makes the reinsurer liable to us to the extent the risk is transferred or ceded to the reinsurer, it does not relieve us of our liability to our policyholders. Accordingly, we bear credit risk with respect to our reinsurers. We cannot assure that our reinsurers will pay all of our reinsurance claims, or that they will pay our claims on a timely basis. At September 30, 2007, we had a total of $5.8 million due us from reinsurers for recovery of losses. The largest amount due us from a single reinsurer as of September 30, 2007 was $1.4 million from QBE Reinsurance Corporation. If any of our reinsurers are unable or unwilling to pay amounts they owe us in a timely fashion, we could suffer a significant loss or a shortage of liquidity, which would have a material adverse effect on our business and results of operations.

Catastrophic losses are unpredictable and may adversely affect our results of operations, liquidity and financial condition.

Property/casualty insurance companies are subject to claims arising out of catastrophes that may have a significant effect on their results of operations, liquidity and financial condition. Catastrophes can be caused by various events, including hurricanes, windstorms, earthquakes, hail storms, explosions, severe winter weather and fires, and may include man-made events, such as the September 11, 2001 terrorist attacks on the World Trade Center. The incidence, frequency, and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Claims from catastrophic events could reduce our net income, cause substantial volatility in our financial results for any fiscal quarter or year or otherwise adversely affect our financial condition, liquidity or results of operations. Catastrophes may also negatively affect our ability to write new business. Increases in the value and geographic concentration of insured property and the effects of inflation could increase the severity of claims from catastrophic events in the future.

Catastrophe models may not accurately predict future losses.

Along with other insurers in the industry, we use models developed by third-party vendors in assessing our exposure to catastrophe losses that assume various conditions and probability scenarios. However, these models do not necessarily accurately predict future losses or accurately measure losses currently incurred. Catastrophe models, which have been evolving since the early 1990s, use historical information about various catastrophes and detailed information about our in-force business. While we use this information in connection with our pricing and risk management activities, there are limitations with respect to their usefulness in predicting losses in any reporting period. Examples of these limitations are significant variations in estimates between models and modelers and material increases and decreases in model results due to changes and refinements of the underlying data elements and assumptions. Such limitations lead to questionable predictive capability and post-event measurements that have not been well understood or proven to be sufficiently reliable. In addition, the models are not necessarily reflective of company or state-specific policy language, demand surge for labor and materials or loss settlement expenses, all of which are subject to wide variation by catastrophe. Because the occurrence and severity of catastrophes are inherently unpredictable and may vary significantly from year to year, historical results of operations may not be indicative of future results of operations.

We are subject to comprehensive regulation, and our results may be unfavorably impacted by these regulations.

We are subject to comprehensive governmental regulation and supervision. Most insurance regulations are designed to protect the interests of policyholders rather than of the stockholders and other investors of the insurance companies. These regulations, generally administered by the department of insurance in each state in which we do business, relate to, among other things:

Ÿ approval of policy forms and rates;

Ÿ standards of solvency, including risk-based capital measurements, which are a measure developed by the National Association of Insurance Commissioners and used by the state insurance regulators to identify insurance companies that potentially are inadequately capitalized;

Ÿ licensing of insurers and their agents;

Ÿ restrictions on the nature, quality and concentration of investments;

Ÿ restrictions on the ability of insurance company subsidiaries to pay dividends;

Ÿ restrictions on transactions between insurance company subsidiaries and their affiliates;

Ÿ requiring certain methods of accounting;

Ÿ periodic examinations of operations and finances;

Ÿ the use of non-public consumer information and related privacy issues;

Ÿ the use of credit history in underwriting and rating;

Ÿ limitations on the ability to charge policy fees;

Ÿ the acquisition or disposition of an insurance company or of any company controlling an insurance company;

Ÿ involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;

Ÿ restrictions on the cancellation or non-renewal of policies and, in certain jurisdictions, withdrawal from writing certain lines of business;

Ÿ prescribing the form and content of records of financial condition to be filed;

Ÿ requiring reserves for unearned premium, losses and other purposes; and

Ÿ with respect to premium finance business, the federal Truth-in-Lending Act and similar state statutes. In states where specific statutes have not been enacted, premium finance is generally subject to state usury laws that are applicable to consumer loans.

State insurance departments also conduct periodic examinations of the affairs of insurance companies and require filing of annual and other reports relating to the financial condition of insurance companies, holding company issues and other matters. Our business depends on compliance with applicable laws and regulations and our ability to maintain valid licenses and approvals for our operations. Regulatory authorities may deny or revoke licenses for various reasons, including violations of regulations. Changes in the level of regulation of the insurance industry or changes in laws or regulations themselves or interpretations by regulatory authorities could have a material adverse affect on our operations. In addition, we could face individual, group and class-action lawsuits by our policyholders and others for alleged violations of certain state laws and regulations. Each of these regulatory risks could have an adverse effect on our profitability.

State statutes limit the aggregate amount of dividends that our subsidiaries may pay Hallmark, thereby limiting its funds to pay expenses and dividends.

Hallmark is a holding company and a legal entity separate and distinct from its subsidiaries. As a holding company without significant operations of its own, Hallmark’s principal sources of funds are dividends and other sources of funds from its subsidiaries. State insurance laws limit the ability of Hallmark’s insurance company subsidiaries to pay dividends and require our insurance company subsidiaries to maintain specified minimum levels of statutory capital and surplus. The aggregate maximum amount of dividends permitted by law to be paid by an insurance company does not necessarily define an insurance company’s actual ability to pay dividends. The actual ability to pay dividends may be further constrained by business and regulatory considerations, such as the impact of dividends on surplus, by our competitive position and by the amount of premiums that we can write. Without regulatory approval, the aggregate maximum amount of dividends that could be paid to Hallmark in 2007 by our insurance company subsidiaries is $12.4 million. State insurance regulators have broad discretion to limit the payment of dividends by insurance companies and Hallmark’s right to participate in any distribution of assets of one of our insurance company subsidiaries is subject to prior claims of policyholders and creditors except to the extent that its rights, if any, as a creditor are recognized. Consequently, Hallmark’s ability to pay debts, expenses and cash dividends to our stockholders may be limited.

Our insurance company subsidiaries are subject to minimum capital and surplus requirements. Failure to meet these requirements could subject us to regulatory action.

Our insurance company subsidiaries are subject to minimum capital and surplus requirements imposed under the laws of their respective states of domicile and each state in which they issue policies. Any failure by one of our insurance company subsidiaries to meet minimum capital and surplus requirements imposed by applicable state law will subject it to corrective action, which may include requiring adoption of a comprehensive financial plan, revocation of its license to sell insurance products or placing the subsidiary under state regulatory control. Any new minimum capital and surplus requirements adopted in the future may require us to increase the capital and surplus of our insurance company subsidiaries, which we may not be able to do.

We are subject to assessments and other surcharges from state guaranty funds, mandatory reinsurance arrangements and state insurance facilities, which may reduce our profitability.

Virtually all states require insurers licensed to do business therein to bear a portion of the unfunded obligations of impaired or insolvent insurance companies. These obligations are funded by assessments, which are levied by guaranty associations within the state, up to prescribed limits, on all member insurers in the state on the basis of the proportionate share of the premiums written by member insurers in the lines of business in which the impaired, insolvent or failed insurer was engaged. Accordingly, the assessments levied on us by the states in which we are licensed to write insurance may increase as we increase our premiums written. In addition, as a condition to the ability to conduct business in certain states, insurance companies are required to participate in mandatory reinsurance funds. The effect of these assessments and mandatory reinsurance arrangements, or changes in them, could reduce our profitability in any given period or limit our ability to grow our business.

We are currently monitoring developments with respect to various state facilities, such as the Texas FAIR Plan and the Texas Windstorm Insurance Association, and the various guaranty funds in which we participate. The ultimate impact of recent catastrophe experience on these facilities is currently uncertain but could result in the facilities recognizing a financial deficit or a financial deficit greater than the level currently estimated. They may, in turn, have the ability to assess participating insurers when financial deficits occur, adversely affecting our results of operations. While these facilities are generally designed so that the ultimate cost is borne by policyholders, the exposure to assessments and the availability of recoupments or premium rate increases from these facilities may not offset each other in our financial statements. Moreover, even if they do offset each other, they may not offset each other in financial statements for the same fiscal period due to the ultimate timing of the assessments and recoupments or premium rate increases, as well as the possibility of policies not being renewed in subsequent years.

Adverse securities market conditions can have a significant and negative impact on our investment portfolio.

Our results of operations depend in part on the performance of our invested assets. As of September 30, 2007, 84% of our investment portfolio was invested in fixed-income securities. Certain risks are inherent in connection with fixed-income securities, including loss upon default and price volatility in reaction to changes in interest rates and general market factors. In general, the fair market value of a portfolio of fixed-income securities increases or decreases inversely with changes in the market interest rates, while net investment income realized from future investments in fixed-income securities increases or decreases along with interest rates. In addition, 20% of our fixed-income securities have call or prepayment options. This subjects us to reinvestment risk should interest rates fall and issuers call their securities. Furthermore, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that cash flows from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates.

In addition to the general risks described above, although 90% of our fixed-income portfolio is investment-grade, our fixed-income securities are nonetheless subject to credit risk. If any of the issuers of our fixed-income securities suffer financial setbacks, the ratings on the fixed-income securities could fall (with a concurrent fall in market value) and, in a worst case scenario, the issuer could default on its obligations. Hallmark has no exposure in its investment portfolio to sub-prime mortgages and $4 thousand total exposure in mortgage backed securities. Future changes in the fair market value of our available-for-sale securities will be reflected in other comprehensive income. Similar treatment is not available for liabilities. Therefore, interest rate fluctuations could adversely affect our stockholders’ equity, total comprehensive income and/or our cash flows.

As of September 30, 2007, 16% of our investment portfolio was invested in equity securities. The equity securities that we hold are subject to economic loss from a decline in share price. As a result, the values of these equity securities are heavily influenced by the specific financial prospects of each issuer. In addition, general economic conditions, stock market conditions and other factors may adversely affect the value of our equity investments. As a result, we may not realize the desired returns on our equity investments, may incur losses on sales of our equity securities or may be required to write down the value of our equity securities.

We rely on independent agents and specialty brokers to market our products and their failure to do so would have a material adverse effect on our results of operations.

We market and distribute our insurance programs exclusively through independent insurance agents and specialty insurance brokers. As a result, our business depends in large part on the marketing efforts of these agents and brokers and on our ability to offer insurance products and services that meet the requirements of the agents, the brokers and their customers. However, these agents and brokers are not obligated to sell or promote our products and many sell or promote competitors’ insurance products in addition to our products. Some of our competitors have higher financial strength ratings, offer a larger variety of products, set lower prices for insurance coverage and/or offer higher commissions than we do. Therefore, we may not be able to continue to attract and retain independent agents and brokers to sell our insurance products. The failure or inability of independent agents and brokers to market our insurance products successfully could have a material adverse impact on our business, financial condition and results of operations.

We may experience difficulty in integrating recent or future acquisitions into our operations.

We completed the acquisitions of the subsidiaries now comprising both our TGA Operating Unit and our Aerospace Operating Unit during January 2006. We may pursue additional acquisitions in the future. The successful integration of newly acquired businesses into our operations will require, among other things, the retention and assimilation of their key management, sales and other personnel; the coordination of their lines of insurance products and services; the adaptation of their technology, information systems and other processes; and the retention and transition of their customers. Unexpected difficulties in integrating any acquisition could result in increased expenses and the diversion of management time and resources. If we do not successfully integrate any acquired business into our operations, we may not realize the anticipated benefits of the acquisition, which could have a material adverse impact on our financial condition and results of operations. Further, any potential acquisitions may require significant capital outlays and, if we issue equity or convertible debt securities to pay for an acquisition, the issuance may be dilutive to our existing stockholders.

Our geographic concentration ties our performance to the business, weather, economic and regulatory conditions of certain states.

The following five states accounted for 79% of our gross written premiums for the nine months ended September 30, 2007: Texas (44%), Oregon (14%), New Mexico (9%), Idaho (7%) and Arizona (5%). Our revenues and profitability are subject to the prevailing regulatory, legal, economic, political, demographic, competitive, weather and other conditions in the principal states in which we do business. Changes in any of these conditions could make it less attractive for us to do business in such states and would have a more pronounced effect on us compared to companies that are more geographically diversified. In addition, our exposure to severe losses from localized natural perils, such as windstorms or hailstorms, is increased in those areas where we have written significant numbers of property/casualty insurance policies.

The exclusions and limitations in our policies may not be enforceable.

Many of the policies we issue include exclusions or other conditions that define and limit coverage, which exclusions and conditions are designed to manage our exposure to certain types of risks and expanding theories of legal liability. In addition, many of our policies limit the period during which a policyholder may bring a claim under the policy, which period in many cases is shorter than the statutory period under which these claims can be brought by our policyholders. While these exclusions and limitations help us assess and control our loss exposure, it is possible that a court or regulatory authority could nullify or void an exclusion or limitation, or legislation could be enacted modifying or barring the use of these exclusions and limitations. This could result in higher than anticipated losses and loss adjustment expenses by extending coverage beyond our underwriting intent or increasing the number or size of claims, which could have a material adverse effect on our operating results. In some instances, these changes may not become apparent until some time after we have issued the insurance policies that are affected by the changes. As a result, the full extent of liability under our insurance contracts may not be known for many years after a policy is issued.

We rely on our information technology and telecommunications systems and the failure or disruption of these systems could disrupt our operations and adversely affect our results of operations.

Our business is highly dependent upon the successful and uninterrupted functioning of our information technology and telecommunications systems. We rely on these systems to process new and renewal business, provide customer service, make claims payments and facilitate collections and cancellations, as well as to perform actuarial and other analytical functions necessary for pricing and product development. Our systems could fail of their own accord or might be disrupted by factors such as natural disasters, power disruptions or surges, computer hackers or terrorist attacks. Failure or disruption of these systems for any reason could interrupt our business and adversely affect our results of operations.

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.

None.

Item 5. Other Information.

None.

Item 6. Exhibits.

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

Exhibit Number		Description

3(a)		Articles of Incorporation of the registrant, as amended (incorporated by reference to Exhibit 3(a) to the registrant’s Annual Report on Form 10-KSB for the fiscal year ended December 31, 1993).

3(b)		Restated By-Laws of the registrant, as amended (incorporated by reference to Exhibit 3.1 to the registrant’s Current Report on Form 8K 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 the registrant’s Post-Effective Amendment No. 1 to Registration Statement on Form S-1 filed October 3, 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)		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(g)		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(h)		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).

4(i)		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(j)		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).

Exhibit
Number

Description


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: November 7, 2007		/s/ Mark J. Morrison
		Mark J. Morrison, Chief Executive Officer and President (Principal Executive Officer)

Date: November 7, 2007		/s/ Jeffrey R. Passmore
		Jeffrey R. Passmore, Chief Accounting Officer and Senior Vice President
		(Principal Financial Officer)