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)
 
 
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
 
(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  Accelerated filer 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
   
2


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

3


Hallmark Financial Services, Inc. and Subsidiaries
Consolidated Statements of Operations
(Unaudited)
($ in thousands, except per share amounts)

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
   
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

4


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

5


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

6


Hallmark Financial Services, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)

1. General
 
Hallmark Financial Services, Inc. (“Hallmark” and, together with subsidiaries, “we,” “us” or “our”) is an insurance holding company which, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing commercial insurance, non-standard automobile insurance and general aviation insurance, as well as providing other insurance related services. Our business is geographically concentrated in the south central and northwest regions of the United States, except for our general aviation business which is written on a national basis.

We pursue our business activities through subsidiaries whose operations are organized into four operating units which are supported by our three insurance company subsidiaries. Our HGA Operating Unit handles standard lines commercial insurance products and services and is comprised of 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.

7


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.

8


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.

9


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.

10


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.

11


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
 
 
12

 
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:

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

13


 
o
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:

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

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

 
o
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:

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

 
o
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:

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

 
o
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

 
o
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.

14


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.

15


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.

16


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

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 insurance company subsidiaries.
 
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.

17

 
 
·
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.

18

 
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.

19


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.

20


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.

21


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.

22


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.

23


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
%

(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.

24


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.

25

 
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.
 
26

 
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.
 
27

 
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.
 
28

 
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

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.

29

 
Trust Preferred Securities

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.

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.
 
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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.

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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:

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the availability of sufficient reliable data and our ability to properly analyze available data;
 
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the uncertainties that inherently characterize estimates and assumptions;
 
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our selection and application of appropriate pricing techniques; and
 
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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.
 
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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 historica