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

Introduction

Hallmark Financial Services, Inc. ("Hallmark" and, together with subsidiaries, "we," "us" or "our") is an insurance holding company which, through its subsidiaries, engages in the sale of property/casualty insurance products to businesses and individuals. Our business involves marketing, distributing, underwriting and servicing commercial insurance, personal insurance and general aviation insurance, as well as providing other insurance related services. Our business is geographically concentrated in the south central and northwest regions of the United States, except for our general aviation business which is written on a national basis. We pursue our business activities through subsidiaries whose operations are organized into five operating units which are supported by our three 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 AHIS Operating Unit which is comprised of our American Hallmark Insurance Services, Inc. and Effective Claims Management, Inc. subsidiaries.

· Specialty Commercial Segment. Our Specialty Commercial Segment includes the excess and surplus lines commercial property/casualty insurance products and services handled by our TGA Operating Unit, the general aviation insurance products and services handled by our Aerospace Operating Unit, and the excess commercial automobile and commercial umbrella insurance products handled by our Heath XS Operating Unit. Our TGA Operating Unit is comprised of our TGA Insurance Managers, Inc., Pan American Acceptance Corporation ("PAAC") and TGA Special Risk, Inc. subsidiaries. Our Aerospace Operating Unit is comprised of our Aerospace Insurance Managers, Inc., Aerospace Special Risk, Inc. and Aerospace Claims Management Group, Inc. subsidiaries. Our Heath XS Operating Unit is compromised of our Heath XS, LLC and Hardscrabble Data Solutions, LLC subsidiaries.

· Personal Segment. Our Personal Segment includes the non-standard personal automobile insurance and complementary personal insurance products and services handled by our Personal Lines Operating Unit which is comprised of American Hallmark General Agency, Inc. and Hallmark Claims Services, Inc., both of which do business as Hallmark 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 within the Standard Commercial Segment and assumes a portion of the risks on the commercial and aviation property/casualty policies marketed within the Specialty Commercial Segment.

· Hallmark Specialty Insurance Company ("HSIC") presently retains a portion of the risks on the commercial property/casualty policies marketed within the Specialty Commercial Segment.

· Hallmark Insurance Company ("HIC") presently assumes all of the risks on the personal property/casualty policies marketed by our Personal Lines Operating Unit and assumes a portion of the risks on the aviation property/casualty products marketed within the Specialty Commercial Segment.

Our insurance company subsidiaries have entered into a pooling arrangement pursuant to which AHIC retains 46% of the total net premiums written by all of our operating units, HIC retains 34% of our total net premiums written and HSIC retains 20% of our total net premiums written. This pooling arrangement has no impact on our consolidated financial statements under GAAP.

Results of Operations

Management Overview. During the three months ended March 31, 2009, our total revenues were $70.9 million, representing a $0.6 million decrease over the $71.5 million in total revenues for the same period of 2008. The decrease in total revenue for the period was primarily due to recognized losses on our investment portfolio and lower commission income partially offset by higher earned premium and investment income. Standard Commercial revenues decreased $2.0 million during the three months ended March 31, 2009 due primarily to lower earned premium as a result of increased competition, rate pressure, and deterioration of the economic environment in our major markets. The acquisition of our Heath XS Operating Unit in 2008 drove the $0.6 million increase in revenue by our Specialty Commercial Segment during the three months ended March 31, 2009 as compared to the same period during 2008. Revenues from our Personal Segment increased $1.8 million during the three months ended March 31, 2009 as compared to the same period during 2008, due largely to geographic expansion into new states. Corporate revenue decreased $1.0 million during the three months ended March 31, 2009 as compared to the same period during 2008 due to recognized losses on our investment portfolio of $0.3 million as compared to recognized gains of $0.9 million during the same period of 2008.

We reported net income attributable to Hallmark of $6.8 million for the three months ended March 31, 2009, compared to $7.3 million for the same period in 2008. On a diluted per share basis, net income was $0.33 for the three months ended March 31, 2009 as compared to $0.35 for the same period in 2008. The decrease in net income attributable to Hallmark was primarily attributable to decreased revenue discussed above and a modestly higher loss and loss adjustment expenses ("LAE") due to $1.6 million of favorable prior year loss development recognized during the three months ended March 31, 2008. These factors were partially offset by a lower effective tax rate driven primarily by a $0.8 million reduction in the deferred tax asset valuation allowance during the first three months of 2009.

First Quarter 2009 as Compared to First Quarter 2008

The following is additional business segment information for the three months ended March 31, 2009 and 2008 (in thousands):

Hallmark Financial Services, Inc.

                           Consolidated Segment Data

                                                            Three Months Ended March 31, 2009
                                        Standard        Specialty
                                       Commercial      Commercial       Personal
                                        Segment          Segment        Segment        Corporate       Consolidated

Produced premium (1)                  $     19,147     $    34,282     $   20,626     $         -     $       74,055

Gross premiums written                      19,147          31,706         20,626               -             71,479
Ceded premiums written                      (1,103 )        (1,129 )            -               -             (2,232 )
Net premiums written                        18,044          30,577         20,626               -             69,247
Change in unearned premiums                    406          (5,626 )       (4,597 )             -             (9,817 )
Net premiums earned                         18,450          24,951         16,029               -             59,430

Total revenues                              20,020          32,825         17,535             530             70,910

Losses and loss adjustment expenses         11,346          14,933         10,563               -             36,842

Pre-tax income (loss), net of
non-controlling interest                     2,576           5,682          2,619          (2,425 )            8,452

Net loss ratio (2)                            61.5 %          59.8 %         65.9 %                             62.0 %
Net expense ratio (2)                         27.3 %          30.6 %         23.1 %                             29.5 %
Net combined ratio (2)                        88.8 %          90.4 %         89.0 %                             91.5 %



                                                            Three Months Ended March 31, 2008
                                        Standard        Specialty
                                       Commercial      Commercial       Personal
                                        Segment          Segment        Segment        Corporate       Consolidated

Produced premium (1)                  $     21,749     $    32,020     $   17,727     $         -     $       71,496

Gross premiums written                      21,749          24,761         17,727               -             64,237
Ceded premiums written                      (1,187 )          (817 )            -               -             (2,004 )
Net premiums written                        20,562          23,944         17,727               -             62,233
Change in unearned premiums                    404            (155 )       (3,238 )             -             (2,989 )
Net premiums earned                         20,966          23,789         14,489               -             59,244

Total revenues                              22,006          32,238         15,726           1,551             71,521

Losses and loss adjustment expenses         11,310          15,003          9,191               -             35,504

Pre-tax income (loss)                        4,058           5,444          2,590          (1,298 )           10,794

Net loss ratio (2)                            53.9 %          63.1 %         63.4 %                             59.9 %
Net expense ratio (2)                         27.2 %          30.5 %         22.5 %                             28.9 %
Net combined ratio (2)                        81.1 %          93.6 %         85.9 %                             88.8 %

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

(2) The net loss ratio is calculated as incurred losses and LAE divided by net premiums earned, each determined in accordance with GAAP. The net expense ratio is calculated as underwriting expenses of our insurance company subsidiaries (which include provisional ceding commissions, direct agent commissions, premium taxes and assessments, professional fees, other general underwriting expenses and allocated overhead expenses) and offset by agency fee income, divided by net premiums earned, each determined in accordance with GAAP. Net combined ratio is calculated as the sum of the net loss ratio and the net expense ratio.

Standard Commercial Segment

Gross premiums written for the Standard Commercial Segment were $19.1 million for the three months ended March 31, 2009, which was $2.6 million, or 12% less than the $21.7 million reported for the same period in 2008. Net premiums written were $18.0 million for the three months ended March 31, 2009 as compared to $20.6 million reported for the same period in 2008. The decrease in premium volume was due to increased competition, rate pressure and the deterioration of the general economic environment.

Total revenue for the Standard Commercial Segment of $20.0 million for the three months ended March 31, 2009 was $2.0 million less than the $22.0 million reported during the same period in 2008. This 9% decrease in total revenue was primarily due to decreased net premiums earned of $2.5 million. The decrease in net premiums earned was partially offset by a contingent commission adjustment reducing revenue by $0.4 million during the three months ended March 31, 2008. The contingent commission adjustment related to adverse loss development on prior accident years. Increased net investment income of $0.1 million during the three months ended March 31, 2009 also partially offset the decrease in net premiums earned.

Pre-tax income for our Standard Commercial Segment of $2.6 million for the three months ended March 31, 2009 decreased $1.5 million, or 37%, from the $4.1 million reported for the same period of 2008. Decreased revenue as discussed above was the primary reason for the decrease in pre-tax income, offset by lower operating expenses of $0.5 million, mostly due to lower premium volume during the three months ended March 31, 2009 as compared to the same period during 2008.

The Standard Commercial Segment reported a net loss ratio of 61.5% for the three months ended March 31, 2009 as compared to 53.9% for 2008. The gross loss ratio before reinsurance for the three months ended March 31, 2009 was 62.3% as compared to the 50.4% reported for the same period of 2008. The higher net and gross loss ratios for the first quarter of fiscal 2009 as compared to the same period in fiscal 2008 were largely the result of the recognition of $1.8 million in favorable prior year loss development during the first quarter of fiscal 2008, which represented 8.4% of net earned premiums and 8.0% of gross earned premiums for that period. The Standard Commercial Segment reported net expense ratios of 27.3% and 27.2% for the first quarters of 2009 and 2008, respectively.

Specialty Commercial Segment

The $32.8 million of total revenue for the three months ended March 31, 2009 was $0.6 million higher than the $32.2 million reported for the same period in 2008. This increase in revenue was largely due to increased net premiums earned of $1.2 million as a result of the increased retention of business and the acquisition of the Heath XS Operating Unit during the third quarter of 2008 and increased net investment income of $0.2 million. These increases were offset by lower commission income of $0.8 million due primarily to the shift from a third party agency structure to an insurance underwriting structure partially offset by increased commission income in our newly acquired Heath XS Operating Unit.

Pre-tax income for the Specialty Commercial Segment of $5.7 million was $0.3 million higher than the $5.4 million reported for the same period in 2008. Increased revenue, discussed above, and lower loss and LAE of $0.1 million, was partially offset by increased operating expenses of $0.3 million due mostly to increased production related expenses related to the acquisition of our Heath XS Operating Unit partially offset by reduced production related expenses in our TGA and Aerospace Operating Units and increased amortization of intangible assets of $0.1 million related to our acquisition of the Heath XS Operating Unit during 2008.

The Specialty Commercial Segment reported a net loss ratio of 59.8% for the three months ended March 31, 2009 as compared to 63.1% for 2008. The gross loss ratio before reinsurance was 59.6% for the three months ended March 31, 2009 as compared to 62.0% for the same period the prior year. The gross loss results for the three months ended March 31, 2008 included $0.5 million of adverse prior year development. The Specialty Commercial Segment reported a net expense ratio of 30.6% for the first quarter of 2009 as compared to 30.5% for the first quarter of 2007.

Personal Segment

Net premiums written for our Personal Segment increased $2.9 million during the first quarter of 2009 to $20.6 million compared to $17.7 million for the first quarter of 2008. The increase in premium was due mostly to continued geographic expansion that began in 2006.

Total revenue for the Personal Segment increased 12% to $17.5 million for the first quarter of 2009 from $15.7 million for the first quarter of 2008. Higher earned premium of $1.5 million was the primary reason for the increase in revenue for the period. Increased finance charges of $0.2 million and higher investment income of $0.1 million further contributed to the increase in revenue during the first quarter of 2009.

Pre-tax income for the Personal Segment was $2.6 million for the three months ended March 31, 2009 and 2008. The increased revenue, as discussed above, was offset by increased losses and LAE of $1.4 million and increased operating expenses of $0.4 million due mostly to production related expenses attributable to the increased earned premium.

The Personal Segment reported a net loss ratio of 65.9% for the three months ended March 31, 2009 as compared to 63.4% for the first quarter of 2008. We recognized $0.3 million of favorable prior accident year development for the three months ended March 31, 2008. The Personal Segment reported a net expense ratio of 23.1% for the three months ended March 31, 2009 as compared to 22.5% for the first quarter of 2008.

Corporate

Total revenue for corporate decreased by $1.0 million for the three months ended March 31, 2009 as compared to the same period the prior year. Recognized losses of $0.3 million on our investment portfolio as compared to recognized gains of $0.9 million during the same period in 2008 was partially offset by increased investment income of $0.2 million primarily due to changes in capital allocation.

Corporate pre-tax loss was $2.4 million for the three months ended March 31, 2009 as compared to $1.3 million for the same period the prior year. The increased loss was mostly due to the decreased revenues discussed above as well as increased operating expenses of $0.1 million.

Financial Condition and Liquidity

Sources and Uses of Funds

Our sources of funds are from insurance-related operations, financing activities and investing activities. Major sources of funds from operations include premiums collected (net of policy cancellations and premiums ceded), commissions, and processing and service fees. As a holding company, Hallmark is dependent on dividend payments and management fees from its subsidiaries to meet operating expenses and debt obligations. As of March 31, 2009, Hallmark had $12.1 million in unrestricted cash and invested assets at the holding company. Unrestricted cash and invested assets of our non-insurance subsidiaries were $3.8 million as of March 31, 2009.

AHIC, domiciled in Texas, is limited in the payment of dividends in any 12-month period, without the prior written consent of the Texas Department of Insurance, to the greater of statutory net income for the prior calendar year or 10% of statutory surplus as of the prior year end. Dividends may only be paid from unassigned surplus funds. HIC, domiciled in Arizona, is limited in the payment of dividends to the lesser of 10% of prior year surplus or prior year's net investment income, without prior written approval from the Arizona Department of Insurance. HSIC, domiciled in Oklahoma, is limited in the payment of dividends to the greater of 10% of prior year surplus or prior year's statutory net income, without prior written approval from the Oklahoma Insurance Department. During 2009, our insurance company subsidiaries' ordinary dividend capacity is $18.4 million, of which $13.8 million is available to Hallmark. None of our insurance company subsidiaries paid a dividend to Hallmark during the first three months of 2009 or the 2008 fiscal year.

Comparison of March 31, 2009 to December 31, 2008

On a consolidated basis, our cash and investments (excluding restricted cash) at March 31, 2009 were $362.2 million compared to $352.7 million at December 31, 2008. An increase in market value of our investment portfolio for the period was the primary reason for this increase.

Comparison of Three Months Ended March 31, 2009 and March 31, 2008

Net cash provided by our consolidated operating activities was $8.9 million for the first three months of 2009 compared to $12.4 million for the first three months of 2008. The decrease in operating cash flow was primarily due to the timing of premium settlements with third party insurance carriers.

Net cash used in investing activities during the first three months of 2009 was $10.5 million as compared to $87.2 million for the same period in 2008. Contributing to the decrease in cash used in investing activities was a decrease of $213.8 million in purchases of debt and equity securities, offset by a $8.5 million reduction in the change in restricted cash, $125.0 million reduction in maturities, sales and redemptions of investment securities and $3.3 million for the payment of contingent consideration to the sellers of the subsidiaries comprising our TGA Operating Unit.

Cash used in financing activities during the first three months of 2009 was $1.2 million as compared to $9.8 million for the same period of 2008. The cash used during the first three months of 2008 was primarily for the payment of consideration to the sellers of the subsidiaries comprising our TGA Operating Unit. As of March 31, 2009 we had fully repaid our obligation to the sellers.

Credit Facilities

On June 29, 2005, we entered into a credit facility with The Frost National Bank. The credit facility was amended and restated on January 27, 2006 to a $20.0 million revolving credit facility, with a $5.0 million letter of credit sub-facility. The credit facility was further amended effective May 31, 2007 to increase the revolving credit facility to $25.0 million and establish a new $5.0 million revolving credit sub-facility for the premium finance operations of PAAC. The credit agreement was again amended effective February 20, 2008 to extend the termination to January 27, 2010, revise various affirmative and negative covenants and decrease the interest rate in most instances to the three month Eurodollar rate plus 1.90 percentage points, payable quarterly in arrears. We pay letter of credit fees at the rate of 1.00% per annum. Our obligations under the revolving credit facility are secured by a security interest in the capital stock of all of our subsidiaries, guaranties of all of our subsidiaries and the pledge of all of our non-insurance company assets. The revolving credit facility contains covenants which, among other things, require us to maintain certain financial and operating ratios and restrict certain distributions, transactions and organizational changes. As of March 31, 2009 we were in compliance with all of our covenants. As of March 31, 2009, we had $2.9 million outstanding under this credit facility.

Trust Preferred Securities

On June 21, 2005, an unconsolidated trust subsidiary completed a private placement of $30.0 million of 30-year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million from the trust subsidiary and contributed $30.0 million to one of our insurance company subsidiaries in order to increase policyholder surplus. The note bears an initial interest rate of 7.725% until June 15, 2015, at which time interest will adjust quarterly to the three-month LIBOR rate plus 3.25 percentage points. As of March 31, 2009, the note balance was $30.9 million. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity.

On August 23, 2007, an unconsolidated trust subsidiary completed a private placement of $25.0 million of 30-year floating rate trust preferred securities. Simultaneously, we borrowed $25.8 million from the trust subsidiary for working capital and general corporate purposes. The note bears an initial interest rate at 8.28% until September 15, 2017, at which time interest will adjust quarterly to the three-month LIBOR rate plus 2.90 percentage points. As of March 31, 2009, the note balance was $25.8 million. Under the terms of the note, we pay interest only each quarter and the principal of the note at maturity.