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 that, 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 and Excess & Umbrella business which is written on a national basis. We pursue our business activities through subsidiaries whose operations are organized into six business units, which are supported by our insurance company subsidiaries.

Our non-carrier insurance activities are segregated by business 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 Standard Commercial business unit and the workers compensation insurance products handled by our Workers Compensation business unit.

· Specialty Commercial Segment. Our Specialty Commercial Segment includes the excess and surplus lines commercial property/casualty, medical professional liability and satellite launch insurance products and services handled by our E&S Commercial business unit, the general aviation insurance products and services handled by our General Aviation business unit, and the commercial excess liability and umbrella insurance products handled by our Excess & Umbrella business unit.

· Personal Segment. Our Personal Segment includes the non-standard personal automobile insurance, low value dwelling/homeowners, renters, motorcycle and business auto insurance products and services handled by our Personal Lines business unit.

The retained premium produced by our business units is supported by the following insurance company subsidiaries:

· American Hallmark Insurance Company of Texas ("AHIC") presently retains a portion of the risks on the commercial property/casualty and workers compensation policies marketed within the Standard Commercial Segment, retains a portion of the risks on personal policies marketed within the Personal Segment and retains a portion of the risks on the commercial, medical professional liability, aviation and satellite launch 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 and medical professional liability policies marketed within the Specialty Commercial Segment.

· Hallmark Insurance Company ("HIC") presently retains a portion of the risks on both the personal policies marketed within the Personal Segment and the commercial and aviation property/casualty products marketed within the Specialty Commercial Segment.

· Hallmark National Insurance Company ("HNIC") was acquired on December 31, 2010. Simultaneous with the closing of the acquisition, HNIC entered into reinsurance contracts with an affiliate of the seller, pursuant to which such affiliate of the seller will handle all claims and assume all liabilities arising under policies issued by HNIC prior to the closing or during a transition period of up to six months following the closing. Commencing January 1, 2011, HNIC retains a portion of the risks on the personal policies marketed within the Personal Segment.

· Hallmark County Mutual Insurance Company ("HCM") control and management is maintained through our wholly owned subsidiary CYR Insurance Management Company ("CYR"). CYR has as its primary asset a management agreement with HCM, which provides for CYR to have management and control of HCM. HCM is used to front certain lines of business in our Specialty Commercial and Personal Segments in Texas. HCM does not retain any business.

· Texas Builders Insurance Company ("TBIC") was acquired on July 1, 2011 and retains a portion of the risks on the workers compensation policies marketed within our Standard Commercial Segment.

AHIC, HIC, HSIC and HNIC have entered into a pooling arrangement pursuant to which AHIC retains 33% of the total net premiums written by any of them, HIC retains 28% of our total net premiums written by any of them, HSIC retains 28% of our total net premiums written by any of them and HNIC retains 11% of our total premiums written by any of them. Neither HCM nor TBIC is a party to the intercompany pooling arrangement. This pooling arrangement has no impact on our consolidated financial statements reported in accordance with U.S. generally accepted accounting principles ("GAAP").

Results of Operations

Management Overview During the three and six months ended June 30, 2012, our total revenues were $84.6 million and $167.6 million, representing an 8% and 7% increase, respectively, from the $78.5 million and $155.9 million in total revenues for the same period of 2011. This increase in revenue was primarily attributable to increased earned premium largely from increased production by our E&S Commercial business unit and the acquisition of our Workers Compensation business unit during the third quarter of 2011. These increases in revenue were partially offset by lower net realized gains and lower finance charges and earned premium in our Personal Lines business unit due mostly to the impact of rate increases, the reduction of premium written in Florida and exiting certain other underperforming states and programs.

The increase in revenue for the three months and six months ended June 30, 2012 was complemented by slightly decreased loss and loss adjustment expenses ("LAE") due primarily to lower current accident year loss trends. During the three months ended June 30, 2012 we recorded $1.6 million unfavorable prior year loss development. During the six months ended June 30, 2012 we recorded $1.4 million of favorable prior year loss development. During the three and six months ended June 30, 2011 we recorded $0.7 million and $15.8 million, respectively, of unfavorable prior year loss development. Of the $15.8 million unfavorable development recognized for the six months ended June 30, 2011, $9.5 million was a result of adverse prior year loss reserve development in our Personal Lines Segment in Florida. In addition, the results for the six months ended June 30, 2012 and 2011 included $10.4 million and $9.4 million, respectively, in net losses from weather related claims.

We reported a $1.8 million net loss attributable to Hallmark for the three months ended June 30, 2012 as compared to $87 thousand net loss attributable to Hallmark for the same period during 2011. We reported a net loss attributable to Hallmark of $1.7 million for the six months ended June 30, 2012, which was $9.6 million lower than the $11.3 million net loss reported for the six months ended June 30, 2011. On a diluted basis per share, we reported a net loss of $0.10 per share for the three months ended June 30, 2012, as compared to net loss of $0.00 per share for the same period in 2011. On a diluted basis per share, net loss per share was $0.09 for the six months ended June 30, 2012 as compared to net loss per share of $0.56 for the same period during 2011. We reported an income tax benefit of $2.3 million, or an effective income tax rate of 59.2%, for the six months ended June 30, 2012, as compared to income tax benefit of $9.7 million, or an effective rate of 46.1%, for the same period during 2011.

Second Quarter 2012 as Compared to Second Quarter 2011

The following is additional business segment information for the three months ended June 30, 2012 and 2011 (in thousands):

                        Hallmark Financial Services, Inc

                           Consolidated Segment Data



                                                      Three Months Ended June 30, 2012
                                Standard        Specialty
                               Commercial       Commercial       Personal
                                Segment          Segment          Segment        Corporate       Consolidated

Gross premiums written        $     20,739     $     61,456     $    18,620               -     $      100,815
Ceded premiums written              (1,730 )        (13,749 )          (199 )             -            (15,678 )
Net premiums written                19,009           47,707          18,421               -             85,137
Change in unearned premiums         (2,369 )         (7,017 )         2,498               -             (6,888 )
Net premiums earned                 16,640           40,690          20,919               -             78,249

Total revenues                      17,924           43,046          22,905             696             84,571

Losses and loss adjustment
expenses                            13,013           28,286          19,930               -             61,229

Pre-tax income (loss), net
of non-controlling interest           (710 )          2,929          (4,211 )        (2,202 )           (4,194 )

Net loss ratio (1)                    78.2 %           69.5 %          95.3 %                             78.2 %
Net expense ratio (1)                 34.2 %           28.4 %          28.8 %                             30.5 %
Net combined ratio (1)               112.4 %           97.9 %         124.1 %                            108.7 %




                                                      Three Months Ended June 30, 2011
                                Standard        Specialty
                               Commercial       Commercial       Personal
                                Segment          Segment          Segment        Corporate       Consolidated

Gross premiums written        $     18,549     $     48,533     $    24,289               -     $       91,371
Ceded premiums written              (1,392 )        (10,877 )          (146 )             -            (12,415 )
Net premiums written                17,157           37,656          24,143               -             78,956
Change in unearned premiums         (1,796 )         (5,171 )          (411 )             -             (7,378 )
Net premiums earned                 15,361           32,485          23,732               -             71,578

Total revenues                      16,241           34,476          25,869           1,927             78,513

Losses and loss adjustment
expenses                            15,789           23,549          22,582               -             61,920

Pre-tax income (loss), net
of non-controlling interest         (4,767 )            812          (4,620 )          (776 )           (9,351 )

Net loss ratio (1)                   102.8 %           72.5 %          95.2 %                             86.5 %
Net expense ratio (1)                 34.0 %           30.6 %          27.7 %                             31.9 %
Net combined ratio (1)               136.8 %          103.1 %         122.9 %                            118.4 %

(1) 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 for our business units that retain 100% of produced premium as total operating expenses for the unit offset by agency fee income divided by net premiums earned, each determined in accordance with GAAP. For the business units that do not retain 100% of the produced premium, the net expense ratio is calculated as underwriting expenses of the insurance company subsidiaries for the unit 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 $20.7 million for the three months ended June 30, 2012, which was $2.2 million, or 12%, more than the $18.5 million reported for the same period in 2011. Net premiums written were $19.0 million for the three months ended June 30, 2012 as compared to $17.2 million reported for the same period in 2011. The increase in premium volume was primarily due to the acquisition of our Workers Compensation business unit during the third quarter of 2011.

Total revenue for the Standard Commercial Segment of $17.9 million for the three months ended June 30, 2012 was $1.7 million more than the $16.2 million reported during the same period in 2011. This 10% increase in total revenue was mostly due to increased net premiums earned of $1.3 million due primarily to the acquisition of our Workers Compensation business unit during the third quarter of 2011, higher net investment income of $0.3 million, and a $0.1 million lower adverse profit share commission revenue adjustment as compared to the second quarter of 2011.

Our Standard Commercial Segment reported a pre-tax loss of $0.7 million for the three months ended June 30, 2012 as compared to a pre-tax loss of $4.8 million for the same period of 2011. This decrease in pre-tax loss was primarily the result of lower loss and LAE of $2.8 million and the increased revenue discussed above, partially offset by higher operating expenses of $0.4 million due primarily to the acquisition of our Workers Compensation business unit during the third quarter of 2011.

The Standard Commercial Segment reported a net loss ratio of 78.2% for the three months ended June 30, 2012 as compared to 102.8% for the same period of 2011. The gross loss ratio before reinsurance for the three months ended June 30, 2012 was 86.4% as compared to the 90.3% reported for the same period of 2011. The decrease in the net loss ratio was impacted by lower current accident year loss trends excluding catastrophe losses during the second quarter of 2012 as compared to the same period in 2011. The gross and net loss results for the three months ended June 30, 2012 and 2011 include $4.8 million and $3.7 million, respectively, of weather related losses. During the three months ended June 30, 2012, the Standard Commercial Segment reported unfavorable loss reserve development of $0.2 million as compared to $0.8 million favorable loss development during the same period of 2011.

Specialty Commercial Segment

The $43.0 million of total revenue for the three months ended June 30, 2012 was $8.5 million higher than the $34.5 million reported by the Specialty Commercial Segment for the same period in 2011. This increase in revenue was primarily due to higher net premiums earned of $8.2 million largely from increased production in our E&S Commercial business unit, Excess & Umbrella business unit and a new space risk program entered into during the first quarter of 2011. Further contributing to this increased revenue was higher net investment income of $0.4 million.

Pre-tax income for the Specialty Commercial Segment of $2.9 million for the second quarter of 2012 was $2.1 million higher than the $0.8 million reported for the same period in 2011. The increase in pre-tax income was primarily due to the increased revenue discussed above partially offset by higher loss and LAE expenses of $4.7 million and higher operating expenses of $1.8 million. Our E&S Commercial business unit reported a $6.2 million increase in loss and LAE due primarily to increased premium production as well as higher current accident year loss trends. Our General Aviation business unit reported a $1.9 million decrease in loss and LAE due primarily to weather related losses during the three months ended June 30, 2011, as well as increased favorable prior year loss development of $2.7 million during the three months ended June 30, 2012 as compared to $2.1 million favorable development recognized during the second quarter of 2011, partially offset by higher current accident year loss trends. The increase in operating expenses for the three months ended June 30, 2012 were primarily the result of increased production related expenses of $1.5 million and increased salary and related expenses of $0.3 million.

The Specialty Commercial Segment reported a net loss ratio of 69.5% for the three months ended June 30, 2012 as compared to 72.5% for the same period during 2011. The gross loss ratio before reinsurance was 66.1% for the three months ended June 30, 2012 as compared to 68.8% for the same period in 2011. Our E&S Commercial business unit reported $2.6 million and $2.1 million of unfavorable prior years' loss development, respectively, for the three months ended June 30, 2012 and 2011. Our General Aviation business unit reported $2.7 million and $2.1 million of favorable prior years' loss development, respectively, for the three months ended June 30, 2012 and 2011.

Personal Segment

Net premiums written for our Personal Segment decreased $5.7 million during the second quarter of 2012 to $18.4 million compared to $24.1 million for the second quarter of 2011. The decrease in premium was due mostly to the impact of rate increases, the reduction of premium written in Florida and exiting certain other underperforming states and programs. Total revenue for the Personal Segment decreased 11% to $22.9 million for the second quarter of 2012 from $25.9 million for the second quarter of 2011. Lower earned premium of $2.8 million and lower finance charges of $0.2 million were the primary reason for the decrease in revenue for the period.

Pre-tax loss for the Personal Segment was $4.2 million for the three months ended June 30, 2012 as compared to pre-tax loss of $4.6 million for the same period of 2011. The decreased pre-tax loss was driven by decreased losses and LAE of $2.7 million and lower operating expenses of $0.7 million due mostly to decreased production related expense, partially offset by the lower revenue discussed above.

The Personal Segment reported a net loss ratio of 95.3% for the three months ended June 30, 2012 as compared to 95.2% for the second quarter of 2011. The loss ratio for the three months ended June 30, 2012 includes favorable current accident year loss trends in our non-standard auto line of business offset by increased weather and fire related losses in our low value dwelling/homeowners line of business. The loss and LAE during the three months ended June 30, 2012 and 2011 included $1.5 million of adverse prior year development. The Personal Segment reported a net expense ratio of 28.8% for the three months ended June 30, 2012 as compared to 27.7% for the second quarter of 2011. The increase in the expense ratio was due predominately to growth in headcount.

Corporate

Total revenue for Corporate decreased by $1.2 million for the three months ended June 30, 2012 as compared to the same period the prior year. This decrease in total revenue was due to lower net investment income of $0.5 million and lower net realized gains of $0.7 million for the three months ended June 30, 2012 as compared to the same period of the prior year.

Corporate pre-tax loss was $2.2 million for the three months ended June 30, 2012 as compared to $0.8 million pre-tax loss for the same period the prior year. The increase in pre-tax loss was the result of the decreased revenue discussed above and higher operating expenses of $0.2 million due primarily to an adjustment to the expected earn-out payable in conjunction with the acquisition of HNIC during the second quarter of 2011.

Six Months Ended June 30, 2012 as Compared to Six Months Ended June 30, 2011

The following is additional business segment information for the six months ended June 30, 2012 and 2011 (in thousands):

                       Hallmark Financial Services, Inc.

                           Consolidated Segment Data



                                                       Six Months Ended June 30, 2012
                                Standard        Specialty
                               Commercial       Commercial       Personal
                                Segment          Segment          Segment        Corporate       Consolidated

Gross premiums written        $     39,586     $    116,341     $    42,283               -     $      198,210
Ceded premiums written              (3,187 )        (24,563 )          (361 )             -            (28,111 )
Net premiums written                36,399           91,778          41,922               -            170,099
Change in unearned premiums         (2,930 )        (13,053 )         1,341               -            (14,642 )
Net premiums earned                 33,469           78,725          43,263               -            155,457

Total revenues                      36,030           83,439          47,336             752            167,557

Losses and loss adjustment
expenses                            26,777           51,295          37,948               -            116,020

Pre-tax income (loss), net
of non-controlling interest         (2,072 )          8,906          (5,402 )        (5,432 )           (4,000 )

Net loss ratio (1)                    80.0 %           65.2 %          87.7 %                             74.6 %
Net expense ratio (1)                 34.0 %           28.7 %          28.1 %                             30.5 %
Net combined ratio (1)               114.0 %           93.9 %         115.8 %                            105.1 %




                                                      Six Months Ended June 30, 2011
                                Standard        Specialty
                               Commercial       Commercial       Personal
                                Segment          Segment         Segment        Corporate       Consolidated

Gross premiums written        $     36,004     $     88,615     $   56,464               -     $      181,083
Ceded premiums written              (2,564 )        (18,597 )       (4,732 )             -            (25,893 )
Net premiums written                33,440           70,018         51,732               -            155,190
Change in unearned premiums         (2,187 )         (6,318 )       (4,994 )             -            (13,499 )
Net premiums earned                 31,253           63,700         46,738               -            141,691

Total revenues                      33,668           67,619         50,919           3,715            155,921

Losses and loss adjustment
expenses                            28,414           43,350         53,941               -            125,705

Pre-tax income (loss), net
of  non-controlling
interest                            (5,150 )          4,263        (17,804 )        (2,259 )          (20,950 )

Net loss ratio (1)                    90.9 %           68.1 %        115.4 %                             88.7 %
Net expense ratio (1)                 32.7 %           30.4 %         25.8 %                             31.2 %
Net combined ratio (1)               123.6 %           98.5 %        141.2 %                            119.9 %

(1) 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 for our business units that retain 100% of produced premium as total operating expenses for the unit offset by agency fee income divided by net premiums earned, each determined in accordance with GAAP. For the business units that do not retain 100% of the produced premium, the net expense ratio is calculated as underwriting expenses of the insurance company subsidiaries for the unit 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 $39.6 million for the six months ended June 30, 2012, which was $3.6 million, or 10%, more than the $36.0 million reported for the same period in 2011. Net premiums written were $36.4 million for the six months ended June 30, 2012 as compared to $33.4 million reported for the same period in 2011. The increase in premium volume was primarily due to the acquisition of our Workers Compensation business unit during the third quarter of 2011.

Total revenue for the Standard Commercial Segment of $36.0 million for the six months ended June 30, 2012 was $2.3 million more than the $33.7 million reported during the same period in 2011. This 7% increase in total revenue was mostly due to increased net premiums earned of $2.2 million due primarily to the acquisition of our Workers Compensation business unit during the third quarter of 2011, higher net investment income of $0.5 million, partially offset by an adverse profit share commission revenue adjustment of $0.1 million during the second quarter of 2012 related to unfavorable development on the treaty year beginning July 1, 2003 as compared to a $0.2 million favorable profit share commission adjustment during the same period the prior year.

Our Standard Commercial Segment reported a pre-tax loss of $2.1 million for the six months ended June 30, 2012 as compared to pre-tax loss of $5.2 million for the same period of 2011. Lower loss and LAE expenses of $1.6 million and increased revenue contributed to this decrease in pre-tax loss for the six months ended June 30, 2012. Partially offsetting the decline in pre-tax loss were higher operating expenses of $0.9 million primarily due to the acquisition of our Workers Compensation business unit during the third quarter of 2011.

The Standard Commercial Segment reported a net loss ratio of 80.0% for the six months ended June 30, 2012 as compared to 90.9% for the same period in 2011. The gross loss ratio before reinsurance for the six months ended June 30, 2012 was 79.3% as compared to the 92.3% reported for the same period of 2011. The lower gross and net loss ratios for the six months ended June 30, 2012 were aided by lower current accident year loss trends excluding catastrophe losses. The gross and net loss results for the six months ended June 30, 2012 and 2011 include $8.8 million and $6.7 million, respectively, of weather related losses. During the six months ended June 30, 2012 the Standard Commercial Segment reported favorable loss reserve development of $2.8 million, as compared to unfavorable development of $0.5 million for the same period during 2011.

Specialty Commercial Segment

The $83.4 million of total revenue for the Specialty Commercial Segment during the six months ended June 30, 2012 was $15.8 million higher than the $67.6 million reported for the same period in 2011. This increase in revenue was due to higher net premiums earned of $15.0 million due predominately to increased production in our E&S Commercial business unit, Excess & Umbrella business unit and a new space risk program entered into during the first quarter of 2011. Further contributing to this increased revenue was higher net investment income of $0.7 million.

Pre-tax income for the Specialty Commercial Segment of $8.9 million for the first six months of 2012 was $4.6 million higher than the $4.3 million reported for the same period in 2011. The increase in pre-tax income was primarily due to the increased revenue discussed above partially offset by higher loss and LAE expenses of $7.9 million and higher operating expenses of $3.3 million. Our E&S Commercial business unit reported a $9.6 million increase in loss and LAE due primarily to increased premium volume as well as higher current accident year loss trends. Our General Aviation business unit reported a $2.2 million decrease in loss and LAE due primarily to weather related losses during the six months ended June 30, 2011, as well as favorable prior year loss development of $2.7 million during the six months ended June 30, 2012 as compared to $2.1 million favorable development recognized during the same period the prior year, partially offset by higher current accident year loss trends. The increased . . .