Hallmark Financial Srvcs (HALL)

On October 6, 2006, the shares of Hallmark began trading under the ticker symbol "HALL" on NASDAQ. The company had begun operating as a publicly traded entity on September 19, 2005, with shares previously traded under the ticker symbol "HAF" on the American Stock Exchange. Formed in 1987, Hallmark Financial Services - headquartered in Fort Worth, Texas - initially operated a small chain of retail outlets specializing in financing for eyeglasses and contact lenses. The focus changed to insurance products following the 1990 acquisitions of American Hallmark Insurance Company (AHIC) and American Hallmark General Agency (AHGA). Today, the company has evolved into a holding company for a group of diversified property and casualty insurance subsidiaries that retain low-severity (low losses) and short-tailed risks (for one year only). The company's product structure focuses on marketing, distributing, underwriting, and servicing commercial and personal property and casualty insurance to underserved niche markets. The company provides commercial insurance in eight southern and western states (Texas, New Mexico, Idaho, Oregon, Montana, Louisiana, Oklahoma and Washington) non-standard personal automobile insurance in five western states (Texas, New Mexico, Arizona, Oklahoma and Idaho) and general aviation insurance in nearly every state (excluding Alaska, Massachusetts, and Washington D.C.), besides providing other insurance related services. On December 21, 2006, Hallmark Financial Services restructured its four operating units into three operating segments: Personal Insurance segment (which consists solely of the Phoenix Operating Unit), the Standard Commercial segment (which consists solely of the HGA Operating Unit), and the Commercial Specialty Segment (which is a combination of the TGA Operating Unit and the Aerospace Operating Unit).

Standard Commercial

Hallmark General Agency (HGA)

The unit specializes in small low-hazard commercial package business (general liability, property, auto, multi-peril, umbrella, fire, and theft) for small to medium businesses (such as office mercantile, light manufacturing, and artisan contractors). The main focus is on rural and suburban markets. This grouping typically has relatively stable loss results, with low severity and short-tailed liability.

The company focuses on the recruiting and the retaining of agents that closely match the company's culture. These agents are given a degree of non-contractual geographic exclusivity within which to operate. During 2007, 200 independent agents had a relationship with the company for nearly 19 years, with each agent accounting for more than $1.0 million in premium production. The top 10 agents accounted for 39% of the premium production (no agent produced more than 8% of the premium production for HGA). Of the 200 independent agents distributing HGA products, most are located in non-urban markets in Texas, New Mexico, Oregon, Idaho, Montana, and Washington.

Personal Insurance

Phoenix General Agency (PGA)

This segment provides liability coverage for drivers desiring the minimum automobile insurance mandated by state law. These policies are requested by individuals who typically do not conform to standard carrier underwriting guidelines, but not limited to driving record, age of driver, claims history, age of vehicle, or limited financial resources.

While this is a niche insurance line of business, non-standard personal automobile insurance is more of a commodity product than others in Hallmark's stable. National and larger regional players have benefited from back-office cost saves (i.e. centralized claims handling), advances in technology, and underwriting via multivariate modeling. The results are likely to create downward profitability pressures if somewhat irrational pricing were to seep into the market during the softer segments of the cycle.

However, given the potential for increased competition, we think the company would be proactive with respect to product evolution and take advantage of market opportunities to stave off at least some of the potential market pressure, vis- -vis add-on products or services that match its insured's needs. For example, with most non-standard automobile insurance purchasers, the client is typically unable to pay the whole premium initially. For them, PGA effectively offers a direct bill program ($3 9 per payment or installment).

This non-standard personal auto insurance is marketed and serviced by PGA through 1,640 independent agents in Texas, New Mexico, Arizona, Arkansas, Oklahoma, Oregon, and Idaho, with three main premium producing states (Texas, Arizona, and New Mexico). The company underwrites both personal automobile liability and physical damage insurance to the tune of 78% and 22%, respectively, of the total premium.

In December 2006, Hallmark's two operating segments (Texas General Agency and Aerospace Insurance Managers) were merged into one segment and renamed the Commercial Specialty Segment. During 2006, Texas General Agency accounted for approximately 80.7% of the aggregate premiums produced by the Commercial Specialty Segment, with the remaining 19.3% coming from the Aerospace operating unit.

Commercial Specialty Segment

Texas General Agency (TGA)

This segment predominately provides mono-line commercial automobile, excess and surplus insurance for general liability and property as well as some non-standard auto and low-value personal property products. Currently, policies are being issued in Texas, Louisiana, and Oklahoma. The major attributes for this low premium policy product stem from the defensive and profitability nature of this business line as the risks are short-tailed and low-hazard by nature. If a risk fails to meet the underwriting criteria for a standard market risk, the coverage would be written under an excess and surplus policy. Justification for writing a risk under this type of policy could be limited if a business entity had a limited number of years of operation, a defined minimum premium sized, or had an adverse loss history.

Nearly 97% of TGA's premiums come from commercial automobile and general liability coverage. Focus on Commercial Automobile risk is for the coverage of 10 or less vehicles used for business or light-to-medium service. Generally, these vehicles are used for short hauls of 200 miles or less (i.e. delivery services, artisans, cement mixers, and dump trucks). General liability coverage is for small business owners (i.e. apartments/retail dwellings, artisan contractors, convenience stores, restaurants, and sales and service entities). The remaining 3% of TGA's premiums comes from legacy personal lines products.

TGA distributes its products through 39 independent agents, in addition to the 730 retail agents in Texas. For FY07, 79% of TGA's total premium production is attributable to general agents, with the remainder coming from retail agents. During 2007, the top 10 general agents and top 10 retail agents produced 47% and 4% of the premiums, respectively. In addition, no single general agent or retail agent produced more than 9% or 1% of the total premiums, respectively.

Aerospace Insurance Managers (AIM)

Hall's AIM unit is one of only a handful of operations in the U.S. that has developed a niche focus of providing aircraft liability, aircraft hull, and airport liability covering smaller aircrafts, nonstandard aircrafts (such as Cherokee Six, a six-seat aircraft), older aircrafts, airports, non-standard pilots (retiring, new, or between crafts), and aviation-related business. AIM markets excess and surplus coverage through its affiliate Aerospace Special Risk Inc. and its claims management practice through Aerospace Claims Management Corp.

This unit's property-casualty insurance business is about a 60 40% mix, respectively, and is short-tailed. AIM currently has 10 underwriters with 3 40 years of aviation experience, including former pilots and air traffic controllers (i.e. a substantial intellectual property base upon which to draw). While the underwriters control the liability limits, about 99% of the business is restricted to $1.0 million per occurrence limit and $100,000 per person limit. About 80% of the covered aircrafts are single engine (about half with engines of 200 horsepower or less), with $127,869 in average hull value coverage and a modest $6,000 annual premium.

AIM distributes its products through 200 aviation specialty brokers (no binding authority) in 47 states. In FY07, the top 10 agencies produced 31% of AIM's premium production, and no broker produced more than 6% of the total premium volume.

Major Business Segments

Standard Commercial

Personal

Specialty Commercial

% 2007 Revenue

31.4%

21.2%

46.0%

% 2007 Pre-tax income

29.3%

18.3%

68.2%

HGA

PGA

TGA

AIM*

EXISTING MARKETS

TEXAS

X

X

X

X

LOUISIANA

X

X

OKLAHOMA

X

X

X

NEW MEXICO

X

X

X

ARIZONA

X

X

Potential Markets

Nevada

X

Utah

X

Wyoming

X

Colorado

X

EXISTING MARKETS

WASHINGTON

X

X

OREGON

X

X

IDAHO

X

X

X

Montana

X

X

* AIM currently operates throughout the U.S. with the exception of Alaska, Massachusetts, and the District of Columbia

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