8. 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 initially approved by the shareholders on May 26, 2005. There are 2,000,000 shares authorized for issuance under the 2005 LTIP. As of September 30, 2014, there were outstanding incentive stock options to purchase 1,010,594 shares of our common stock, non-qualified stock options to purchase 304,157 shares of our common stock and restricted stock units representing the right to receive up to 464,771 shares of our common stock. There are 202,504 shares reserved for future issuance under the 2005 LTIP. 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.

Stock Options:

Incentive stock options granted under the 2005 LTIP prior to 2009 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. Incentive stock options granted in 2009 and one grant of 5,000 incentive stock options in 2011 vest in equal annual increments on each of the first seven anniversary dates and terminate ten years from the date of grant. One grant of 25,000 incentive stock options in 2010 vests in equal annual increments on each of the first three anniversary dates and terminates ten years from the date of grant. Non-qualified stock options granted under the 2005 LTIP generally vest 100% six months after the date of grant and terminate ten years from the date of grant. One grant of 200,000 non-qualified stock options in 2009 vests in equal annual increments on each of the first seven anniversary dates and terminates ten years from the date of grant.

A summary of the status of our stock options as of and changes during the nine months ended September 30, 2014 is presented below:

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

Outstanding at January 1, 2014	1,387,489	$ 9.66
Granted	-
Exercised	(2,142)	$ 6.61
Forfeited or expired	(70,596)	$ 9.50
Outstanding at September 30, 2014	1,314,751	$ 9.67	3.5	$ 2,098
Exercisable at September 30, 2014	1,201,178	$ 9.96	3.4	$ 1,683

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,
	2014	2013	2014	2013

Intrinsic value of options exercised	$ -	$ -	$ 9	$ -

Cost of share-based payments (non-cash)	$ 35	$ 52	$ 133	$ 156

Income tax benefit of share-based
payments recognized in income	$ 8	$ 8	$ 23	$ 23

As of September 30, 2014, there was $262 thousand of total unrecognized compensation cost related to non-vested stock options granted under our plans, of which $43 thousand is expected to be recognized for the remainder of 2014, $171 thousand is expected to be recognized during 2015, $45 thousand is expected to be recognized in 2016 and $3 thousand is expected to be recognized in 2017.

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 the historical volatility of Hallmark’s and similar companies’ common stock for a period equal to the expected term. 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. Expected term is determined based on the simplified method as we do not have sufficient historical exercise data to provide a basis for estimating the expected term. There were no stock options granted during the first nine months of 2014 or 2013.

Restricted Stock Units:

The 2005 LTIP was amended by the stockholders on May 30, 2013 to authorize the grant of restricted stock units, in addition to the other types of awards available thereunder. Restricted stock units represent the right to receive shares of common stock upon the satisfaction of vesting requirements, performance criteria and other terms and conditions. On July 27, 2012 and April 10, 2013, an aggregate of 129,463 and 122,823 restricted stock units, respectively, were conditionally granted to certain employees of the Company subject to shareholder approval of the amendments to the 2005 LTIP at the May 30, 2013 shareholder meeting. One conditional grant of 9,280 restricted stock units was forfeited prior to approval at the shareholder meeting. Subsequently on September 8, 2014, an aggregate of 175,983 restricted stock units were granted to certain employees.

The performance criteria for all restricted stock units require that the Company achieve certain compound average annual growth rates in book value per share over the vesting period in order to receive shares of common stock in amounts ranging from 50% to 150% of the number of restricted stock units granted. In addition, certain restricted stock units contain an additional performance criteria related to the attainment of an average combined ratio percentage over the vesting period. If and to the extent specified performance criteria have been achieved, the restricted stock units granted on July 27, 2012 will vest on March 31, 2015, the restricted stock units granted on April 10, 2013 will vest on March 31, 2016, the restricted stock units granted on September 8, 2014 (except for one grant) will vest on March 31, 2017 and one grant of restricted stock units on September 8, 2014 will vest on March 31, 2018. Grantees of restricted stock units do not have any rights of a stockholder of the Company, and do not participate in any distributions to common stockholders of the Company until the award fully vests upon satisfaction of the vesting schedule, performance criteria and other conditions set forth in the grant agreement.

Compensation cost is measured as an amount equal to the fair value of the restricted stock units and is expensed over the vesting period if achievement of the performance criteria is deemed probable, with the amount of the expense recognized based on the Company’s best estimate of the ultimate achievement level. The grant date fair value of the restricted stock units granted in 2012 and 2013 is $9.20 per unit. The grant date fair value of the restricted stock units granted in 2014 is $9.66 per unit. The Company incurred a benefit to compensation expense of $170 thousand and $46 thousand related to the restricted stock units during the three and nine months ended September 30, 2014, respectively. The Company incurred compensation expense of $58 thousand and $89 thousand related to the restricted stock units during the three and nine months ended September 30, 2013, respectively. The Company recorded an income tax expense of $59 thousand and $16 thousand related to the restricted stock units during the three and nine months ended September 30, 2014, respectively. The Company recorded an income tax benefit of $20 thousand and $31 thousand related to the restricted stock units during the three and nine months ended September 30, 2013, respectively.

A summary of the status of our restricted stock units as of September 30, 2014 and changes during the nine months then ended is presented below:

	Number of
	Restricted
	Stock Units

Non-vested at January 1, 2014	236,851
Granted	175,983
Vested	-
Forfeited	(102,987)
Non-vested at September 30, 2014	309,847

As of September 30, 2014, there was $979 thousand of total unrecognized compensation cost related to non-vested restricted stock units granted under our 2005 LTIP, of which $95 thousand is expected to be recognized during the remainder of 2014, $352 thousand is expected to be recognized in 2015, $334 thousand is expected to be recognized in 2016, $169 thousand is expected to be recognized in 2017 and $29 thousand is expected to be recognized in 2018.