##### 









UNITED STATES SECURITIES AND EXCHANGE
COMMISSION


Washington, D.C. 20549


FORM 10-K

|           |  |                                                                                                 
|---------- |  | ------------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                                 
|þ          |  | ANNUAL REPORT PURSUANT TO SECTION 13 OR
    15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934    
|          
|           |  | For the fiscal year ended December 31,
    2003                                                 
|or        
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13
    OR 15(d)
    OF THE SECURITIES EXCHANGE ACT OF 1934
|          
|           |  | For the transition period
    from             to                                               

Commission File Number: 000-50360

DIRECT GENERAL CORPORATION

(Exact name of registrant as specified in its
charter)


|                                                                   |  |                                     
|------------------------------------------------------------------ |  | ------------------------------------
|Tennessee                                                          |  | 62-1564496                          
|(State or other jurisdiction of
    incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                                  
|1281 Murfreesboro Road,
    Nashville, TN                          |  | 37217                               
|(Address of principal
    executive offices)                       |  | (Zip Code)                          

(615) 399-0600

(Registrants telephone number, including
area code)


Securities registered pursuant to
Section 12(b) of the Act:

|                    |  |                                          
|------------------- |  | -----------------------------------------
|Title of each class |  | Name of each exchange on which registered
|None                |  | N/A                                      

Securities registered pursuant to
Section 12(g) of the Act:

Common stock, no par value


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 þ          No o

Indicate by check mark if disclosure of
delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be
contained, to the best of the registrants knowledge, in
definitive proxy or information statements incorporated by
reference in Part III of this Form 10-K or any amendment to
this
Form 10-K.     o

Indicate by check mark whether the registrant is
an accelerated filer (as defined in Rule 12b-2 of the
Act).     Yes o          No þ

The aggregate market value of the voting and
non-voting common equity held by non-affiliates of the
registrant as of the most recently completed third fiscal
quarter (quotation date of June 30, 2003), based on the
price at which the common equity was last sold on such date: $0.

Indicate the number of shares outstanding of each
of the issuers classes of common stock, as of the latest
practicable date: 21,588,055 shares of common stock, no par
value, at March 3, 2004.

DOCUMENTS INCORPORATED BY REFERENCE

All of the information called for by Part III of
this report is incorporated by reference to the Proxy Statement
for our 2004 Annual Meeting of Shareholders, which will be filed
with the Securities and Exchange Commission no later than
April 29, 2004.



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PART I

Item 1.  Business.

Direct General Corporation, headquartered in
Nashville, Tennessee, was incorporated in 1993 and completed the
initial public offering of its common stock in August 2003.
We are a financial services holding company whose principal
operating subsidiaries provide non-standard personal automobile
insurance, term life insurance, premium finance and other
consumer products and services through neighborhood sales
offices staffed primarily by employee-agents. Our operations are
concentrated in the southeastern part of the United States.

Our Business Model

Our model emphasizes the distribution of our
products and services through neighborhood sales offices staffed
by employee-agents as opposed to commissioned agents. Relative
to the independent agency distribution model relied upon by many
of our insurance competitors, our business model allows us to
generate significant revenue from sources other than premiums
from our core product, non-standard personal automobile
insurance. These additional revenues include premium finance
revenues, commissions from the sale of non-core insurance
products and other revenues, none of which entails insurance
underwriting risk. In the independent agency distribution model,
these additional revenues would typically be paid to an
unaffiliated premium finance company, independent agent, or
other third party.

Our Products and Services

Our core business involves issuing non-standard
personal automobile insurance policies. These policies, which
generally are issued for the minimum limits of coverage required
by state laws, provide coverage to drivers who cannot obtain
insurance from standard carriers due to a variety of factors,
including the lack of flexible payment plans, the failure to
maintain continuous coverage, age, prior accidents, driving
violations, occupation and type of vehicle.

Through our premium finance subsidiary, we
finance the majority of the insurance policies that we sell.
Premium finance involves making a loan to the customer backed by
the unearned portion of the insurance premiums being financed,
which is the portion of the loan attributable to future periods
of coverage. We offer our customers a variety of flexible
payment plans that allow for low down payments, which we believe
is a significant factor our customers consider when purchasing
insurance.

We offer a variety of other insurance products
designed to appeal to purchasers of our non-standard personal
automobile insurance policies, including term life insurance
currently offered through one of our wholly-owned life insurance
subsidiaries, as well as vehicle protection insurance, travel
protection insurance and hospital indemnity insurance
underwritten by unaffiliated insurers, for which we receive a
commission, but do not bear insurance underwriting risk. We are
exploring the possibility of offering additional insurance
products, such as renters, homeowners (including
mobile homeowners), motorcycle, boat and personal
watercraft policies. These additional insurance products may
either be underwritten by unaffiliated insurers, from which we
would receive a commission, or underwritten by us. The majority
of the underwriting risk with respect to the new products
underwritten by us is expected to be ceded to unaffiliated
reinsurers from which we would receive a ceding commission.

1



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The following table summarizes the components of
our gross revenues for the periods indicated.

|                                                                          |                        |                         |       |       |  |      |       |       |  |   |       |       | 
|------------------------------------------------------------------------- | ---------------------- | ----------------------- | ----- | ----- |  | ---- | ----- | ----- |  | - | ----- | ----- | 
|                                                                          |                        |                        
|                                                                          |                        | Year Ended December 31,
|                                                                          |                        |                        
|                                                                          |                        | 2003                    |       | 2002  |  | 2001
|                                                                          |                        |                         |       |       |  |     
|                                                                          |                        |                        
|                                                                          |                        | ($ in millions)        
|Gross premiums:                                                           |                        |                         |       |       |  |      |       |       |  |   |       |      
|Gross premiums written  automobile                                       |                        | $                       | 421.7 |       |  | $    | 327.6 |       |  | $ | 234.8 |      
|Gross premiums written  life                                             |                        |                         | 13.5  |       |  |      | 7.6   |       |  |   | 3.9   |      
|                                                                          |                        |                         |       |       |  |      |       |       |  |   |       |      
|                                                                          | Total gross premiums   |                         | $     | 435.2 |  |      | $     | 335.2 |  |   | $     | 238.7 | 
|                                                                          |                        |                         |       |       |  |      |       |       |  |   |       |      
|Ancillary income(1):                                                      |                        |                         |       |       |  |      |       |       |  |   |       |      
|Finance income                                                            |                        |                         | 44.9  |       |  |      | 35.7  |       |  |   | 27.3  |      
|Commission and service fee income                                         |                        |                         | 33.6  |       |  |      | 27.2  |       |  |   | 22.1  |      
|                                                                          |                        |                         |       |       |  |      |       |       |  |   |       |      
|                                                                          | Total ancillary income |                         |       | 78.5  |  |      |       | 62.9  |  |   |       | 49.4  | 
|                                                                          |                        |                         |       |       |  |      |       |       |  |   |       |      
|Net investment income including realized gains
    (losses) on securities |                        |                         | 10.1  |       |  |      | 5.2   |       |  |   | 7.3   |      
|                                                                          |                        |                         |       |       |  |      |       |       |  |   |       |      
|                                                                          | Gross revenues(2)      |                         | $     | 523.8 |  |      | $     | 403.3 |  |   | $     | 295.4 | 
|                                                                          |                        |                         |       |       |  |      |       |       |  |   |       |      



---



|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Ancillary income includes income derived from
    revenue sources that do not entail insurance underwriting risk.                                                                                                                                                                                                                                                                                                                                    
|   
|(2) | Gross revenues, which we consider to be a
    non-GAAP financial measure, is defined as gross premiums
    written, including direct premiums written and assumed premiums
    written, finance income, commission and service fee income, net
    investment income and net realized gains (losses) on
    securities. See Managements Discussion and Analysis
    of Financial Condition and Results of Operations 
    Measurement of Results.

Our Favorable Cost Structure

We emphasize the use of neighborhood sales
offices staffed by employee-agents as opposed to commissioned
agents, thereby replacing a variable operating cost structure
with a largely fixed operating cost structure. Our sales offices
staffed by company employees enable us to capture a significant
source of ancillary income that does not entail insurance
underwriting risk. Compared to companies operating under the
traditional non-standard automobile insurance business model,
where revenues from underwriting operations must cover the
operating costs, our ancillary income provides us with a
significant source of additional revenues.

We also rely on distribution relationships with
independent agencies, generally as a transitional step in the
acquisition of those agencies. We currently have a distribution
relationship with an independent agency in Texas, which
commenced in January 2003. We have an option to acquire
that Texas agency in December 2004. In pursuing our
strategy of expansion in selected states, since 1991 we have
acquired and integrated 11 independent insurance agencies with
over 170 sales offices in five states.

We seek to attract customers by developing strong
brand name recognition in our markets through our low-cost
television advertising campaigns that emphasize our low down
payments, flexible payment plans, convenient neighborhood
locations and customer service. Our television advertising
campaign is designed to generate telephone inquiries to our
neighborhood sales offices or our centralized call center where
indications of estimated premiums are given to prospective
customers, who are then directed to the nearest neighborhood
sales office.

Our neighborhood offices serve as a channel for
both product delivery and payment collection. Our widespread and
convenient local presence appeals to our customers, most of whom
would prefer to conduct business face to face rather than by
telephone or the Internet. All policy applications are completed
in the neighborhood sales offices, and most of our customers
revisit these offices at least monthly to make their periodic
payments.

2



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The following table summarizes our operating
costs and the percentage of such costs covered by ancillary
income for the periods indicated.

|                                                          |  |                         |      |      |  |      |      |   |  |   |      |  
|--------------------------------------------------------- |  | ----------------------- | ---- | ---- |  | ---- | ---- | - |  | - | ---- | -
|                                                          |  |                        
|                                                          |  | Year Ended December 31,
|                                                          |  |                        
|                                                          |  | 2003                    |      | 2002 |  | 2001
|                                                          |  |                         |      |      |  |     
|                                                          |  |                        
|                                                          |  | ($ in millions)        
|Ancillary income                                          |  | $                       | 78.5 |      |  | $    | 62.9 |   |  | $ | 49.4 |  
|                                                          |  |                         |      |      |  |      |      |   |  |   |      |  
|Operating expenses                                        |  |                         |      |      |  |      |      |   |  |   |      |  
|Selling, general and administrative costs                 |  | $                       | 74.5 |      |  | $    | 59.7 |   |  | $ | 53.9 |  
|Interest expense                                          |  |                         | 6.4  |      |  |      | 6.2  |   |  |   | 7.6  |  
|                                                          |  |                         |      |      |  |      |      |   |  |   |      |  
|Total operating expenses                                  |  | $                       | 80.9 |      |  | $    | 65.9 |   |  | $ | 61.5 |  
|                                                          |  |                         |      |      |  |      |      |   |  |   |      |  
|Ratio of ancillary income to total
    operating expenses |  |                         | 97.0 | %    |  |      | 95.4 | % |  |   | 80.3 | %

Our Strengths

We believe that our strengths provide a
foundation for profitable growth.



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                     
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Our integrated business modelenables us to better manage our
    business and capture a significant amount of premium finance
    revenues, term life insurance premiums, commissions from the
    sale of non-core insurance products and other revenues that
    would typically be paid, in an independent agency distribution
    model, to an unaffiliated premium finance company, independent
    agent or other third party.
|
| |  | Our broad sales office network,which emphasizes the use of
    employee-agents, is the cornerstone of our relationship with our
    customers, who typically would prefer to conduct business face
    to face than by telephone or on the Internet.                                                                                                                                                                                
|
| |  | Our premium finance operations,which support almost all of the
    policies that we sell, provide attractive payment plans for our
    policyholders and allow us to adjust payment plan structures to
    meet changes in market demands more quickly than most of our
    competitors.                                                                                                                                            
|
| |  | Our favorable cost structureenables us to leverage our largely
    fixed cost neighborhood sales offices staffed by company
    employees and reduce our marginal operating cost as we increase
    revenues.                                                                                                                                                                                                                       
|
| |  | Our ancillary revenues,including premium finance revenues,
    commissions from the sale of non-core insurance products and
    other revenues, none of which currently entails insurance
    underwriting risk, defray a significant amount of our operating
    expenses.                                                                                                                                                         
|
| |  | Our claims settlement philosophy and
    procedureshave been designed with a
    clear emphasis on controlling costs through the use of our
    employee-staffed claims operations.                                                                                                                                                                                                                                                 
|
| |  | Our controlled policy underwriting and pricingare supported by an integrated point
    of sale agency system and back office control system.                                                                                                                                                                                                                                                                                        
|
| |  | Strong name branding in our marketsresults from our extensive use of
    television advertising and the presence of our neighborhood
    sales offices throughout the states in which we operate.                                                                                                                                                                                                                                   

Our Future Growth

We intend to continue our growth primarily
through:



| |   |                                                                                                              
| | - | -------------------------------------------------------------------------------------------------------------
| |  | Increasing Revenues in Existing Markets.We are focused on increasing revenues
    in our existing markets by:



| |   |                                                                                            
| | - | -------------------------------------------------------------------------------------------
| |  | generating new customers through our advertising
    campaigns; and                        
|
| |  | increasing the sales of our non-core insurance
    and non-insurance products and services.

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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Expanding Our Product and Service Offerings.We intend to expand the range of
    non-core insurance and non-insurance products and services we
    offer.                                                                                                                                                                                                                                                                                                                                  
|
| |  | Expanding Our Distribution Network.We intend to expand into new states
    through acquisitions of local agencies and the opening of new
    sales offices. In January 2003, we began our expansion into
    Texas through an independent agency relationship that includes
    an option to acquire the agencys business in
    December 2004. We also intend to begin our expansion into
    Missouri during 2004 and Virginia during 2005 through the
    opening of new sales offices.

Our Market

The personal automobile insurance market is
comprised of preferred, standard and non-standard insurance
segments. The coverages offered by these segments generally
include liability (coverage for losses suffered by third
parties), physical damage, personal injury protection (no-fault)
and uninsured/underinsured motorist coverages. The non-standard
automobile insurance coverages, which are generally issued for
the minimum limits of coverage required by state laws, provide
coverage to drivers who cannot obtain insurance from standard
carriers due to a variety of factors, including lack of flexible
payment plans, the failure to maintain continuous coverage, age,
prior accidents, driving violations, occupation and type of
vehicle. In general, customers in the non-standard market have
higher average premiums for a comparable amount of coverage than
customers who qualify for the standard market. The higher
average premiums compared to the standard market generally
result from an increased frequency of losses, which is partially
offset by the lower severity of losses resulting from lower
limits of coverage. While there is no established
industry-recognized demarcation between non-standard and other
personal automobile insurance markets, based upon data compiled
from A.M. Best, we believe that, as of December 31, 2002,
the size of the non-standard automobile market segment in the
United States was approximately $30 billion representing
approximately 20% of the total personal automobile insurance
market.

In our experience, customers of the non-standard
segment generally consider four primary factors when purchasing
a personal automobile insurance policy:



| |   |                              
| | - | -----------------------------
| |  | down payment;                
|
| |  | payment frequency and amount;
|
| |  | total policy premium; and    
|
| |  | customer service.            

Our products, premium financing capabilities,
neighborhood accessibility, policyholder service, and claims
service are designed to meet the needs of our customers, in a
manner that recognizes and accommodates our customers
lifestyles and financial capabilities.

Our Competition

The non-standard automobile insurance business is
highly competitive. Since we emphasize sales of insurance
policies through neighborhood sales offices staffed by
employee-agents, we primarily compete against independent
agencies that market insurance on behalf of a number of
insurers. We compete with these other insurers based on factors
such as price, availability of flexible payment plans, customer
service, and claims service. Competition is also based on the
availability and quality of products, financial strength,
distribution systems and technical expertise.

Based upon data compiled from A.M. Best, we
believe that, as of December 31, 2002, ten insurance groups
accounted for approximately 70% of the approximately
$30 billion non-standard market segment. We believe that
our primary insurance company competition comes not only from
national companies or their subsidiaries, such as the
Progressive insurance group, the Allstate insurance group, the
Infinity insurance group, the State Farm insurance group, the
Berkshire Hathaway insurance group (including GEICO) and the
Bristol West insurance group, but also from non-standard
insurers and independent agents that operate in a specific
region or single state in which we operate. Based upon our
direct written premiums for 2002, we

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believe that, as of December 31, 2002, we
would be ranked 17th nationally and sixth in the nine states in
which we operated among non-standard automobile insurers, using
the 2002 market data compiled from A.M. Best.


Marketing and Distribution

Television advertising is our most heavily used
and, we believe, our most effective advertising medium for
reaching our customers. We believe that our local sales office
presence, along with our extensive television advertising,
allows us to generate strong brand name recognition in our
markets.

Television
Advertising.Our commercials are
frequently aired over all of our markets on network-affiliated
stations. As a result of our bulk purchase advertising, the
average 30-second television commercial is relatively
inexpensive. Additionally, we advertise in The Real Yellow
Pages®in selected markets. We believe that we have achieved
meaningful brand recognition in our markets, particularly
compared to other non-standard personal automobile insurers and
independent agencies.

Our advertisements present potential customers
with a local phone number, as well as a toll free number for our
customer service center in Baton Rouge, Louisiana, and encourage
the potential customer to call us for information. Indications
of estimated premiums are provided by our employee-agents in our
neighborhood sales offices or our representatives located in our
customer service center in Baton Rouge. Once the preliminary
estimates have been provided, prospective customers are directed
to the nearest neighborhood sales office where our
employee-agents assist in the completion of the policy
application, provide an explanation of coverages and policy
options, perform an inspection of the insured vehicle and
finalize the quote for the coverages selected. Employee-agents
then complete the premium finance agreement and collect all
amounts due under the policy or premium finance agreement.

Neighborhood Sales
Offices.Our neighborhood sales office
distribution system comprises offices that we have developed,
offices that we have obtained through strategic acquisitions of
agency operations, offices of an independent agency that we have
an option to purchase and a small number of offices of other
independent agents. Beginning in January 2003, we began
distributing the insurance product of an unaffiliated insurer in
Texas through an independent agency. We have an option to
acquire this agency in December 2004. Our strategy is to
place our sales offices in a strip mall on a major thoroughfare
in well-populated areas of cities and towns with a population of
at least 12,000. We currently lease almost all of our offices
subject to operating leases with terms ranging from one month to
three years.

We have grown, and we intend to continue to grow,
our business by expanding our neighborhood sales office network
through the acquisition of independent insurance agencies and
the opening of new neighborhood sales offices. The acquisition
of independent insurance agencies generally involves the
purchase of only the assets of the agency (including customer
lists, rights to the agency name and the exclusive right to
solicit the customer), and the assumption of certain agreed upon
liabilities (generally, office space and equipment leases). We
typically hire the employee-agents of the acquired agency and in
many cases hire key managers, as well. The acquisition purchase
price, which is based on an arms-length negotiation,
generally varies with the volume of non-standard personal
automobile insurance premiums produced by the agency over the
twelve months preceding the acquisition.

Since our inception, we have acquired the assets
of 11 independent insurance agencies using this model that
included over 170 neighborhood offices in five states. In
March 1998, we were presented with an opportunity to
acquire the assets of a Florida agency and its 64 neighborhood
sales offices in Florida for an aggregate purchase price of
$7.5 million which was our initial entry into the Florida
market. The primary purpose of our other acquisitions was to
increase our sales office network in both new and existing
states. In our initial expansion into Tennessee, we completed
five acquisitions in 1992 and one acquisition in 1993 of
relatively small agencies that contributed a total of 16 offices
for a total cost of approximately $2.2 million. Our initial
entrance into Louisiana in 1994 and 1995 was aided by two
acquisitions of Louisiana agencies that included a total of 30
offices for an aggregate purchase price of approximately
$1.5 million. In January 1999, we paid
$1.9 million for the assets of an independent agency that
included 23 offices in Tennessee, Kentucky and Georgia.
Additionally, in November 2003, we paid $13.8 million
for the assets of

5



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an independent agency that included 42 offices in
Florida. Because only a minimal amount of tangible assets was
acquired in these transactions, the majority of the purchase
price in all of these acquisitions was attributable to goodwill.
The portion of goodwill associated with these acquisitions was
$20.1 million at December 31, 2003.


We currently have an agreement with an
independent insurance agency network to produce business for us
in Texas. The agency network includes sales office locations
operated by employee-agents and under franchise agreements. We
have an option to acquire the assets of the Texas agency in
December 2004, including the option to acquire the rights
as franchisor in accordance with the franchise agreement.

We believe that our convenient neighborhood sales
office concept is an essential component of our business model.
Our licensed employee-agents have frequent direct contact with
our customers. This direct contact gives us an opportunity to
establish a personal relationship with the customer, who in our
experience generally prefers face-to-face interaction, and helps
us provide quality and efficient service. Our customers use
neighborhood sales offices not only to purchase automobile
insurance, but also as a convenient location to make their
periodic payments and purchase other insurance and non-insurance
products and services.

Employee-Agents.We
believe that our emphasis on the use of employee-agents has made
a significant contribution to the overall success of our
business model. At our neighborhood sales offices, our
employee-agents provide quotes on insurance premiums and payment
plan options, sell non-standard personal automobile insurance
policies and other insurance and ancillary products, process the
relevant forms, inspect the customers vehicle and collect
and process payments. Additionally, our agents provide other
customer support functions, such as contacting customers when
they are late on their payments or advising customers when their
policies are up for renewal. This level of personal interaction
with our customers helps us identify opportunities to provide
additional products and services.

Internet Sales.Through an independent agency, we have recently entered into an
arrangement that permits our personal automobile insurance
polices to be sold and premiums financed over the Internet. This
pilot program is limited to one state and will allow us to
analyze whether this method of distribution appeals to our
customer base.

Our Products and Services



| |                                               
| | ----------------------------------------------
| | Non-Standard Personal Automobile
    Insurance

Non-standard personal automobile insurance
policies constitute our core product. These policies, which
generally are issued for the minimum limits of coverage required
by state laws, provide coverage to drivers who cannot obtain
insurance from standard carriers due to a variety of factors,
including the lack of flexible payment plans, the failure to
maintain continuous coverage, age, prior accidents, driving
violations, occupation and type of vehicle. In general,
customers in the non-standard market have higher average
premiums for a comparable amount of coverage than customers who
qualify for the standard market. The higher average premiums
compared to the standard market generally result from an
increased frequency of losses, which is partially offset by the
lower severity of losses resulting from lower limits of coverage.

We believe that the majority of our customers do
not qualify for insurance from standard carriers because of
financial reasons, including the failure to maintain continuous
coverage. In 2003, over 75% of the drivers included under our
insurance policies had no points associated with moving
violations on their driving record at the time they purchased
their policy.

The following table provides a summary of gross
personal automobile insurance premiums written for the periods
indicated.

|                                    |  |                         |       |      |  |      |       |  |  |   |       | 
|----------------------------------- |  | ----------------------- | ----- | ---- |  | ---- | ----- |  |  | - | ----- | 
|                                    |  |                        
|                                    |  | Year Ended December 31,
|                                    |  |                        
|                                    |  | 2003                    |       | 2002 |  | 2001
|                                    |  |                         |       |      |  |     
|                                    |  |                        
|                                    |  | ($ in millions)        
|Gross premiums written  Automobile |  | $                       | 421.7 |      |  | $    | 327.6 |  |  | $ | 234.8 | 

6



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| |                                   
| | ----------------------------------
| | Individual Term Life
    Insurance

In 1999, we began offering our customers
individual term life insurance policies with $10,000 of coverage
through our life insurance subsidiary. These are basic, one-year
term policies that are guaranteed to be renewable for two
additional one-year periods. Underwriting for this product
generally consists of applicants answering certain health
related questions. This product is sold in our neighborhood
sales offices by our licensed employee-agents in each of the
states in which we operate with the exception of North Carolina,
where our life insurance company is not currently licensed, and
Texas. Our employee-agents presently receive a small commission
on the sale of this term life product.

On January 30, 2004, we acquired an inactive
life insurance company for a purchase price of
$7.3 million. The assets of this life insurance company
consist primarily of (i) licenses to conduct life and
accident and health insurance business in 43 states and the
District of Columbia and (ii) cash and debt securities with
an aggregate market value of approximately $6 million. We
acquired licenses to sell our life insurance product in North
Carolina, and in Texas, where we are currently expanding, and in
Missouri and Virginia where we intend to expand in the future.
We plan to start offering our term life insurance policies in
North Carolina through this newly-acquired life insurance
company during 2004 and will begin transferring our current life
insurance business in other states from our existing life
insurance company to the newly-acquired company. We may also use
this newly-acquired company to offer life insurance products in
other states where we may expand in the future.

The following table provides a summary of gross
term life insurance premiums written for the periods indicated.

|                              |  |                         |      |      |  |      |     |  |  |   |     | 
|----------------------------- |  | ----------------------- | ---- | ---- |  | ---- | --- |  |  | - | --- | 
|                              |  |                        
|                              |  | Year Ended December 31,
|                              |  |                        
|                              |  | 2003                    |      | 2002 |  | 2001
|                              |  |                         |      |      |  |     
|                              |  |                        
|                              |  | ($ in millions)        
|Gross premiums written  Life |  | $                       | 13.5 |      |  | $    | 7.6 |  |  | $ | 3.9 | 



| |                
| | ---------------
| | Premium Finance

In 2003, our premium finance subsidiary financed
the premiums on 94% of the insurance policies that we sold and
approximately 96% excluding the policies produced through the
Texas agency network which are one month term polices and are
not financed. Premium finance involves making a loan to the
customer that is backed by the unearned portion of the insurance
premiums being financed. We offer our customers a variety of
payment plans that allow for low down payments.

We believe that the amount of down payment and
the availability of flexible payment plans are two of the
primary factors that our customers consider when purchasing
non-standard personal automobile insurance. Down payment and
payment plans typically are offered by insurers and agents in
the form of either installment billing or premium financing
arrangements. Insurers typically use installment billing
arrangements to bill for the premium of a single policy.
Independent agents, who may offer policies from multiple
insurers, use premium financing to finance multiple policies
through one premium finance agreement. We have chosen to use
premium financing versus installment billing because we believe
it offers several advantages, including:



| |   |                                                                                         
| | - | ----------------------------------------------------------------------------------------
| |  | the ability to finance multiple policies through
    a single premium finance agreement,
|
| |  | returns comparable to or exceeding those of
    installment billing,                    
|
| |  | a greater flexibility of payment plan structure
    and down payment,                   
|
| |  | the ability to generate revenues in our
    non-insurance subsidiaries, and             
|
| |  | a more defined regulatory framework for financing
    premiums.                         

In a typical premium finance arrangement, the
premium finance company lends the amount of the premium (minus
the insureds down payment) to the insured and pays it to
the insurance company on behalf of the insured. The insured
makes periodic payments to the premium finance company over the
term of the finance agreement. Our payment plans and down
payments are developed giving considerations to expected

7



---



##### 



default rates and their timing and the amount of
the unearned portion of the insurance premiums being financed,
which backs the loan.


If the policy is cancelled before its term
expires, the policyholder has a right to receive a return of the
unearned premium. Under a premium finance agreement, the
policyholder assigns this right to the premium finance company
to secure his or her obligations under the loan. If the
policyholder fails to make a payment, the premium finance
company has the right to request the insurance company to cancel
the policy and pay to the premium finance company the amount of
any unearned premium on the policy. If the amount of unearned
premium exceeds the balance due on the loan plus any interest
and applicable fees owed by the policyholder to the premium
finance company, then the premium finance company returns the
excess amount to the policyholder in accordance with applicable
law.

The regulatory framework under which our premium
finance procedures are established is generally set forth in the
premium finance statutes of the states in which we operate.
Among other restrictions, the interest rate we may charge our
customers for financing their premiums is limited by these state
statutes. In Arkansas, which has not enacted legislation or
established premium finance regulations, we are generally
subject to the usury laws of that state that are applicable to
consumer loans. See Regulatory Environment 
Premium Finance Regulation for additional information
about state usury and other regulatory restrictions applicable
to our premium finance operations.

We strive to mitigate the risk of the
insureds default under the premium finance agreement by
designing payment plans that give consideration to the principal
amount of the loan that is outstanding and the unearned premium
backing the loan (as noted above) and by acting on a timely
basis to request cancellation of the policy if the policyholder
defaults on his or her obligation to repay the premium finance
loan. Our premium finance operations are integrated with our
sales office and insurance policy administration systems.
Because of the efficiencies derived from the integration of
these systems and the attractiveness of our payment plans, our
overall profitability is enhanced by our premium finance
operations.

The following table provides a summary of our
finance income for the periods indicated.

|               |  |                         |      |      |  |      |      |  |  |   |      | 
|-------------- |  | ----------------------- | ---- | ---- |  | ---- | ---- |  |  | - | ---- | 
|               |  |                        
|               |  | Year Ended December 31,
|               |  |                        
|               |  | 2003                    |      | 2002 |  | 2001
|               |  |                         |      |      |  |     
|               |  |                        
|               |  | ($ in millions)        
|Finance income |  | $                       | 44.9 |      |  | $    | 35.7 |  |  | $ | 27.3 | 



| |                                                             
| | ------------------------------------------------------------
| | Ancillary Insurance Products and
    Administrative Services

We also offer ancillary insurance products and
services designed to meet the needs of our customers. In doing
so, we take advantage of our largely fixed cost neighborhood
sales offices staffed by company employees to generate
commission income for us with minimal incremental cost. The
unaffiliated insurance companies that underwrite these products
bear the insurance risk associated with these policies. The
commission income generated from sales of these policies is a
revenue source that is not typically available to non-standard
personal automobile insurance companies that utilize the
independent agency business model.

The ancillary insurance products we currently
offer include vehicle protection, travel protection, and
hospital indemnity. These insurance policies generally provide
coverage and options that include reimbursement for medical
expenses and hospital room coverage as a result of injuries
sustained in automobile accidents, reimbursement for premiums
for bail bonds, ambulance assistance in the event of automobile
accidents, automobile rental reimbursement if the insured
vehicle is involved in an accident or is stolen and
reimbursement for personal effects losses caused by damage to
rented automobiles.

Our agency and administrative subsidiaries
produce and service non-standard personal automobile insurance
and ancillary insurance products for other insurers. We receive
administrative service fees for the agency, underwriting, policy
administration and claims adjusting services performed on behalf
of these unaffiliated insurers. Additionally, our insurance
subsidiaries generally assume a portion of the non-standard
personal automobile business, and in some cases assume the
entire premium and related insurance risk, through reinsurance
treaties.

8



---



##### 



The following table provides a summary of our
commission and service fee income generated from sales of
ancillary insurance products and the administration of products
on behalf of unaffiliated insurers for the periods indicated.

|                                  |  |                         |      |      |  |      |      |  |  |   |      | 
|--------------------------------- |  | ----------------------- | ---- | ---- |  | ---- | ---- |  |  | - | ---- | 
|                                  |  |                        
|                                  |  | Year Ended December 31,
|                                  |  |                        
|                                  |  | 2003                    |      | 2002 |  | 2001
|                                  |  |                         |      |      |  |     
|                                  |  |                        
|                                  |  | ($ in millions)        
|Commission and service fee income |  | $                       | 33.6 |      |  | $    | 27.2 |  |  | $ | 22.1 | 

We are exploring the possibility of offering
additional insurance products, such as renters,
homeowners (including mobile homeowners),
motorcycle, boat and personal watercraft policies. These
additional insurance products may either be underwritten by
unaffiliated insurers, from which we would receive a commission,
or underwritten by us, with the majority of the underwriting
risk expected to be ceded to unaffiliated reinsurers from which
we would receive a ceding commission.

We have also been studying the feasibility of
providing other administrative services to third party insurers.
Such administrative services could include managing general
agency, underwriting and accounting services, reinsurance
consulting and other management services provided for a fee to a
risk retention group that would provide excess liability stop
loss insurance to members of the group. The fees or commissions
we might generate from these services would not involve the
assumption by us of any insurance underwriting risk. We are
considering providing these other administrative services
through our existing subsidiaries or a new subsidiary. Any new
subsidiary may either be wholly owned by us or majority owned by
us, in which case third party investors would own the remaining
equity interests in the new subsidiary.



| |                            
| | ---------------------------
| | Other Products and Services

We offer other non-insurance products and
services designed to appeal to our customers. Our intention is
to continue to expand the number of insurance and non-insurance
products and services offered to our existing customers and to
attract new customers to our neighborhood sales offices. We
anticipate that the additional flow of potential customers will
provide us with the increased opportunity to sell our core
product and generate additional revenue streams that further
leverage our largely fixed cost distribution system. Revenues
from sales of our other non-insurance products and services have
not been meaningful to date.

The non-insurance consumer products and services
we currently offer include prepaid cellular telephones, prepaid
local telephone and long distance phone services. We typically
receive commissions and fees from unaffiliated third party
vendors for the sale of these products and services. In
July 2003, we hired a senior officer for our consumer
products subsidiary who has extensive experience in retail sales
and marketing. We have begun to study the feasibility of
offering a variety of consumer retail products and consumer
financial services, including pre-paid debit cards and
short-term consumer loans, which we believe will appeal to our
customers. We currently plan to introduce a pre-paid debit card
at selected offices in the second quarter of 2004 and anticipate
that additional products and services may be test marketed in
selected sales offices as early as the third quarter of 2004.

Underwriting and Pricing

Non-Standard Personal Automobile
Insurance.We strive to diligently
price and closely control the underwriting standards for our
non-standard personal automobile insurance policies that we
sell. We generally do not sell personal automobile insurance
policies to persons whom we deem to have an excessive number of
points on their driving record. Our underwriting and rating
systems are fully automated, including on-line driving records
and on-line credit scoring in some of the states in which we
operate. We believe that our automated underwriting and pricing
controls provide a significant competitive advantage to us,
because these controls give us the ability to capture relevant
pricing information, improve efficiencies, increase the accuracy
and consistency of underwriting decisions and reduce training
costs. Our controls can be changed easily on a state-by-state
basis to reflect new rates and underwriting guidelines necessary
to compete effectively in our markets.

9



---



##### 



We set premium rates based on specific type of
vehicle, garage location and the drivers age, gender,
marital status, driving experience and location. Currently, we
use credit scoring as an additional rating factor in Kentucky
and South Carolina. We seek to maintain competitive, but
adequate, rates to attract responsible drivers in our
non-standard market. We review loss trends in every state on a
quarterly basis to identify changes in frequency and severity,
and to assess the adequacy of our rates and underwriting
standards. We are committed to maintaining discipline in our
pricing by adjusting rates, as necessary, to maintain or improve
profit margins in each market.

Individual Term Life
Insurance.Our underwriting of
individual term life insurance polices is limited, due to the
face amount of the policies being $10,000. Applicants are
required to provide proof of age and answer six questions that
are designed to determine the possible existence of serious
health conditions. Our guidelines prohibit issuance of a term
life insurance policy to any applicant that currently has any of
the conditions mentioned in the underwriting questions.

Claims Handling

We believe that one of the most significant keys
to our success is our disciplined focus on controlling the
claims process and claims costs. Since non-standard personal
automobile insurance customers generally have a higher frequency
of claims than preferred and standard insurance customers, it is
important that we successfully manage the claims process and
claims costs to limit our losses. The entire claims process is
managed by our in-house claims operation. By controlling this
process, rather than having all or parts of it outsourced to
third parties, we can quickly assess claims, identify loss
trends early and manage against fraud. We can also readily
capture information that is useful in establishing loss reserves
and determining premium rates. We believe that our claims
process is designed to promote expedient, fair and consistent
claims handling, while controlling loss adjustment expenses.

As of January 31, 2004, our claims operation
had a staff of approximately 500 employees, including adjusters,
appraisers, re-inspectors, special investigators and claims
administrative personnel. We conduct our claims operations out
of two major regional claims centers and three smaller regional
centers. Our employees handle all claims from the initial report
of the claim until the final settlement. The regional claims
offices are assigned geographic service areas with enough
flexibility for any office to handle claims from other areas, as
claims volume, workloads and available staff require. We believe
that our in-house employment of salaried claims personnel,
including appraisers and adjusters, and our control of the
entire claims process result in a reduction of our ultimate loss
payments, lower loss adjustment expenses and improved customer
service.

All of our claims personnel are hired and trained
in our in-house training program regardless of previous
experience. In addition to initial training, we support
continuing education of seasoned claims staff to ensure that
they are up to date in all of the newest claims processes, fraud
detection and legislative and litigation issues. In addition to
other qualifications, our field and re-inspection appraisers
typically have obtained hands-on experience with automobile body
and mechanical repair before we employ them.

While we are strongly committed to promptly and
fairly settling the meritorious claims of our customers and
claimants, we are equally committed to defending against
non-meritorious claims. Litigated claims and lawsuits are
primarily managed by one of our specially trained litigation
adjusters. Suspicious claims are referred to our special
investigation unit, which we refer to as our SIU. Our SIU
routinely investigates claims reflecting repetitive fact
patterns or other unusual circumstances. Our SIU has been
involved with investigations, assisting local authorities in
combating fraud, organized crime and fraud rings in the states
in which we conduct business.

We seek to minimize our claims litigation defense
costs by attempting to negotiate flat-fee representation with
outside counsel specializing in automobile insurance claim
defense. Generally, the fee covers all activity from opening a
litigation file through final disposition of the case. We
believe that our efforts to obtain high quality claims defense
litigation services at a fixed or carefully controlled cost have
helped us control claims losses and expenses.

10



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##### 



Loss and Loss Adjustment Expense
Reserves

Automobile accidents generally result in
insurance companies paying amounts to individuals or companies
resulting from physical damage to an automobile or other
property and an injury to a person. Months and sometimes years
may elapse between the occurrence of an accident, reporting of
the accident to the insurer and payment of the claim. Insurers
record a liability for estimates of losses that will be paid for
accidents reported to it, which we refer to as case reserves. In
addition, since accidents are not always reported promptly upon
the occurrence, insurers estimate liabilities for accidents that
have occurred but have not been reported to the insurer, which
we refer to as incurred but not reported or IBNR reserves.

We are directly liable for loss and loss
adjustment expenses under the terms of the insurance policies
underwritten by our insurance subsidiaries. Each of our
insurance subsidiaries establishes a reserve for all unpaid
losses and loss adjustment expenses, which we occasionally refer
to as LAE, including case and IBNR reserves and estimates for
the cost to settle the claims. We rely primarily on historical
loss experience in determining reserve levels, on the assumption
that historical loss experience provides a good indication of
future loss experience. We also give consideration to various
factors, such as inflation, historical claims, settlement
patterns, legislative activity and litigation trends. We
continually monitor these estimates and, if necessary, increase
or decrease the level of our reserves as experience develops or
new information becomes known.

We believe that the liabilities that we have
recorded for unpaid losses and loss adjustment expenses are
adequate to cover the ultimate net cost of losses and loss
adjustment expenses incurred to date. We periodically review our
methods of establishing case and IBNR reserves and update our
estimates. Our actuarial staff performs quarterly comprehensive
reviews of reserves and loss trends. In addition, Ernst &
Young LLP, our independent consulting actuary, provides
certification of our reserves at each year end.

The following table presents development
information on changes in reserves for losses and loss
adjustment expenses of our insurance subsidiaries for the
periods indicated.

|                                                                |                |                         |       |       |  |      |       |       |   |   |      |      | 
|--------------------------------------------------------------- | -------------- | ----------------------- | ----- | ----- |  | ---- | ----- | ----- | - | - | ---- | ---- | 
|                                                                |                |                        
|                                                                |                | Year Ended December 31,
|                                                                |                |                        
|                                                                |                | 2003                    |       | 2002  |  | 2001
|                                                                |                |                         |       |       |  |     
|                                                                |                |                        
|                                                                |                | ($ in millions)        
|Balance at beginning of period                                  |                | $                       | 86.9  |       |  | $    | 77.5  |       |   | $ | 74.0 |     
|Less reinsurance recoverables on
    unpaid losses              |                |                         | 29.0  |       |  |      | 40.5  |       |   |   | 39.5 |     
|                                                                |                |                         |       |       |  |      |       |       |   |   |      |     
|Net balance at beginning of period                              |                |                         | 57.9  |       |  |      | 37.0  |       |   |   | 34.5 |     
|Losses and LAE incurred, net of reinsurance
    related to:     |                |                         |       |       |  |      |       |       |   |   |      |     
|                                                                | Current period |                         |       | 168.1 |  |      |       | 106.1 |   |   |      | 86.1 | 
|                                                                | Prior period   |                         |       | .1    |  |      |       | (5.5  | ) |   |      | 7.8  | 
|                                                                |                |                         |       |       |  |      |       |       |   |   |      |     
|Net losses and LAE incurred during the
    current year         |                |                         | 168.2 |       |  |      | 100.6 |       |   |   | 93.9 |     
|                                                                |                |                         |       |       |  |      |       |       |   |   |      |     
|Deduct losses and LAE paid, net of reinsurance,
    related to: |                |                         |       |       |  |      |       |       |   |   |      |     
|                                                                | Current period |                         |       | 107.6 |  |      |       | 66.6  |   |   |      | 60.2 | 
|                                                                | Prior period   |                         |       | 43.8  |  |      |       | 13.1  |   |   |      | 31.2 | 
|                                                                |                |                         |       |       |  |      |       |       |   |   |      |     
|Net claim payments made during the
    current period           |                |                         | 151.4 |       |  |      | 79.7  |       |   |   | 91.4 |     
|                                                                |                |                         |       |       |  |      |       |       |   |   |      |     
|Net balance at end of period                                    |                |                         | 74.7  |       |  |      | 57.9  |       |   |   | 37.0 |     
|Plus reinsurance recoverables on
    unpaid losses              |                |                         | 37.9  |       |  |      | 29.0  |       |   |   | 40.5 |     
|                                                                |                |                         |       |       |  |      |       |       |   |   |      |     
|Balance at end of period                                        |                | $                       | 112.6 |       |  | $    | 86.9  |       |   | $ | 77.5 |     
|                                                                |                |                         |       |       |  |      |       |       |   |   |      |     

Net loss and LAE incurred included the impact of
minimal unfavorable development in 2003 of $0.1 million,
favorable development in 2002 of $5.5 million that included
$1.8 million related to the commutation of certain
reinsurance contracts, and unfavorable development of
$7.8 million in 2001 that included $6.5 million
relating to the write-off of reinsurance recoverables from
Reliance Insurance Company.

11



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##### 



The remaining favorable and unfavorable
development is primarily a result of changes in frequency and
severity trends.


The portion of net losses and LAE paid during
2002 that related to prior periods was lower than other periods
because the payment of $13.1 million was net of
$10.5 million of reinsurance payments received in
conjunction with the commutation of a reinsurers
obligation for unpaid losses and $7.4 million of
reinsurance payments received in conjunction with the
commutation of our stop loss reinsurance agreement.

The table provided after the following paragraph
presents the development of reserves, net of reinsurance, from
1993 through 2003. The top line of the table presents the
reserves at the balance sheet date for each of the years
indicated. This represents the estimated amounts of losses and
loss adjustment expenses for claims arising in all years that
were unpaid at the balance sheet date, including losses that had
been incurred but not yet reported to us. The upper portion of
the table presents the cumulative amounts paid as of the end of
each successive year with respect to those claims. The lower
portion of the table presents the re-estimated amount of the
previously recorded reserves based on experience as of the end
of each succeeding year, including cumulative payments made
since the end of the respective year. The estimate changes, as
more information becomes known about the payments, frequency and
severity of claims for individual years. Favorable loss
development, shown as a cumulative redundancy in the table,
exists when the original reserve estimate is greater than the
re-estimated reserves. Information with respect to the
cumulative development of gross reserves (that is, without
deduction for reinsurance ceded) also appears at the bottom
portion of the table.

In evaluating the information in the table
provided below, you should note that each amount entered
incorporates the cumulative effects of all changes in amounts
entered for prior periods. You should also note that the table
does not present accident or policy year development data. In
addition, conditions and trends that have affected the
development of liability in the past may not necessarily recur
in the future. The net cumulative deficiency of
$5.4 million in 1999 and $9.3 million in 2000 included
approximately $0.9 million

12



---



##### 



and $6.5 million, respectively, related to the
write-off of reinsurance recoverables from Reliance Insurance
Company.


|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|---------------------------------------------------- |  | ------------------ | ---- | ---- |  | ---- | ---- | ---- |  | ---- | ---- | ---- |  | ---- | ---- | ---- |  | ---- | ---- | ---- |  | ---- | ---- | - |  | - | ---- |  |  | - | ---- |  |  | - | ---- | - |  | - | ---- |  |  | - | ----- | 
|                                                     |  |                   
|                                                     |  | As of December 31,
|                                                     |  |                   
|                                                     |  | 1993               |      | 1994 |  | 1995 |      | 1996 |  | 1997 |      | 1998 |  | 1999 |      | 2000 |  | 2001 |      | 2002 |  | 2003
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |     
|                                                     |  |                   
|                                                     |  | ($ in millions)   
|Reserves for losses and loss adjustment
    expense: |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Originally estimated                                 |  | $                  | 5.2  |      |  | $    | 12.9 |      |  | $    | 16.8 |      |  | $    | 16.0 |      |  | $    | 18.4 |      |  | $    | 31.4 |   |  | $ | 33.9 |  |  | $ | 34.5 |  |  | $ | 37.0 |   |  | $ | 57.9 |  |  | $ | 74.7  | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Cumulative amounts paid as of:                       |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|One year later                                       |  |                    | 3.6  |      |  |      | 8.6  |      |  |      | 10.1 |      |  |      | 9.7  |      |  |      | 9.7  |      |  |      | 18.4 |   |  |   | 25.0 |  |  |   | 31.2 |  |  |   | 13.1 |   |  |   | 43.8 |  |  |   |       | 
|Two years later                                      |  |                    | 4.6  |      |  |      | 10.9 |      |  |      | 13.3 |      |  |      | 12.4 |      |  |      | 12.2 |      |  |      | 24.8 |   |  |   | 33.7 |  |  |   | 35.3 |  |  |   | 26.9 |   |  |   |      |  |  |   |       | 
|Three years later                                    |  |                    | 5.3  |      |  |      | 12.0 |      |  |      | 14.3 |      |  |      | 13.2 |      |  |      | 13.7 |      |  |      | 27.6 |   |  |   | 36.1 |  |  |   | 41.3 |  |  |   |      |   |  |   |      |  |  |   |       | 
|Four years later                                     |  |                    | 5.5  |      |  |      | 12.2 |      |  |      | 14.6 |      |  |      | 13.7 |      |  |      | 14.4 |      |  |      | 28.7 |   |  |   | 38.4 |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Five years later                                     |  |                    | 5.6  |      |  |      | 12.3 |      |  |      | 14.9 |      |  |      | 13.9 |      |  |      | 14.7 |      |  |      | 29.3 |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Six years later                                      |  |                    | 5.6  |      |  |      | 12.4 |      |  |      | 15.0 |      |  |      | 14.0 |      |  |      | 14.8 |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Seven years later                                    |  |                    | 5.6  |      |  |      | 12.5 |      |  |      | 15.0 |      |  |      | 14.1 |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Eight years later                                    |  |                    | 5.6  |      |  |      | 12.5 |      |  |      | 15.1 |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Nine years later                                     |  |                    | 5.6  |      |  |      | 12.5 |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Ten years later                                      |  |                    | 5.6  |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Reserves re-estimated as of:                         |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|One year later                                       |  |                    | 6.1  |      |  |      | 13.4 |      |  |      | 15.9 |      |  |      | 15.7 |      |  |      | 16.6 |      |  |      | 29.1 |   |  |   | 36.2 |  |  |   | 43.1 |  |  |   | 31.5 |   |  |   | 58.0 |  |  |   |       | 
|Two years later                                      |  |                    | 5.8  |      |  |      | 13.3 |      |  |      | 16.2 |      |  |      | 15.6 |      |  |      | 15.6 |      |  |      | 28.8 |   |  |   | 38.3 |  |  |   | 42.7 |  |  |   | 33.6 |   |  |   |      |  |  |   |       | 
|Three years later                                    |  |                    | 5.9  |      |  |      | 13.2 |      |  |      | 16.0 |      |  |      | 14.9 |      |  |      | 15.3 |      |  |      | 29.4 |   |  |   | 38.7 |  |  |   | 43.8 |  |  |   |      |   |  |   |      |  |  |   |       | 
|Four years later                                     |  |                    | 5.8  |      |  |      | 12.9 |      |  |      | 15.5 |      |  |      | 14.6 |      |  |      | 15.1 |      |  |      | 29.5 |   |  |   | 39.3 |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Five years later                                     |  |                    | 5.8  |      |  |      | 12.8 |      |  |      | 15.3 |      |  |      | 14.3 |      |  |      | 14.8 |      |  |      | 29.7 |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Six years later                                      |  |                    | 5.7  |      |  |      | 12.6 |      |  |      | 15.2 |      |  |      | 14.1 |      |  |      | 14.9 |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Seven years later                                    |  |                    | 5.7  |      |  |      | 12.5 |      |  |      | 15.0 |      |  |      | 14.1 |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Eight years later                                    |  |                    | 5.6  |      |  |      | 12.5 |      |  |      | 15.1 |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Nine years later                                     |  |                    | 5.6  |      |  |      | 12.5 |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Ten years later                                      |  |                    | 5.6  |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Cumulative deficiency/(redundancy):                  |  | $                  | 0.4  |      |  | $    | (0.4 | )    |  | $    | (1.7 | )    |  | $    | (1.9 | )    |  | $    | (3.5 | )    |  | $    | (1.7 | ) |  | $ | 5.4  |  |  | $ | 9.3  |  |  | $ | (3.4 | ) |  | $ | 0.1  |  |  |   |       | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Gross liability  originally estimated               |  | $                  | 12.5 |      |  | $    | 21.0 |      |  | $    | 23.1 |      |  | $    | 21.0 |      |  | $    | 25.7 |      |  | $    | 39.9 |   |  | $ | 53.2 |  |  | $ | 74.0 |  |  | $ | 77.5 |   |  | $ | 86.9 |  |  | $ | 112.6 | 
|Reinsurance recoverables                             |  |                    | 7.3  |      |  |      | 8.1  |      |  |      | 6.3  |      |  |      | 5.0  |      |  |      | 7.3  |      |  |      | 8.5  |   |  |   | 19.3 |  |  |   | 39.5 |  |  |   | 40.5 |   |  |   | 29.0 |  |  |   | 37.9  | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Net liability  originally estimated                 |  | $                  | 5.2  |      |  | $    | 12.9 |      |  | $    | 16.8 |      |  | $    | 16.0 |      |  | $    | 18.4 |      |  | $    | 31.4 |   |  | $ | 33.9 |  |  | $ | 34.5 |  |  | $ | 37.0 |   |  | $ | 57.9 |  |  | $ | 74.7  | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Gross estimated liability  latest                   |  | $                  | 15.3 |      |  | $    | 19.8 |      |  | $    | 20.6 |      |  | $    | 18.3 |      |  | $    | 21.9 |      |  | $    | 38.1 |   |  | $ | 62.2 |  |  | $ | 82.0 |  |  | $ | 79.0 |   |  | $ | 87.6 |  |  | $ | 112.6 | 
|Reinsurance recoverables  latest                    |  |                    | 9.7  |      |  |      | 7.3  |      |  |      | 5.5  |      |  |      | 4.2  |      |  |      | 7.0  |      |  |      | 8.4  |   |  |   | 22.9 |  |  |   | 38.2 |  |  |   | 45.4 |   |  |   | 29.6 |  |  |   | 37.9  | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Net estimated liability  as
    of 2003             |  | $                  | 5.6  |      |  | $    | 12.5 |      |  | $    | 15.1 |      |  | $    | 14.1 |      |  | $    | 14.9 |      |  | $    | 29.7 |   |  | $ | 39.3 |  |  | $ | 43.8 |  |  | $ | 33.6 |   |  | $ | 58.0 |  |  | $ | 74.7  | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Gross cumulative deficiency/(redundancy)             |  | $                  | 2.8  |      |  | $    | (1.2 | )    |  | $    | (2.5 | )    |  | $    | (2.7 | )    |  | $    | (3.8 | )    |  | $    | (1.8 | ) |  | $ | 9.0  |  |  | $ | 8.0  |  |  | $ | 1.5  |   |  | $ | 0.7  |  |  |   |       | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 
|Net cumulative deficiency/(redundancy)               |  | $                  | 0.4  |      |  | $    | (0.4 | )    |  | $    | (1.7 | )    |  | $    | (1.9 | )    |  | $    | (3.5 | )    |  | $    | (1.7 | ) |  | $ | 5.4  |  |  | $ | 9.3  |  |  | $ | (3.4 | ) |  | $ | 0.1  |  |  |   |       | 
|                                                     |  |                    |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |      |  |      |      |   |  |   |      |  |  |   |      |  |  |   |      |   |  |   |      |  |  |   |       | 

Reinsurance



| |        
| | -------
| | Summary

Reinsurance refers to an arrangement in which a
company called a reinsurer agrees in a contract (often referred
to as a treaty) to assume specified risks written by an
insurance company (known as a ceding company) by paying the
insurance company all or a portion of the insurance
companys losses arising under specified classes of
insurance policies. Insurance companies like us use reinsurance
to reduce their exposures, to increase their underwriting
capacity and to manage their capital more efficiently, among
other reasons. We have historically relied on various quota
share and excess of loss reinsurance treaties to maintain our
exposure to loss at or below a level that is within the capacity
of our capital resources to handle. In quota share reinsurance,
the reinsurer agrees to assume a specified percentage of the
ceding companys losses arising out of a defined class of
business (for example, 50% of all losses arising from
non-standard automobile insurance written in a particular state
in a particular year), in exchange for a corresponding
percentage of premium. In excess of loss reinsurance, the
reinsurer agrees to assume all or a portion of the ceding
companys losses, in excess of a specified amount (called
the attachment point or the ceding companys retention),
arising out of a defined class of business (for example, 80% of
all losses in excess of $50 million, or all losses in
excess of

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$50,000 per policy, arising from non-standard
auto insurance written in a particular state in a particular
year). In excess of loss reinsurance, the premium payable to the
reinsurer is negotiated by the parties based on their assessment
of the amount of risk being ceded to the reinsurer because the
reinsurer does not share proportionately in the ceding
companys loss.


Historically, we have ceded a portion of our
non-standard automobile insurance premiums and losses to
unaffiliated reinsurers in accordance with these contracts.
However, we have not ceded any portion of our life insurance
premiums and losses to reinsurers since the life premium volume
is relatively low. Ceded premiums written were equal to 32.2%,
46.0% and 52.7% of our gross premiums written for the years
ended December 31, 2003, 2002 and 2001, respectively.
Increases to our statutory surplus in 2002 and 2003 enabled us
to retain more of the business we underwrote and reduced our use
of quota share reinsurance. In addition to quota share, we cede
all of the premiums and losses associated with policies written
for coverage limits in excess of the state required minimum
coverages. Only a minimal amount of our non-standard automobile
policies are written at these higher limits. We also maintain
catastrophe excess of loss reinsurance that provides coverage
for losses up to $15 million, less our retention of 100% of
the first $2 million of losses and 2.5% of the losses
covered under this reinsurance arrangement in order to limit our
exposure to losses from a single catastrophic event such as a
hurricane, earthquake, or hailstorm.

The following amounts are reflected in our
financial statements as a result of reinsurance arrangements:

|                 |              |                         |        |        |  |                 |        |        |  |         |        |        |  |   |        |       |  |   |        |       |  |   |        |      | 
|---------------- | ------------ | ----------------------- | ------ | ------ |  | --------------- | ------ | ------ |  | ------- | ------ | ------ |  | - | ------ | ----- |  | - | ------ | ----- |  | - | ------ | ---- | 
|                 |              |                        
|                 |              | Year Ended December 31,
|                 |              |                        
|                 |              |                         |        |        |  |                
|                 |              | 2003                    |        | 2002   |  | 2001           
|                 |              |                         |        |        |  |                
|                 |              | Written                 |        | Earned |  | Written         |        | Earned |  | Written |        | Earned
|                 |              |                         |        |        |  |                 |        |        |  |         |        |       
|                 |              |                         |        |        |  |                 |        |        |  |        
|                 |              |                         |        |        |  | ($ in millions) |        |        |  |        
|Direct premiums  |              | $                       | 410.0  |        |  | $               | 370.9  |        |  | $       | 326.6  |        |  | $ | 276.1  |       |  | $ | 229.8  |       |  | $ | 200.8  |     
|Assumed premiums |              |                         | 25.2   |        |  |                 | 24.0   |        |  |         | 8.6    |        |  |   | 8.2    |       |  |   | 8.9    |       |  |   | 6.4    |     
|                 |              |                         |        |        |  |                 |        |        |  |         |        |        |  |   |        |       |  |   |        |       |  |   |        |     
|Gross premiums   |              |                         | 435.2  |        |  |                 | 394.9  |        |  |         | 335.2  |        |  |   | 284.3  |       |  |   | 238.7  |       |  |   | 207.2  |     
|Ceded premiums   |              |                         | (140.1 | )      |  |                 | (166.4 | )      |  |         | (154.2 | )      |  |   | (139.3 | )     |  |   | (125.8 | )     |  |   | (109.2 | )   
|                 |              |                         |        |        |  |                 |        |        |  |         |        |        |  |   |        |       |  |   |        |       |  |   |        |     
|                 | Net premiums |                         | $      | 295.1  |  |                 | $      | 228.5  |  |         | $      | 181.0  |  |   | $      | 145.0 |  |   | $      | 112.9 |  |   | $      | 98.0 | 
|                 |              |                         |        |        |  |                 |        |        |  |         |        |        |  |   |        |       |  |   |        |       |  |   |        |     



| |                  
| | -----------------
| | Reinsurance Risks

Reinsurance is subject to certain risks,
particularly credit risk, which relates to our ability to
collect the payments for reinsured losses due from our
reinsurers, and market risk, which affects the cost and
availability of reinsurance.

Credit Risk.We
attempt to select financially strong reinsurers with an A.M.
Best rating of A- or better and continue to evaluate
their financial condition and monitor various credit risks to
minimize our exposure to losses from reinsurer insolvencies.
However, we remain obligated for amounts ceded in the event that
the reinsurers do not meet their obligations. Following the
insolvency of one of our reinsurers, Reliance Insurance Company,
which resulted in our write-off of our entire $11.1 million
receivable (as described in Managements Discussion
and Analysis of Financial Condition and Results of
Operations  Overview of Operating Results 
Reinsurance Recoverable Write-off), we have implemented
several changes to our reinsurance program over the past several
years designed to reduce our exposures to the credit risk from
uncollectible reinsurance recoverables. These changes include
shifting the settlement of reinsurance premiums to an earned
basis versus a written basis, requiring reinsurers to fund a
trust account or provide a letter of credit in the event of a
downgrade by A.M. Best below a specified level and limiting the
maximum participation by any one reinsurer.

In September 2003, the A.M. Best Company
downgraded the financial strength rating of one of our
reinsurers, SCOR Reinsurance Company (SCOR) to
B++ (Very Good) from A- (Excellent).
SCOR, a participant in our reinsurance treaties since
July 2001, has established a trust account for our benefit
totalling $7.9 million at December 31, 2003. In
addition, for settlements occurring subsequent to the downgrade,
we

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are retaining an amount equal to the unsecured
portion of their obligations to us for losses and unearned
premiums.


Our reinsurers have established letters of credit
and trust accounts covering $17.5 million of their
obligations to us at December 31, 2003, which resulted in
unsecured reinsurance recoverables of $32.7 million as of
December 31, 2003, compared to $31.4 million as of
December 31, 2002. The largest unsecured recoverable from a
single reinsurer was $9.2 million as of December 31,
2003, compared to $12.2 million as of December 31,
2002.

The following table provides a summary of our
reinsurance recoverables by reinsurer as of December 31,
2003.

|                              |  |           |                  |                |  |                |      |            |  |              |      |                |  |   |      |  |  |   |      |  |  |   |      | 
|----------------------------- |  | --------- | ---------------- | -------------- |  | -------------- | ---- | ---------- |  | ------------ | ---- | -------------- |  | - | ---- |  |  | - | ---- |  |  | - | ---- | 
|                              |  |           |                  |                |  |                |      |            |  |              |      | Amount        
|                              |  |           |                  |                |  |                |      | Funds Held |  |              |      | Secured by    
|                              |  |           |                  | Net            |  |                |      | and Ceded  |  |              |      | Letters of    
|                              |  | A.M. Best |                  | Recoverable    |  | Net Receivable |      | Premiums   |  | Net Exposure |      | Credit or     
|Reinsurer                     |  | Rating    |                  | on Paid Losses |  | on Reserves    |      | Payable    |  | to Reinsurer |      | Trust Accounts
|                              |  |           |                  |                |  |                |      |            |  |              |      |               
|                             
|($ in millions)              
|AXA Corporate Solutions       |  |           | A- (Excellent)   |                |  | $              | 0.6  |            |  | $            | 1.5  |                |  | $ |     |  |  | $ | 2.1  |  |  | $ | 2.1  | 
|Dorinco Reinsurance           |  |           | A- (Excellent)   |                |  |                | 3.4  |            |  |              | 21.5 |                |  |   | 14.8 |  |  |   | 10.1 |  |  |   | 1.3  | 
|Folksamerica Reinsurance Co.  |  |           | A (Excellent)    |                |  |                | 0.4  |            |  |              | 1.1  |                |  |   |     |  |  |   | 1.5  |  |  |   |     | 
|National Union Fire Insurance |  |           | A++ (Superior)   |                |  |                | 3.3  |            |  |              | 22.4 |                |  |   | 16.5 |  |  |   | 9.2  |  |  |   |     | 
|Overseas Partners             |  |           | NR-5 (Not Rated) |                |  |                | 1.8  |            |  |              | 4.8  |                |  |   |     |  |  |   | 6.6  |  |  |   | 6.2  | 
|SCOR Reinsurance Co.          |  |           | B++ (Very Good)  |                |  |                | 2.6  |            |  |              | 20.0 |                |  |   | 11.9 |  |  |   | 10.7 |  |  |   | 7.9  | 
|Swiss Re America              |  |           | A+ (Superior)    |                |  |                | 3.3  |            |  |              | 22.4 |                |  |   | 16.5 |  |  |   | 9.2  |  |  |   |     | 
|Other Reinsurers              |  |           |                  |                |  |                | 0.3  |            |  |              | 0.6  |                |  |   | 0.1  |  |  |   | 0.8  |  |  |   |     | 
|                              |  |           |                  |                |  |                |      |            |  |              |      |                |  |   |      |  |  |   |      |  |  |   |      | 
|Total                         |  |           |                  |                |  | $              | 15.7 |            |  | $            | 94.3 |                |  | $ | 59.8 |  |  | $ | 50.2 |  |  | $ | 17.5 | 
|                              |  |           |                  |                |  |                |      |            |  |              |      |                |  |   |      |  |  |   |      |  |  |   |      | 

Market Risk.The
reinsurance market has changed dramatically over the past few
years as a result of inadequate pricing, poor underwriting and
the significant losses incurred in conjunction with the
terrorist attacks on September 11, 2001. As a result,
generally reinsurers have exited lines of business, reduced
available capacity, and implemented provisions in their
contracts designed to reduce or limit their exposure to loss.

Beginning in 2001, in an effort to manage the
cost of quota share reinsurance in the time of rising cost and
limited availability, we added provisions for loss ratio
corridors and loss ratio caps to our quota share reinsurance
agreements that reduce the cost of reinsurance to us. These
provisions have been structured to provide the reinsurers with
some limit on the amount of potential loss being assumed, while
maintaining the transfer of significant insurance risk with the
possibility of a significant loss to the reinsurer. Loss ratio
corridors provide for layers of losses in which the reinsurer
does not participate in the losses while loss ratio caps cut off
the reinsurers liability for losses above a specified loss
ratio. We believe our reinsurance arrangements qualify for
reinsurance accounting in accordance with SFAS 113
Accounting for Reinsurance Contracts. There was no
effect from the loss ratio cap provisions in our 2003, 2002 and
2001 agreements. However, the net incurred losses were increased
due to the impact of loss corridor provisions by approximately
$0.8 million attributed to our 2003 agreements,
$0.5 million attributable to our 2002 agreements and
$1.7 million attributable to our 2001 agreements.



| |                         
| | ------------------------
| | 2004 Reinsurance Program

Quota Share.For
policies written in 2004, we maintain a quota share agreement
covering personal automobile insurance policies up to the
respective states minimum statutory limits of coverage. In
addition, coverages for rental, towing, and accidental death are
excluded from these agreements. The agreement covers business
written in our existing states (including Texas) and would cover
business written in our targeted expansion states of Missouri
and Virginia. The agreement provides us with the ability to cede
varying amounts of business, which we refer to as cession
percentages, from each of our property and casualty insurance
subsidiaries.

Dorinco Reinsurance Company (30%), National Union
Fire Insurance Company of Pittsburgh (30%), a member of American
International Group, Swiss Reinsurance America Corporation
(30%), and AXA Re

15



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(Paris) (10%) participate in the agreement. This
agreement includes a sliding scale commission, loss ratio
corridor and a loss ratio cap.


Excess Cessions.Consistent with prior years, we entered into an excess cessions
reinsurance agreement whereby the reinsurers are liable for 100%
of the ultimate net losses in excess of the respective
states compulsory and/or financial responsibility
automobile liability limits. This business is ceded to SCOR
Reinsurance Company (50%) and QBE Reinsurance Corporation (50%),
rated A (Excellent) by A.M. Best.

Catastrophe
Reinsurance.We purchased property
catastrophe excess of loss reinsurance that provides coverage
for losses up to $15 million, less our retention of both
100% of the first $2 million of losses and 2.5% of losses
covered under this reinsurance arrangement. The contract covers
in force, new, renewed, and assumed personal automobile physical
damage business with the maximum value per vehicle covered of
$75,000. If we incur losses from a catastrophic event that
results in recoveries under this contract, we have the option to
purchase one reinstatement of coverage with a $26 million
aggregate limitation for all losses occurring during the term of
the agreement. Based on computer modeling, we believe this level
of coverage is more than sufficient to cover our probable
maximum loss from a once in a thousand year catastrophic event.
Losses from terrorist events including nuclear, chemical and
biochemical acts are excluded from coverage. Our catastrophe
reinsurers for 2004 include IPCRe Limited, rated A+
(Superior) by A.M. Best, Endurance Specialty Insurance
Limited, rated A (Excellent) by A.M. Best, QBE
Reinsurance Corporation, XL Re Limited, rated A+
(Superior) by A.M. Best, and certain syndicates from
Lloyds of London.

Assumed Reinsurance.Effective January 1, 2003, we agreed to assume a 100% quota
share percentage of certain personal automobile liability and
physical damage business in Texas underwritten by Old American
County Mutual Fire Insurance Company, an unaffiliated insurance
company, for which we are responsible for sales, service and
claims administration related to such business. We also assume a
significant portion of the personal automobile physical damage
business in North Carolina underwritten by State National
Insurance Company, an unaffiliated insurance company for which
we sell, service, finance and administer claims related to such
business.

Technology

The effectiveness of our business model depends
in large part on the technology systems we have developed
specifically to implement our business model. Our technology
systems enable timely and efficient communication and data
sharing among the various segments of our integrated operations.
The coordination of the operations of our neighborhood sales
offices, insurance companies, premium finance company and claims
company provides us with the opportunity to use technology more
effectively than many of our competitors who must communicate
with unaffiliated premium finance companies and with a large
number of independent agents, many of which use different
computer systems that may not be fully compatible with the
insurance companys systems. Our central processing
computer is an IBM iSeries located in Nashville, Tennessee,
which was upgraded in October 2002. As part of our business
continuity plan, we also maintain a backup IBM AS/400 in Baton
Rouge, Louisiana. These systems maintain our official
transaction records and are updated each night. The capacity of
the iSeries computer permits historical detail to be maintained
and available for use in rate analysis, projections and modeling.

Sales Office
Automation.We strive to standardize
and integrate the technology systems between and among our
subsidiaries that facilitate the automated capture of
information at the earliest point in the sales cycle. All of our
neighborhood sales office computers transmit information
directly to our central processing computer located in Nashville
where policy information and premium finance agreement data are
added to our systems with nominal additional manual handling.
Our sales offices also have immediate on-line access to current
information on policies and premium finance agreements by a
common computer interface or through a distributed database
downloaded from our iSeries central processing computer.

We strive to enhance the current sales office
system and improve our back office integration. These systems
include features for issuing policies and premium finance
agreements, processing new business and renewals, generating all
necessary documents at the neighborhood sales offices, and, in
the future, for processing all endorsements. Ultimately, we
expect to eliminate the mailing of declaration pages, ID cards,

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payment coupon books and other documents from the
main office. Connection to the iSeries is through an Internet
virtual private network.


Integration of Insurance and Premium Finance
Systems.The integration of the policy
processing and premium finance computer systems reduces much of
the time consuming paper-based transactions that typically arise
in this process. Technology is used to process policy
cancellations, reinstatements and return premiums between our
insurance subsidiaries and our premium finance company,
resulting in reduced overhead, more timely information and
improved customer service. Throughout this process, our systems
generate the appropriate statutory notices which are mailed
automatically to the insured.

Payment Processing.Most of our customers revisit our sales offices at least monthly
to make a periodic payment on their premium finance agreement.
System generated receipts are required for all payments
collected in our sales offices. Our sales offices generate
balancing reports at the end of each day, prepare bank deposit
documents and transmit all payment records to our Nashville
office. Depository accounts are swept daily, which results in
prompt availability of funds. Typically, premium finance
agreement payments are automatically applied to the applicable
premium finance agreement during the night following their
collection in our sales offices. This results in fewer notices
of intent to cancel being generated from the premium finance
company and fewer policies being canceled by the insurance
company, which must be reinstated if a customers late
payment is processed after cancellation. Thus, not only are
mailing costs reduced, but we believe that unnecessary policy
cancellations also are kept to a minimum, which in turn leads to
better customer relations.

Ratings

A.M. Best rates insurance companies based on
factors of concern to policyholders. Three of our property and
casualty insurance subsidiaries have been assigned a B
(Fair) rating and our other property and casualty
insurance subsidiary has been assigned a B- (Fair)
rating. A.M. Best assigns 15 ratings to insurance companies,
which currently range from A++ (Superior) to F
(In Liquidation).

B (Fair) and B- (Fair)
are the seventh and eighth highest ratings, respectively.
Publications of A.M. Best indicate that the B (Fair)
and B-(Fair) rating is assigned to those companies
that in A.M. Bests opinion have a fair ability to meet
their current obligations to policyholders, but are financially
vulnerable to adverse changes in underwriting and economic
conditions. In evaluating a companys financial and
operating performance, A.M. Best reviews the companys
profitability, leverage and liquidity, as well as its book of
business, the adequacy and soundness of its reinsurance, the
quality and estimated market value of its assets, the adequacy
of its loss reserves, the adequacy of its surplus, its capital
structure, the experience and competence of its management and
its market presence. A.M. Bests ratings reflect its
opinion of an insurance companys financial strength,
operating performance and ability to meet its obligations to
policyholders, and are not evaluations directed to potential or
current investors in our common stock and are not
recommendations to buy, sell or hold our common stock.

Financial institutions and reinsurance companies
use the A.M. Best ratings to help assess the financial strength
and quality of insurance companies. The current ratings of our
property and casualty insurance subsidiaries or their failure to
maintain such ratings may dissuade a financial institution or
reinsurance company from conducting business with us or increase
our interest or reinsurance costs. We do not believe that most
customers are motivated to purchase our products and services
based on our A.M. Best rating.

17



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Insurance Subsidiaries

We currently have six insurance subsidiaries.
Four are property and casualty insurance companies and two are
life insurance companies. The following table lists our
insurance subsidiaries and their states of domicile.

|                                                    |  |                   |                   | 
|--------------------------------------------------- |  | ----------------- | ----------------- | 
|Subsidiary                                          |  | State of Domicile
|                                                    |  |                  
|Direct General Insurance Company                    |  |                   | South Carolina(1) | 
|Direct Insurance Company                            |  |                   | Tennessee         | 
|Direct General Insurance Company of Louisiana       |  |                   | Louisiana         | 
|Direct General Insurance Company
    of Mississippi |  |                   | Mississippi       | 
|Direct Life Insurance Company                       |  |                   | Georgia           | 
|New York Life and Health Insurance Company          |  |                   | Delaware(2)       | 



---



|    |                                                                                                                                                                                                              
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Direct General Insurance Company is also
    commercially domiciled in Florida.                                                                                                                              
|   
|(2) | We are in the process of filing an application to
    have New York Life and Health Insurance Company redomesticated
    to South Carolina and its name changed to Direct General Life
    Insurance Company.

Regulatory Environment

Insurance
Regulation Generally.We and our
insurance subsidiaries are regulated by governmental agencies in
the states in which we conduct business and also are subject to
various federal statutes and regulations. State insurance
regulations generally are designed to protect the interests of
policyholders, state insurance consumers or claimants rather
than shareholders or other investors. These state regulations
vary by jurisdiction but, among other matters, usually involve:



| |   |                                                                                                
| | - | -----------------------------------------------------------------------------------------------
| |  | regulating premium rates and forms;                                                            
|
| |  | setting minimum solvency standards;                                                            
|
| |  | setting capital and surplus requirements;                                                      
|
| |  | licensing companies, agents and, in some states,
    adjusters;                                
|
| |  | setting requirements for and limiting the types
    and amounts of investments;                
|
| |  | establishing requirements for the filing of
    annual statements and other financial reports; 
|
| |  | conducting periodic statutory examinations of the
    affairs of insurance companies;          
|
| |  | requiring prior approval of changes in control
    and of certain transactions with affiliates;
|
| |  | limiting the amount of dividends that may be paid
    without prior regulatory approval; and   
|
| |  | setting standards for advertising and other
    market conduct activities.                     

Required Licensing.We operate under licenses issued by various state insurance,
consumer credit and banking authorities. Such licenses may be of
perpetual duration or renewable periodically, provided we
continue to meet applicable regulatory requirements. The
licenses govern, among other things, the types of insurance
coverages, agency and claims services, and premium finance
products that may be offered in the licensing state. Such
licenses are typically issued only after the filing of an
appropriate application and the satisfaction of prescribed
criteria. All licenses that are material to our business are in
good standing. Currently, we hold property and liability
insurance licenses in the states of Alabama, Arkansas, Florida,
Georgia, Kentucky, Louisiana, Mississippi, South Carolina and
Tennessee. Also, we hold managing general agency licenses in
Florida and Texas and life insurance licenses in 44 states and
the District of Columbia. We hold the required premium finance
licenses in all states in which we currently operate. We must
apply for and obtain the appropriate new licenses before we can
implement any plan to expand into a new state or offer a new
line of insurance or other new product that requires separate
licensing.

18



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Insurance Holding Company
Regulation.We operate as an insurance
holding company system and are subject to regulation in the
jurisdictions in which our insurance subsidiaries conduct
business. These regulations require that each insurance company
in the system register with the insurance department of its
state of domicile and furnish information concerning the
operations of companies within the holding company system which
may materially affect the operations, management or financial
condition of the insurers within the system domiciled in that
state. We have insurance subsidiaries that are organized and
domiciled or commercially domiciled under the insurance statutes
of each of Delaware, Florida, Georgia, Louisiana, Mississippi,
South Carolina and Tennessee. The insurance laws in each of
these states similarly provide that all transactions among
members of a holding company system must be fair and reasonable.
Transactions between insurance subsidiaries and their parents
and affiliates generally must be disclosed to the state
regulators, and prior approval of the applicable state insurance
regulator generally is required for any material or
extraordinary transaction. In addition, a change of control of a
domestic insurer or of any controlling person requires the prior
approval of the state insurance regulator. Generally, any person
who acquires 10% or more of the outstanding voting securities of
the insurer or its parent company (5% or more in Florida) is
presumed to have acquired control of the domestic insurer.

Restrictions on Paying
Dividends.We rely, in part, on
receiving dividends from our insurance subsidiaries to meet our
cash requirements. State insurance regulatory authorities
require insurance companies to maintain specified levels of
statutory capital and surplus. The amount of an insurers
surplus following payment of any dividends must be reasonable in
relation to the insurers outstanding liabilities and
adequate to meet its financial needs. Prior approval from state
insurance regulatory authorities is generally required in order
for our insurance subsidiaries to declare and pay extraordinary
dividends to us. The maximum amount of dividends our insurance
subsidiaries can pay us during 2004 without regulatory approval
is $10.5 million. The payment of dividends is limited by the
amount of surplus available to the insurer, as determined in
accordance with state statutory accounting practices and other
applicable limitations. State insurance regulatory authorities
that have jurisdiction over the payment of dividends by our
insurance subsidiaries may in the future adopt statutory
provisions more restrictive than those currently in effect.

Regulation of Rates and Policy
Forms.Most states in which our
insurance subsidiaries operate have insurance laws requiring
insurance companies to file premium rate schedules and policy or
coverage forms for review and approval. In many cases, such
rates and policy forms must be approved prior to use. State
insurance regulators have broad discretion in judging whether an
insurers rates are adequate, not excessive and not
unfairly discriminatory. Property and casualty insurers are
generally unable to implement rate increases until they show
that the costs associated with providing such coverage have
increased. The speed at which an insurer can change rates in
response to competition or to increasing costs depends, in part,
on the method by which the applicable states rating laws
are administered. There are three basic rate administration
systems: (i) the insurer must file and obtain regulatory
approval of the new rate before using it; (ii) the insurer
may begin using the new rate and immediately file it for
regulatory review; or (iii) the insurer may begin using the
new rate and file it within a specified period of time for
regulatory review. Under all three rating systems, the state
insurance regulators have the authority to disapprove the rate
subsequent to its filing. Thus, insurers who begin using new
rates before the rates are approved may be required to issue
premium refunds or credits to policyholders if the new rates are
ultimately deemed excessive and disapproved by the applicable
state insurance authorities. In addition, in some states, there
has been some pressure in the past years to reduce premium rates
for automobile and other personal insurance or to limit how
often an insurer may request increases for such rates.

Shared or Residual
Markets.As a condition of maintaining
our automobile insurance licenses to do business in various
states, like other insurers, we are required to participate in
mandatory shared market mechanisms or state pooling
arrangements. The purpose of these state-mandated arrangements
is to provide insurance coverages to individuals who, because of
poor driving records or other underwriting reasons, are unable
to purchase such coverage voluntarily provided by private
insurers. These risks are assigned to all insurers licensed in
the state and the maximum volume of such risks that any one
insurer may be assigned typically is based on that
insurers annual premium volume in that state. While this
mandated business

19



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typically is not profitable for us, our
underwriting results related to these states organizations
have not been material to our overall results of operations and
financial condition.


Guaranty Funds.Under state insurance guaranty fund laws, insurers doing
business in a state can be assessed for certain obligations of
insolvent insurance companies to policyholders and claimants.
Maximum contributions required by law in any one year vary
between 1% and 2% of annual premiums written in that state. In
most states guaranty fund assessments are recoverable either
through future policy surcharges or offsets to state premium tax
liability.

Investment
Regulation.Our insurance subsidiaries
are subject to state laws and regulations that require
diversification of their investment portfolios and that limit
the amount of investments in certain categories. Failure to
comply with these laws and regulations would cause
non-conforming investments to be treated as non-admitted assets
for purposes of measuring statutory surplus and, in some
instances, would require divestiture.

Other Insurance Regulatory Initiatives and
Proposed Legislation.Regulation of
insurance companies constantly changes as governmental agencies
and legislatures react to real or perceived issues. In recent
years, the state insurance regulatory framework has come under
increased federal scrutiny, and some state legislatures have
considered or enacted laws that alter and, in many cases,
increase state authority to regulate insurance companies and
insurance holding company systems. Further, the NAIC and state
insurance regulators are re-examining existing laws and
regulations specifically focusing on issues relating to the
solvency of insurance companies, interpretations of existing
laws and the development of new laws. Examples of these
regulatory initiatives and proposals that may affect our
business or operations include:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the approval by the U.S. House of Representatives
    in June 2003 and consideration by the U.S. Senate of class
    action tort reform legislation that would allow defendants to
    move large national class actions from state courts to federal
    courts. The legislation also purports to provide protections to
    consumer class members;                                                                                                                                                                              
|
| |  | restrictions on the use of credit scoring by
    insurance companies when deciding whether to cover, or how much
    premium to charge, potential customers, which have been in
    recent years, and continue to be, a frequent subject of state
    legislation. On the federal level, a U.S. House of
    Representatives subcommittee has held hearings to determine
    whether credit scoring is a fair and cost effective tool for
    assessing risk;                                                                      
|
| |  | the examination by committee hearings of the U.S.
    House of Representatives of whether federal legislation is
    needed to establish uniform standards for state insurance
    regulation. The National Association of Independent Insurers
    (now known as The Property Casualty Insurers of America) has
    stated that it expects legislation to be introduced in the House
    that would address areas of concern such as product
    availability, speed to market of new products, and insurance
    agent licensing;
|
| |  | the implementation of the Fair and Accurate
    Credit Transactions Act and the duties and responsibilities that
    will be imposed on insurers concerning affiliate sharing of
    information and adverse action notices;                                                                                                                                                                                                                                                                                                       
|
| |  | the proposal by NAIC to use a best
    practices process to develop a market conduct model that
    would apply consistent standards among multiple state insurance
    departments;                                                                                                                                                                                                                                                                                                                                             
|
| |  | reevaluation by the NAIC of current RBC formulas
    which could lead to a recommendation to change the company
    action level in the RBC Model Act (see Regulatory
    Environment  Risk Based Capital);                                                                                                                                                                                                                                                                                                                   
|
| |  | various state legislative initiatives that
    purport to benefit or provide protection to automobile insurance
    consumers, such as the recent enactment in Florida of limits on
    the amount of deductibles that insurers may offer their
    customers;                                                                                                                                                                                                                                                                     
|
| |  | individual state statutes and developing
    regulations concerning consumer privacy, including the mandate
    for creating specific written programs to safeguard
    customers privacy; and                                                                                                                                                                                                                                                                                                                                    

20



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| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | legislation in Texas that requires, among other
    things, the Department of Insurance to (i) approve premium
    rates and policy forms filed by county mutual insurance
    companies and (ii) conduct periodic examinations of the
    books and records of such insurance companies. This legislation
    will make county mutual insurance companies more closely
    resemble other property and casualty insurers conducting
    business in Texas.

Restrictions on Cancellation, Non-Renewal or
Withdrawal.Many states have laws and
regulations that limit an insurers ability to exit a
market. For example, certain states limit an automobile
insurers ability to cancel or not renew policies. Some
states prohibit an insurer from withdrawing one or more lines of
business from the state, except pursuant to a plan approved by
the state insurance department. The state insurance department
may disapprove a plan that may lead to market disruption. Laws
and regulations that limit cancellations and non-renewals and
that subject business withdrawals to prior approval requirements
may restrict an insurers ability to exit unprofitable
markets.

Premium Finance
Regulation.Our premium finance
subsidiary is regulated by governmental agencies in states in
which it conducts business. The agency responsible for such
regulation varies by state, but generally is the banking
department or the insurance department of the applicable state.
These regulations, which generally are designed to protect the
interests of our policyholders who elect to finance their
insurance premiums, vary by jurisdiction, but usually, among
other matters, involve:



| |   |                                                                                                                                                                                                                                                            
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | regulating the interest rates, fees and service
    charges we may charge our customers;                                                                                                                                                                   
|
| |  | imposing minimum capital requirements for our
    premium finance subsidiary or requiring surety bonds in addition
    to or as an alternative to such capital requirements;                                                                               
|
| |  | governing the form and content of our financing
    agreements;                                                                                                                                                                                            
|
| |  | prescribing minimum notice and cure periods
    before we may cancel a customers policy for non-payment
    under the terms of the financing agreement;                                                                                                   
|
| |  | prescribing timing and notice procedures for
    collecting unearned premium from the insurance company, applying
    the unearned premium to our customers premium finance
    account, and, if applicable, returning any refund due to our
    customer;
|
| |  | establishing standards for filing annual
    financial reports of our premium finance company;                                                                                                                                                             
|
| |  | requiring our premium finance company to qualify
    for and obtain a license and to renew the license each year;                                                                                                                                          
|
| |  | conducting periodic financial and market conduct
    examinations and investigations of our premium finance company
    and its operations; and                                                                                                            
|
| |  | requiring prior notice to the regulating agency
    of any change of control of our premium finance company.                                                                                                                                               

The following table sets forth the maximum
permissible interest rate in the nine states in which we
currently finance insurance premiums:

|               |  |                           |          |       
|-------------- |  | ------------------------- | -------- | ------
|State          |  | Permissible Interest Rate
|               |  |                          
|Arkansas       |  |                           | Variable | (1)(2)
|Florida        |  |                           | 12.0%    | (3)   
|Georgia        |  |                           | 12.0%    | (3)   
|Kentucky       |  |                           | 12.0%    | (3)   
|Louisiana      |  |                           | 36.0%    | (2)   
|Mississippi    |  |                           | 24.0%    | (2)   
|North Carolina |  |                           | 12.0%    | (3)   
|South Carolina |  |                           | 12.0%    | (3)   
|Tennessee      |  |                           | 24.0%    | (2)   

21



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---



|    |                                                                                                                                                                                                                                        
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The maximum allowable interest rate in Arkansas
    is equal to 500 basis points above the Federal Reserve discount
    rate on 90-day commercial paper.                                                                               
|   
|(2) | In these states the maximum permissible interest
    rate is calculated on an actuarial basis, meaning
    that the interest is calculated to apply to the average of
    balances outstanding throughout the period of indebtedness.
|   
|(3) | In these states the maximum permissible interest
    rate is calculated on an add-on basis, meaning that
    the annual interest rate is applied to the initial amount
    financed.                                                 

Four of these nine states require our premium
finance subsidiary to maintain a specified minimum net worth,
post a surety bond or deposit securities with the state
regulator.

In addition, our premium finance business is
subject to the federal Truth-in-Lending Act and similar state
statutes, and in Arkansas, which has not enacted a premium
finance statute, we generally are subject to state usury laws
that are applicable to consumer loans.

Privacy Regulations.In 1999, the United States Congress enacted the
Gramm-Leach-Bliley Act, which protects consumers from the
unauthorized dissemination of certain personal information.
Subsequently, the majority of states have implemented additional
regulations to address privacy issues. These laws and
regulations apply to all financial institutions, including
insurance and finance companies, and require us to maintain
appropriate procedures for managing and protecting certain
personal information of our customers and to fully disclose our
privacy practices to our customers. We may also be exposed to
future privacy laws and regulations, which could impose
additional costs and impact our results of operations or
financial condition.

Regulation of Our Ancillary Product
Vendors.The vendors of the ancillary
products and services we offer to our customers are also subject
to various federal and state laws and regulations. The failure
of any vendor to comply with such laws and regulations could
affect our ability to sell the ancillary products or services of
that particular vendor. However, we believe that there are
adequate alternative vendors of all the material ancillary
products and services sold by us.

Licensing of Our Employee Agents and
Adjustors.Generally, all of our
employees who sell, solicit or negotiate insurance are required
to be licensed by the state in which they work for the
applicable line or lines of insurance they offer. Our
employee-agents generally must renew their licenses annually and
complete a certain number of hours of continuing education. In
certain states in which we operate, insurance claims adjusters
are also required to be licensed and some must fulfill annual
continuing education requirements.

Trade Practices.The
manner in which insurance companies and insurance agents conduct
the business of insurance is regulated by state statutes in an
effort to prohibit practices that constitute unfair methods of
competition or unfair or deceptive acts or practices. Prohibited
practices include, but are not limited to:



| |   |                                                
| | - | -----------------------------------------------
| |  | disseminating false information or advertising;
|
| |  | defamation;                                    
|
| |  | boycotting, coercion and intimidation;         
|
| |  | false statements or entries;                   
|
| |  | unfair discrimination;                         
|
| |  | rebating;                                      
|
| |  | lessening competition by a stock transaction;  
|
| |  | improper replacement of life insurance;        
|
| |  | improper use of proprietary information;       
|
| |  | illegal dealings in premiums;                  

22



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| |   |                                                          
| | - | ---------------------------------------------------------
| |  | excess or reduced charges for insurance; and             
|
| |  | sliding, packaging and other deceptive sales
    conduct.

We set business conduct policies and provide
regular training to make our employee-agents and other sales
personnel aware of these prohibitions, and we require them to
conduct their activities in compliance with these statutes.

Claims Practices.Generally, insurance companies, adjusting companies and
individual claims adjusters are prohibited by state statutes
from engaging in unfair claims practices on a flagrant basis or
with such frequency to indicate a general business practice.
Unfair claims practices include, but are not limited to:



| |   |                                                                                                                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | misrepresenting pertinent facts or insurance
    policy provisions relating to coverages at issue;                                                                                                                                                                                                                  
|
| |  | failing to acknowledge and act reasonably
    promptly upon communications with respect to claims arising
    under insurance policies;                                                                                                                                                                             
|
| |  | failing to affirm or deny coverage of claims
    within a reasonable time after proof of loss statements have
    been completed;                                                                                                                                                                                   
|
| |  | attempting to settle a claim for less than the
    amount to which a reasonable person would have believed such
    person was entitled;                                                                                                                                                                            
|
| |  | attempting to settle claims on the basis of an
    application which was altered without notice to or knowledge or
    consent of the insured;                                                                                                                                                                      
|
| |  | making known to insureds or claimants a policy of
    appealing from arbitration awards in favor of insureds or
    claimants for the purpose of compelling them to accept
    settlements or compromises less than the amount awarded in
    arbitration;                                                          
|
| |  | delaying the investigation or payment of claims
    by requiring an insured, claimant, or the physician of either to
    submit a preliminary claim report and then requiring the
    subsequent submission of formal proof of loss forms, both of
    which submissions contain substantially the same information;
|
| |  | failing to promptly settle claims, where
    liability has become reasonably clear, under one portion of the
    insurance policy coverage in order to influence settlements
    under other portions of the insurance policy coverage; and                                                                         
|
| |  | not attempting in good faith to effectuate
    prompt, fair and equitable settlements of claims in which
    liability has become reasonably clear.                                                                                                                                                                 

We set business conduct policies and conduct
regular training to make our employee-adjusters and other claims
personnel aware of these prohibitions, and we require them to
conduct their activities in compliance with these statutes.

Quarterly and Annual Financial
Reporting.We are required to file
quarterly and annual financial reports with states utilizing
statutory accounting practices that are different from GAAP,
which reflect our insurance subsidiaries on a going concern
basis. The statutory accounting practices used by state
regulators, in keeping with the intent to assure policyholder
protection, are generally based on a liquidation concept. For a
summary of the significant differences for our insurance
subsidiaries between statutory accounting practices and GAAP,
see Note 11 to our audited consolidated financial statements
included in this report.

Periodic Financial and Market Conduct
Examinations.The state insurance
departments that have jurisdiction over our insurance
subsidiaries conduct on-site visits and examinations of the
insurers affairs, especially as to their financial
condition, ability to fulfill their obligations to
policyholders, market conduct, claims practices and compliance
with other laws and applicable regulations. Typically, these
examinations are conducted every three to five years. In
addition, if circumstances dictate, regulators are authorized to
conduct special or target examinations of insurers, insurance
agencies and insurance adjusting companies to address particular
concerns or issues. The results of these examinations can give
rise to regulatory orders requiring

23



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remedial, injunctive or other corrective action
on the part of the company that is the subject of the
examination.


Risk Based Capital.In order to enhance the regulation of insurer solvency, the NAIC
has adopted a formula and model law to implement RBC
requirements designed to assess the minimum amount of capital
that an insurance company needs to support its overall business
operations and to ensure that it has an acceptably low
expectation of becoming financially impaired. RBC is used to set
capital requirements considering the size and degree of risk
taken by the insurer and taking into account various risk
factors such as asset risk, credit risk, underwriting risk,
interest rate risk and other relevant business risks. The NAIC
model law for RBC applies to both life and property and casualty
companies. The model law provides for increasing levels of
regulatory intervention as the ratio of an insurers total
adjusted capital and surplus decreases relative to its risk
based capital, culminating with mandatory control of the
operations of the insurer by the domiciliary insurance
department at the so-called mandatory control level. At
December 31, 2003, each of our insurance subsidiaries
maintained an RBC level that is in excess of an amount that
would require any corrective actions on our part.

IRIS Ratios.The
NAIC Insurance Regulatory Information System or IRIS is part of
a collection of analytical tools designed to provide state
insurance regulators with an integrated approach to screening
and analyzing the financial condition of insurance companies
operating in their respective states. IRIS is intended to assist
state insurance regulators in targeting resources to those
insurers in greatest need of regulatory attention. IRIS consists
of two phases: statistical and analytical. In the statistical
phase, the NAIC database generates key financial ratio results
based on financial information obtained from insurers
annual statutory statements. The analytical phase is a review of
the annual statements, financial ratios and other automated
solvency tools. The primary goal of the analytical phase is to
identify companies that appear to require immediate regulatory
attention. A ratio result falling outside the usual range of
IRIS ratios is not considered a failing result; rather, unusual
values are viewed as part of the regulatory early monitoring
system. Furthermore, in some years, it may not be unusual for
financially sound companies to have several ratios with results
outside the usual ranges. An insurance company may fall out of
the usual range for one or more ratios because of specific
transactions that are in themselves immaterial.

As of December 31, 2003, Direct General
Insurance Company, Direct General Insurance Company of Louisiana
and Direct Life Insurance Company, each had three IRIS ratios
outside the usual range; Direct Insurance Company had two IRIS
ratios outside the usual range and Direct General Insurance
Company of Mississippi had four IRIS ratios outside the usual
range. The majority of the unusual results were attributable to
the significant growth in premiums and surplus, low investment
yields due to the current interest rate environment and the fact
that the majority of our capital contributions occurred late in
the year. We do not expect any material regulatory action as a
result of these unusual results.

Risks Related to Our Business



| |                                                                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because our core product is non-standard
    personal automobile insurance, our business may be adversely
    affected by negative developments in the conditions in this
    industry.

Approximately 97% of our gross premiums written
for 2003 were generated from sales of non-standard personal
automobile insurance policies. As a result of our concentration
in this line of business, negative developments in the economic,
competitive or regulatory conditions affecting the non-standard
personal automobile insurance industry could have a material
adverse effect on our results of operations and financial
condition. In addition, these developments could have a greater
effect on us, compared to more diversified insurers that also
sell other types of automobile insurance products.

For example, in the late 1990s, the automobile
insurance industry experienced severe price competition, rapidly
rising medical costs and high levels of fraudulent claims which
resulted in a significant deterioration in underwriting
profitability. According to the Insurance Information Institute,
an insurance industry research organization, the cost of
automobile insurance declined in 1998 and 1999. During this same
period and in 2000, as indicated in this report, the amount of
claims paid by automobile insurers rose sharply, particularly

24



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with respect to personal injury claims. The
combination of these events adversely impacted our underwriting
results and the underwriting results of most of our competitors.


Because of the currently favorable pricing
conditions in our industry, it is likely that new competitors
will enter the market and existing insurers will attempt to
increase market share by lowering rates. These conditions could
cause us to lose market share or have a material adverse effect
on our underwriting results due to a reduction in our
underwriting margin.



| |                                                                                                                                                                    
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Because we write a substantial number of
    insurance policies in Florida and Tennessee, our business may be
    adversely affected by conditions in these states.

In 2003, approximately 51% and 14% of our gross
premiums written were generated from non-standard personal
automobile and life insurance policies written in Florida and
Tennessee, respectively. Our revenues and profitability are
affected by the prevailing regulatory, economic, demographic,
competitive and other conditions in these states. For example,
from 1998 through 2001, our underwriting results in Florida were
adversely affected by high levels of fraudulent claims and
increased price competition. Changes in any of these conditions
could make it more costly or difficult for us to conduct our
business. Adverse regulatory developments in Florida or
Tennessee, which could include reductions in the maximum rates
permitted to be charged, restrictions on rate increases or
fundamental changes to the design or implementation of the
automobile insurance regulatory framework, could have a material
adverse effect on our results of operations and financial
condition.



| |                                                                                                                                        
| | ---------------------------------------------------------------------------------------------------------------------------------------
| | Severe weather conditions and other
    catastrophes may result in an increase in the number and amount
    of claims filed against us.

Our business is exposed to the risk of severe
weather conditions and other catastrophes. Catastrophes can be
caused by various events, including natural events such as
severe winter weather, hurricanes, tornadoes, windstorms,
earthquakes, hailstorms, severe thunderstorms and fires, and
other events such as explosions, terrorist attacks and riots.
The incidence and severity of catastrophes and severe weather
conditions are inherently unpredictable. Severe weather
conditions generally result in higher incidence of automobile
accidents and an increase in the number of claims filed as well
as the amount of compensation sought by claimants.

Because some of our insureds live near the
coastlines of the Atlantic Ocean and the Gulf of Mexico, we have
potential exposure to catastrophic losses related to hurricanes
and major coastal storms. We currently maintain property
catastrophe excess of loss reinsurance, excluding terrorism and
acts of war, that provides coverage for losses up to
$15 million, less our retention of both 100% of the first
$2.0 million of losses and 2.5% of losses covered under
this reinsurance arrangement. In the event a major catastrophe
were to occur resulting in property losses to us in excess of
our coverage, our losses could have a material adverse effect on
our results of operations and financial condition.



| |                                                                                                                                       
| | --------------------------------------------------------------------------------------------------------------------------------------
| | Our business is highly competitive, which
    may make it difficult for us to market our core products
    effectively and profitably.

The non-standard personal automobile insurance
business is highly competitive. We compete with other insurers
that, in most cases, sell through independent agencies. We also
compete with insurers that sell insurance policies directly to
their customers. We believe that our primary insurance company
competition comes not only from national companies or their
subsidiaries, such as the Progressive insurance group, the
Allstate insurance group, the Infinity insurance group, the
State Farm insurance group, the Berkshire Hathaway insurance
group (including GEICO) and the Bristol West insurance group,
but also from non-standard insurers and independent agents that
operate in a specific region or single state in which we operate.

Based upon written premium data compiled from
A.M. Best, we believe that, as of December 31, 2002, ten
insurance groups accounted for approximately 70% of the
approximately $30 billion non-standard market segment.
Further, based upon our direct written premiums for 2002, we
believe that, as of December 31,

25



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##### 



2002, we would be ranked 17th nationally and
sixth in the nine states in which we operated among non-standard
automobile insurers, using the 2002 market data compiled from
A.M. Best.


Some of our competitors have substantially
greater financial and other resources than we have, and they may
offer a broader range of products or offer competing products at
lower prices. Our results of operations and financial condition
could be materially and adversely affected by a loss of business
to competitors offering similar insurance products at lower
prices or having other competitive advantages.



| |                                                                                                                 
| | ----------------------------------------------------------------------------------------------------------------
| | Our results may fluctuate as a result of
    cyclical changes in the personal automobile insurance
    industry.

The personal automobile insurance industry is
cyclical in nature. In the past, the industry has been
characterized by periods of price competition and excess
capacity followed by periods of high premium rates and shortages
of underwriting capacity. We believe that during 2001, 2002 and
2003, the underwriting results in the personal automobile
insurance industry improved as a result of favorable pricing and
competitive conditions that allowed for broad increases in rate
levels by insurers. However, new competitors may enter this
market and existing competitors may attempt to increase market
share by lowering rates. Such conditions would cause a downturn
in the current cycle and could negatively impact our revenues
and profitability.



| |                                                                                                                                                                                                                                                                                    
| | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Current ratings of our insurance
    subsidiaries or any failure of our insurance subsidiaries to
    maintain current financial strength ratings could materially and
    adversely affect our business and our ability to obtain
    financing or reinsurance at favorable rates.

A.M. Best provides a variety of products and
services to the insurance industry and is generally considered
to be a leading authority on insurance company ratings and
information. Three of our property and casualty insurance
subsidiaries have been assigned a B (Fair) rating
and our other property and casualty insurance subsidiary has
been assigned a B- (Fair) rating. A.M. Best assigns
15 ratings to insurance companies, which currently range from
A++ (Superior) to F (In Liquidation).

B (Fair) and B- (Fair)
are the seventh and eighth highest ratings, respectively, issued
by A.M. Best. Publications of A.M. Best indicate that the
B (Fair) and B- (Fair) rating is
assigned to those companies that in A.M. Bests opinion
have a fair ability to meet their current obligations to
policyholders, but are financially vulnerable to adverse changes
in underwriting and economic conditions. In evaluating a
companys financial and operating performance, A.M. Best
reviews the companys profitability, leverage and
liquidity, as well as its book of business, the adequacy and
soundness of its reinsurance, the quality and estimated market
value of its assets, the adequacy of its loss reserves, the
adequacy of its surplus, its capital structure, the experience
and competence of its management and its market presence. A.M.
Bests ratings reflect its opinion of an insurance
companys financial strength, operating performance, and
ability to meet its obligations to policyholders and are not
evaluations directed to potential or current investors in our
common stock and are not recommendations to buy, sell, or hold
our common stock.

Financial institutions and reinsurance companies
use the A.M. Best insurance ratings to help assess the financial
strength and quality of insurance companies. The current ratings
of our property and casualty insurance subsidiaries or their
failure to maintain such ratings may dissuade a financial
institution or reinsurance company from conducting business with
us or increase our interest or reinsurance costs. See
Business  Ratings.



| |                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------
| | Our principal shareholder has the ability
    to control our operations, including the election of our
    directors.

The William C. Adair,
Jr.Trust, over which Ms. Tammy
Adair, our Executive Vice President, has sole voting control,
beneficially owns approximately 29.06% of our common stock.
Ms. Adair, as trustee, has the ability to affect
significantly the composition of our board of directors and the
approval of any action requiring a shareholder vote, including
amendments to our charter or bylaws and approvals of mergers or
sales of substantially all of our assets. The interests of the
trustee and the beneficiaries of the trust may differ from the
interests of our other shareholders.

26



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##### 





| |                                                                                                                                                                                                                
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | As a holding company, we are dependent on
    the results of operations of our operating subsidiaries and the
    regulatory and contractual capacity of our operating
    subsidiaries to pay dividends to us.

We are a holding company and a legal entity
separate and distinct from our operating subsidiaries. As a
holding company without significant operations of our own, the
principal sources of our funds are dividends and other payments
from our operating subsidiaries. State insurance laws limit the
ability of our insurance subsidiaries to pay dividends and
require our insurance subsidiaries to maintain specified minimum
levels of statutory capital and surplus. These restrictions
affect the ability of our insurance subsidiaries to pay
dividends to us without prior notice to, or approval of,
regulatory authorities and the timing of such payments. During
2004, our insurance subsidiaries will be able to pay maximum
dividends of $10.5 million to Direct General Corporation
without seeking regulatory approval. Dividends from our premium
finance subsidiary are limited by the minimum capital
requirements in applicable state regulations and by covenants in
our loan agreements that require approval of our lenders. There
are no other restrictions on payments of dividends from our
subsidiaries except for typical state corporation law
requirements. Consequently, our ability to repay debts, pay
expenses and pay cash dividends to our shareholders may be
limited. See Managements Discussion and Analysis of
Financial Condition and Results of Operations 
Financial Condition  Liquidity and Capital
Resources  Sources and Uses of Funds and
Business  Regulatory Environment 
Restrictions on Paying Dividends.



| |                                                                                              
| | ---------------------------------------------------------------------------------------------
| | We are subject to comprehensive regulation
    that may restrict our ability to earn profits.

Our insurance, agency and premium finance
subsidiaries are subject to comprehensive regulation and
supervision by the insurance and financial institution
departments in the states where our subsidiaries are domiciled
and where our subsidiaries sell insurance products, issue
policies, finance premiums and handle claims. Certain regulatory
restrictions and prior approval requirements may affect our
subsidiaries ability to operate, innovate, obtain
necessary rate adjustments in a timely manner or may increase
our cost and reduce profitability.

Supervision and regulation by insurance and
financial institution departments extend, among other things,
to:

Required Licensing.We operate under licenses issued by various state insurance,
consumer credit and banking authorities. These licenses govern,
among other things, the types of insurance coverages, agency and
claims services, and premium finance products that we may offer
consumers in these states. Such licenses typically are issued
only after we file an appropriate application and satisfy
prescribed criteria. We must apply for and obtain the
appropriate new licenses before we can implement any plan to
expand into a new state or offer a new line of insurance or
other new product that requires separate licensing. If a
regulatory authority denies or delays granting such new license,
our ability to enter new markets quickly or offer new products
we believe will be profitable can be substantially impaired. See
Business  Regulatory Environment 
Required Licensing.

Transactions Between Insurance Companies and
Their Affiliates.We operate as an
insurance holding company system and are subject to regulation
in the jurisdictions in which our insurance subsidiaries conduct
business. Our insurance subsidiaries are organized and domiciled
or commercially domiciled under the insurance statutes of
Delaware, Florida, Georgia, Louisiana, Mississippi, South
Carolina and Tennessee. The insurance laws in these states
provide that all transactions among members of an insurance
holding company system must be fair and reasonable. Transactions
between our insurance subsidiaries and other members of our
holding company system generally must be disclosed to the state
regulators, and prior approval of the applicable regulator
generally is required before any material or extraordinary
transaction may be consummated. State regulators may refuse to
approve or delay approval of such a transaction, which may
impact our ability to innovate or operate efficiently. See
Business  Regulatory Environment 
Insurance Holding Company Regulation.

Regulation of Premium Rates and Approval of
Policy Forms.The insurance laws of
most states in which our insurance subsidiaries operate require
insurance companies to file premium rate schedules and insurance
policy forms for review and approval. State insurance regulators
have broad discretion in judging whether our rates are adequate,
not excessive and not unfairly discriminatory. The speed at
which we can change our rates

27



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##### 



in response to competition or to increasing costs
depends, in part, on the method by which the applicable
states rating laws are administered. Generally, state
insurance regulators have the authority to disapprove our
requested rates. Thus, if as permitted in some states, we begin
using new rates before they are approved, we may be required to
issue premium refunds or credits to our policyholders if the new
rates are ultimately deemed excessive or unfair and disapproved
by the applicable state regulator. In addition, in some states,
there has been some pressure in past years to reduce premium
rates for automobile and other personal insurance or to limit
how often an insurer may request increases for such rates. In
states where such pressure is applied, our ability to respond to
market developments or increased costs in that state can be
adversely affected. See Business  Regulatory
Environment  Regulation of Rates and Policy
Forms.


Investment
Restrictions.Our insurance
subsidiaries are subject to state laws and regulations that
require diversification of their investment portfolios and that
limit the amount of investments in certain categories. Failure
to comply with these laws and regulations would cause
non-conforming investments to be treated as non-admitted assets
for purposes of measuring statutory surplus and, in some
instances, would require divestiture. See
Business  Regulatory Environment 
Investment Regulation.

Restrictions on Cancellation, Non-Renewal or
Withdrawal.Many states have laws and
regulations that limit an insurers ability to exit a
market. For example, certain states limit an automobile
insurers ability to cancel or not renew policies. Some
states prohibit an insurer from withdrawing from one or more
lines of business in the state, except pursuant to a plan
approved by the state insurance department. The state insurance
department may disapprove a plan that may lead to market
disruption. To date, none of these restrictions has had an
impact on our operations or strategic planning in the states in
which we operate. However, these laws and regulations that limit
cancellations and non-renewals and that subject business
withdrawals to prior approval restrictions could limit our
ability to exit unprofitable markets or discontinue unprofitable
products in the future. See Business 
Regulatory Environment  Restrictions on Cancellation,
Non-Renewal or Withdrawal.

Other Regulations.We must also comply with regulations involving, among other
things:



| |   |                                                                                                                                                                                                                     
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | the use of non-public consumer information and
    related privacy issues;                                                                                                                                          
|
| |  | investment restrictions;                                                                                                                                                                                            
|
| |  | the use of credit history in underwriting and
    rating;                                                                                                                                                           
|
| |  | the payment of dividends;                                                                                                                                                                                           
|
| |  | the acquisition or disposition of an insurance
    company or of any company controlling an insurance company;                                                                                                      
|
| |  | the involuntary assignments of high-risk
    policies, participation in reinsurance facilities and
    underwriting associations, assessments and other governmental
    charges;                                   
|
| |  | reporting to state regulators with respect to
    financial condition;                                                                                                                                              
|
| |  | periodic reporting, corporate governance and
    other compliance requirements imposed by the Sarbanes-Oxley Act
    of 2002 and other federal laws and regulations applicable to
    publicly traded companies; and
|
| |  | rules and regulations of the Nasdaq National
    Market, on which our common stock is listed for trading.                                                                                                           

In addition, our premium finance business is
subject to the federal Truth-in-Lending Act and similar state
statutes, and in states where premium finance statutes have not
been enacted, we generally are subject to state usury laws that
are applicable to consumer loans. See Business 
Regulatory Environment.



| |                                                                                                 
| | ------------------------------------------------------------------------------------------------
| | Regulation may become more extensive in the
    future, which may adversely affect our business.

We cannot assure you that states will not make
existing insurance laws and regulations more restrictive in the
future or enact new restrictive laws. In such events, we may
seek to reduce our writings in, or to withdraw entirely from,
these states. In addition, from time to time, the United States
Congress and certain federal agencies investigate the current
condition of the insurance industry to determine whether federal

28



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##### 



regulation is necessary. We are unable to predict
whether and to what extent new laws and regulations that would
affect our business will be adopted in the future, the timing of
any such adoption and what effects, if any, they may have on our
operations, profitability and financial condition.




| |                                                                                                                                                                                
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our insurance and premium finance
    subsidiaries are subject to capital requirements, and our
    failure to meet these standards could subject us to regulatory
    actions.

Our insurance subsidiaries are subject to
risk-based capital standards (which we refer to in this report
as RBC standards) and other minimum capital and surplus
requirements imposed under the laws of their states of domicile.
The RBC standards, based upon the RBC Model Act adopted by the
National Association of Insurance Commissioners (which we refer
to in this report as the NAIC) require our insurance
subsidiaries to report their results of risk-based capital
calculations to the state departments of insurance and the NAIC.
Our premium finance subsidiary is subject to minimum capital
requirements imposed under the laws of some of the states in
which it conducts business.

Failure to meet applicable risk-based capital
requirements or minimum statutory capital requirements could
subject our insurance subsidiaries or our premium finance
subsidiary to further examination or corrective action imposed
by state regulators, including limitations on our writing of
additional business or engaging in finance activities, state
supervision or even liquidation. Any changes in existing RBC
requirements or minimum statutory capital requirements may
require us to increase our statutory capital levels, which we
may be unable to do. As of December 31, 2003, each of our
insurance subsidiaries maintained an RBC level that is in excess
of an amount that would require any corrective actions on our
part and our premium finance subsidiary was in compliance with
the minimum capital requirements of the applicable state
regulations. See Business  Regulatory
Environment.



| |                                                                                                                                                                                                                                                        
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | New pricing, claim, coverage and financing
    issues and class action litigation are continually emerging in
    the automobile insurance industry, and these new issues could
    adversely impact our revenues or our methods of doing
    business.

As automobile insurance industry practices and
regulatory, judicial and consumer conditions change, unexpected
and unintended issues related to claims, coverages, business
practices and premium financing plans may emerge. These issues
can have an adverse effect on our business by changing the way
we price our products, by extending coverage beyond our
underwriting intent, or by increasing the size of claims. Recent
examples of some emerging issues include:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | concerns over the use of an applicants
    credit score and zip code as a factor in making risk selections
    and pricing decisions;                                                                                                                                                                                                                                                                                                  
|
| |  | a growing trend of plaintiffs targeting
    automobile insurers, including us, in purported class action
    litigation relating to claims-handling practices, such as the
    permitted use of aftermarket (non-original equipment
    manufacturer) parts, total loss evaluation methodology and the
    alleged diminution in value to insureds vehicles involved
    in accidents;                                                 
|
| |  | a relatively new trend of plaintiffs targeting
    insurers, including automobile insurers, in purported class
    action litigation which seek to recharacterize installment fees
    and other allowed charges related to insurers installment
    billing programs (which we currently do not employ, but could
    implement in the future) as interest that violates state usury
    laws or other interest rate restrictions; and
|
| |  | attempts by plaintiffs to initiate purported
    class action litigation targeting premium finance operations
    relating to unearned interest rebates and the collection of
    service and finance charges.                                                                                                                                                                                                                          

The effects of these and other unforeseen
emerging issues could negatively affect our revenues or our
methods of doing business.

29



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##### 





| |                                                                                                         
| | --------------------------------------------------------------------------------------------------------
| | Our assumed reinsurance arrangements may be
    deemed to be the unauthorized business of
    insurance.

Our agency subsidiaries have sold non-standard
automobile insurance for State National Specialty Insurance
Company in North Carolina and currently sell non-standard
automobile insurance in North Carolina for that companys
affiliate, State National Insurance Company. We also service,
finance and administer claims related to this business. One of
our insurance subsidiaries reinsures a 100% quota share
percentage of State Nationals physical damage business in
North Carolina. In January 2003, we began assuming a 100%
quota share percentage of the non-standard personal automobile
liability and physical damage business in Texas underwritten by
Old American County Mutual Fire Insurance Company, an
unaffiliated insurance company, for which we are responsible for
the sales, service, and claims administration related to such
business.

We believe that these arrangements comply with
applicable law and we are not aware of any pending regulatory or
legislative action that could affect these arrangements.
However, we can provide no assurance that the state legislatures
or insurance regulators of North Carolina and Texas will
continue to permit these types of assumed reinsurance
arrangements whereby all or substantially all of the insurance
risk is transferred to a single assuming reinsurer that is not a
licensed insurer in that state. If not, then insurance
regulators in these states could construe our assumed
reinsurance arrangements as the conduct of the unauthorized
business of insurance by us, or the aiding and abetting by the
policy issuing companies of the unauthorized business of
insurance. Any such adverse regulatory decision may have a
material adverse effect on our results of operations.



| |                                                                                                                           
| | --------------------------------------------------------------------------------------------------------------------------
| | Our largely fixed cost structure would work
    to our disadvantage if our sales volume were to decline
    significantly.

Because of our emphasis on the use of
employee-agents, our cost of acquiring business is largely
fixed. In times of increasing sales volume, our acquisition cost
per policy decreases, improving our expense and combined ratios,
which we believe is one of the significant advantages of our
business model. However, in times of declining sales volume, the
opposite would occur. A decline in sales volume could decrease
our profitability, cause us to close some of our neighborhood
sales offices or lay-off employee-agents to manage our expenses.



| |                                                                                                                                                           
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our inability to refinance our current
    lines of credit or obtain additional financing could have an
    adverse effect on our premium finance revenue.

Through our premium finance subsidiary, we
finance almost all of the insurance policies we sell. Our
working capital needs are substantially dependent on bank lines
of credit that include covenants requiring us to pass specified
financial tests and to refrain from certain kinds of actions.
Such actions include incurring or guaranteeing additional
indebtedness; granting mortgages or liens on our and certain of
our subsidiaries assets; selling our premium finance
subsidiary receivables; merging into, consolidating with, or
acquiring the assets of another business corporation outside
defined limitations; disposing of all or a substantial portion
of our assets; making loans or investments other than to our
subsidiaries; or entering into a new line of business not
related to insurance, financial and related services. In the
event we fail to meet our covenants or are unable to refinance,
replace or increase our bank line of credit on economically
feasible terms, our income and the marketability of our
insurance products could be adversely affected. An alternative
to financing our policies through our premium finance subsidiary
would be to finance or installment bill the policies through our
insurance subsidiaries, which would eliminate the requirement
for outside working capital. However, certain regulatory
restrictions may make it more difficult to finance other
insurance products which could adversely affect our results of
operations.



| |                                                                                                                                                         
| | --------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our losses and loss adjustment expenses may
    exceed our reserves, which would adversely impact our results of
    operations and financial condition.

We record reserve liabilities for the estimated
payment of losses and loss adjustment expenses for both reported
and unreported claims. The amount of reserves is based on
historical claims information, industry

30



---



##### 



statistics and other factors. The establishment
of appropriate reserves is an inherently uncertain process. This
uncertainty arises from a number of factors, including the
difficulty in predicting the rate of inflation and the rate and
direction of changes in trends, ongoing interpretation of
insurance policy provisions by courts, inconsistent decisions in
lawsuits regarding coverage and expanded theories of liability.
In addition, ongoing changes in claims settlement practices can
lead to changes in loss payment patterns, which are used to
estimate reserve levels. If our reserves prove to be inadequate,
we would be required to increase them and would charge the
amount of such increase to our earnings in the period in which
the deficiency is recognized. Due to the inherent uncertainty of
estimating reserves, it has been necessary, and will over time
continue to be necessary, to revise estimated future liabilities
as reflected in our reserves for claims and policy expenses, and
these revisions can cause our results to fluctuate. For the year
ended December 31, 2003, we experienced adverse reserve
development that increased our losses and loss adjustment
expenses incurred by $0.1 million. During the year ended
December 31, 2002, our reserves for prior years developed
favorably, which resulted in reductions in losses and loss
adjustment expenses incurred of $5.5 million. For the year
ended December 31, 2001, we experienced adverse reserve
development that increased our losses and loss adjustment
expenses incurred by $7.8 million. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Results of
Operations  Expenses  Insurance Losses and
Loss Adjustment Expenses for a discussion of the reasons
for these changes. The historic development of reserves for
losses and loss adjustment expenses may not necessarily reflect
future trends in the development of these amounts. Consequently,
ultimate losses could materially exceed loss reserves and have a
material adverse effect on our results of operations and
financial condition. See Business  Regulatory
Environment.




| |                                                                                                                                                
| | -----------------------------------------------------------------------------------------------------------------------------------------------
| | We are party to litigation, which, if
    decided adversely to us, could affect our business, results of
    operations or financial condition.

We are named as a defendant in various legal
actions arising out of claims made in connection with our
insurance policies, our premium finance agreements, other
contracts we have entered into, our relationships with our
employees and other matters. These legal actions include nine
purported class action lawsuits:



| |   |                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | one alleges we wrongfully calculated unearned
    interest rebates owed to customers on prepaid premium finance
    accounts;                                                            
|
| |  | six allege we violated Florida law regarding
    payments to medical magnetic resonance imaging providers;                                                                               
|
| |  | one alleges we improperly cancelled insurance
    policies; and                                                                                                                          
|
| |  | one alleges we charged and collected unlawful
    service and finance charges with respect to the financing of
    purported automobile club memberships in violation of Florida
    law.

In addition, during 2003 we settled a class
action lawsuit in Tennessee in which approximately 130 persons
purported to give notice that they elected not to participate in
the settlement. Some or all of these persons could file
individual actions or join together and file an additional
purported class action lawsuit. A majority of these persons are
represented by a single law firm; this increases the risk that
an additional class action lawsuit may be filed.

We intend to vigorously defend each of these
lawsuits. However, all litigation is unpredictable and the
ultimate outcome of these cases is uncertain. These matters are
in their early procedural stages, and thus we are unable to
predict the likelihood or range of our potential liability or
the potential financial impact on our future operations, if we
are not able to successfully defend or settle these cases. Also,
we are unable to predict the effect that these pending lawsuits,
or similar lawsuits filed against us in the future, may have on
our business, financial condition and results of operations.

In addition, our Chairman, Chief Executive
Officer and President has been named as a defendant in a lawsuit
that alleges misrepresentation and breach of contract that
resulted in a loss of commissions to the plaintiff. We are not
named as a defendant in this lawsuit; however, the
plaintiffs counsel has recently stated an intention to add
us as a defendant. If we are named as a defendant in this
lawsuit, we will vigorously defend against any claims. See
Legal Proceedings.

31



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##### 





| |                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------
| | If we lose key personnel or are unable to
    recruit qualified personnel, our ability to implement our
    business strategies could be delayed or hindered.

Our future success will depend, in part, upon the
efforts of our executive officers. The loss of any of these
officers or other key personnel could prevent us from fully
implementing our business strategies and could materially and
adversely affect our business, financial condition and results
of operations. We have employment agreements with William C.
Adair, Jr., Jacqueline C. Adair, Tammy R. Adair, Barry D. Elkins
and William J. Harter. We do not have key person insurance on
the lives of any of our key management personnel. As we continue
to grow, we will need to recruit and retain additional qualified
management personnel, but we may not be able to do so. Our
ability to recruit and retain such personnel will depend upon a
number of factors, such as our results of operations and
prospects and the level of competition then prevailing in the
market for qualified personnel.



| |                                                                                                            
| | -----------------------------------------------------------------------------------------------------------
| | Our investment portfolio may suffer reduced
    returns or losses which could reduce our
    profitability.

Our results of operations depend, in part, on the
performance of our invested assets. As of December 31,
2003, 99.5% of the fair value of our investment portfolio was
invested in debt securities, primarily in liquid state,
municipal, corporate and federal government bonds and 0.5% in
other short-term investments. Fluctuations in interest rates
affect our returns on, and the fair value of, fixed income
securities. Unrealized gains and losses on debt securities are
recognized in other comprehensive income and increase or
decrease our shareholders equity. As of December 31,
2003 and 2002, pretax net unrealized gains in our investment
portfolio amounted to $1.1 million and $4.3 million,
respectively. Interest rates in the United States are currently
low relative to recent historical levels. Based on data compiled
from Bloomberg L.P., the pretax yield on U.S. Treasury
securities with a five-year maturity has steadily declined over
the past few years from approximately 6.3% at December 31,
1999 to approximately 3.2% at December 31, 2003. An
increase in interest rates could reduce the fair value of our
investments in debt securities. As of December 31, 2003,
the impact of an immediate 100 basis point increase in market
interest rates on our debt securities portfolio would have
resulted in an estimated decrease in fair value of 4.1% or
approximately $10.8 million. In addition, defaults by third
parties who fail to pay or perform obligations could reduce our
investment income and realized investment gains and could result
in investment losses to our portfolio. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations 
Investments.



| |                                                                                                                                                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may not be successful in reducing our
    risk and increasing our underwriting capacity through
    reinsurance arrangements, which could adversely affect our
    business, financial condition and results of
    operations.

In order to reduce our underwriting risk and
increase our underwriting capacity, we transfer portions of our
insurance risk to other insurers through reinsurance contracts.
Historically, we have ceded a portion of our non-standard
automobile insurance premiums and losses to unaffiliated
reinsurers in accordance with these contracts. However, we have
not ceded any portion of our life insurance premiums and losses
to reinsurers since the life premium volume is relatively low.
Ceded premiums written were equal to 32.2%, 46.0% and 52.7% of
our gross premiums written for the years ended December 31,
2003, 2002 and 2001, respectively. The availability, cost and
structure of reinsurance protection is subject to changing
market conditions, which are outside of our control. In order
for these contracts to qualify for reinsurance accounting and
thereby provide the additional underwriting capacity that we
desire, the reinsurer generally must assume significant risk and
have a reasonable possibility of a significant loss.

Although the reinsurer is liable to us to the
extent we transfer, or cede, risk to the reinsurer,
we remain ultimately liable to the policyholder on all risks
reinsured. As a result, ceded reinsurance arrangements do not
limit our ultimate obligations to policyholders to pay claims.
We are subject to credit risks with respect to the financial
strength of our reinsurers. We are also subject to the risk that
our reinsurers may dispute their obligations to pay our claims.
As a result, we may not recover claims made to our reinsurers in
a timely manner, if at all. As of December 31, 2003, we had
a total of $32.7 million of unsecured reinsurance
recoverables, which represented 18.4% of our total
shareholders equity, and our largest unsecured recoverable
from a single reinsurer was $9.2 million, which represented
5.2% of our total

32



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shareholders equity. In addition, if
insurance departments deem that under our existing or future
reinsurance contracts the reinsurer does not assume significant
risk and has a reasonable possibility of significant loss, we
may not be able to increase our ability to write business based
on this reinsurance. Any of these events could have a material
adverse effect on our business, financial condition and results
of operations.




| |                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------
| | Because we have reduced our use of quota
    share reinsurance, we will retain more risk, which could result
    in losses.

We currently use quota share reinsurance
primarily to increase our underwriting capacity and to reduce
our exposure to losses. Quota share reinsurance refers to a form
of pro rata reinsurance arrangement pursuant to which the
reinsurer participates in a specified percentage of the premiums
and losses on every risk that comes within the scope of the
reinsurance agreement. See Managements Discussion
and Analysis of Financial Condition and Results of
Operations  Reinsurance and
Business  Reinsurance. During 2003, we
reduced, but did not eliminate, our use of quota share
reinsurance. Thus, we will retain and earn more of the premiums
we write, but also retain more of the related losses. Reducing
our use of quota share reinsurance has increased our risk and
exposure to such losses, which could have a material adverse
effect on our business, financial condition and results of
operations.



| |                                                                                                                                                                      
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We rely on our information technology and
    telecommunication systems, and the failure of these systems
    could materially and adversely affect our
    business.

Our business is highly dependent upon the
successful and uninterrupted functioning of our information
technology and telecommunications systems. We rely on these
systems to support our direct marketing operations, as well as
to process new and renewal business, provide customer service,
make claims payments, support premium financing activities, and
facilitate collections and cancellations. These systems also
enable us to perform actuarial and other modeling functions
necessary for underwriting and rate development. We have a
highly trained staff that is committed to the continual
development and maintenance of these systems. However, the
failure of these systems could interrupt our operations or
materially impact our ability to evaluate and write new
business. Because our information technology and
telecommunications systems interface with and depend on third
party systems, we could experience service denials if demand for
such service exceeds capacity or such third party systems fail
or experience interruptions. If sustained or repeated, a system
failure or service denial could result in a deterioration of our
ability to write and process new and renewal business and
provide customer service or compromise our ability to pay claims
in a timely manner. This could result in a material adverse
effect on our business. See Business 
Technology.

We maintain insurance on our real property and
other physical assets. This insurance will not compensate us for
losses that may occur due to disruptions in service as a result
of a computer, data processing or telecommunication systems
failure that is unrelated to covered property damage, nor will
such insurance necessarily compensate us for all losses
resulting from covered events. We maintain redundant systems or
facilities for our principal information services to help
maintain functionality and reduce the risk of significant
interruptions of our operations.



| |                                                                                                                                                                                            
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | We may have difficulties in managing our
    expansion into new markets, and we may not be successful in
    identifying agency acquisition candidates or integrating their
    operations.

Our future growth plans include expanding into
new states by acquiring the business and assets of local
agencies, opening new sales offices, introducing additional
insurance products, and retaining more of our insurance risk by
reducing our use of reinsurance. Our future growth will face
risks, including risks associated with obtaining necessary
licenses, the proper design and pricing of our products, our
ability to identify, hire and train new claims and sales
employees and our ability to identify agency acquisition
candidates or, if acquired, to integrate their operations. In
addition, we may acquire business in states in which market and
other conditions may not be favorable to us. For example, we
commenced writing business in Florida in 1998 through the
acquisition of the business and assets of a 64 office agency,
and continued our expansion into Florida in 1999 by arranging to
distribute our policies through a 42 office independent
insurance agency, the assets and business of which we acquired
in 2003. Our entrance into the Florida market

33



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##### 



was at the beginning of a period of significant
deterioration of results due largely to increased levels of
state-wide fraud in Floridas required personal injury
protection coverage that was further compounded by a period of
increased price competition. Accordingly, from 1998 to 2000, our
overall loss ratio increased approximately 24 points due to the
results of our Florida business.


Our inability to identify and acquire agency
acquisition candidates could hinder our growth by slowing down
our ability to expand into new states. If we do acquire
additional agencies, we could suffer increased costs, disruption
of our business and distraction of our management if we are
unable to integrate the acquired agencies into our operations
smoothly. Our expansion will also continue to place significant
demands on our management, operations, systems, accounting,
internal controls and financial resources. Any failure by us to
manage our growth and to respond to changes in our business
could have a material adverse effect on our business, financial
condition and results of operations.



| |                                                                                                                                                                                                                   
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Our plans to introduce new insurance and
    ancillary products and offer administrative services to other
    insurance companies may prove unsuccessful or subject us to
    greater liability than anticipated.

We are exploring the possibility of offering
additional insurance products, such as renters,
homeowners (including mobile homeowners),
motorcycle, boat and personal watercraft policies. These
additional insurance products may either be underwritten by
unaffiliated insurers from which we receive a commission or
underwritten by us. The majority of the underwriting risk with
respect to these products is expected to be ceded to
unaffiliated reinsurers from which we would receive a ceding
commission.

We have also been studying the feasibility of
providing other administrative services to third party insurers.
Such administrative services could include managing general
agency, underwriting and accounting services, reinsurance
consulting and other management services provided for a fee to a
risk retention group that would provide excess liability stop
loss insurance to members of the group. The fees or commissions
we might generate from these services would not involve the
assumption by us of any insurance underwriting risk. We are
considering providing these other administrative services
through our existing subsidiaries or a new subsidiary. Any new
subsidiary may either be wholly owned by us or majority owned by
us, in which case third party investors would own the remaining
equity interests in the new subsidiary.

Since we have no experience in providing the
insurance products and types of administrative services
discussed above, our attempt to enter these markets and/or
provide these services may prove unsuccessful. In order to
succeed in these new ventures, we will need to, among other
things, establish operating procedures, attract and retain
qualified employees with experience in handling these products
and services, install management information and other systems
relevant to supporting these products and services and complete
other tasks necessary to conduct our intended business
activities. We cannot assure you that we will be as successful
in accomplishing these necessary tasks as we have been in
providing our core business insurance products. We may also
encounter unforeseen situations that might lead to delays in
providing the products and services. In addition, we will, to
some extent, bear the underwriting risk related to the new
insurance products we may offer. These products may subject us
to greater liability than we currently anticipate.

Employees

As of January 31, 2004, we employed
approximately 2,000 employees. Our employees are not covered by
any collective bargaining agreements.

Item 2.  Properties.

We lease approximately 37,500 square feet of
office space in Nashville, Tennessee for our corporate
headquarters and approximately 30,000 square feet of office
space in Memphis, Tennessee for our executive offices and a
claims center. We also lease an aggregate of approximately
135,000 square feet of office space for additional claims
centers in Columbia, South Carolina, Knoxville, Tennessee and
Tampa, Florida and for our administrative and customer service
center located in Baton Rouge, Louisiana. In addition, we lease
office space for our numerous neighborhood sales offices, none
of which is material to our business.

34



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Item 3.  Legal
Proceedings.

We and our subsidiaries are named from time to
time as defendants in various legal actions that are incidental
to our business and arise out of or are related to claims made
in connection with our insurance policies, claims handling,
premium finance agreements and other contracts, and employment
related disputes. The plaintiffs in some of these lawsuits have
alleged bad faith or extracontractual damages and some have
claimed punitive damages. We believe that the resolution of
these legal actions will not have a material adverse effect on
our financial position or results of operations.

In addition to legal actions that are incidental
to our business, one or more of our subsidiaries has been named
as a defendant in a number of currently pending putative class
action lawsuits. These legal actions are described below.

During 2003, we entered into a voluntary
settlement agreement regarding all aspects of two proposed class
actions filed in Tennessee state courts alleging, among other
things, that certain business practices relating to our premium
finance and insurance operations were unlawful. The settlement
became final on June 9, 2003. Out of over 1.1 million
settlement class members to whom notices of the settlement were
sent, approximately 130 persons gave notice that they elected
not to participate in the settlement (opt-out). None
of the class members objected to the settlement. The court has
determined that the majority of the purported opt-out notices
were timely and properly submitted. The majority of the opt-out
class members are represented by a single law firm; this
increases the risk that new lawsuits, including an additional
class action lawsuit, may be filed.

We are the subject of a purported class action in
Georgia which alleges that we have wrongfully calculated
unearned interest rebates owed to customers who have prepaid
their premium finance account balance. In addition, the
complaint contains allegations of fraud, deceptive trade
practices and usury violations. This matter is in the discovery
stage, and the ultimate outcome of this case is uncertain.

We are the subject of six purported class action
lawsuits in Florida brought by plaintiffs alleging that we have
violated Florida law in making payments to medical magnetic
resonance imaging providers in Florida. The ultimate outcome of
these cases is uncertain.

We are also subject to two purported class
actions in Florida, each of which was filed in April 2003.
One of these actions alleges that we improperly cancelled
insurance policies, and the second action alleges that we
charged and collected unlawful service and finance charges with
respect to the financing of purported automobile club
memberships. These cases are in the discovery stage, and the
ultimate outcome of these cases is uncertain.

We believe that a substantial portion of the
damages claimed in these purported class action lawsuits are
covered by insurance, although under these policies, we will be
required to pay the first $1 million of defense costs or
judgments in each of these actions. It is possible that our
insurance carriers could deny coverage, which, if successful,
could result in our being liable for the full amount of defense
costs, settlements or judgments.

We and our subsidiaries intend to vigorously
defend each of the above referenced lawsuits, including any new
lawsuits filed by the opt-out class members described in
connection with the settled Tennessee class action. Although we
are optimistic regarding our successful defense of the above
cases, because of the inherent uncertainties related to this
type of litigation, we are unable to predict the ultimate
outcome of these cases, or the likelihood or amount of our
potential liability, if any, of these cases if they are not
successfully defended or settled, or the effect that these
pending cases may have on our business, operations,
profitability, or financial condition, if they are not
successfully defended.

William C. Adair, Jr., our Chairman, Chief
Executive Officer and President has been named as a defendant in
a lawsuit filed in Tennessee state court in November 2003.
The complaint alleges that Mr. Adair induced the plaintiff
to market a Health Plan, that Mr. Adair made
certain misrepresentations to the plaintiff and that
Mr. Adair breached a contract that resulted in a loss of
commissions to the plaintiff. Based on these allegations,
plaintiff is seeking compensatory damages and an unspecified
amount of punitive

35



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##### 



damages. We are not named as a defendant in this
lawsuit; however, the plaintiffs counsel has recently
stated an intention to add us as a defendant. This lawsuit
against Mr. Adair is still in the early procedural stages, and
the ultimate outcome of this case is uncertain. If we are named
as a defendant in this lawsuit, we will vigorously defend
against any claims.


Item 4.  Submission of
Matters to a Vote of Security Holders.

No matter was submitted to a vote of the security
holders by us during the fourth quarter of 2003.

PART II

Item 5.  Market for
Registrants Common Equity and Related Stockholder
Matters.



Market Information


Our common stock has been traded on the Nasdaq
National Market under the symbol DRCT since our
initial public offering on August 11, 2003. The initial
public offering price of our common stock was $21 per share. The
following table sets forth, for the periods indicated, the high
and low sales prices for our common stock as reported on the
Nasdaq National Market:

|                                      |  |      |       |     |  |   |       | 
|------------------------------------- |  | ---- | ----- | --- |  | - | ----- | 
|                                      |  | High |       | Low
|                                      |  |      |       |    
|2004                                  |  |      |       |     |  |   |       | 
|First quarter (through March 3, 2004) |  | $    | 36.20 |     |  | $ | 30.64 | 
|2003                                  |  |      |       |     |  |   |       | 
|Fourth quarter                        |  | $    | 33.78 |     |  | $ | 25.00 | 
|Third quarter (from August 12, 2003)  |  | $    | 26.69 |     |  | $ | 23.01 | 

Holders

On March 3, 2004, the last quoted sale price
of our common stock as reported by the Nasdaq National Market
was $34.10 per share. As of March 3, 2004, there were 59
holders of record of our common stock.

Dividends

We declared a quarterly dividend of $0.04 per
common share on November 7, 2003 for shareholders of record
on December 1, 2003, and the dividend was paid on
December 15, 2003. We declared a quarterly dividend of
$0.04 per common share on February 25, 2004 for
shareholders of record on March 1, 2004, and the dividend
will be paid on March 15, 2004. We presently anticipate
continuing the payment of quarterly cash dividends.

The declaration and payment of dividends is
subject to the discretion of our board of directors and will
depend on our financial condition, results of operations, cash
requirements, future prospects, regulatory and contractual
restrictions on the payment of dividends by our subsidiaries,
and other factors deemed relevant by our board of directors.
Further, we may enter into new agreements or incur additional
indebtedness in the future which may further prohibit or
restrict the payment of dividends. There is no requirement that
we must, and we cannot assure you that we will, declare and pay
any dividends in the future. Our board of directors may
determine to retain such capital for general corporate or other
purposes. For a discussion of our cash resources and needs, see
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Financial
Condition  Liquidity and Capital Resources.

Direct General Corporation is a holding company
and a legal entity separate and distinct from our operating
subsidiaries. As a holding company without significant
operations of our own, our principal sources of funds are
dividends and other payments from our operating subsidiaries.
The ability of our insurance subsidiaries to pay dividends is
subject to limits under insurance laws of the states in which we
conduct business. Furthermore, while there are no restrictions
on payment of dividends from our agency,

36



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##### 



administrative, and consumer products
subsidiaries, other than typical state corporation law
requirements, dividends from our premium finance subsidiary are
limited by the minimum capital requirements in state regulations
and by covenants in our loan agreements that require approval of
our lenders. See Managements Discussion and Analysis
of Financial Condition and Results of Operations 
Financial Condition  Liquidity and Capital
Resources and Business  Regulatory
Environment.


Securities Authorized for Issuance Under
Equity Compensation Plans

The following table sets forth information as of
December 31, 2003 about all of our equity compensation
plans. All plans have been approved by our shareholders.

|                                                                |                                    |                  |           |                |  |                      |       |       |  |  |         |         | 
|--------------------------------------------------------------- | ---------------------------------- | ---------------- | --------- | -------------- |  | -------------------- | ----- | ----- |  |  | ------- | ------- | 
|                                                                |                                    |                  |           |                |  | Number of           
|                                                                |                                    |                  |           |                |  | securities          
|                                                                |                                    |                  |           |                |  | remaining           
|                                                                |                                    |                  |           | Weighted-      |  | available for       
|                                                                |                                    | Number of        |           | average        |  | future issuance     
|                                                                |                                    | securities to be |           | exercise price |  | under equity        
|                                                                |                                    | issued upon      |           | of outstanding |  | compensation        
|                                                                |                                    | exercise of      |           | options,       |  | plans (excluding    
|                                                                |                                    | outstanding      |           | warrants and   |  | securities reflected
|Plan Category                                                   |                                    | and rights       |           | rights         |  | in column (a))      
|                                                                |                                    |                  |           |                |  |                     
|                                                                |                                    | (a)              |           | (b)            |  | (c)                 
|Equity compensation plans approved by security
    holders:     |                                    |                  |           |                |  |                      |       |       |  |  |         |        
|                                                                | 1996 Employee Stock Incentive Plan |                  |           | 678,000        |  |                      | $     | 1.94  |  |  |         | 0       | 
|                                                                | 2003 Equity Incentive Plan         |                  |           | 924,000        |  |                      | $     | 21.00 |  |  |         | 756,000 | 
|Equity compensation plans not approved by
    security holders: |                                    |                  |           |                |  |                      |       |       |  |  |         |        
|                                                                |                                    |                  |           |                |  |                      |       |       |  |  |         |        
|Total                                                           |                                    |                  | 1,602,000 |                |  | $                    | 12.93 |       |  |  | 756,000 |        
|                                                                |                                    |                  |           |                |  |                      |       |       |  |  |         |        

For other information on our equity compensation
plans, refer to Item 12, Security Ownership of
Certain Beneficial Owners and Management.

37



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##### 



Item 6.  Selected Financial
Data.

The following tables provide selected historical
consolidated financial and operating data of Direct General as
of the dates and for the periods indicated. In conjunction with
the data provided in the following tables and in order to more
fully understand our historical consolidated financial and
operating data, you should also read Managements
Discussion and Analysis of Financial Condition and Results of
Operations and our consolidated financial statements and
the accompanying notes included in this report. We derived our
selected historical consolidated financial data as of
December 31, 2003 and 2002 and for the years ended
December 31, 2003, 2002 and 2001 from our audited
consolidated financial statements included in this report. We
derived our selected historical consolidated financial data as
of December 31, 2001, 2000 and 1999 and for the years ended
December 31, 2000 and 1999 from our audited consolidated
financial statements not included in this report. The results
for past accounting periods are not necessarily indicative of
the results to be expected for any future accounting period.

|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |            |       | 
|----------------------------------------------------------------------------------------------------------- | ------------------------------------------------------ | -------------------------------------- | ---------- | ---------- | ----- | ---- | ---------- | ---------- | ----- | ---- | ---------- | ---------- | ----- | - | ---------- | ---------- | ----- | - | ---------- | ---------- | ----- | 
|                                                                                                            |                                                        |                                       
|                                                                                                            |                                                        | Year Ended December 31,               
|                                                                                                            |                                                        |                                       
|                                                                                                            |                                                        | 2003                                   |            | 2002       |       | 2001 |            | 2000       |       | 1999
|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |     
|                                                                                                            |                                                        |                                       
|                                                                                                            |                                                        | ($ in millions, except per share data)
|Statement of Operations Data:                                                                               |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|Premiums earned                                                                                             |                                                        | $                                      | 228.5      |            |       | $    | 145.0      |            |       | $    | 98.0       |            |       | $ | 73.9       |            |       | $ | 91.6       |           
|Finance income                                                                                              |                                                        |                                        | 44.9       |            |       |      | 35.7       |            |       |      | 27.3       |            |       |   | 24.6       |            |       |   | 21.6       |           
|Commission and service fee income                                                                           |                                                        |                                        | 33.6       |            |       |      | 27.2       |            |       |      | 22.1       |            |       |   | 21.9       |            |       |   | 21.1       |           
|Net investment income                                                                                       |                                                        |                                        | 6.7        |            |       |      | 5.3        |            |       |      | 5.1        |            |       |   | 5.0        |            |       |   | 5.2        |           
|Net realized gains (losses) on securities
    and other                                                     |                                                        |                                        | 3.4        |            |       |      | (0.1       | )          |       |      | 2.2        |            |       |   | 0.0        |            |       |   | (0.1       | )         
|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|                                                                                                            |                                                        | Total revenues                         |            |            | 317.1 |      |            |            | 213.1 |      |            |            | 154.7 |   |            |            | 125.4 |   |            |            | 139.4 | 
|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|Insurance losses and loss adjustment expenses                                                               |                                                        |                                        | 168.2      |            |       |      | 100.7      |            |       |      | 93.9       |            |       |   | 72.5       |            |       |   | 69.1       |           
|Selling, general and administrative costs                                                                   |                                                        |                                        | 74.5       |            |       |      | 59.7       |            |       |      | 53.9       |            |       |   | 47.5       |            |       |   | 53.2       |           
|Interest expense                                                                                            |                                                        |                                        | 6.4        |            |       |      | 6.2        |            |       |      | 7.6        |            |       |   | 8.8        |            |       |   | 6.7        |           
|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|                                                                                                            |                                                        | Total expenses                         |            |            | 249.1 |      |            |            | 166.6 |      |            |            | 155.4 |   |            |            | 128.8 |   |            |            | 129.0 | 
|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|Income (loss) before income taxes                                                                           |                                                        |                                        | 68.0       |            |       |      | 46.5       |            |       |      | (0.7       | )          |       |   | (3.4       | )          |       |   | 10.4       |           
|Income tax expense (benefit)                                                                                |                                                        |                                        | 24.9       |            |       |      | 15.5       |            |       |      | (1.1       | )          |       |   | (1.7       | )          |       |   | 2.8        |           
|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|                                                                                                            |                                                        | Net income (loss)                      |            | $          | 43.1  |      |            | $          | 31.0  |      |            | $          | 0.4   |   |            | $          | (1.7  | ) |            | $          | 7.6   | 
|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|                                                                                                            | Net income (loss) available to common
    shareholders |                                        | $          | 42.7       |       |      | $          | 30.5       |       |      | $          | (0.1       | )     |   | $          | (2.2       | )     |   | $          | 7.0        |      
|                                                                                                            |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|Operating Data:                                                                                             |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|Gross premiums written(1)                                                                                   |                                                        | $                                      | 435.2      |            |       | $    | 335.2      |            |       | $    | 238.7      |            |       | $ | 179.4      |            |       | $ | 156.5      |           
|Net premiums written(2)                                                                                     |                                                        |                                        | 295.1      |            |       |      | 181.0      |            |       |      | 112.9      |            |       |   | 72.5       |            |       |   | 77.3       |           
|Gross revenues(3)                                                                                           |                                                        |                                        | 523.8      |            |       |      | 403.3      |            |       |      | 295.4      |            |       |   | 230.9      |            |       |   | 204.3      |           
|Net income (loss) adjusted for write-off of
    reinsurance recoverables from Reliance Insurance Company(4) |                                                        |                                        | 43.1       |            |       |      | 31.0       |            |       |      | 7.8        |            |       |   | (1.7       | )          |       |   | 7.6        |           
|Balance Sheet Data:                                                                                         |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|Cash, cash equivalents and total investments                                                                |                                                        | $                                      | 353.6      |            |       | $    | 213.3      |            |       | $    | 145.2      |            |       | $ | 91.4       |            |       | $ | 100.8      |           
|Total assets                                                                                                |                                                        |                                        | 751.2      |            |       |      | 569.1      |            |       |      | 433.0      |            |       |   | 335.2      |            |       |   | 291.9      |           
|Total liabilities and redeemable preferred stock                                                            |                                                        |                                        | 573.8      |            |       |      | 509.9      |            |       |      | 402.0      |            |       |   | 303.5      |            |       |   | 259.6      |           
|Total shareholders equity                                                                                  |                                                        |                                        | 177.4      |            |       |      | 59.2       |            |       |      | 31.0       |            |       |   | 31.7       |            |       |   | 32.3       |           
|Per Share Data(5):                                                                                          |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|Earnings per common share:                                                                                  |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|                                                                                                            | Basic                                                  |                                        | $          | 2.74       |       |      | $          | 2.30       |       |      | $          | (0.01      | )     |   | $          | (0.17      | )     |   | $          | 0.53       |      
|                                                                                                            | Diluted(6)                                             |                                        |            | 2.20       |       |      |            | 1.68       |       |      |            | (0.01      | )     |   |            | (0.17      | )     |   |            | 0.43       |      
|Book value per common share                                                                                 |                                                        |                                        | 8.31       |            |       |      | 4.12       |            |       |      | 1.62       |            |       |   | 1.69       |            |       |   | 1.73       |           
|Weighted average shares outstanding:                                                                        |                                                        |                                        |            |            |       |      |            |            |       |      |            |            |       |   |            |            |       |   |            |           
|                                                                                                            | Basic                                                  |                                        |            | 15,609,411 |       |      |            | 13,264,452 |       |      |            | 13,366,404 |       |   |            | 13,307,868 |       |   |            | 13,307,868 |      
|                                                                                                            | Diluted(6)                                             |                                        |            | 19,679,610 |       |      |            | 18,733,056 |       |      |            | 18,918,096 |       |   |            | 18,928,056 |       |   |            | 18,928,080 |      
|Common shares outstanding                                                                                   |                                                        |                                        | 21,350,640 |            |       |      | 12,119,148 |            |       |      | 13,447,512 |            |       |   | 13,307,868 |            |       |   | 13,307,868 |           

38



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|    |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Gross premiums written is the sum of direct
    premiums written and assumed premiums written. Direct premiums
    written is the sum of the total policy premiums, net of
    cancellations, associated with policies underwritten and issued
    by our insurance subsidiaries. Assumed premiums written is the
    sum of total premiums associated with the insurance risk
    transferred to us by other insurance companies pursuant to
    reinsurance contracts. See Note 7 to our audited
    consolidated financial statements included in this report.                                                                                                                                                                                                                                                                                                                                                 
|   
|(2) | Net premiums written is the sum of direct
    premiums written and assumed premiums written less ceded
    premiums written. Ceded premiums written is the portion of our
    direct and assumed premiums written that we transfer to our
    reinsurers in accordance with the terms of our reinsurance
    contracts based upon the risks they accept. See Note 7 to
    our audited consolidated financial statements included in this
    report.                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|   
|(3) | Gross revenues is the sum of direct premiums
    written and assumed premiums written (which we refer to in this
    report as gross premiums written) plus all other revenues
    (finance income, commission and service fee income, net
    investment income and net realized gains (losses) on
    securities). We consider gross revenues to be a non-GAAP
    financial measure and have provided, in Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations  Measurement of Results, an
    explanation of why we believe gross revenues is a financial
    measure that is useful to management and investors and a
    reconciliation of gross revenues to total revenues, which is the
    most directly comparable GAAP financial measure included in our
    financial statements.                                                                         
|   
|(4) | Net income for the year ended December 31,
    2001 reflects a $7.4 million after-tax loss attributable to
    a write-off of reinsurance recoverables from Reliance Insurance
    Company. We consider net income (loss) adjusted for
    write-off of reinsurance recoverables from Reliance Insurance
    Company to be a non-GAAP financial measure. Because we have not
    had any other material write-offs of reinsurance recoverables in
    our history, we believe that the $7.8 million adjusted net
    income ($0.4 million reported net income plus the
    $7.4 million after-tax impact of the write-off) is useful
    to management and investors in understanding our improvement in
    operating results from 2000 to 2003. See Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations  Results of Operations 
    Overview of Operating Results.
|   
|(5) | Adjusted to reflect a 12 for 1 stock split that
    became effective prior to the closing of our initial public
    offering in August 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
|   
|(6) | Includes the weighted average common shares
    outstanding and assumes conversion of our Series A
    redeemable preferred stock and Series B preferred stock
    because both series of preferred stock were convertible at the
    option of the holders and were dilutive. Also includes the
    dilutive effect of the common stock warrant which was exercised
    upon the closing of our initial public offering; however, for
    the years ended December 31, 2002, 2001, 2000 and 1999, the
    warrant was anti-dilutive and was not included in those periods.                                                                                                                                                                                                                                                                                                                                       



|        |                                                                                           
|------- | ------------------------------------------------------------------------------------------
|Item 7. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations.

The following discussion should be read in
conjunction with our consolidated financial statements and
accompanying notes included in this report. This discussion
contains forward-looking statements that involve risks and
uncertainties. Our actual results could differ materially from
those anticipated in these forward-looking statements as a
result of various factors, including those discussed below and
elsewhere in this report, particularly under the caption
Business  Risk Related to our
Business.

Overview

We are a provider of non-standard personal
automobile insurance, premium finance and other insurance and
non-insurance products and services. Our operations are
concentrated in the southeastern part of the United States. Our
business model integrates our insurance, premium finance and
agency subsidiaries. Our model also emphasizes the distribution
of our products and services through neighborhood sales offices
staffed by employee-agents as opposed to commissioned agents.
The expansion of our neighborhood sales offices in selected
states includes the use of independent insurance agencies, which
we generally have options to acquire in the future.

39



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Our core business involves issuing non-standard
personal automobile insurance policies. These policies, which
are generally issued for the minimum limits of coverage required
by state laws, provide coverage to drivers who cannot obtain
insurance from standard carriers due to a variety of factors,
including the lack of flexible payment plans, the failure to
maintain continuous coverage, age, prior accidents, driving
violations, occupation and type of vehicle. Customers in the
non-standard market generally have higher average premiums for a
comparable amount of coverage than customers who qualify for the
standard market. The higher average premiums typically result
from an increased frequency of losses, which is partially offset
by the lower severity of losses resulting from lower limits of
coverage. In some states, we produce personal automobile
insurance policies for unaffiliated insurance companies through
our distribution system. We assume this business from
unaffiliated insurers through reinsurance agreements and earn
service fees for our agency, underwriting, policy administration
and claims adjustment services performed for the unaffiliated
insurers.

Through our premium finance subsidiary, we
finance the premiums on the majority of the insurance policies
that we sell by lending to customers the premium due to the
insurance company. We earn fees and interest income from our
premium finance operations. These loans are backed by the
unearned portion of the insurance premiums being financed, which
is the portion of the loan attributable to future periods of
coverage. We structure our payment plans and integrate our
systems in an attempt to minimize principal losses on our
premium finance loans.

We seek to attract customers by developing strong
brand name recognition in our markets through our low-cost
television advertising campaigns that emphasize our low down
payment, flexible payment plans, convenient neighborhood
locations and customer service. Our neighborhood offices serve
as a network for both product delivery and payment collection.
All policy applications are completed in the neighborhood sales
offices, and most of our customers revisit these offices at
least monthly to make their periodic payments.

Our business model provides our employee-agents
with customer contact at the point of sale and when the customer
returns to make periodic payments. This contact allows us to
offer a variety of products in addition to our core product,
non-standard personal automobile insurance. We provide term life
insurance policies through our wholly-owned life insurance
subsidiary, as well as vehicle protection insurance, travel
protection insurance and hospital indemnity insurance
underwritten by unaffiliated insurers, for which we receive
commission and service fee income. We also offer ancillary
non-insurance products and services.

Our revenues are derived principally from:



| |   |                                                                                                                                                                                                                                                                                                                                                                                 
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | premiums we earn from sales of direct and assumed
    non-standard personal automobile and term life insurance
    policies, which we refer to in this report as gross premiums,
    less the portion of those premiums that is ceded to other
    insurers, which we refer to in this report as ceded premiums,
    with the difference being what we refer to as net premiums;
|
| |  | ancillary income, which includes:                                                                                                                                                                                                                                                                                                                                               



| |   |                                                                                                                                                                             
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | interest and fees earned on the financing of
    insurance policies; and                                                                                                    
|
| |  | commission and service fee income that we earn in
    connection with the sales and servicing of insurance products
    underwritten by other insurers and other income; and



| |   |                                                                               
| | - | ------------------------------------------------------------------------------
| |  | investment income that we earn on the invested
    assets of our subsidiaries.

Our expenses consist predominately of:



| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | insurance losses and loss adjustment expenses
    (which we sometimes refer to in this report as LAE) including
    estimates for losses incurred during the period and changes in
    estimates from prior periods related to direct and assumed
    non-standard personal automobile and term life insurance
    policies (which we refer to in this report as gross insurance
    losses and loss adjustment expenses), less the portion of those
    insurance losses and loss adjustment expenses that are ceded to
    other insurers (which we refer to in this report as ceded
    insurance losses and loss adjustment expenses) (we refer to the
    difference as net insurance losses and loss adjustment
    expenses); and

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| |   |                                 
| | - | --------------------------------
| |  | operating expenses that include:



| |   |                                                                                                                                                                                                                                                       
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | selling, general and administrative, or SGA
    costs, including salaries, advertising, commissions and other
    expenses of our employee-agent distribution channel reduced by
    ceding commissions received under our reinsurance agreements; and
|
| |  | interest expense under our premium finance
    revolving credit facility.                                                                                                                                                                             

Measurement of Results

We evaluate our operations by monitoring key
measures of growth and profitability. We measure our growth by
examining our gross revenues, which are comprised of gross
premiums written and revenues from all other sources produced
through our distribution system. We generally measure our
operating results by examining our net income, return on equity,
and our loss, expense and combined ratios. In addition, we
evaluate our performance by comparing the level of our ancillary
income to premiums earned and to operating expenses. The
following provides further explanation of the key measures that
we use to evaluate our results:

Gross Premiums
Written.Gross premiums written is the
sum of direct premiums written and assumed premiums written.
Direct premiums written is the sum of the total policy premiums,
net of cancellations, associated with policies underwritten and
issued by our insurance subsidiaries. Assumed premiums written
is the sum of total premiums associated with the insurance risk
transferred to us by other insurance companies pursuant to
reinsurance contracts. See Note 7 to our audited
consolidated financial statements included in this report. We
use gross premiums written, which excludes the impact of
premiums ceded to reinsurers, as a measure of the underlying
growth of our insurance business from period to period.

Net Premiums
Written.Net premiums written is the
sum of direct premiums written and assumed premiums written less
ceded premiums written. Ceded premiums written is the portion of
our direct and assumed premiums that we transfer to our
reinsurers in accordance with the terms of our reinsurance
contracts based upon the risks they accept. See Note 7 to our
audited consolidated financial statements included in this
report. We use net premiums written, primarily in relation to
gross premiums written, to measure the amount of business
retained after cessions to reinsurers.

Gross Revenues (a non-GAAP financial
measure).Gross revenues is the sum of
gross premiums written plus all other revenues (finance income,
commission and service fee income, net investment income and net
realized gains (losses) on securities). We use gross revenues as
the primary measure of the underlying growth of our revenue
streams from period to period. Gross revenues are reconciled to
total revenues in the Managements Discussion and
Analysis of Financial Condition and Results of
Operations  Results of Operations.

Loss Ratio.Loss
ratio is the ratio (expressed as a percentage) of losses and
loss adjustment expenses incurred to premiums earned and
measures the underwriting profitability of a companys
insurance business. Loss ratio generally is measured on both a
gross (direct and assumed) and net (gross less ceded) basis. We
use the gross loss ratio as a measure of the overall
underwriting profitability of the insurance business we write
and to assess the adequacy of our pricing. Our net loss ratio is
meaningful in evaluating our financial results, which are net of
ceded reinsurance, as reflected in our consolidated financial
statements. Our loss ratios are generally calculated in the same
way for GAAP and statutory accounting purposes.

Expense Ratio.Expense ratio is the ratio (expressed as a percentage) of net
operating expenses to premiums earned and measures a
companys operational efficiency in producing, underwriting
and administering its insurance business. For statutory
accounting purposes, operating expenses of an insurance company
exclude investment expenses, and are reduced by other income.
There is no such industry definition for determining an expense
ratio for GAAP purposes. As a result, we apply the statutory
definition to calculate our expense ratio on a GAAP basis. We
reduce our operating expenses by ancillary income (excluding net
investment income and realized gains (losses) on
securities) to calculate our net operating expenses. Due to our
historically high levels of reinsurance, we calculate our
expense ratio on both a gross basis (before the effect of ceded
reinsurance) and a net basis (after the effect of ceded
reinsurance). Although

41



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##### 



the net basis is meaningful in evaluating our
financial results that are net of ceded reinsurance, as
reflected in our consolidated financial statements, we believe
that the gross expense ratio better reflects the operational
efficiency of the underlying business and is a better measure of
future trends.


Combined Ratio.Combined ratio is the sum of the loss ratio and the expense
ratio and measures a companys overall underwriting profit.
If the combined ratio is at or above 100, an insurance company
cannot be profitable without investment income (and may not be
profitable if investment income is insufficient). We use the
GAAP combined ratio in evaluating our overall underwriting
profitability and as a measure for comparison of our
profitability relative to the profitability of our competitors.

Ancillary Income
Measures.We have developed measures
of our ability to generate ancillary income that reflect the
differences between our business model and those used by our
competitors. We measure our ancillary income as a percentage of
premiums earned and as a percentage of our operating expenses.
We believe that most of our competitors only achieve point of
sale contact through an independent agent and are therefore
typically unable to generate significant amounts of ancillary
income.

Critical Accounting Policies

The preparation of financial statements in
conformity with GAAP requires management to make estimates and
assumptions that affect amounts reported in the financial
statements. As more information becomes known, these estimates
and assumptions could change, thus having an impact on the
amounts reported in the future. We view the estimates and
assumptions used in establishing our reserves for losses and
loss adjustment expenses and the estimates of future policy
cancellations used in determining the amounts recorded as
commissions and service fees and ceding commissions as our
critical accounting policies.

Insurance Losses and Loss Adjustment Expense
Reserves.Months and sometimes years
may elapse between the occurrence of an automobile accident
covered by one of our policies, reporting of the accident to us
and our payment of the claim. We record a liability for
estimates of losses that will be paid for accidents that have
been reported to us, which we refer to in this report as case
reserves. In addition, since accidents are not always reported
when they occur, we estimate liabilities for accidents that have
occurred but have not been reported to us, which we refer to in
this report as incurred but not reported, or IBNR reserves.

We are directly liable for loss and loss
adjustment expenses under the terms of the insurance policies
our insurance subsidiaries underwrite. Each of our insurance
subsidiaries establishes a reserve for all of its unpaid losses
and loss adjustment expenses, including case and IBNR reserves,
and estimates for the cost to settle the claims. We rely
primarily on historical loss experience in determining reserve
levels, on the assumption that historical loss experience
provides a good indication of future loss experience. Our
internal actuarial staff reviews our insurance
subsidiaries reserves quarterly for each year on a state
and coverage level. Quarterly reviews allow for timely
adjustments to reserves based on additional information. As part
of these quarterly reviews, our actuarial staff performs various
tests to estimate ultimate average severity and frequency of
claims. Severity represents the average cost per claim and
frequency represents the number of claims per policy. As part of
the overall review, the staff then evaluates loss and LAE ratios
by accident year by state and by coverage for reasonableness.
Estimation of LAE reserves is subject to variation as a result
of factors such as inflation, claims settlement patterns,
legislative activity and litigation trends. Also, we make key
assumptions regarding future claims emergence, the number of
claims to be closed in the future, the future impact of
inflation, amounts that may be collected from subrogation or
salvage and amount of claims that can be closed with or without
payment. Changes in the assumptions we employ or our estimates
associated with such assumptions could result in materially
different amounts being reported as reserves. If necessary, we
will increase or decrease the level of our reserves as
experience develops or new information becomes known, in the
period in which changes to the estimates are determined.
Accordingly, the actual losses and loss adjustment expenses may
differ materially from the estimates we have recorded. See
Business  Loss and Loss Adjustment Expense
Reserves for additional information.

Effect of Future
Cancellations.The insurance policies
that we write, through our insurance subsidiaries and on behalf
of other insurers for which we receive a commission, are subject
to being cancelled by the policyholder prior to the policy
expiration date. As a result, we estimate the effect of future
cancellations in

42



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##### 



determining the amount of commission and service
fee income and ceding commissions that are recorded in our
consolidated financial statements. We use historical
cancellation rates that are updated quarterly to estimate future
cancellations with the effect of any changes in our estimates
being recorded in the period in which the change in the estimate
is determined to be necessary. However, actual cancellations may
differ materially from the cancellation estimates that we used.
As of December 31, 2003, the reserve for return of
commission and service fee income and return of ceding
commissions was $4.9 million and $3.1 million,
respectively.


Allowance for Finance Receivable
Losses.Losses on finance receivables
include an estimate of future credit losses on premium finance
accounts. Credit losses on premium finance accounts occur when
the unearned premiums received from the insurer upon
cancellation of a financed policy are inadequate to pay the
balance of the premium finance account. The majority of these
shortfalls result in the write-off of unrealized interest and
premium finance acquisition fees. We review historical trends of
such losses relative to finance receivable balances to develop
estimates of future losses. However, actual write-offs may
differ materially from the write-off estimates that we used. As
of December 31, 2003, the allowance for finance receivable
losses was $5.9 million.

See Note 1 to our audited consolidated financial
statements included in this report for a discussion of our other
significant accounting polices.

Results of Operations

The table below summarizes certain operating
results and key measures we use in monitoring and evaluating our
operations. The information provided is intended to summarize
and supplement information contained in our consolidated
financial statements and to assist the reader in gaining a
better understanding of our results of operations.

|                                                                                                     |                      |                         |        |       |  |      |        |       |  |   |        |       | 
|---------------------------------------------------------------------------------------------------- | -------------------- | ----------------------- | ------ | ----- |  | ---- | ------ | ----- |  | - | ------ | ----- | 
|                                                                                                     |                      |                        
|                                                                                                     |                      | Year Ended December 31,
|                                                                                                     |                      |                        
|                                                                                                     |                      | 2003                    |        | 2002  |  | 2001
|                                                                                                     |                      |                         |        |       |  |     
|                                                                                                     |                      |                        
|                                                                                                     |                      | ($ in millions)        
|Selected Financial Data                                                                              |                      |                         |        |       |  |      |        |       |  |   |        |      
|Gross premiums written                                                                               |                      | $                       | 435.2  |       |  | $    | 335.2  |       |  | $ | 238.7  |      
|Ancillary income                                                                                     |                      |                         | 78.5   |       |  |      | 62.9   |       |  |   | 49.4   |      
|Net investment income                                                                                |                      |                         | 10.1   |       |  |      | 5.2    |       |  |   | 7.3    |      
|                                                                                                     |                      |                         |        |       |  |      |        |       |  |   |        |      
|                                                                                                     | Gross revenues       |                         | $      | 523.8 |  |      | $      | 403.3 |  |   | $      | 295.4 | 
|Ceded premiums written                                                                               |                      |                         | (140.1 | )     |  |      | (154.2 | )     |  |   | (125.8 | )    
|Change in net unearned premiums                                                                      |                      |                         | (66.6  | )     |  |      | (36.0  | )     |  |   | (14.9  | )    
|                                                                                                     |                      |                         |        |       |  |      |        |       |  |   |        |      
|                                                                                                     | Total revenues       |                         | $      | 317.1 |  |      | $      | 213.1 |  |   | $      | 154.7 | 
|                                                                                                     |                      |                         |        |       |  |      |        |       |  |   |        |      
|Net income                                                                                           |                      | $                       | 43.1   |       |  | $    | 31.0   |       |  | $ | 0.4    |      
|                                                                                                     |                      |                         |        |       |  |      |        |       |  |   |        |      
|Net income adjusted for write-off of reinsurance
    recoverables from Reliance Insurance Company(1) |                      | $                       | 43.1   |       |  | $    | 31.0   |       |  |   | 7.8    |      
|                                                                                                     |                      |                         |        |       |  |      |        |       |  |   |        |      
|Key Financial Ratios                                                                                 |                      |                         |        |       |  |      |        |       |  |   |        |      
|Loss ratio  net                                                                                     |                      |                         | 73.6   | %     |  |      | 69.4   | %     |  |   | 95.8   | %    
|Expense ratio  net                                                                                  |                      |                         | 1.1    |       |  |      | 2.1    |       |  |   | 12.3   |      
|                                                                                                     |                      |                         |        |       |  |      |        |       |  |   |        |      
|                                                                                                     | Combined ratio  net |                         |        | 74.7  |  |      |        | 71.5  |  |   |        | 108.1 | 
|                                                                                                     |                      |                         |        |       |  |      |        |       |  |   |        |      
|Ancillary income to gross premiums earned                                                            |                      |                         | 19.9   |       |  |      | 22.1   |       |  |   | 23.8   |      
|Ancillary income to net operating expenses                                                           |                      |                         | 97.0   |       |  |      | 95.4   |       |  |   | 80.3   |      



---



|    |                                                                                                                                                                                                                                                                                                                              
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | Amounts adjusted for the $7.4 million
    after-tax effect of the write-off in 2001 of reinsurance
    balances recoverable from Reliance Insurance Company. If we
    exclude the impact of the write-off, the 2001 net loss ratio,
    net expense ratio and net combined ratio would have been 84.3%,
    12.6% and 96.9%,

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| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | respectively. We consider net income adjusted for
    the write-off of reinsurance recoverables from Reliance
    Insurance Company and the adjusted net loss, net expense and net
    combined ratios to be non-GAAP financial measures. Because we
    have not had any other material write-offs of reinsurance
    recoverables in our history, we believe that the adjusted net
    income and the corresponding adjusted net loss, net expense and
    net combined ratios are useful to management and investors in
    understanding our improvement in operating results from 2001 to
    2003. Reconciliations of the adjusted net income and the
    adjusted ratios are provided in Managements
    Discussion and Analysis of Financial Condition and Results of
    Operations  Overview of Operating Results.



| |                              
| | -----------------------------
| | Overview of Operating Results

Year Ended December 31, 2003 Compared to
Year Ended December 31, 2002.Net
income increased to $43.1 million in 2003 from
$31.0 million in 2002. The increase in net income was
primarily attributable to an increase in premium volume that
provided additional underwriting income and growth in ancillary
income, both of which were partially offset by an increase in
operating expenses. Our loss ratio in 2003 was 73.6% compared to
a 69.4% loss ratio in 2002. The impact of loss reserve
development was insignificant to our 2003 loss ratio; however,
our 2002 loss ratio was decreased by approximately
4.4 points due to the combined impact of favorable
development on prior year reserves and a gain on the commutation
of obligations of one of our reinsurers. Ancillary income
increased to $78.5 million in 2003 from $62.9 million
in 2002, which was sufficient to offset all but
$2.4 million and $3.0 million of operating expenses in
2003 and 2002, respectively. During 2003, we realized net gains
on securities and other of $3.4 million as compared to a
net realized loss of $0.1 million in 2002.

Year Ended December 31, 2002 Compared to
Year Ended December 31, 2001.Net
income was $31.0 million in 2002, compared to net income of
$0.4 million in 2001. The increase in net income from 2001
was primarily attributable to improved underwriting results from
decreasing loss ratios, an increase in premium volume that
provided additional underwriting margins and related ancillary
income, and the impact of the write-off of reinsurance
recoverable from Reliance in 2001. Our loss ratio in 2002
improved by 26.4 points to 69.4% compared to a 95.8% loss ratio
in 2001. The 2002 loss ratio was favorably impacted by
2.6 points due to favorable development of prior year
reserves and by 1.8 points attributable to a gain on the
commutation of prior year obligations of one of our reinsurers.
Our 2001 loss ratio was adversely impacted by 11.5 points as a
result of the write-off of recoverables from Reliance and an
additional 1.3 points of adverse development of prior year
reserves.

Our results improved during 2002 in virtually
every state in which we operate, with the most significant
improvement occurring in Florida, where our net loss ratio
improved from approximately 98% in 2001 to 68% in 2002. On a
direct basis, which excludes the impact of reinsurance including
the commutation in 2002 and the Reliance Insurance Company
write-off in 2001, the Florida loss ratio improved from
approximately 92% in 2001 to 71% in 2002. This improvement
resulted from the impact of rate increases, strengthened claims
procedures and fraud detection practices, and improved
underwriting standards. In addition, in response to the
September 2000 grand jury report on the level of fraud in
Floridas mandatory PIP coverage, the Florida legislature
enacted new laws in July and October 2001 designed to deter
insurance fraud by delaying the availability of accident
reports, requiring the registration of medical clinics, and
improving companies rights to investigate suspicious
claims.

We believe that the discussion about the
write-off of reinsurance recoverables from Reliance Insurance
Company provided below is useful to management and investors in
understanding the comparability of results between 2003, 2002
and 2001 because we have not had any other material write-offs
of reinsurance recoverables in our history. In 2001, our results
were adversely impacted by a write-off of $11.1 million,
$7.4 million after taxes, in reinsurance recoverables from
Reliance Insurance Company. Reliance Insurance Company was one
of the reinsurers in our quota share reinsurance program from
October 1996 to December 2000. Due to a rapid and
significant deterioration in Reliance Insurance Companys
underwriting results, adverse development on its loss reserves,
and liquidity issues that arose after the terrorist attacks on
September 11, 2001, Reliance Insurance Company was placed
into liquidation by the Pennsylvania Department of Insurance in
October 2001. The table provided below reconciles net
income to net income

44



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adjusted for the write-off of reinsurance
recoverables from Reliance Insurance Company (which is a
non-GAAP financial measure). The table below reflects the impact
of the write-off on each line item affected on our Statement of
Operations for the year ended December 31, 2001 and certain
key financial ratios (all of which are non-GAAP financial
measures).


|                                              |  |                 |       |           |  |              |       |    |  |   |       |  
|--------------------------------------------- |  | --------------- | ----- | --------- |  | ------------ | ----- | -- |  | - | ----- | -
|                                              |  |                 |       | Impact of |  | Adjusted    
|                                              |  | December 31,    |       | Reliance  |  | December 31,
|                                              |  | 2001            |       | Write-off |  | 2001        
|                                              |  |                 |       |           |  |             
|                                              |  |                
|                                              |  | ($ in millions)
|Premiums earned                               |  | $               | 98.0  |           |  | $            | 1.4   |    |  | $ | 99.4  |  
|                                              |  |                 |       |           |  |              |       |    |  |   |       |  
|Total revenues                                |  |                 | 154.7 |           |  |              | 1.4   |    |  |   | 156.1 |  
|                                              |  |                 |       |           |  |              |       |    |  |   |       |  
|Insurance losses and loss adjustment expenses |  |                 | 93.9  |           |  |              | (10.1 | )  |  |   | 83.8  |  
|Selling, general and administrative costs     |  |                 | 53.9  |           |  |              | 0.4   |    |  |   | 54.3  |  
|                                              |  |                 |       |           |  |              |       |    |  |   |       |  
|Total expenses                                |  |                 | 155.4 |           |  |              | (9.7  | )  |  |   | 145.7 |  
|                                              |  |                 |       |           |  |              |       |    |  |   |       |  
|Income (loss) before income taxes             |  |                 | (0.7  | )         |  |              | 11.1  |    |  |   | 10.4  |  
|Income tax expense (benefit)                  |  |                 | (1.1  | )         |  |              | 3.7   |    |  |   | 2.6   |  
|                                              |  |                 |       |           |  |              |       |    |  |   |       |  
|Net income                                    |  | $               | 0.4   |           |  | $            | 7.4   |    |  | $ | 7.8   |  
|                                              |  |                 |       |           |  |              |       |    |  |   |       |  
|Loss ratio  net                              |  |                 | 95.8  | %         |  |              | (11.5 | )% |  |   | 84.3  | %
|Expense ratio  net                           |  |                 | 12.3  |           |  |              | 0.3   |    |  |   | 12.6  |  
|                                              |  |                 |       |           |  |              |       |    |  |   |       |  
|Combined ratio  net                          |  |                 | 108.1 |           |  |              | (11.2 | )  |  |   | 96.9  |  



| |         
| | --------
| | Revenues



| |         
| | --------
| | Premiums

Premiums include non-standard personal automobile
insurance premiums and term life insurance premiums underwritten
by our insurance subsidiaries (which we refer to in this report
as direct premiums) and a percentage of non-standard personal
automobile insurance premiums assumed from other insurers
generally in states where we do not currently have a licensed
insurance subsidiary (which we refer to in this report as
assumed premiums). We refer to direct and assumed premiums
together as gross premiums. We manage virtually every aspect of
the assumed business, including pricing and underwriting, claims
settlement and customer service. We currently assume a
significant portion of non-standard personal automobile
insurance premiums for business produced in North Carolina and
Texas.

Premiums written refers to the total amount of
premiums billed to the policyholder less the amount of premiums
returned, generally as a result of cancellations, during a given
period. Premiums written become premiums earned as the policy
ages. Barring premium rate changes, if an insurance company
writes the same mix of business each year, premiums written and
premiums earned will be equal, and the unearned premium reserve
will remain constant. During periods of growth, the unearned
premium reserve will increase, causing premiums earned to be
less than premiums written. Conversely, during periods of
decline, the unearned premium reserve will decrease, causing
premiums earned to be greater than premiums written.

We have historically relied on quota share,
excess of loss, and catastrophe reinsurance primarily to manage
our regulatory capital requirements and also to limit our
exposure to loss. Generally, we have ceded a significant portion
of our non-standard automobile insurance premiums to
unaffiliated reinsurers in order to maintain a net premiums
written to statutory surplus ratio of approximately 3 to 1. We
retain 100% of our term life insurance premiums.

45



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The following table presents our gross premiums
written in our major markets and provides a summary of gross,
ceded and net premiums written and earned for the periods
indicated.

|                                                    |                  |                         |        |       |  |      |        |       |  |   |        |       | 
|--------------------------------------------------- | ---------------- | ----------------------- | ------ | ----- |  | ---- | ------ | ----- |  | - | ------ | ----- | 
|                                                    |                  |                        
|                                                    |                  | Year Ended December 31,
|                                                    |                  |                        
|                                                    |                  | 2003                    |        | 2002  |  | 2001
|                                                    |                  |                         |        |       |  |     
|                                                    |                  |                        
|                                                    |                  | ($ in millions)        
|Gross premiums written                              |                  |                         |        |       |  |      |        |       |  |   |        |      
|                                                    | Florida          |                         | $      | 223.5 |  |      | $      | 174.3 |  |   | $      | 110.2 | 
|                                                    | Tennessee        |                         |        | 63.0  |  |      |        | 58.6  |  |   |        | 42.6  | 
|                                                    | Georgia          |                         |        | 32.2  |  |      |        | 30.4  |  |   |        | 31.0  | 
|                                                    | Louisiana        |                         |        | 31.3  |  |      |        | 23.8  |  |   |        | 18.4  | 
|                                                    | Mississippi      |                         |        | 22.3  |  |      |        | 18.8  |  |   |        | 17.8  | 
|                                                    | Texas            |                         |        | 15.6  |  |      |        |      |  |   |        |      | 
|                                                    | All other states |                         |        | 47.3  |  |      |        | 29.3  |  |   |        | 18.7  | 
|                                                    |                  |                         |        |       |  |      |        |       |  |   |        |      
|Gross premiums written                              |                  | $                       | 435.2  |       |  | $    | 335.2  |       |  | $ | 238.7  |      
|Ceded premiums written                              |                  |                         | (140.1 | )     |  |      | (154.2 | )     |  |   | (125.8 | )    
|                                                    |                  |                         |        |       |  |      |        |       |  |   |        |      
|Net premiums written                                |                  | $                       | 295.1  |       |  | $    | 181.0  |       |  | $ | 112.9  |      
|                                                    |                  |                         |        |       |  |      |        |       |  |   |        |      
|Gross premiums earned                               |                  | $                       | 394.9  |       |  | $    | 284.3  |       |  | $ | 207.2  |      
|Ceded premiums earned                               |                  |                         | (166.4 | )     |  |      | (139.3 | )     |  |   | (109.2 | )    
|                                                    |                  |                         |        |       |  |      |        |       |  |   |        |      
|Net premiums earned                                 |                  | $                       | 228.5  |       |  | $    | 145.0  |       |  | $ | 98.0   |      
|                                                    |                  |                         |        |       |  |      |        |       |  |   |        |      
|Net premiums written to gross
    premiums written  |                  |                         | 67.8   | %     |  |      | 54.0   | %     |  |   | 47.3   | %    
|Gross premiums earned to gross
    premiums written |                  |                         | 90.7   |       |  |      | 84.8   |       |  |   | 86.8   |      
|Net premiums earned to net premiums written         |                  |                         | 77.4   |       |  |      | 80.1   |       |  |   | 86.8   |      



| |               
| | --------------
| | Gross Premiums

Year Ended December 31, 2003 Compared to
Year Ended December 31, 2002.Gross premiums written increased $100.0 million or 29.8% to
$435.2 million in 2003 from $335.2 million in 2002.
The majority of our growth occurred in our largest state,
Florida, which represented 51.4% of our business and accounted
for $49.2 million of the increase. Approximately 80% of the
growth in Florida was attributable to an increase in average
policies inforce, including an increase in the number of renewal
policies, with the remaining 20% coming from an increase in the
average premiums per policy. In January 2003, we began our
expansion into the state of Texas and are assuming non-standard
personal automobile insurance policies underwritten by a Texas
county mutual insurer. We assumed $15.6 million of gross
premiums written in Texas during 2003. The majority of the
increases in gross premiums written in our other states were due
primarily to increased market penetration. Gross premiums
earned, a function of gross premiums written over the current
and prior periods, increased to $394.9 million in 2003 from
$284.3 million in 2002.

Year Ended December 31, 2002 Compared to
Year Ended December 31, 2001.Gross premiums written increased $96.5 million or 40.4% in
2002 compared to 2001, while gross premiums earned increased
$77.1 million or 37.2%. These increases were primarily due
to increased market penetration and an increase in average
policy premiums. During 2002, average inforce policies increased
19.3%, while the average premium per policy inforce increased
11.4% compared to 2001. The majority of this growth occurred in
the states of Florida and Tennessee, which accounted for
$80.1 million or 83.0% of the growth in gross premium
written in 2002.



| |             
| | ------------
| | Net Premiums

Year Ended December 31, 2003 Compared to
Year Ended December 31, 2002.Net
premiums written increased 63.0% to $295.1 million in 2003
from $181.0 million in 2002. The ratio of net premiums
written to gross premiums written increased to 67.8% in 2003
from 54.0% in 2002 as the increased capitalization of our

46



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##### 



insurance subsidiaries enabled us to reduce our
ceding percentage and retain more business. Net premiums earned,
a function of net premiums written over the current and prior
periods, amounted to $228.5 million and equaled 77.4% of
net premiums written. This percentage is lower than the
relationship of gross premiums earned to gross premiums written
of 90.7% since the majority of the increase in business retained
did not occur until the third and fourth quarters of 2003.


Year Ended December 31, 2002 Compared to
Year Ended December 31, 2001.Net
premiums written for 2002 were $181.0 million, an increase
of 60.3%. Net premiums written were 54.0% of gross premiums
written, compared to 47.3% for 2001, reflecting a change in
reinsurance agreements that resulted in a decrease in the
percentage of business ceded during 2002. Net premiums earned, a
function of net premiums written for 2002, amounted to
$145.0 million and constituted 80.1% of net premiums
written, which is comparable to the relationship of gross
premiums earned to gross premiums written of 84.8%.



| |                 
| | ----------------
| | Ancillary Income

Ancillary income includes finance income,
commission and service fee income and other income. Finance
income primarily consists of interest, acquisition and service
fees, and delinquency fees on the premium finance agreements
related to the insurance policies we finance. Our agency and
administrative subsidiaries produce and service non-standard
personal automobile insurance business for other insurers from
which we assume a portion of this business, and in some cases
the entire premium, through reinsurance treaties. We receive
service fees for agency, underwriting, policy administration,
and claims adjusting services performed on behalf of these
unaffiliated insurers. We also receive commission and service
fee income on other insurance products produced for unaffiliated
insurance companies on which we do not bear underwriting risk,
including travel protection, vehicle protection and hospital
indemnity insurance policies. Our business model allows us to
generate a significant amount of ancillary income, which we
measure as a percentage of gross earned premiums and as a
percentage of our operating expenses. Our goal is to generate
ancillary income in amounts that will exceed all of our
operating expenses. The following table summarizes the
components of our ancillary income for the periods indicated.

|                                  |                        |                         |      |      |  |      |      |      |  |   |      |      | 
|--------------------------------- | ---------------------- | ----------------------- | ---- | ---- |  | ---- | ---- | ---- |  | - | ---- | ---- | 
|                                  |                        |                        
|                                  |                        | Year Ended December 31,
|                                  |                        |                        
|                                  |                        | 2003                    |      | 2002 |  | 2001
|                                  |                        |                         |      |      |  |     
|                                  |                        |                        
|                                  |                        | ($ in millions)        
|Finance income                    |                        | $                       | 44.9 |      |  | $    | 35.7 |      |  | $ | 27.3 |     
|Commission and service fee income |                        |                         | 33.6 |      |  |      | 27.2 |      |  |   | 22.1 |     
|                                  |                        |                         |      |      |  |      |      |      |  |   |      |     
|                                  | Total ancillary income |                         | $    | 78.5 |  |      | $    | 62.9 |  |   | $    | 49.4 | 
|                                  |                        |                         |      |      |  |      |      |      |  |   |      |     

Year Ended December 31, 2003 Compared to
Year Ended December 31, 2002.Ancillary income in 2003 increased 24.8% to $78.5 million
from $62.9 million in 2002. This increase was primarily due
to increased premium finance income as a result of higher
premium volumes, increased sales of ancillary insurance products
including business produced by the 42 Florida neighborhood sales
offices acquired in November 2003 and increased service fee
income related to the administration of our assumed business in
Texas. The increase in premium finance income is net of an
increase in the provision for finance receivable losses to
$7.0 million in 2003 from $5.3 million in 2002. The
majority of the increase in premium finance income is
attributable to the increase in average gross premium finance
receivables outstanding during the year. The allowance for
credit losses remained at 2.9% of gross finance receivables in
both 2003 and 2002. For the year ended December 31, 2003
and 2002, the ratio of ancillary income to gross premiums earned
was 19.9% and 22.1%, respectively, and the ratio of ancillary
income to operating expenses was 97.0% and 95.4%, respectively.

Year Ended December 31, 2002 Compared to
Year Ended December 31, 2001.Ancillary income was $62.9 million in 2002, an increase of
$13.5 million or 27.3% compared to 2001. This increase was
primarily due to an increase in premium finance income as a
result of increased premium volumes and increased penetration in
the sales of ancillary insurance products. The increase in
premium finance income also reflected a reduction in the
allowance for credit losses as a percentage of finance
receivables that resulted

47



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##### 



largely from the growth in the percentage of our
business in Florida. This business experienced actual write-offs
that were approximately 38% and 50% better than the combined
average of the other states in which we operated in 2002 and
2001, respectively. Additionally, the provision for finance
receivable losses decreased slightly in 2002 because we
experienced an overall reduction in the percentage of accounts
canceling within the first two months from inception, which
generally accounts for the majority of our write-offs. Ancillary
income constituted 22.1% of gross premiums earned and 95.4% of
our operating expenses for 2002 compared to 23.8% and 80.3% for
2001, respectively.




| |                      
| | ---------------------
| | Net Investment Income

Our investment portfolio is generally highly
liquid and consists substantially of readily marketable,
investment-grade debt securities. Net investment income is
primarily comprised of interest earned on these securities, net
of related investment expenses.

Year Ended December 31, 2003 Compared to
Year Ended December 31, 2002.Net
investment income increased to $6.7 million in 2003 from
$5.3 million in 2002 as a result of an increase in average
invested assets that was partially offset by a decrease in the
average yield on investments. Average invested assets increased
55.8% to $180.9 million in 2003 from $116.1 million in
2002 primarily as a result of the proceeds from our initial
public offering, the majority of which were invested in the
fourth quarter of 2003. The average investment yield decreased
to 3.7% in 2003 from 4.4% in 2002 since a large portion of our
portfolio was invested during the lower interest rate
environment prevailing in 2003.

Year Ended December 31, 2002 Compared to
Year Ended December 31, 2001.Net
investment income increased to $5.3 million from
$5.1 million in 2002 and 2001, respectively, due primarily
to an increase in invested assets largely offset by a decrease
in investment yields. Average invested assets grew 23.0% to
$116.1 million in 2002 from $94.4 million in 2001. Our
average investment yield for in 2002 was 4.4% compared to 4.5%
for 2001.



| |                                          
| | -----------------------------------------
| | Realized Gains (Losses) on
    Securities

Realized gains and losses on securities are
principally affected by changes in interest rates, the timing of
sales of investments and changes in credit quality of the
securities we hold as investments.

Year Ended December 31, 2003 Compared to
Year Ended December 31, 2002.Gross gains on debt securities for the year ended
December 31, 2003 were $2.6 million, which were partially
offset by gross losses of $0.6 million. Gross gains were
primarily attributable to the sale of certain securities as we
repositioned our bond portfolio based on our investment
guidelines for changes in market conditions and other factors.
Comparatively, in 2002, we realized gross gains on debt
securities of $0.9 million that largely offset our gross
losses of $1.0 million resulting from our investment in
WorldCom, Inc. bonds. There was no impact on realized losses
attributable to adjustments for other than temporary impairment
of securities held in our portfolio as of the end of either
period.

In 2003, we also realized gross gains of
$2.7 million and gross losses of $0.9 million on
closed contracts in our trading portfolio. The trading portfolio
primarily consists of futures contracts, swaps, and other
derivative instruments. This represents a speculative investment
and does not represent a hedge; accordingly, all open contracts
are marked to market with the change in market values included
in net realized gains (losses) on securities and
other in our consolidated statement of operations. For the
year ended December 31, 2003, net realized gains
(losses) on securities and other included a net loss
of $0.4 million related to open contracts which included
gross increases of $0.3 million and gross decreases of
$0.7 million.

Year Ended December 31, 2002 Compared to
Year Ended December 31, 2001.We
realized gross gains of $0.9 million and $2.4 million
and gross losses of $1.0 million and $0.2 million on the
sale of available for sale securities during 2002 and 2001,
respectively. The gross losses in 2002 were primarily
attributable to a loss on the sale of our investment in WorldCom
bonds. In 2001, we took advantage of the declining interest rate
environment and sold certain securities in our portfolio that
generated $2.4 million in gains. There was no impact on
realized losses attributable to adjustment for other than
temporary impairment of securities still

48



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held during these periods. Based on our analysis,
the securities that were determined to be impaired were sold in
the same period of the determination and the resulting loss was
included in net realized gains or losses on securities.




| |         
| | --------
| | Expenses



| |                                                  
| | -------------------------------------------------
| | Insurance Losses and Loss Adjustment
    Expenses

Insurance losses and loss adjustment expenses
represent our largest expense item and include payments made to
settle claims, estimates for future claim payments and changes
in those estimates for current and prior periods, as well as
adjusting costs incurred in connection with settling claims.
Insurance losses and loss adjustment expenses are influenced by
claim frequency and severity trends, the impact of changes in
estimates for prior accident years, and increases in the cost of
medical treatment and automobile repairs. The anticipated impact
of inflation is considered when we establish our premium rates
and set loss reserves. We perform an actuarial analysis each
quarter and establish or adjust (for prior accident quarters),
our best estimate of the ultimate incurred losses and loss
adjustment expenses to reflect loss development information and
trends that have been updated for the most recent quarters
activity. Our estimate of ultimate loss and loss adjustment
expenses is evaluated and re-evaluated by accident quarter, by
state and by major coverage grouping (e.g., bodily injury,
physical damage) and changes in estimates are reflected in the
period the additional information becomes known.

Our reinsurance program significantly influences
our net retained losses. In exchange for premiums ceded to
reinsurers under quota share and excess of loss reinsurance
agreements, our reinsurers assume a portion of the losses and
loss adjustment expenses incurred. See
Business  Reinsurance. We remain
obligated for amounts ceded in the event that the reinsurers do
not meet their obligations under the agreements (due to, for
example, disputes with the reinsurer or the reinsurers
insolvency). Since 2001, in an effort to manage the cost of
quota share reinsurance during a period of rising cost and
limited availability, we have added provisions for loss ratio
corridors and loss ratio caps to our quota share reinsurance
agreements that reduces the cost of reinsurance to us. These
provisions have been structured to provide the reinsurers with
some limit on the amount of potential loss being assumed, while
maintaining the transfer of significant insurance risk with the
possibility of a significant loss to the reinsurer, and
therefore reduce the cost of reinsurance to us. Loss ratio
corridors provide for layers of losses in which the reinsurer
does not participate in the losses while loss ratio caps cut off
the reinsurers liability for losses above a specified loss
ratio. We believe our reinsurance arrangements qualify for
reinsurance accounting in accordance with SFAS 113
Accounting for Reinsurance Contracts.

Year Ended December 31, 2003 Compared to
Year Ended December 31, 2002.For
the year ended December 31, 2003, insurance losses and loss
adjustment expenses increased to $168.2 million from
$100.7 million in 2002, and the net loss ratio was 73.6% in
2003 compared to 69.4% in 2002. The 2003 insurance losses and
loss adjustment expenses included $0.1 million in adverse
development. Our 2002 results included $5.5 million in
favorable development on prior years reserves that
included $1.8 million related to a gain on the commutation
of a reinsurers obligations related to prior year
reserves. The commutation also resulted in a $0.9 million
gain related to current year obligations. Our loss ratios,
excluding the impact of the commutation gains and adjustments to
prior years reserves, were 73.5% in 2003 and 73.8% in
2002. Catastrophic losses increased our annual loss ratios by
approximately 0.6 points in 2003 and 0.3 points in
2002.

In 2003, the frequency and severity trends in the
majority of our coverages remained relatively flat on a
country-wide basis. We did note an increase in claims frequency
in the Florida personal injury protection coverage, which we
believe is generally attributable to increased fraud activity in
the Miami market. We increased rates for personal injury
protection coverages in October 2003 and noted a
substantial reduction in new business in this market in November
and December. Our special investigations unit is actively
challenging those claims believed to be fraudulent. Overall, the
gross accident year loss ratio for the Florida automobile book
of business increased 1.7 points during 2003. The increase
in the Florida gross accident year loss ratio was offset by
lower accident year loss ratios in the majority of the states in
which we operate,

49



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including Texas where our loss experience was
below our countrywide average. Accident year loss ratios, as
compared to the loss ratios included in our financial
statements, include the impact of losses occurring within the
current accident year and exclude the current year impact of any
increase or decrease in losses and loss adjustment expenses
related to losses that occurred in prior years.


Our reserve for loss and loss adjustment expenses
as of December 31, 2003 was $112.6 million as
estimated through our actuarial analysis. During the year, our
actuarial analysis concluded that the December 31, 2002
reserve for loss and loss adjustment expenses of
$86.9 million was generally adequate as the adverse reserve
development for prior years reflected in the 2003 results was
only $0.1 million.

Year Ended December 31, 2002 Compared to
Year Ended December 31, 2001.Insurance losses and loss adjustment expenses increased to
$100.7 million in 2002 from $93.9 million in 2001. Net
loss ratios for 2002 and 2001 were 69.4% and 95.8%,
respectively. Net loss ratios in 2002 improved in virtually
every state in which we operate, reflecting the impact of
increased rate levels, stabilized loss trends and favorable loss
reserve development. We experienced favorable loss reserve
development of $5.5 million in 2002, as compared to
unfavorable development of $7.8 million in 2001. Included
in the favorable reserve development in 2002 was
$1.8 million attributable to the gain on the commutation of
prior year obligations of one of our reinsurers. The commutation
also resulted in a $0.9 million gain related to current
year obligations. The favorable loss reserve development and the
commutation gains resulted in an overall 4.4 point
reduction in the 2002 net loss ratio. The $7.8 million
unfavorable development in 2001 included $6.5 million of
the $11.1 million write-off of reinsurance recoverables
from Reliance that related to prior years. The unfavorable loss
reserve development and write-off of reinsurance recoverables
increased the 2001 net loss ratio by 12.9 points.
Catastrophic losses increased our annual loss ratios by
approximately 0.3 points in 2002 and 0.1 points in
2001.

Our reserve for loss and loss adjustment expenses
as of December 31, 2002 was $86.9 million as estimated
through our actuarial analysis. During the year, our actuarial
analysis concluded that the December 31, 2001 reserve for
loss and loss adjustment expenses of $77.5 million was
redundant by approximately $5.5 million. Several factors
contributed to this redundancy. We recognized a gain on the
commutation of obligations of one of our reinsurers that
resulted in $1.8 million of favorable development on prior
years reserves. We also determined we had overestimated
the frequency of bodily injury claims in Florida for the 2001
accident year based on trends that occurred in 1999 and 2000.
During 2001, we implemented numerous changes to our claims
processes and increased our claims staffing, which resulted in a
quicker settlement process. We initially attributed the increase
in claims paid in 2001 to a new frequency trend rather than the
quicker settlement, which resulted in favorable reserve
development of approximately $2.5 million. This
overestimation of frequency also resulted in approximately
$0.8 million of favorable development on our reserves for
Florida personal injury protection claims. Finally, in 2001 we
overestimated the severity of bodily injury losses in Georgia
related to a regulatory change resulting in an increase in the
minimum limits of coverage required by that state. As a result,
our reserve for bodily injury losses in Georgia decreased by
approximately $0.4 million.



| |                   
| | ------------------
| | Operating Expenses

Operating expenses include SGA costs, advertising
and interest expense. These expenses include the amortization of
policy acquisition and maintenance costs that are net of ceding
commissions, costs associated with generating ancillary income
and other revenues and corporate overhead. Our business model
emphasizes the use of our largely fixed cost neighborhood sales
offices staffed by company employees, which results in only
marginal increases in operating expenses as we increase our
premiums and other revenues.

Year Ended December 31, 2003 Compared to
Year Ended December 31, 2002.Operating expenses increased 22.8% to $80.9 million for the
year ended December 31, 2003 from $65.9 million in
2002. Excluding the effect of reinsurance commissions, operating
expenses increased $9.7 million. The $9.7 million
increase was primarily attributable to $3.6 million related
to our expansion into Texas, $1.3 million in commission
paid to our employee agents on the sale of ancillary insurance
products and term life insurance, and other increases in
operating costs primarily associated with increased premium
volumes.

50



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##### 



Year Ended December 31, 2002 Compared to
Year Ended December 31, 2001.Operating expenses increased $4.4 million or 7.2%, to
$65.9 million in 2002, compared to $61.5 million in
2001. The increase was primarily attributable to a
$5.5 million increase in commissions paid to an independent
agency associated with the increase in the volume of insurance
produced for us, a $1.0 million increase related to our
office expansion in the state of South Carolina and increases in
other costs associated with increased premium volumes. These
increases were partially offset by a $10.0 million increase
in ceding commissions attributable to the increase in ceded
premiums and a $1.4 million reduction in interest expense
due to a the declining interest rate environment.



| |             
| | ------------
| | Income Taxes

We file a consolidated federal income tax return
that includes all of our subsidiaries other than our life
insurance subsidiary, which files a separate federal income tax
return. The statutory rate used in calculating our tax provision
was 35% in 2003 and 2002 compared to 34% in 2001. Our effective
tax rates for the years ended December 31, 2003 and 2002
were 36.6% and 33.3%, respectively. Our effective tax rate has
been increasing due to an increase in state income taxes, the
elimination of the small life insurance company deduction, and a
reduction in tax-exempt interest resulting from a decreased
allocation of our investment portfolio to municipal securities.
As our ancillary income has increased in our non-insurance
subsidiaries, more of our income becomes subject to state income
taxes. The provision for state income taxes increased our
overall effective tax rate by 2.9 points in 2003, as
compared to 1.0 point in 2002. In certain states, we are
able to offset the state income taxes paid by our insurance
subsidiaries against their provision for premium taxes.

Income tax expense (benefit) differed from
the amounts computed at the statutory rate as demonstrated in
the following table:

|                                          |                                        |                         |      |      |   |      |      |      |   |   |      |      |  
|----------------------------------------- | -------------------------------------- | ----------------------- | ---- | ---- | - | ---- | ---- | ---- | - | - | ---- | ---- | -
|                                          |                                        |                        
|                                          |                                        | Year Ended December 31,
|                                          |                                        |                        
|                                          |                                        | 2003                    |      | 2002 |   | 2001
|                                          |                                        |                         |      |      |   |     
|                                          |                                        |                        
|                                          |                                        | ($ in millions)        
|Income (loss) before income taxes         |                                        | $                       | 68.0 |      |   | $    | 46.5 |      |   | $ | (0.7 | )   
|                                          |                                        |                         |      |      |   |      |      |      |   |   |      |     
|Provision for taxes at the statutory rate |                                        | $                       | 23.8 |      |   | $    | 16.3 |      |   | $ | (0.2 | )   
|Increase (reduction) in taxes for:        |                                        |                         |      |      |   |      |      |      |   |   |      |     
|                                          | Tax-exempt interest income             |                         |      | (0.6 | ) |      |      | (0.7 | ) |   |      | (0.6 | )
|                                          | Small life insurance company deduction |                         |      |     |   |      |      | (0.5 | ) |   |      | (0.6 | )
|                                          | State income taxes                     |                         |      | 2.0  |   |      |      | 0.5  |   |   |      | 0.1  |  
|                                          | Other, net                             |                         |      | (0.3 | ) |      |      | (0.1 | ) |   |      | 0.2  |  
|                                          |                                        |                         |      |      |   |      |      |      |   |   |      |     
|                                          | Income tax expense (benefit)           |                         | $    | 24.9 |   |      | $    | 15.5 |   |   | $    | (1.1 | )
|                                          |                                        |                         |      |      |   |      |      |      |   |   |      |     

Financial Condition



| |                                    
| | -----------------------------------
| | Liquidity and Capital
    Resources



| |                          
| | -------------------------
| | Sources and Uses of Funds

We are organized as a holding company system with
all of our operations being conducted by our wholly-owned
insurance, premium finance, agency, administrative and consumer
product subsidiaries. Accordingly, Direct General Corporation
receives cash through loans from banks, issuance of equity
securities, subsidiary dividends and other transactions. We may
use the proceeds from these sources to contribute to the capital
of our insurance subsidiaries and premium finance company in
order to support premium growth, to repurchase our common stock,
to retire our outstanding indebtedness, to pay interest,
dividends, and taxes, and for other business purposes. We
operate under an Intercompany Tax Allocation Agreement whereby
our eligible subsidiaries compute tax provisions as if filing
separate returns based on taxable income. Each subsidiarys
resulting provision (or credit) will be currently payable to (or
receivable from) Direct General Corporation.

51



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##### 



Under state insurance laws, dividends, which must
be paid from earned surplus, and capital distributions from our
insurance companies are subject to restrictions relating to
statutory surplus and earnings. Our insurance companies
collectively paid dividends of $1.0 million,
$1.3 million, and $2.1 million in 2003, 2002 and 2001,
respectively. These dividends were generally reinvested in the
capital of other insurance subsidiaries. Prior approval from
state insurance regulatory authorities is generally required in
order for our insurance companies to declare and pay
extraordinary dividends to us. The maximum amount of dividend
capacity available for payment to Direct General Corporation
during the remainder of 2004 by our insurance subsidiaries
without seeking regulatory approval is $10.5 million.
Dividends from our premium finance subsidiary are limited by the
minimum capital requirements in applicable state regulations and
by covenants in our bank loan agreements, which require approval
of our lenders. There are no restrictions on the payment of
dividends from our agency, administrative and other
non-insurance subsidiaries, other than typical state corporation
law requirements to avoid insolvency. In addition, the NAIC
Model Act for RBC provides formulas to determine the amount of
capital that an insurance company needs to ensure that it has an
acceptable expectation of not becoming financially impaired; a
low RBC ratio would prevent an insurance company from paying
dividends. At December 31, 2003, each of our insurance
subsidiaries maintained an RBC level that is in excess of an
amount that would require any corrective actions on our part.

Our operating subsidiaries primary sources
of funds are premiums received, finance income, commission and
service fee income, investment income, borrowings under credit
facilities and proceeds from the sale and redemption of
investments. Funds are used to pay claims and operating
expenses, to pay interest and principal repayments under the
terms of our indebtedness for borrowed money, to purchase
investments and to pay dividends to Direct General Corporation.
We had positive cash flow from operations of approximately
$67.1 million in 2003, $52.4 million in 2002, and
$45.5 million in 2001. We expect our cash flows to be
positive in both the short-term and reasonably foreseeable
future.



| |                      
| | ---------------------
| | Financing and Capital

Initial Public
Offering.In August 2003, we
completed our initial public offering of 7,972,276 shares of
common stock. We sold 3,750,000 shares and selling shareholders
sold 4,222,276 shares resulting in net proceeds to us (after
deducting issuance costs) of approximately $71.6 million.
In conjunction with the offering of common stock, all
outstanding shares of preferred stock were converted into common
stock and we received an additional $0.8 million from the
exercise of a common stock warrant. We used $51.9 million
of the proceeds to increase our investment in our insurance
subsidiaries and $0.6 million to increase the
capitalization of our non-insurance subsidiaries. In addition,
we used $7.7 million of the proceeds to pay off a term loan
with two banks. The remaining proceeds have not been permanently
deployed to date and generally have been used to reduce the
amount outstanding under the premium finance revolving credit
facility described below. During 2004, we anticipate using the
remainder of these proceeds to further increase the capital in
our insurance subsidiaries and for general corporate purposes.

Premium Finance Revolving Credit
Facility.Our premium finance
operations are supported by a revolving credit agreement with a
group of banks. The size of the facility was $190.0 million
at December 31, 2003, and is periodically increased to
support the growth in premiums we finance. We would expect to
continue this practice with our group of banks. There is the
risk that our attempt to increase this revolving credit line
facility would not be successful, in which case we would be
forced to seek alternative methods of financing premiums.

Our premium finance subsidiary utilizes the
revolving credit facility by drawing on the facility at the end
of every month to settle amounts due to the insurance companies.
As payments from our customers are received, the revolving
credit facility is reduced over the course of the month. This
cycle repeats itself monthly, with historically, some seasonal
fluctuation on total amounts drawn at the end of each month.

Amounts outstanding under this facility were
$148.0 million and $115.0 million as of December 31,
2003 and 2002, respectively. Interest on the facility is payable
quarterly and all outstanding advances and accrued interest are
due on or before June 30, 2004. Based upon communications
with our lenders, we expect our premium finance revolving credit
facility to be renewed for an additional two year period. The
amount

52



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##### 



and terms of the credit facility have not been
negotiated, but we do not anticipate that the terms will change
materially. The weighted average interest rate in effect was
3.4% in 2003 and 4.6% in 2002. The loan is principally secured
by our finance receivables of the premium finance subsidiary and
is guaranteed by Direct General Corporation. See Note 6 to
our audited consolidated financial statements included in this
report for further discussion regarding our current outstanding
debt.


In an effort to manage our interest rate risk
related to our premium finance revolving credit agreement,
effective November 1, 2001, we purchased a derivative
instrument known as a zero-cost collar from Bank One, NA. This
derivative instrument requires monthly settlements whereby we
pay the difference to the extent the then current 30-day LIBOR
rate is below the floor of 5.05% on $25 million and receive
the excess of the 30-day LIBOR rate over the cap of 5.05% on
$50 million. This derivative instrument was designed to
reduce our exposure to changes in LIBOR under our bank loan
facilities. Since interest rates are below 5.05% (30-day LIBOR
was 1.17% at December 31, 2003), the fair market value of
this derivative instrument is unfavorable to us and,
accordingly, we recorded a liability of $1.4 million at
December 31, 2003. This unrealized loss is reported as a
separate component of shareholders equity on an after-tax
basis. Payments associated with the floor were
$1.0 million, $0.8 million and $0.1 million for
the years ended December 31, 2003, 2002 and 2001,
respectively, and were reported in the income statement as
interest expense. This derivative instrument is scheduled to
terminate on November 1, 2005. See Note 12 to our
audited consolidated financial statements included in this
report for further discussion on this derivative instrument.

For the year ended December 31, 2003, we
received net proceeds from the issuance of common stock of
$72.5 million and increased our borrowings on the premium
finance revolving credit facility by $33.0 million. During
the year, we repaid all outstanding principal under our term
loans totaling $10.2 million, paid interest on outstanding
indebtedness of $5.3 million, interest on the Series A
redeemable preferred stock of $0.3 million, dividends on
the Series B preferred stock of $0.3 million, and
dividends on common stock of $0.9 million. The
Series A redeemable preferred stock and Series B
preferred stock were converted to common stock in connection
with our initial public offering in August 2003.

For the year ended December 31, 2002, we
received net proceeds from borrowings on capital loans of
$1.2 million and borrowings on the premium finance
revolving credit facility of $18.9 million, repurchased
1,328,364 shares of our Treasury stock at a total cost of
$4.5 million (average of $3.42 per share), paid interest on
outstanding indebtedness of $6.2 million, interest on the
Series A redeemable preferred stock of $0.5 million,
and dividends on the Series B preferred stock of
$0.6 million.

For the year ended December 31, 2001, we
repaid $6.0 million of principal on our capital loan,
received $18.4 million in net proceeds from borrowings
under the premium finance revolving credit facility, paid
interest on outstanding indebtedness of $7.7 million,
dividends on the Series A redeemable preferred stock
totaling $0.5 million and dividends on the Series B
preferred stock of $0.6 million.

Contractual
Obligations.The following table
summarizes our contractual obligations as of December 31,
2003.

|                                          |       |                        |       |           |  |       |       |       |  |           |     |      |  |   |     |     |  |   |   |   | 
|----------------------------------------- | ----- | ---------------------- | ----- | --------- |  | ----- | ----- | ----- |  | --------- | --- | ---- |  | - | --- | --- |  | - | - | - | 
|                                          |       |                       
|                                          |       | Payments due by Period
|                                          |       |                       
|                                          |       |                        |       | Less than |  | 1-3   |       | 3-5   |  | More than
|                                          |       | Total                  |       | 1 Year    |  | Years |       | Years |  | 5 Years  
|                                          |       |                        |       |           |  |       |       |       |  |          
|                                          |       |                       
|                                          |       | ($ in millions)       
|Premium finance revolving credit facility |       | $                      | 150.5 |           |  | $     | 150.5 |       |  | $         |    |      |  | $ |    |     |  | $ |  |  
|Capital leases obligations                |       |                        | 5.2   |           |  |       | 1.4   |       |  |           | 3.6 |      |  |   | 0.2 |     |  |   |  |  
|Operating leases obligations              |       |                        | 16.2  |           |  |       | 7.2   |       |  |           | 8.1 |      |  |   | 0.9 |     |  |   |  |  
|Other long-term debt                      |       |                        | 1.0   |           |  |       | 0.6   |       |  |           | 0.4 |      |  |   |    |     |  |   |  |  
|                                          |       |                        |       |           |  |       |       |       |  |           |     |      |  |   |     |     |  |   |   |  
|                                          | Total |                        | $     | 172.9     |  |       | $     | 159.7 |  |           | $   | 12.1 |  |   | $   | 1.1 |  |   | $ |  | 
|                                          |       |                        |       |           |  |       |       |       |  |           |     |      |  |   |     |     |  |   |   |  

53



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##### 





| |            
| | -----------
| | Reinsurance

We have historically operated with a limited
amount of capital and, as a result, have extensively used the
reinsurance market to maintain our net exposures within our
capital resources. We cede premiums and losses to unaffiliated
insurance companies under quota share, excess of loss and
catastrophe reinsurance agreements. We evaluate the financial
condition of our reinsurers and monitor various credit risks to
minimize our exposure to losses from reinsurer insolvencies.
However, we remain obligated for amounts ceded in the event that
the reinsurers do not meet their obligations. Because we cede a
high percentage of our premiums and the associated losses, a
failure of one of our reinsurers to pay could have a significant
adverse effect on our capital and our financial condition and
results of operations. In 2001, one of our reinsurers, Reliance,
was declared insolvent and, as a result, we wrote off
reinsurance recoverables of $11.1 million. See
Managements Discussion and Analysis of Financial
Condition and Results of Operations  Overview of
Operating Results.

Over the past few years, we have implemented
several changes to our reinsurance program designed to reduce
our exposures to unsecured reinsurance recoverables, including
changing the settlement of reinsurance premiums to an earned
basis versus a written basis, requiring reinsurers to fund a
trust account in the event of a rating downgrade by A.M. Best,
and limiting the maximum participation by any one reinsurer. As
a result, the amount of unsecured reinsurance recoverables at
December 31, 2003 was reduced to 18.4% of
shareholders equity or $32.7 million from 53.0% of
shareholders equity or $31.4 million at
December 31, 2002. In addition, the largest unsecured
recoverable from a single reinsurer was $9.2 million at
December 31, 2003. This same amount was due from both
National Union Fire Insurance Company of Pittsburgh, PA, a
subsidiary of American International Group, Inc., and Swiss Re
America, which are rated A++ (Superior) and A+
(Superior), respectively, by A.M. Best.



| |            
| | -----------
| | Investments

We had total cash, cash equivalents and invested
assets of $353.6 million as of December 31, 2003. The
following table summarizes our cash, cash equivalents and
invested assets as of the dates indicated.

|                                    |       |                 |       |            |  |            |       |       |  |  |      |       |  
|----------------------------------- | ----- | --------------- | ----- | ---------- |  | ---------- | ----- | ----- |  |  | ---- | ----- | -
|                                    |       |                 |       |            |  | % of Total
|                                    |       |                 |       |            |  | at Fair   
|                                    |       | Amortized Cost  |       | Fair Value |  | Value     
|                                    |       |                 |       |            |  |           
|                                    |       |                
|                                    |       | ($ in millions)
|December 31, 2003                   |       |                 |       |            |  |            |       |       |  |  |      |      
|Debt securities, available for sale |       | $               | 263.9 |            |  | $          | 265.0 |       |  |  | 74.9 | %    
|Cash and cash equivalents           |       |                 | 87.3  |            |  |            | 87.3  |       |  |  | 24.7 | %    
|Short-term investments              |       |                 | 1.3   |            |  |            | 1.3   |       |  |  | 0.4  | %    
|                                    |       |                 |       |            |  |            |       |       |  |  |      |      
|                                    | Total |                 | $     | 352.5      |  |            | $     | 353.6 |  |  |      | 100.0 | %
|                                    |       |                 |       |            |  |            |       |       |  |  |      |      
|December 31, 2002                   |       |                 |       |            |  |            |       |       |  |  |      |      
|Debt securities, available for sale |       | $               | 119.3 |            |  | $          | 123.6 |       |  |  | 57.9 | %    
|Cash and cash equivalents           |       |                 | 87.0  |            |  |            | 87.0  |       |  |  | 40.8 | %    
|Short-term investments              |       |                 | 2.7   |            |  |            | 2.7   |       |  |  | 1.3  | %    
|                                    |       |                 |       |            |  |            |       |       |  |  |      |      
|                                    | Total |                 | $     | 209.0      |  |            | $     | 213.3 |  |  |      | 100.0 | %
|                                    |       |                 |       |            |  |            |       |       |  |  |      |      

Investment Strategy.We believe that our investment portfolio is highly liquid and
consists substantially of readily marketable, investment-grade
debt securities. We currently do not invest in equity securities
or securities with exposure to foreign currency risk. Effective
April 1, 2003, Bank One Investment Advisors and U.S.
Bancorp Asset Management provide our investment portfolio
management advisory services. Prior to

54



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##### 



March 31, 2003, our investment advisors were
Deutsche Asset Management. These advisors operate under
investment guidelines approved by our investment committee.
These guidelines emphasize:




| |   |                                                             
| | - | ------------------------------------------------------------
| |  | preservation of capital with a focus on total
    return,   
|
| |  | achieving the highest risk adjusted after tax
    return and
|
| |  | diversification in order to reduce risk.                    

Our investment strategy recognizes our need to
maintain capital adequate to support our insurance operations.
Our investment objectives also include maximizing the benefit
from premium tax credits. Certain of the states in which we do
business provide relief from premium taxes to the extent we
maintain qualifying investments in those states and their
municipalities. As a result, historically a significant amount
of debt securities in our portfolio were comprised of tax-exempt
obligations of the states of Louisiana, Mississippi and
Tennessee, in order to maximize these premium tax credits.
Additionally, we invested in tax-exempt obligations of Georgia
prior to 2003.

Our investment guidelines also permit us to
invest up to 2% of the fair value of our investment portfolio in
alternative investments, including commodities. Within those
guidelines, we invested $1.0 million in September 2002 in a
managed trading account with a commodities trading company. Net
realized gains from the trading activities were reinvested and
the fair value of this account was $2.6 million as of
December 31, 2003. This investment represents less than 1%
of our entire investment portfolio. Generally, only 15% of the
account balance is invested in commodities and related
investments and the remaining portion of the account balance is
held in cash, cash equivalents and U.S. Treasury obligations.
Because this is a margin account, the ultimate
losses generated by this investment may greatly exceed the
portion of the account balance so invested. However, we reduce
the risk of margin call by limiting our investment to 15% of the
account balance. In addition, we closely monitor the performance
of the account in an effort to reduce the risk of losses. During
2003, we realized gross gains of $2.7 million and gross
losses of $0.9 million on closed contracts in our trading
portfolio. Since the trading portfolio, which primarily consists
of futures contracts, swaps, and other derivative instruments,
represents a speculative investment and does not represent a
hedge, all open contracts are marked to market with the change
in market values included in net realized gains
(losses) on securities and other in our consolidated
statement of operations. For the year ended December 31,
2003, net realized gains (losses) on securities and
other included a net loss of $0.4 million related to
open contracts which included gross increases of
$0.3 million and gross decreases of $0.7 million.

Debt Securities.Our
investment portfolio consists primarily of debt securities, all
of which are classified as available for sale and are carried at
fair value with unrealized gains and losses reported in our
financial statements as a separate component of
shareholders equity on an after-tax basis. As of
December 31, 2003, the fair value of our investment
portfolio of $265.0 million included $1.1 million in
pretax net unrealized gains. As of December 31, 2002, the
fair value of our investment portfolio of$123.6 million
included $4.3 million in pretax net unrealized gains. The
increase in net unrealized gains during 2002 was attributable to
the declining interest rate environment.

We realized pretax net gains on the sale of
securities of $2.0 million in 2003. Comparatively, we
realized pretax net losses of $0.1 million in 2002, which
was comprised of a $1.0 million loss on our investment in
WorldCom bonds that was almost entirely offset by gains on the
sale of other debt securities. Net realized gains on securities
available for sale were $2.2 million in 2001. The weighted
average book yield of the portfolio was 3.7% for the year ended
December 31, 2003, 4.4% for 2002 and 4.5% for 2001. The
effective duration of our investment portfolio was
3.3 years at December 31, 2003, compared to
3.8 years at December 31, 2002.

We monitor our investment results by comparing
the total return on our portfolio of debt securities to the
total return for a customized benchmark based on a blend of
Lehman indices. Total return is comprised of interest income and
the change in the fair value of the securities. Prior to 2003,
we did not manage our investment returns by individual asset
class because one of our primary investment objectives was to
maximize the premium tax credits available to us by investing a
significant portion of our portfolio in the municipal
obligations of Tennessee, Louisiana, Mississippi and Georgia. In
2003, we changed investment

55



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##### 



advisors, divided the portfolio management
between two firms, and, in an effort to increase the overall
yield of the portfolio, liquidated our investment in tax-exempt
obligations of Georgia. In conjunction with these changes, we
now separately evaluate the total return of our taxable and
tax-exempt securities by comparing them to customized benchmarks
for each investment class. The total return on our portfolio of
debt securities was 3.7% for the year ended December 31,
2003, 8.5% in 2002 and 6.5% in 2001.


The following table presents the composition by
our internal industry classification of the amortized cost,
gross unrealized gains, gross unrealized losses and fair value
of debt securities in our investment portfolio as of the dates
indicated.

|                                                                                          |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |      | 
|----------------------------------------------------------------------------------------- | -------------------------------- | --------------- | ----- | ---------- |  | ---------- | --- | ----- |  | - | --- | --- |  | - | ----- | ---- | 
|                                                                                          |                                  |                 |       | Gross      |  | Gross      |     |      
|                                                                                          |                                  | Amortized       |       | Unrealized |  | Unrealized |     | Fair 
|                                                                                          |                                  | Cost            |       | Gains      |  | Losses     |     | Value
|                                                                                          |                                  |                 |       |            |  |            |     |      
|                                                                                          |                                  |                
|                                                                                          |                                  | ($ in millions)
|December 31, 2003                                                                         |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|U.S. Treasury securities and obligations of U.S.
    government corporations and agencies |                                  | $               | 94.8  |            |  | $          | 0.3 |       |  | $ | 1.1 |     |  | $ | 94.0  |     
|Obligations of states and
    political subdivisions                                      |                                  |                 | 49.9  |            |  |            | 1.8 |       |  |   |    |     |  |   | 51.7  |     
|Corporate debt securities                                                                 |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|                                                                                          | Banks and financial institutions |                 |       | 41.7       |  |            |     | 0.4   |  |   |     | 0.4 |  |   |       | 41.7 | 
|                                                                                          | Credit cards and auto loans      |                 |       | 37.7       |  |            |     | 0.3   |  |   |     | 0.2 |  |   |       | 37.8 | 
|                                                                                          | Industrial                       |                 |       | 23.8       |  |            |     | 0.3   |  |   |     | 0.3 |  |   |       | 23.8 | 
|                                                                                          | Telecommunications               |                 |       | 9.6        |  |            |     | 0.1   |  |   |     | 0.1 |  |   |       | 9.6  | 
|                                                                                          | Utilities                        |                 |       | 6.4        |  |            |     | 0.1   |  |   |     | 0.1 |  |   |       | 6.4  | 
|                                                                                          |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|Total corporate debt securities                                                           |                                  |                 | 119.2 |            |  |            | 1.2 |       |  |   | 1.1 |     |  |   | 119.3 |     
|                                                                                          |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|Total                                                                                     |                                  | $               | 263.9 |            |  | $          | 3.3 |       |  | $ | 2.2 |     |  | $ | 265.0 |     
|                                                                                          |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|December 31, 2002                                                                         |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|U.S. Treasury securities and obligations of U.S.
    government corporations and agencies |                                  | $               | 16.4  |            |  | $          | 0.6 |       |  |   |    |     |  | $ | 17.0  |     
|Obligations of states and
    political subdivisions                                      |                                  |                 | 69.6  |            |  |            | 2.5 |       |  |   |    |     |  |   | 72.1  |     
|Corporate debt securities                                                                 |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|                                                                                          | Banks and financial institutions |                 |       | 10.4       |  |            |     | 0.4   |  |   |     |    |  |   |       | 10.8 | 
|                                                                                          | Credit cards and auto loans      |                 |       | 9.8        |  |            |     | 0.3   |  |   |     |    |  |   |       | 10.1 | 
|                                                                                          | Industrial                       |                 |       | 9.0        |  |            |     | 0.4   |  |   |     |    |  |   |       | 9.4  | 
|                                                                                          | Telecommunications               |                 |       | 2.1        |  |            |     | 0.1   |  |   |     |    |  |   |       | 2.2  | 
|                                                                                          | Utilities                        |                 |       | 2.0        |  |            |     |      |  |   |     |    |  |   |       | 2.0  | 
|                                                                                          |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|Total corporate debt securities                                                           |                                  |                 | 33.3  |            |  |            | 1.2 |       |  |   |    |     |  |   | 34.5  |     
|                                                                                          |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     
|Total                                                                                     |                                  | $               | 119.3 |            |  | $          | 4.3 |       |  |   |    |     |  | $ | 123.6 |     
|                                                                                          |                                  |                 |       |            |  |            |     |       |  |   |     |     |  |   |       |     

56



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##### 



The amortized cost and fair value of debt
securities in our investment portfolio as of December 31,
2003, by contractual maturity, is shown below.

|                   |                        |                 |       |            |  |   |       |       | 
|------------------ | ---------------------- | --------------- | ----- | ---------- |  | - | ----- | ----- | 
|                   |                        | Amortized Cost  |       | Fair Value
|                   |                        |                 |       |           
|                   |                        |                
|                   |                        | ($ in millions)
|Years to maturity: |                        |                 |       |            |  |   |       |      
|                   | One or less            |                 | $     | 9.9        |  |   | $     | 9.9   | 
|                   | After one through five |                 |       | 136.8      |  |   |       | 137.5 | 
|                   | After five through ten |                 |       | 91.4       |  |   |       | 91.8  | 
|                   | After ten              |                 |       | 25.8       |  |   |       | 25.8  | 
|                   |                        |                 |       |            |  |   |       |      
|Total              |                        | $               | 263.9 |            |  | $ | 265.0 |      
|                   |                        |                 |       |            |  |   |       |      

The Securities Valuation Office of the NAIC
evaluates the bond investments of insurers for regulatory
reporting purposes and assigns securities to one of six
investment categories called NAIC designations. The
NAIC designations generally parallel the credit ratings of the
nationally recognized statistical rating organizations for
marketable bonds. NAIC designations 1 and 2 include bonds
considered to be investment grade, which are those rated
BBB- or higher by Standard & Poors, a
division of The McGraw-Hill Companies, Inc. NAIC designations 3
through 6 include bonds considered to be below investment grade,
rated BB+ or lower by S&P. All of the debt
securities in our portfolio were rated investment grade by the
NAIC and S&P as of December 31, 2003. Investment grade
securities generally bear lower yields and lower degrees of risk
than those that are unrated or are rated non-investment grade.
The quality distribution of our investment portfolio as of
December 31, 2003 was as follows:

|                |  |             |   |           |  |            |       |               |  |   |       |  |  |  |       |  
|--------------- |  | ----------- | - | --------- |  | ---------- | ----- | ------------- |  | - | ----- |  |  |  | ----- | -
|                |  |             |   | Amortized |  |            |       | % of Total   
|S&P Rating      |  | NAIC Rating |   | Cost      |  | Fair Value |       | at Fair Value
|                |  |             |   |           |  |            |       |              
|               
|($ in millions)
|AAA             |  |             | 1 |           |  | $          | 140.7 |               |  | $ | 140.9 |  |  |  | 53.2  | %
|AA              |  |             | 1 |           |  |            | 29.9  |               |  |   | 30.6  |  |  |  | 11.5  | %
|A               |  |             | 1 |           |  |            | 45.1  |               |  |   | 45.3  |  |  |  | 17.1  | %
|BBB             |  |             | 2 |           |  |            | 24.1  |               |  |   | 24.1  |  |  |  | 9.1   | %
|Agency          |  |             | 1 |           |  |            | 24.1  |               |  |   | 24.1  |  |  |  | 9.1   | %
|                |  |             |   |           |  |            |       |               |  |   |       |  |  |  |       |  
|                |  |             |   |           |  | $          | 263.9 |               |  | $ | 265.0 |  |  |  | 100.0 | %
|                |  |             |   |           |  |            |       |               |  |   |       |  |  |  |       |  

We evaluate the risk versus reward tradeoffs of
investment opportunities, measuring their effects on the
stability, diversity, overall quality and liquidity of our
investment portfolio. The primary market risk exposure to our
debt securities portfolio is interest rate risk, which we strive
to limit by managing duration to a defined range of three to
four years. Interest rate risk includes the risk from movements
in the underlying market rate and in credit spreads of the
respective sectors of debt securities held in our portfolio. The
fair value of our fixed maturity portfolio is directly impacted
by changes in market interest rates.

As of December 31, 2003, the impact of an
immediate 100 basis point increase in market interest rates on
our debt securities portfolio would have resulted in an
estimated decrease in fair value of 4.1%, or approximately
$10.8 million. As of the same date, the impact of an
immediate 100 basis point decrease in market interest rates
on our debt securities portfolio would have resulted in an
estimated increase in fair value of 4.1%, or approximately
$10.8 million.

An additional exposure to our debt securities
portfolio is credit risk. Our ability to manage credit risk is
essential to our business and our profitability. We attempt to
manage our credit risk through issuer and industry
diversification. Our investment committee establishes our
investment guidelines and supervises our investment activity. It
regularly monitors our overall investment results, reviews
compliance with our investment objectives and guidelines, and
ultimately reports our overall investment results to our board
of directors. Our investment guidelines include limitations on
the minimum rating of debt securities in our investment
portfolio as well as restrictions on investments in debt
securities of a single issuer.

57



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##### 



On a quarterly basis, we examine our investment
portfolio for evidence of impairment. The assessment of whether
such impairment has occurred is based on managements
evaluation, on an individual security basis, of the underlying
reasons for the decline in fair value. In such cases, changes in
fair value are discussed with our investment advisors and
evaluated to determine the extent to which such changes are
attributable to interest rates, market-related factors other
than interest rates, as well as financial conditions, business
prospects and other fundamental factors specific to the issuer.
Declines attributable to issuer fundamentals are reviewed in
further detail. When one of our securities has a decline in fair
value that is determined to be other than temporary, we reduce
the carrying value of such security to its current fair value as
required by GAAP.

Based upon our analysis, we believe that we will
recover all contractual principal and interest payments related
to those securities that currently reflect unrealized losses and
that we have the ability to hold these securities until they
mature or recover in value. Should either of these beliefs
change with regard to a particular security, a charge for
impairment would likely be required. While it is not possible to
accurately predict if or when a specific security will become
impaired, charges for other than temporary impairment could be
material to our results of operations in a future period.
Management believes it is not likely that future impairment
charges will have a significant effect on our liquidity.

As of December 31, 2003, investments carried
at fair value of $8.2 million and approximately
$0.1 million of cash were on deposit with state insurance
regulatory authorities. Additionally, investments carried at
fair value of $3.8 million and cash of $4.0 million
had been pledged to secure letters of credit in connection with
our reinsurance obligations.

Cash and Cash
Equivalents.Our balance in cash and
cash equivalents was $87.3 million and $87.0 million
as of December 31, 2003 and 2002, respectively.

Short-Term Investments.Our short-term investments primarily
consist of investments in commercial paper, other
interest-bearing time deposits with original maturities from
three months to one year and our managed commodities trading
account.



2004 Outlook


Growth.We expect
our gross revenues to increase between 15% and 20% annually over
the next 5 years through additional market penetration in
many of our existing states and the opportunities that we
believe we have to expand into other markets. However, during
2004 we expect that gross revenues will grow in excess of 20%.
We anticipate continued overall growth in our existing markets
as a result of increasing renewal of policies, modest additional
market penetration and an increase in ancillary products and
term life premiums that we expect to be produced by the 42
Florida neighborhood sales offices that we acquired in
November 2003. In addition, we are continuing our expansion
into the state of Texas through a relationship with an
independent agency network. We have obtained an option to
acquire the assets of this Texas network at the end of 2004. We
also expect to begin developing up to 20 of our own neighborhood
sales offices in areas of Texas where we believe additional
market presence is needed to supplement the independent agency
network. Based upon existing market conditions, we currently
estimate gross premiums written in Texas will be approximately
$40 million in 2004 and could be as much as $80 to
$90 million in 2005, assuming that we exercise our option
to acquire the Texas agency network and successfully integrate
its operations. We also plan to commence our initial expansion
into Missouri during the second half of 2004 with the
development of up to 20 of our own neighborhood sales offices.
We continue to evaluate our expansion opportunities into other
states and currently expect to begin expansion into Virginia in
2005 through the opening of neighborhood sales offices. We are
continually looking for expansion opportunities through organic
growth and through the acquisition of independent agency
networks. As a result, future expansion states may change from
time to time depending on the opportunities that are presented
and possible changes in market conditions.

Cash Register Agency
Acquisition.Effective
November 1, 2003, we purchased the assets of Cash Register,
a 42-office independent agency network, for $13.8 million.
The assets acquired primarily consisted of intangible assets
recorded as goodwill. Cash Register had been producing business
for us as an agent in

58



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##### 



Florida since 1999 and produced approximately
$87 million of non-standard personal automobile insurance
premiums for us in the first ten months of 2003. Prior to our
acquisition, this agency did not produce term life insurance
business for us, and the commission income generated from the
sale of ancillary products remained with the agency. As a result
of the acquisition, the majority of the agencys employees
became our salaried employees and we assumed the operating
leases of most the neighborhood sales offices. We believe that
we will benefit from this acquisition by receiving the
commission income generated on the sale of ancillary products,
increasing the distribution of our term life insurance product,
and converting the cost structure from a variable structure with
commissioned independent agents to a largely fixed cost
structure provided by our business model.


During November and December 2003, after the
completion of the acquisition, the 42 sales offices acquired
from the Cash Register agency network generated commission and
administrative fee income of $0.8 million and term life
insurance premiums of $0.3 million for us. Based upon
historical trends of our neighborhood sales offices and the
trends of the sales offices acquired from Cash Register, we
estimate that the former Cash Register sales offices could
contribute between $6 million and $10 million of
additional gross revenues from term life insurance premiums, and
commission and service fee income on the sales of ancillary
products in 2004.

During 2003, the cost of operating our
neighborhood sales offices in Florida was approximately $17,000
per office per month or $14,000 per office per month excluding
advertising costs, which operating costs represented 11% and 9%
of gross premiums written, respectively. In comparison, prior to
the acquisition, our commission expense incurred less service
fees earned related to the Cash Register offices was
$16.9 million or 19.5% of gross premiums written by the
agency. Since the acquisition, the average monthly operating
costs per office (excluding advertising costs) for the former
Cash Register offices was approximately $14,000 or 9% of the
gross premiums written produced by those offices. Assuming that
the average monthly operating costs per office of the former
Cash Register offices remain at levels that are consistent with
the historical operating costs per office of our Florida
neighborhood sales offices, we estimate that operating expense
savings could range from $6 million to $9 million,
excluding the effects of the capitalization and amortization of
policy acquisition costs. These estimated savings assume that
gross written premiums produced by the former Cash Register
offices remain consistent with their historical levels of
production.

Reduction in Quota Share
Reinsurance.In 2003, we used
$51.9 million of the proceeds from our initial public
offering to increase our investment in our insurance
subsidiaries. As a result, we have been able to significantly
reduce the amount of quota share reinsurance necessary for us to
manage our gross and net premiums written to surplus ratios
within the guidelines of the states in which we operate. During
2003, we retained 67.8% of gross premiums written as compared to
54.0% in 2002. For 2004, we expect to retain 80% to 90% of our
gross premiums written. The reduction in quota share reinsurance
should increase our invested assets and allow us to earn
investment income on those assets. In addition, we expect to
benefit from a proportionate decrease in the effective margin
paid to our reinsurers.

Life Company
Acquisition.On January 30, 2004,
we acquired an inactive life insurance company for a total
purchase price of $7.3 million, including approximately
$1.3 million of goodwill. The assets of this life insurance
company consist primarily of (i) licenses to conduct life
and/or accident and health insurance business in 43 states
and the District of Columbia and (ii) cash and debt
securities with an aggregate market value of approximately
$6 million. This acquisition provided us with a license to
sell our life insurance product in North Carolina and includes
licenses in Texas where we are currently expanding and Missouri
and Virginia where we intend to expand in the future. We plan to
start offering our term life insurance policies in North
Carolina through this newly-acquired life insurance company
during 2004.

Assumptions.Statements made in this section, including those concerning our
anticipated growth in gross revenues, our estimated gross
premiums to be written in Texas in 2004 and 2005, our estimated
revenue to be generated by the offices acquired in 2003 and the
estimated operating expense savings with respect to

59



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##### 



those offices are forward-looking statements.
Some important factors that must occur in order for us to
achieve these results include:




| |   |                                                                                                                                               
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------
| |  | increase in the renewal of insurance policies and
    sales of new policies;                                                                  
|
| |  | increase in sales of ancillary products;                                                                                                      
|
| |  | increase in sales of term life insurance policies;                                                                                            
|
| |  | the exercise of the option to acquire the Texas
    independent agency network and the successful integration of its
    operations into ours;
|
| |  | the timely and successful development and opening
    of up to 20 neighborhood sales offices in Texas;                                        
|
| |  | increase in sales of insurance policies in Texas
    through the independent agency network and our future
    neighborhood sales offices;    
|
| |  | favorable trends in inflation and other matters
    that could affect operating expenses;                                                     
|
| |  | our ability to effectively compete against other
    insurance companies and independent agencies selling similar
    products in our markets;
|
| |  | our ability to obtain timely approval of
    requested rate changes; and                                                                      
|
| |  | absence of unfavorable judicial and regulatory
    developments relative to the automobile insurance industry.                                



Forward-Looking Statements


This report contains forward-looking statements
within the meaning of Section 27A of the Securities Act of
1933, as amended, and Section 21E of the Securities
Exchange Act of 1934, as amended. All statements made in the
report, other than statements of historical fact, are forward
looking statements. You can identify these statements from our
use of the words may, should,
could, potential, continue,
plan, forecast, estimate,
project, believe, intend,
anticipate, expect, target,
is likely, will, or the negative of
these terms, and similar expressions. These statements are made
pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. These forward-looking statements
may include, among other things:



| |   |                                                                                                                                                                                                             
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | statements and assumptions relating to future
    growth, earnings, earnings per share and other financial
    performance measures, as well as managements short-term
    and long-term performance goals;
|
| |  | statements relating to the anticipated effects on
    results of operations or financial condition from recent and
    expected developments or events;                                                     
|
| |  | statements relating to our business and growth
    strategies; and                                                                                                                                          
|
| |  | any other statements or assumptions that are not
    historical facts.                                                                                                                                      

We believe that our expectations are based on
reasonable assumptions. However, these forward-looking
statements involve known and unknown risks, uncertainties and
other important factors that could cause our actual results,
performance or achievements, or industry results, to differ
materially from our expectations of future results, performance
or achievements expressed or implied by these forward-looking
statements. In addition, our past results of operations do not
necessarily indicate our future results. We discuss these and
other uncertainties in the Business  Risk
Related to our Business section of this report.

You should not place undue reliance on any
forward-looking statements. These statements speak only as of
the date of this report. Except as otherwise required by
applicable laws, we undertake no obligation to publicly update
or revise any forward-looking statements or the risk factors
described in this report, whether as a result of new
information, future events, changed circumstances or any other
reason after the date of this report.



|         |                                                                
|-------- | ---------------------------------------------------------------
|Item 7A. | Quantitative and Qualitative Disclosures
    About Market Risk.

Please see the discussion under the caption
Financial Condition  Liquidity and Capital
Resources in Part II, Item 7. Managements
Discussion and Analysis of Financial Condition and Results of
Operations of this report for our quantitative and qualitative
disclosures about market risk.

60



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##### 



Item 8.  Financial
Statements and Supplementary Data.

REPORT OF INDEPENDENT AUDITORS

Board of Directors

Direct General Corporation and Subsidiaries


We have audited the accompanying consolidated
balance sheets of Direct General Corporation and Subsidiaries as
of December 31, 2003 and 2002, and the related consolidated
statements of operations, shareholders equity, and cash
flows for each of the three years in the period ended
December 31, 2003. These financial statements are the
responsibility of the Companys management. Our
responsibility is to express an opinion on these financial
statements based on our audits.

We conducted our audits in accordance with
auditing standards generally accepted in the United States.
Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion.

In our opinion, the financial statements referred
to above present fairly, in all material respects, the
consolidated financial position of Direct General Corporation
and Subsidiaries as of December 31, 2003 and 2002 and the
consolidated results of its operations and its cash flows for
each of the three years in the period ended December 31,
2003 in conformity with accounting principles generally accepted
in the United States.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Nashville, Tennessee

February 17, 2004


61



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DIRECT GENERAL CORPORATION AND
SUBSIDIARIES



CONSOLIDATED STATEMENTS OF
OPERATIONS

|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |        |         |  
|---------------------------------------- | ------------------------------------------------------- | ------------------------------------------------------ | ---- | ------- | ------- | ---- | ---- | ------- | ------- | - | ----- | ------ | ------- | -
|                                         |                                                         |                                                       
|                                         |                                                         | For the Years Ended December 31,                      
|                                         |                                                         |                                                       
|                                         |                                                         | 2003                                                   |      | 2002    |         | 2001
|                                         |                                                         |                                                        |      |         |         |     
|                                         |                                                         |                                                       
|                                         |                                                         | (In thousands,                                        
|                                         |                                                         | except per share amounts)                             
|Revenues                                 |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|                                         | Premiums earned                                         |                                                        | $    | 228,529 |         |      | $    | 144,975 |         |   | $     | 98,029 |        
|                                         | Finance income                                          |                                                        |      | 44,886  |         |      |      | 35,726  |         |   |       | 27,283 |        
|                                         | Commission and service fee income                       |                                                        |      | 33,579  |         |      |      | 27,167  |         |   |       | 22,052 |        
|                                         | Net investment income                                   |                                                        |      | 6,730   |         |      |      | 5,345   |         |   |       | 5,092  |        
|                                         | Net realized gains (losses) on securities
    and other |                                                        |      | 3,393   |         |      |      | (75     | )       |   |       | 2,236  |        
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|                                         |                                                         | Total revenues                                         |      |         | 317,117 |      |      |         | 213,138 |   |       |        | 154,692 |  
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|Expenses                                 |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|                                         | Insurance losses and loss adjustment expenses           |                                                        |      | 168,196 |         |      |      | 100,683 |         |   |       | 93,859 |        
|                                         | Selling, general and administrative costs               |                                                        |      | 74,493  |         |      |      | 59,740  |         |   |       | 53,814 |        
|                                         | Interest expense                                        |                                                        |      | 6,376   |         |      |      | 6,160   |         |   |       | 7,646  |        
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|                                         |                                                         | Total expenses                                         |      |         | 249,065 |      |      |         | 166,583 |   |       |        | 155,319 |  
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|                                         | Income (loss) before income taxes                       |                                                        |      | 68,052  |         |      |      | 46,555  |         |   |       | (627   | )      
|                                         | Income tax expense (benefit)                            |                                                        |      | 24,960  |         |      |      | 15,518  |         |   |       | (1,075 | )      
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|                                         |                                                         | Net income                                             |      |         | 43,092  |      |      |         | 31,037  |   |       |        | 448     |  
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|                                         | Preferred stock dividends 
    Series B                |                                                        |      | 345     |         |      |      | 561     |         |   |       | 561    |        
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|                                         |                                                         | Net income (loss) available to
    common shareholders |      | $       | 42,747  |      |      | $       | 30,476  |   |       | $      | (113    | )
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|Earnings per Share                       |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|Basic earnings (loss) per common share   |                                                         | $                                                      | 2.74 |         |         | $    | 2.30 |         |         | $ | (0.01 | )     
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       
|Diluted earnings (loss) per common share |                                                         | $                                                      | 2.20 |         |         | $    | 1.68 |         |         | $ | (0.01 | )     
|                                         |                                                         |                                                        |      |         |         |      |      |         |         |   |       |       

See notes to consolidated financial statements.

62



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##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES



CONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |         |         |         | 
|--------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------------------------------- | -------------------------------------------------------------------------- | ------- | ------- | ------- | ------- | ------- | ------- | ------- | 
|                                                                                                                                                                |                                                                                                                                                  |                                                                    
|                                                                                                                                                                |                                                                                                                                                  | As of December 31,                                                 
|                                                                                                                                                                |                                                                                                                                                  |                                                                    
|                                                                                                                                                                |                                                                                                                                                  | 2003                                                                |                                                                            | 2002   
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |        
|                                                                                                                                                                |                                                                                                                                                  |                                                                    
|                                                                                                                                                                |                                                                                                                                                  | (In thousands)                                                     
|ASSETS                                                                                                                                                         
|Investments:                                                                                                                                                    |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|                                                                                                                                                                | Debt securities available-for-sale at fair value
    (amortized cost $263,929 and $119,292 at December 31, 2003
    and 2002, respectively)      |                                                                     | $                                                                          | 264,998 |         |         | $       | 123,576 |        
|                                                                                                                                                                | Short-term investments                                                                                                                           |                                                                     |                                                                            | 1,322   |         |         |         | 2,745   |        
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|                                                                                                                                                                |                                                                                                                                                  | Total investments                                                   |                                                                            |         | 266,320 |         |         |         | 126,321 |        
|Cash and cash equivalents                                                                                                                                       |                                                                                                                                                  |                                                                     | 87,342                                                                     |         |         |         | 87,027  |        
|Finance receivables, net                                                                                                                                        |                                                                                                                                                  |                                                                     | 201,271                                                                    |         |         |         | 166,935 |        
|Reinsurance balances receivable                                                                                                                                 |                                                                                                                                                  |                                                                     | 57,472                                                                     |         |         |         | 50,874  |        
|Prepaid reinsurance premiums                                                                                                                                    |                                                                                                                                                  |                                                                     | 56,397                                                                     |         |         |         | 82,648  |        
|Deferred policy acquisition costs                                                                                                                               |                                                                                                                                                  |                                                                     | 11,432                                                                     |         |         |         | 8,165   |        
|Deferred income taxes                                                                                                                                           |                                                                                                                                                  |                                                                     | 18,539                                                                     |         |         |         | 12,740  |        
|Property and equipment                                                                                                                                          |                                                                                                                                                  |                                                                     | 13,775                                                                     |         |         |         | 12,791  |        
|Goodwill, net                                                                                                                                                   |                                                                                                                                                  |                                                                     | 20,840                                                                     |         |         |         | 7,409   |        
|Other assets                                                                                                                                                    |                                                                                                                                                  |                                                                     | 17,766                                                                     |         |         |         | 14,210  |        
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|                                                                                                                                                                |                                                                                                                                                  |                                                                     | Total assets                                                               |         | $       | 751,154 |         |         | $       | 569,120 | 
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|LIABILITIES, REDEEMABLE PREFERRED STOCK AND
    SHAREHOLDERS EQUITY                                                                                           
|Loss and loss adjustment expense reserves                                                                                                                       |                                                                                                                                                  | $                                                                   | 112,618                                                                    |         |         | $       | 86,898  |        
|Unearned premiums                                                                                                                                               |                                                                                                                                                  |                                                                     | 213,250                                                                    |         |         |         | 172,971 |        
|Reinsurance balances payable and funds held                                                                                                                     |                                                                                                                                                  |                                                                     | 62,223                                                                     |         |         |         | 76,722  |        
|Accounts payable and accrued expenses                                                                                                                           |                                                                                                                                                  |                                                                     | 13,105                                                                     |         |         |         | 13,629  |        
|Income taxes payable                                                                                                                                            |                                                                                                                                                  |                                                                     | 2,369                                                                      |         |         |         | 3,182   |        
|Notes payable                                                                                                                                                   |                                                                                                                                                  |                                                                     | 148,946                                                                    |         |         |         | 126,880 |        
|Capital lease obligations                                                                                                                                       |                                                                                                                                                  |                                                                     | 4,556                                                                      |         |         |         | 4,310   |        
|Other liabilities                                                                                                                                               |                                                                                                                                                  |                                                                     | 16,692                                                                     |         |         |         | 19,648  |        
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|                                                                                                                                                                |                                                                                                                                                  |                                                                     | Total liabilities                                                          |         |         | 573,759 |         |         |         | 504,240 | 
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|Redeemable Series A preferred stock, no par;
    authorized shares  2,937.7; issued shares 
    0 and 2,937.7 at December 31, 2003 and
    2002, respectively |                                                                                                                                                  |                                                                     |                                                                           |         |         |         | 5,685   |        
|Shareholders equity                                                                                                                                            |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|                                                                                                                                                                | Series B preferred stock, no par; authorized
    shares  2,700.0; issued shares  0 and
    2,078.2 at December 31, 2003 and 2002, respectively |                                                                     |                                                                            |        |         |         |         | 9,219   |        
|                                                                                                                                                                | Preferred stock, no par; authorized
    shares  10,000.0 and 4,362.3 at December 31,
    2003 and 2002, respectively; no shares issued          |                                                                     |                                                                            |        |         |         |         |        |        
|                                                                                                                                                                | Common stock, no par; authorized
    shares  100,000.0; issued shares  21,350.6
    and 13,447.5 at December 31, 2003 and 2002, respectively   |                                                                     |                                                                            | 91,853  |         |         |         | 9,037   |        
|                                                                                                                                                                | Retained earnings                                                                                                                                |                                                                     |                                                                            | 85,735  |         |         |         | 43,842  |        
|                                                                                                                                                                | Accumulated other comprehensive income (loss):                                                                                                   |                                                                     |                                                                            |         |         |         |         |         |        
|                                                                                                                                                                |                                                                                                                                                  | Net unrealized appreciation on investment
    securities, after tax |                                                                            |         | 695     |         |         |         | 2,789   |        
|                                                                                                                                                                |                                                                                                                                                  | Net loss on cash flow hedge                                         |                                                                            |         | (888    | )       |         |         | (1,144  | )      
|                                                                                                                                                                | Treasury stock, at cost; 1,328.4 shares at
    December 31, 2002                                                                                 |                                                                     |                                                                            |        |         |         |         | (4,548  | )      
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|                                                                                                                                                                |                                                                                                                                                  | Total shareholders equity                                          |                                                                            |         | 177,395 |         |         |         | 59,195  |        
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        
|                                                                                                                                                                |                                                                                                                                                  |                                                                     | Total liabilities, redeemable preferred stock and
    shareholders equity |         | $       | 751,154 |         |         | $       | 569,120 | 
|                                                                                                                                                                |                                                                                                                                                  |                                                                     |                                                                            |         |         |         |         |        

See notes to consolidated financial statements.

63



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES



CONSOLIDATED STATEMENTS OF CHANGES IN
SHAREHOLDERS EQUITY

|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |        |        |  
|----------------------------- | --------------------------------------------------------------------------------------------------------- | --------------------------------------------------------------------------------------- | ----- | ----------- | - | -------- | ------ | ------------- | - | -------- | ------ | ------------- | ------ | - | ----- | - | ------ | - | ------ | ------ | - | - | ------- | ------ | ------ | -
|                              |                                                                                                           |                                                                                        
|                              |                                                                                                           | For the Years Ended December 31, 2003, 2002 and 2001                                   
|                              |                                                                                                           |                                                                                        
|                              |                                                                                                           |                                                                                         |       | Accumulated |   |         
|                              |                                                                                                           | Series B                                                                                |       |             |   | Other    |        |               |   | Total   
|                              |                                                                                                           | Preferred                                                                               |       | Common      |   | Retained |        | Comprehensive |   | Treasury |        | Shareholders
|                              |                                                                                                           | Stock                                                                                   |       | Stock       |   | Earnings |        | Income (Loss) |   | Stock    |        | Equity       
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |              
|                              |                                                                                                           |                                                                                        
|                              |                                                                                                           | (In thousands)                                                                         
|Balances at January 1, 2001   |                                                                                                           | $                                                                                       | 9,219 |             |   | $        | 9,113  |               |   | $        | 13,479 |               |        | $ | (59   | ) |        | $ | (12    | )      |   | $ | 31,740  |       
|                              | Comprehensive income:                                                                                     |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |        |       
|                              |                                                                                                           | Net income                                                                              |       |             |  |          |        |               |  |          |        |               | 448    |   |       |   |       |   |        |        |  |   |         |        | 448    |  
|                              |                                                                                                           | Net unrealized depreciation on securities
    available-for-sale, net of deferred taxes |       |             |  |          |        |               |  |          |        |               |       |   |       |   | (671   | ) |        |        |  |   |         |        | (671   | )
|                              |                                                                                                           | Net change during the year related to cash
    flow hedge                               |       |             |  |          |        |               |  |          |        |               |       |   |       |   | 115    |   |        |        |  |   |         |        | 115    |  
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|                              | Total comprehensive loss                                                                                  |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         | (108   | )     
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|                              | Dividends on preferred stock                                                                              |                                                                                         |       |            |   |          |        |              |   |          |        | (561          | )      |   |       |  |        |   |        |       |   |   |         | (561   | )     
|                              | Issuance of stock related to exercise of
    stock options                                                |                                                                                         |       |            |   |          |        | (76           | ) |          |        |              |        |   |       |  |        |   |        | 12     |   |   |         | (64    | )     
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|Balances at December 31, 2001 |                                                                                                           |                                                                                         | 9,219 |             |   |          | 9,037  |               |   |          | 13,366 |               |        |   | (615  | ) |        |   |       |        |   |   | 31,007  |       
|                              | Comprehensive income:                                                                                     |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |        |       
|                              |                                                                                                           | Net income                                                                              |       |             |  |          |        |               |  |          |        |               | 31,037 |   |       |   |       |   |        |        |  |   |         |        | 31,037 |  
|                              |                                                                                                           | Net unrealized appreciation on securities
    available-for-sale, net of deferred taxes |       |             |  |          |        |               |  |          |        |               |       |   |       |   | 3,519  |   |        |        |  |   |         |        | 3,519  |  
|                              |                                                                                                           | Net change during the year related to cash
    flow hedge                               |       |             |  |          |        |               |  |          |        |               |       |   |       |   | (1,259 | ) |        |        |  |   |         |        | (1,259 | )
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|                              | Total comprehensive income                                                                                |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         | 33,297 |       
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|                              | Dividends on preferred stock                                                                              |                                                                                         |       |            |   |          |        |              |   |          |        | (561          | )      |   |       |  |        |   |        |       |   |   |         | (561   | )     
|                              | Purchase of treasury stock (110,697 shares)                                                               |                                                                                         |       |            |   |          |        |              |   |          |        |              |        |   |       |  |        |   |        | (4,548 | ) |   |         | (4,548 | )     
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|Balances at December 31, 2002 |                                                                                                           |                                                                                         | 9,219 |             |   |          | 9,037  |               |   |          | 43,842 |               |        |   | 1,645 |   |        |   | (4,548 | )      |   |   | 59,195  |       
|                              | Comprehensive income:                                                                                     |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |        |       
|                              |                                                                                                           | Net income                                                                              |       |             |  |          |        |               |  |          |        |               | 43,092 |   |       |   |       |   |        |        |  |   |         |        | 43,092 |  
|                              |                                                                                                           | Net unrealized depreciation on securities
    available-for-sale, net of deferred taxes |       |             |  |          |        |               |  |          |        |               |       |   |       |   | (2,093 | ) |        |        |  |   |         |        | (2,093 | )
|                              |                                                                                                           | Net change during the year related to cash
    flow hedge                               |       |             |  |          |        |               |  |          |        |               |       |   |       |   | 255    |   |        |        |  |   |         |        | 255    |  
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|                              | Total comprehensive income                                                                                |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         | 41,254 |       
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|                              | Dividends on preferred stock                                                                              |                                                                                         |       |            |   |          |        |              |   |          |        | (345          | )      |   |       |  |        |   |        |       |   |   |         | (345   | )     
|                              | Dividends on common stock                                                                                 |                                                                                         |       |            |   |          |        |              |   |          |        | (854          | )      |   |       |  |        |   |        |       |   |   |         | (854   | )     
|                              | Common stock issued for conversion of
    Series A and Series B preferred stock
    (5,264.0 shares)      |                                                                                         |       | (9,219      | ) |          |        | 14,904        |   |          |        |              |        |   |       |  |        |   |        |       |   |   |         | 5,685  |       
|                              | Common stock issued for exercise of warrant
    (195.1 shares)                                            |                                                                                         |       |            |   |          |        | 800           |   |          |        |              |        |   |       |  |        |   |        |       |   |   |         | 800    |       
|                              | Common stock issued pursuant to initial public
    offering, net of $7,122.2 issue costs (3,750.0 shares) |                                                                                         |       |            |   |          |        | 71,628        |   |          |        |              |        |   |       |  |        |   |        |       |   |   |         | 71,628 |       
|                              | Exercise of stock options (24.0 shares)                                                                   |                                                                                         |       |            |   |          |        | 65            |   |          |        |              |        |   |       |  |        |   |        |       |   |   |         | 65     |       
|                              | Purchase of treasury stock (1.6 shares)                                                                   |                                                                                         |       |            |   |          |        |              |   |          |        |              |        |   |       |  |        |   |        | (33    | ) |   |         | (33    | )     
|                              | Retirement of treasury stock (1,330.0 shares)                                                             |                                                                                         |       |            |   |          |        | (4,581        | ) |          |        |              |        |   |       |  |        |   |        | 4,581  |   |   |         |       |       
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       
|Balances at December 31, 2003 |                                                                                                           | $                                                                                       |      |             |   | $        | 91,853 |               |   | $        | 85,735 |               |        | $ | (193  | ) |        | $ |       |        |   | $ | 177,395 |       
|                              |                                                                                                           |                                                                                         |       |             |   |          |        |               |   |          |        |               |        |   |       |   |        |   |        |        |   |   |         |       

See notes to consolidated financial statements.

64



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH
FLOWS

|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |          |         |         |  
|----------------------------------------------------- | -------------------------------------------------------------------------------------------- | -------------------------------------------------- | ------------------------------------------- | -------- | -------- | ------- | - | ------- | ------- | ------- | - | -------- | ------- | ------- | -
|                                                      |                                                                                              |                                                   
|                                                      |                                                                                              | For the Years Ended December 31,                  
|                                                      |                                                                                              |                                                   
|                                                      |                                                                                              | 2003                                               |                                             | 2002     |          | 2001   
|                                                      |                                                                                              |                                                    |                                             |          |          |        
|                                                      |                                                                                              |                                                   
|                                                      |                                                                                              | (In thousands)                                    
|Operating activities                                  |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      | Net income                                                                                   |                                                    | $                                           | 43,092   |          |         | $ | 31,037  |         |         | $ | 448      |        
|                                                      | Adjustments to reconcile net income to net cash                                              |                                                    |                                             |          |          |         |   |         |         |         |   |          |        
|                                                      | Provided by operating activities:                                                            |                                                    |                                             |          |          |         |   |         |         |         |   |          |        
|                                                      |                                                                                              | Net realized capital (gains) losses                |                                             |          | (3,393   | )       |   |         | 75      |         |   |          | (2,236  | )      
|                                                      |                                                                                              | Depreciation and amortization                      |                                             |          | 4,514    |         |   |         | 5,385   |         |   |          | 5,610   |        
|                                                      |                                                                                              | Deferred income taxes                              |                                             |          | (5,822   | )       |   |         | (4,921  | )       |   |          | (2,264  | )      
|                                                      |                                                                                              | Changes in operating assets and liabilities:       |                                             |          |          |         |   |         |         |         |   |          |         |        
|                                                      |                                                                                              |                                                    | Finance receivables                         |          |          | (34,336 | ) |         |         | (45,004 | ) |          |         | (26,787 | )
|                                                      |                                                                                              |                                                    | Reinsurance balances receivable             |          |          | (6,598  | ) |         |         | (1,292  | ) |          |         | 3,308   |  
|                                                      |                                                                                              |                                                    | Prepaid reinsurance premiums                |          |          | 26,251  |   |         |         | (14,871 | ) |          |         | (16,554 | )
|                                                      |                                                                                              |                                                    | Deferred policy acquisition costs           |          |          | (3,267  | ) |         |         | (2,145  | ) |          |         | (1,203  | )
|                                                      |                                                                                              |                                                    | Income taxes recoverable/payable            |          |          | (813    | ) |         |         | 5,413   |   |          |         | 1,599   |  
|                                                      |                                                                                              |                                                    | Loss and loss adjustment expense reserves   |          |          | 25,720  |   |         |         | 9,357   |   |          |         | 3,553   |  
|                                                      |                                                                                              |                                                    | Unearned premiums                           |          |          | 40,279  |   |         |         | 50,859  |   |          |         | 31,447  |  
|                                                      |                                                                                              |                                                    | Reinsurance balances payable and funds held |          |          | (14,499 | ) |         |         | 17,075  |   |          |         | 46,039  |  
|                                                      |                                                                                              |                                                    | Accounts payable and accrued expenses       |          |          | (524    | ) |         |         | 4,085   |   |          |         | 2,140   |  
|                                                      |                                                                                              |                                                    | Other                                       |          |          | (3,497  | ) |         |         | (2,606  | ) |          |         | 420     |  
|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      |                                                                                              | Net cash provided by operating activities          |                                             |          | 67,107   |         |   |         | 52,447  |         |   |          | 45,520  |        
|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|Investing activities                                  |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      | Proceeds from sales and maturities of debt
    securities available-for-sale and real estate |                                                    |                                             | 96,675   |          |         |   | 36,870  |         |         |   | 101,466  |        
|                                                      | Purchase of debt securities available-for-sale                                               |                                                    |                                             | (239,291 | )        |         |   | (50,739 | )       |         |   | (121,577 | )      
|                                                      | Net sales (purchases) of
    short-term investments                                          |                                                    |                                             | 1,423    |          |         |   | (1,345  | )       |         |   | (1,400   | )      
|                                                      | Purchase of property and equipment, net                                                      |                                                    |                                             | (5,380   | )        |         |   | (4,851  | )       |         |   | (2,918   | )      
|                                                      | Purchase of insurance agency assets                                                          |                                                    |                                             | (13,792  | )        |         |   |        |         |         |   |         |        
|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      |                                                                                              | Net cash used in investing activities              |                                             |          | (160,365 | )       |   |         | (20,065 | )       |   |          | (24,429 | )      
|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|Financing activities                                  |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      | Issuances of common stock                                                                    |                                                    |                                             | 72,493   |          |         |   |        |         |         |   |         |        
|                                                      | Proceeds from borrowings                                                                     |                                                    |                                             | 34,063   |          |         |   | 23,585  |         |         |   | 18,368   |        
|                                                      | Payment of principal on borrowings                                                           |                                                    |                                             | (11,751  | )        |         |   | (3,289  | )       |         |   | (7,768   | )      
|                                                      | Payment of preferred stock dividends                                                         |                                                    |                                             | (345     | )        |         |   | (561    | )       |         |   | (561     | )      
|                                                      | Payment of common stock dividends                                                            |                                                    |                                             | (854     | )        |         |   |        |         |         |   |         |        
|                                                      | Purchase of treasury stock                                                                   |                                                    |                                             | (33      | )        |         |   | (4,548  | )       |         |   |         |        
|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      |                                                                                              | Net cash provided by financing activities          |                                             |          | 93,573   |         |   |         | 15,187  |         |   |          | 10,039  |        
|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      |                                                                                              | Net increase in cash and cash equivalents          |                                             |          | 315      |         |   |         | 47,569  |         |   |          | 31,130  |        
|                                                      |                                                                                              | Cash and cash equivalents at beginning
    of year |                                             |          | 87,027   |         |   |         | 39,458  |         |   |          | 8,328   |        
|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      |                                                                                              |                                                    | Cash and cash equivalents at end of year    |          | $        | 87,342  |   |         | $       | 87,027  |   |          | $       | 39,458  |  
|                                                      |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|Supplemental disclosures of cash flow
    information |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|Cash paid (received) during the year for:             |                                                                                              |                                                    |                                             |          |          |         |   |         |         |         |   |         
|                                                      | Interest                                                                                     |                                                    | $                                           | 5,565    |          |         | $ | 7,104   |         |         | $ | 8,167    |        
|                                                      | Income taxes                                                                                 |                                                    |                                             | 30,756   |          |         |   | 15,109  |         |         |   | (354     | )      

See notes to consolidated financial statements.

65



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS



|   |                                                             
|-- | ------------------------------------------------------------
|1. | Nature of Operations and Significant
    Accounting Policies

Direct General Corporation, headquartered in
Nashville, Tennessee, is a financial services holding company
whose principal operating subsidiaries provide non-standard
personal automobile insurance, term life insurance, premium
finance and other consumer products and services primarily on a
direct basis throughout most of the southeastern United States.
Direct General Corporation owns four property/casualty insurance
companies, one life/health insurance company, two premium
finance companies, twelve insurance agencies, two administrative
service companies and one company that provides non-insurance
consumer products and services.



| |                      
| | ---------------------
| | Basis of Presentation

The accompanying consolidated financial
statements include the accounts of Direct General Corporation
and subsidiaries (collectively referred to as the Company or
Direct General). These financial statements have been prepared
in accordance with accounting principles generally accepted in
the United States (GAAP). All intercompany accounts and
transactions have been eliminated.



| |                 
| | ----------------
| | Use of Estimates

The preparation of financial statements requires
management to make estimates and assumptions that affect amounts
reported in the financial statements and accompanying notes.
Such estimates and assumptions could change in the future as
more information becomes known that could impact the amounts
reported and disclosed herein.



| |                                          
| | -----------------------------------------
| | Premiums Earned and Unearned
    Premiums

Property and casualty insurance premiums and life
insurance premiums are earned pro rata over the terms of the
respective policies. The reserve for unearned premiums is
determined on a daily pro rata basis.



| |                                                          
| | ---------------------------------------------------------
| | Insurance Losses and Loss Adjustment
    Expense Reserves

Insurance losses and loss adjustment expense
reserves represent the estimated ultimate net cost of all unpaid
reported and unreported losses incurred through
December 31. The loss and loss adjustment expense reserves
are estimated on an undiscounted basis, using individual
case-basis valuations and statistical analyses. Those estimates,
which are reported net of anticipated salvage and subrogation,
are subject to the effects of trends in loss severity and
frequency. Although considerable variability is inherent in such
estimates, management believes the loss and loss adjustment
expense reserves are adequate. The estimates are continually
reviewed and adjusted as necessary as experience develops or new
information becomes known; such adjustments are included in
current operations.



| |            
| | -----------
| | Reinsurance

Reinsurance premiums, losses and loss adjustment
expenses are accounted for on bases consistent with those used
in accounting for the original policies issued and the terms of
the reinsurance contracts. Ceding commissions are recognized net
of a provision for return commissions on anticipated
cancellations and the amount necessary to cover future
maintenance costs.



| |                                   
| | ----------------------------------
| | Finance Income and
    Receivables

The Company finances the majority of the
insurance policies sold under a variety of payment plans.
Finance income consists of interest, installment fees,
acquisition and service fees, and delinquency fees. Finance
income, other than delinquency fees, is recognized using the
interest (actuarial) method or similar methods that produce
a level yield. Delinquency fees are earned when billed.
Acquisition fees, net of directly

66



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##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

related lending costs, are deferred and amortized
into finance income over the remaining lives of the related
loans. Upon cancellation of the underlying insurance policies,
any uncollected earned interest or fees are charged off. The
Companys allowance for finance receivable losses is
comprised of a reserve for uncollected finance acquisition fees
and a provision for the write-off of premium finance balances
(primarily realized but uncollected interest), which is
calculated using the historical level of finance receivable
losses as a percentage of outstanding balances under the premium
finance agreements.



| |                  
| | -----------------
| | Commission Income

The Companys insurance agencies receive
commission income on the sale of ancillary insurance products
offered by non-affiliated insurance companies. Commission is
generally recognized into income when the ancillary insurance
policies are issued, net of a provision for return commissions
on anticipated cancellations.



| |             
| | ------------
| | Service Fees

The Company receives service fees for agency,
underwriting, policy administration, and claims adjusting
services performed on behalf of other insurance companies for
insurance policies produced through the Companys insurance
agency subsidiaries. Service fees are recorded net of the
related fronting fees and premium taxes and are recognized as
the services are performed, less amounts necessary to cover
future processing and administrative costs.



| |            
| | -----------
| | Investments

The Companys entire portfolio of debt
securities is classified as available-for-sale and
reported at fair value, with unrealized gains and losses
excluded from earnings and reported as a separate component of
other comprehensive income, net of deferred income taxes. The
Company may sell its available-for-sale securities in response
to changes in interest rates, risk/reward characteristics,
liquidity needs, or other economic factors.

Short-term investments, which are carried at
cost, include investments in commercial paper, certificates of
deposit, and other interest-bearing time deposits with original
maturities of more than three months to one year. In addition,
short-term investments include a trading portfolio, which
consists primarily of futures contracts, swaps, and other
derivative instruments. The trading portfolio represents a
speculative investment and does not represent a hedge;
accordingly, all contracts are marked to market with the change
in market values reported as net realized gains (losses) on
securities and other in the Companys consolidated
statements of operations.

Cash and cash equivalents include
interest-bearing time deposits with original maturities of three
months or less.

The Companys investment portfolio is
primarily exposed to interest rate risk and to a lesser extent
market and credit risk. The fair value of our portfolio is
directly impacted by changing interest rates, market conditions
and financial conditions of the issuer. The Company examines its
portfolio on at least a quarterly basis for evidence of
impairment. If an investment becomes other than temporarily
impaired, such impairment is treated as a realized loss and the
investment is adjusted to fair value. Realized investment gains
and losses are recognized using the specific identification
method.



| |                                      
| | -------------------------------------
| | Deferred Policy Acquisition
    Costs

Policy acquisition costs include advertising,
commissions, premium taxes and certain other underwriting and
direct sales costs incurred in connection with writing business.
These costs are deferred and are reported net of the related
ceding commission received from reinsurers. Such deferred policy
acquisition costs are being amortized over the effective period
of the related insurance policies. Amortization charged to
operations

67



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##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

amounted to $26,271,000, $21,060,000 and
$16,258,000 in 2003, 2002 and 2001, respectively. The Company
considers anticipated investment income in determining the
recoverability of these costs and believes they will be fully
recovered over the next twelve months.



| |                       
| | ----------------------
| | Property and Equipment

Property and equipment is recorded at cost.
Depreciation is calculated using the straight-line method over
the estimated useful lives of the respective assets, which are
principally as follows: computer hardware and software (3-7
years), furniture and equipment (3-7 years), and
Company-occupied buildings and improvements (30 years).
Property and equipment includes software developed and
capitalized for internal use.



| |         
| | --------
| | Goodwill

Goodwill represents the amount by which the cost
of acquired net assets exceeds their related fair value. In
accordance with Financial Accounting Standards No. 142, the
Company ceased amortizing goodwill effective January 1,
2002. Prior to January 1, 2002, goodwill was amortized on a
straight-line basis over 10 to 15 years. Amortization
charged to operations amounted to $719,000 in 2001. The related
accumulated amortization was $2,829,000 at December 31,
2001. Had the Company adopted Financial Accounting Standards
No. 142 effective January 1, 2001, net income would have
been $923,000 for the year ended December 31, 2001. The
carrying value of goodwill was initially reviewed for impairment
as of January 1, 2002, and is reviewed annually or whenever
events or changes in circumstances indicate that the carrying
amount might not be recoverable. If the fair value of the
operations to which goodwill relates is less than the carrying
amount of those operations, including unamortized goodwill, the
carrying amount of goodwill is reduced accordingly with a charge
to expense. Based on its most recent analysis, the Company
believes that no impairment of goodwill exists at
December 31, 2003.



| |                
| | ---------------
| | Cash Flow Hedge

The Company uses a derivative financial
instrument known as an interest rate collar primarily for the
purpose of hedging exposures to the variability in future cash
flows associated with fluctuating interest rates on its
revolving credit agreement. At the inception of the derivative
contract and at least quarterly thereafter, the Company formally
documents and updates the risk management strategy, the
underlying exposure of the hedge, and the effectiveness of the
hedging transaction in offsetting changes in the fair value or
cash flows of the exposure being hedged. This derivative is
recorded at fair value on the balance sheet with the changes in
fair value recognized in earnings or other comprehensive income.
Gains or losses reported in other comprehensive income are
reclassified into income in the period in which earnings are
affected by the underlying hedged item. The ineffective portion
of the hedge is recognized in earnings in the current period.



| |             
| | ------------
| | Income Taxes

Deferred tax assets and liabilities are
established for temporary differences between the financial
reporting basis and the tax basis of assets and liabilities, at
the enacted tax rates expected to be in effect when the
temporary differences reverse. The effect of a tax rate change
is recognized in income in the period of enactment. State income
taxes are included in income tax expense.

A valuation allowance for deferred tax assets is
provided for all or some portion of the deferred tax asset when
it is more likely than not that an amount will not be realized.
An increase or decrease in a valuation allowance that results
from a change in circumstances that causes a change in judgment
about the realizability of the related deferred tax asset is
included in income. The Company believes its deferred tax assets
are fully realizable at December 31, 2003.

68



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##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |            
| | -----------
| | Stock Split

Effective August 11, 2003, the Company
effected a stock split pursuant to which each outstanding share
of the Companys common stock became 12 new shares of
common stock (see Note 10). The Company has adjusted all share
and per share amounts in the financial statements and
accompanying notes to reflect the 12 for 1 split.



| |              
| | -------------
| | Stock Options

The Company follows the provisions of Accounting
Principles Board (APB) Opinion No. 25, Accounting for
Stock Issued to Employees, to account for its stock option
activity in the financial statements. The Company granted all
options currently outstanding at an exercise price equal to the
market price at the date of grant and, therefore, under APB
No. 25, no compensation expense is recorded. The Company
follows the disclosure provisions of Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting
for Stock-Based Compensation (see Note 10).



| |                  
| | -----------------
| | Segment Reporting

The Company has determined that it has two
reportable segments. The primary reportable segment is comprised
of principally all of the Companys operations. The
Companys primary operating segments have been aggregated
into this primary reportable segment. The other reportable
segment consists of corporate operations and is not material to
either revenues or net income.

The Company monitors, controls and manages its
business lines as an integrated entity offering one product.
Management believes that the finance and insurance businesses
are dependent on each other. The finance company only provides
financing for the Companys insurance customers and
insurance policy sales are dependent, in part, upon the flexible
payment plan structures of the finance company. The
Companys agency subsidiaries complete the premium finance
paperwork at the same time they are selling the underlying
insurance policy. In addition, because our systems are
integrated, any change to the underlying insurance policy such
as a cancellation or endorsement will automatically result in a
corresponding change to the premium finance agreement.

The Company primarily analyzes its results on a
state-by-state basis because the insurance rates and finance
plan structures are subject to state regulation. All revenue and
expense streams are considered when analyzing a particular
states operating results. Accordingly, management may
change any number of factors to achieve the desired results in a
state including the premium rates, finance plan structure,
amount of advertising, or other factors. The Companys
state operating segments constitute one primary reporting
segment that can be appropriately aggregated because each of the
state operating segments has identical operations and products;
however, varying state regulations require the operations to be
divided geographically.

69



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##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |            
|-- | -----------
|2. | Investments

The amortized cost, gross unrealized gains, gross
unrealized losses, and fair value of debt securities
available-for-sale at December 31 are as follows:

|                                                                                          |       |                |         |            |  |            |       |       |  |   |       |       |  |   |         |         | 
|----------------------------------------------------------------------------------------- | ----- | -------------- | ------- | ---------- |  | ---------- | ----- | ----- |  | - | ----- | ----- |  | - | ------- | ------- | 
|                                                                                          |       |                |         | Gross      |  | Gross      |       |      
|                                                                                          |       | Amortized      |         | Unrealized |  | Unrealized |       | Fair 
|                                                                                          |       | Cost           |         | Gains      |  | Losses     |       | Value
|                                                                                          |       |                |         |            |  |            |       |      
|                                                                                          |       |               
|                                                                                          |       | (In thousands)
|2003                                                                                      |       |                |         |            |  |            |       |       |  |   |       |       |  |   |         |        
|U.S. Treasury securities and obligations of U.S.
    government corporations and agencies |       | $              | 94,802  |            |  | $          | 289   |       |  | $ | 1,115 |       |  | $ | 93,976  |        
|Obligations of states and
    political subdivisions                                      |       |                | 49,920  |            |  |            | 1,766 |       |  |   | 24    |       |  |   | 51,662  |        
|Corporate debt securities                                                                 |       |                | 119,207 |            |  |            | 1,276 |       |  |   | 1,123 |       |  |   | 119,360 |        
|                                                                                          |       |                |         |            |  |            |       |       |  |   |       |       |  |   |         |        
|                                                                                          | Total |                | $       | 263,929    |  |            | $     | 3,331 |  |   | $     | 2,262 |  |   | $       | 264,998 | 
|                                                                                          |       |                |         |            |  |            |       |       |  |   |       |       |  |   |         |        
|2002                                                                                      |       |                |         |            |  |            |       |       |  |   |       |       |  |   |         |        
|U.S. Treasury securities and obligations of U.S.
    government corporations and agencies |       | $              | 16,371  |            |  | $          | 608   |       |  | $ | 2     |       |  | $ | 16,977  |        
|Obligations of states and
    political subdivisions                                      |       |                | 69,587  |            |  |            | 2,473 |       |  |   | 9     |       |  |   | 72,051  |        
|Corporate debt securities                                                                 |       |                | 33,334  |            |  |            | 1,227 |       |  |   | 13    |       |  |   | 34,548  |        
|                                                                                          |       |                |         |            |  |            |       |       |  |   |       |       |  |   |         |        
|                                                                                          | Total |                | $       | 119,292    |  |            | $     | 4,308 |  |   | $     | 24    |  |   | $       | 123,576 | 
|                                                                                          |       |                |         |            |  |            |       |       |  |   |       |       |  |   |         |        

Substantially all of the gross unrealized losses
on securities at December 31, 2003 were attributable to
securities purchased within the past twelve months and are
deemed to be temporary.

The components of pretax net investment income
and net realized gains (losses) on sales of securities for
the years ended December 31 were:

|                                         |                                             |                             |       |       |       |      |        |       |       |   |       |       |       | 
|---------------------------------------- | ------------------------------------------- | --------------------------- | ----- | ----- | ----- | ---- | ------ | ----- | ----- | - | ----- | ----- | ----- | 
|                                         |                                             | 2003                        |       | 2002  |       | 2001
|                                         |                                             |                             |       |       |       |     
|                                         |                                             |                            
|                                         |                                             | (In thousands)             
|Gross investment income:                 |                                             |                             |       |       |       |      |        |       |       |   |       |      
|                                         | Debt securities available-for-sale          |                             | $     | 6,636 |       |      | $      | 5,255 |       |   | $     | 4,655 |      
|                                         | Short-term investments and cash equivalents |                             |       | 413   |       |      |        | 367   |       |   |       | 616   |      
|                                         |                                             |                             |       |       |       |      |        |       |       |   |       |      
|Total investment income                  |                                             |                             | 7,049 |       |       |      | 5,622  |       |       |   | 5,271 |      
|Investment expenses                      |                                             |                             | 319   |       |       |      | 277    |       |       |   | 179   |      
|                                         |                                             |                             |       |       |       |      |        |       |       |   |       |      
|                                         |                                             | Net investment income       |       | $     | 6,730 |      |        | $     | 5,345 |   |       | $     | 5,092 | 
|                                         |                                             |                             |       |       |       |      |        |       |       |   |       |      
|Realized gains on investments            |                                             | $                           | 4,341 |       |       | $    | 949    |       |       | $ | 2,415 |      
|Realized losses on investments           |                                             |                             | (559  | )     |       |      | (1,024 | )     |       |   | (179  | )    
|Net unrealized loss on trading portfolio |                                             |                             | (389  | )     |       |      |       |       |       |   |      |      
|                                         |                                             |                             |       |       |       |      |        |       |       |   |       |      
|                                         |                                             | Net realized gains (losses) |       | $     | 3,393 |      |        | $     | (75   | ) |       | $     | 2,236 | 
|                                         |                                             |                             |       |       |       |      |        |       |       |   |       |      

70



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##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The amortized cost and fair value of debt
securities available-for-sale at December 31, 2003, by
contractual maturity, is shown below:

|                   |                        |                |   |         |         |  |   |         |         | 
|------------------ | ---------------------- | -------------- | - | ------- | ------- |  | - | ------- | ------- | 
|                   |                        | Amortized      |   | Fair   
|                   |                        | Cost           |   | Value  
|                   |                        |                |   |        
|                   |                        |               
|                   |                        | (In thousands)
|Years to maturity: |                        |                |   |         |         |  |   |        
|                   | One or less            |                | $ | 9,875   |         |  | $ | 9,909   |        
|                   | After one through five |                |   | 136,790 |         |  |   | 137,445 |        
|                   | After five through ten |                |   | 91,470  |         |  |   | 91,847  |        
|                   | After ten              |                |   | 25,794  |         |  |   | 25,797  |        
|                   |                        |                |   |         |         |  |   |        
|                   |                        | Total          |   | $       | 263,929 |  |   | $       | 264,998 | 
|                   |                        |                |   |         |         |  |   |        

At December 31, 2003, investments carried at
market value of $8,203,000 and cash of approximately $127,000
were on deposit with regulatory authorities. Additionally,
investments carried at market value of $3,801,000 and cash of
$4,000,000 were pledged to secure letters of credit and
reinsurance security trusts.



|   |                    
|-- | -------------------
|3. | Finance Receivables

Finance receivables net of unearned interest,
unearned acquisition fees and deferred costs for the years ended
December 31 were:

|                          |  |                |         |      |  |   |         |  
|------------------------- |  | -------------- | ------- | ---- |  | - | ------- | -
|                          |  | 2003           |         | 2002
|                          |  |                |         |     
|                          |  |               
|                          |  | (In thousands)
|Finance receivables       |  | $              | 207,213 |      |  | $ | 171,945 |  
|Less allowance for losses |  |                | (5,942  | )    |  |   | (5,010  | )
|                          |  |                |         |      |  |   |         |  
|Finance receivables, net  |  | $              | 201,271 |      |  | $ | 166,935 |  
|                          |  |                |         |      |  |   |         |  

A progression of the allowance for finance
receivable losses is as follows:

|                                        |  |                |        |      |  |      |        |   |  |   |        |  
|--------------------------------------- |  | -------------- | ------ | ---- |  | ---- | ------ | - |  | - | ------ | -
|                                        |  | 2003           |        | 2002 |  | 2001
|                                        |  |                |        |      |  |     
|                                        |  |               
|                                        |  | (In thousands)
|Balance at January 1                    |  | $              | 5,010  |      |  | $    | 4,811  |   |  | $ | 3,264  |  
|Provision for finance receivable losses |  |                | 6,962  |      |  |      | 5,346  |   |  |   | 5,559  |  
|Charge-offs, net of recoveries          |  |                | (6,030 | )    |  |      | (5,147 | ) |  |   | (4,012 | )
|                                        |  |                |        |      |  |      |        |   |  |   |        |  
|Balance at December 31                  |  | $              | 5,942  |      |  | $    | 5,010  |   |  | $ | 4,811  |  
|                                        |  |                |        |      |  |      |        |   |  |   |        |  

Geographic concentrations of finance receivables
at December 31 are as follows:

|                       |  |      |       |      |  |  |       |  
|---------------------- |  | ---- | ----- | ---- |  |  | ----- | -
|                       |  | 2003 |       | 2002
|                       |  |      |       |     
|Florida                |  |      | 50.4  | %    |  |  | 48.6  | %
|Tennessee              |  |      | 15.3  |      |  |  | 16.6  |  
|Georgia                |  |      | 7.8   |      |  |  | 9.0   |  
|Louisiana              |  |      | 7.8   |      |  |  | 7.0   |  
|Other states, combined |  |      | 18.7  |      |  |  | 18.8  |  
|                       |  |      |       |      |  |  |       |  
|Total                  |  |      | 100.0 | %    |  |  | 100.0 | %
|                       |  |      |       |      |  |  |       |  

71



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##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

Finance receivables are collateralized by the
unearned premiums of the related insurance policies. These
finance receivables have an average remaining contractual
maturity of approximately six months, with the longest
contractual maturity being approximately eleven months.



|   |                       
|-- | ----------------------
|4. | Property and Equipment

Property and equipment at December 31 is as
follows:

|                               |           |                |         |       |  |   |         |       | 
|------------------------------ | --------- | -------------- | ------- | ----- |  | - | ------- | ----- | 
|                               |           | 2003           |         | 2002 
|                               |           |                |         |      
|                               |           |               
|                               |           | (In thousands)
|Land                           |           | $              | 171     |       |  | $ | 171     |      
|Buildings and improvements     |           |                | 3,964   |       |  |   | 2,709   |      
|Computer hardware and software |           |                | 16,095  |       |  |   | 14,267  |      
|Furniture and equipment        |           |                | 6,633   |       |  |   | 5,590   |      
|Projects in progress           |           |                | 265     |       |  |   | 270     |      
|Capital leases:                |           |                |         |       |  |   |         |      
|                               | Building  |                |         | 6,364 |  |   |         | 6,364 | 
|                               | Equipment |                |         | 3,970 |  |   |         | 2,908 | 
|                               |           |                |         |       |  |   |         |      
|                               |           |                | 37,462  |       |  |   | 32,279  |      
|Less accumulated depreciation  |           |                | (23,687 | )     |  |   | (19,488 | )    
|                               |           |                |         |       |  |   |         |      
|Net property and equipment     |           | $              | 13,775  |       |  | $ | 12,791  |      
|                               |           |                |         |       |  |   |         |      

Depreciation expense was approximately
$4,472,000, $5,385,000 and $4,691,000 in 2003, 2002 and 2001,
respectively.

During April 1998, the Company entered into
a sale and leaseback transaction of its building located in
Baton Rouge, Louisiana. The gain of $1,068,000 is being
amortized over the term of the lease. At December 31, 2003
and 2002, the unamortized portion of the deferred gain was
$456,000 and $563,000, respectively, and is included as a
component of other liabilities. The building under capital lease
was capitalized using the Companys average borrowing rate
at inception of the lease. Depreciation expense on the
capitalized building lease was $636,000 during 2003, 2002 and
2001, and related accumulated depreciation on the building under
capital lease was approximately $3,500,000 and $2,864,000 at
December 31, 2003 and 2002, respectively.

The Company also leases certain computer
equipment under capital lease arrangements. Depreciation expense
on capitalized equipment leases during 2003, 2002 and 2001 was
$149,000, $828,000 and $1,004,000 respectively, and related
accumulated depreciation as of December 31, 2003 and 2002,
was $2,934,000 and $2,785,000, respectively.

72



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##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                                                  
|-- | -------------------------------------------------
|5. | Insurance Losses and Loss Adjustment
    Expenses

The following table provides a reconciliation of
insurance losses and loss adjustment expenses
(LAE) reserves, net of reinsurance recoverables:

|                                                                |              |                |         |         |  |      |         |         |   |   |        |        | 
|--------------------------------------------------------------- | ------------ | -------------- | ------- | ------- |  | ---- | ------- | ------- | - | - | ------ | ------ | 
|                                                                |              | 2003           |         | 2002    |  | 2001
|                                                                |              |                |         |         |  |     
|                                                                |              |               
|                                                                |              | (In thousands)
|Balance at January 1                                            |              | $              | 86,898  |         |  | $    | 77,541  |         |   | $ | 73,988 |       
|Less reinsurance recoverables on
    unpaid losses              |              |                | 28,974  |         |  |      | 40,555  |         |   |   | 39,454 |       
|                                                                |              |                |         |         |  |      |         |         |   |   |        |       
|Net balance at January 1                                        |              |                | 57,924  |         |  |      | 36,986  |         |   |   | 34,534 |       
|Add losses and LAE incurred, net of reinsurance
    related to: |              |                |         |         |  |      |         |         |   |   |        |       
|                                                                | Current year |                |         | 168,066 |  |      |         | 106,175 |   |   |        | 86,080 | 
|                                                                | Prior years  |                |         | 130     |  |      |         | (5,492  | ) |   |        | 7,779  | 
|                                                                |              |                |         |         |  |      |         |         |   |   |        |       
|Net losses and LAE incurred during the
    current year         |              |                | 168,196 |         |  |      | 100,683 |         |   |   | 93,859 |       
|                                                                |              |                |         |         |  |      |         |         |   |   |        |       
|Deduct losses and LAE paid, net of reinsurance,
    related to: |              |                |         |         |  |      |         |         |   |   |        |       
|                                                                | Current year |                |         | 107,649 |  |      |         | 66,619  |   |   |        | 60,181 | 
|                                                                | Prior years  |                |         | 43,808  |  |      |         | 13,126  |   |   |        | 31,226 | 
|                                                                |              |                |         |         |  |      |         |         |   |   |        |       
|Net claim payments made during the
    current year             |              |                | 151,457 |         |  |      | 79,745  |         |   |   | 91,407 |       
|                                                                |              |                |         |         |  |      |         |         |   |   |        |       
|Net balance at December 31                                      |              |                | 74,663  |         |  |      | 57,924  |         |   |   | 36,986 |       
|Plus reinsurance recoverables on
    unpaid losses              |              |                | 37,955  |         |  |      | 28,974  |         |   |   | 40,555 |       
|                                                                |              |                |         |         |  |      |         |         |   |   |        |       
|Balance at December 31                                          |              | $              | 112,618 |         |  | $    | 86,898  |         |   | $ | 77,541 |       
|                                                                |              |                |         |         |  |      |         |         |   |   |        |       

The Companys net loss and LAE reserve
development included favorable development in 2002 of $1,790,000
related to the commutation of certain reinsurance contracts and
unfavorable development of $6,526,000 in 2001 relating to the
write-off of reinsurance recoverable from an insolvent reinsurer
(see Note 7). The remaining favorable and unfavorable
development is primarily a result of changes in frequency and
severity trends.

The net losses and LAE paid during 2002 that
related to prior years was net of $10,463,000 of reinsurance
payments received in conjunction with the commutation of a
reinsurers obligation for unpaid losses and $7,357,000 of
reinsurance payments received in conjunction with the
commutation of the Companys stop loss reinsurance
agreement.

The anticipated effect of inflation is implicitly
considered when estimating liabilities for losses and LAE. While
anticipated price increases due to inflation are considered in
estimating the ultimate claim costs, the increase in average
severities of claims is caused by a number of factors that vary
with the individual type of policy written. Future average
severities are projected based on historical trends adjusted for
implemented changes in underwriting standards, policy
provisions, and general economic trends. Those anticipated
trends are monitored based on actual development and are
modified if necessary.

The Company is exposed to natural catastrophes
such as hurricanes, earthquakes, and hailstorms. While the
Companys results from operations would be negatively
impacted by a major catastrophe, the Company maintains
catastrophe insurance that limits its exposure to such events.
The Company is generally not exposed to asbestos and
environmental claims since it writes only personal automobile
and life insurance.

73



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |              
|-- | -------------
|6. | Notes Payable

Notes payable at December 31 were as follows:

|                          |       |                |         |         |  |   |         |         | 
|------------------------- | ----- | -------------- | ------- | ------- |  | - | ------- | ------- | 
|                          |       | 2003           |         | 2002   
|                          |       |                |         |        
|                          |       |               
|                          |       | (In thousands)
|Revolving credit facility |       | $              | 148,000 |         |  | $ | 115,000 |        
|Term notes                |       |                |        |         |  |   | 10,200  |        
|Other                     |       |                | 946     |         |  |   | 1,680   |        
|                          |       |                |         |         |  |   |         |        
|                          | Total |                | $       | 148,946 |  |   | $       | 126,880 | 
|                          |       |                |         |         |  |   |         |        



| |                          
| | -------------------------
| | Revolving Credit Facility

The Company has maintained a revolving credit
facility with a consortium of banks to fund the working capital
needs of the Companys premium finance operations since
1994. Under the terms of the current facility, interest is
payable quarterly at a rate elected by the Company of either the
base commercial rate of First Tennessee Bank, N.A., as
Agent, or at 1.5% to 2.0% above LIBOR. The LIBOR
spread at the time of the election is determined based upon the
Companys Average Funded Debt to EBITDA Ratio
as defined in the agreement. At December 31, 2003, the
weighted average rate in effect was 3.38%. Under terms of the
current facility, the Company may borrow up to $190,000,000. As
of December 31, 2003, the unused amount was $42,000,000.
The current facility matures on June 30, 2004. The loan is
principally secured by finance receivables, as well as the stock
of Direct Insurance Company.

The revolving credit facility contains covenants
which, among other matters 1) limit the Companys ability
to incur or guarantee indebtedness, merge, consolidate and
acquire or sell assets without bank approval; 2) require the
Company to satisfy certain financial ratios, including those
related to net worth, debt-to-equity, and profitability; and 3)
restrict the payment of cash dividends on common stock. As of
December 31, 2003, the Company was in compliance with all
covenants related to the credit agreement.



| |           
| | ----------
| | Term Notes

As of December 31, 2002, the Company had a
$7,500,000 and a $2,700,000 bank term note, both bearing
interest at 9.0% with interest being payable quarterly. The term
notes were repaid in August 2003.



| |      
| | -----
| | Other

The Company enters into various other credit
agreements from time to time, primarily to finance the purchase
of computer equipment and other assets. As of December 31,
2003, the Company has one such credit agreement bearing interest
at 5.46%. Principal and interest are payable monthly, with
principal totaling $520,000 and $426,000 due in 2004 and 2005
respectively. The note is secured by computer equipment.



| |                     
| | --------------------
| | Scheduled Maturities

Aggregate principal payments on debt outstanding
at December 31, 2003 are $148,520,000 for 2004 and $426,000
for 2005.



|   |            
|-- | -----------
|7. | Reinsurance



| |                  
| | -----------------
| | Ceded Reinsurance

The Company cedes certain premiums and risks of
loss to other insurance companies under quota share, excess of
loss, and catastrophe forms of reinsurance agreements. The ceded
reinsurance agreements provide the Company with increased
capacity to write additional business while limiting its
exposure to loss within its

74



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

capital resources. The Company evaluates the
financial condition of its reinsurers and monitors various
credit risks to minimize its exposure to significant losses from
reinsurer insolvencies. The Company remains obligated for
amounts ceded in the event that the reinsurers do not meet their
obligations.

Reliance Insurance Company (Reliance) was a
reinsurer in the Companys quota share reinsurance program
from October 1996 to December 2000. Reliance was
placed into liquidation by the Pennsylvania Department of
Insurance in October 2001 due to a rapid and significant
deterioration in underwriting results, adverse development in
loss reserves, and liquidity issues that were accelerated by the
terrorist attacks of September 11, 2001. During the third
quarter of 2001, the Company wrote off its entire receivable
from Reliance of approximately $11,130,000.

The Company is the beneficiary of letters of
credit totaling approximately $3,469,000 and trust accounts
totaling $14,026,000 in accordance with the terms of its
reinsurance agreements. The letters of credit and trust accounts
were unused at December 31, 2003.



| |                    
| | -------------------
| | Assumed Reinsurance

The Company assumed, under quota-share
reinsurance agreements, a percentage of personal automobile
insurance produced for other insurers (see Note 8). As of
December 31, 2003, the Company provided a letter of credit
in the amount of $4,000,000 which is secured by a certificate of
deposit and security trust accounts totaling $4,213,000 for the
benefit of the other insurers with respect to its obligations
under the assumed reinsurance agreements.

The following amounts are reflected in the
financial statements as a result of reinsurance arrangements for
the years ended December 31:

|        |  |                |          |          |  |            |          |   |  |   |          |  
|------- |  | -------------- | -------- | -------- |  | ---------- | -------- | - |  | - | -------- | -
|        |  | Premiums       |          | Premiums |  | Losses and
|        |  | Written        |          | Earned   |  | LAE       
|        |  |                |          |          |  |           
|        |  |               
|        |  | (In thousands)
|2003    |  |                |          |          |  |            |          |   |  |   |          |  
|Direct  |  | $              | 409,967  |          |  | $          | 370,888  |   |  | $ | 275,964  |  
|Assumed |  |                | 25,220   |          |  |            | 24,021   |   |  |   | 14,164   |  
|Ceded   |  |                | (140,128 | )        |  |            | (166,380 | ) |  |   | (121,932 | )
|        |  |                |          |          |  |            |          |   |  |   |          |  
|Net     |  | $              | 295,059  |          |  | $          | 228,529  |   |  | $ | 168,196  |  
|        |  |                |          |          |  |            |          |   |  |   |          |  
|2002    |  |                |          |          |  |            |          |   |  |   |          |  
|Direct  |  | $              | 326,593  |          |  | $          | 276,098  |   |  | $ | 198,153  |  
|Assumed |  |                | 8,569    |          |  |            | 8,205    |   |  |   | 5,987    |  
|Ceded   |  |                | (154,199 | )        |  |            | (139,328 | ) |  |   | (103,457 | )
|        |  |                |          |          |  |            |          |   |  |   |          |  
|Net     |  | $              | 180,963  |          |  | $          | 144,975  |   |  | $ | 100,683  |  
|        |  |                |          |          |  |            |          |   |  |   |          |  
|2001    |  |                |          |          |  |            |          |   |  |   |          |  
|Direct  |  | $              | 229,826  |          |  | $          | 200,829  |   |  | $ | 169,251  |  
|Assumed |  |                | 8,888    |          |  |            | 6,438    |   |  |   | 6,024    |  
|Ceded   |  |                | (125,792 | )        |  |            | (109,238 | ) |  |   | (81,416  | )
|        |  |                |          |          |  |            |          |   |  |   |          |  
|Net     |  | $              | 112,922  |          |  | $          | 98,029   |   |  | $ | 93,859   |  
|        |  |                |          |          |  |            |          |   |  |   |          |  

75



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                        
|-- | -----------------------
|8. | Administrative Services

The Companys agency subsidiaries and
administrative service subsidiaries produce and administer
personal automobile insurance business for other insurers. The
Company receives service fees for its underwriting, policyholder
administration and claims processing services. Administrative
service fees earned, net of the related fronting fees and
premium taxes, were approximately $7,574,000, $7,018,000 and
$6,693,000 in 2003, 2002 and 2001, respectively, and are
included in the caption commissions and service fee income in
the Statements of Operations.

Premiums associated with personal automobile
insurance produced for other insurers and related assumed
premiums were as follows:

|                                     |                  |                |   |        |  |      |   |        |  |  |   |        | 
|------------------------------------ | ---------------- | -------------- | - | ------ |  | ---- | - | ------ |  |  | - | ------ | 
|                                     |                  | 2003           |   | 2002   |  | 2001
|                                     |                  |                |   |        |  |     
|                                     |                  |               
|                                     |                  | (In thousands)
|Premiums produced for other carriers |                  |                |   |        |  |      |   |        |  |  |   |       
|                                     | Written premiums |                | $ | 33,818 |  |      | $ | 24,338 |  |  | $ | 27,662 | 
|                                     | Earned premiums  |                |   | 34,993 |  |      |   | 26,692 |  |  |   | 27,165 | 
|Premiums assumed by the Company      |                  |                |   |        |  |      |   |        |  |  |   |       
|                                     | Written premiums |                | $ | 25,220 |  |      | $ | 8,569  |  |  | $ | 8,888  | 
|                                     | Earned premiums  |                |   | 24,021 |  |      |   | 8,205  |  |  |   | 6,438  | 



|   |             
|-- | ------------
|9. | Income Taxes

The Company and its non-life subsidiaries file a
consolidated federal income tax return, while Direct Life
Insurance Company files a separate federal income tax return.

Income tax expense (benefit) is as follows:

|          |         |                |                                    |        |        |        |   |        |        |        |   |        |        |        |  
|--------- | ------- | -------------- | ---------------------------------- | ------ | ------ | ------ | - | ------ | ------ | ------ | - | ------ | ------ | ------ | -
|          |         | 2003           |                                    | 2002   |        | 2001  
|          |         |                |                                    |        |        |       
|          |         |               
|          |         | (In thousands)
|Current:  |         |                |                                    |        |        |        |   |        |        |        |   |       
|          | Federal |                | $                                  | 26,918 |        |        | $ | 18,449 |        |        | $ | 379    |       
|          | State   |                |                                    | 3,864  |        |        |   | 1,990  |        |        |   | 810    |       
|          |         |                |                                    |        |        |        |   |        |        |        |   |       
|          |         | Total current  |                                    |        | 30,782 |        |   |        | 20,439 |        |   |        | 1,189  |       
|Deferred: |         |                |                                    |        |        |        |   |        |        |        |   |       
|          | Federal |                |                                    | (5,332 | )      |        |   | (4,109 | )      |        |   | (1,869 | )     
|          | State   |                |                                    | (490   | )      |        |   | (812   | )      |        |   | (395   | )     
|          |         |                |                                    |        |        |        |   |        |        |        |   |       
|          |         | Total deferred |                                    |        | (5,822 | )      |   |        | (4,921 | )      |   |        | (2,264 | )     
|          |         |                |                                    |        |        |        |   |        |        |        |   |       
|          |         |                | Total income tax expense (benefit) |        | $      | 24,960 |   |        | $      | 15,518 |   |        | $      | (1,075 | )
|          |         |                |                                    |        |        |        |   |        |        |        |   |       

76



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The provision (benefit) for income taxes in
the accompanying consolidated statements of income differed from
the statutory rate (35% in 2003 and 2002 and 34% in 2001) as
follows:

|                                                   |                                        |                                    |        |       |        |      |        |      |        |   |      |      |        |  
|-------------------------------------------------- | -------------------------------------- | ---------------------------------- | ------ | ----- | ------ | ---- | ------ | ---- | ------ | - | ---- | ---- | ------ | -
|                                                   |                                        | 2003                               |        | 2002  |        | 2001
|                                                   |                                        |                                    |        |       |        |     
|                                                   |                                        |                                   
|                                                   |                                        | (In thousands)                    
|Income (loss) before income taxes                  |                                        | $                                  | 68,052 |       |        | $    | 46,555 |      |        | $ | (627 | )   
|                                                   |                                        |                                    |        |       |        |      |        |      |        |   |      |     
|Income tax expense (benefit) at
    statutory rate |                                        | $                                  | 23,818 |       |        | $    | 16,294 |      |        | $ | (213 | )   
|                                                   | Tax effect of:                         |                                    |        |       |        |      |        |      |        |   |      |      |       
|                                                   | State income taxes                     |                                    |        | 2,022 |        |      |        | 481  |        |   |      | 140  |       
|                                                   | Tax exempt interest                    |                                    |        | (578  | )      |      |        | (731 | )      |   |      | (634 | )     
|                                                   | Small life insurance company deduction |                                    |        |      |        |      |        | (517 | )      |   |      | (610 | )     
|                                                   | Other, net                             |                                    |        | (302  | )      |      |        | (9   | )      |   |      | 242  |       
|                                                   |                                        |                                    |        |       |        |      |        |      |        |   |      |     
|                                                   |                                        | Total income tax expense (benefit) |        | $     | 24,960 |      |        | $    | 15,518 |   |      | $    | (1,075 | )
|                                                   |                                        |                                    |        |       |        |      |        |      |        |   |      |     

The balance sheets reflect net deferred income
tax asset amounts that resulted from temporary differences as of
December 31 as follows:

|                                      |                                                               |                                       |        |        |        |   |        |       |        | 
|------------------------------------- | ------------------------------------------------------------- | ------------------------------------- | ------ | ------ | ------ | - | ------ | ----- | ------ | 
|                                      |                                                               | 2003                                  |        | 2002  
|                                      |                                                               |                                       |        |       
|                                      |                                                               |                                      
|                                      |                                                               | (In thousands)                       
|Deferred income tax assets:           |                                                               |                                       |        |        |        |   |        |      
|                                      | Unearned premiums                                             |                                       | $      | 10,507 |        |   | $      | 7,393 |       
|                                      | Loss and loss adjustment expense reserves                     |                                       |        | 2,341  |        |   |        | 1,548 |       
|                                      | Provision for return and unearned
    reinsurance commissions |                                       |        | 1,860  |        |   |        | 2,158 |       
|                                      | Provision for return and unearned
    service fees            |                                       |        | 1,021  |        |   |        | 226   |       
|                                      | Provision for return commissions                              |                                       |        | 857    |        |   |        | 859   |       
|                                      | Allowance for losses on finance receivables                   |                                       |        | 2,080  |        |   |        | 1,754 |       
|                                      | Deferred gain on sale and leaseback                           |                                       |        | 160    |        |   |        | 197   |       
|                                      | Depreciation                                                  |                                       |        | 108    |        |   |        | 302   |       
|                                      | Unrealized loss related to cash flow hedge                    |                                       |        | 478    |        |   |        | 615   |       
|                                      | Other                                                         |                                       |        | 2,457  |        |   |        | 1,538 |       
|                                      |                                                               |                                       |        |        |        |   |        |      
|                                      |                                                               | Total deferred income tax assets      |        |        | 21,869 |   |        |       | 16,590 | 
|                                      |                                                               |                                       |        |        |        |   |        |      
|Deferred income tax liabilities:      |                                                               |                                       |        |        |        |   |        |      
|                                      | Deferred policy acquisition costs                             |                                       |        | 4,001  |        |   |        | 2,858 |       
|                                      | Net unrealized gains on
    available-for-sale securities     |                                       |        | 374    |        |   |        | 1,495 |       
|                                      | Other                                                         |                                       |        | 752    |        |   |        | 804   |       
|                                      |                                                               |                                       |        |        |        |   |        |      
|                                      |                                                               | Total deferred income tax liabilities |        |        | 5,127  |   |        |       | 5,157  | 
|                                      |                                                               |                                       |        |        |        |   |        |      
|Net federal deferred income tax asset |                                                               |                                       | 16,742 |        |        |   | 11,433 |      
|State deferred income tax asset       |                                                               |                                       | 1,797  |        |        |   | 1,307  |      
|                                      |                                                               |                                       |        |        |        |   |        |      
|Net deferred income tax asset         |                                                               | $                                     | 18,539 |        |        | $ | 12,740 |      
|                                      |                                                               |                                       |        |        |        |   |        |      

77



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |              
|--- | -------------
|10. | Capital Stock



| |                        
| | -----------------------
| | Initial Public Offering

In August 2003, the Company completed the
initial public offering of 7,972,276 shares of common stock
(after effect of a 12 for 1 stock split  see Note 1).
The Company sold 3,750,000 shares and selling shareholders sold
4,222,276 shares resulting in net proceeds to the Company (after
deducting issuance costs) of $71,628,000. Of the offering
proceeds, $7,700,000 was used to repay outstanding term loans
with First Tennessee Bank National Association and Hibernia
National Bank. Direct General Corporation used $51,900,000 to
increase its investment in insurance subsidiaries and $600,000
to increase the capitalization of its non-insurance
subsidiaries. The Company intends to utilize the remaining
proceeds to further increase the capital of its insurance
subsidiaries and for general corporate purposes.

In conjunction with the Companys initial
public offering of common stock, all outstanding shares of
preferred stock were converted into, and a common stock warrant
was exercised for, shares of common stock.



| |                                        
| | ---------------------------------------
| | Redeemable Series A Preferred
    Stock

On December 2, 1994, the Company issued
2,937,744 shares of no par value convertible Series A
preferred stock in a private placement offering at a price of
$2.04 per share. Each share of Series A preferred stock was
converted into one share of common stock in conjunction with the
Companys initial public offering in August 2003.
Dividends on Series A shares were payable in cash quarterly
at an annual rate of 8% and are included in interest expense in
the accompanying financial statements.



| |                         
| | ------------------------
| | Series B Preferred Stock

On November 25, 1996, the Company issued
1,776,588 shares of no par value convertible Series B
preferred stock in a private placement offering at a price of
$4.50 per share. During 1997 and 1998, a total of 301,656
additional Series B shares were issued as dividends
resulting in a total number issued and outstanding at
December 31, 2002 of 2,078,244. Each share of Series B
preferred stock was converted into 1.119 shares of common stock
in conjunction with the Companys initial public offering
in August 2003. Dividends on the Series B preferred
stock were payable semiannually at an annual rate of 6% per
share.



| |                                 
| | --------------------------------
| | Common Stock  Stock
    Warrant

On November 25, 1996, the Company issued a
stock warrant for the purchase of 195,060 shares of the
Companys common stock, no par value, in return for
consulting services to be provided by a company affiliated with
a member of the board of directors. The common stock warrant was
exercised in August 2003 for an aggregate exercise price of
$800,000.



| |                   
| | ------------------
| | Stock Option Plans

In April 2003, the Companys board of
directors adopted and the shareholders approved the 2003 Equity
Incentive Plan (the 2003 Plan). Under terms of the
2003 Plan, 1,680,000 shares of common stock are reserved and
available for distribution. Under the 2003 Plan, incentive stock
options and non-qualified stock options may be granted. Exercise
provisions may vary, however, the term shall not exceed ten
years from the date of grant.

On August 11, 2003, the Company granted
options to purchase 924,000 shares of the Companys common
stock under the 2003 Plan to certain of its executive officers
and employees, the exercise price of which equals the initial
public offering price of $21 per share. Each of the options
issued in August 2003 have a ten-year term with a five-year
vesting schedule.

78



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

On April 29, 1996, the shareholders of
Direct General Corporation approved the 1996 Employee Stock
Incentive Plan (the 1996 Plan). Under the 1996 Plan,
incentive stock options and nonqualified stock options were
granted. Exercise provisions varied, but most options are
exercisable, in whole or in part, beginning six months after
grant and ending ten years after grant. In April 2003, upon
approval of the 2003 Plan, no further awards could be granted
under the 1996 Plan.

As of December 31, 2003, the average
remaining contractual life of options outstanding under both
plans is approximately seven years.

A summary of the status of the Companys
stock option plans as of December 31, 2003, 2002 and 2001,
and changes during the years ending on these dates is as follows:

|                                                                |           |           |           |                |  |   |       |       | 
|--------------------------------------------------------------- | --------- | --------- | --------- | -------------- |  | - | ----- | ----- | 
|                                                                |           |           |           | Weighted      
|                                                                |           | Number of |           | Average       
|                                                                |           | Shares    |           | Exercise Price
|                                                                |           |           |           |               
|Options outstanding January 1, 2001
    (744,000 exercisable)   |           |           | 780,000   |                |  | $ | 1.47  |      
|                                                                | Granted   |           |           | 216,000        |  |   |       | 2.71  | 
|                                                                | Exercised |           |           | 318,000        |  |   |       | 1.32  | 
|                                                                | Forfeited |           |           | 36,000         |  |   |       | 2.71  | 
|                                                                |           |           |           |                |  |   |       |      
|Options outstanding December 31, 2001
    (482,016 exercisable) |           |           | 642,000   |                |  |   | 1.89  |      
|                                                                | Granted   |           |           | 60,000         |  |   |       | 2.71  | 
|                                                                |           |           |           |                |  |   |       |      
|Options outstanding December 31, 2002
    (558,036 exercisable) |           |           | 702,000   |                |  |   | 1.96  |      
|                                                                | Granted   |           |           | 924,000        |  |   |       | 21.00 | 
|                                                                | Exercised |           |           | 24,000         |  |   |       | 2.71  | 
|                                                                |           |           |           |                |  |   |       |      
|Options outstanding December 31, 2003
    (610,008 exercisable) |           |           | 1,602,000 |                |  | $ | 12.93 |      
|                                                                |           |           |           |                |  |   |       |      

The Company follows the provisions of Accounting
Principles Board (APB) Opinion No. 25, Accounting for
Stock Issued to Employees, to account for its stock option
activity in the financial statements. The Company granted all
options currently outstanding at an exercise price equal to the
market price at the date of grant and, therefore, under APB
No. 25, no compensation expense is recorded. The Company
follows the disclosure provisions of Statement of Financial
Accounting Standards (SFAS) No. 123, Accounting
for Stock-Based Compensation.

79



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

If the Company had elected to recognize stock
compensation expense based on the fair value of stock options at
the grant date, as prescribed by SFAS No. 123, net income
available to common shareholders and basic and diluted earnings
per share would have been reported as presented in the following
table.

|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |       |  
|---------------------------------------------------------------------------------------------------------------------------------------- | --------------------- | ------------------------- | ------ | ---- |  | ---- | ------ | ---- |  | - | ---- | ----- | -
|                                                                                                                                         |                       | 2003                      |        | 2002 |  | 2001
|                                                                                                                                         |                       |                           |        |      |  |     
|                                                                                                                                         |                       |                          
|                                                                                                                                         |                       | (In thousands,           
|                                                                                                                                         |                       | except per share amounts)
|Net income (loss) available to common
    shareholders, as reported                                                                      |                       | $                         | 42,747 |      |  | $    | 30,476 |      |  | $ | (113 | )    
|Deduct: Total stock-based employee compensation
    expense determined under the fair value based method, net of
    related tax effects |                       |                           | (218   | )    |  |      | (59    | )    |  |   | (219 | )    
|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |      
|Net income (loss) available to common
    shareholders, pro forma                                                                        |                       | $                         | 42,529 |      |  | $    | 30,417 |      |  | $ | (332 | )    
|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |      
|Income for purposes of computing diluted earnings
    per share common, as reported                                                      |                       | $                         | 43,386 |      |  | $    | 31,517 |      |  | $ | 928  |      
|Deduct: Total stock-based employee compensation
    expense determined under fair value based method, net of related
    tax effects     |                       |                           | (218   | )    |  |      | (59    | )    |  |   | (219 | )    
|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |      
|Income for purposes of computing diluted earnings
    per share common, pro forma                                                        |                       | $                         | 43,168 |      |  | $    | 31,458 |      |  | $ | 709  |      
|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |      
|Earnings per share                                                                                                                       |                       |                           |        |      |  |      |        |      |  |   |      |      
|                                                                                                                                         | Basic  as reported   |                           | $      | 2.74 |  |      | $      | 2.30 |  |   | $    | (0.01 | )
|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |      
|                                                                                                                                         | Basic  pro forma     |                           | $      | 2.72 |  |      | $      | 2.29 |  |   | $    | (0.04 | )
|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |      
|                                                                                                                                         | Diluted  as reported |                           | $      | 2.20 |  |      | $      | 1.68 |  |   | $    | (0.01 | )
|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |      
|                                                                                                                                         | Diluted  pro forma   |                           | $      | 2.19 |  |      | $      | 1.68 |  |   | $    | (0.04 | )
|                                                                                                                                         |                       |                           |        |      |  |      |        |      |  |   |      |      

The Company uses the Black-Scholes pricing model
to calculate the fair value of the options awarded as of the
date of grant based on the following factors:

|                                |  |      |         |      |  |      |          |   |  |  |          |  
|------------------------------- |  | ---- | ------- | ---- |  | ---- | -------- | - |  |  | -------- | -
|                                |  | 2003 |         | 2002 |  | 2001
|                                |  |      |         |      |  |     
|Expected option term            |  |      | 5 years |      |  |      | 10 years |   |  |  | 10 years |  
|Annualized volatility rate      |  |      | 35      | %    |  |      | 35       | % |  |  | 35       | %
|Risk-free rate of return        |  |      | 3.37    | %    |  |      | 4.93     | % |  |  | 5.14     | %
|Fair value at the date of grant |  |      | $21.00  |      |  |      | $2.71    |   |  |  | $2.71    |  
|Dividend yield                  |  |      | 0.76    | %    |  |      | 0        | % |  |  | 0        | %
|Black-Scholes value             |  |      | 33.8    | %    |  |      | 56.2     | % |  |  | 56.8     | %



| |                
| | ---------------
| | Reserved Shares

As of December 31, 2003, shares of common
stock have been reserved for the following:

|                                              |  |  |           | 
|--------------------------------------------- |  |  | --------- | 
|Exercise of stock options under the 1996 Plan |  |  | 678,000   | 
|Exercise of stock options under the 2003 Plan |  |  | 1,680,000 | 
|                                              |  |  |           | 
|Total common shares reserved                  |  |  | 2,358,000 | 
|                                              |  |  |           | 

80



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                           
| | --------------------------
| | Repurchase of Common Stock

In 2002, the Company repurchased 1,328,364 shares
of stock from selling shareholders at a total price of
$4,548,000 (cost per share ranging from $2.29 to $3.52). These
shares were included in treasury stock in the accompanying
financial statements at cost as of December 31, 2002.



|    |                                                            
|--- | -----------------------------------------------------------
|11. | Statutory Financial Information and Accounting
    Policies

The Companys statutory-basis financial
statements of its insurance subsidiaries are prepared in
accordance with accounting practices prescribed or permitted by
the Department of Insurance in each state of domicile. Effective
January 1, 2001, each state of domicile required that
insurance companies domiciled in those states prepare their
statutory basis financial statements in accordance with the NAIC
Accounting Principles and Procedures Manual subject to any
deviations prescribed or permitted by the insurance commissioner
in each state of domicile.

The monetary effect on statutory capital and
surplus of the Companys insurance subsidiaries of using
accounting practices prescribed or permitted by the Department
of Insurance in each state of domicile as of December 31 is
as follows:

|                                                                                         |                                               |                |         |      |  |   |        |     | 
|---------------------------------------------------------------------------------------- | --------------------------------------------- | -------------- | ------- | ---- |  | - | ------ | --- | 
|                                                                                         |                                               | 2003           |         | 2002
|                                                                                         |                                               |                |         |     
|                                                                                         |                                               |               
|                                                                                         |                                               | (In thousands)
|Statutory capital and surplus                                                            |                                               | $              | 114,050 |      |  | $ | 52,562 |    
|Effect of prescribed practices of:                                                       |                                               |                |         |      |  |   |        |    
|                                                                                         | Immediate write-off of goodwill               |                |         |     |  |   |        | 166 | 
|                                                                                         | Provision for unearned ceding commissions     |                |         | 333  |  |   |        | 450 | 
|                                                                                         | Limitations on admitted value of subsidiaries |                |         |     |  |   |        | 465 | 
|                                                                                         |                                               |                |         |      |  |   |        |    
|Statutory capital and surplus in accordance with
    NAIC statutory accounting practices |                                               | $              | 114,383 |      |  | $ | 53,643 |    
|                                                                                         |                                               |                |         |      |  |   |        |    

Statutory accounting practices differ from GAAP.
Significant differences for the Companys insurance
subsidiaries were as follows:

|                        |                                                                             |                         |        |                      |   |      |        |        |   |      |        |        |   |   |         |        |   |   |        |        |   |   |        |        |  
|----------------------- | --------------------------------------------------------------------------- | ----------------------- | ------ | -------------------- | - | ---- | ------ | ------ | - | ---- | ------ | ------ | - | - | ------- | ------ | - | - | ------ | ------ | - | - | ------ | ------ | -
|                        |                                                                             |                         |        |                      |   |      |        |       
|                        |                                                                             | Net Income (Loss)       |        |                     
|                        |                                                                             | Year ended December 31, |        | Surplus December 31,
|                        |                                                                             |                         |        |                     
|                        |                                                                             | 2003                    |        | 2002                 |   | 2001 |        | 2003   |   | 2002 |        | 2001  
|                        |                                                                             |                         |        |                      |   |      |        |        |   |      |        |       
|                        |                                                                             |                        
|                        |                                                                             | (In thousands)         
|Statutory basis amounts |                                                                             | $                       | 6,569  |                      |   | $    | 17,109 |        |   | $    | 595    |        |   | $ | 114,050 |        |   | $ | 52,562 |        |   | $ | 32,631 |       
|                        | Deferred policy acquisition costs                                           |                         |        | 3,267                |   |      |        | 2,145  |   |      |        | 1,203  |   |   |         | 11,432 |   |   |        | 8,165  |   |   |        | 6,020  |  
|                        | Deferred income taxes                                                       |                         |        | 4,323                |   |      |        | 3,740  |   |      |        | 1,049  |   |   |         | 1,324  |   |   |        | 708    |   |   |        | 1,624  |  
|                        | Salvage and subrogation recoverable                                         |                         |        |                     |   |      |        | (976   | ) |      |        | 976    |   |   |         |       |   |   |        |       |   |   |        | 976    |  
|                        | Reinsurance commissions                                                     |                         |        | 850                  |   |      |        | 651    |   |      |        | (1,437 | ) |   |         | (4,982 | ) |   |        | (4,335 | ) |   |        | (5,135 | )
|                        | Guaranty fund assessments                                                   |                         |        | 809                  |   |      |        | (1,072 | ) |      |        | (790   | ) |   |         | (1,052 | ) |   |        | (1,862 | ) |   |        | (790   | )
|                        | Reversal of statutory adjustment to beginning of
    year reserves          |                         |        |                     |   |      |        |       |   |      |        | (3,868 | ) |   |         |       |   |   |        |       |   |   |        |       |  
|                        | Nonadmitted assets                                                          |                         |        |                     |   |      |        |       |   |      |        |       |   |   |         | 1,539  |   |   |        | 1,735  |   |   |        | 898    |  
|                        | Unrealized appreciation (depreciation) of
    securities available-for-sale |                         |        |                     |   |      |        |       |   |      |        |       |   |   |         | 1,069  |   |   |        | 4,284  |   |   |        | (1,034 | )
|                        | Other                                                                       |                         |        | (507                 | ) |      |        | (897   | ) |      |        | (759   | ) |   |         | 104    |   |   |        | (1,927 | ) |   |        | (1,030 | )
|                        |                                                                             |                         |        |                      |   |      |        |        |   |      |        |        |   |   |         |        |   |   |        |        |   |   |        |       
|GAAP amounts            |                                                                             | $                       | 15,311 |                      |   | $    | 20,700 |        |   | $    | (3,031 | )      |   | $ | 123,484 |        |   | $ | 59,330 |        |   | $ | 34,160 |       
|                        |                                                                             |                         |        |                      |   |      |        |        |   |      |        |        |   |   |         |        |   |   |        |        |   |   |        |       

81



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The Companys insurance subsidiaries are
restricted by state insurance laws as to the amounts they may
pay as dividends without prior approval from their respective
state insurance departments. For 2004, $10,542,000 in dividends
are available to be paid to the Company from insurance
subsidiaries without prior approval. Property and casualty
insurance companies are subject to certain Risk-Based Capital
(RBC) requirements as specified by the NAIC. Under those
requirements, the amount of capital maintained by an insurance
company is to be determined based on the various risk factors
related to it. At December 31, 2003, each of the
Companys insurance subsidiaries exceeds the RBC
requirements.



|    |                
|--- | ---------------
|12. | Cash Flow Hedge

The Company maintains a $190,000,000 variable
rate revolving credit agreement with a group of banks (Note 6),
which subjects the Company to exposures from fluctuations in
interest rates under the agreement. Effective November 1,
2001, the Company purchased an interest rate cap and sold an
interest rate floor in a combined derivative instrument known as
a zero-cost collar (derivative), which has been designated as a
hedge of variable cash flows associated with interest rate
increases above the 30-day LIBOR rate of 5.05% on a notional
amount of $50,000,000 (cap) and interest rate decreases
below the 30-day LIBOR rate of 5.05% on a notional amount of
$25,000,000 (floor). This derivative instrument requires monthly
settlements whereby the Company pays the difference between the
current 30-day LIBOR rate and the floor of 5.05% on $25,000,000
and receives the excess of the 30-day LIBOR rate over the cap of
5.05% on $50,000,000. At December 31, 2003, the 30-day
LIBOR rate in effect was 1.17%, which resulted in an increase to
the monthly interest payments of approximately $86,000. The
derivative expires on November 1, 2005.

The Company has designated this derivative
instrument as a cash flow hedge in accordance with Statement of
Financial Accounting Standards (SFAS) No. 133,
Accounting for Derivative Instruments and Hedging
Activities as subsequently amended by SFAS No. 138,
Accounting for Certain Derivative Instruments and Certain
Hedging Activities  an amendment of SFAS
No. 133. The credit risk associated with this
contract is limited to the uncollected interest payments and the
fair market value of the derivative to the extent it has become
favorable to the Company.

In accordance with SFAS No. 133, as amended,
the Company recorded a liability representing the fair market
value of the derivative instrument based on a quoted market
price of such instrument as of December 31, 2003 of
$1,366,000, which is included in other liabilities in the
accompanying financial statements. During 2003, the Company paid
$969,000 under this contract, which was transferred net of taxes
of $339,000, from other comprehensive income to interest expense
and income tax expense, respectively. In addition, the Company
recorded an unrealized loss of $374,000, net of deferred taxes
of $202,000 that is included in other comprehensive income in
the accompanying financial statements. As of December 31,
2002, the Company recorded a liability of $1,759,000, which is
included in other liabilities in the accompanying financial
statements. During 2002, the Company paid $824,000 under this
contract, which is recorded in interest expense and also
recorded an unrealized loss of $1,259,000, net of deferred taxes
of $674,000, which are included in other income and other
comprehensive income, respectively, in the accompanying
financial statements. As of December 31, 2001, the Company
recorded an asset representing the fair market value of the
derivative instrument based on a quoted market price of such
instrument of $304,000, which is included in other assets in the
accompanying financial statements. During 2001, the Company
recognized a gain of $130,000 and also recorded an unrealized
gain of $115,000, net of deferred taxes of $59,000, which are
included in other income and other comprehensive income,
respectively, in the accompanying financial statements.

82



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |                              
|--- | -----------------------------
|13. | Commitments and Contingencies



| |            
| | -----------
| | Commitments

The Company leases various office space and
equipment. Total rent expense was approximately $6,248,000,
$5,710,000 and $4,990,000 in 2003, 2002 and 2001, respectively.
Approximate future minimum lease commitments for leases having
an initial or remaining term of more than one year are as
follows at December 31, 2003:

|                                        |  |                |       |           |  |   |        | 
|--------------------------------------- |  | -------------- | ----- | --------- |  | - | ------ | 
|                                        |  | Capital        |       | Operating
|                                        |  | Leases         |       | Leases   
|                                        |  |                |       |          
|                                        |  |               
|                                        |  | (In thousands)
|2004                                    |  | $              | 1,420 |           |  | $ | 7,239  | 
|2005                                    |  |                | 1,367 |           |  |   | 3,864  | 
|2006                                    |  |                | 1,286 |           |  |   | 2,628  | 
|2007                                    |  |                | 984   |           |  |   | 1,568  | 
|2008                                    |  |                | 164   |           |  |   | 864    | 
|                                        |  |                |       |           |  |   |        | 
|Total minimum lease payments            |  |                | 5,221 |           |  | $ | 16,163 | 
|                                        |  |                |       |           |  |   |        | 
|Less amount representing interest       |  |                | 665   |           |  |   |        | 
|                                        |  |                |       |           |  |   |        | 
|Present value of minimum lease payments |  | $              | 4,556 |           |  |   |        | 
|                                        |  |                |       |           |  |   |        | 



| |              
| | -------------
| | Contingencies

The Company is named as defendant in various
legal actions arising in the ordinary course of business.
Estimates of losses from legal actions pertaining to claims made
under insurance policies underwritten by the Company are
included in loss and loss adjustment expense reserves.
Management believes that the resolution of all other actions
will not have a material adverse effect on the Companys
financial position or results of operations.



|    |                                    
|--- | -----------------------------------
|14. | Fair Value of Financial Instruments

The following methods and assumptions are used by
the Company in estimating the fair value disclosures for
financial instruments:



| |                                                                                                                                                                                                                                                                                                                                                              
| | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | Debt
    Securities Additional fair
    value disclosures for debt securities are included in Note 2.                                                                                                                                                                                                                                                       
|
| | Short-Term
    Investments The carrying
    values reported in the accompanying balance sheets for these
    financial instruments approximate their fair values.                                                                                                                                                                                           
|
| | Finance Receivables,
    Net Fair value of finance
    receivables, which approximates carrying value, was estimated
    using projected cash flows, discounted at the weighted-average
    rates currently being offered for similar finance receivables.
    Cash flows were based on contractual payment terms adjusted for
    delinquencies and losses.
|
| | Reinsurance Balances Receivable and
    Reinsurance Balances
    Payable The carrying
    values reported in the accompanying balance sheets for these
    financial instruments approximate their fair values.                                                                                                                                             
|
| | Notes
    payable The carrying
    values reported in the accompanying balance sheets for these
    financial instruments were estimated using projected cash flows,
    discounted at rates currently being offered for similar notes.                                                                                                                     

83



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The carrying values and fair values of certain of
the Companys financial instruments as of December 31
were as follows:

|            |                                             |                |   |         |  |          |   |         |  |  |   |         |  |  |   |         | 
|----------- | ------------------------------------------- | -------------- | - | ------- |  | -------- | - | ------- |  |  | - | ------- |  |  | - | ------- | 
|            |                                             |                |   |        
|            |                                             | 2003           |   | 2002   
|            |                                             |                |   |        
|            |                                             | Carrying       |   | Fair    |  | Carrying |   | Fair   
|            |                                             | Value          |   | Value   |  | Value    |   | Value  
|            |                                             |                |   |         |  |          |   |        
|            |                                             |               
|            |                                             | (In thousands)
|Assets      |                                             |                |   |         |  |          |   |         |  |  |   |         |  |  |   |        
|            | Debt securities available-for-sale          |                | $ | 264,998 |  |          | $ | 264,998 |  |  | $ | 123,576 |  |  | $ | 123,576 | 
|            | Short-term investments                      |                |   | 1,322   |  |          |   | 1,322   |  |  |   | 2,745   |  |  |   | 2,745   | 
|            | Finance receivables, net                    |                |   | 201,271 |  |          |   | 201,271 |  |  |   | 166,935 |  |  |   | 166,935 | 
|            | Reinsurance balances receivable             |                |   | 57,472  |  |          |   | 57,472  |  |  |   | 50,874  |  |  |   | 50,874  | 
|Liabilities |                                             |                |   |         |  |          |   |         |  |  |   |         |  |  |   |        
|            | Reinsurance balances payable and funds held |                |   | 62,233  |  |          |   | 62,233  |  |  |   | 76,722  |  |  |   | 76,722  | 
|            | Notes payable                               |                |   | 148,946 |  |          |   | 148,946 |  |  |   | 126,880 |  |  |   | 126,880 | 
|            | Capital lease obligations                   |                |   | 4,556   |  |          |   | 4,556   |  |  |   | 4,310   |  |  |   | 4,310   | 



|    |                   
|--- | ------------------
|15. | Earnings per Share

The following table sets forth the computation of
basic and diluted earnings (loss) per share:

|                                         |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |          |  
|---------------------------------------- | --------------------------------------------------------------------------------------------------------------------- | ---------------------------------------- | ---- | -------- |  | ---- | ---- | -------- |  | - | ----- | -------- | -
|                                         |                                                                                                                       | 2003                                     |      | 2002     |  | 2001
|                                         |                                                                                                                       |                                          |      |          |  |     
|                                         |                                                                                                                       |                                         
|                                         |                                                                                                                       | (In thousands, except per share amounts)
|Numerator:                               |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |         
|                                         | Net income (loss) available to
    common shareholders                                                                |                                          | $    | 42,747   |  |      | $    | 30,476   |  |   | $     | (113     | )
|                                         | Dividends paid to preferred shareholders                                                                              |                                          |      | 639      |  |      |      | 1,041    |  |   |       | 1,041    |  
|                                         |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |         
|                                         | Income for purposes of computing diluted earnings
    per common share                                                |                                          | $    | 43,386   |  |      | $    | 31,517   |  |   | $     | 928      |  
|                                         |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |         
|Denominator:                             |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |         
|                                         | Weighted average common shares outstanding                                                                            |                                          |      | 15,609.4 |  |      |      | 13,264.5 |  |   |       | 13,366.4 |  
|                                         | Dilutive stock options                                                                                                |                                          |      | 712.1    |  |      |      | 204.6    |  |   |       | 287.7    |  
|                                         | Dilutive warrants                                                                                                     |                                          |      | 84.3     |  |      |      |         |  |   |       |         |  
|                                         | Dilutive preferred stock                                                                                              |                                          |      | 3,273.8  |  |      |      | 5,264.0  |  |   |       | 5,264.0  |  
|                                         |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |         
|                                         | Weighted average common shares outstanding for
    purposes of computing diluted earnings (loss) per
    common share |                                          |      | 19,679.6 |  |      |      | 18,733.1 |  |   |       | 18,918.1 |  
|                                         |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |         
|Basic earnings (loss) per common share   |                                                                                                                       | $                                        | 2.74 |          |  | $    | 2.30 |          |  | $ | (0.01 | )       
|                                         |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |         
|Diluted earnings (loss) per common share |                                                                                                                       | $                                        | 2.20 |          |  | $    | 1.68 |          |  | $ | (0.01 | )       
|                                         |                                                                                                                       |                                          |      |          |  |      |      |          |  |   |       |         



|    |            
|--- | -----------
|16. | Acquisition

Effective November 1, 2003, the Company
exercised its option with LR3 Enterprises, Inc., Maitland
Underwriters, Inc., and each of the Cash Register Auto Insurance
Agencies, Friendly Auto Insurance Agencies, and Insurance
Options Agencies to purchase the assets of 42 offices used to
conduct their automobile insurance agency business in the State
of Florida. The purchase price was $13,792,000, which resulted
in approximately $13,400,000 of goodwill.

84



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES


NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |                 
|--- | ----------------
|17. | Subsequent Event

On January 30, 2004, the Company acquired an
inactive life insurance company for a total purchase price of
$7,330,000 of which approximately $1,300,000 was attributable to
goodwill. The assets of this life insurance company consist of
licenses to conduct life and/or accident and health insurance
business in 43 states and the District of Columbia and debt
securities.



|    |                                     
|--- | ------------------------------------
|18. | Quarterly Financial Data (unaudited)

Quarterly results of operations for 2003 and 2002
are summarized as follows:

|     |  |                                          |         |        |  |              |        |              |  |                |      |        |  |          |      |  |  |   |       |  |  |   |       |  |  |   |       | 
|---- |  | ---------------------------------------- | ------- | ------ |  | ------------ | ------ | ------------ |  | -------------- | ---- | ------ |  | -------- | ---- |  |  | - | ----- |  |  | - | ----- |  |  | - | ----- | 
|     |  |                                          |         |        |  |              |        |              |  |               
|     |  |                                          |         |        |  | Basic        |        | Diluted      |  | Stock Price(2)
|     |  | Total                                    |         | Net    |  | Earnings     |        | Earnings     |  |               
|     |  | Revenues                                 |         | Income |  | Per Share(1) |        | Per Share(1) |  | High(3)        |      | Low(3) |  | Close(3)
|     |  |                                          |         |        |  |              |        |              |  |                |      |        |  |         
|     |  |                                         
|     |  | (In thousands, except per share amounts)
|2003 |  |                                          |         |        |  |              |        |              |  |                |      |        |  |          |      |  |  |   |       |  |  |   |       |  |  |   |       | 
|Q1   |  | $                                        | 69,048  |        |  | $            | 9,810  |              |  | $              | 0.80 |        |  | $        | 0.56 |  |  |   | *     |  |  |   | *     |  |  |   | *     | 
|Q2   |  |                                          | 75,700  |        |  |              | 10,134 |              |  |                | 0.82 |        |  |          | 0.58 |  |  |   | *     |  |  |   | *     |  |  |   | *     | 
|Q3   |  |                                          | 81,092  |        |  |              | 11,736 |              |  |                | 0.70 |        |  |          | 0.58 |  |  | $ | 26.69 |  |  | $ | 23.01 |  |  | $ | 25.07 | 
|Q4   |  |                                          | 91,277  |        |  |              | 11,412 |              |  |                | 0.53 |        |  |          | 0.51 |  |  |   | 33.78 |  |  |   | 25.00 |  |  |   | 33.10 | 
|     |  |                                          |         |        |  |              |        |              |  |                |      |        |  |          |      |  |  |   |       |  |  |   |       |  |  |   |       | 
|     |  | $                                        | 317,117 |        |  | $            | 43,092 |              |  | $              | 2.74 |        |  | $        | 2.20 |  |  | $ | 33.78 |  |  | $ | 23.01 |  |  | $ | 33.10 | 
|     |  |                                          |         |        |  |              |        |              |  |                |      |        |  |          |      |  |  |   |       |  |  |   |       |  |  |   |       | 
|2002 |  |                                          |         |        |  |              |        |              |  |                |      |        |  |          |      |  |  |   |       |  |  |   |       |  |  |   |       | 
|Q1   |  | $                                        | 48,776  |        |  | $            | 4,537  |              |  | $              | 0.33 |        |  | $        | 0.25 |  |  |   | *     |  |  |   | *     |  |  |   | *     | 
|Q2   |  |                                          | 49,820  |        |  |              | 5,834  |              |  |                | 0.42 |        |  |          | 0.31 |  |  |   | *     |  |  |   | *     |  |  |   | *     | 
|Q3   |  |                                          | 54,622  |        |  |              | 7,019  |              |  |                | 0.52 |        |  |          | 0.38 |  |  |   | *     |  |  |   | *     |  |  |   | *     | 
|Q4   |  |                                          | 59,920  |        |  |              | 13,647 |              |  |                | 1.04 |        |  |          | 0.74 |  |  |   | *     |  |  |   | *     |  |  |   | *     | 
|     |  |                                          |         |        |  |              |        |              |  |                |      |        |  |          |      |  |  |   |       |  |  |   |       |  |  |   |       | 
|     |  | $                                        | 213,138 |        |  | $            | 31,037 |              |  | $              | 2.30 |        |  | $        | 1.68 |  |  |   | *     |  |  |   | *     |  |  |   | *     | 
|     |  |                                          |         |        |  |              |        |              |  |                |      |        |  |          |      |  |  |   |       |  |  |   |       |  |  |   |       | 



---



|    |                                                                                                                                                                                            
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | As a result of rounding and weighted averages,
    the total of the four quarters earnings per share may not
    equal the earnings per share for the full year.                          
|   
|(2) | The Companys Common Shares are listed on
    the NASDAQ National Market under the symbol of DRCT.                                                                                       
|   
|(3) | Stock prices (high, low, close) for third quarter
    2003 are from August 11, 2003 to September 30, 2003
    and for the full year 2003 are from August 11, 2003 to
    December 31, 2003.



|  |                                                                                                                  
|- | -----------------------------------------------------------------------------------------------------------------
|* | Information is not meaningful since prior to
    August 11, 2003 the Companys stock was not publicly
    traded.

85



---



##### 





|        |                                                                                              
|------- | ---------------------------------------------------------------------------------------------
|Item 9. | Changes in and Disagreements With
    Accountants on Accounting and Financial
    Disclosure.

None.



|         |                         
|-------- | ------------------------
|Item 9A. | Controls and Procedures.

Our management, with the participation of our
Chief Executive Officer and Chief Financial Officer, has
evaluated the effectiveness of the design and operation of our
disclosure controls and procedures (as defined in Exchange Act
Rule 13a-15(e) and 15d-15(e)) as of the end of the period
covered by this report. Based on that evaluation, the Chief
Executive Officer and Chief Financial Officer have concluded
that our disclosure controls and procedures are effective to
ensure that material information relating to us and our
consolidated subsidiaries is made known to such officers by
others within these entities, particularly during the period for
which this report was prepared, in order to allow timely
decisions regarding required disclosure. There have not been any
changes in our internal control over financial reporting during
our last fiscal quarter that have materially affected, or are
reasonably likely to materially affect, our internal control
over financial reporting.

PART III



|         |                                                        
|-------- | -------------------------------------------------------
|Item 10. | Directors and Executive Officers of the
    Registrant.

The information relating to this Item 10 is
incorporated by reference to the Proxy Statement for our 2004
Annual Meeting of Shareholders, which will be filed with the
Securities and Exchange Commission no later than April 29,
2004.



|         |                        
|-------- | -----------------------
|Item 11. | Executive Compensation.

The information relating to this Item 11 is
incorporated by reference to the Proxy Statement for our 2004
Annual Meeting of Shareholders, which will be filed with the
Securities and Exchange Commission no later than April 29,
2004.



|         |                                                                                                        
|-------- | -------------------------------------------------------------------------------------------------------
|Item 12. | Security Ownership of Certain Beneficial
    Owners and Management and Related Stockholder
    Matters.

The information relating to this Item 12 is
incorporated by reference to the Proxy Statement for our 2004
Annual Meeting of Shareholders, which will be filed with the
Securities and Exchange Commission no later than April 29,
2004. Other information related to the security ownership of
certain of our executive officers is set forth below.

Rule 10b5-1 Trading
Plans.Certain of our executive
officers have established trading plans with their respective
brokers pursuant to Rule 10b5-1(c) under the Securities Exchange
Act of 1934 (the Exchange Act). These plans allow
such brokers to effect orderly and systematic open market sales
of our common stock on behalf of such executive officers in
accordance with predetermined instructions regarding the amount,
price, and date of such sales. Transactions under the plans are
not exempt from applicable securities law requirements, such as
the reporting and short-swing profit rules under Section 16 of
the Exchange Act, the reporting requirements and sales volume
and other limitations imposed by Rule 144 under the
Securities Act of 1933, and the reporting obligations, if any,
on Schedules 13D and 13G.

Ronald F. Wilson, our General Counsel and
Secretary, has established a 10b5-1 plan that allows him to
diversify his personal investment portfolio and manage the
alternative minimum income tax consequences of his recent
exercise of incentive stock options granted to him under our
1996 Employee Stock Incentive Plan. Under Mr. Wilsons
plan, up to 36,000 shares of common stock he currently owns may
be systematically sold at market prices on sale dates between
April 13, 2004 and May 3, 2005 and in weekly amounts
predetermined by the plan. Mr. Wilsons current 10b5-1 plan
terminates the date on which all the shares subject to the plan
have been sold, or on May 3, 2005, whichever occurs first.

86



---



##### 



Brian G. Moore, President of our premium finance
subsidiary, has established a 10b5-1 plan that allows him to
diversify his personal investment portfolio and manage the
alternative minimum income tax consequences of his recent
exercise of incentive stock options granted to him under our
1996 Employee Stock Incentive Plan. Under Mr. Moores
plan, up to 24,000 shares of common stock he currently owns may
be systematically sold at market prices on sale dates between
August 23, 2004 and November 30, 2004 and in weekly
amounts predetermined by the plan. Mr. Moores current
10b5-1 plan terminates the date on which all the shares subject
to the plan have been sold, or on November 30, 2004,
whichever occurs first.



|         |                                                    
|-------- | ---------------------------------------------------
|Item 13. | Certain Relationships and Related
    Transactions.

The information relating to this Item 13 is
incorporated by reference to the Proxy Statement for our 2004
Annual Meeting of Shareholders, which will be filed with the
Securities and Exchange Commission no later than April 29,
2004.



|         |                                            
|-------- | -------------------------------------------
|Item 14. | Principal Accounting Fees and
    Services.

The information relating to this Item 14 is
incorporated by reference to the Proxy Statement for our 2004
Annual Meeting of Shareholders, which will be filed with the
Securities and Exchange Commission no later than April 29,
2004.

PART IV



|         |                                                                      
|-------- | ---------------------------------------------------------------------
|Item 15. | Exhibits, Financial Statement Schedules,
    and Reports on Form 8-K.

(a)(1) Financial Statements  The
following consolidated financial statements of the Registrant
and its subsidiaries included in the Registrants 2003
Annual Report are incorporated by reference in Item 8:

Report of Independent Accountants



| |                                                                                                 
| | ------------------------------------------------------------------------------------------------
| | Consolidated Statements of Operations 
    For the Years Ended December 31, 2003, 2002 and 2001
|
| | Consolidated Balance Sheets  As of
    December 31, 2003 and 2002                              

Consolidated Statements of Changes in
Shareholders Equity -For the Years Ended December 31,
2003, 2002 and 2001

Consolidated Statements of Cash Flows 
For the Years Ended December 31, 2003, 2002 and 2001

Notes to Consolidated Financial Statements

(a)(2) Financial Statement Schedules 
The following financial statement schedules of the Registrant
and its subsidiaries, Report of Independent Accountants and
Consent of Independent Accountants are included in
Item 14(d):

Schedule I  Summary of
Investments  Other Than Investments in Related Parties

Schedule IV  Reinsurance

Schedule V  Valuation and
Qualifying Accounts

Schedule VI  Supplemental
Information Concerning Property and Casualty Insurance Operations

Report of Independent Accountants

Consent of Independent Accountants

No other schedules are required to be filed
herewith pursuant to Article 7 of Regulation S-X.

87



---



##### 



(a)(3) List of exhibits:

| |    |     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | -- | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 3  | .1  |  | Second Amended and Restated Charter of Direct
    General Corporation incorporated herein by reference to Exhibit
    3.1 of the Registration Statement No. 333-113289 filed with the
    SEC on March 4, 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 3  | .2  |  | Amended and Restated Bylaws of Direct General
    Corporation, dated August 11, 2003, incorporated herein by
    reference to Exhibit 3.2 of the Registration Statement No.
    333-113289 filed with the SEC on March 4, 2004.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 4  | .1  |  | Specimen stock certificate representing the
    common stock, no par value per share of Direct General
    Corporation incorporated herein by reference to Exhibit 4.1 of
    the Registration Statement No. 333-105505 filed with the SEC on
    August 1, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | 10 | .1 |  | Employment Agreement by and between Direct
    General Corporation and William C. Adair, Jr. dated as of July
    21, 2003 incorporated herein by reference to Exhibit 10.1 of the
    Registration Statement No. 333-105505 filed with the SEC on July
    21, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | 10 | .2+ |  | Employment Agreement by and between Direct
    General Corporation and Jacqueline C. Adair dated as of July 21,
    2003 incorporated herein by reference to Exhibit 10.2 of the
    Registration Statement No. 333-105505 filed with the SEC on July
    21, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | 10 | .3+ |  | Employment Agreement by and between Direct
    General Corporation and Tammy R. Adair dated as of July 21, 2003
    incorporated herein by reference to Exhibit 10.3 of the
    Registration Statement No. 333-105505 filed with the SEC on July
    21, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         
| | 10 | .4 |  | Employment Agreement by and between Direct
    General Corporation and William J. Harter dated as of July 21,
    2003 incorporated herein by reference to Exhibit 10.4 of the
    Registration Statement No. 333-105505 filed with the SEC on July
    21, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | 10 | .5 |  | Employment Agreement by and between Direct
    General Corporation and Barry D. Elkins dated as of July 21,
    2003 incorporated herein by reference to Exhibit 10.5 of the
    Registration Statement No. 333-105505 filed with the SEC on July
    21, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 10 | .6 |  | Direct General Corporation 1996 Employee Stock
    Incentive Plan incorporated herein by reference to Exhibit 10.6
    of the Registration Statement No. 333-105505 filed with the SEC
    on May 23, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | 10 | .7 |  | Direct General Corporation 2003 Equity Incentive
    Plan incorporated herein by reference to Exhibit 10.7 of the
    Registration Statement No. 333-105505 filed with the SEC on May
    23, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    
| | 10 | .8  |  | Excess of Liability Reinsurance Agreement between
    Direct General Insurance Company and State National Specialty
    Insurance Company dated as of October 1, 2002 incorporated
    herein by reference to Exhibit 10.12 of the Registration
    Statement No. 333-105505 filed with the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      
| | 10 | .9  |  | Quota Share Reinsurance Agreement between Direct
    General Insurance Company and State National Specialty Insurance
    Company dated as of October 1, 2002 incorporated herein by
    reference to Exhibit 10.13 of the Registration Statement No.
    333-105505 filed with the SEC on May 23, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | 10 | .10 |  | Quota Share Reinsurance Agreement between Direct
    General Insurance Company and Old American County Mutual Fire
    Insurance Company dated as of January 1, 2003 incorporated
    herein by reference to Exhibit 10.14 of the Registration
    Statement No. 333-105505 filed with the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       
| | 10 | .11 |  | Eighth Amended and Restated Loan Agreement by and
    among Direct General Corporation and certain of its subsidiaries
    and First Tennessee Bank National Association, as agent, and
    other banks described therein dated as of October 31, 2002, as
    amended by the First Amendment to the Eighth Amended and
    Restated Loan Agreement dated as of March 31, 2003 and the
    Second Amendment to the Eighth Amended and Restated Loan
    Agreement dated as of May 28, 2003 and the Third Amendment to
    the Eighth Amended and Restated Loan Agreement dated as of June
    30, 2003 and the Fourth Amendment to the Eighth Amended and
    Restated Loan Agreement dated as of July 17, 2003 incorporated
    herein by reference to Exhibit 10.15 of the Registration
    Statement No. 333-105505 filed with the SEC on August 1, 2003
    and the Fifth Amendment to the Eighth Amended and Restated Loan
    Agreement dated as of November 26, 2003 incorporated herein by
    reference to Exhibit 10.11 of the Registration Statement No.
    333-113289 filed with the SEC on March 4, 2004.

88



---



##### 



| |    |     |  |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  
| | -- | --- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10 | .12 |  | Seventh Amended and Restated Pledge and Security
    Agreement made by Direct General Corporation in favor of First
    Tennessee Bank National Association, as agent, and other banks
    described therein dated as of October 31, 2002, as amended by
    the First Amendment to the Seventh Amended and Restated Pledge
    and Security Agreement dated as of March 31, 2003 and the Second
    Amendment to the Seventh Amended and Restated Pledge and
    Security Agreement dated as of May 28, 2003 and the Third
    Amendment to the Seventh Amended and Restated Pledge and
    Security Agreement dated as of June 30, 2003 incorporated herein
    by reference to Exhibit 10.16 of the Registration Statement No.
    333-105505 filed with the SEC on August 1, 2003 and the Forth
    Amendment to the Seventh Amended and Restated Pledge and
    Security Agreement dated as of November 26, 2003 incorporated
    herein by reference to Exhibit 10.12 of the Registration
    Statement No. 333-113289 filed with the SEC on March 4, 2004.
| | 10 | .13 |  | Seventh Amended and Restated Security Agreement
    by and between Direct General Financial Services, Inc. and First
    Tennessee Bank National Association, as agent, and other banks
    described therein dated as of October 31, 2002, as amended by
    the First Amendment to the Seventh Amended and Restated Security
    Agreement dated as of March 31, 2003 and the Second Amendment to
    the Seventh Amended and Restated Security Agreement dated as of
    May 28, 2003 and the Third Amendment to the Seventh Amended and
    Restated Security Agreement dated as of June 30, 2003
    incorporated herein by reference to Exhibit 10.17 of the
    Registration Statement No. 333-105505 filed with the SEC on
    August 1, 2003 and the Fourth Amendment to the Seventh Amended
    and Restated Security Agreement dated as of November 26, 2003
    incorporated herein by reference to Exhibit 10.13 of the
    Registration Statement No. 333-113289 filed with the SEC on
    March 4, 2004.                                          
| | 10 | .14 |  | Third Amended and Restated Loan Agreement among
    Direct General Corporation, Direct General Financial Services,
    Inc., First Tennessee Bank National Association and Hibernia
    National Bank dated as of October 31, 2002 incorporated herein
    by reference to Exhibit 10.19 of the Registration Statement No.
    333-105505 filed with the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   
| | 10 | .15 |  | Florida MGA Agreement between Direct General
    Insurance Company, Inc. and the Maitland Underwriters dated as
    of August 16, 1999 incorporated herein by reference to Exhibit
    10.22 of the Registration Statement No. 333-105505 filed with
    the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               
| | 10 | .16 |  | Option Agreement between Direct General Insurance
    Agency, Inc. and LR3 Enterprises, Inc. and Maitland
    Underwriters, Inc. dated as of August 16, 1999 as amended by the
    Letter Agreements dated January 9, 2001 and February 20, 2002
    incorporated herein by reference to Exhibit 10.23 of the
    Registration Statement No. 333-105505 filed with the SEC on June
    27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 
| | 10 | .17 |  | Managing General Agency Agreement between Direct
    General Insurance Agency Inc. and Old American County Mutual
    Fire Insurance Company dated as of January 1, 2003 incorporated
    herein by reference to Exhibit 10.24 of the Registration
    Statement No. 333-105505 filed with the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | 10 | .18 |  | Option Agreement between Direct General Insurance
    Agency, Inc. and All American General Agency, Inc., Guaranteed
    Insurance Agency, Inc., and certain guarantors described therein
    dated as of January 1, 2003 incorporated herein by reference to
    Exhibit 10.25 of the Registration Statement No. 333-105505 filed
    with the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | 10 | .19 |  | Texas Sub-Producers Agreement between Direct
    General Insurance Agency, Inc. and All American General Agency,
    Inc. dated as of January 1, 2003 incorporated herein by
    reference to Exhibit 10.26 of the Registration Statement No.
    333-105505 filed with the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                
| | 10 | .20 |  | Security Trust Agreement between Direct General
    Insurance Company and Old American County Mutual Fire Insurance
    Company and First Tennessee Bank National Association dated as
    of January 1, 2003 incorporated herein by reference to Exhibit
    10.27 of the Registration Statement No. 333-105505 filed with
    the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
| | 10 | .21 |  | Stock Purchase Agreement and Letter between
    Direct General Corporation and Mutual Service Casualty Insurance
    Company dated as of December 2, 2002 incorporated herein by
    reference to Exhibit 10.28 of the Registration Statement No.
    333-105505 filed with the SEC on June 27, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | 10 | .22 |  | Stock Purchase Agreement among Direct General
    Corporation, New York Life and Health Insurance Company, NYLCare
    Health Plans, Inc. and Aetna Inc. dated as of June 26, 2003
    incorporated herein by reference to Exhibit 10.31 of the
    Quarterly Report on Form 10-Q filed with the SEC on September
    23, 2003.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  

89



---



##### 



| |     |     |  |                                                                                                                                                                                                                                                                                                                                                     
| | --- | --- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | 10  | .23 |  | Private Passenger Automobile Quota Share
    Reinsurance Contract issued to each of the property and casualty
    insurance subsidiaries of Direct General Corporation dated as of
    January 1, 2004 incorporated herein by reference to Exhibit 3.1
    of the Registration Statement No. 333-113289 filed with the SEC
    on March 4, 2004.    
| | 10  | .24 |  | Private Passenger Automobile Excess Cessions
    Reinsurance Contract issued to each of the property and casualty
    insurance subsidiaries of Direct General Corporation dated as of
    January 1, 2004 incorporated herein by reference to Exhibit 3.1
    of the Registration Statement No. 333-113289 filed with the SEC
    on March 4, 2004.
| | 10  | .25 |  | Property Catastrophe Excess of Loss Reinsurance
    Contract issued to each of the property and casualty insurance
    subsidiaries of Direct General Corporation dated as of January
    1, 2004 incorporated herein by reference to Exhibit 3.1 of the
    Registration Statement No. 333-113289 filed with the SEC on
    March 4, 2004.         
| | 14* |     |  | Policy on Business Conduct (Code of Ethics).                                                                                                                                                                                                                                                                                                        
| | 23* |     |  | Consent of Ernst & Young LLP, as to
    incorporation by reference in Registration Statement
    No. 333-108126 of Direct General Corporation on Form S-8,
    with respect to the consolidated financial statements and
    schedules of Direct General Corporation included in this Annual
    Report on Form 10-K.                               
| | 31  | .1* |  | Rule 13a-14(a) Certifications of CEO (pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002).                                                                                                                                                                                                                                               
| | 31  | .2* |  | Rule 13a-14(a) Certifications of CFO (pursuant to
    Section 302 of the Sarbanes-Oxley Act of 2002).                                                                                                                                                                                                                                               
| | 32  | .1* |  | Rule 1350 Certifications of CEO (pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002).                                                                                                                                                                                                                                                    
| | 32  | .2* |  | Rule 1350 Certifications of CFO (pursuant to
    Section 906 of the Sarbanes-Oxley Act of 2002).                                                                                                                                                                                                                                                    



---



|  |                                          
|- | -----------------------------------------
| | Management contract or compensatory plan.



|  |                
|- | ---------------
|* | Filed herewith.

(b) Reports of Form 8-K:



| |     |                                                                                                                                        
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------
| | (i) | Current Report on Form 8-K filed on
    November 5, 2003 announcing its financial results for the
    quarter ended September 30, 2003.

(c) Exhibits:

The applicable exhibits are included immediately
after the signature pages.

(d) Financial Statement Schedules:

The applicable financial statement schedules are
included immediately after the signature pages.

90



---



##### 



SIGNATURES

Pursuant to the requirements of Sections 13
or 15 (d) of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.



| |                           
| | --------------------------
| | DIRECT GENERAL CORPORATION
| | (Registrant)              

March 8, 2004


| |     |                          
| | --- | -------------------------
| | By: | /s/ WILLIAM C. ADAIR, JR.

| |                                                    
| | ---------------------------------------------------
| | William C. Adair, Jr.                              
| | Chairman, Chief Executive Officer and
    President

Pursuant to the requirements of the Securities
Exchange Act of 1934, this report has been signed by the
following persons on behalf of the registrant and in the
capacities and on the dates indicated.

|                                               |  |                                                                                                                      |  |               |  |     
|---------------------------------------------- |  | -------------------------------------------------------------------------------------------------------------------- |  | ------------- |  | ----
|                                               |  | Signature                                                                                                            |  | Title         |  | Date
|                                               |  |                                                                                                                      |  |               |  |     
|                                              
|/s/ WILLIAM C. ADAIR, JR.William C. Adair, Jr. |  | Chairman, Chief Executive Officer and President
    (Principal Executive Officer)                                    |  | March 8, 2004
|                                              
|/s/ JACQUELINE C. ADAIRJacqueline C. Adair     |  | Director, Executive Vice President and Chief
    Operating Officer                                                   |  | March 8, 2004
|                                              
|/s/ FRED H. MEDLINGFred H. Medling             |  | Director                                                                                                             |  | March 8, 2004
|                                              
|/s/ RAYMOND L. OSTERHOUTRaymond L. Osterhout   |  | Director                                                                                                             |  | March 8, 2004
|                                              
|/s/ STEPHEN L. ROHDEStephen L. Rohde           |  | Director                                                                                                             |  | March 8, 2004
|                                              
|/s/ BARRY D. ELKINSBarry D. Elkins             |  | Senior Vice President and Chief Financial Officer
    (Principal Financial Officer and Principal Accounting Officer) |  | March 8, 2004

91



---



##### 



REPORT OF INDEPENDENT AUDITORS

Board of Directors

Direct General Corporation and Subsidiaries


We have audited the consolidated financial
statements of Direct General Corporation and Subsidiaries as of
December 31, 2003 and 2002, and for each of the three years
in the period ended December 31, 2003, and have issued our
report thereon dated February 17, 2004 (included elsewhere
in this Annual Report on Form 10-K). Our audits also
included the financial statement schedules listed in
Item 15(a)(2) of this Annual Report on Form 10-K.
These schedules are the responsibility of the Companys
management. Our responsibility is to express an opinion based on
our audits.

In our opinion, the financial statement schedules
referred to above, when considered in relation to the basic
financial statements taken as a whole, present fairly in all
material respects the information set forth therein.



| |                      
| | ---------------------
| | /s/ ERNST & YOUNG LLP

Nashville, Tennessee

February 17, 2004


92



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES

SCHEDULE I. SUMMARY OF INVESTMENTS

OTHER THAN INVESTMENTS IN RELATED
PARTIES

December 31, 2003


|                                              |        |                                                                      |                        |       |         |                |       |   |         |         |       |   |         |         | 
|--------------------------------------------- | ------ | -------------------------------------------------------------------- | ---------------------- | ----- | ------- | -------------- | ----- | - | ------- | ------- | ----- | - | ------- | ------- | 
|                                              |        |                                                                      |                        |       |         | Amount at     
|                                              |        |                                                                      |                        |       |         | Which Shown in
|                                              |        |                                                                      |                        |       |         | the Balance   
|Type of Investment                            |        | Cost                                                                 |                        | Value |         | Sheet         
|                                              |        |                                                                      |                        |       |         |               
|                                              |        |                                                                     
|                                              |        | (In thousands)                                                      
|Available-for-sale fixed maturity securities: |        |                                                                      |                        |       |         |                |       |   |         |         |       |  
|                                              | Bonds: |                                                                      |                        |       |         |                |       |   |         |         |       |   |        
|                                              |        | United States government and government agencies
    and authorities |                        | $     | 94,802  |                |       | $ | 93,976  |         |       | $ | 93,976  |        
|                                              |        | States, municipalities, and
    political subdivisions               |                        |       | 49,920  |                |       |   | 51,662  |         |       |   | 51,662  |        
|                                              |        | Public utilities                                                     |                        |       | 6,448   |                |       |   | 6,457   |         |       |   | 6,457   |        
|                                              |        | All other corporate bonds                                            |                        |       | 112,759 |                |       |   | 112,903 |         |       |   | 112,903 |        
|                                              |        |                                                                      |                        |       |         |                |       |   |         |         |       |  
|                                              |        |                                                                      | Total fixed maturities |       |         | 263,929        |       |   |         | 264,998 |       |   |         | 264,998 | 
|                                              |        |                                                                      |                        |       |         |                |       |   |         |         |       |  
|Short-term investments                        |        |                                                                      | 1,322                  |       |         |                | 1,322 |   |         |         | 1,322 |  
|                                              |        |                                                                      |                        |       |         |                |       |   |         |         |       |  
|                                              |        |                                                                      | Total investments      |       | $       | 265,251        |       |   | $       | 266,320 |       |   | $       | 266,320 | 
|                                              |        |                                                                      |                        |       |         |                |       |   |         |         |       |  

93



---



##### 



DIRECT GENERAL CORPORATION (PARENT
COMPANY)

SCHEDULE II. CONDENSED FINANCIAL INFORMATION
OF REGISTRANT

Condensed Statements of Operations

|         |                                                                                   |                                 |   |        |        |      |   |        |        |  |   |        |       | 
|-------- | --------------------------------------------------------------------------------- | ------------------------------- | - | ------ | ------ | ---- | - | ------ | ------ |  | - | ------ | ----- | 
|         |                                                                                   |                                
|         |                                                                                   | For the Year Ended December 31,
|         |                                                                                   |                                
|         |                                                                                   | 2003                            |   | 2002   |        | 2001
|         |                                                                                   |                                 |   |        |        |     
|         |                                                                                   |                                
|         |                                                                                   | (In thousands)                 
|Revenues |                                                                                   |                                 |   |        |        |      |   |        |        |  |   |       
|         | Equity earnings (losses) in subsidiaries
    (eliminated in consolidation)        |                                 | $ | 31,649 |        |      | $ | 27,864 |        |  | $ | (2,010 | )    
|         | Dividends from insurance subsidiaries (eliminated
    in consolidation)           |                                 |   | 1,000  |        |      |   | 2,250  |        |  |   | 2,142  |      
|         | Management fees from non-insurance subsidiaries
    (eliminated in consolidation) |                                 |   | 18,307 |        |      |   | 3,241  |        |  |   | 2,251  |      
|         | Other income                                                                      |                                 |   | 70     |        |      |   |       |        |  |   | 49     |      
|         |                                                                                   |                                 |   |        |        |      |   |        |        |  |   |       
|         |                                                                                   | Total revenues                  |   |        | 51,026 |      |   |        | 33,355 |  |   |        | 2,432 | 
|Expenses |                                                                                   |                                 |   |        |        |      |   |        |        |  |   |       
|         | General and administrative expenses                                               |                                 |   | 250    |        |      |   | 147    |        |  |   | 153    |      
|         | Interest expense                                                                  |                                 |   | 958    |        |      |   | 1,071  |        |  |   | 1,493  |      
|         |                                                                                   |                                 |   |        |        |      |   |        |        |  |   |       
|         |                                                                                   | Total expenses                  |   |        | 1,208  |      |   |        | 1,218  |  |   |        | 1,646 | 
|         |                                                                                   |                                 |   |        |        |      |   |        |        |  |   |       
|         | Income before income taxes                                                        |                                 |   | 49,818 |        |      |   | 32,137 |        |  |   | 786    |      
|         | Income tax expense                                                                |                                 |   | 6,726  |        |      |   | 1,100  |        |  |   | 338    |      
|         |                                                                                   |                                 |   |        |        |      |   |        |        |  |   |       
|         |                                                                                   | Net income                      |   | $      | 43,092 |      |   | $      | 31,037 |  |   | $      | 448   | 
|         |                                                                                   |                                 |   |        |        |      |   |        |        |  |   |       

See note to condensed financial statements.

94



---



##### 



DIRECT GENERAL CORPORATION (PARENT
COMPANY)

SCHEDULE II. CONDENSED FINANCIAL INFORMATION
OF REGISTRANT

Condensed Balance Sheets

|                                                                     |                                                                              |                                               |                            |                                                                            |        |         |         |        |        |        |        | 
|-------------------------------------------------------------------- | ---------------------------------------------------------------------------- | --------------------------------------------- | -------------------------- | -------------------------------------------------------------------------- | ------ | ------- | ------- | ------ | ------ | ------ | ------ | 
|                                                                     |                                                                              |                                              
|                                                                     |                                                                              | As of December 31,                           
|                                                                     |                                                                              |                                              
|                                                                     |                                                                              | 2003                                          |                            | 2002                                                                      
|                                                                     |                                                                              |                                               |                            |                                                                           
|                                                                     |                                                                              |                                              
|                                                                     |                                                                              | (In thousands)                               
|Assets                                                               |                                                                              |                                               |                            |                                                                            |        |         |         |       
|                                                                     | Cash and cash equivalents                                                    |                                               | $                          | 5,184                                                                      |        |         | $       | 2,366  |       
|                                                                     | Receivables from affiliated companies, net
    (eliminated in consolidation) |                                               |                            | 9,867                                                                      |        |         |         |       |       
|                                                                     | Investment in subsidiaries (eliminated
    in consolidation)                 |                                               |                            | 161,143                                                                    |        |         |         | 78,835 |       
|                                                                     | Other assets                                                                 |                                               |                            | 2,393                                                                      |        |         |         | 903    |       
|                                                                     |                                                                              |                                               |                            |                                                                            |        |         |         |       
|                                                                     |                                                                              |                                               | Total assets               |                                                                            | $      | 178,587 |         |        | $      | 82,104 |       
|                                                                     |                                                                              |                                               |                            |                                                                            |        |         |         |       
|Liabilities, redeemable preferred stock and
    shareholders equity |                                                                              |                                               |                            |                                                                            |        |         |         |       
|                                                                     | Income taxes payable                                                         |                                               | $                          | 536                                                                        |        |         | $       | 35     |       
|                                                                     | Deferred income taxes                                                        |                                               |                            | 606                                                                        |        |         |         | 605    |       
|                                                                     | Payable to affiliated companies, net (eliminated
    in consolidation)       |                                               |                            |                                                                           |        |         |         | 5,766  |       
|                                                                     | Notes payable                                                                |                                               |                            |                                                                           |        |         |         | 10,442 |       
|                                                                     | Other liabilities                                                            |                                               |                            | 50                                                                         |        |         |         | 376    |       
|                                                                     |                                                                              |                                               |                            |                                                                            |        |         |         |       
|                                                                     |                                                                              | Total liabilities                             |                            |                                                                            | 1,192  |         |         |        | 17,224 |       
|                                                                     |                                                                              |                                               |                            |                                                                            |        |         |         |       
|                                                                     | Redeemable Series A preferred stock                                          |                                               |                            |                                                                           |        |         |         | 5,685  |       
|                                                                     | Shareholders equity                                                         |                                               |                            |                                                                            |        |         |         |        |       
|                                                                     |                                                                              | Series B preferred stock                      |                            |                                                                            |       |         |         |        | 9,219  |       
|                                                                     |                                                                              | Common stock                                  |                            |                                                                            | 91,853 |         |         |        | 9,037  |       
|                                                                     |                                                                              | Retained earnings                             |                            |                                                                            | 85,735 |         |         |        | 43,842 |       
|                                                                     |                                                                              | Accumulated other comprehensive income (loss) |                            |                                                                            | (193   | )       |         |        | 1,645  |       
|                                                                     |                                                                              | Treasury stock                                |                            |                                                                            |       |         |         |        | (4,548 | )     
|                                                                     |                                                                              |                                               |                            |                                                                            |        |         |         |       
|                                                                     |                                                                              |                                               | Total shareholders equity |                                                                            |        | 177,395 |         |        |        | 59,195 |       
|                                                                     |                                                                              |                                               |                            |                                                                            |        |         |         |       
|                                                                     |                                                                              |                                               |                            | Total liabilities, redeemable preferred stock and
    shareholders equity |        | $       | 178,587 |        |        | $      | 82,104 | 
|                                                                     |                                                                              |                                               |                            |                                                                            |        |         |         |       

See note to condensed financial statements.

95



---



##### 



DIRECT GENERAL CORPORATION (PARENT
COMPANY)

SCHEDULE II. CONDENSED FINANCIAL INFORMATION
OF REGISTRANT

Condensed Statements of Cash Flows

|                                              |                                                               |                                 |       |         |   |      |       |        |   |   |       |        |  
|--------------------------------------------- | ------------------------------------------------------------- | ------------------------------- | ----- | ------- | - | ---- | ----- | ------ | - | - | ----- | ------ | -
|                                              |                                                               |                                
|                                              |                                                               | For the Year Ended December 31,
|                                              |                                                               |                                
|                                              |                                                               | 2003                            |       | 2002    |   | 2001
|                                              |                                                               |                                 |       |         |   |     
|                                              |                                                               |                                
|                                              |                                                               | (In thousands)                 
|Net cash provided by operating
    activities |                                                               | $                               | 2,996 |         |   | $    | 6,024 |        |   | $ | 4,217 |       
|                                              |                                                               |                                 |       |         |   |      |       |        |   |   |       |       
|Investing activities                          |                                                               |                                 |       |         |   |      |       |        |   |   |       |       
|                                              | Investment in subsidiaries                                    |                                 |       | (52,497 | ) |      |       | (2,250 | ) |   |       |       |  
|                                              | Advance to subsidiary to paydown on
    credit facility       |                                 |       | (7,000  | ) |      |       |       |   |   |       |       |  
|                                              | Advance to subsidiary to purchase insurance
    agency assets |                                 |       | (2,500  | ) |      |       |       |   |   |       |       |  
|                                              | Dividends received from
    insurance subsidiaries            |                                 |       | 1,000   |   |      |       | 2,250  |   |   |       | 2,142  |  
|                                              |                                                               |                                 |       |         |   |      |       |        |   |   |       |       
|                                              | Net cash (used in) provided by
    investing activities       |                                 |       | (60,997 | ) |      |       |       |   |   |       | 2,142  |  
|                                              |                                                               |                                 |       |         |   |      |       |        |   |   |       |       
|Financing activities                          |                                                               |                                 |       |         |   |      |       |        |   |   |       |       
|                                              | Issuances of common stock                                     |                                 |       | 72,493  |   |      |       |       |   |   |       |       |  
|                                              | Proceeds from borrowings                                      |                                 |       |        |   |      |       | 3,179  |   |   |       |       |  
|                                              | Payment of principal on borrowings                            |                                 |       | (10,442 | ) |      |       | (1,737 | ) |   |       | (6,000 | )
|                                              | Payment of preferred stock dividends                          |                                 |       | (345    | ) |      |       | (561   | ) |   |       | (561   | )
|                                              | Payment of common stock dividends                             |                                 |       | (854    | ) |      |       |       |   |   |       |       |  
|                                              | Purchase of treasury stock                                    |                                 |       | (33     | ) |      |       | (4,548 | ) |   |       |       |  
|                                              |                                                               |                                 |       |         |   |      |       |        |   |   |       |       
|                                              | Net cash provided by (used in)
    financing activities       |                                 |       | 60,819  |   |      |       | (3,667 | ) |   |       | (6,561 | )
|                                              |                                                               |                                 |       |         |   |      |       |        |   |   |       |       
|                                              | Net increase in cash and cash equivalents                     |                                 |       | 2,818   |   |      |       | 2,357  |   |   |       | (202   | )
|                                              | Cash and cash equivalents at the beginning of
    the year    |                                 |       | 2,366   |   |      |       | 9      |   |   |       | 211    |  
|                                              |                                                               |                                 |       |         |   |      |       |        |   |   |       |       
|                                              | Cash and cash equivalents at the end of
    the year          |                                 | $     | 5,184   |   |      | $     | 2,366  |   |   | $     | 9      |  
|                                              |                                                               |                                 |       |         |   |      |       |        |   |   |       |       

See note to condensed financial statements.

96



---



##### 



DIRECT GENERAL CORPORATION (PARENT
COMPANY)

SCHEDULE II. CONDENSED FINANCIAL INFORMATION
OF REGISTRANT



Note to Condensed Financial
Statements



|   |                      
|-- | ---------------------
|1. | Basis of Presentation

The condensed financial statements should be read
in conjunction with the consolidated financial statements and
notes thereto of Direct General Corporation.

In the parent company financial statements, the
Companys investment in subsidiaries is stated at cost plus
equity in undistributed income of subsidiaries since the date of
acquisition, net unrealized gains/losses on the
subsidiaries debt securities available-for-sale, and other
changes in subsidiaries accumulated other comprehensive
income.

See Note 6 to consolidated financial statements
for a description of the parent companys notes payable.

See Note 10 to the consolidated financial
statements for a description of the parent companys
capital structure and related obligations.

97



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES

SCHEDULE IV. REINSURANCE

|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |      |      |  
|---------------------------- | -------------------------------- | -------------- | --------- | --------- | ------- | ------------ | - | ------- | ------- | ---------- | - | ------ | ------ | - | --------- | ------- | ------- |  | --- | ---- | ---- | -
|                             |                                  |                |           |           |         |              |   |         |         | Percentage
|                             |                                  |                |           | Ceded to  |         | Assumed from |   |         |         | of Amount 
|                             |                                  | Gross          |           | Other     |         | Other        |   | Net     |         | Assumed   
|                             |                                  | Amount         |           | Companies |         | Companies    |   | Amount  |         | to Net    
|                             |                                  |                |           |           |         |              |   |         |         |           
|                             |                                  |               
|                             |                                  | (In thousands)
|Year ended December 31, 2003 |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|Life insurance in force      |                                  | $              | 1,013,010 |           |         | $            |  |         |         | $          |  |        |        | $ | 1,013,010 |         |         |  | 0.0 | %   
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|Premiums:                    |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|                             | Life insurance                   |                | $         | 10,596    |         |              | $ |        |         |            | $ |       |        |   | $         | 10,596  |         |  |     | 0.0  | %   
|                             | Property and liability insurance |                |           | 360,292   |         |              |   | 166,380 |         |            |   | 24,021 |        |   |           | 217,933 |         |  |     | 11.0 | %   
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|                             |                                  | Total premiums |           | $         | 370,888 |              |   | $       | 166,380 |            |   | $      | 24,021 |   |           | $       | 228,529 |  |     |      | 10.5 | %
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|Year ended December 31, 2002 |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|Life insurance in force      |                                  | $              | 560,300   |           |         | $            |  |         |         | $          |  |        |        | $ | 560,300   |         |         |  | 0.0 | %   
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|Premiums:                    |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|                             | Life insurance                   |                | $         | 5,760     |         |              | $ |        |         |            | $ |       |        |   | $         | 5,760   |         |  |     | 0.0  | %   
|                             | Property and liability insurance |                |           | 270,338   |         |              |   | 139,328 |         |            |   | 8,205  |        |   |           | 139,215 |         |  |     | 5.9  | %   
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|                             |                                  | Total premiums |           | $         | 276,098 |              |   | $       | 139,328 |            |   | $      | 8,205  |   |           | $       | 144,975 |  |     |      | 5.7  | %
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|Year ended December 31, 2001 |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|Life insurance in force      |                                  | $              | 275,220   |           |         | $            |  |         |         | $          |  |        |        | $ | 275,220   |         |         |  | 0.0 | %   
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|Premiums:                    |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|                             | Life insurance                   |                | $         | 2,483     |         |              | $ |        |         |            | $ |       |        |   | $         | 2,483   |         |  |     | 0.0  | %   
|                             | Property and liability insurance |                |           | 198,346   |         |              |   | 109,238 |         |            |   | 6,438  |        |   |           | 95,546  |         |  |     | 6.7  | %   
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     
|                             |                                  | Total premiums |           | $         | 200,829 |              |   | $       | 109,238 |            |   | $      | 6,438  |   |           | $       | 98,029  |  |     |      | 6.6  | %
|                             |                                  |                |           |           |         |              |   |         |         |            |   |        |        |   |           |         |         |  |     |     

98



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES

SCHEDULE V. VALUATION AND QUALIFYING
ACCOUNTS

|                                                  |  |                |       |            |  |                |        |            |  |            |       |     |  |   |        |      |  |   |       | 
|------------------------------------------------- |  | -------------- | ----- | ---------- |  | -------------- | ------ | ---------- |  | ---------- | ----- | --- |  | - | ------ | ---- |  | - | ----- | 
|                                                  |  | Balance at     |       | Charged to |  |                |        |            |  | Balance at
|                                                  |  | Beginning of   |       | Costs and  |  | Charged to     |        |            |  | End of    
|Description                                       |  | Period         |       | Expenses   |  | Other Accounts |        | Deductions |  | Period    
|                                                  |  |                |       |            |  |                |        |            |  |           
|                                                  |  |               
|                                                  |  | (In thousands)
|Year ended December 31, 2003                      |  |                |       |            |  |                |        |            |  |            |       |     |  |   |        |      |  |   |       | 
|Allowance for finance receivable losses           |  | $              | 5,010 |            |  | $              |       |            |  | $          | 6,962 | (a) |  | $ | (6,030 | )(c) |  | $ | 5,942 | 
|Provision for return ceding commissions           |  |                | 4,960 |            |  |                | (1,869 | )          |  |            |      |     |  |   |       |      |  |   | 3,091 | 
|Provision for return commissions and service fees |  |                | 2,623 |            |  |                |       |            |  |            | 2,306 | (b) |  |   |       |      |  |   | 4,929 | 
|                                                  |  |                |       |            |  |                |        |            |  |            |       |     |  |   |        |      |  |   |       | 
|Year ended December 31, 2002                      |  |                |       |            |  |                |        |            |  |            |       |     |  |   |        |      |  |   |       | 
|Allowance for finance receivable losses           |  | $              | 4,811 |            |  | $              |       |            |  | $          | 5,346 | (a) |  | $ | (5,147 | )(c) |  | $ | 5,010 | 
|Provision for return ceding commissions           |  |                | 4,048 |            |  |                | 912    |            |  |            |      |     |  |   |       |      |  |   | 4,960 | 
|Provision for return commissions and service fees |  |                | 1,828 |            |  |                |       |            |  |            | 795   | (b) |  |   |       |      |  |   | 2,623 | 
|                                                  |  |                |       |            |  |                |        |            |  |            |       |     |  |   |        |      |  |   |       | 
|Year ended December 31, 2001                      |  |                |       |            |  |                |        |            |  |            |       |     |  |   |        |      |  |   |       | 
|Allowance for finance receivable losses           |  | $              | 3,264 |            |  | $              |       |            |  | $          | 5,559 | (a) |  | $ | (4,012 | )(c) |  | $ | 4,811 | 
|Provision for return ceding commissions           |  |                | 3,096 |            |  |                | 952    |            |  |            |      |     |  |   |       |      |  |   | 4,048 | 
|Provision for return commissions and service fees |  |                | 1,557 |            |  |                |       |            |  |            | 271   | (b) |  |   |       |      |  |   | 1,828 | 
|                                                  |  |                |       |            |  |                |        |            |  |            |       |     |  |   |        |      |  |   |       | 



---



|    |                                                                      
|--- | ---------------------------------------------------------------------
|(a) | provision for finance receivable losses charged
    to finance income



|    |                                                                                                          
|--- | ---------------------------------------------------------------------------------------------------------
|(b) | provision for return commissions and
    administrative fees charged to commission and service fee income



|    |                               
|--- | ------------------------------
|(c) | charge-offs, net of recoveries

99



---



##### 



DIRECT GENERAL CORPORATION AND
SUBSIDIARIES

SCHEDULE VI. SUPPLEMENTAL
INFORMATION

|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  |            |         |              |  |             |         |            |  |         |       |  |  |   |         |  |  |   |        |   |  |   |        |  |  |   |         |  |  |   |         | 
|---------------------------------------------- |  | -------------- | ------ | ------------ |  | --------- | ------- | -------- |  | -------- | - | ---------- |  | ---------- | ------- | ------------ |  | ----------- | ------- | ---------- |  | ------- | ----- |  |  | - | ------- |  |  | - | ------ | - |  | - | ------ |  |  | - | ------- |  |  | - | ------- | 
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  |            |         |              |  |             |         |           
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  | Claims and |         |              |  |             |         |           
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  | Claim      |         |              |  |             |         |           
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  | Adjustment |         |              |  |             |         |           
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  | Expenses   |         |              |  |             |         |           
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  | Incurred   |         | Amortization |  |             |         |           
|                                               |  | Deferred       |        | Reserves for |  | Discount, |         |          |  |          |   |            |  | Related to |         | of Deferred  |  | Paid Claims |         |           
|                                               |  | Policy         |        | Unpaid       |  | if any,   |         |          |  |          |   | Net        |  |            |         | Policy       |  | and Claim   |         |           
|                                               |  | Acquisition    |        | Claims and   |  | Deducted  |         | Unearned |  | Earned   |   | Investment |  | Current    |         | Prior        |  | Acquisition |         | Adjustment |  | Written
|Affiliation with Registrant                    |  | Costs          |        | Adjustment   |  | In Col. C |         | Premiums |  | Premiums |   | Income     |  | Year       |         | Years        |  | Costs       |         | Expenses   |  | Premium
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  |            |         |              |  |             |         |            |  |        
|                                               |  |               
|                                               |  | (In thousands)
|Consolidated property  casualty
    entities: |  |                |        |              |  |           |         |          |  |          |   |            |  |            |         |              |  |             |         |            |  |         |       |  |  |   |         | 
|December 31, 2003                              |  | $              | 11,012 |              |  | $         | 112,108 |          |  | $        | 0 |            |  | $          | 206,490 |              |  | $           | 217,932 |            |  | $       | 6,350 |  |  | $ | 166,866 |  |  | $ | 309    |   |  | $ | 25,287 |  |  | $ | 150,707 |  |  | $ | 281,526 | 
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  |            |         |              |  |             |         |            |  |         |       |  |  |   |         |  |  |   |        |   |  |   |        |  |  |   |         |  |  |   |         | 
|December 31, 2002                              |  | $              | 8,165  |              |  | $         | 86,658  |          |  | $        | 0 |            |  | $          | 169,148 |              |  | $           | 139,215 |            |  | $       | 5,050 |  |  | $ | 105,575 |  |  | $ | (5,492 | ) |  | $ | 21,060 |  |  | $ | 79,315  |  |  | $ | 173,360 | 
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  |            |         |              |  |             |         |            |  |         |       |  |  |   |         |  |  |   |        |   |  |   |        |  |  |   |         |  |  |   |         | 
|December 31, 2001                              |  | $              | 6,020  |              |  | $         | 77,471  |          |  | $        | 0 |            |  | $          | 120,132 |              |  | $           | 95,546  |            |  | $       | 4,850 |  |  | $ | 85,870  |  |  | $ | 7,779  |   |  | $ | 16,258 |  |  | $ | 91,247  |  |  | $ | 109,019 | 
|                                               |  |                |        |              |  |           |         |          |  |          |   |            |  |            |         |              |  |             |         |            |  |         |       |  |  |   |         |  |  |   |        |   |  |   |        |  |  |   |         |  |  |   |         | 

100