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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-K  (Mark One)[X]
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934For the Fiscal Year Ended June 30, 2004
 OR [   ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period fromto.
 Commission file number 1-6802 FIRST ACCEPTANCE CORPORATION (Exact name of registrant as specified in its charter)
 Delaware(State or Other Jurisdiction of
Incorporation or Organization)
    
    75-1328153(I.R.S. Employer Identification No.)3813 Green Hills Village Drive, Nashville, Tennessee(Address of Principal Executive Offices)
    
    37215(Zip Code)
 (615) 844-2800(Registrants telephone number, including area code)Securities registered pursuant to Section 12(b) of the Act: Title of Each Class
    
    Name of exchange on which registeredCommon Stock, $.01 par value per share
    
    New York Stock Exchange
 Securities registered pursuant to Section 12(g) of the Act:None 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 x 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 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 Exchange Act Rule 12b-2). Yes o No x The aggregate market value of the voting stock held by non-affiliates of
the registrant, based on the closing price of these shares on the New York
Stock Exchange on December 31, 2003 was $66,469,241. For the purposes of this
disclosure only, the registrant has assumed that its directors, executive
officers and beneficial owners of 5% or more of the registrants common stock
are the affiliates of the registrant. As of September 22, 2004, there were 46,681,438 shares of the registrants
common stock outstanding. 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 held on October 28, 2004.




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FIRST ACCEPTANCE CORPORATION Table of Contents  
 PagePART IItem 1. Business
    
    
    1Item 2. Properties
    
    
    21Item 3. Legal Proceedings
    
    
    21Item 4. Submission of Matters to a Vote of Security Holders
    
    
    21PART IIItem 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
    
    
    23Item 6. Selected Financial Data
    
    
    24Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    27Item 7A. Quantitative and Qualitative Disclosures About Market Risk
    
    
    36Item 8. Financial Statements and Supplementary Data
    
    
    37Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    63Item 9A. Controls and Procedures
    
    
    63Item 9B. Other Information
    
    
    63PART IIIItem 10. Directors and Executive Officers of the Registrant
    
    
    63Item 11. Executive Compensation
    
    
    63Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    63Item 13. Certain Relationships and Related Transactions
    
    
    64Item 14. Principal Accountant Fees and Services
    
    
    64PART IVItem 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K
    
    
    64Signatures
    
    
    67EX-3.2  AMENDED AND RESTATED BYLAWSEX-10.15  SEVERANCE COMPENSATION AGREEMENTEX-14  CODE OF BUSINESS CONDUCT AND ETHICSEX-21  LIST OF SUBSIDIARIES OF THE COMPANYEX-23  CONSENT OF KPMGEX-31.1  SECTION 302 CERTIFICATION BY CEOEX-31.2  SECTION 302 CERTIFICATION BY CFOEX-32.1  SECTION 906 CERTIFICATION BY CEOEX-32.2  SECTION 906 CERTIFICATION BY CFO




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FIRST ACCEPTANCE CORPORATION 
 PART I 
 Item 1. Business General First Acceptance Corporation (the Company, we or us) is a retailer,
servicer and underwriter of non-standard personal automobile insurance based in
Nashville, Tennessee. We currently write non-standard personal automobile
insurance in seven states: Georgia, Tennessee, Alabama, Mississippi, Ohio,
Missouri and Indiana. We are licensed as an insurer in 16 additional states.
Non-standard personal automobile insurance is made available to individuals who
are categorized as non-standard because of their inability or unwillingness
to obtain standard insurance coverage due to various factors, including payment
history, payment preference, failure in the past to maintain continuous
insurance coverage, driving record and/or vehicle type, and in most instances
who are required by law to buy a minimum amount of automobile insurance. As of
September 1, 2004, we own and operate 146 retail locations, staffed by
employee-agents. Our employee-agents exclusively sell insurance products
either underwritten or serviced by us. Acquisition of USAuto Our company was formed in April 1996 to effect the reorganization of our
predecessor, Liberté Investors, Inc., a Massachusetts business trust (the
Trust). Since August 1996, we have actively pursued opportunities to acquire
one or more operating companies in order to increase value to our stockholders
and provide us with a new focus and direction. On April 30, 2004, we acquired
USAuto Holdings, Inc. (USAuto), a retailer, servicer and underwriter of
non-standard personal automobile insurance, which was formed in October 1995.
Prior to the acquisition of USAuto, we owned foreclosed real estate for sale in
the form of undeveloped land (classified as non-earning). We still own land
with a book value of $1.1 million totaling approximately 310 acres in San
Antonio, Texas. We intend to continue to hold this land for sale. We acquired USAuto for consideration consisting of $76.0 million in cash,
13,250,000 shares of our common stock, and up to an additional 750,000 shares
of our common stock that may be issued at a later date if certain financial
targets are achieved. We raised $50.2 million in gross proceeds from the cash
portion of the consideration for the acquisition by selling 12,559,552 shares
of our common stock to our stockholders at $4.00 per share in a rights
offering. In connection with the completion of the acquisition of USAuto, we
changed our name from Liberté Investors, Inc. to First Acceptance Corporation
and moved our principal executive offices from Dallas, Texas to Nashville,
Tennessee. Following completion of the USAuto acquisition, Stephen J.
Harrison, the president and chief executive officer of USAuto, became the
president and chief executive officer of the company. Our Business Strategy USAuto has achieved growth as a provider of non-standard personal
automobile insurance by adhering to a focused business model and disciplined
execution of an efficient operating strategy. Our business model for our
insurance operations includes the following core strategies:  
    
    Integrated System. In order to meet the preference of our
customers for convenient, personal service, we have integrated the
retail distribution, underwriting and service functions of personal
automobile insurance into one system. By doing so, we are able to
provide prompt and personal service to meet effectively the insurance
needs of our customers while capturing revenue that would otherwise be
shared with several participants under a traditional, non-integrated
insurance business model. Our integrated model is supported by both a
point of sale agency and back office control systems.
    
    Extensive Office Network. We emphasize the use of employee-agents
as the cornerstone of our customer relationship. We have based our
business strategy partially on the belief that our customers value
face-to-face contact, speed of service and convenient locations.
Consequently, we train our employee-agents to 1




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cultivate client relationships and utilize real-time service and
information enabled by access to our intranet system. We own and operate
146 retail sales offices staffed with our employee-agents and
strategically located in geographic markets to reach and service our
customers.
    
    Favorable Customer Payment Plans. We enable customers to initiate
insurance coverage with a modest down payment that is equal to one
months premium payment. We have designed our product based on this
modest initial payment and believe that this favorable payment plan is
a major factor in our success in meeting a market demand for low
monthly insurance payments.
    
    Strong Sales and Marketing. We build brand recognition and
generate valuable sales leads through extensive use of television
advertising, Yellow Pages® and a broad network of neighborhood sales
offices.
    
    Efficient Technology Systems. Our information technology employees
have developed technology systems that enable timely and efficient
communication and data sharing among the various segments of our
integrated operations. All of our neighborhood sales office computers
transmit information directly to our central processing computer where
policy information, customer profiles, risk assessment and underwriting
criteria are entered into our database. Our Business Model We believe that USAutos success is largely due to its ability to identify
and satisfy the needs of its target customers and to eliminate many of the
inefficiencies associated with a traditional automobile insurance model. Our
senior executives have developed the business model by drawing on significant
experience in the auto insurance industry. We are a vertically integrated
business that acts as the agency, servicer and underwriter of non-standard
personal automobile insurance. We own two insurance company subsidiaries:
USAuto Insurance Company, Inc. and Village Auto Insurance Company, Inc. Our
146 company-owned and -operated retail locations in seven states are staffed by
employee-agents who are connected to our intranet and exclusively sell
insurance products either underwritten or serviced by us. Our vertical integration, combined with our conveniently located retail
locations, enables us to control the point of sale and to retain significant
revenue that would otherwise be lost in a traditional, non-integrated insurance
business model. We generate additional revenue by fully servicing our book of
business, which often allows us to collect policy, billing and other fees. Our strategy is to offer customers automobile insurance with low down
payments in each individual marketplace, competitive equal monthly payments,
convenient locations and a high level of personal contact. This strategy makes
it easier for our customers to obtain automobile insurance, which in many
instances is legally mandated. In addition, we accept customers for our
insurance who have previously terminated coverage provided by us without
imposing any additional or onerous requirements on such customers. Our
estimated policy renewal rate is approximately 30%, which is lower than the
average renewal rate of standard personal automobile insurance providers. We
are able to calculate and accept a low down payment because all business is
processed immediately through on-line access to our systems. Our model and
systems processing allows us to write efficiently and, when necessary, cancel
insurance while minimizing potential for credit loss and adhering to regulatory
cancellation notice requirements. In addition to a low down payment and competitive monthly rates, we offer
customers valuable face-to-face contact and speed of service. Many of our
customers prefer not to conduct business via the internet or over the
telephone. Approximately 85% of our customers choose to make their payments at
our offices. For these consumers, our employee-agents are not only the face of
our company, but also the preferred interface for buying insurance. Our ability to process business quickly and accurately gives us an
advantage over more traditional insurance companies that produce business using
independent agents. Our policies are issued at the point of sale, and
applications are processed within two business days, as opposed to the two or
more weeks that is often typical in the auto insurance industry. The
traditional automobile insurance model typically involves interaction and
paperwork exchange between the insurance company, independent agent and premium
finance provider. This complicated interaction presents numerous opportunities
for miscommunication, delays or lost information. 2




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Accordingly, we believe that our competitors who rely on the traditional model
based upon independent agents cannot match our degree of efficiency in serving
our targeted customer base. Another distinct advantage of our model over the traditional independent
agency approach is the fact that our employee-agents offer a single
non-standard insurance product as opposed to many products from many insurance
companies. The typical independent agent selling non-standard personal
automobile insurance generally has multiple non-standard insurance companies
and premium finance sources from which to quote based on agent commission,
price and other factors. This means that the insurance companies using the
independent agent model must compete to provide the most attractive agent
commissions and absolute lowest prices to encourage the independent agent to
sell their product. Our employee-agents, on the other hand, sell our products
exclusively. Therefore, we do not have to compete for the attention of those
distributing our product on the basis of agent commissions, price or other
factors. Personal Automobile Insurance Market Personal automobile insurance is the largest line of property and casualty
insurance in the United States. According to A.M. Best, as of December 31,
2003, the size of the non-standard automobile market segment in the United
States was approximately $34 billion, representing approximately 22% of the
total personal automobile insurance market. According to the Federal Highway
Administration, using the latest available statistics as of the end of 2001,
the total number of registered motor vehicles was approximately 235.3 million.
Personal automobile insurance provides drivers with coverage for liability to
others for bodily injury and property damage and for physical damage to the
drivers vehicle from collision and other perils. All but two states require
drivers to buy a minimum amount of bodily injury and property damage insurance. Within the personal automobile insurance market, drivers can choose from
various insurance products distinguished by such factors as the amount of
coverage offered and the method of payment. The cost and availability of each
product depend on the insurance risk profile of the driver, taking into account
such factors as the drivers driving history, age, gender, location and type of
vehicle. The market for personal automobile insurance is generally divided into
three product segments: non-standard, standard and preferred insurance.
Non-standard personal automobile insurance is designed to be attractive to
drivers who prefer to purchase only the minimum amount of coverage required by
law or to minimize the amount of required payment each payment period. The main
customers in the non-standard personal automobile insurance segment are drivers
who are unable or do not wish to secure insurance with standard insurance
companies, due to costs, convenience or risk profile. Our Products Our core business involves issuing automobile insurance policies to
individuals who are categorized as non-standard, based primarily on their
inability or unwillingness to obtain coverage from standard carriers due to
various factors, including their need for monthly payment plans, failure to
maintain continuous insurance coverage or driving record. We believe that a
majority of our customers seeks non-standard insurance due to their failure to
maintain continuous coverage or their need for affordable monthly payments,
rather than for poor driving records. The minimum automobile insurance limits per individual, per accident for
bodily injury and per accident for property damage are $25,000, $50,000 and
$25,000 in Georgia; $20,000, $40,000 and $10,000 in Alabama; and $25,000,
$50,000 and $10,000 in Tennessee. Comprehensive and collision policies are
underwritten for the actual cash value of the insureds automobile less a
deductible. The average six-month premium on our policies currently in force is $744.
We allow customers to pay for their insurance with an initial down payment and
five equal monthly installments, which typically include a billing fee and a
policy fee. We believe that our target customers greatly prefer lower down
payments and level monthly payments over the payment options traditionally
offered by other non-standard providers. Because our proprietary technology
enables us to control all aspects of servicing our insurance policies, we can
generally cancel the policy of a customer who neglects to make a payment, while
remaining within the regulatory cancellation guidelines. 3




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A single Product Template serves as a basis for our rates, rules and
forms. Product uniformity greatly simplifies our business in providing speed to
market when entering a new state, modifying an existing program or introducing
a new one. In addition, our underwriters and claims adjusters only need to be
trained in one basic set of underwriting guidelines and one basic auto policy,
respectively, and programming and systems maintenance is simplified. In addition to non-standard personal automobile insurance, we also offer
our customers optional products and policies which provide ancillary
reimbursements and benefits in the event of an automobile accident. Those
products and policies generally provide reimbursements for medical expenses and
hospital rooms as a result of injuries sustained in an automobile accident,
automobile towing and rental reimbursement, reimbursement of bail bond premiums
and ambulance services. Our Growth Strategy USAuto has experienced significant growth since its inception in 1995 in
both total revenues and net income. We intend to continue such growth primarily
through two strategies:  
    
    Increase the Number of Customers in Existing Geographic Markets.
We will work to continue to increase the number of customers through
expanded advertising campaigns and the opening of new retail sales
offices in those states where we currently do business.
    
    Expand into New Geographic Markets. We currently operate in seven
states and are licensed as an insurer in an additional 16 states. We
may also expand into those states where we currently have no presence
through the opening of sales offices and through selective acquisitions
of local agencies who write non-standard automobile insurance for other
insurance companies. Competition The non-standard personal automobile insurance business is highly
competitive. Based upon data compiled from A.M. Best, we believe that, as of
December 31, 2003, ten insurance groups accounted for about 70% of the
approximately $34 billion non-standard personal automobile insurance market
segment. We are not a member of these groups. We believe that our primary
insurance company competition comes not only from national companies or their
subsidiaries but also from non-standard insurers and independent agents that
operate in a specific region or state. We compete against independent agencies
that market insurance on behalf of a number of insurers by selling insurance
policies through their own neighborhood sales offices staffed by their own
employee-agents. We compete with these other insurers on factors such as
initial down payment, availability of monthly payment plans, price, customer
service and claims service. Allstate Insurance Company, Progressive Corporation
and Direct General Corporation are all significant providers of non-standard
personal automobile insurance in Alabama (excepting Direct General
Corporation), Georgia and Tennessee and constitute our largest competitors. Marketing and Distribution Our marketing strategy is based on promoting brand recognition of our
product and encouraging prospective customers to visit one of our 146 retail
locations. Our advertising strategy combines low-cost television advertising
with local print media advertising, such as the Yellow Pages®. Our product is distributed through our retail sales office. We believe
that the local office concept is very attractive to most of our customers, as
they desire face-to-face assistance that they cannot receive via the internet
or over the telephone. Accordingly, all advertisements promote local phone
numbers that are answered at either the local retail office or at our Nashville
customer service center. Quotes are provided over the telephone highlighting
the low down payment and monthly payments, and prospective customers are
directed to the nearest local retail office to complete an application. The
entire sales process can be completed at the local retail office where the down
payment is collected and a policy issued. Future payments can be made either at
the local office or mailed to our Nashville customer service center. 4




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Approximately 92% of our revenue is derived from retail locations owned
and operated by us. However, in select geographic areas in Tennessee, business
is produced for us by four independently-owned insurance agencies. Although
these agencies operate under their own name and transact other insurance
business, they are contracted to write all of their non-standard automobile
business through us and in return are given access to our intranet and systems
so that they function much like our own retail locations. Underwriting and Pricing Our underwriting and rating systems are fully automated, including on-line
driving records, where available. 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. We set premium rates based on the specific type of vehicle, garage
location and the drivers age, gender, marital status, driving experience and
location. We seek to remain competitive and to maintain adequate rates to
attract responsible drivers in the non-standard market. We review loss trends
in every state to identify changes in the frequency and severity of accidents
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 and permitted by applicable regulatory authorities, in order to
maintain or improve underwriting profit margins in each market. Claims Handling Non-standard personal automobile insurance customers generally have a
higher frequency of claims than preferred and standard insurance customers. We
believe that one of the keys to our success is our focus on controlling the
claims process and costs, thereby limiting losses. By managing the entire
claims process in house, we can quickly assess claims, identify loss trends
early and manage against fraud. We also can 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 September 1, 2004, our claims operation had a staff of 121
employees, including adjusters, appraisers, re-inspectors, special
investigators and claims administrative personnel. We conduct our claims
operations out of our Nashville office. Our employees handle all claims from
the initial report of the claim until the final settlement. We believe that our
employment of salaried claims personnel, including appraisers and adjusters,
and our control of the entire claims process result in improved customer
service, lower loss payments and lower loss adjustment expenses. In territories
where we do not believe a staff appraiser would be cost-effective, we utilize
the services of independent appraisers to inspect physical damage to
automobiles. The work of independent appraisers is supervised by regional staff
appraisal managers. While we are strongly committed to settling promptly and fairly 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 a special investigation unit. When a dispute arises, 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. 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. Loss and Loss Adjustment Expense Reserves Automobile accidents generally result in insurance companies paying
amounts to individuals or companies to compensate for physical damage to an
automobile or other property and/or an injury to a person. Months and sometimes
years may elapse between the occurrence of an accident, report 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, 5




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which are referred to herein as case reserves. In addition, because accidents
are not always reported promptly upon the occurrence, insurers estimate their
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 company
subsidiaries. Each of our insurance company subsidiaries establishes a reserve
for all unpaid losses, 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 final net cost of losses
and loss adjustment expenses incurred to date. We periodically review our
methods of establishing case and IBNR reserves and update, if necessary, our
estimates. Our actuarial staff performs quarterly comprehensive reviews of
reserves and loss trends. Since our actual financial results for the year ended June 30, 2004 only
reflect two months of insurance operations, the disclosures regarding loss and
loss adjustment expense development have not been presented. However, we
believe that for the two months ended June 30, 2004, there was no change in our
estimate of unpaid loss and loss adjustment expense reserves for losses and
loss adjustment expenses incurred prior to the April 30, 2004 acquisition date
of USAuto. A reconciliation of our reserve for unpaid loss and loss adjustment
expenses is presented in note 10 to the consolidated financial statements. Reinsurance 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 can
use reinsurance to reduce their exposures, to increase their underwriting
capacity and to manage their capital more efficiently. Historically, USAuto
has relied on quota share reinsurance to maintain its exposure to loss at or
below a level that is within the capacity of its 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 personal
automobile insurance written in a particular state in a particular year) in
exchange for a corresponding percentage of premium, less a ceding commission as
compensation for underwriting costs incurred by the ceding company. Historically, USAuto has ceded a portion of its non-standard personal
automobile insurance premiums and losses to unaffiliated reinsurers in
accordance with these contracts. As of June 30, 2004, we had in place a quota
share treaty whereby we ceded approximately 50% of the premiums written by the
insurance company subsidiaries. In addition, we maintained excess-of-loss
reinsurance coverage that provides coverage for certain catastrophic events.
However, as a result of available liquidity to increase the statutory capital
and surplus of the insurance company subsidiaries, effective September 1, 2004,
we have non-renewed the quota-share reinsurance treaty. Our insurance company subsidiaries are not licensed in the state of
Alabama. Therefore, through quota-share reinsurance, we currently assume 50% of
the premiums our managing general agency subsidiary writes there on behalf of
two other insurance companies. This arrangement will continue until such time
as we obtain an Alabama license for one of our insurance company subsidiaries. On June 30, 2004, our reinsurance recoverables totaled $12.3 million,
which consisted entirely of unpaid losses. Technology The effectiveness of our business model depends in part on the
effectiveness of our internally-developed technology system that supports our
operations. Our technology systems enable timely and efficient communication 6




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and data-sharing among the various segments of our integrated operations,
including our neighborhood sales offices, insurance underwriters and claims
processors. We believe that this sharing capability provides us with a
competitive advantage over many of our competitors, who must communicate with
unaffiliated premium finance companies and with a large number of independent
agents, many of whom use different record keeping and computer systems that may
not be fully compatible with the insurance companys systems. Sales Office Automation. We have emphasized standardization and
integration of the technology systems among our subsidiaries to 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 where policy information is added to our systems
with little additional handling. Our sales offices also have immediate on-line
access to current information on policies by a common computer interface or
through a distributed database downloaded from our central processing computer. We have taken steps to enhance the current sales office system and back
office integration. Systems currently in place include features enabling
neighborhood sales offices to process new business, renewals and endorsements
and issue policies, declaration pages and identification cards. Payment Processing. Most of our customers visit our sales offices at
least monthly to make a payment on their policies. 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 electronically all payment records to our Nashville
office. Typically, payments are automatically applied to the applicable
policies during the night following their collection in our sales offices. This
results in fewer notices of intent to cancel being generated and fewer policies
being cancelled that must be reinstated if a customers late payment is
processed after cancellation. We believe that our payment processing methods
reduce mailing costs and limit premature policy cancellations. Ratings A.M. Best, which rates insurance companies based on factors of concern to
policyholders, has rated our property and casualty insurance company
subsidiaries NR-2 (Insufficient Size or Operating Experience). This rating is
assigned to companies that do not meet A.M. Bests minimum size and/or
operating experience requirements. Although USAuto has operated as an insurance
company since 1995 and exceeds the minimum requirement for policyholders
surplus, we believe that we have received the NR-2 rating as a result of the
rapid growth within our insurance company subsidiaries, which has likely
resulted in insufficient operating experience for A.M. Best to adequately
evaluate our financial performance. On August 13, 2004, our financial management met with A.M. Best to discuss
obtaining a rating this year. It is likely that during or shortly after
October, 2004, our insurance company subsidiaries will receive a rating from
A.M. Best. Regulatory Environment Insurance Regulation Generally. We and our insurance company subsidiaries
are regulated by governmental agencies in the states in which we conduct
business and by various federal statutes and regulations. 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; 7




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
    
    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 and our subsidiaries operate under licenses issued
by various state insurance 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 motor club 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
following 22 states: Arizona, Arkansas, Colorado, Florida, Georgia, Illinois,
Indiana, Iowa, Kansas, Kentucky, Louisiana, Mississippi, Missouri, New Mexico,
Ohio, Oklahoma, Pennsylvania, South Carolina, Tennessee, Texas, Utah and West
Virginia. In addition, as required by our current operations, we hold a managing
general agency license in Alabama and motor club licenses in Alabama,
Mississippi and Tennessee. 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. Insurance Holding Company Regulation. We operate as an insurance holding
company system and are subject to regulation in the jurisdictions in which our
insurance company subsidiaries conduct business. These regulations require that
each insurance company in the holding company 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 holding company domiciled in that state. We have insurance company
subsidiaries that are organized and domiciled under the insurance statutes of
both Georgia and Tennessee. The insurance laws in each of these states
similarly provide that all transactions among members of a holding company
system be done at arms length and be shown to be fair and reasonable to the
regulated insurer. Transactions between insurance company subsidiaries and
their parents and affiliates typically 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. In
general, any person who acquires 10% or more of the outstanding voting
securities of the insurer or its parent company is presumed to have acquired
control of the domestic insurer. To the best of our knowledge, we are in
compliance with these regulations. Restrictions on Paying Dividends. In the future, we may need to rely, in
part, on receiving dividends from our insurance company subsidiaries to meet
cash requirements. State insurance regulatory authorities require insurance
companies to maintain specified levels of statutory capital and surplus. The
amount of an insurers capital and 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 its insurance company
subsidiaries to declare and pay extraordinary dividends. The payment of
dividends is limited by the amount of capital and 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 company
subsidiaries may in the future adopt statutory provisions more restrictive than
those currently in effect. See note 8 to the consolidated financial statements
for a discussion of the insurance company subsidiaries dividend-paying ability. Regulation of Rates and Policy Forms. Most states in which our insurance
company 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 8




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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 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 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. To the best of our knowledge,
we are in compliance with all such applicable rate regulations. Shared or Residual Markets. As a condition of maintaining our automobile
insurance licenses to do business in various states, we, like other insurers,
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. To the extent required, we have participated in these mandatory shared
market mechanisms or state pooling arrangements. While this mandated business
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 company 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 policyholders surplus and, in some instances, would require
divestiture. If a non-conforming asset is treated as a non-admitted asset, it
would lower the affected subsidiarys policyholders surplus and thus, its
ability to write additional premiums and pay dividends. To the best of our
knowledge, our insurance company subsidiaries are in compliance with all such
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 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. To the best of our knowledge, we are in compliance with such laws and
regulations. 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
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. To the best of our
knowledge, we are in compliance with such privacy laws and regulations. 9




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Licensing of Our Employee-Agents and Adjustors.To the extent required,
all of our employees who sell, solicit or negotiate insurance are 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 and to the extent it is required, our insurance claims
adjusters are also required to be licensed and are subject to annual continuing
education requirements. Unfair 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 regarding 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 claims 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 that 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 settle claims promptly, 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. Periodic Financial and Market Conduct Examinations. The state insurance
departments that have jurisdiction over our insurance company 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 remedial, injunctive or other corrective action on the part of the
company that is the subject of the examination. USAuto Insurance Company has
been examined by the Tennessee Department of Commerce and Insurance for
financial condition through December 31, 2001 and for market conduct through
December 31, 2003. Village Auto Insurance Company commenced operations in
October 2002 and has yet to be examined by the Georgia Department of Insurance.
In addition, none of our insurance company subsidiaries has ever been the
subject of a target examination. Risk Based Capital. In order to enhance the regulation of insurer
solvency, the National Association of Insurance Commissioners, or NAIC, has
adopted a formula and model law to implement risk based capital, or 10




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RBC, requirements designed to assess the minimum amount of statutory 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 based on 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 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, all
of our insurance company subsidiaries maintained an RBC level that is in excess
of an amount that would require any corrective actions on its part. RBC is a comprehensive financial analysis system affecting nearly all
types of licensed insurers, including us and our subsidiaries. It is designed
to evaluate the relative financial condition of the insurer by application of a
weighting formula to the companys assets and its policyholder obligations. The
key RBC calculation is to recast total surplus, after application of the RBC
formula, in terms of an authorized control level RBC. Once the authorized
control level RBC is determined, it is contrasted against the companys total
adjusted capital. A high multiple generally indicates stronger capitalization
and financial strength, while a lower multiple reflects lesser capitalization
and strength. Each states statutes also create certain RBC multiples at which
either the company or the regulator must take action. For example, there are
four defined RBC levels that trigger different regulatory events. The minimum
RBC level is called the company action level RBC and is generally defined as
the product of 2.0 and the companys authorized control level RBC. The
authorized control level RBC is a number determined under the risk-based
capital formula in accordance with certain RBC instructions. Next is a
regulatory action level RBC, which is defined as the product of 1.5 and the
companys authorized control level RBC. Below the regulatory action level RBC
is the authorized control level RBC. Finally, there is a mandatory control
level RBC, which means the product of 0.70 and the companys authorized control
level RBC. As long as the companys total adjusted capital stays above the company
action level RBC (i.e., at greater than 2.0 times the authorized control level
RBC), regulators generally will not take any corrective action. However, if an
insurance companys total adjusted capital falls below the company action level
RBC, but remains above the regulatory action level RBC, the company is required
to submit an RBC plan to the applicable state regulator(s) that identifies the
conditions that contributed to the substandard RBC level and identifies a
remediation plan to increase the companys total adjusted capital above 2.0
times its authorized control level RBC. If a companys total adjusted capital
falls below its regulatory action level RBC but remains above its authorized
control level RBC, then the regulator may require the insurer to submit an RBC
plan, perform a financial examination or analysis on the companys assets and
liabilities, and may issue an order specifying corrective action for the
company to take to improve its RBC number. In the event an insurance companys
total adjusted capital falls below its authorized control level RBC the state
regulator may require the insurer to submit an RBC plan or may place the
insurer under regulatory supervision. If an insurance companys total adjusted
capital were to fall below its mandatory control level RBC, the regulator is
obligated to place the insurer under regulatory control, which could ultimately
include, among other actions, administrative supervision, rehabilitation or
liquidation. As of December 31, 2003, USAuto Insurance Companys total adjusted capital
was 2.9 times its authorized control level RBC, requiring no corrective action
on USAuto Insurance Companys part. As of December 31, 2003, Village Auto
Insurance Companys total adjusted capital was 2.4 times its authorized control
level RBC, requiring no corrective action on Village Auto Insurance Companys
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 11




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insurance 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, USAuto Insurance Company had one IRIS ratio
outside the usual range and Village Auto Insurance Company had four IRIS ratios
outside the usual range as follows:  
    
    Both had ratios outside the usual range for low investment
yields as their calculated yields were below 4.5%. The calculated
yields for USAuto Insurance Company and Village Auto Insurance were
2.1% and 2.2%, respectively. Such yields are based upon simple
annual averages and do not take into account any weighing for the
fact that the companies increased their invested assets
significantly during the year. In addition, the 4.5% yield is not
reflective of current market rates for the tax-free municipal bonds
which the companies recently have purchased as their invested assets
have increased through increased premium writings and additional
capital and surplus.
    
    Village Auto Insurance Company had a ratio result outside of
the usual range for growth in net premiums written as it exceeded
33%. Net premiums written increased 521% as 2003 represented its
first full year of operations since commencing business in October
2002.
    
    Village Auto Insurance Company had a ratio outside of the
usual range for growth in capital and surplus as its growth exceeded
50%. Village Auto Insurance Company increased its capital and
surplus by 108% primarily through capital contributions to support
its premium growth.
    
    Village Auto Insurance Company had a ratio outside of the
usual range for the estimated current reserve deficiency to
policyholders surplus as it exceeded 25%. The actual ratio was 27%.
This estimate produced a result outside of the range primarily due
to the fact that Village Auto Insurance Company only started writing
business in October 2002 and the estimated reserve deficiency was
calculated on a small premium base in 2002 and applied to a full
years premium base in 2003. These IRIS results were provided to regulators on February 25, 2004 and
since such date no regulatory action has been taken nor is any such action
anticipated. Employees As of June 30, 2004, we had approximately 475 employees. Our employees
are not covered by any collective bargaining agreements. Available Information We file reports with the Securities and Exchange Commission, including
Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and other reports
from time to time. The public may read and copy any materials filed with the
SEC at the SECs Public Reference Room at 450 Fifth Street, NW, Washington, DC
20549. The public may obtain information about the operation of the Public
Reference Room online at www.sec.gov/info/edgar/prrrules.htm or by calling the
SEC at 1-800-SEC-0330. We are an electronic filer, and the SEC maintains an
Internet site at www.sec.gov that contains our reports, proxy and information
statements, and other information filed electronically. These website addresses are provided as inactive
textual references only, and information provided on those websites is not part of this report and is
therefore not incorporated by reference unless such information is otherwise
specifically referenced elsewhere in this report. 12




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Risk Factors Our ability to use net operating loss carryforwards to reduce future tax
payments may be limited. Based on our calculations prepared in consultation with our internal tax
advisors, and in accordance with the rules stated in the Internal Revenue Code
of 1986, as amended, we do not believe that any ownership change, as
described in the following paragraph and as defined in Section 382 of the Code,
has occurred with respect to our net operating losses, or NOLs, and
accordingly we believe that there is no existing annual limitation under
Section 382 of the Code on our ability to use NOLs to reduce future taxable
income. We did not obtain, and currently do not plan to obtain, an IRS ruling
or opinion of counsel regarding either of these conclusions. Generally, an ownership change occurs if certain persons or groups
increase their aggregate ownership of our total capital stock by more than 50
percentage points in any three-year period. If an ownership change occurs, our
ability to use our NOLs to reduce income taxes is limited to an annual amount
(the Section 382 limitation) equal to the fair market value of our stock
immediately prior to the ownership change multiplied by the long term
tax-exempt interest rate, which is published monthly by the Internal Revenue
Service. In the event of an ownership change, NOLs that exceed the Section 382
limitation in any year will continue to be allowed as carryforwards for the
remainder of the carryforward period and such excess NOLs can be used to offset
taxable income for years within the carryforward period subject to the Section
382 limitation in each year. Regardless of whether an ownership change occurs,
the carryforward period for NOLs is either 15 or 20 years from the year in
which the losses giving rise to the NOLs were incurred, depending on when those
losses were incurred. The earliest losses that gave rise to our NOLs were
incurred in 1990 and will expire in 2005. The most recent losses that gave rise
to our NOLs were incurred in 2004 and will expire in 2024. If the carryforward
period for any NOL were to expire before that NOL had been fully utilized, the
use of the unutilized portion of that NOL would be permanently prohibited. Our
use of new NOLs arising after the date of an ownership change would not be
affected by the Section 382 limitation, unless there were another ownership
change after those new NOLs arose. It is impossible for us to ensure that an ownership change will not occur
in the future. In addition, limitations imposed by Code Section 382 and the
restrictions contained in our certificate of incorporation may prevent us from
issuing additional stock to raise capital or acquire businesses or properties.
To the extent not prohibited by our certificate of incorporation, we may decide
in the future that it is necessary or in our interest to take certain actions
that could result in an ownership change. Application of Code Section 269 Code Section 269 permits the IRS to disallow any deduction, credit or
allowance, including the utilization of NOLs, that otherwise would not be
available but for the acquisition of control of a corporation, including
acquisition by merger, for the principal purpose of avoiding federal income
taxes, including avoidance through the use of NOLs. If the IRS were to assert
that the principal purpose of the USAuto acquisition was the avoidance of
federal income tax, we would have the burden of proving that this was not the
principal purpose. The determination of the principal purpose of a transaction
is purely a question of fact and requires an analysis of all the facts and
circumstances surrounding the transaction. Courts generally have been reluctant
to apply Code Section 269 where a reasonable business purpose existed for the
timing and form of the transaction, even if the availability of tax benefits
was also an acknowledged consideration in the transaction. We think that Code
Section 269 should not apply to the acquisition of USAuto because we can show
that genuine business purposes existed for the USAuto acquisition and that tax
avoidance was not the principal purpose for the merger. Our primary objective
of the merger was to seek long-term growth for our stockholders through an
acquisition. To that end, we redeployed a significant amount of our existing
capital and offered our existing stockholders the right to make a substantial
additional investment in the company to facilitate the acquisition of USAuto.
If, nevertheless, the IRS were to assert that Code Section 269 applied and if
such assertion were sustained, our ability to utilize our existing NOLs would
be severely limited or extinguished. Due to the fact that the application of
Code Section 269 is ultimately a question of fact, there can be no assurance
that the IRS would not prevail if it were to assert the application of Code
Section 269. 13




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Our losses and loss adjustment expenses may exceed our reserves, which would
adversely impact our results of operations and financial condition. We maintain reserves for the estimated payment of losses and loss
adjustment expenses for both reported and unreported claims. The amount of
reserves is established and maintained based on historical claims information,
industry statistics and other factors. The establishment of appropriate
reserves is an inherently uncertain process due to 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
broader 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 income in the period that the deficiency is recognized. Due to the
inherent uncertainty of estimating reserves, it may be necessary to revise
estimated future liabilities as reflected in our reserves for loss and loss
adjustment expenses The historic development of reserves for losses and loss
adjustment expenses may not necessarily reflect future trends in the
development of these amounts. Consequently, actual losses could materially
exceed loss reserves, which would have a material adverse effect on our results
of operations and financial condition. The loss of our President and Chief Executive Officer, Stephen J. Harrison,
could negatively affect our ability to conduct our business efficiently and
could lead to loss of customers and proprietary information. Our success is largely dependent on the skills, experience, effort and
performance of our President and Chief Executive Officer, Stephen J. Harrison.
The loss of the services of Mr. Harrison could have a material adverse effect
on us and could hinder our ability to implement our business strategy
successfully. We have an employment agreement with Mr. Harrison that is renewed
each year. We also maintain a key man insurance policy for Mr. Harrison. 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 believe that our primary insurance company competition comes
not only from national insurance companies or their subsidiaries, but also from
non-standard insurers and independent agents that operate in a specific region
or single state in which we also operate. Allstate Insurance Company,
Progressive Corporation and Direct General Corporation are all significant
providers of non-standard personal automobile insurance in Alabama (excepting
Direct General Corporation), Georgia and Tennessee and constitute our largest
competitors. Some of our competitors have substantially greater financial and other
resources, and they may offer a broader range of products or competing products
at lower prices. Our revenues, profitability and financial condition could be
materially adversely affected if we had to lower prices to stay competitive or
if a significant number of our current and prospective customers were instead
to buy insurance from our competitors. Our business may be adversely affected by negative developments in Georgia,
Alabama, and Tennessee. For the two months ended June 30, 2004, approximately 50%, 20% and 19% of
our gross premiums written were generated from non-standard personal automobile
insurance policies written in Georgia, Tennessee and Alabama, respectively. Our
revenues and profitability are affected by the prevailing regulatory, economic,
demographic, competitive and other conditions in these states. Changes in any
of these conditions could make it more costly or difficult for us to conduct
business. Adverse regulatory developments in Georgia, Tennessee and Alabama,
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 reduce
our revenues, increase our expenses or otherwise have a material adverse effect
on our results of operations and financial condition. In addition, these
developments could have a greater effect on us, as compared to more
diversified insurers that also sell other types of automobile insurance
products, write other additional lines of insurance coverages or whose premiums
are not as concentrated in a single line of insurance. 14




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Our business may be adversely affected by negative developments in the
non-standard personal automobile insurance industry. Substantially all of our gross premiums written are 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 reduce our revenues, increase our expenses
or otherwise 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 or write other additional lines of insurance. Our business may be adversely affected by the general tendency of our customers
to incur above-average losses and to experience more frequent losses. Non-standard automobile insureds generally have above-average losses and
experience more frequent losses than standard automobile insureds. If we do not
compensate for the additional exposure by adjusting premiums to reflect the
additional risks and by issuing policies primarily for minimum liability
limits, we could incur losses which would result in a material adverse effect
on our results of operations and financial condition. Our results may fluctuate as a result of cyclical changes in the personal
automobile insurance industry. The non-standard 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. If new competitors enter this market,
existing competitors may attempt to increase market share by lowering rates.
Such conditions could lead to reduced prices, which would negatively impact our
revenues and profitability. However, we believe that during 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. In 2004, we witnessed a stabilization of
premiums and rates across most states. Given the cyclical nature of the
industry, current favorable pricing and competitive conditions may change,
which may cause us to reduce rates or to lose customers. There are risks associated with the non-renewal of our quota share reinsurance
that could impact our results of operations and financial condition. Historically, USAuto utilized reinsurance to leverage its surplus to
increase its underwriting capacity to write additional premiums. Therefore,
its historical financial results reflect to some degree stabilization of
results from the effect of sharing premiums and losses with the reinsurer.
Recently, we have carefully examined the costs and benefits of the current
quota share reinsurance program and determined that it was no longer essential
due to the additional capital available as a result of our acquisition of
USAuto. While management believes its pricing, underwriting discipline and
claims practices will control the level of losses incurred, it is possible that
losses could exceed expected levels thereby reducing income and statutory
capital and surplus. This would require either a reduction in premium writings
or entering into a new quota share reinsurance contract, at potentially less
favorable terms than reflected in the existing quota share reinsurance
contract, as a result of changing market conditions. 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 on the proprietary integrated technology
systems that enable timely and efficient communication and data sharing among
the various segments of our integrated operations. These systems are used in
all our operations, including quotation, policy issuance, customer service,
underwriting, claims, accounting, and communications. We have a technical
staff that develops, maintains and supports all elements of the technology
infrastructure. However, disruption of power systems or telecommunication
systems could result in deterioration in our ability to respond to customers
requests, write and service new business, and process claims in a timely
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We have secured appropriate types and levels of insurance to protect our
real property, systems, and other assets. However, insurance does not provide
full indemnification for all losses, both direct and indirect, that may result
from such an event. We have developed disaster recovery plans and redundancy
in systems designed to mitigate or eliminate the ramifications of disruptions
in power and telecommunication services. We may have difficulties in managing our expansion into new markets. Our future growth plans include expanding into new states by opening new
sales offices, acquiring the business and assets of local agencies and
introducing additional insurance products. In order to grow our business
successfully, we must apply for and maintain necessary licenses, properly
design and price our products, and identify, hire and train new claims,
underwriting and sales employees. In this regard, we currently have
applications for licenses to conduct insurance business pending in several
states and cannot state with certainty if any or all such applications will be
approved. Our expansion will also place significant demands on our management,
operations, systems, accounting, internal controls and financial resources. If
we fail to do any of these, we may not be able to expand our business
successfully. Even if we successfully complete an acquisition, we face the risk
that we may acquire business in states in which market and other conditions may
not be favorable to us. Any failure by us to manage growth and to respond to
changes in our business could have a material adverse effect on our business,
financial condition and results of operations. We may not be successful in identifying agency acquisition candidates or
integrating their operations, which could harm our financial results. In order to grow our business by acquisition, we must identify agency
candidates and integrate the operations of acquired agencies. If we are unable
to identify and acquire appropriate agency acquisition candidates, we will
experience slower growth, and it will be more difficult to expand into new
states. If we do acquire additional agencies, we could face increased costs,
or, if we are unable to successfully integrate the operations of the acquired
agency into our operations, we could experience disruption of our business and
distraction of our management, which may not be offset by corresponding
increases in revenues. The integration of operations after an acquisition is
subject to risks commonly encountered in making such acquisitions, including,
among others, loss of key personnel of the acquired company, difficulty
associated with assimilating the personnel and operations of the acquired
company, potential disruption of ongoing business, maintenance of uniform
standards, controls, procedures and policies and impairment of the acquired
companys reputation and relationships with its employees and clients. Any of
these may result in the loss of customers. It is also possible that we may not
realize, either at all or in a timely manner, any or all benefits from recent
and future acquisitions and may incur significant costs in connection with
these acquisitions. Failure to successfully integrate future acquisitions could
materially adversely affect the results of our operations. Our insurance company subsidiaries are subject to statutory capital and surplus
requirements and other standards, and their failure to meet these requirements
or standards could subject them to regulatory actions. Our insurance company subsidiaries are subject to risk-based capital
standards, which we refer to as RBC standards, and other minimum statutory
capital and surplus requirements imposed under the laws of their respective
states of domicile. The RBC standards, which are based upon the RBC Model Act
adopted by the National Association of Insurance Commissioners, or NAIC,
require our insurance company subsidiaries to annually report their results of
risk-based capital calculations to the state departments of insurance and the
NAIC. Failure to meet applicable risk-based capital requirements or minimum
statutory capital and surplus requirements could subject our insurance company
subsidiaries to further examination or corrective action imposed by state
regulators, including limitations on their writing of additional business,
state supervision or even liquidation. Any changes in existing RBC requirements
or minimum statutory capital and surplus requirements may require them to
increase their statutory capital and surplus levels, which they may be unable
to do. As of December 31, 2003, each of our insurance company subsidiaries
maintained an RBC level in excess of an amount that would require any
corrective actions on their part. State regulators also screen and analyze the financial condition of
insurance companies using the NAIC Insurance Regulatory Information System, or
IRIS. As part of IRIS, the NAIC database generates key financial ratio 16




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##### Table of Contents



results obtained from an insurers annual statutory statements. A ratio result
falling outside the usual range of IRIS ratios may result in further
examination by a state regulator to determine if corrective action is
necessary. As of December 31, 2003, each of our insurance company subsidiaries
had IRIS ratios outside the usual ranges, but no regulatory authority has
informed the insurance company subsidiaries that it intends to conduct a
further examination of their financial condition. See Business  Regulatory
Environment. New pricing, claim and coverage 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 and business practices may emerge. These issues can have an adverse
effect on our business by changing the way we price our products, extending
coverage beyond our underwriting intent, requiring us to obtain additional
licenses or increasing the size of claims. Recent examples of some emerging
issues include:  
    
    concerns over the use of an applicants credit score or zip code as
a factor in making risk selections and pricing decisions;
    
    a growing trend of plaintiffs targeting automobile insurers in
purported class action litigation relating to claims-handling
practices, such as total loss evaluation methodology and the alleged
diminution in value to insureds vehicles involved in accidents; and
    
    consumer groups lobbying state legislatures to regulate and require
separate licenses for individuals and companies engaged in the sale of
ancillary products or services. The effects of these and other unforeseen emerging issues could negatively
affect our revenues or our methods of doing business. Due to our largely fixed cost structure, our profitability may decline if our
sales volume were to decline significantly. Our reliance on employee-agents results in a fixed cost structure. In
times of increasing sales volume, our acquisition cost per policy decreases,
improving our expense ratio, 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 some employee-agents to manage our expenses. 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, tornados, windstorms,
earthquakes, hailstorms, 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 more automobile accidents, leading to an
increase in the number of claims filed and/or the amount of compensation sought
by claimants. In the event that a severe weather condition or other major catastrophe
were to occur resulting in property losses to us, we would have to cover such
losses using additional resources, which could increase our losses incurred,
cause our statutory capital and surplus to fall below required levels or
otherwise have a material adverse effect on our results of operations and
financial condition. We have purchased reinsurance for certain catastrophic
events, which may help limit our losses from such events. Based on our
geographical spread of risk, we had no exposure to significant losses as a
result of hurricanes Charley, Frances, Ivan and Jeanne, all of which occurred
in August and September 2004. 17




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##### Table of Contents



A few of our stockholders have significant control over us, and their interests
may differ from yours. Three of our stockholders, Gerald J. Ford, our Chairman of the Board;
Stephen J. Harrison, our President and Chief Executive Officer; and Thomas M.
Harrison, Jr., our Executive Vice President and Secretary; in the aggregate
control 62.2% of our outstanding common stock. If these stockholders acted or
voted together, they would have the power to exercise significant influence
over the election and removal of our directors. They would also have
significant control over other matters requiring stockholder approval,
including the approval of major corporate transactions and proposed amendments
to our certificate of incorporation covering the transfer restrictions on the
shares of our common stock. In addition, this concentration of ownership may
delay or prevent a change in control of our company, as well as frustrate
attempts to replace or remove current management, even when a change may be in
the best interests of our other stockholders. Furthermore, the interests of
these stockholders may not always coincide with the interests of our company or
other stockholders. Our insurance company subsidiaries are subject to regulatory restrictions on
paying dividends to us. State insurance laws limit the ability of our insurance company
subsidiaries to pay dividends and require our insurance company subsidiaries to
maintain specified minimum levels of statutory capital and surplus. Our
insurance company subsidiary in Tennessee is required by the Tennessee
Department of Commerce and Insurance to maintain statutory capital and surplus
of $2,000,000, and our insurance company subsidiary in Georgia is required by
the Georgia Department of Insurance to maintain statutory capital and surplus
of $3,000,000.These restrictions affect the ability of our insurance company
subsidiaries to pay dividends to us and may require our subsidiaries to obtain
the prior approval of regulatory authorities, which could slow the timing of
such payments to us or reduce the amount that can be paid. To the extent we
may need to rely, in part, on receiving dividends from the insurance company
subsidiaries, the limit on the amount of dividends that can be paid by the
insurance company subsidiaries may affect our ability to pay dividends to our
stockholders. The dividend-paying ability of the insurance company
subsidiaries is discussed in note 8 to the consolidated financial statements. We and our subsidiaries are subject to comprehensive regulation and supervision
that may restrict our ability to earn profits. We and our subsidiaries are subject to comprehensive regulation and
supervision by the insurance departments in the states where our subsidiaries
are domiciled and where our subsidiaries sell insurance and ancillary products,
issue policies and handle claims. Certain regulatory restrictions and prior
approval requirements may affect our subsidiaries ability to operate, innovate
or obtain necessary rate adjustments in a timely manner or may increase our
costs and reduce profitability. Among other things, regulation and supervision of us and our subsidiaries
extends to: Required Licensing. We and our subsidiaries operate under licenses issued
by various state insurance authorities. These licenses govern, among other
things, the types of insurance coverages, agency and claims services and motor
club products that we and our subsidiaries may offer consumers in the
particular state. Such licenses typically are issued only after the filing of
an appropriate application and the satisfaction of prescribed criteria. In
addition, the licensing procedures of the states in which we and our
subsidiaries operate differ somewhat from state-to-state. We and our
subsidiaries must determine which licenses, if any, are required in a
particular state and apply for and obtain the appropriate licenses before they
can implement any plan to expand into a new state or offer a new line of
insurance or other new product. If a regulatory authority denies or delays
granting such new license, our ability to enter new markets quickly or offer
new products can be substantially impaired. Transactions Between Insurance Companies and Their Affiliates. Our
insurance company subsidiaries are organized and domiciled under the insurance
statutes of Georgia and Tennessee. The insurance laws in these states provide
that all transactions among members of an insurance holding company system must
be done at arms length and shown to be fair and reasonable to the regulated
insurer. Transactions between our insurance company subsidiaries and other
subsidiaries 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. 18




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##### Table of Contents



Regulation of Rates and Policy Forms. The insurance laws of most states
in which our insurance company subsidiaries operate require insurance companies
to file premium rate schedules and 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 in response to market conditions or 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 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. Investment Restrictions. Our insurance company 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 capital and surplus and, in some instances, would require
divestiture. If a non-conforming asset is treated as a non-admitted asset, it
would lower the affected subsidiarys capital and surplus and thus, its ability
to write additional premiums and pay dividends. 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. Provisions in our certificate of incorporation and bylaws may prevent a
takeover or a change in management that you may deem favorable. Our certificate of incorporation contains prohibitions on the transfer of
our common stock to avoid limitations on the use of the NOL carryforwards and
other federal income tax attributes that we inherited from our predecessor.
These restrictions could prevent or inhibit a third party from acquiring us.
Our certificate of incorporation generally prohibits, without the prior
approval of our board of directors, any transfer of common stock, any
subsequent issue of voting stock or stock that participates in our earnings or
growth, and certain options with respect to such stock, if the transfer of such
stock or options would (i) cause any group or person to own 4.9% or more, by
aggregate value, of the outstanding shares of our common stock, (ii) increase
the ownership position of any person or group that already owns 4.9% or more,
by aggregate value, of the outstanding shares of our common stock, or (iii)
cause any person or group to be treated like the owner of 4.9% or more, by
aggregate value, of our outstanding shares of common stock for tax purposes. Our certificate of incorporation and bylaws also contain the following
provisions that could prevent or inhibit a third party from acquiring us:  
    
    the requirement that only stockholders owning at least one-third of
the outstanding shares of our common stock may call a special
stockholders meeting; and
    
    the requirement that stockholders owning at least two-thirds of the
outstanding shares of our common stock must approve any amendment to
our certificate of incorporation provisions concerning the transfer
restrictions and the special stockholders meetings. In addition, under our certificate of incorporation, we may issue shares
of preferred stock on terms that are unfavorable to the holders of our common
stock. Any outstanding shares of preferred stock could also prevent or 19




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##### Table of Contents



inhibit a third party from acquiring us. The existence of these provisions
could depress the price of our common stock, could delay or prevent a takeover
attempt or could prevent attempts to replace or remove incumbent management Executive Officers The following table sets forth certain information concerning our
executive officers: Name
    
    Age
    
    PositionStephen J. Harrison
    
    52
    
    President and Chief Executive OfficerThomas M. Harrison, Jr.
    
    54
    
    Executive Vice President and SecretaryCharles D. Hamilton
    
    48
    
    Senior Vice President, Chief Financial Officer and TreasurerMichael J. Bodayle
    
    48
    
    Chief Financial Officer - Insurance Company OperationsWilliam R. Pentecost
    
    46
    
    Chief Information OfficerRandy L. Reed
    
    48
    
    Senior Vice President  Sales and MarketingJames R. Dickson
    
    38
    
    Senior Vice President  Claims
 Stephen J. Harrisonhas served as President and Chief Executive Officer of
the company since April 2004. Mr. Harrison co-founded USAuto Insurance
Company, Inc., USAutos predecessor company, in 1995 and has served as
President and Chief Executive Officer of USAuto since USAutos inception. He
has over 30 years experience in insurance and related industries, including
automobile insurance and insurance agency operations. From 1974 to 1991, he
served in various capacities with the Harrison Insurance Agency, a family-owned
multi-line insurance agency. From 1991 to 1993, Mr. Harrison served as
President of Direct Insurance Company, a non-standard automobile insurance
company. Mr. Harrison is the brother of Thomas M. Harrison, Jr., who is
Executive Vice President and Secretary of the Company. Thomas M. Harrison, Jr.has served as Executive Vice President and
Secretary of the company since April 2004. Mr. Harrison co-founded USAuto
Insurance Company, Inc., USAutos predecessor company, in 1995 and has served
as Vice President and Secretary of USAuto since USAutos inception. He has over
30 years experience in insurance and related industries, including automobile
insurance and insurance agency operations. From 1976 to 1995, Mr. Harrison
served in various capacities with the Harrison Insurance Agency, a family-owned
multi-line insurance agency. Mr. Harrison is the brother of Stephen J.
Harrison, who is President and Chief Executive Officer of the Company. Charles D. Hamiltonhas served as Senior Vice President, Chief Financial
Officer and Treasurer of the company since April 2004. Mr. Hamilton was
appointed in March 2004 as USAutos Treasurer and Chief Financial Officer. He
has over 25 years of experience in the insurance industry. From 1986 until
2004, Mr. Hamilton held various executive financial and administrative roles at
Willis Group Holdings, including Chief Financial Officer for the U.S.
subsidiary from 1996 until 2003. From 1979 until 1984, Mr. Hamilton was a
commercial insurance underwriter for Federated Mutual Insurance of Owatonna,
Minnesota. He is also a Certified Public Accountant and a Chartered Property
Casualty Underwriter. Michael J. Bodaylehas served as Chief Financial Officer  Insurance
Company Operations of the company since April 2004. Mr. Bodayle has been
Treasurer and Chief Financial Officer of the insurance company subsidiaries
since March 2004 and was USAutos Treasurer and Chief Financial Officer since
July 1998. He has over 25 years of experience focused primarily in the
insurance industry, which includes auditing, financial reporting and insurance
agency operations. He has over seven years of public accounting experience and
was formerly a Senior Audit Manager with Peat, Marwick, Main (now known as
KPMG) from 1980 to 1985. From 1985 until 1996, Mr. Bodayle was Treasurer and
Chief Financial Officer for Titan Holdings, Inc., a publicly-traded insurance
holding company. Mr. Bodayle is also a Certified Public Accountant. William R. Pentecosthas been Chief Information Officer of the company
since April 2004. Mr. Pentecost has been USAutos Chief Information Officer
since USAutos inception in 1995. He has over 15 years experience 20




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##### Table of Contents



with insurance company information systems with both Graward General and
Direct Insurance Company. He is also a Chartered Property Casualty
Underwriter. Randy L. Reedhas been Senior Vice President  Sales and Marketing of the
company since April 2004. Mr. Reed has been USAutos Vice President  Sales
and Marketing since February 1997. He previously spent over ten years as
co-owner and President of Reed Oil Company, Inc., a wholesaler and retailer
involved in the oil jobber business. James R. Dicksonhas been Senior Vice President  Claims of the company
since April 2004. Mr. Dickson has been USAutos Vice President  Claims since
June 2000. From 1996 to 2000, Mr. Dickson was a principal in the Dickson
Company, a claims management company. Prior to that, Mr. Dickson had over eight
years of multi-line claims experience with Cunningham Lindsay, U.S. and the
Littleton Group. 
 Item 2. Properties Our principal executive offices are located in approximately 44,000 square
feet of office space located at 3813 Green Hills Village Drive, Nashville,
Tennessee and are occupied by us under a lease agreement expiring December 31,
2011. Our retail locations typically are located in leased storefronts in
retail shopping centers, and each location contains less than 1,000 square feet
of space. The leases for our retail locations are generally for terms of less
than three years. 
 Item 3. Legal Proceedings Our subsidiaries are named from time to time as defendants in various
legal actions that are incidental to their business and arise out of or are
related to claims made in connection with their insurance policies, claims
handling 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. 
 Item 4. Submission of Matters to a Vote of Security Holders The following five matters were submitted to a vote at a special meeting
of our stockholders on April 30, 2004:  
    
    the issuance of 13,250,000 shares of common stock to certain of the
then current owners of USAuto as partial consideration for the
acquisition of USAuto that were issued at the time of the closing of
the acquisition of USAuto and up to an additional 750,000 shares that
may be issued at a later date if certain financial targets are reached.
The voting results were as follows: FOR
    
    AGAINST
    
    WITHHELD14,181,077
    
    
    40,699
    
    
    
    27,911
  
    
    the issuance and sale of our common stock in the rights offering of
up to 5,711,271 shares to Hunters Glen/Ford and certain other
affiliates of Gerald J. Ford, Chairman of the Board of Directors, and
up to 6,848,281 shares of our common stock, to Hunters Glen/Ford under
a backstop arrangement, at the subscription price, if no other
stockholders purchase shares in the rights offering. The voting
results were as follows: FOR
    
    AGAINST
    
    WITHHELD14,176,295
    
    
    46,471
    
    
    
    26,921
 21




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##### Table of Contents




    
    amending our certificate of incorporation, which would, among other
things, change our name from Liberté Investors Inc. to First Acceptance
Corporation, increase our number of authorized shares of common stock
and require a supermajority vote to amend the number of directors which
constitute the entire board. The voting results were as follows: FOR
    
    AGAINST
    
    WITHHELD14,116,145
    
    
    107,119
    
    
    
    26,243
  
    
    an amendment to our 2002 Incentive Plan to increase the number of
shares of our common stock reserved for issuance under the plan. The
voting results were as follows: FOR
    
    AGAINST
    
    WITHHELD13,782,012
    
    
    314,228
    
    
    
    153,447
  
    
    election of two persons, Stephen J. Harrison and Thomas M.
Harrison, Jr., to our Board of Directors. The results were as follows: FOR
    
    AGAINST/WITHHELDStephen J. Harrison
    
    
    14,019,712
    
    
    
    229,975Thomas M. Harrison, Jr.
    
    
    14,019,612
    
    
    
    230,075
 The following members of our Board of Directors continued to serve as directors
following the special meeting: Gerald J. Ford, Donald J. Edwards, Gene H.
Bishop, Harvey B. Cash and Edward W. Rose, III. 22




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##### Table of Contents



PART II 
 Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities Trading Prices Our common stock is currently quoted on the New York Stock Exchange under
the symbol FAC. Prior to the merger with USAuto and our change of name to
First Acceptance Corporation, our common stock traded under the symbol LBI.
The following table sets forth quarterly high and low bid prices for our common
stock for the periods indicated based upon quotations periodically published on
the New York Stock Exchange. All price quotations represent prices between
dealers, without accounting for retail mark-ups, mark-downs or commissions and
may not represent actual transactions. Price RangeHigh
    
    LowYear Ended June 30, 2003First Quarter
    
    $
    4.85
    
    
    $
    3.40Second Quarter
    
    
    4.35
    
    
    
    3.80Third Quarter
    
    
    4.50
    
    
    
    3.91Fourth Quarter
    
    
    5.79
    
    
    
    3.94Year Ended June 30, 2004First Quarter
    
    $
    5.75
    
    
    $
    5.09Second Quarter
    
    
    7.45
    
    
    
    5.25Third Quarter
    
    
    9.35
    
    
    
    7.10Fourth Quarter
    
    
    8.05
    
    
    
    6.53
 According to the records of our transfer agent, there were 644 holders of
record of our common stock on September 22, 2004, including record holders such
as banks and brokerage firms who hold shares for beneficial holders, and
46,681,438 shares of our common stock were outstanding. Dividend Policy We paid no dividends during the two most recent fiscal years. We do not
anticipate paying cash dividends in the future. Any future determination to pay
dividends will be at the discretion of our Board of Directors and will depend
upon, among other factors, results of operations, financial condition, capital
requirements and contractual restrictions. Stock Transfer Restrictions Our certificate of incorporation (the Charter) contains prohibitions on
the transfer of our common stock to avoid limitations on the use of the NOL
carryforwards and other federal income tax attributes that we inherited from
the Trust. The Charter generally prohibits, without the prior approval of our
Board of Directors, any transfer of common stock, any subsequent issue of
voting stock or stock that participates in our earnings or growth, and certain
options with respect to such stock, if the transfer of such stock would cause
any group or person to own 4.9% or more (by aggregate value) of the outstanding
shares or cause any person to be treated like the owner of 4.9% or more (by
aggregate value) of the outstanding shares for tax purposes. Transfers in
violation of this prohibition will be void, unless our Board of Directors
consents to the transfer. If void, upon our demand, the purported transferee
must return the shares to our agent to be sold, or if already sold, the
purported transferee must forfeit some, or possibly all, of the sale proceeds.
In addition, in connection with certain changes in the ownership of the holders
of our shares, we may require the holder to dispose of some or all of such
shares. For this purpose, person is defined broadly to mean any individual,
corporation, estate, debtor, association, company, partnership, joint venture,
or similar organization. 23




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##### Table of Contents



Item 6. Selected Financial Data The following tables provide selected historical consolidated financial
and operating data of the Company 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 June 30, 2004 and 2003
and for the years ended June 30, 2004, 2003, and 2002 from our audited
consolidated financial statements included in this report. We derived our
selected historical consolidated financial data as of June 30, 2002, 2001 and
2000 and for the years ended June 30, 2001 and 2000 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. The actual results for the year ended June 30, 2004 reflect only the
results of USAutos operations since the date of acquisition (April 30, 2004).
The unaudited pro forma results for the years ended June 30, 2004 and 2003 give
effect to the USAuto acquisition and related transactions as if they had been
consummated on July 1, 2002. The assumptions used in developing the unaudited
pro forma results are further described in note 22 to the consolidated
financial statements. The unaudited pro forma results should not be considered indicative of
actual results that would have been achieved had the USAuto acquisition and
related transactions been consummated on July 1, 2002 and do not purport to
indicate results of operations for any future period. 24




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##### Table of Contents



Year Ended June 30,Actual
    
    Pro forma
    
    Actual
    
    Pro forma2004
    
    2004
    
    2003
    
    2003
    
    2002
    
    2001
    
    2000(in thousands, except per share data)Statement of Operations Data:Revenues:Premiums earned
    
    $
    11,728
    
    
    $
    57,716
    
    
    $
    
    
    
    $
    38,353
    
    
    $
    
    
    
    $
    
    
    
    $
    Commissions and fees
    
    
    4,401
    
    
    
    26,275
    
    
    
    
    
    
    
    33,462
    
    
    
    
    
    
    
    
    
    
    
    Ceding commissions from reinsurer
    
    
    1,925
    
    
    
    10,674
    
    
    
    
    
    
    
    6,952
    
    
    
    
    
    
    
    
    
    
    
    Gains on sales of foreclosed real estate
    
    
    4,147
    
    
    
    4,147
    
    
    
    233
    
    
    
    233
    
    
    
    139
    
    
    
    378
    
    
    
    119Investment income
    
    
    958
    
    
    
    1,431
    
    
    
    1,098
    
    
    
    1,289
    
    
    
    1,335
    
    
    
    2,922
    
    
    
    2,854Other
    
    
    (6
    )
    
    
    80
    
    
    
    
    
    
    
    148
    
    
    
    
    
    
    
    21
    
    
    
    Total revenues
    
    
    23,153
    
    
    
    100,323
    
    
    
    1,331
    
    
    
    80,437
    
    
    
    1,474
    
    
    
    3,321
    
    
    
    2,973Expenses:Losses and loss adjustment expenses
    
    
    7,167
    
    
    
    36,616
    
    
    
    
    
    
    
    25,905
    
    
    
    
    
    
    
    
    
    
    
    Insurance operating expenses
    
    
    7,194
    
    
    
    41,142
    
    
    
    
    
    
    
    35,962
    
    
    
    
    
    
    
    
    
    
    
    Other operating expenses
    
    
    6,235
    
    
    
    2,278
    
    
    
    2,637
    
    
    
    1,648
    
    
    
    988
    
    
    
    797
    
    
    
    742Stock-based compensation
    
    
    7,850
    
    
    
    
    
    
    
    546
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Depreciation and amortization
    
    
    648
    
    
    
    1,366
    
    
    
    10
    
    
    
    1,954
    
    
    
    6
    
    
    
    8
    
    
    
    13Interest expense
    
    
    44
    
    
    
    318
    
    
    
    
    
    
    
    29
    
    
    
    
    
    
    
    
    
    
    
    Total expenses
    
    
    29,138
    
    
    
    81,720
    
    
    
    3,193
    
    
    
    65,498
    
    
    
    994
    
    
    
    805
    
    
    
    755(Loss) income before income taxes
    
    
    (5,985
    )
    
    
    18,603
    
    
    
    (1,862
    )
    
    
    14,939
    
    
    
    480
    
    
    
    2,516
    
    
    
    2,218Income tax benefit (1)
    
    
    (2,189
    )
    
    
    6,983
    
    
    
    
    
    
    
    5,844
    
    
    
    
    
    
    
    
    
    
    
    Net (loss) income
    
    $
    (3,796
    )
    
    $
    11,620
    
    
    $
    (1,862
    )
    
    $
    9,095
    
    
    $
    480
    
    
    $
    2,516
    
    
    $
    2,218Basic net (loss) income per share
    
    $
    (0.15
    )
    
    $
    0.25
    
    
    $
    (0.09
    )
    
    $
    0.20
    
    
    $
    0.02
    
    
    $
    0.12
    
    
    $
    0.11Diluted net (loss) income per share
    
    $
    (0.15
    )
    
    $
    0.24
    
    
    $
    (0.09
    )
    
    $
    0.19
    
    
    $
    0.02
    
    
    $
    0.12
    
    
    $
    0.11Weighted average basic shares
    
    
    24,965
    
    
    
    46,405
    
    
    
    20,420
    
    
    
    46,229
    
    
    
    20,256
    
    
    
    20,256
    
    
    
    20,256Weighted average diluted shares
    
    
    24,965
    
    
    
    47,883
    
    
    
    20,420
    
    
    
    46,985
    
    
    
    20,256
    
    
    
    20,256
    
    
    
    20,256Cash dividend declared per share of common stock
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    0.006
    
    
    $
    0.125
    
    
    $
    0.094
 Year Ended June 30,2004
    
    2003
    
    2002
    
    2001
    
    2000(in thousands, except per share data)Balance Sheet Data:Fixed maturities, available for sale
    
    $
    33,243
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Cash and cash equivalents
    
    
    38,352
    
    
    
    56,847
    
    
    
    56,510
    
    
    
    56,103
    
    
    
    55,888Foreclosed real estate held for sale
    
    
    1,108
    
    
    
    1,594
    
    
    
    2,175
    
    
    
    2,359
    
    
    
    2,462Deferred tax asset
    
    
    45,493
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Goodwill and identifiable intangible asset
    
    
    102,914
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total assets
    
    
    285,667
    
    
    
    59,053
    
    
    
    58,919
    
    
    
    58,564
    
    
    
    58,475Loss and loss adjustment expense reserves
    
    
    30,434
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Unearned premiums
    
    
    33,433
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Note payable
    
    
    4,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total liabilities
    
    
    91,441
    
    
    
    978
    
    
    
    528
    
    
    
    531
    
    
    
    427Total stockholders equity
    
    
    194,226
    
    
    
    58,075
    
    
    
    58,391
    
    
    
    58,033
    
    
    
    58,048Book value per share
    
    $
    4.17
    
    
    $
    2.82
    
    
    $
    2.88
    
    
    $
    2.86
    
    
    $
    2.87
 25




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##### Table of Contents



Year EndedJune 30, 2004GAAP Combined Ratios (Insurance Companies)
    
    Actual
    
    Pro formaLoss and loss adjustment expense
    
    
    61.1
    %
    
    
    63.4
    %Expense (2)
    
    
    13.7
    %
    
    
    15.8
    %74.8
    %
    
    
    79.2
    %
   (1)
    
    There was no income tax expense (benefit) recorded for the years
presented prior to the year ended June 30, 2004 because we had NOLs
available to offset federal taxable income for which a full valuation
allowance had been established. For financial reporting purposes, the
benefit resulting from the utilization of NOLs directly offsets federal
income taxes that would have otherwise been payable.(2)
    
    Insurance operating expenses are reduced by fee income from insureds
and ceding commissions received from our reinsurer as compensation for the
costs incurred on servicing the business on their behalf. 26




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##### Table of Contents



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 Factors. General Prior to our April 30, 2004 acquisition of USAuto Holdings, Inc., we were
engaged in pursuing opportunities to acquire one or more operating companies in
order to increase value to existing stockholders and provide us with a new
focus and direction. In addition, we marketed for sale a portfolio of
foreclosed real estate. We will continue to market the remaining real estate
held (six tracts of land in San Antonio, Texas) and will attempt to sell it on
a basis that provides us with the best economic return. New investments in real
estate are not anticipated. In addition, our acquisition opportunities will
most likely be limited to those that would be related to the insurance
operations. As a result of the USAuto acquisition, we are now principally a retailer,
servicer and underwriter of non-standard personal automobile insurance, based
in Nashville, Tennessee. Non-standard personal automobile insurance is made
available to individuals who are categorized as non-standard because of their
inability or unwillingness to obtain standard insurance coverage due to various
factors, including payment history, payment preference, failure in the past to
maintain continuous insurance coverage, driving record and/or vehicle type, and
in most instances who are required by law to buy a minimum amount of automobile
insurance. As of September 1, 2004, we owned and operated 146 retail locations,
staffed by employee-agents. Our employee-agents exclusively sell insurance
products either underwritten or serviced by us. We currently write
non-standard personal automobile insurance in seven states: Georgia,
Tennessee, Alabama, Mississippi, Ohio, Missouri and Indiana. We are also
licensed as an insurer in 16 additional states. Our consolidated financial statements now vary in important respects from
our historical consolidated financial statements due to the acquisition of
USAuto. For the year ended June 30, 2004, the recorded financial results
reflect twelve months of our previous operations, but only the two months of
results of the insurance operations since the April 30, 2004 acquisition date.
Our future operating results will be more reflective of those of a
fully-integrated retailer, servicer and underwriter of non-standard personal
automobile insurance. The acquisition of USAuto was accounted for using the purchase method of
accounting. The consideration consisted of $76.0 million in cash, 13,250,000
shares of our common stock issued at closing and up to an additional 750,000
shares that may be issued at a later date if certain financial targets are
reached at the end of calendar year 2004. The aggregate purchase price of
$160.1 million was allocated to the tangible and intangible assets acquired and
the liabilities assumed based upon their respective fair values as of the date
of the acquisition. Total goodwill and identifiable intangible assets recorded
from the acquisition were $103.3 million, which was net of a $41.3 million
reduction in our deferred tax allowance based upon our projections of USAutos
future taxable income. Of the purchase price, $1.2 million was allocated to an
identifiable intangible asset relating to future policy renewals existing as of
April 30, 2004. This asset is amortizable and resulted in amortization expense
of $0.4 million for the year ended June 30, 2004. Amortization expense for the
years ended June 30, 2005 and 2006 will be $0.7 million and a $0.1 million,
respectively. Our results for the year ended June 30, 2004 included expenses that will
be discontinued as a result of the acquisition of USAuto. These principally
include compensation to employees who were terminated in connection with the
acquisition. Future periods will also include the cost of the advisory services
agreement with an entity controlled by Donald J. Edwards, our former Chief
Executive Officer, as described in note 17 to the consolidated financial
statements. These items have been incorporated into the presentation of pro
forma operating results for the years ended June 30, 2004 and 2003, which
assume that the acquisition of USAuto occurred on July 1, 2002. See note 22 to
the consolidated financial statements. 27




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##### Table of Contents



Consolidated Results of Operations Overview For the year ended June 30, 2004, the consolidated financial statements
include the results of our acquisition activities and the real estate
operations for the full year, and the results of our insurance operations for
the two months since the date of the USAuto acquisition. In addition to the
actual results, we will also discuss pro forma operating results that assume
that the USAuto acquisition occurred on July 1, 2002. We will also separately
discuss both the results of the real estate and corporate activities and the
insurance operations. Such segment information is summarized below on both an
actual and pro forma basis for the periods presented. Actual
    
    Pro formaYear Ended June 30,
    
    Year Ended June 30,Insurance
    
    2004
    
    2003
    
    2004
    
    2003Revenues:Premiums earned
    
    $
    11,728
    
    
    $
    
    
    
    $
    57,716
    
    
    $
    38,353Commissions and fees
    
    
    4,401
    
    
    
    
    
    
    
    26,275
    
    
    
    33,462Ceding commissions from reinsurer
    
    
    1,925
    
    
    
    
    
    
    
    10,674
    
    
    
    6,952Investment income
    
    
    180
    
    
    
    
    
    
    
    1,007
    
    
    
    545Other
    
    
    (6
    )
    
    
    
    
    
    
    80
    
    
    
    148Total revenues
    
    
    18,228
    
    
    
    
    
    
    
    95,752
    
    
    
    79,460Expenses:Losses and loss adjustment expenses
    
    
    7,167
    
    
    
    
    
    
    
    36,616
    
    
    
    25,905Operating expenses
    
    
    7,194
    
    
    
    
    
    
    
    41,142
    
    
    
    35,962Depreciation and amortization
    
    
    608
    
    
    
    
    
    
    
    1,366
    
    
    
    1,954Total expenses
    
    
    14,969
    
    
    
    
    
    
    
    79,124
    
    
    
    63,821Income before income taxes
    
    $
    3,259
    
    
    $
    
    
    
    $
    16,628
    
    
    $
    15,639
 Actual
    
    Pro formaYear Ended June 30,
    
    Year Ended June 30,Real Estate And Corporate
    
    2004
    
    2003
    
    2004
    
    2003Revenues:Gains on sales of foreclosed real estate
    
    $
    4,147
    
    
    $
    233
    
    
    $
    4,147
    
    
    $
    233Investment income
    
    
    778
    
    
    
    1,098
    
    
    
    424
    
    
    
    744Other
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Total revenues
    
    
    4,925
    
    
    
    1,331
    
    
    
    4,571
    
    
    
    977Expenses:Operating expenses
    
    
    6,235
    
    
    
    2,637
    
    
    
    2,278
    
    
    
    1,648Stock-based compensation
    
    
    7,850
    
    
    
    546
    
    
    
    
    
    
    
    Depreciation
    
    
    40
    
    
    
    10
    
    
    
    
    
    
    
    Interest expense
    
    
    44
    
    
    
    
    
    
    
    318
    
    
    
    29Total expenses
    
    
    14,169
    
    
    
    3,193
    
    
    
    2,596
    
    
    
    1,677(Loss) income before income taxes
    
    $
    (9,244
    )
    
    $
    (1,862
    )
    
    $
    1,975
    
    
    $
    (700
    )
 Our insurance operation derives its revenues from selling, servicing and
underwriting non-standard personal automobile insurance policies in seven
states. We conduct our underwriting operations through two insurance company
subsidiaries, USAuto Insurance Company, Inc. and Village Auto Insurance
Company, Inc. Our insurance operations revenues are primarily derived from:  
    
    premiums earned from sales of policies issued by the
insurance company subsidiaries, net of the portion of those
premiums that are ceded to reinsurers;
    
    fee income, which includes policy and installment
billing fees on policies written as well as fees for other
ancillary services (principally a motor club product); 28




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##### Table of Contents




    
    commission income paid by our reinsurer to us for ceded premiums; and
    
    investment income earned on the invested assets of the insurance company subsidiaries. To a lesser extent, we are also winding down operations in which our managing
general agency subsidiaries (MGA subsidiaries) received commissions for selling
and servicing policies sold on behalf of third-party insurance companies. The following table presents gross premiums earned by state for the
insurance operations separately for policies written by the insurance company
subsidiaries and for policies issued by the MGA subsidiaries on behalf of other
insurance companies, on both an actual and a pro-forma basis for the periods
presented. This table is therefore reflective of the total gross premiums
serviced by us and under our control. Actual
    
    Pro formaYear Ended June 30,
    
    Year Ended June 30,2004
    
    2003
    
    2004
    
    2003Insurance company subsidiaries:Georgia
    
    $
    10,582
    
    
    $
    
    
    
    $
    53,878
    
    
    $
    34,898Tennessee
    
    
    4,460
    
    
    
    
    
    
    
    25,387
    
    
    
    22,672Mississippi
    
    
    680
    
    
    
    
    
    
    
    3,822
    
    
    
    3,323Ohio
    
    
    1,250
    
    
    
    
    
    
    
    5,789
    
    
    
    1,694Missouri
    
    
    587
    
    
    
    
    
    
    
    3,125
    
    
    
    1,794Indiana
    
    
    23
    
    
    
    
    
    
    
    25
    
    
    
    Total gross premiums earned
    
    $
    17,582
    
    
    $
    
    
    
    $
    92,026
    
    
    $
    64,381MGA subsidiaries:Georgia
    
    $
    837
    
    
    $
    
    
    
    $
    11,618
    
    
    $
    28,853Tennessee
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    25Alabama
    
    
    4,331
    
    
    
    
    
    
    
    24,219
    
    
    
    19,832Total gross premiums earned
    
    $
    5,168
    
    
    $
    
    
    
    $
    35,837
    
    
    $
    48,710
 The following table presents net premiums earned by state for the
insurance operations on both an actual and a pro-forma basis for the periods
presented. This table is reflective of the net underwriting risk retained by us
after considering the effects of reinsurance. Note that Alabama premiums are
assumed by us through a quota share reinsurance contract which was increased
from 15% to 50% effective February 1, 2004. Actual
    
    Pro FormaYear Ended June 30,
    
    Year Ended June 30,2004
    
    2003
    
    2004
    
    2003Georgia
    
    $
    5,828
    
    
    $
    
    
    
    $
    29,802
    
    
    $
    20,184Tennessee
    
    
    2,300
    
    
    
    
    
    
    
    13,115
    
    
    
    11,613Alabama
    
    
    2,247
    
    
    
    
    
    
    
    8,057
    
    
    
    2,919Ohio
    
    
    650
    
    
    
    
    
    
    
    3,013
    
    
    
    862Missouri
    
    
    309
    
    
    
    
    
    
    
    1,620
    
    
    
    995Mississippi
    
    
    371
    
    
    
    
    
    
    
    2,083
    
    
    
    1,780Indiana
    
    
    23
    
    
    
    
    
    
    
    26
    
    
    
    Total net premiums earned
    
    $
    11,728
    
    
    $
    
    
    
    $
    57,716
    
    
    $
    38,353
 Insurance companies present a combined ratio as a measure of their
overall underwriting profitability. The components of the combined ratio are
as follows: Loss Ratio Loss ratio is the ratio (expressed as a percentage) of
losses and loss adjustment expenses incurred to premiums earned and is a basic
element of underwriting profitability. We calculate this ratio based on all
direct and assumed premiums earned, net of ceded reinsurance. Expense Ratio Expense ratio is the ratio (expressed as a percentage) of
operating expenses to premiums earned. This is a measurement which illustrates
relative management efficiency in administering our operations. We calculate
this ratio on a net basis as a percentage of net premiums earned. Insurance
operating expenses are 29




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##### Table of Contents



reduced by fee income from insureds and ceding commissions received from
our reinsurer as compensation for the costs we incur in servicing this
business on their behalf. Combined Ratio Combined ratio is the sum of the loss ratio and the
expense ratio. If the combined ratio is at or above 100, an insurance company
cannot be profitable without sufficient investment income. The following table
presents the combined ratios for the insurance operations on both an actual
and a pro-forma basis for the periods presented. Actual
    
    Pro FormaYear Ended June 30,
    
    Year Ended June 30,2004
    
    2003
    
    2004
    
    2003Loss and loss adjustment expense
    
    
    61.1
    %
    
    
    
    
    
    
    63.4
    %
    
    
    67.5
    %Expense
    
    
    13.7
    %
    
    
    
    
    
    
    15.8
    %
    
    
    13.1
    %74.8
    %
    
    
    
    
    
    
    79.2
    %
    
    
    80.6
    %
 The invested assets of the insurance operations are generally highly
liquid and consist substantially of readily marketable, investment grade,
tax-free, municipal bonds. At June 30, 2004, approximately 69% of our fixed
maturities portfolio was tax-exempt. Most securities held are issued by
political subdivisions in the states of Georgia and Tennessee, which enables
our insurance company subsidiaries to obtain premium tax credits. Investment
income is primarily composed of interest earned on these securities, net of
related investment expenses. Realized gains and losses on our investment
portfolio may occur from time-to-time as changes are made to our holdings based
upon changes in interest rates and changes in the credit quality of securities
held. The non-standard 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. If new competitors enter this market,
existing competitors may attempt to increase market share by lowering rates.
Such conditions could lead to reduced prices, which would negatively impact
USAutos revenues and profitability. However, we believe that during 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. Rates and premium
levels for non-standard automobile insurance have stabilized during 2004. Fiscal Year Ended June 30, 2004 Compared With Fiscal Year Ended June 30, 2003 Actual Consolidated Results Net loss for the year ended June 30, 2004 was $3.8 million, as compared to
a net loss of $1.9 million for the year ended June 30, 2003. The prior years
results reflect only real estate operations and the costs associated with
acquisition opportunities. The current years results are significantly
impacted by the inclusion of two months of insurance operating results as well
as the severance cost to our former employees. Total severance costs were $3.3
million. In addition, we recognized $7.9 million of expenses in the current
year related to stock-based compensation, most of which related to stock
options which became fully vested upon the termination of employees as a result
of the USAuto acquisition. For the year ended June 30, 2004, we also recognized
gains on the sale of foreclosed real estate of $4.1 million versus gains of
$0.2 million in the prior year. Loss per share on a fully diluted basis for the year ended June 30, 2004
was $0.15, as compared to a loss of $0.09 for the year ended June 30, 2003.
The net loss for the year ended June 30, 2004 was net of an income tax benefit
of $2.2 million, while no tax benefit was recognized in the prior year as a
result of the uncertainty of its utilization. Pro forma Consolidated Results On a pro forma basis, net income for the year ended June 30, 2004 was
$11.6 million, versus $9.1 million for the year ended June 30, 2003. Pro forma
income per share on a fully diluted based for the year ended June 30, 2004 was
$0.24, as compared to $0.19 for the year ended June 30, 2003. 30




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##### Table of Contents



Actual Results  Real Estate and Corporate Loss before income taxes for the year ended June 30, 2004 was $9.2 million
versus a loss before income taxes of $1.9 million for the year ended June 30,
2003. Investment income related to cash equivalents decreased to $0.8 million
for the year ended June 30, 2004 versus $1.1 million for the same period last
year. This decrease is due to lower interest rates and a decrease in the amount
of available cash equivalents as a result of the effects of the USAuto
acquisition. Gains on sales of foreclosed real estate for the year ended June 30, 2004
were $4.1 million resulting from the sale of a total of ten parcels, as
compared to $0.2 million for the same period last year. Gains on sales of real
estate represents proceeds received from the sale of foreclosed real estate in
excess of carrying value, less selling costs. Stock-based compensation for the year ended June 30, 2004 was $7.9 million
compared to $0.5 million for the same period last year. This increase was
primarily the result of recognizing the expense for the immediate vesting, upon
his termination, of nonqualified stock options granted to our former President
and Chief Executive Officer, Donald J. Edwards, for an option to purchase
2,573,678 shares of our common stock at an exercise price of $3.00 per share.
Additionally, this expense also includes the cost associated with an option to
purchase 1,152,000 shares granted to Mr. Edwards as a result of the rights
offering in accordance with the anti-dilution terms of his employment
agreement, and options to purchase 392,000 shares granted to other former
employees. Other operating expenses increased for the year ended June 30, 2004
primarily as a result of the $3.3 million in severance cost to former employees
who were terminated as a result of the USAuto acquisition. Pro forma Results  Real Estate and Corporate On a pro forma basis, income before taxes for the year ended June 30, 2004
was $2.0 million versus a loss before taxes of $0.7 million for the year ended
June 30, 2003. These results exclude compensation of terminated employees and
reflect only the real estate operations and costs related to acquisition
opportunities. Actual Results  Insurance Operations For the two months included in the operating results for the year ended
June 30, 2004, the insurance operations recorded income before taxes of $3.2
million. The combined ratio for this period was 74.8% which was comprised of a
loss and loss adjustment expense ratio of 61.1% and an expense ratio of 13.7%. Pro forma Results  Insurance Operations On a pro forma basis, income before taxes for the year ended June 30, 2004
was $16.6 million versus $15.6 million for the year ended June 30, 2003. These
results assume that the acquisition had occurred on July 1, 2002 and therefore
these results include twelve months of insurance operations. Net premiums earned increased 50% to $57.7 million for the year ended June
30, 2004 from $38.4 million for the same period last year. This increase is
primarily related to the fact that more of our insurance business was written
through our insurance company subsidiaries than for other insurance companies
through our managing general agency operations. In addition, effective February
1, 2004, we increased our assumed reinsurance percentage from 15% to 50% for
our Alabama business, which is written through another insurance company since
we are not licensed there. Likewise, as a result of shifting the insurance
underwriting to our insurance subsidiaries, commissions and fees declined over
the same period and ceding commissions from our reinsurer increased. During the year ended June 30, 2004, the number of sales offices (or
stores) expanded by 30, increasing from 109 at June 30, 2003 to 139 at June
30, 2004. During the fiscal year ended June 30, 2003, we opened 17 stores.
The stores opened during the 2004 fiscal year were profit neutral, but are
expected to be profit accretive during the 2005 fiscal year. There were a
total of 146 offices open as of September 1, 2004. 31




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##### Table of Contents



Investment income increased as the increase in invested assets more than
offset the reduction in yield. The weighted average investment yield for the
portfolio was 3.84% at June 30, 2004 with a duration of 4.55 years. The yield
for the comparable Lehman Brothers municipal bond indices at June 30, 2004 was
3.72%. The loss and loss adjustment expense ratio improved from 67.5% for the
year ended June 30, 2003 to 63.4% for the year ended June 30, 2004. Insurance operating expenses increased 14% from $36.0 million for the year
ended June 30, 2003 to $41.1 million for the year ended June 30, 2004. Such
increase is primarily due to the increase in net premiums earned. Insurance
operating expenses for the year ended June 30, 2004 did include $1.0 million in
costs incurred by USAuto as result of its acquisition by us. Fiscal Year Ended June 30, 2003 Compared With Fiscal Year Ended June 30, 2002 Actual Consolidated Results Prior to April 30, 2004, our operations consisted solely of acquisition
activities and real estate operations. Net loss for the year ended June 30, 2003 was $1.9 million, as compared to
net income of $0.5 million for the year ended June 30, 2002. Investment income on cash equivalents decreased to $1.1 million for the
year ended June 30, 2003 from $1.3 million for the year ended June 30, 2002.
This decrease was primarily due to a decrease in interest rates. Unrestricted
cash increased from $56.5 million at June 30, 2002 to $56.8 million at June 30,
2003 primarily due to interest earned on unrestricted cash accounts, proceeds
from the sale of foreclosed real estate and proceeds from the sale of shares of
our common stock. Gains on sales of foreclosed real estate were $0.2 million for the year
ended June 30, 2003 as compared to $0.1 million for the year ended June 30,
2002. The gains on sales of real estate represent proceeds received from the
sale of foreclosed real estate in excess of carrying value. The gains
recognized for the years ended June 30, 2003 and 2002 were from the sale of
58.6 acres and 59.4 acres, respectively, in San Antonio, Texas. Other operating expenses included compensation expense of $1.8 million for
the year ended June 30, 2003 as compared to $0.1 million for the year ended
June 30, 2002. The increased expense included the addition of salary expense
for our President and Chief Executive Officer and two other new employees. The
expense also includes $0.5 million in stock-based compensation resulting from
the issuance of common stock to Mr. Edwards at a price less than the then
current market value, as well as the grant of in-the-money stock options to Mr.
Edwards and one other employee. There was a loss on the write-down of foreclosed real estate of $0.1
million for the year ended June 30, 2003. We recorded a write-down on the book
values of certain parcels of land in San Antonio, Texas to adjust for decreased
market values on the properties due to a softening of the local real estate
market as well as the continued general economic downturn. No losses on
write-downs of real estate were recognized in the same period in 2002. Liquidity and Capital Resources Prior to the USAuto acquisition, our historical funding requirements have
been operating expenses, including legal, audit, and consulting expenses
incurred in connection with evaluation of potential acquisition candidates and
other strategic opportunities. Our historical primary sources of funding for
operating expenses have been proceeds from the sales of foreclosed real estate,
investment income on cash and cash equivalents, and cash on hand. Since the completion of the USAuto acquisition, our liquidity and capital
resources have become more reflective of those of a fully-integrated retailer,
servicer, and underwriter of non-standard personal automobile insurance.
Primary sources of funds are from premiums received, commission and fee income
and investment 32




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##### Table of Contents



income. Funds are used to pay claims and operating expenses, pay interest
and principal repayments under the terms of our loan agreement, and purchase
investments. Operating activities for the year ended June 30, 2004 used $0.5 million of
cash compared to $1.1 million used in the same period last year. In each of
the periods, cash was used for operating expenses, partially offset by
investment income and proceeds from the sales of foreclosed real estate. During
the year ended June 30, 2004, cash was also used for the severance costs
related to the acquisition of USAuto. However, this period also included the
results of insurance company operations since the April 30, 2004 acquisition. Net cash used by investing activities for the year ended June 30, 2004 was
$67.5 million compared to $0.5 million provided in the same period last year.
During the year ended June 30, 2004, $72.4 million was used in the acquisition
of USAuto (net of cash received) and $4.6 million was provided from the
proceeds of sales of foreclosed real estate versus only $0.7 million provided
in the same period last year. Net cash provided by financing activities for the year ended June 30, 2004
was $49.5 million versus $1.0 million in the same period last year. During the
year ended June 30, 2004, we received net proceeds of $49.4 million through the
issuance of stock in the rights offering on April 30, 2004. The acquisition of USAuto, including acquisition expenses, required total
cash of $77.7 million, which came from our cash on hand, as well as a portion
of the $49.4 million net proceeds received from the rights offering. At
closing, we also paid $2.9 million to extinguish a portion of USAutos debt. In
addition, we used $5.0 million to increase the statutory capital and surplus of
the insurance company subsidiaries. At June 30, 2004, we had $20.5 million
available in unrestricted cash and cash equivalents outside of the insurance
company subsidiaries. The remaining note payable to a financial institution at June 30, 2004
consisted of a term loan with an unpaid balance of $4 million, that bears
interest at LIBOR plus 366 basis points. The note is payable in scheduled
quarterly installments through June 30, 2007 and is secured by the common stock
and certain assets of USAutos direct wholly-owned subsidiaries. The term loan
contains certain financial covenants and requires USAuto to maintain certain
financial ratios. At June 30, 2004, USAuto was in compliance with all
provisions of the loan agreement, including the financial covenants and ratios,
except for a Risk Based Capital ratio and a Debt Service Coverage ratio for
which waivers had been obtained. As a result of the USAuto acquisition, we are now part of an insurance
holding company system with substantially all of our operations being conducted
by our insurance company subsidiaries. Accordingly, the holding company will
only receive cash from operating activities as a result of investment income
and the ultimate liquidation of our foreclosed real estate held for sale. Cash
could be made available through loans from financial institutions, the sale of
common stock, and dividends from insurance company subsidiaries. In addition,
as a result of our tax net operating loss carryforwards, taxable income
generated by the insurance company subsidiaries will provide cash to the
holding company through an intercompany tax allocation agreement through which
the insurance company subsidiaries will reimburse the holding company for
current tax benefits utilized through recognition of the net operating loss
carryforwards. State insurance laws limit the amount of dividends that may be paid from
the insurance company subsidiaries. These limitations relate to statutory
capital and surplus and net income. In addition, the National Association of
Insurance Commissioners Model Act for risk-based capital (RBC) provides
formulas to determine the amount of statutory capital and surplus 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. Statutory guidelines suggest that the insurance company subsidiaries
should not exceed a ratio of net premiums written to statutory capital and
surplus of 3-to-1. We believe that the insurance company subsidiaries have
sufficient financial resources available to support their net premium writings
in both the short-term and the reasonably foreseeable future. There was a loss for the write-down of foreclosed real estate of $142,000
for the year ended June 30, 2003 as a result of a write-down on the book values
of certain parcels of land in San Antonio, Texas to adjust for 33




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decreased market values on the properties due to a softening of the local
real estate market. No losses for write-downs of real estate were recognized in
the same period in 2004. There are six remaining parcels of land remaining to
be sold in the San Antonio area, totaling 310 acres. As of August 31, 2004, we
have received conditional contracts or letters of intent on properties totaling
more than $0.9 million in book value. No assurance can be provided, however,
that any of these contracts or expressions of interest ultimately will
culminate in a successful sale. We believe that existing cash and investment balances, when combined with
anticipated cash flows generated from operations, will be adequate to meet our
expected liquidity needs in both the short term and the reasonably foreseeable
future. Non-renewal of Quota-Share Reinsurance As a result of the additional available liquidity to increase the
statutory capital and surplus of the insurance company subsidiaries, effective
September 1, 2004, we have elected to not renew our 50% quota share reinsurance
treaty. This non-renewal will have the effect of eliminating quota-share
reinsurance on all premiums earned after the non-renewal date. This
non-renewal will have the effect of recapturing the portion of our net
underwriting profit that was ceded to the quota-share reinsurer. In addition,
we expect our invested assets to increase which will allow us to earn
additional investment income. Likewise, in the future, our consolidated
balance sheet will no longer reflect prepaid reinsurance premiums and the
reinsurance recoverables and amounts due to reinsurance will decrease
significantly. On a pro-forma basis for the year ended June 30, 2004, ceded
premiums earned by the reinsurer were $44.4 million. Contractual Obligations The following table summarizes all of our contractual obligations by
period as of June 30, 2004 (in thousands): Payments Due By PeriodLess than
    
    
    
    
    
    
    
    
    
    More thanTotal
    
    1 year
    
    1-3 Years
    
    3-5 Years
    
    5 yearsNote payable to financial institution
    
    $
    4,000
    
    
    $
    1,000
    
    
    $
    3,000
    
    
    $
    
    
    
    $
    Operating leases
    
    
    6,392
    
    
    
    1,735
    
    
    
    2,211
    
    
    
    1,128
    
    
    
    1,318Total contractual cash obligations
    
    $
    10,392
    
    
    $
    2,735
    
    
    $
    5,211
    
    
    $
    1,128
    
    
    $
    1,318
 Off-Balance Sheet Arrangements We have no off-balance sheet arrangements (other than operating leases) or
financing activities with special-purpose entities. Critical Accounting Policies The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect amounts reported in the consolidated financial
statements. As more information becomes known, these estimates and assumptions
could change, thus having an impact on the amounts reported in the future. The
following are considered to be our critical accounting policies: Valuation of deferred tax asset.Income taxes are maintained in
accordance with SFAS No. 109, Accounting for Income Taxes, whereby deferred
income tax assets and liabilities result from temporary differences. Temporary
differences are differences between the tax basis of assets and liabilities and
operating loss and tax credit carryforwards and their reported amounts in the
consolidated financial statements that will result in taxable or deductible
amounts in future years. Valuation of the deferred tax asset is considered a
critical accounting policy because the determination of our ability to utilize
the asset involves a number of management assumptions relating to future
operations that could materially affect the determination of the ultimate value
and, therefore, the carrying amount of our deferred tax asset. 34




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Based on business activity prior to the USAuto acquisition, management
believed it was more likely than not that we would not realize the benefits of
the loss carryforwards. Therefore, a full valuation allowance had been
established. Based upon our estimates of our future taxable income after the
USAuto acquisition, we have reduced our deferred tax valuation allowance by
$41.3 million. At June 30, 2004, our total gross deferred tax asset is $85.8
million, and we had net operating loss carryforwards for federal income tax
purposes of approximately $222 million. On a net basis, the deferred tax asset
is $45.4 million after an allowance of $40.4 million. Realization of this
deferred tax asset is dependent upon our generation of sufficient taxable
income in the future. If future taxable income is not sufficient to recover the
deferred tax assets, the maximum charge to the provision for income taxes will
be $45.4 million. If we generate sufficient future taxable income to fully
utilize the deferred tax assets as of June 30, 2004, the maximum benefit for
income taxes will be $40.4 million. Losses and loss adjustment expense reserves.Months and sometimes years
may elapse between the occurrence of an automobile accident covered by one of
our insurance policies, the reporting of the accident and the payment of the
claim. We record a liability for estimates of losses that will be paid for
accidents that have been reported, which is referred to 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, which
are referred to herein 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 that the insurance company subsidiaries
underwrite. Each of the insurance company 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. We also consider various other factors, such as inflation,
claims settlement patterns, legislative activity and litigation trends. We
continually monitor these estimates and as experience develops or new
information becomes known, increase or decrease the level of its reserves 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. Goodwill and identifiable intangible assets.The USAuto acquisition
resulted in goodwill of $97.3 million, subject to increase in the event
additional shares are issued pursuant to the terms of the acquisition. Goodwill
represents the excess of the purchase price over the fair value of the net
assets of USAuto. The acquisition also resulted in other identifiable
intangible assets of $6.0 million. As required by SFAS No. 142, we will perform
an annual impairment test of goodwill and identifiable intangible assets. If
impairment indicators exist between the annual testing periods, management will
perform an interim impairment test. Should either an annual or interim
impairment test determine that the fair value of USAuto is below the carrying
value, a write-down of these assets for USAuto will be required. In evaluating
whether impairment exists, management also considers the fair value in excess
of the carrying value for certain assets. Recent Accounting Pronouncements In December 2002, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard, (SFAS) No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure, which is effective for
fiscal years beginning after December 31, 2002. SFAS No. 148 amends SFAS No.
123, Accounting for Stock-Based Compensation, to provide alternative methods
of transition to the fair value method of accounting for stock-based
compensation. In addition, SFAS No. 148 amends the disclosure provisions of
Statement 123 to require disclosure in the summary of significant accounting
policies of the effects of an entitys accounting policy with respect to
stock-based employee compensation on reported net income (loss) and income
(loss) per share in annual and interim financial statements. Effective July 1,
2003, the Company adopted the prospective method provisions of SFAS No. 148. EITF 00-21, Revenue Arrangements with Multiple Deliverables, addresses
certain aspects of accounting for arrangements in which a vendor performs
multiple revenue-generating activities. EITF 00-21 specifies certain criteria
to determine whether multiple revenue-generating activities represent one or
more units of accounting and how the arrangement consideration should be
allocated to the separate units of accounting. EITF 00-21 is applicable to
revenue arrangements entered into in fiscal periods beginning after June 15,
2003. Management has determined that the adoption of the provisions of EITF
00-21 did not have a material impact on the Companys consolidated financial
position, results of operations or cash flows. 35




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Item 7A. Quantitative and Qualitative Disclosures About Market Risk We have an exposure to interest rate risk relating to fixed maturity
investments. Changes in market interest rates directly impact the market value
of the fixed maturity securities. Some fixed income securities have call or
prepayment options. This subjects us to reinvestment risk as issuers may call
their securities, which could result in us reinvesting the proceeds at lower
interest rates. We manage exposure to interest rate risks by adhering to
specific guidelines in connection with its investment portfolio. We exclusively
invest in municipal bonds that have been rated A or better by Standard &
Poors. At June 30, 2004, 95.5% of the portfolio was invested in securities
rated AA or better by Standard & Poors and 100% in securities rated A or
better by Standard & Poors. We have not recognized any other than temporary
losses on the investment portfolio. We also utilize the services of a
professional fixed income investment manager. As of June 30, 2004, the impact of an immediate 100 basis point increase
in market interest rates on our fixed maturities portfolio would have resulted
in an estimated decrease in fair value of 5%, or approximately $1.7 million. As
of the same date, the impact of an immediate 100 basis point decrease in market
interest rates on our fixed maturities portfolio would have resulted in an
estimated increase in fair value of 5%, or approximately $1.7 million. 36




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Item 8. Financial Statements and Supplementary Data Report of Independent Registered Public Accounting Firm Consolidated Balance Sheets as of June 30, 2004 and 2003 Consolidated Statements of Operations for the Years Ended June 30, 2004, 2003 and 2002 Consolidated Statements of Stockholders Equity for the Years Ended June 30, 2004, 2003 and 2002 Consolidated Statements of Cash Flows for the Years Ended June 30, 2004, 2003 and 2002 Notes to Consolidated Financial Statements 37




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Report of Independent Registered Public Accounting Firm The Board of Directors and Stockholders
First Acceptance Corporation: We have audited the accompanying consolidated balance sheets of First
Acceptance Corporation and subsidiaries, formerly known as Liberté Investors,
Inc., as of June 30, 2004 and 2003, and the related consolidated statements of
operations, stockholders equity, and cash flows for each of the years in the
three-year period ended June 30, 2004. These consolidated financial statements
are the responsibility of the Companys management. Our responsibility is to
express an opinion on these consolidated financial statements based on our
audits. We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (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 consolidated financial statements referred to above present
fairly, in all material respects, the financial position of First Acceptance
Corporation and subsidiaries as of June 30, 2004 and 2003, and the results of
their operations and their cash flows for each of the years in the three-year
period ended June 30, 2004, in conformity with U.S. generally accepted
accounting principles. /s/ KPMG LLP Dallas, Texas
September 23, 2004 38




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data) June 30, 2004 and 2003 2004
    
    2003ASSETSFixed maturities, available-for-sale at market value (amortized
cost: $33,298)
    
    $
    33,243
    
    
    $
    Cash and cash equivalents
    
    
    38,352
    
    
    
    56,847Fiduciary funds  restricted
    
    
    1,851
    
    
    
    Premiums and fees receivable from policyholders and agents
    
    
    32,076
    
    
    
    Reinsurance recoverables
    
    
    12,297
    
    
    
    Prepaid reinsurance premiums
    
    
    12,384
    
    
    
    Deferred tax asset
    
    
    45,493
    
    
    
    Other assets
    
    
    3,545
    
    
    
    425Property and equipment
    
    
    2,404
    
    
    
    187Foreclosed real estate held for sale
    
    
    1,108
    
    
    
    1,594Goodwill
    
    
    97,304
    
    
    
    Identifiable intangible assets
    
    
    5,610
    
    
    
    TOTAL
    
    $
    285,667
    
    
    $
    59,053LIABILITIES AND STOCKHOLDERS EQUITYLoss and loss adjustment expense reserves
    
    $
    30,434
    
    
    $
    Unearned premiums
    
    
    33,433
    
    
    
    Deferred fee income
    
    
    2,590
    
    
    
    Amounts due to reinsurers
    
    
    11,899
    
    
    
    Amounts due to insurance companies
    
    
    1,851
    
    
    
    Note payable to financial institution
    
    
    4,000
    
    
    
    Deferred ceding commissions, net
    
    
    300
    
    
    
    Federal income taxes payable
    
    
    1,032
    
    
    
    Other liabilities
    
    
    5,902
    
    
    
    978Total liabilities
    
    
    91,441
    
    
    
    978Commitments and contingencies (notes 4, 5, 7, 13, 15 and 18)Stockholders equity:Common stock, $.01 par value, 75,000 and 50,000 shares
authorized, respectively; 46,535 and 20,589 shares issued and
outstanding, respectively
    
    
    465
    
    
    
    206Preferred stock, $.01 par value, 10,000 shares authorized in 2004
    
    
    
    
    
    
    Additional paid-in capital
    
    
    450,658
    
    
    
    312,451Deferred compensation expense
    
    
    
    
    
    
    (1,516
    )Accumulated other comprehensive loss:Net unrealized depreciation on investments
    
    
    (35
    )
    
    
    Accumulated deficit
    
    
    (256,862
    )
    
    
    (253,066
    )Total stockholders equity
    
    
    194,226
    
    
    
    58,075TOTAL
    
    $
    285,667
    
    
    $
    59,053
 See notes to consolidated financial statements. 39




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data) Years Ended June 30, 2004, 2003 and 2002 2004
    
    2003
    
    2002Revenues:Premiums earned
    
    $
    11,728
    
    
    $
    
    
    
    $
    Commissions and fees
    
    
    4,401
    
    
    
    
    
    
    
    Ceding commissions from reinsurer
    
    
    1,925
    
    
    
    
    
    
    
    Gains on sales of foreclosed real estate
    
    
    4,147
    
    
    
    233
    
    
    
    139Investment income
    
    
    958
    
    
    
    1,098
    
    
    
    1,335Net realized losses on sales of investments
    
    
    (6
    )
    
    
    
    
    
    
    Total revenues
    
    
    23,153
    
    
    
    1,331
    
    
    
    1,474Expenses:Losses and loss adjustment expenses
    
    
    7,167
    
    
    
    
    
    
    
    Insurance operating expenses
    
    
    7,194
    
    
    
    
    
    
    
    Other operating expenses
    
    
    6,235
    
    
    
    2,637
    
    
    
    988Stock-based compensation
    
    
    7,850
    
    
    
    546
    
    
    
    Depreciation
    
    
    258
    
    
    
    10
    
    
    
    6Amortization of identifiable intangible assets
    
    
    390
    
    
    
    
    
    
    
    Interest expense
    
    
    44
    
    
    
    
    
    
    
    Total expenses
    
    
    29,138
    
    
    
    3,193
    
    
    
    994(Loss) income before income taxes
    
    
    (5,985
    )
    
    
    (1,862
    )
    
    
    480Income tax benefit
    
    
    2,189
    
    
    
    
    
    
    
    Net (loss) income
    
    $
    (3,796
    )
    
    $
    (1,862
    )
    
    $
    480Basic and diluted net (loss) income per share
    
    $
    (0.15
    )
    
    $
    (0.09
    )
    
    $
    0.02Basic and diluted weighted average shares outstanding
    
    
    24,965
    
    
    
    20,420
    
    
    
    20,256
 See notes to consolidated financial statements. 40




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
(in thousands) Years Ended June 30, 2004, 2003 and 2002 AccumulatedCommon Stock
    
    Additionalpaid-in
    
    Deferredcompensation
    
    othercomprehensive
    
    Accumulated
    

TotalstockholdersShares
    
    Amount
    
    capital
    
    expense
    
    loss
    
    deficit
    
    equityBalances at July 1, 2001
    
    
    20,256
    
    
    $
    203
    
    
    $
    309,392
    
    
    $
    
    
    
    $
    
    
    
    $
    (251,562
    )
    
    $
    58,033Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    480
    
    
    
    480Dividends paid ($0.006 per share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (122
    )
    
    
    (122
    )Balances at June 30, 2002
    
    
    20,256
    
    
    
    203
    
    
    
    309,392
    
    
    
    
    
    
    
    
    
    
    
    (251,204
    )
    
    
    58,391Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,862
    )
    
    
    (1,862
    )Stock issued to officer
    
    
    333
    
    
    
    3
    
    
    
    1,197
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,200Issuance of stock options
    
    
    
    
    
    
    
    
    
    
    1,862
    
    
    
    (1,862
    )
    
    
    
    
    
    
    
    
    
    
    Amortization of deferred
compensation expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    346
    
    
    
    
    
    
    
    
    
    
    
    346Balances at June 30, 2003
    
    
    20,589
    
    
    
    206
    
    
    
    312,451
    
    
    
    (1,516
    )
    
    
    
    
    
    
    (253,066
    )
    
    
    58,075Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,796
    )
    
    
    (3,796
    )Other comprehensive losschange
in unrealized depreciation on
investments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (35
    )
    
    
    
    
    
    
    (35
    )Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,831
    )Issuance of stock options
    
    
    
    
    
    
    
    
    
    
    6,334
    
    
    
    (92
    )
    
    
    
    
    
    
    
    
    
    
    6,242Stock rights offering
    
    
    12,560
    
    
    
    126
    
    
    
    49,238
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    49,364Stock issued in acquisition
    
    
    13,250
    
    
    
    132
    
    
    
    82,230
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    82,362Exercise of stock options
    
    
    136
    
    
    
    1
    
    
    
    405
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    406Amortization of deferred
compensation expense
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,608
    
    
    
    
    
    
    
    
    
    
    
    1,608Balances at June 30, 2004
    
    
    46,535
    
    
    $
    465
    
    
    $
    450,658
    
    
    $
    
    
    
    $
    (35
    )
    
    $
    (256,862
    )
    
    $
    194,226
 See notes to consolidated financial statements. 41




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands) Years Ended June 30, 2004, 2003 and 2002 2004
    
    2003
    
    2002Cash flows from operating activities:Net (loss) income
    
    $
    (3,796
    )
    
    $
    (1,862
    )
    
    $
    480Adjustments to reconcile net (loss) income to cash (used in)
provided by operating activities:Depreciation and amortization
    
    
    648
    
    
    
    10
    
    
    
    6Stock-based compensation
    
    
    7,850
    
    
    
    546
    
    
    
    Amortization of premium on fixed maturities
    
    
    65
    
    
    
    
    
    
    
    Deferred income taxes
    
    
    (2,283
    )
    
    
    
    
    
    
    Gains on sales of foreclosed real estate
    
    
    (4,147
    )
    
    
    (233
    )
    
    
    (139
    )Loss on write-down of foreclosed real estate
    
    
    
    
    
    
    142
    
    
    
    Net realized losses on sales of investments
    
    
    6
    
    
    
    
    
    
    
    Change in:Fiduciary funds  restricted
    
    
    125
    
    
    
    
    
    
    
    Premiums and fees receivable from policyholders and agents
    
    
    2,518
    
    
    
    
    
    
    
    Reinsurance recoverables
    
    
    (1,015
    )
    
    
    
    
    
    
    Prepaid reinsurance premiums
    
    
    (215
    )
    
    
    
    
    
    
    Other assets
    
    
    (9
    )
    
    
    (192
    )
    
    
    (138
    )Loss and loss adjustment expense reserves
    
    
    2,440
    
    
    
    
    
    
    
    Unearned premiums
    
    
    (1,535
    )
    
    
    
    
    
    
    Deferred fee income
    
    
    (168
    )
    
    
    
    
    
    
    Amounts due to reinsurers
    
    
    (949
    )
    
    
    
    
    
    
    Amounts due to insurance companies
    
    
    (125
    )
    
    
    
    
    
    
    Deferred ceding commissions, net
    
    
    300
    
    
    
    
    
    
    
    Federal income taxes payable
    
    
    (525
    )
    
    
    
    
    
    
    Other liabilities
    
    
    330
    
    
    
    449
    
    
    
    22Net cash (used in) provided by operating activities
    
    
    (485
    )
    
    
    (1,140
    )
    
    
    231Cash flows from investing activities:Proceeds from sales of foreclosed real estate
    
    
    4,634
    
    
    
    672
    
    
    
    298Acquisitions of property and equipment
    
    
    (68
    )
    
    
    (195
    )
    
    
    Purchases of fixed maturities, available-for-sale
    
    
    (10,371
    )
    
    
    
    
    
    
    Sales and maturities of fixed maturities, available-for-sale
    
    
    10,673
    
    
    
    
    
    
    
    Acquisition, net of cash received
    
    
    (72,398
    )
    
    
    
    
    
    
    Net cash (used in) provided by investing activities
    
    
    (67,530
    )
    
    
    477
    
    
    
    298Cash flows from financing activities:Net proceeds from issuance of common stock
    
    
    49,364
    
    
    
    1,000
    
    
    
    Exercise of stock options
    
    
    406
    
    
    
    
    
    
    
    Dividends on common stock
    
    
    
    
    
    
    
    
    
    
    (122
    )Payments on borrowings
    
    
    (250
    )
    
    
    
    
    
    
    Net cash provided by (used in) financing activities
    
    
    49,520
    
    
    
    1,000
    
    
    
    (122
    )Net (decrease) increase in cash and cash equivalents
    
    
    (18,495
    )
    
    
    337
    
    
    
    407Cash and cash equivalents, beginning of year
    
    
    56,847
    
    
    
    56,510
    
    
    
    56,103Cash and cash equivalents, end of year
    
    $
    38,352
    
    
    $
    56,847
    
    
    $
    56,510
 See notes to consolidated financial statements. 42




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 1. Summary of Significant Accounting Policies A. General First Acceptance Corporation, f/k/a Liberté Investors Inc., a Delaware
corporation (the Company), was organized in April 1996 in order to effect the
reorganization of Liberté Investors, a Massachusetts business trust (the
Trust). At a special meeting of the shareholders of the Trust held on August
15, 1996, the Trusts shareholders approved a plan of reorganization whereby
the Trust contributed its assets to the Company and received all of the
Companys outstanding common stock, par value $.01 per share. The Trust then
distributed to its shareholders, in redemption of all outstanding shares of
beneficial interest in the Trust, the shares of the Company. The Company
assumed all of the Trusts assets and outstanding liabilities and obligations. Since August 1996, the Company has been actively pursuing opportunities to
acquire one or more operating companies in order to increase value to existing
stockholders and provide a new focus and direction for the Company. The
Companys primary objective has been to seek long-term growth through an
acquisition of a business rather than short-term earnings. As further
discussed in Note 2, to that end, on April 30, 2004, the Company acquired
USAuto Holdings, Inc. (USAuto) for consideration consisting of $76.0 million
in cash, 13,250 shares of the Companys common stock, and up to an additional
750 shares of common stock that may be issued at a later date if certain
financial targets are reached. A portion of the cash consideration was raised
in a stock rights offering. USAuto is a retailer, servicer and underwriter of non-standard personal
automobile insurance based in Nashville, Tennessee. USAuto currently writes
non-standard personal automobile insurance in Georgia, Tennessee, Alabama,
Ohio, Missouri, Mississippi and Indiana, and is licensed as an insurer in 16
additional states. Business is written through two subsidiaries, USAuto
Insurance Company, Inc. and Village Insurance Company, Inc. (the Insurance
Companies.) Neither company is licensed in Alabama where business is assumed
through reinsurance contracts with unaffiliated insurance companies.
Incidental run-off operations are also conducted by USAuto as a managing
general agency whereby premiums are written on behalf of other insurance
companies. For the two months ended June 30, 2004, approximately 50%, 20% and
19% of USAutos gross premiums written were generated in Georgia, Tennessee and
Alabama, respectively. Effective at the consummation of the acquisition of USAuto, the Company
changed its name to First Acceptance Corporation. At such time, the executive
officers of USAuto were appointed as executive officers of the newly combined
enterprise and the Companys previous executive officers resigned from their
positions, and their employment was terminated. B. Basis of Consolidation and Reporting The accompanying consolidated financial statements include the accounts of
the Company and its subsidiaries which are all wholly owned. All intercompany
accounts and transactions are eliminated in consolidation. C. Use of Estimates The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities. It also requires disclosure of contingent assets
and liabilities at the date of the consolidated financial statements and the
reported amounts of revenue and expenses during the period. Actual results
could differ from those estimates. 43




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 D. Investments Fixed maturities, available for sale, are bonds with fixed principal
payment schedules, held for indefinite periods of time, and may be used as a
part of the Companys asset/liability strategy or sold in response to changes
in interest rates, anticipated prepayments, risk/reward characteristics,
liquidity needs or other economic factors. These securities are carried at
market value with the corresponding unrealized appreciation or depreciation,
net of deferred income taxes, reported in other comprehensive income or loss.
Market values are obtained from a recognized pricing service. Investment securities are exposed to various risks such as interest rate,
market and credit risk. Market values of securities fluctuate based on the
magnitude of changing market conditions; significant changes in market
conditions could materially affect portfolio value in the near term. When a
security has a decline in market value which is other than temporary, the
Company reduces the carrying value of such security to its current market
value. Realized gains and losses on sales of securities are computed based on
specific identification. E. Fiduciary Funds-Restricted Fiduciary funds-restricted represent premiums received from insureds (net
of commissions and fee income) not yet remitted to the insurance companies
represented by the Companys managing general agency subsidiaries. Fiduciary
funds are required to be kept in regulated bank accounts subject to guidelines
which emphasize capital preservation and liquidity. Such funds are not
available for corporate purposes. The Company is entitled to retain interest
income earned on fiduciary funds. Fiduciary funds-restricted consist solely of
cash balances. F. Property and Equipment Property and equipment are recorded at cost. Depreciation is provided
over the estimated useful lives of the assets (ranging from three to seven
years) using the straight-line method. G. Insurance Premiums Insurance premiums are earned on a pro-rata basis over the respective
terms of the policies. Premiums are paid monthly by insureds and are generally
collected in advance of providing risk coverage, minimizing the Companys
exposure to credit risk. H. Reinsurance Reinsurance arrangements are short-duration prospective contracts for
which prepaid reinsurance premiums are amortized ratably over the related
policy terms. Ceding commission income with retrospective adjustment features
is calculated based upon the related estimated incurred losses and loss
expenses including a provision for unreported losses. I. Deferred Ceding Commissions / Deferred Acquisition Costs Deferred acquisition costs include premium taxes and other variable
underwriting and direct sales costs incurred in connection with writing
business. These costs are deferred and amortized, net of deferred ceding
commission income from our reinsurer, over the policy period in which the
related premiums are earned. 44




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 J. Loss and Loss Adjustment Expense Reserves Loss and loss adjustment expense reserves are undiscounted (except for the
purchase accounting as discussed below) and represent case-basis estimates of
reported losses and estimates based on certain actuarial assumptions regarding
the past experience of reported losses, including an estimate of losses
incurred but not reported (IBNR). Management believes that the losses and
loss adjustment reserves are adequate to cover the ultimate liability.
However, such estimate may be more or less than the amount ultimately paid when
the claims are finally settled. Under purchase accounting, the fair value of loss and loss adjustment
expense reserves and related reinsurance recoverables as of the April 30, 2004
acquisition date was estimated based on the present value of the expected
underlying cash flows of the loss reserves and reinsurance recoverables, and
included a profit and risk margin. In determining the fair value estimate,
USAutos historical undiscounted net loss reserves were adjusted to present
value assuming a 1.5% discount rate, which approximated the two-year U.S.
Treasury rate. The discounting pattern was actuarially developed from USAutos
historical loss data. An estimated profit and risk margin of 4% was then
applied to the discounted loss reserves to reflect an estimate of the cost
USAuto would incur to reinsure the full amount of the net loss and loss
adjustment expense reserves with a third party reinsurer. This margin was
based upon managements assessment of the uncertainty inherent in the net loss
reserves and our knowledge of the reinsurance marketplace. For the two months
ended June 30, 2004, $214 of the net margin/discount was accreted to income. K. Fee Income The Company offers policyholders the option, for a fixed monthly fee, to
pay for their insurance premium in equal monthly installments. Such
installment billing fees are recognized as revenue when each installment is
billed. Motor club fees written by an affiliate are earned on a pro-rata basis
over the respective terms of the contracts. Fees are paid monthly by motor
club members and are generally collected in advance of providing coverage,
minimizing the Companys exposure to credit risk. L. Foreclosed Real Estate Held for Sale Foreclosed real estate held for sale is recorded at the lower of cost or
fair value less estimated costs to sell. Cost is the carrying amount of the
mortgage note at the time of foreclosure net of any allowances. The Company
periodically reviews its portfolio of foreclosed real estate held for sale
using current information including (i) independent appraisals, (ii) general
economic factors affecting the area where the property is located, (iii) recent
sales activity and asking prices for comparable properties and (iv) costs to
sell and/or develop that would serve to lower the expected proceeds from the
disposal of the real estate. Gains (losses) realized on liquidation are
recorded directly to operations. M. Goodwill and Other Identifiable Intangible Assets Goodwill and other identifiable intangible assets are solely attributable
to the Companys April 30, 2004 acquisition of USAuto. Goodwill and
indefinite-life intangible assets are not amortized for financial statement
purposes but are instead tested annually for impairment. On a go-forward
basis, the Company has chosen June 30 of each year as its annual impairment
testing date for goodwill and other intangible assets. Included in other
identifiable intangible assets is an amount related to the value of policy
renewals at the date of acquisition which is being amortized over a 24-month
period in proportion to anticipated policy expirations. As of June 30, 2004,
the Company has recorded no impairment in connection with goodwill and other
intangible assets. For the two months ended June 30, 2004, $390 relating to
the identifiable intangible assets was amortized against income. Amortization
expense for the years ended June 30, 2005 and 2006 will be $744 and $66,
respectively. 45




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 N. Income Taxes Income taxes are accounted for under the asset and liability method.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax
rates expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred
tax assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date. O. New Accounting Standards In December 2002, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standard, (SFAS) No. 148, Accounting for
Stock-Based Compensation  Transition and Disclosure, which is effective for
fiscal years beginning after December 31, 2002. SFAS No. 148 amends SFAS No.
123, Accounting for Stock-Based Compensation, to provide alternative methods
of transition to the fair value method of accounting for stock-based
compensation. In addition, SFAS No. 148 amends the disclosure provisions of
Statement 123 to require disclosure in the summary of significant accounting
policies of the effects of an entitys accounting policy with respect to
stock-based employee compensation on reported net income (loss) and income
(loss) per share in annual and interim financial statements. Effective July 1,
2003, the Company adopted the prospective method provisions of SFAS No. 148. EITF 00-21, Revenue Arrangements with Multiple Deliverables, addresses
certain aspects of accounting for arrangements in which a vendor performs
multiple revenue-generating activities. EITF 00-21 specifies certain criteria
to determine whether multiple revenue-generating activities represent one or
more units of accounting and how the arrangement consideration should be
allocated to the separate units of accounting. EITF 00-21 is applicable to
revenue arrangements entered into in fiscal periods beginning after June 15,
2003. Management has determined that the adoption of the provisions of EITF
00-21 did not have a material impact on the Companys consolidated financial
position, results of operations or cash flows. P. Supplemental Cash Flow Information Cash and cash equivalents consist of bank demand deposits and
highly-liquid investments. For purposes of the consolidated statement of cash
flows, the Company considers all investments with original maturities of three
months or less to be cash. During the year ended June 30, 2004, the Company paid $670 in income taxes
and $44 in interest. Q. Basic and Diluted Net (Loss) Income Per Share Basic net (loss) income per share is computed by dividing net (loss)
income available to common shareholders by the weighted average number of
common shares, while diluted net income per share is computed by dividing net
income available to common shareholders by the weighted average number of such
common shares and dilutive share equivalents. R. Financial Statement Presentation Certain amounts in the consolidated financial statements for prior years
have been reclassified to conform with the current years presentation. 46




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 S. Stock-based compensation Prior to July 1, 2003, the Company applied APB No. 25 in accounting for
employee stock options. Under APB No. 25, the difference between the aggregate
market value and exercise price of the securities underlying the stock options
at grant date, or intrinsic value, is recorded as compensation expense on a
straight-line basis over the vesting period. If the employee stock options had
been accounted for under SFAS No. 123, the fair value of the stock options
would have been recorded as compensation expense on a straight-line basis over
the vesting period. The following table, as prescribed by SFAS No. 148,
illustrates the effect on net loss and loss per share if the Company had
applied the fair value recognition provisions of SFAS No. 123 to all
stock-based employee compensation. The fair value of the options awarded was
estimated at the grant date using the Black-Scholes option pricing model, which
includes the following assumptions: risk-free interest rate based on the
ten-year U.S. Treasury Note rate; expected option life of ten years; expected
volatility of 36% to 38%; and no expected dividends. Years Ended June 30,2004
    
    2003Net loss before income taxes, as reported
    
    $
    (5,985
    )
    
    $
    (1,862
    )Add: Stock-based employee compensation expense
included in reported net loss
    
    
    7,850
    
    
    
    546Deduct: Stock-based employee compensation
expense determined under fair value based
method for all awards
    
    
    (11,598
    )
    
    
    (1,443
    )Net loss before income taxes, pro forma
    
    
    (9,733
    )
    
    
    (2,759
    )Income tax benefit, pro forma
    
    
    3,501
    
    
    
    Net loss, pro forma
    
    $
    (6,232
    )
    
    $
    (2,759
    )Net loss per share:Basic and diluted  as reported
    
    $
    (0.15
    )
    
    $
    (0.09
    )Basic and diluted  pro forma
    
    $
    (0.25
    )
    
    $
    (0.14
    )
 There was no stock-based employee compensation during the fiscal year
ended June 30, 2002. 2. Acquisition of USAuto and Stock Rights Offering On April 30, 2004, the Company consummated an agreement dated December 15,
2003 to acquire 100% of the outstanding common stock of USAuto. The results of
USAutos operations have been included in the consolidated financial statements
since that date. The aggregate purchase price was $160,080 consisting of $76,000 in cash,
13,250 shares of the Companys common stock valued at $82,362 and $1,718 in
acquisition expenses. In addition, the Company paid $2,905 in USAuto debt at
closing. The value of the shares issued was determined based on the average
market price of the Companys common stock over the three-day period before and
after the terms of the acquisition were agreed to and announced. Up to an
additional 750 shares may also be issued at a later date if certain financial
targets through December 31, 2004 are reached. Such consideration will be
recorded as additional goodwill related to the acquisition at such time that
the financial targets may be reached. 47




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 The following table summarizes the estimated fair value of the assets
acquired and liabilities assumed at the date of acquisition based on
third-party valuations. Cash and cash equivalents
    
    $
    8,225Net tangible assets
    
    
    7,274Identifiable intangible assets
    
    
    6,000Goodwill
    
    
    97,304Change in deferred tax asset valuation allowance
    
    
    41,277Total assets acquired
    
    $
    160,080
 As a result of the USAuto acquisition, management reduced the Companys
deferred tax allowance by $41,277 based upon internally-prepared projected
operating results for USAuto and such amount was recorded as a reduction in
goodwill. Of the $6,000 in acquired identifiable intangible assets, $1,500 and
$3,300 were assigned to state insurance licenses and trademark and trade names,
respectively, that are not subject to amortization. The remaining $1,200 of
acquired identifiable intangible assets relate to the value of policy renewals
and is being amortized over a 24-month period in proportion to anticipated
policy expirations. The Company raised a part of the cash portion of the consideration to fund
the acquisition by offering the Companys stockholders the opportunity to
purchase shares of common stock through a stock rights offering at $4.00 per
share, which raised $49,364 net of expenses. In order to guarantee that the
Company would be able to raise the entire amount of the offering, Gerald J.
Ford, the Companys Chairman of the Board of Directors, agreed, through certain
of his affiliates, to backstop the rights offering by purchasing, at the
subscription price, the shares of the stock that were not purchased by other
stockholders. Such affiliates purchased 599 shares, or 4.8%, of the total
shares sold in the rights offering. 3. Investments A. Restriction At June 30, 2004, the Insurance Companies had fixed maturities and cash
with an amortized cost of $3,982 on deposit with various insurance departments
as a requirement of doing business in those states. B. Investment Income and Net Realized Gains and Losses The major categories of investment income are as follows: Years ended June 30,2004
    
    2003
    
    2002Fixed maturities, available for sale
    
    $
    200
    
    
    $
    
    
    
    $
    Cash and cash equivalents
    
    
    778
    
    
    
    1,098
    
    
    
    1,335Investment expenses
    
    
    (20
    )
    
    
    
    
    
    
    $
    958
    
    
    $
    1,098
    
    
    $
    1,335
 Net realized losses on investments for the year ended June 30, 2004 were
all derived from fixed maturities available for sale and consisted of losses of
$47 net of gains of $41. 48




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 C. Fixed Maturities, Available for Sale The composition of the portfolio at June 30, 2004 was as follows. At June
30, 2004, approximately 69% of the portfolio was tax-exempt. Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    MarketCost
    
    Gains
    
    Losses
    
    ValueU.S. Government
    
    $
    295
    
    
    $
    9
    
    
    $
    
    
    
    $
    304State
    
    
    3,839
    
    
    
    15
    
    
    
    (18
    )
    
    
    3,836Political subdivisions
    
    
    7,103
    
    
    
    17
    
    
    
    (63
    )
    
    
    7,057Special revenue and special assessment
    
    
    22,061
    
    
    
    136
    
    
    
    (151
    )
    
    
    22,046$
    33,298
    
    
    $
    177
    
    
    $
    (232
    )
    
    $
    33,243
 The composition of maturities of the portfolio at June 30, 2004 was as
follows: Amortized
    
    MarketCost
    
    ValueOne year or less
    
    $
    1,062
    
    
    $
    1,064One to five years
    
    
    8,243
    
    
    
    8,330Five to ten years
    
    
    14,582
    
    
    
    14,497Greater than ten years
    
    
    9,411
    
    
    
    9,352$
    33,298
    
    
    $
    33,243
 4. Reinsurance The Insurance Companies reinsure risks on both a quota-share and
excess-of-loss basis (for catastrophic events) with other insurance
organizations to provide them with additional underwriting capacity and
minimize their risk. Although the reinsurance agreements contractually
obligate the reinsurers to reimburse the Insurance Companies for their
proportionate share of losses, they do not discharge the primary liability of
the Insurance Companies, who remain contingently liable in the event the
reinsurers are unable to meet their contractual obligations. The Insurance
Companies evaluate the financial condition of their reinsurers and monitor
concentrations of credit risk to minimize their exposure to significant losses
from reinsurer insolvencies. Amounts related to ceded unpaid losses are included in reinsurance
recoverables while amounts related to ceded unearned premiums are reflected as
prepaid reinsurance premiums in the consolidated financial statements. At June 30, 2004, the Insurance Companies had a net unsecured aggregate
recoverable for unpaid losses, including IBNR, and prepaid reinsurance premiums
of $12,782 from Transatlantic Reinsurance Company. Reinsurance recoverables at
June 30, 2004 consisted entirely of amounts related to unpaid losses. Ceded premiums earned and reinsurance recoveries on losses and loss
adjustment expenses for the year ended June 30, 2004 were as follows: Ceded premiums earned
    
    $
    8,459Reinsurance recoveries on losses and loss adjustment expenses
    
    $
    5,846
 USAuto also has assumed private-passenger non-standard automobile
insurance premiums from other insurance companies produced by the USAutos
managing general agency subsidiary in Alabama. 49




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 An analysis of net premiums written and earned for the year ended June 30,
2004 is summarized as follows: Written
    
    EarnedDirect
    
    $
    15,553
    
    
    $
    17,582Assumed
    
    
    2,303
    
    
    
    2,605Ceded
    
    
    (7,435
    )
    
    
    (8,459
    )Net
    
    $
    10,421
    
    
    $
    11,728
 The percentage of premiums assumed to net premiums written for the year
ended June 30, 2004 was 22%. 5. Federal Income Taxes There was no income tax expense (benefit) recorded for the years ended
June 30, 2003 or 2002 as a result of the uncertainty of the utilization of any
tax benefit. Income tax expense for the year ended June 30, 2004 consisted of
the following: Federal income taxescurrent
    
    $
    Federal income taxesdeferred
    
    
    (2,283
    )State income taxes
    
    
    94$
    (2,189
    )
 The federal income tax expense (benefit) for the years ended June 30,
2004, 2003 and 2002 differs from the amounts computed by applying the U.S.
Federal corporate tax rate of 35% (34% in 2003 and 2002) to (loss) income
before income taxes as follows: 2004
    
    2003
    
    2002Computed expected income tax (benefit)
expense
    
    $
    (2,095
    )
    
    $
    (633
    )
    
    $
    163Increase (decrease) in taxes resulting from:Stock options exercised
    
    
    (158
    )
    
    
    
    
    
    
    Other
    
    
    (30
    )
    
    
    1
    
    
    
    5Change in the beginning of the year balance
of the valuation allowance for deferred tax
assets allocated to income taxes
    
    
    
    
    
    
    632
    
    
    
    (168
    )$
    (2,283
    )
    
    $
    
    
    
    $
    
 The tax effects of temporary differences that give rise to the deferred
tax assets at June 30, 2004 and 2003 are presented below: 2004
    
    2003Deferred tax assets:Net operating loss carryforwards
    
    $
    77,736
    
    
    $
    75,899Stock option compensation
    
    
    2,590
    
    
    
    Unearned premiums and loss and loss
adjustment expense reserves
    
    
    1,920
    
    
    
    Basis differences of foreclosed real estate
    
    
    1,250
    
    
    
    1,623Other
    
    
    2,353
    
    
    
    2,005Total gross deferred tax assets
    
    
    85,849
    
    
    
    79,527Less: valuation allowance
    
    
    (40,356
    )
    
    
    (79,527
    )Net deferred tax assets
    
    $
    45,493
    
    
    $
    
 50




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 The net change in the valuation allowance for the years ended June 30,
2004, 2003 and 2002 was a (decrease) increase of ($39,171), $632 and ($168),
respectively. Prior to the acquisition of USAuto, a full valuation allowance
had been established, as management believed that it was more likely than not
that the Company would not realize the benefits of the loss carryforwards.
However, as result of the acquisition, management has reduced the valuation
allowance based upon internally-prepared projected operating results. At June 30, 2004, the Company had net operating loss (NOL) carryforwards
for federal income tax purposes of $222,103, which are available to offset
future federal taxable income. The NOL carryforwards will expire in 2005
through 2024, as shown in the table below. Expiration Year
    
    Amount2005
    
    $
    9,7232006
    
    
    45,0912007
    
    
    32,5842008
    
    
    36,1882009
    
    
    84,791Thereafter
    
    
    13,726Total NOL carryforwards
    
    $
    222,103
 6. Net (Loss) Income Per Share Statement of Financial Accounting Standard No. 128 Earnings Per Share
(EPS) specifies the computation, presentation and disclosure requirements for
earnings per share. Basic EPS excludes all dilution while diluted EPS reflects
the potential dilution that could occur if securities or other contracts to
issue common shares were exercised or converted into common shares. Due to the net losses incurred for the years ended June 30, 2004 and 2003,
the effects of common stock equivalents have been excluded from diluted EPS.
There were no common stock equivalents outstanding at June 30, 2002. Diluted
weighted average shares for the years ended June 30, 2004 and 2003 exclude
incremental shares from assumed conversion of stock options of 1,101 and 593,
respectively, granted to employees of the Company under the Companys long term
incentive plan. The weighted average shares for the year ended June 30, 2003
also excludes 27 available shares under the stock purchase rights granted to an
officer of the Company. 7. Stock-Based Compensation In July 2002, the Company and Donald J. Edwards entered into an employment
agreement, which was approved by the Companys Board of Directors (the
Employment Agreement), that set forth the terms and
conditions of Mr. Edwards then employment as the Companys President and
Chief Executive Officer. The Employment Agreement provided for a grant of a
stock option to Mr. Edwards pursuant to a Nonqualified Stock Option Agreement
by and between the Company and Mr. Edwards (the Option Agreement). In
addition, in July 2002, the Companys Board of Directors also approved the
Companys 2002 Long Term Incentive Plan (the Plan). In July 2002, in
accordance with the terms of the Employment Agreement, the Companys Board of
Directors granted to Mr. Edwards an option, under the Plan, to purchase 2,574
shares of common stock of the Company at an exercise price of $3.00 per share
pursuant to the terms of the Option Agreement. The option expires on July 9,
2012. The aggregate market value of the securities underlying Mr. Edwards
options at the grant date was $9,265. On April 30, 2004, as a result of the
rights offering and in accordance with the terms of the Employment Agreement,
Mr. Edwards was granted an additional 1,152 anti-dilution options on the same
terms, and as a result of the termination of his employment, all of Mr. Edwards
options were fully vested. The aggregate market value of the securities
underlying Mr. Edwards anti-dilution options at the grant date was $7,546. The Employment Agreement further granted Mr. Edwards, as an inducement to
his employment with the Company, the right to purchase up to 333 shares of
common stock of the Company (the Purchased Shares) at a 51




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 price of $3.00 per
share. Mr. Edwards purchased 166 and 167 shares contemplated by the Employment
Agreement on July 9, 2002 and June 30, 2003, respectively. The aggregate
market value of the Purchased Shares at the grant date was $1,200. The
difference between the aggregate market value and purchase price of the
Purchased Shares of $200 was recorded as stock-based compensation expense in
the consolidated statement of operations for the year ended June 30, 2003. During the year ended June 30, 2003, in accordance with the terms of the
Plan, the Companys Board of Directors granted to another employee an option to
purchase 250 shares of common stock of the Company at an exercise price of
$3.00 per share. The option expires on November 30, 2012. The aggregate
market value of the securities underlying the employees options at the grant
date was approximately $1,068. Amortization of stock-based compensation for
the year ended June 30, 2003 was $346. During the year ended June 30, 2004, in accordance with the terms of the
Plan, the Companys Board of Directors granted to employees, options to
purchase 142 shares of common stock of the Company at an exercise price of
$3.00 per share. Of these shares, 122 shares were issued upon the termination
of an employee. The options expire between June 30, 2013 and April 29, 2014.
The aggregate market value of the securities underlying the employees options
at the grant dates was approximately $928. Stock-based compensation for the
year ended June 30, 2004 was $7,850 which included the acceleration of
amortizable amounts as a result of the immediate vesting of terminated
employees options. As a closing condition to the USAuto acquisition, the Company issued to
each of two USAuto executives, options to purchase 100 shares of the Companys
common stock at an exercise price of $6.64 per share which was equal to the
fair market value at the time of grant. The options are subject to vesting,
which is subject to acceleration upon certain events such as a change of
control (as defined therein), termination of employment by such executive for
good reason (as defined in their respective employment agreement), by us
without cause (as defined in their respective employment agreement) or due to
death or disability. The options terminate upon the first to occur: (i) the
tenth anniversary of the date of grant, (ii) 12 months following the date of an
executives termination of employment by us for cause or (iii) 24 months
following the date of an executives termination of services for any reason
other than cause. A summary of the status of the Companys 2002 Long Term Incentive Plan as
of June 30, 2004 and 2003 and changes during the years then ended is presented
below: Number
    
    
    
    
    
    Number ofof
    
    Exercise
    
    OptionsOptions
    
    Price
    
    ExercisableBalance/price at June 30, 2002
    
    
    
    
    
    
    
    
    
    
    Granted
    
    
    2,824
    
    
    $
    3.00Exercised
    
    
    
    
    
    
    N/AForfeited
    
    
    
    
    
    
    N/ABalance/price at June 30, 2003
    
    
    2,824
    
    
    $
    3.00
    
    
    
    544Granted
    
    
    1,494
    
    
    $
    3.00-$6.64Exercised
    
    
    (136
    )
    
    
    3.00Forfeited
    
    
    
    
    
    
    N/ABalance/price at June 30, 2004
    
    
    4,182
    
    
    $
    3.00-$6.64
    
    
    
    3,982
 52




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 8. Statutory Financial Information and Accounting Policies The Insurance Companies are required to file statutory-basis financial
statements each December 31 with state insurance departments in all states
where they are licensed. These statements are prepared in accordance with
accounting practices prescribed or permitted by the Department of Insurance in
each companys respective 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
(National Association of Insurance Commissioners) Accounting Principles and
Procedures Manual subject to any deviations prescribed or permitted by the
insurance commissioner in each state of domicile. In addition, the Insurance
Companies are required to report their risk based capital or RBC each
December 31. Failure to maintain an adequate RBC could subject the Insurance
Companies to regulatory action and maintaining an adequate RBC could restrict
the payment of dividends. As of December 31, 2004, the Insurance Companies
RBC levels did not subject them to any regulatory action. USAuto Insurance Company, Inc. (USAuto Insurance) is required by the
Tennessee Department of Commerce and Insurance to maintain statutory capital
and surplus of $2,000 and at June 30, 2004, its statutory capital and surplus
as filed was $17,573. Village Auto Insurance Company, Inc. (Village) is
required by the Georgia Department of Insurance to maintain statutory capital
and surplus of $3,000 and at June 30, 2004, its statutory capital and surplus
as filed was $14,516. At June 30, 2004, on a consolidated statutory basis,
capital and surplus as calculated was $27,088. For the twelve months ended
June 30, 2004, consolidated statutory net income as filed was $3,854. There are no material accounting methods prescribed or permitted by state
insurance departments for either USAuto Insurance or Village that differ from
NAIC statutory accounting practices. The maximum amount of dividends which can be paid by Tennessee and Georgia
insurance companies to shareholders, without the prior approval of the
respective insurance commissioner, is limited to the greater of 10% of
statutory capital and surplus as of December 31 next preceding or net income
(not including realized capital gains) for the year. Accordingly, as of
December 31, 2003, the maximum dividend payouts which may be made by USAuto
Insurance and Village without prior approval within any preceding twelve-month
period are $2,800 and $950, respectively (subject to the sufficiency of
unassigned surplus). USAuto Insurance paid dividends of $500 and $3,000 in
October 2003 and April 2004, respectively. A portion of the April 2004
dividend was considered extraordinary and required prior approval. 53




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 9. Parent Company Financial Information A summarized balance sheet, statement of operations and statement of cash
flows, as of and for the year ended June 30, 2004, of First Acceptance
Corporation (parent company), are presented below: June 30,2004Balance SheetAssets:Investment in subsidiaries, at equity in net assets
    
    $
    22,874Cash and cash equivalents
    
    
    20,530Deferred tax asset
    
    
    44,660Other assets
    
    
    681Foreclosed real estate held for sale
    
    
    1,108Goodwill and identifiable intangible assets
    
    
    102,914Amounts due from subsidiaries
    
    
    3,562$
    196,329Liabilities:Other liabilities
    
    $
    2,103Stockholders equity
    
    
    194,226$
    196,329
 Year EndedJune 30,2004Statement of OperationsGains on sales of foreclosed real estate
    
    $
    4,147Investment income
    
    
    778Equity in income of subsidiaries, net of tax
    
    $
    2,411Expenses
    
    
    (14,515
    )Loss before income taxes
    
    
    (7,179
    )Income tax benefit
    
    
    3,383Net loss
    
    $
    (3,796
    )
 54




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 Year EndedJune 30, 2004Statement of Cash FlowsOperating activities:Net loss
    
    $
    (3,796
    )Equity in income of subsidiaries, net of tax
    
    
    (2,411
    )Depreciation and amortization
    
    
    430Stock-based compensation
    
    
    7,850Deferred income taxes
    
    
    (3,383
    )Gains on sales of foreclosed real estate
    
    
    (4,147
    )Change in assets and liabilities
    
    
    (2,546
    )Net cash used in operating activities
    
    
    (8,003
    )Investing activities:Proceeds from sales of foreclosed real estate
    
    
    4,634Investment in subsidiary
    
    
    (5,000
    )Acquisition
    
    
    (77,718
    )Net cash used in investing activities
    
    
    (78,084
    )Financing activities:Proceeds from issuance of common stock
    
    
    49,364Exercise of stock options
    
    
    406Net cash provided by financing activities
    
    
    49,770Net decrease in cash and cash equivalents
    
    $
    (36,317
    )
 10. Losses and Loss Adjustment Expenses Incurred and Paid Information regarding the reserve for unpaid losses and loss adjustment
expenses for the year ended June 30, 2004 is as follows. Management believes
that, for the two months ended June 30, 2004, there was no change in the
estimate of unpaid loss and loss adjustment expense for losses and loss
adjustment expenses incurred prior to the April 30,2004 acquisition date of
USAuto. Liability for unpaid loss and loss adjustment expenses at date of acquisition, gross
    
    $
    27,993Reinsurance balances recoverable
    
    
    (11,281
    )Liability for unpaid loss and loss adjustment expenses at date of acquisition, net
    
    
    16,712Add: Provision for losses and loss adjustment expenses
    
    
    7,381Accretion of net risk margin/discounting as of the date of acquisition
    
    
    (214
    )Net loss and loss adjustment expenses incurred
    
    
    7,167Less: Loss and loss adjustment expense payments
    
    
    (5,742
    )Liability for unpaid loss and loss adjustment expenses at end of year, gross
    
    
    30,434Reinsurance balances recoverable
    
    
    (12,297
    )Liability for unpaid loss and loss adjustment expenses at end of year, net
    
    $
    18,137
 11. Deferred Ceding Commissions / Deferred Acquisition Costs The costs of acquiring new and renewal business, which vary with and are
directly related to the production of such business, have been deferred (net of
ceding commission income from reinsurer) to the extent that such costs 55




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 are
deemed recoverable from future unearned premiums and anticipated investment
income. Amortization charged to income for the year ended June 30, 2004 was
$18. 12. Note Payable to Financial Institution Note payable to financial institution at June 30, 2004 consisted of a term
loan with an unpaid principal balance of $4,000, at LIBOR plus 366 basis points
(4.77%) due in scheduled quarterly installments through June 30, 2007, secured
by the common stock and certain assets of the USAutos direct wholly-owned
subsidiaries. The maturities of the note payable as of June 30, 2004 were as follows: Years Ending June 30,
    
    Amount2005
    
    $
    1,0002006
    
    
    1,2502007
    
    
    1,750Total
    
    $
    4,000
 The term loan contains certain financial covenants and requires USAuto to
maintain certain financial ratios. At June 30, 2004, USAuto was in compliance
with all provisions of the loan agreement, including the financial covenants
and ratios, except for a Risk Based Capital ratio and a Debt Service Coverage
ratio for which waivers had been obtained. 13. Lease Commitments The Company is committed under various lease agreements for office space
and equipment. Rental expense for 2004, 2003 and 2002 was $528, $87 and $76,
respectively. Future minimum lease payments under these agreements are as
follows: Years Ending June 30,
    
    Amount2005
    
    $
    1,7352006
    
    
    1,3002007
    
    
    9112008
    
    
    5772009
    
    
    551Thereafter
    
    
    1,318Total
    
    $
    6,392
 Effective with the USAuto acquisition and in accordance with the terms of
the severance agreement of Mr. Donald J. Edwards, the Companys former
President and Chief Executive Officer, the Company has assigned and transferred
to a new entity controlled by Mr. Edwards, all of the Companys rights, title
and interest in its lease for office space in Chicago, Illinois. Such entity
has assumed all obligations under the lease and such obligations will be
reimbursed to the entity by the Company during the term of the lease. The
total estimated future cost of this obligation is $1,086 and such amount has
been accrued in the consolidated financial statements by the Company as part of
the cost of Mr. Edwards severance. 56




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 14. Property and Equipment The components of property and equipment as of June 30, 2004 is as
follows: Leasehold improvements
    
    $
    1,529Vehicles
    
    
    79Aircraft
    
    
    985Furniture and equipment
    
    
    2,564Total property and equipment at cost
    
    
    5,157Less: accumulated depreciation
    
    
    (2,753
    )Total property and equipment, net
    
    $
    2,404
 15. Concentrations of Credit Risk At June 30, 2004, the Company had certain concentrations of credit risk
with several financial institutions in the form of cash, which amounted to
$38,352. For purposes of evaluating credit risk, the stability of financial
institutions conducting business with the Company is periodically reviewed. If
the financial institutions failed to completely perform under the terms of the
financial instruments, the exposure for credit loss would be the amount of the
financial instruments less amounts covered by regulatory insurance. USAuto primarily transacts business either directly with its policyholders
or through four independently-owned insurance agencies in Tennessee who
exclusively write insurance policies on behalf of USAuto. Direct policyholders make payments directly to USAuto. Balances due from
policyholders are generally secured by the related unearned premium. USAuto
requires a down payment at the time the policy is originated and subsequent
scheduled payments are monitored in order to prevent USAuto from providing
coverage beyond the date for which payment has been received. If subsequent
payments are not made timely, the policy is generally cancelled at no loss to
USAuto. Policyholders whose premiums are written through the independent agencies
make their payments to these agencies who in turn remit these payments to
USAuto. Balances due to USAuto resulting from premium payments made to these
agencies are unsecured. Reinsurance is subject to credit risk relating to USAutos ability to
collect the payments from reinsured losses due from reinsurers. Since December
1, 2000, the Companys primary reinsurer has been Transatlantic Reinsurance
Company. The current treaty took effect September 1, 2003 and is continuous,
subject to annual cancellation by either party with 90 days prior written
notice. (See note 21.B.) The limit, per state, on the reinsurers liability
for its share of losses paid in excess of policy limits and for its share of
extra contractual obligations is $500 each risk, each loss, subject to a total
annual per state limit of liability of $2,000 for all such losses. The
reinsurers liability arising from any act(s) of terrorism is subject to an
annual per state limit of $1,500. 16. Employee Benefit Plan USAuto sponsors a defined contribution retirement plan under Section
401(k) of the Internal Revenue Code. This plan covers substantially all
employees who meet specified service requirements. Under this plan, USAuto
may, at its discretion, match 50% of each employees contribution up to 6% of
the employees salary. USAutos contributions to the plan for the year ended
June 30, 2004 were $38. 57




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 17. Related Party Transactions The Company has entered into employment agreements with certain executives
which grant the executives the right to receive certain benefits, including
base salary, should such executives be terminated other than for cause. Jeremy B. Ford, a former director of the Company, is the son of Gerald J.
Ford, the Chairman of the Board of Directors of the Company. Jeremy B. Ford
was also an employee of the Company. For the fiscal years ended June 30, 2004
and 2003, Jeremy B. Fords total compensation was $253 and $130, respectively. Brandon L. Jones was the Companys Senior Vice President of Business
Development and is the son-in-law of Edward W. Rose, III, a former director of
the Company. For the fiscal years ended June 30, 2004 and 2003, Mr. Jones
total cash compensation was $207 and $260, respectively. Also, on December 1,
2002, pursuant to the 2002 Long Term Incentive Plan, the Company granted Mr.
Jones an option to purchase 250 shares of common stock of the Company at an
exercise price of $3.00 per share. In addition, upon the termination of his
employment, Mr. Jones was granted an option to purchase an additional 122
shares at the same exercise price. Effective May 1, 2004, the Company entered into an advisory services
agreement with an entity controlled by Donald J. Edwards, the former President
and Chief Executive Officer and a current director of the Company, as an
advisor to the Company to render advisory services (which services will be
personally rendered by Mr. Edwards) in connection with financings, mergers and
acquisitions and other related matters involving the Company. In consideration
for the advisory services to be provided, the Company will pay to the advisor a
quarterly fee of $62.5 for a four-year period. The advisory agreement may be
terminated by the Company if the advisor fails or refuses to perform its
services pursuant to the agreement, does any act, or fails to do any act which
results in an indictment for or conviction of a felony or other similarly
serious offense or upon the written agreement of the advisor. The advisor may
terminate the agreement upon written consent of the Company or if the Company
is in material breach of its obligations thereunder. 18. Litigation USAuto is named as a defendant in various lawsuits, arising in the
ordinary course of business, generally relating to its insurance operations.
All legal actions relating to claims made under insurance policies are
considered by USAuto in establishing its loss and loss adjustment expense
reserves. Management believes that the ultimate resolution of these matters
will not materially affect the consolidated financial statements. 19. Fair Value of Financial Instruments The fair value of financial instruments has been estimated by the Company
using available market information as of June 30, 2004 and 2003, and valuation
methodologies considered appropriate to the circumstances:  Investments in fixed maturities are carried at market values which are
obtained from a recognized pricing service.The fair values of cash equivalents and cash and fiduciary
funds-restricted approximate their carrying amounts based upon their
short maturities.The fair values of the note payable to financial institution approximates
its carrying amount based upon its variable interest rate and
comparability to rates currently being offered for similar notes.20.
    
    Segment Information Prior to the April 30, 2004 acquisition of USAuto, the Companys business
activities were limited to pursuing opportunities to acquire an operating
company and to dispose of foreclosed real estate held for sale. As a 58




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 result of the acquisition, the Companys primary focus is now the selling,
servicing and underwriting of non-standard personal automobile insurance.
Segment information is therefore only presented as of and for the year ended
June 30, 2004. The Real Estate and Corporate segment consists of the Companys
above-mentioned business activities prior to the USAuto acquisition and
interest expense associated with all debt. Total assets by segment are those
assets used in the operation of each segment. The following table presents selected financial data as of and for the
year ended June 30, 2004: Real Estateand
    
    ConsolidatedInsurance
    
    Corporate
    
    TotalRevenues:Premiums earned
    
    $
    11,728
    
    
    $
    
    
    
    $
    11,728Commissions and fees
    
    
    4,401
    
    
    
    
    
    
    
    4,401Ceding commissions from reinsurer
    
    
    1,925
    
    
    
    
    
    
    
    1,925Gains on sales of foreclosed real estate
    
    
    
    
    
    
    4,147
    
    
    
    4,147Investment income
    
    
    180
    
    
    
    778
    
    
    
    958Net realized losses on sales of investments
    
    
    (6
    )
    
    
    
    
    
    
    (6
    )Total revenues
    
    
    18,228
    
    
    
    4,925
    
    
    
    23,153Expenses:Losses and loss adjustment expenses
    
    
    7,167
    
    
    
    
    
    
    
    7,167Operating expenses
    
    
    7,194
    
    
    
    6,235
    
    
    
    13,429Stock-based compensation
    
    
    
    
    
    
    7,850
    
    
    
    7,850Depreciation and amortization
    
    
    608
    
    
    
    40
    
    
    
    648Interest expense
    
    
    
    
    
    
    44
    
    
    
    44Total expenses
    
    
    14,969
    
    
    
    14,169
    
    
    
    29,138Income (loss) before income taxes
    
    $
    3,259
    
    
    $
    (9,244
    )
    
    $
    (5,985
    )Total assets
    
    $
    117,823
    
    
    $
    167,844
    
    
    $
    285,667
 21. Subsequent Events A. Release of Real Estate Property Tax Liens The Companys wholly-owned subsidiary, LNC Holdings, Inc., owned
approximately 41 acres of land located in Arlington, Texas until July 6, 2004.
This property was encumbered by property tax liens totaling $1,700, including
penalties and interest. The property has no carrying value due to the
encumbrances. On July 6, 2004, the City of Arlington took possession of and
title to the property in order to satisfy outstanding tax liens. LNC Holdings,
Inc. has accrued property taxes and related penalties and interest for calendar
years 1996 through 2004 totaling $433. The remainder of the tax lien relates
to the property prior to LNC Holdings, Inc.s ownership of the property, and is
against the property in remonly. Since the sole asset has been taken by the
City of Arlington, it is managements belief that the Company has no obligation
for any outstanding tax liens for this property for the period of 1996 though
2004, or until the date of possession by the City in 2004. As a result of the
Citys action, the Company will reverse the $433 accrual during the three
months ended September 30, 2004. 59




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 B. Non-renewal of Quota-Share Reinsurance As a result of its acquisition by the Company and the resulting available
liquidity to increase the statutory capital and surplus of the Insurance
Companies, effective September 1, 2004, the Insurance Companies have elected to
not renew their 50% quota-share reinsurance treaty. As part of such
non-renewal, an election was also made to cut-off the reinsurance as of the
non-renewal date. Therefore, on such date, the reinsurer will return the ceded
unearned premium, net of ceding commissions, to the Insurance Companies, and
the reinsurer will not be liable for any losses incurred after the non-renewal
date. 22. Business Combination (unaudited) The following unaudited pro forma consolidated statements of income have
been derived by the application of pro forma adjustments to the Companys
historical consolidated statements of income. The unaudited pro forma
consolidated statements of income for the years ended June 30, 2004 and 2003
give effect to the USAuto acquisition and related transactions, including the
rights offering and the application of the proceeds therefrom, as if they had
been consummated on July 1, 2002. Assumptions underlying the pro forma
adjustments are described in the accompanying notes which should be read in
conjunction with these unaudited pro forma consolidated statements of income. USAutoHistoricalTen Months Ended
    
    Pro forma
    
    
    
    
    CompanyPro forma Statement of Income
    
    Company
    
    April 30, 2004
    
    Adjustments
    
    
    
    
    Pro formaYear Ended June 30, 2004
    
    Historical
    
    (unaudited)
    
    (unaudited)
    
    
    
    
    (unaudited)Revenues:Premiums earned
    
    $
    11,728
    
    
    $
    45,988
    
    
    $
    
    
    
    
    
    
    $
    57,716Commissions and fees
    
    
    4,401
    
    
    
    21,874
    
    
    
    
    
    
    
    
    
    
    26,275Ceding commissions from reinsurer
    
    
    1,925
    
    
    
    8,749
    
    
    
    
    
    
    
    
    
    
    10,674Gains on sales of foreclosed real estate
    
    
    4,147
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,147Investment income
    
    
    958
    
    
    
    827
    
    
    
    (354
    )  (a)
    
    
    
    
    
    1,431Net realized (losses) gains on sales of
investments
    
    
    (6
    )
    
    
    86
    
    
    
    
    
    
    
    
    
    
    80Total revenues
    
    
    23,153
    
    
    
    77,524
    
    
    
    (354
    )
    
    
    
    
    
    100,323Expenses:Losses and loss adjustment expenses
    
    
    7,167
    
    
    
    29,465
    
    
    
    (16
    )  (b)
    
    
    
    
    
    36,616Insurance operating expenses
    
    
    7,194
    
    
    
    34,015
    
    
    
    (67
    )  (c)
    
    
    
    
    
    41,142Operating expenses
    
    
    6,235
    
    
    
    
    
    
    
    (3,957
    )  (d)
    
    
    
    
    
    2,278Stock-based compensation
    
    
    7,850
    
    
    
    
    
    
    
    (7,850
    )  (e)
    
    
    
    
    
    Depreciation and amortization
    
    
    648
    
    
    
    536
    
    
    
    182
    (f)
    
    
    
    
    
    1,366Interest
    
    
    44
    
    
    
    274
    
    
    
    
    
    
    
    
    
    
    318Total expenses
    
    
    29,138
    
    
    
    64,290
    
    
    
    (11,708
    )
    
    
    
    
    
    81,720Income (loss) before income taxes
    
    
    (5,985
    )
    
    
    13,234
    
    
    
    11,354
    
    
    
    
    
    
    18,603Income tax (benefit) expense
    
    
    (2,189
    )
    
    
    2,373
    
    
    
    6,799
    (g)
    
    
    
    
    
    6,983Net (loss) income
    
    $
    (3,796
    )
    
    $
    10,861
    
    
    $
    4,555
    
    
    
    
    
    $
    11,620Basic net (loss) income per share
    
    $
    (0.15
    )
    
    
    
    
    
    
    
    
    
    
    
    
    $
    0.25Diluted net (loss) income per share
    
    $
    (0.15
    )
    
    
    
    
    
    
    
    
    
    
    
    
    $
    0.24Weighted average basic shares
    
    
    24,965
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    46,405
    (h)Weighted average diluted shares
    
    
    24,965
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    47,883
    (h)
 60




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002 USAutoHistoricalYear Ended
    
    Pro forma
    
    
    
    
    
    CompanyPro forma Statement of Income
    
    Company
    
    June 30, 2003
    
    Adjustments
    
    
    
    
    
    Pro formaYear Ended June 30, 2003
    
    Historical
    
    (unaudited)
    
    (unaudited)
    
    
    
    
    
    (unaudited)Revenues:Premiums earned
    
    $
    
    
    
    $
    38,353
    
    
    $
    
    
    
    
    
    
    
    $
    38,353Commissions and fees
    
    
    
    
    
    
    33,462
    
    
    
    
    
    
    
    
    
    
    
    33,462Ceding commissions from reinsurer
    
    
    
    
    
    
    6,952
    
    
    
    
    
    
    
    
    
    
    
    6,952Gains on sales of foreclosed real estate
    
    
    233
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    233Investment income
    
    
    1,098
    
    
    
    545
    
    
    
    (354
    )
    
    
    (a
    )
    
    
    1,289Net realized gains on sales of investments
    
    
    
    
    
    
    148
    
    
    
    
    
    
    
    
    
    
    
    148Total revenues
    
    
    1,331
    
    
    
    79,460
    
    
    
    (354
    )
    
    
    
    
    
    
    80,437Expenses:Losses and loss adjustment expenses
    
    
    
    
    
    
    26,034
    
    
    
    (129
    )
    
    
    (b
    )
    
    
    25,905Insurance operating expenses
    
    
    
    
    
    
    36,362
    
    
    
    (400
    )
    
    
    (c
    )
    
    
    35,962Operating expenses
    
    
    2,637
    
    
    
    
    
    
    
    (989
    )
    
    
    (d
    )
    
    
    1,648Stock-based compensation
    
    
    546
    
    
    
    
    
    
    
    (546
    )
    
    
    (e
    )
    
    
    Depreciation and amortization
    
    
    10
    
    
    
    736
    
    
    
    1,208
    
    
    
    (f
    )
    
    
    1,954Interest
    
    
    
    
    
    
    29
    
    
    
    
    
    
    
    
    
    
    
    29Total expenses
    
    
    3,193
    
    
    
    63,161
    
    
    
    (856
    )
    
    
    
    
    
    
    65,498Income (loss) before income taxes
    
    
    (1,862
    )
    
    
    16,299
    
    
    
    502
    
    
    
    
    
    
    
    14,939Income tax expense
    
    
    
    
    
    
    1,904
    
    
    
    3,940
    
    
    
    (g
    )
    
    
    5,844Net (loss) income
    
    $
    (1,862
    )
    
    $
    14,395
    
    
    $
    (3,438
    )
    
    
    
    
    
    $
    9,095Basic net (loss) income per share
    
    $
    (0.09
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    0.20Diluted net (loss) income per share
    
    $
    (0.09
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    0.19Weighted average basic shares
    
    
    20,420
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    46,229
    
    
    
    (h
    )Weighted average diluted shares
    
    
    20,420
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    46,985
    
    
    
    (h
    )
 Notes to unaudited pro forma consolidated statements of income:  (a)
    
    To eliminate investment income that would not have been
earned if the acquisition had been completed on July 1, 2002.(b)
    
    To accrete fair value adjustment to loss and loss adjustment
expense reserves.(c)
    
    To record net increase in salary expense reflecting new
employment agreements with USAuto executives effective with the
acquisition and eliminate loan guarantee fees that are no longer
required following the acquisition.(d)
    
    To eliminate compensation expense of Company employees
terminated pursuant to the terms of the acquisition agreement
effective upon closing of acquisition and to include the expense of
a new advisory agreement (see note 17).(e)
    
    To eliminate stock-based compensation expense of Company
employees terminated pursuant to the terms of the acquisition
agreement effective upon closing of the acquisition.(f)
    
    To amortize identifiable intangible assets resulting from the
acquisition and also eliminate depreciation on assets disposed of as
part of Company employee severance cost as result of the
acquisition.(g)
    
    To record the additional income tax expense as result of (1)
the change in tax status of certain USAuto subsidiary companies from
S corporation to C corporation, (2) expected utilization of
available NOL carryforwards and (3) the tax-effect of deductible pro
forma adjustments. 61




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
(F/K/A LIBERTÉ INVESTORS, INC.)
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
(in thousands, except per share data)
Years Ended June 30, 2004, 2003 and 2002  (h)
    
    Includes the dilutive effect of stock options issued to
Company employees as result of the acquisition as if such options
had been issued on July 1, 2002. 23. Selected Quarterly Financial Data (unaudited) Interim results are not necessarily indicative of fiscal year performance
because of the impact of seasonal and short-term variations. Selected
quarterly financial data are summarized as follows. Note that there was no
income tax expense (benefit) recorded for the years ended June 30, 2003 and
2002 as a result of the uncertainty of the utilization of any tax benefit. QuartersFirst
    
    Second
    
    Third
    
    FourthFiscal Year 2002Operating revenues
    
    $
    455
    
    
    $
    474
    
    
    $
    277
    
    
    $
    268Net income
    
    $
    239
    
    
    $
    216
    
    
    $
    16
    
    
    $
    9Basic and diluted net income per share:
    
    $
    0.01
    
    
    $
    0.01
    
    
    $
    0.00
    
    
    $
    0.00Fiscal Year 2003Operating revenues
    
    $
    525
    
    
    $
    280
    
    
    $
    265
    
    
    $
    261Net loss
    
    $
    (341
    )
    
    $
    (279
    )
    
    $
    (447
    )
    
    $
    (795
    )Basic and diluted net loss per share:
    
    $
    (0.02
    )
    
    $
    (0.01
    )
    
    $
    (0.02
    )
    
    $
    (0.04
    )Fiscal Year 2004Operating revenues
    
    $
    1,549
    
    
    $
    301
    
    
    $
    2,917
    
    
    $
    18,386Net income (loss) before income taxes
    
    $
    880
    
    
    $
    (754
    )
    
    $
    2,194
    
    
    $
    (8,305
    )Net income (loss)
    
    $
    880
    
    
    $
    (754
    )
    
    $
    2,194
    
    
    $
    (6,116
    )Basic and diluted net income (loss) per share:
    
    $
    0.04
    
    
    $
    (0.04
    )
    
    $
    0.10
    
    
    $
    (0.16
    )
 62




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##### Table of Contents



Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure Not applicable. 
 Item 9A. Controls and Procedures Evaluation of Disclosure Controls and Procedures Under the supervision and with the participation of our management team,
including our chief executive officer and chief financial officer, we conducted
an evaluation of our disclosure controls and procedures (as defined in Rules
13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, or
the Exchange Act) as of June 30, 2004. Based on that evaluation, our chief
executive officer (principal executive officer) and chief financial officer
(principal accounting officer) have concluded that our disclosure controls and
procedures are effective in timely alerting them to material information
required to be included in our periodic reports. Changes in Internal Control Over Financial Reporting During the fourth fiscal quarter of the period covered by this report,
there has been no change in our internal control over financial reporting that
has materially affected or is reasonably likely to materially affect our
internal control over financial reporting. 
 Item 9B. Other Information Not applicable. 
 PART III 
 Item 10. Directors and Executive Officers of the Registrant Information with respect to our directors, set forth in our Definitive
Proxy Statement for the Annual Meeting of Shareholders to be held October 28,
2004, under the caption Election of Directors, is incorporated herein by
reference. Pursuant to General Instruction G(3), information concerning our
executive officers is included in Part I of this Annual Report on Form 10-K
under the caption Executive Officers of the Registrant. Information with respect to compliance with Section 16(a) of the
Securities Exchange Act of 1934, set forth in our Definitive Proxy Statement
for the Annual Meeting of Shareholders to be held October 28, 2004, under the
caption Section 16(a) Beneficial Ownership Reporting Compliance, is
incorporated herein by reference. Information with respect to our code of business conduct and ethics, set
forth in our Definitive Proxy Statement for the Annual Meeting of Stockholders
to be held October 28, 2004, under the caption Code of Business Conduct and
Ethics, is incorporated herein by reference. 
 Item 11. Executive Compensation Information with respect to our executive officers, set forth in our
Definitive Proxy Statement for the Annual Meeting of Shareholders to be held
October 28, 2004, under the caption Executive Compensation, is incorporated
herein by reference. 
 Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters Information with respect to security ownership of certain beneficial
owners and management and related stockholder matters, set forth in our
Definitive Proxy Statement for the Annual Meeting of Shareholders to be held
October 28, 2004, under the captions Stock Ownership and Equity Compensation
Plan Information, is incorporated herein by reference. 63




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##### Table of Contents



Item 13. Certain Relationships and Related Transactions Information with respect to certain relationships and related
transactions, set forth in our Definitive Proxy Statement for the Annual
Meeting of Shareholders to be held October 28, 2004, under the caption Certain
Relationships and Related Transactions, is incorporated herein by reference. 
 Item 14. Principal Accountant Fees and Services Information with respect to the fees paid to and services provided by our
principal accountant, set forth in our Definitive Proxy Statement for the
Annual Meeting of Shareholders to be held October 28, 2004, under the caption
Fees Billed to Us by KPMG LLP During 2004, is incorporated herein by
reference. 
 PART IV 
 Item 15. Exhibits, Financial Statement Schedules (a) Financial Statements, Financial Statement Schedules and Exhibits  (1)
    
    Consolidated Financial Statements: see Index to Consolidated
Financial Statements on Page 37.(2)
    
    Financial Statement Schedules. All financial statement schedules
are omitted as the information is either included in the notes to the
consolidated financial statements or is not applicable.(3)
    
    Exhibits: See the exhibit listing set forth below. ExhibitNumber
 2.1
    
    Plan of Reorganization dated as of April 1, 1996, between the Trust and
the Company (incorporated by reference to Exhibit 2.1 of Registration
Statement No. 333-07439 on Form S-4, filed by the Company, (the
Registration Statement)).2.2
    
    Stock Purchase Agreement dated as of January 16, 1996, between Liberté
Investors Trust and Hunters Glen/Ford, Ltd. (the Purchaser)
(incorporated by reference to Exhibit 4.1 of Liberté Investors Trusts
Current Report on Form 8-K filed with the Commission on January 24, 1996),
as amended by the Amendment to the Stock Purchase Agreement, dated as of
February 27, 1996, and the Second Amendment to the Stock Purchase
Agreement, dated as of March 28, 1996 (incorporated by reference to
Exhibit 2.1 of Liberté Investors Trusts Quarterly Report on Form 10-Q for
the quarter ended March 31, 1996).2.3
    
    Agreement and Plan of Merger by and among the Company, USAH Merger Sub,
Inc., USAuto Holdings, Inc. and the Stockholders of USAuto Holdings, Inc.,
dated as of December 15, 2003 (incorporated by reference to Exhibit 2.1 of
Registration Statement No. 333-111161 on Form S-1, filed by the Company).3.1
    
    Restated Certificate of Incorporation of First Acceptance Corporation
(incorporated by reference to Exhibit 3.1 of the Companys Report on Form
8-K dated May 3, 2004).3.2
    
    Amended and Restated Bylaws of First Acceptance Corporation4.1
    
    Form of Registration Rights Agreement dated August 16, 1996, between the
Company and the Purchaser (incorporated by reference to Exhibit 4.1 of the
Registration Statement). 64




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##### Table of Contents



ExhibitNumber
 4.2
    
    Form of Agreement Clarifying Registration Rights dated August 16, 1996,
between the Company, the Purchaser, the Enloe Descendants Trust, and
Robert Ted Enloe, III (incorporated by reference to Exhibit 4.3 of the
Registration Statement).4.3
    
    Registration Rights Agreement dated as of July 1, 2002, by and between
the Company and Donald J. Edwards (incorporated by reference to Exhibit
4.1 of the Companys Current Report on Form 8-K dated July 11, 2002).4.4
    
    Form of certificate representing shares of common stock, par value $0.01
per share (incorporated by reference to Exhibit 4.1 of the Companys
Registration Statement on Form S-8 filed December 26, 2002).10.1
    
    Form of Indemnification Agreement for the Companys directors and
officers and schedule of substantially identical documents (incorporated
by reference to Exhibit 10.2 of the Registration Statement).10.2
    
    Employment Agreement dated as of July 1, 2002, by and between the Company
and Donald J. Edwards (incorporated by reference to Exhibit 10.1 of the
Companys Current Report on Form 8-K dated July 11, 2002).*10.3
    
    First Acceptance Corporation 2002 Long Term Incentive Plan, as amended
(incorporated by reference to Exhibit 4.4 of the Companys Registration
Statement on Form S-8 filed May 18, 2004).*10.4
    
    Nonqualified Stock Option Agreement dated as of July 9, 2002, by and
between the Company and Donald J. Edwards (incorporated by reference to
Exhibit 10.3 of the Companys Current Report on Form 8-K dated July 11,
2002).*10.5
    
    Indemnification Agreement dated as of July 1, 2002, by and between the
Company and Donald J. Edwards (incorporated by reference to Exhibit 10.4
of the Companys Current Report on Form 8-K dated July 11, 2002).10.6
    
    Stock Purchase Agreement dated as of July 9, 2002, by and between the
Company and Donald J. Edwards (incorporated by reference to Exhibit 10.3
of the Companys Registration Statement on Form S-8 dated December 26,
2002).*10.7
    
    Stock Purchase Agreement dated as of June 30, 2003, by and between the
Company and Donald J. Edwards (incorporated by reference to Exhibit 10.8
of the Companys Annual Report on Form 10-K dated September 26, 2003).*10.8
    
    Advisory Services Agreement, dated as of April 30, 2004, by and between
First Acceptance Corporation and Edwards Capital LLC (incorporated by
reference to Exhibit 10.1 of the Companys Current Report on Form 8-K
dated May 3, 2004).*10.9
    
    Separation Agreement dated as of April 30, 2004, by and between First
Acceptance Corporation and Donald J. Edwards (incorporated by reference to
Exhibit 10.2 of the Companys Current Report on Form 8-K dated May 3,
2004).*10.10
    
    Employment Agreement, dated as of April 30, 2004, by and between First
Acceptance Corporation and Stephen J. Harrison (incorporated by reference
to Exhibit 10.3 of the Companys Current Report on Form 8-K dated May 3,
2004).*10.11
    
    Employment Agreement, dated as of April 30, 2004, by and between First
Acceptance Corporation and Thomas M. Harrison, Jr. (incorporated by
reference to Exhibit 10.4 of the Companys Current Report on Form 8-K
dated May 3, 2004).*10.12
    
    Nonqualified Stock Option Agreement, dated as of April 30, 2004, by and
between First Acceptance Corporation and Stephen J. Harrison (incorporated
by reference to Exhibit 10.5 of the Companys Current Report on Form 8-K
dated May 3, 2004).* 65




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##### Table of Contents



ExhibitNumber
 10.13
    
    Nonqualified Stock Option Agreement, dated as of April 30, 2004, by and
between First Acceptance Corporation and Thomas M. Harrison, Jr.
(incorporated by reference to Exhibit 10.6 of the Companys Current Report
on Form 8-K dated May 3, 2004).*10.14
    
    Registration Rights Agreement, dated as of April 30, 2004, by and among
First Acceptance Corporation, Stephen J. Harrison and Thomas M. Harrison,
Jr. (incorporated by reference to Exhibit 10.7 of the Companys Current
Report on Form 8-K dated May 3, 2004).10.15
    
    Severance Compensation Agreement, dated as of August 24,
2004, by and between First Acceptance Corporation and Charles David
Hamilton.*14
    
    First Acceptance Corporation Code of Business Conduct and Ethics.21
    
    Subsidiaries of First Acceptance Corporation.23
    
    Consent of KPMG LLP31.1
    
    Certification of Chief Executive Officer pursuant to Rule 13a-14(a).31.2
    
    Certification of Chief Financial Officer pursuant to Rule 13a-14(a).32.1
    
    Chief Executive Officers Certification pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.32.2
    
    Chief Financial Officers Certification pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.   * Management contract or compensatory plan or arrangement. 66




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 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. FIRST ACCEPTANCE CORPORATIONDate: September 28, 2004
    
    By
    
    /s/ Stephen J. HarrisonStephen J. HarrisonPresident and Chief Executive Officer
 Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated. Signature
    
    Title
    
    Date/s/
    
    Stephen J. Harrison
    
    President, Chief Executive Officer,
and Director(Principal Executive Officer)
    
    September 28, 2004Stephen J. Harrison/s/
    
    Charles D. Hamilton
    
    Treasurer and Chief Financial
Officer
(Principal Financial Officer and Principal Accounting Officer)
    
    September 28, 2004Charles D. Hamilton/s/
    
    Gerald J. Ford
    
    Chairman of the Board of Directors
    
    September 28, 2004Gerald J. Ford/s/
    
    Thomas M. Harrison, Jr
    
    Executive Vice President, Secretary and Director
    
    September 28, 2004Thomas M. Harrison, Jr./s/
    
    Gene H. Bishop
    
    Director
    
    September 28, 2004Gene H. Bishop/s/
    
    Rhodes R. Bobbitt
    
    Director
    
    September 28, 2004Rhodes R. Bobbitt/s/
    
    Harvey B. Cash
    
    Director
    
    September 28, 2004Harvey B. Cash/s/
    
    Donald J. Edwards
    
    Director
    
    September 28, 2004Donald J. Edwards/s/
    
    Lyndon L. Olson
    
    Director
    
    September 28, 2004Lyndon L. Olson/s/
    
    William A. Shipp, Jr.
    
    Director
    
    September 28, 2004William A. Shipp, Jr.
 67