##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-K
 (Mark One)
 þ
    
    ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Fiscal Year Ended June 30, 2006
 OR
 o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to.
 Commission file number 001-12117
 FIRST ACCEPTANCE CORPORATION
 (Exact name of registrant as specified in its charter)
 Delaware
    
    75-1328153(State or other jurisdiction of 
incorporation or organization)
    
    (I.R.S. Employer Identification No.)3813 Green Hills Village Drive, Nashville, Tennessee
    
    37215(Address of principal executive offices)
    
    (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:
 o þ
 o þ
 þ o
 o
  o þ o
 o þ
   DOCUMENTS INCORPORATED BY REFERENCE




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##### 



FIRST
ACCEPTANCE CORPORATION
 Table of
Contents
  
 PagePART IItem 1. Business
    
    
    1Item 1A. Risk Factors
    
    
    14Item 1B. Unresolved Staff Comments
    
    
    21Item 2. Properties
    
    
    22Item 3. Legal Proceedings
    
    
    22Item 4. Submission of Matters to a Vote of Security Holders
    
    
    22PART 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
    
    
    26Item 7A. Quantitative and Qualitative Disclosures About Market Risk
    
    
    38Item 8. Financial Statements and Supplementary Data
    
    
    39Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
    
    
    67Item 9A. Controls and Procedures
    
    
    67Item 9B. Other Information
    
    
    67PART IIIItem 10. Directors and Executive Officers of the Registrant
    
    
    68Item 11. Executive Compensation
    
    
    68Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    68Item 13. Certain Relationships and Related Transactions
    
    
    68Item 14. Principal Accounting Fees and Services
    
    
    68PART IVItem 15. Exhibits, Financial Statement Schedules
    
    
    69SIGNATURES
    
    
    72EX-10.19 Summary of CompensationEx-21  Subsidiaries of First Acceptance CorporationEX-23.1 Consent of Ernst & Young LLPEX-23.2 CONSENT OF KPMG LLPEx-31.1  Section 302 Certification of the CEOEx-31.2  Section 302 Certification of the CFOEx-32.1  Section 906 Certification of the CEOEx-32.2  Section 906 Certification of the CFO
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FIRST ACCEPTANCE CORPORATION
 
 PART I
 
 Item 1. Business
 General
  Acquisition of USAuto
  Our Business Strategy
  
    
    Integrated Operations. 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 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 believe our customers value face-to-face contact, speed of
service and convenient
locations. Consequently, we train our employee-agents to cultivate client relationships and
utilize real-time service and information enabled by access to our intranet system. As of
September 1, 2006, we leased and operated 458 retail sales offices staffed with our
employee-agents and strategically located in geographic markets to reach and service our
customers.
 1




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##### Table of Contents




    
    Favorable Customer Payment Plans. Our customers can initiate insurance coverage with a
modest down payment. Any remaining premium is paid in monthly installments over the term
of the policy. We believe this modest initial payment and favorable payment plan is a
major factor in our success in meeting the 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® advertisements and a
broad network of retail sales offices.
    
    Efficient Technology Systems. We have developed technology systems that enable timely
and efficient communication and data sharing among the various segments of our integrated
operations. All of our retail 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
      2




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Personal Automobile Insurance Market
   Our Products
     Our Growth Strategy
  3




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##### Table of Contents




    
    Increase the Number of Customers in Existing Geographic Markets. We intend to work to
continue to increase the number of our customers through advertising campaigns and opening
new retail sales offices in some of the states where we currently do business. We believe
that the number of our customers will also increase as our recently-added sales offices
continue to add new customers.
    
    Expand into New Geographic Markets. We currently operate in 12 states and are licensed
as an insurer in 13 additional states. We intend to expand into additional states through
the opening of new sales offices and through selective acquisitions. During the fiscal
year ended June 30, 2006, we began operating in South Carolina and opened 21 new sales
offices.
    
    Pursue Acquisitions of Local Agencies.We intend to selectively pursue acquisitions of
local agencies who write non-standard automobile insurance for other insurance companies in
our existing markets and in new markets. During 2006, we completed the acquisition of a
local insurance agency operation in Chicago, Illinois and in 2005 we completed an
acquisition in Texas.
  Competition
  Marketing and Distribution
    4




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Underwriting and Pricing
   Claims Handling
    Loss and Loss Adjustment Expense Reserves
   5




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At June 30 (in thousands)
    
    2004
    
    
    2005
    
    
    2006Net liability for loss and loss adjustment
expense reserves, originally estimated
    
    $
    18,137
    
    
    $
    39,289
    
    
    $
    61,521Cumulative amounts paid as of:One year later
    
    
    13,103
    
    
    
    28,024Two years later
    
    
    16,579Liability reestimated as of:One year later
    
    
    17,781
    
    
    
    37,741Two years later
    
    
    17,244Net cumulative redundancy (deficiency)
    
    
    893
    
    
    
    1,548Gross liability  end of year
    
    $
    30,434
    
    
    $
    42,897
    
    
    $
    62,822Reinsurance recoverables
    
    
    12,297
    
    
    
    3,608
    
    
    
    1,301Net liability  end of year
    
    $
    18,137
    
    
    $
    39,289
    
    
    $
    61,521Gross re-estimated liability  latest
    
    $
    29,441
    
    
    $
    40,934Reestimated reinsurance recoverables  latest
    
    
    12,197
    
    
    
    3,193Net reestimated  latest
    
    $
    17,244
    
    
    $
    37,741Gross cumulative redundancy (deficiency)
    
    $
    993
    
    
    $
    1,963
  6




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Reinsurance
   7




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Technology
  Sales Office Automation
 Payment Processing
 Ratings
   8




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Regulatory Environment
 Insurance Company Regulation
 
    
    regulating premium rates and forms;
    
    setting minimum solvency standards;
    
    setting capital and surplus requirements;
    
    licensing companies, agents and, in some states, adjusters;
    
    setting requirements for and limiting the types and amounts of investments;
    
    establishing requirements for the filing of annual statements and other financial reports;
    
    conducting periodic statutory examinations of the affairs of insurance companies;
    
    requiring prior approval of changes in control and of certain transactions with affiliates;
    
    limiting the amount of dividends that may be paid without prior regulatory approval; and
    
    setting standards for advertising and other market conduct activities.
 Required Licensing.
 Alabama 
Arizona 
Arkansas 
Colorado 
Florida 
Georgia 
Illinois 
Indiana 
Iowa 
Kansas 
Kentucky 
Louisiana 
Mississippi
    
    Missouri
Nevada
New Mexico
Ohio
Oklahoma
Pennsylvania
South Carolina
Tennessee
Texas
Utah
Virginia
West Virginia
  9




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Insurance Holding Company Regulation
 Restrictions on Paying Dividends
 Regulation of Rates and Policy Forms
 Guaranty Funds
 Investment Regulation
 10




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Restrictions on Cancellation, Non-Renewal or Withdrawal
 Privacy Regulations
 Licensing of Our Employee-Agents and Adjusters.
 Unfair Claims Practices
 
    
    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.
 11




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Quarterly and Annual Financial Reporting.
 Periodic Financial and Market Conduct Examinations
 Risk-Based Capital
   12




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IRIS Ratios
  
    
    FAIC had a ratio outside the usual range for high investment yield as the calculated
yield was above 6.5%. The calculated yield was 12.5% and was inflated as a result of
the inclusion of a dividend received during the year from FAIC-GA. Excluding this
dividend, the calculated yield would have been 3.3% which is above the low end of the
investment yield range of 3%.
    
    Both had ratio results outside of the usual IRIS range for changes in net premiums
written, which is plus or minus 33%. Net premiums written increased 114% and 34% for
FAIC and FAIC-GA, respectively. In addition to the growth attributable to increased
business, net premium writings for both companies increased as a result of the
non-renewal of their quota-share reinsurance effective September 1, 2004.
    
    FAIC had ratios outside of the usual IRIS range for both the gross and net changes
in capital and surplus, which are plus or minus 50% and 25%, respectively. FAIC
increased its gross and net capital and surplus by 110% and 68%, respectively,
primarily through capital contributions to support its premium growth. The net change
in capital and surplus excludes amounts that are paid in.
  Employees
  13




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Available Information
  Internet Website
  
 Item 1A.
 Risk Factors
 Our ability to use net operating loss carryforwards to reduce future tax payments may be limited .
    14




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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 .
  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 .
  15




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Our business is highly competitive, which may make it difficult for us to market our core products
effectively and profitably .
  Our business may be adversely affected by negative developments in the states in which we operate .
  Our business may be adversely affected by negative developments in the non-standard personal
automobile insurance industry .
  Our results may fluctuate as a result of cyclical changes in the personal automobile insurance
industry.
  Our investment portfolio may suffer reduced returns or losses, which could reduce our
profitability.
  16




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We rely on our information technology and communication systems, and the failure of these systems
could materially and adversely affect our business.
  We may have difficulties in managing our expansion into new markets .
  We may not be successful in identifying agency acquisition candidates or integrating their
operations, which could harm our financial results .
  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 .
  17




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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 .
  
    
    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, the use of aftermarket (non-original equipment manufacturer) parts 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.
  Due to our largely fixed cost structure, our profitability may decline if our sales volume were to
decline significantly .
  18




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Severe weather conditions and other catastrophes may result in an increase in the number and
amount of claims filed against us .
   A few of our stockholders have significant control over us, and their interests may differ from
yours
  Our insurance company subsidiaries are subject to regulatory restrictions on paying dividends to
us .
 .
 We and our subsidiaries are subject to comprehensive regulation and supervision that may restrict
our ability to earn profits.
   Required Licensing
 19




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Transactions Between Insurance Companies and Their Affiliates
 Regulation of Rates and Policy Forms
 Investment Restrictions
 Restrictions on Cancellation, Non-Renewal or Withdrawal
 Provisions in our certificate of incorporation and bylaws may prevent a takeover or a change in
management that you may deem favorable.
  20




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
    
    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.
  
 Item 1B. Unresolved Staff Comments
  Executive Officers of the Registrant
   Name
    
    Age
    
    PositionStephen J. Harrison
    
    
    54
    
    
    President and Chief Executive OfficerThomas M. Harrison, Jr.
    
    
    56
    
    
    Executive Vice President and SecretaryMichael J. Bodayle
    
    
    50
    
    
    Acting Chief Financial Officer and Chief
Financial Officer  Insurance Company
OperationsWilliam R. Pentecost
    
    
    48
    
    
    Chief Information OfficerRandy L. Reed
    
    
    50
    
    
    Senior Vice President  Sales and MarketingJames R. Dickson
    
    
    40
    
    
    Senior Vice President  Claims
 Stephen J. Harrison
 Thomas M. Harrison, Jr.
 Michael
J. Bodayle
 21




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William R. Pentecost
 Randy L. Reed
 James R. Dickson
 
 Item 2. Properties
  
 Item 3. Legal Proceedings
  
 Item 4. Submission of Matters to a Vote of Security Holders
  22




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PART II
 
 Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer
Purchases of Equity Securities
 Trading Prices
  Price RangeHigh
    
    LowYear Ended June 30, 2005First Quarter
    
    $
    7.45
    
    
    $
    5.83Second Quarter
    
    
    9.08
    
    
    
    7.01Third Quarter
    
    
    10.95
    
    
    
    8.60Fourth Quarter
    
    
    10.85
    
    
    
    8.23Year Ended June 30, 2006First Quarter
    
    $
    10.37
    
    
    $
    8.77Second Quarter
    
    
    10.66
    
    
    
    9.59Third Quarter
    
    
    13.34
    
    
    
    10.06Fourth Quarter
    
    
    13.40
    
    
    
    10.95
  Dividend Policy
  Stock Transfer Restrictions
  23




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Item 6. Selected Financial Data
    24




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Year Ended June 30,Proforma
    
    
    
    
    
    
    ProformaActual
    
    
    2004
    
    
    Actual
    
    
    20032006
    
    
    2005
    
    
    2004
    
    
    (unaudited)
    
    
    2003
    
    
    (unaudited)
    
    
    2002(in thousands, except per share data)Statement of Operations Data:Revenues:Premiums earned
    
    $
    206,754
    
    
    $
    132,347
    
    
    $
    11,728
    
    
    $
    57,716
    
    
    $
    
    
    
    $
    38,353
    
    
    $
    Commissions and fees
    
    
    28,774
    
    
    
    27,151
    
    
    
    4,401
    
    
    
    26,275
    
    
    
    
    
    
    
    33,462
    
    
    
    Transaction service fee
    
    
    4,150
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Ceding commissions from reinsurer
    
    
    
    
    
    
    2,975
    
    
    
    1,925
    
    
    
    10,674
    
    
    
    
    
    
    
    6,952
    
    
    
    Gains on sales of foreclosed real estate
    
    
    3,638
    
    
    
    755
    
    
    
    4,147
    
    
    
    4,147
    
    
    
    233
    
    
    
    233
    
    
    
    139Investment income
    
    
    5,762
    
    
    
    3,353
    
    
    
    958
    
    
    
    1,431
    
    
    
    1,098
    
    
    
    1,289
    
    
    
    1,335Other
    
    
    (76
    )
    
    
    214
    
    
    
    (6
    )
    
    
    80
    
    
    
    
    
    
    
    148
    
    
    
    Total revenues
    
    
    249,002
    
    
    
    166,795
    
    
    
    23,153
    
    
    
    100,323
    
    
    
    1,331
    
    
    
    80,437
    
    
    
    1,474Expenses:Losses and loss adjustment expenses
    
    
    140,845
    
    
    
    87,493
    
    
    
    7,167
    
    
    
    36,616
    
    
    
    
    
    
    
    25,905
    
    
    
    Insurance operating expenses
    
    
    75,773
    
    
    
    49,921
    
    
    
    7,194
    
    
    
    41,142
    
    
    
    
    
    
    
    35,962
    
    
    
    Other operating expenses
    
    
    2,494
    
    
    
    2,775
    
    
    
    6,235
    
    
    
    2,278
    
    
    
    2,637
    
    
    
    1,648
    
    
    
    988Stock-based compensation
    
    
    500
    
    
    
    332
    
    
    
    7,850
    
    
    
    
    
    
    
    546
    
    
    
    
    
    
    
    Depreciation and amortization
    
    
    1,463
    
    
    
    1,920
    
    
    
    648
    
    
    
    1,366
    
    
    
    10
    
    
    
    1,954
    
    
    
    6Interest expense
    
    
    898
    
    
    
    351
    
    
    
    44
    
    
    
    318
    
    
    
    
    
    
    
    29
    
    
    
    Total expenses
    
    
    221,973
    
    
    
    142,792
    
    
    
    29,138
    
    
    
    81,720
    
    
    
    3,193
    
    
    
    65,498
    
    
    
    994Income (loss) before income taxes
    
    
    27,029
    
    
    
    24,003
    
    
    
    (5,985
    )
    
    
    18,603
    
    
    
    (1,862
    )
    
    
    14,939
    
    
    
    480Income tax expense (benefit) (1)
    
    
    (1,039
    )
    
    
    (2,153
    )
    
    
    (2,189
    )
    
    
    6,983
    
    
    
    
    
    
    
    5,844
    
    
    
    Net income (loss)
    
    $
    28,068
    
    
    $
    26,156
    
    
    $
    (3,796
    )
    
    $
    11,620
    
    
    $
    (1,862
    )
    
    $
    9,095
    
    
    $
    480Basic net income (loss) per share
    
    $
    0.59
    
    
    $
    0.56
    
    
    $
    (0.15
    )
    
    $
    0.25
    
    
    $
    (0.09
    )
    
    $
    0.20
    
    
    $
    0.02Diluted net income (loss) per share
    
    $
    0.57
    
    
    $
    0.53
    
    
    $
    (0.15
    )
    
    $
    0.24
    
    
    $
    (0.09
    )
    
    $
    0.19
    
    
    $
    0.02Weighted average basic shares
    
    
    47,487
    
    
    
    47,055
    
    
    
    24,965
    
    
    
    46,405
    
    
    
    20,420
    
    
    
    46,229
    
    
    
    20,256Weighted average diluted shares
    
    
    49,576
    
    
    
    48,989
    
    
    
    24,965
    
    
    
    47,883
    
    
    
    20,420
    
    
    
    46,985
    
    
    
    20,256Cash dividend declared per share of common
stock
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    0.006
 June 30,2006
    
    2005
    
    2004
    
    2003
    
    2002(in thousands, except per share data)Balance Sheet Data:Fixed maturities, available for sale
    
    $
    127,828
    
    
    $
    74,840
    
    
    $
    33,243
    
    
    $
    
    
    
    $
    Cash, cash equivalents and other invested
assets
    
    
    31,534
    
    
    
    35,682
    
    
    
    38,352
    
    
    
    56,847
    
    
    
    56,510Foreclosed real estate held for sale
    
    
    87
    
    
    
    961
    
    
    
    1,108
    
    
    
    1,594
    
    
    
    2,175Deferred tax asset
    
    
    48,068
    
    
    
    48,106
    
    
    
    45,493
    
    
    
    
    
    
    
    Goodwill and identifiable intangible assets
    
    
    143,870
    
    
    
    112,704
    
    
    
    102,914
    
    
    
    
    
    
    
    Total assets
    
    
    434,306
    
    
    
    330,722
    
    
    
    285,667
    
    
    
    59,053
    
    
    
    58,919Loss and loss adjustment expense reserves
    
    
    62,822
    
    
    
    42,897
    
    
    
    30,434
    
    
    
    
    
    
    
    Unearned premiums
    
    
    76,117
    
    
    
    47,752
    
    
    
    33,433
    
    
    
    
    
    
    
    Notes payable and capitalized lease
obligations
    
    
    24,026
    
    
    
    
    
    
    
    4,000
    
    
    
    
    
    
    
    Total liabilities
    
    
    180,883
    
    
    
    102,393
    
    
    
    91,441
    
    
    
    978
    
    
    
    528Total stockholders equity
    
    
    253,423
    
    
    
    228,329
    
    
    
    194,226
    
    
    
    58,075
    
    
    
    58,391Book value per share
    
    $
    5.33
    
    
    $
    4.81
    
    
    $
    4.17
    
    
    $
    2.82
    
    
    $
    2.88
 
 (1)
    
    The income tax benefit for the years ended June 30, 2006 and 2005 include decreases
in the valuation allowance for the deferred tax asset of $10,540 and $10,594, respectively.
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 these years, the benefit resulting from
the utilization of NOLs directly offsets federal income taxes that would have otherwise been
payable. 25




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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 Risk Factors.
 General
     Year Ended June 30,2006
    
    2005Retail locations  beginning of year
    
    
    248
    
    
    
    133Opened
    
    
    149
    
    
    
    101Acquired
    
    
    72
    
    
    
    15Closed
    
    
    (9
    )
    
    
    (1
    )Retail locations  end of year
    
    
    460
    
    
    
    248
  Retail Locations as of
    
    Change in LocationsJune 30,
    
    Year Ended June 30,2006
    
    2005
    
    2004
    
    2006
    
    2005Alabama
    
    
    25
    
    
    
    25
    
    
    
    21
    
    
    
    
    
    
    
    4Florida
    
    
    39
    
    
    
    20
    
    
    
    
    
    
    
    19
    
    
    
    20Georgia
    
    
    63
    
    
    
    62
    
    
    
    54
    
    
    
    1
    
    
    
    8Illinois
    
    
    86
    
    
    
    5
    
    
    
    
    
    
    
    81
    
    
    
    5Indiana
    
    
    26
    
    
    
    21
    
    
    
    4
    
    
    
    5
    
    
    
    17Mississippi
    
    
    8
    
    
    
    8
    
    
    
    5
    
    
    
    
    
    
    
    3Missouri
    
    
    18
    
    
    
    14
    
    
    
    10
    
    
    
    4
    
    
    
    4Ohio
    
    
    30
    
    
    
    29
    
    
    
    23
    
    
    
    1
    
    
    
    6Pennsylvania
    
    
    25
    
    
    
    7
    
    
    
    
    
    
    
    18
    
    
    
    7South Carolina
    
    
    21
    
    
    
    
    
    
    
    
    
    
    
    21
    
    
    
    Tennessee
    
    
    20
    
    
    
    20
    
    
    
    16
    
    
    
    
    
    
    
    4Texas
    
    
    99
    
    
    
    37
    
    
    
    
    
    
    
    62
    
    
    
    37Total
    
    
    460
    
    
    
    248
    
    
    
    133
    
    
    
    212
    
    
    
    115
 26




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##### Table of Contents



Consolidated Results of Operations
 Overview
   27




---



##### Table of Contents



ProformaActual
    
    
      (unaudited)Year Ended June 30,
    
    
    Year Ended June 30,2006
    
    
    2005
    
    
    2004
    
    
    2004Insurance Operations
    
    
    
    
    
    (in thousands)Revenues:Premiums earned
    
    $
    206,754
    
    
    $
    132,347
    
    
    $
    11,728
    
    
    $
    57,716Commissions and fees
    
    
    28,774
    
    
    
    27,151
    
    
    
    4,401
    
    
    
    26,275Transaction service fee
    
    
    4,150
    
    
    
    
    
    
    
    
    
    
    
    Ceding commissions from reinsurer
    
    
    
    
    
    
    2,975
    
    
    
    1,925
    
    
    
    10,674Investment income
    
    
    4,955
    
    
    
    2,287
    
    
    
    180
    
    
    
    1,007Other gains (losses)
    
    
    (76
    )
    
    
    214
    
    
    
    (6
    )
    
    
    80Total revenues
    
    
    244,557
    
    
    
    164,974
    
    
    
    18,228
    
    
    
    95,752Expenses:Losses and loss adjustment expenses
    
    
    140,845
    
    
    
    87,493
    
    
    
    7,167
    
    
    
    36,616Operating expenses
    
    
    75,773
    
    
    
    49,921
    
    
    
    7,194
    
    
    
    41,142Depreciation and amortization
    
    
    1,463
    
    
    
    1,920
    
    
    
    608
    
    
    
    1,366Total expenses
    
    
    218,081
    
    
    
    139,334
    
    
    
    14,969
    
    
    
    79,124Income before income taxes
    
    $
    26,476
    
    
    $
    25,640
    
    
    $
    3,259
    
    
    $
    16,628
 ProformaActual
    
    
    (unaudited)Year Ended June 30,
    
    
    Year Ended June 30,2006


    2005


    2004
    
    
    2004Real Estate and Corporate
    
    (in thousands)Revenues:Gains on sales of foreclosed real estate
    
    $
    3,638
    
    
    $
    755
    
    
    $
    4,147
    
    
    $
    4,147Investment income
    
    
    807
    
    
    
    1,066
    
    
    
    778
    
    
    
    424Total revenues
    
    
    4,445
    
    
    
    1,821
    
    
    
    4,925
    
    
    
    4,571Expenses:Operating expenses
    
    
    2,494
    
    
    
    2,775
    
    
    
    6,235
    
    
    
    2,278Stock-based compensation
    
    
    500
    
    
    
    332
    
    
    
    7,850
    
    
    
    Depreciation
    
    
    
    
    
    
    
    
    
    
    40
    
    
    
    Interest expense
    
    
    898
    
    
    
    351
    
    
    
    44
    
    
    
    318Total expenses
    
    
    3,892
    
    
    
    3,458
    
    
    
    14,169
    
    
    
    2,596Income (loss) before income taxes
    
    $
    553
    
    
    $
    (1,637
    )
    
    $
    (9,244
    )
    
    $
    1,975
  
    
    premiums earned, including policy and renewal fees, from (i) sales of
policies issued by our insurance company subsidiaries, net of the portion of those
premiums ceded to reinsurers, and (ii) the sales of policies issued by our managing
general agency (MGA) subsidiaries that are assumed 100% by our insurance company
subsidiaries through quota-share reinsurance;
    
    fee income, including installment billing fees on policies written as well
as fees for other ancillary services (principally a motor club product);
    
    a transaction service fee for servicing the run-off business previously
written by the Chicago agencies whose business we acquired (for the period from January
12, 2006 through December 31, 2006);
    
    commission income paid by our reinsurer to us for ceded premiums (ceasing
with the September 1, 2004 non-renewal of our quota-share reinsurance); and
    
    investment income earned on the invested assets of the insurance company
subsidiaries.
 28




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##### Table of Contents



Pro formaActual
    
    
    (unaudited)Year Ended June 30,
    
    
    Year Ended June 30,2006
    
    
    2005
    
    
    2004
    
    
    2004Gross premiums earned::Georgia
    
    $
    68,948
    
    
    $
    69,806
    
    
    $
    11,419
    
    
    $
    65,496Alabama
    
    
    28,952
    
    
    
    26,610
    
    
    
    4,331
    
    
    
    24,219Florida
    
    
    26,327
    
    
    
    1,181
    
    
    
    
    
    
    
    Tennessee
    
    
    24,387
    
    
    
    26,205
    
    
    
    4,460
    
    
    
    25,387Texas
    
    
    16,579
    
    
    
    4,569
    
    
    
    
    
    
    
    Ohio
    
    
    14,046
    
    
    
    10,703
    
    
    
    1,250
    
    
    
    5,789Illinois
    
    
    7,680
    
    
    
    112
    
    
    
    
    
    
    
    Indiana
    
    
    6,163
    
    
    
    2,032
    
    
    
    23
    
    
    
    25Missouri
    
    
    5,332
    
    
    
    4,193
    
    
    
    587
    
    
    
    3,125Mississippi
    
    
    5,187
    
    
    
    4,431
    
    
    
    680
    
    
    
    3,822Pennsylvania
    
    
    1,996
    
    
    
    24
    
    
    
    
    
    
    
    South Carolina
    
    
    1,238
    
    
    
    
    
    
    
    
    
    
    
    Total gross premiums earned
    
    
    206,835
    
    
    
    149,866
    
    
    
    22,750
    
    
    $
    127,863Premiums ceded
    
    
    (81
    )
    
    
    (8,732
    )
    
    
    (8,459
    )
    
    
    (44,365
    )Premiums not assumed
    
    
    
    
    
    
    (8,787
    )
    
    
    (2,563
    )
    
    
    (25,782
    )Total net premiums earned
    
    $
    206,754
    
    
    $
    132,347
    
    
    $
    11,728
    
    
    $
    57,716
  Year Ended June 30,Actual
    
    Pro forma2006
    
    2005
    
    2004Policies in force  beginning of period
    
    
    119,422
    
    
    
    91,385
    
    
    
    87,014Acquired
    
    
    
    
    
    
    6,473
    
    
    
    Net increase during period
    
    
    80,979
    
    
    
    21,564
    
    
    
    4,371Policies in force  end of period
    
    
    200,401
    
    
    
    119,422
    
    
    
    91,385
  Loss Ratio 
 Expense Ratio 
 29




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##### Table of Contents



Combined Ratio 
  Pro forma(unaudited)Actual
    
    Year EndedYear Ended June 30,
    
    June 30,2006
    
    2005
    
    2004
    
    2004Loss and loss adjustment expense
    
    
    68.1
    %
    
    
    66.1
    %
    
    
    61.1
    %
    
    
    63.4
    %Expense
    
    
    20.7
    %
    
    
    17.7
    %
    
    
    13.7
    %
    
    
    15.8
    %Combined
    
    
    88.8
    %
    
    
    83.8
    %
    
    
    74.8
    %
    
    
    79.2
    %
   Year Ended June 30, 2006 Compared With Year Ended June 30, 2005
 Consolidated Results
   30




---



##### Table of Contents



Insurance Operations
  Premiums Earned
   Commissions and Fees and Transaction Service Fee
  Investment Income
  Loss and Loss Adjustment Expenses
  31




---



##### Table of Contents



Operating Expenses
    Real Estate and Corporate
   Year Ended June 30, 2005 Compared With Year Ended June 30, 2004
 Actual Consolidated Results
    32




---



##### Table of Contents



Pro forma Consolidated Results
  Actual Results  Insurance Operations
  Pro forma Results  Insurance Operations
  Premiums Earned
    Commissions and Fees and Ceding Commissions from Reinsurer
  Investment Income
  33




---



##### Table of Contents



Loss and Loss Adjustment Expenses
  Operating Expenses
     Actual Results  Real Estate and Corporate
    Pro forma Results  Real Estate and Corporate
  34




---



##### Table of Contents



Liquidity and Capital Resources
     Chicago Acquisition
   35




---



##### Table of Contents



Off-Balance Sheet Arrangements
  Contractual Obligations
  Payments Due By PeriodLess than
    
    
    
    
    
    
    
    
    
    
    More thanTotal
    
    
    1 year
    
    
    1-3 Years
    
    
    3-5 Years
    
    
    5 years(in thousands)Loss and loss adjustment expenses
    
    $
    62,822
    
    
    $
    40,206
    
    
    $
    20,417
    
    
    $
    2,199
    
    
    $
    Notes payable and capitalized lease obligation
    
    
    24,026
    
    
    
    5,691
    
    
    
    11,379
    
    
    
    6,956
    
    
    
    Operating leases
    
    
    33,861
    
    
    
    10,096
    
    
    
    14,725
    
    
    
    7,264
    
    
    
    1,776Employment agreements
    
    
    2,267
    
    
    
    800
    
    
    
    1,467
    
    
    
    
    
    
    
    Severance agreement obligation
    
    
    710
    
    
    
    261
    
    
    
    415
    
    
    
    34
    
    
    
    Advisory services agreement
    
    
    458
    
    
    
    250
    
    
    
    208
    
    
    
    
    
    
    
    Total contractual cash obligations
    
    $
    124,144
    
    
    $
    57,304
    
    
    $
    48,611
    
    
    $
    16,453
    
    
    $
    1,776
  Critical Accounting Policies
  Valuation of deferred tax asset.
  36




---



##### Table of Contents



Losses and loss adjustment expense reserves.
  Goodwill and identifiable intangible assets.
 Forward-Looking Statements
  
    
    statements and assumptions relating to future growth, income, income per share and
other financial performance measures, as well as managements short-term and long-term
performance goals;
    
    statements relating to the anticipated effects on results of operations or financial
condition from recent and expected developments or events;
 37




---



##### Table of Contents




    
    statements relating to our business and growth strategies; and
    
    any other statements or assumptions that are not historical facts.
   
 Item 7A. Quantitative and Qualitative Disclosures About Market Risk
    38




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##### Table of Contents



Item 8.
Financial Statements and Supplementary Data
 PageReports of Independent Registered Public Accounting Firms
    
    
    40Consolidated Balance Sheets
    
    
    43Consolidated Statements of Operations
    
    
    44Consolidated Statements of Stockholders Equity
    
    
    45Consolidated Statements of Cash Flows
    
    
    46Notes to Consolidated Financial Statements
    
    
    47
 39




---



##### Table of Contents



Report of Independent Registered Public Accounting Firm
 
      
 40




---



##### Table of Contents



Report of Independent Registered Public Accounting Firm on Internal Control over Financial Reporting
 
 Internal Control Over Financial Reporting
       
 41




---



##### Table of Contents



Report of Independent Registered Public Accounting Firm
 
     
 42




---



##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
 
 CONSOLIDATED BALANCE SHEETS
 (in thousands, except per share data)
 June 30,2006
    
    
    2005ASSETSFixed maturities, available for sale at fair value (amortized
cost $131,291 and $73,832, respectively)
    
    $
    127,828
    
    
    $
    74,840Investment in mutual fund, at market value
    
    
    
    
    
    
    10,920Cash and cash equivalents
    
    
    31,534
    
    
    
    24,762Fiduciary funds  restricted
    
    
    532
    
    
    
    935Premiums and fees receivable
    
    
    64,074
    
    
    
    42,908Reinsurance recoverables
    
    
    1,344
    
    
    
    4,490Receivable for securities
    
    
    999
    
    
    
    Deferred tax asset
    
    
    48,068
    
    
    
    48,106Other assets
    
    
    7,264
    
    
    
    4,863Property and equipment, net
    
    
    3,376
    
    
    
    1,962Foreclosed real estate held for sale
    
    
    87
    
    
    
    961Deferred acquisition costs
    
    
    5,330
    
    
    
    3,271Goodwill
    
    
    137,045
    
    
    
    107,837Identifiable intangible assets
    
    
    6,825
    
    
    
    4,867TOTAL ASSETS
    
    $
    434,306
    
    
    $
    330,722LIABILITIES AND STOCKHOLDERS EQUITYLoss and loss adjustment expense reserves
    
    $
    62,822
    
    
    $
    42,897Unearned premiums
    
    
    76,117
    
    
    
    47,752Deferred fee income
    
    
    2,214
    
    
    
    2,272Amounts due to insurance companies
    
    
    532
    
    
    
    935Notes payable and capitalized lease obligation
    
    
    24,026
    
    
    
    Payable for securities
    
    
    4,914
    
    
    
    Other liabilities
    
    
    10,258
    
    
    
    8,537Total liabilities
    
    
    180,883
    
    
    
    102,393Stockholders equity:Preferred stock, $.01 par value, 10,000 shares authorized
    
    
    
    
    
    
    Common stock, $.01 par value, 75,000 shares authorized;
47,535 and 47,455 shares issued and outstanding,
respectively
    
    
    475
    
    
    
    475Additional paid-in capital
    
    
    459,049
    
    
    
    457,905Accumulated other comprehensive income (loss):Net unrealized appreciation (depreciation) on investments
    
    
    (3,463
    )
    
    
    655Accumulated deficit
    
    
    (202,638
    )
    
    
    (230,706
    )Total stockholders equity
    
    
    253,423
    
    
    
    228,329TOTAL LIABILITIES AND STOCKHOLDERS EQUITY
    
    $
    434,306
    
    
    $
    330,722
  43




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (in thousands, except per share data)
 Year Ended June 30,2006
    
    
    2005
    
    
    2004Revenues:Premiums earned
    
    $
    206,754
    
    
    $
    132,347
    
    
    $
    11,728Commissions and fees
    
    
    28,774
    
    
    
    27,151
    
    
    
    4,401Transaction service fee
    
    
    4,150
    
    
    
    
    
    
    
    Ceding commissions from reinsurer
    
    
    
    
    
    
    2,975
    
    
    
    1,925Gains on sales of foreclosed real estate
    
    
    3,638
    
    
    
    755
    
    
    
    4,147Investment income
    
    
    5,762
    
    
    
    3,353
    
    
    
    958Gains (losses) on sales of assets
    
    
    (76
    )
    
    
    214
    
    
    
    (6
    )Total revenues
    
    
    249,002
    
    
    
    166,795
    
    
    
    23,153Expenses:Losses and loss adjustment expenses
    
    
    140,845
    
    
    
    87,493
    
    
    
    7,167Insurance operating expenses
    
    
    75,773
    
    
    
    49,921
    
    
    
    7,194Other operating expenses
    
    
    2,494
    
    
    
    2,775
    
    
    
    6,235Stock-based compensation
    
    
    500
    
    
    
    332
    
    
    
    7,850Depreciation
    
    
    851
    
    
    
    990
    
    
    
    258Amortization of identifiable intangible assets
    
    
    612
    
    
    
    930
    
    
    
    390Interest expense
    
    
    898
    
    
    
    351
    
    
    
    44Total expenses
    
    
    221,973
    
    
    
    142,792
    
    
    
    29,138Income (loss) before income taxes
    
    
    27,029
    
    
    
    24,003
    
    
    
    (5,985
    )Income tax benefit
    
    
    (1,039
    )
    
    
    (2,153
    )
    
    
    (2,189
    )Net income (loss)
    
    $
    28,068
    
    
    $
    26,156
    
    
    $
    (3,796
    )Net income (loss) per share:Basic
    
    $
    0.59
    
    
    $
    0.56
    
    
    $
    (0.15
    )Diluted
    
    $
    0.57
    
    
    $
    0.53
    
    
    $
    (0.15
    )Weighted average number of shares used to
calculate net income (loss) per share:Basic
    
    
    47,487
    
    
    
    47,055
    
    
    
    24,965Diluted
    
    
    49,576
    
    
    
    48,989
    
    
    
    24,965
  44




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
 
 CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
 (in thousands)
 AccumulatedAdditional
    
    
    Deferred
    
    
    other
    
    
    
    
    
    
    
    
    
    
    TotalCommon Stock
    
    
    paid-in
    
    
    compensation
    
    
    comprehensive
    
    
    Accumulated
    
    
    Treasury
    
    
    stockholdersShares
    
    
    Amount
    
    
    capital
    
    
    expense
    
    
    income (loss)
    
    
    deficit
    
    
    Stock
    
    
    equityBalances at July 1, 2003
    
    
    20,589
    
    
    $
    206
    
    
    $
    312,451
    
    
    $
    (1,516
    )
    
    $
    
    
    
    $
    (253,066
    )
    
    $
    
    
    
    $
    58,075Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,796
    )
    
    
    
    
    
    
    (3,796
    )Other comprehensive
losschange in unrealized
appreciation
(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
    )
    
    
    
    
    
    
    194,226Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    26,156
    
    
    
    
    
    
    
    26,156Other comprehensive
incomechange in
unrealized appreciation
(depreciation) on
investments (net of tax
of $373)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    690
    
    
    
    
    
    
    
    
    
    
    
    690Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    26,846Issuance of contingent
shares related to
acquisition
    
    
    750
    
    
    
    8
    
    
    
    6,712
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,720Stock-based compensation
    
    
    3
    
    
    
    
    
    
    
    332
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    332Issuance of shares under
Employee Stock Purchase
Plan
    
    
    11
    
    
    
    1
    
    
    
    103
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    104Purchase of treasury
stock, at cost
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (639
    )
    
    
    (639
    )Retirement of treasury
stock, at cost
    
    
    (90
    )
    
    
    (1
    )
    
    
    (638
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    639
    
    
    
    Exercise of stock options
    
    
    246
    
    
    
    2
    
    
    
    738
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    740Balances at June 30, 2005
    
    
    47,455
    
    
    $
    475
    
    
    $
    457,905
    
    
    $
    
    
    
    $
    655
    
    
    $
    (230,706
    )
    
    $
    
    
    
    $
    228,329Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    28,068
    
    
    
    
    
    
    
    28,068Other comprehensive
losschange in unrealized
appreciation
(depreciation) on
investments (net of tax
of $353)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,118
    )
    
    
    
    
    
    
    
    
    
    
    (4,118
    )Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,950Stock-based compensation
    
    
    3
    
    
    
    
    
    
    
    500
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    500Issuance of shares under
Employee Stock Purchase
Plan
    
    
    22
    
    
    
    
    
    
    
    223
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    223Exercise of stock options
    
    
    55
    
    
    
    
    
    
    
    421
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    421Balances at June 30, 2006
    
    
    47,535
    
    
    $
    475
    
    
    $
    459,049
    
    
    $
    
    
    
    $
    (3,463
    )
    
    $
    (202,638
    )
    
    $
    
    
    
    $
    253,423
  45




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (in thousands)
 Year Ended June 30,2006
    
    
    2005
    
    
    2004Cash flows from operating activities:Net income (loss)
    
    $
    28,068
    
    
    $
    26,156
    
    
    $
    (3,796
    )Adjustments to reconcile net income (loss) to cash provided by
(used in) operating activities:Depreciation and amortization
    
    
    1,463
    
    
    
    1,920
    
    
    
    648Stock-based compensation
    
    
    500
    
    
    
    332
    
    
    
    7,850Amortization of premium on fixed maturities
    
    
    460
    
    
    
    357
    
    
    
    65Deferred income taxes
    
    
    (1,533
    )
    
    
    (2,986
    )
    
    
    (2,283
    )Gains on sales of foreclosed real estate
    
    
    (3,638
    )
    
    
    (755
    )
    
    
    (4,147
    )(Gains) losses on sales of assets
    
    
    76
    
    
    
    (214
    )
    
    
    6Change in:Fiduciary funds  restricted
    
    
    403
    
    
    
    916
    
    
    
    125Premiums and fees receivable
    
    
    (21,166
    )
    
    
    (10,832
    )
    
    
    2,518Reinsurance recoverables
    
    
    3,146
    
    
    
    7,807
    
    
    
    (1,015
    )Prepaid reinsurance premiums
    
    
    
    
    
    
    12,384
    
    
    
    (215
    )Other assets
    
    
    (2,401
    )
    
    
    (1,318
    )
    
    
    (9
    )Deferred acquisition costs
    
    
    (2,059
    )
    
    
    (3,571
    )
    
    
    300Loss and loss adjustment expense reserves
    
    
    19,925
    
    
    
    12,463
    
    
    
    2,440Unearned premiums
    
    
    28,365
    
    
    
    14,319
    
    
    
    (1,535
    )Deferred fee income
    
    
    (58
    )
    
    
    (318
    )
    
    
    (168
    )Amounts due to reinsurers
    
    
    
    
    
    
    (11,899
    )
    
    
    (949
    )Amounts due to insurance companies
    
    
    (403
    )
    
    
    (916
    )
    
    
    (125
    )Other liabilities
    
    
    1,721
    
    
    
    1,603
    
    
    
    (195
    )Net cash provided by (used in) operating activities
    
    
    52,869
    
    
    
    45,448
    
    
    
    (485
    )Cash flows from investing activities:Proceeds from sales of foreclosed real estate
    
    
    4,512
    
    
    
    1,202
    
    
    
    4,634Addition to foreclosed real estate
    
    
    
    
    
    
    (300
    )
    
    
    Proceeds from sale of property and equipment
    
    
    
    
    
    
    666
    
    
    
    Acquisitions of property and equipment
    
    
    (2,265
    )
    
    
    (1,053
    )
    
    
    (68
    )Purchases of fixed maturities, available-for-sale
    
    
    (82,144
    )
    
    
    (48,493
    )
    
    
    (10,371
    )Maturities and paydowns of fixed maturities, available-for-sale
    
    
    8,748
    
    
    
    3,502
    
    
    
    Sales of fixed maturities, available-for-sale
    
    
    15,400
    
    
    
    4,153
    
    
    
    10,673Sales (purchases) of investment in mutual fund, net
    
    
    10,920
    
    
    
    (10,920
    )
    
    
    Net increase in payable/receivable for securities
    
    
    3,915
    
    
    
    
    
    
    
    Businesses acquired through asset purchase
    
    
    (29,853
    )
    
    
    (4,000
    )
    
    
    Acquisition, net of cash received
    
    
    
    
    
    
    
    
    
    
    (72,398
    )Net cash used in investing activities
    
    
    (70,767
    )
    
    
    (55,243
    )
    
    
    (67,530
    )Cash flows from financing activities:Proceeds from borrowings
    
    
    30,431
    
    
    
    
    
    
    
    Net proceeds from issuance of common stock
    
    
    223
    
    
    
    104
    
    
    
    49,364Purchase of treasury stock
    
    
    
    
    
    
    (639
    )
    
    
    Proceeds from exercise of stock options
    
    
    421
    
    
    
    740
    
    
    
    406Payments on borrowings
    
    
    (6,405
    )
    
    
    (4,000
    )
    
    
    (250
    )Net cash provided by (used in) financing activities
    
    
    24,670
    
    
    
    (3,795
    )
    
    
    49,520Net increase (decrease) in cash and cash equivalents
    
    
    6,772
    
    
    
    (13,590
    )
    
    
    (18,495
    )Cash and cash equivalents, beginning of year
    
    
    24,762
    
    
    
    38,352
    
    
    
    56,847Cash and cash equivalents, end of year
    
    $
    31,534
    
    
    $
    24,762
    
    
    $
    38,352
  46




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (in thousands, except per share data)
 1. Summary of Significant Accounting Policies
 A. General
     B. Basis of Consolidation and Reporting
   C. Use of Estimates
  47




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 D. Investments
    E. Fiduciary Funds-Restricted
  F. Property and Equipment
  G. Insurance Revenue Recognition
  H. Reinsurance
  I. Deferred Acquisition Costs / Deferred Ceding Commissions
  48




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 J. Loss and Loss Adjustment Expense Reserves
  K. Fee Income
  L. Foreclosed Real Estate Held for Sale
  M. Goodwill and Other Identifiable Intangible Assets
  N. Income Taxes
   O. Recently Issued Accounting Standards
  49




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
   P. Supplemental Cash Flow Information
   Q. Basic and Diluted Net Income (Loss) Per Share
  R. Stock-Based Compensation
   50




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 Year EndedJune 30, 2004Net loss before income taxes, as reported
    
    $
    (5,985
    )Add: Stock-based employee compensation expense included in
reported net loss
    
    
    7,850Deduct: Stock-based employee compensation expense
determined under fair value-based method for all awards
    
    
    (11,598
    )Net loss before income taxes, pro forma
    
    
    (9,733
    )Income tax benefit, pro forma
    
    
    3,501Net loss, pro forma
    
    $
    (6,232
    )Net loss per share:Basic and
diluted  as reported
    
    $
    (0.15
    )Basic and
diluted  pro forma
    
    $
    (0.25
    )
   2. Business Combinations
 A. Acquisition of USAuto and Stock Rights Offering
    51




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 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
    B. Texas Insurance Agency
   C. Chicago Insurance Agencies
  52




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
  Net tangible assets
    
    $
    330Identifiable intangible assets
    
    
    2,570Goodwill
    
    
    27,283Total assets acquired
    
    $
    30,183
    3. Investments
 A. Restrictions
  B. Investment Income and Net Realized Gains and Losses
  Year Ended June 30,2006
    
    
    2005
    
    
    2004Fixed maturities, available for sale
    
    $
    4,411
    
    
    $
    2,419
    
    
    $
    200Investment in mutual fund
    
    
    674
    
    
    
    920
    
    
    
    Cash and cash equivalents
    
    
    983
    
    
    
    198
    
    
    
    778Investment expenses
    
    
    (306
    )
    
    
    (184
    )
    
    
    (20
    )$
    5,762
    
    
    $
    3,353
    
    
    $
    958
  Year Ended June 30,2006
    
    
    2005
    
    
    2004Gains
    
    $
    88
    
    
    $
    72
    
    
    $
    41Losses
    
    
    (164
    )
    
    
    (19
    )
    
    
    (47
    )$
    (76
    )
    
    $
    53
    
    
    $
    (6
    )
 53




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 C. Fixed Maturities, Available for Sale
  Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairJune 30, 2006
    
    Cost
    
    
    Gains
    
    
    Losses
    
    
    ValueU.S. Government
    
    $
    14,808
    
    
    $
    6
    
    
    $
    (466
    )
    
    $
    14,348State
    
    
    7,706
    
    
    
    1
    
    
    
    (196
    )
    
    
    7,511Political subdivisions
    
    
    6,630
    
    
    
    
    
    
    
    (140
    )
    
    
    6,490Revenue and assessment
    
    
    25,597
    
    
    
    4
    
    
    
    (684
    )
    
    
    24,917Corporate bonds
    
    
    22,006
    
    
    
    
    
    
    
    (599
    )
    
    
    21,407Collateralized mortgage
    
    
    54,544
    
    
    
    25
    
    
    
    (1,414
    )
    
    
    53,155$
    131,291
    
    
    $
    36
    
    
    $
    (3,499
    )
    
    $
    127,828
 Gross
    
    
    GrossAmortized
    
    
    Unrealized
    
    
    Unrealized
    
    
    FairJune 30, 2005
    
    Cost
    
    
    Gains
    
    
    Losses
    
    
    ValueU.S. Government
    
    $
    6,115
    
    
    $
    107
    
    
    $
    
    
    
    $
    6,222State
    
    
    5,416
    
    
    
    60
    
    
    
    
    
    
    
    5,476Political subdivisions
    
    
    6,616
    
    
    
    92
    
    
    
    (19
    )
    
    
    6,689Revenue and assessment
    
    
    24,130
    
    
    
    557
    
    
    
    (23
    )
    
    
    24,664Corporate bonds
    
    
    11,110
    
    
    
    58
    
    
    
    (18
    )
    
    
    11,150Collateralized mortgage
    
    
    20,445
    
    
    
    210
    
    
    
    (16
    )
    
    
    20,639$
    73,832
    
    
    $
    1,084
    
    
    $
    (76
    )
    
    $
    74,840
  Amortized
    
    
    FairCost
    
    
    ValueOne year or less
    
    $
    2,740
    
    
    $
    2,725One to five years
    
    
    37,071
    
    
    
    36,116Five to ten years
    
    
    29,759
    
    
    
    28,927Greater than ten years
    
    
    7,177
    
    
    
    6,905No single maturity date
    
    
    54,544
    
    
    
    53,155$
    131,291
    
    
    $
    127,828
  Less than 12 months
    
    
    12 months or longer
    
    
    TotalFair
    
    
    Unrealized
    
    
    Fair
    
    
    Unrealized
    
    
    UnrealizedValue
    
    
    Losses
    
    
    Value
    
    
    Losses
    
    
    LossesU.S. Government
    
    $
    13,349
    
    
    $
    (466
    )
    
    $
    
    
    
    $
    
    
    
    $
    (466
    )State
    
    
    6,372
    
    
    
    (129
    )
    
    
    1,138
    
    
    
    (67
    )
    
    
    (196
    )Political subdivisions
    
    
    5,289
    
    
    
    (118
    )
    
    
    1,027
    
    
    
    (22
    )
    
    
    (140
    )Revenue and assessment
    
    
    18,236
    
    
    
    (472
    )
    
    
    4,610
    
    
    
    (212
    )
    
    
    (684
    )Corporate bonds
    
    
    15,492
    
    
    
    (406
    )
    
    
    5,915
    
    
    
    (193
    )
    
    
    (599
    )Collateralized mortgage
    
    
    46,129
    
    
    
    (934
    )
    
    
    8,986
    
    
    
    (480
    )
    
    
    (1,414
    )$
    104,867
    
    
    $
    (2,525
    )
    
    $
    21,676
    
    
    $
    (974
    )
    
    $
    (3,499
    )
 54




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
   4. Reinsurance
    Year Ended June 30,2006
    
    2005
    
    2004Ceded premiums earned
    
    $
    81
    
    
    $
    8,732
    
    
    $
    8,459Reinsurance recoveries on losses and loss adjustment expenses
    
    
    188
    
    
    
    5,867
    
    
    
    5,846
   Year Ended June 30,2006
    
    
    2005
    
    
    2004Written
    
    
    Earned
    
    
    Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    216,131
    
    
    $
    186,833
    
    
    $
    128,543
    
    
    $
    117,706
    
    
    $
    15,553
    
    
    $
    17,582Assumed
    
    
    19,251
    
    
    
    20,002
    
    
    
    25,343
    
    
    
    23,373
    
    
    
    2,303
    
    
    
    2,605Ceded
    
    
    (81
    )
    
    
    (81
    )
    
    
    6,051
    
    
    
    (8,732
    )
    
    
    (7,435
    )
    
    
    (8,459
    )Net
    
    $
    235,301
    
    
    $
    206,754
    
    
    $
    159,937
    
    
    $
    132,347
    
    
    $
    10,421
    
    
    $
    11,728
  55




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 5. Federal Income Taxes
  Year Ended June 30,2006
    
    
    2005
    
    
    2004Federal:Current
    
    $
    161
    
    
    $
    515
    
    
    $
    Deferred
    
    
    (1,533
    )
    
    
    (2,986
    )
    
    
    (2,283
    )State income taxes
    
    
    333
    
    
    
    318
    
    
    
    94$
    (1,039
    )
    
    $
    (2,153
    )
    
    $
    (2,189
    )
  Year Ended June 30,2006
    
    
    2005
    
    
    2004Income tax expense (benefit) at statutory rate
    
    $
    9,460
    
    
    $
    8,401
    
    
    $
    (2,095
    )Tax effect of:Tax-exempt investment income
    
    
    (221
    )
    
    
    (261
    )
    
    
    (45
    )Change in the beginning of the year balance of
the valuation allowance for deferred tax asset
allocated to income taxes
    
    
    (10,540
    )
    
    
    (10,594
    )
    
    
    Other
    
    
    (71
    )
    
    
    (17
    )
    
    
    (143
    )$
    (1,372
    )
    
    $
    (2,471
    )
    
    $
    (2,283
    )
  2006
    
    
    2005Deferred tax asset:Net operating loss carryforwards
    
    $
    57,847
    
    
    $
    68,724Stock option compensation
    
    
    2,718
    
    
    
    2,634Unearned premiums and loss and loss adjustment expense reserves
    
    
    6,812
    
    
    
    4,280Basis differences of foreclosed real estate
    
    
    47
    
    
    
    606Other
    
    
    1,078
    
    
    
    1,624Total gross deferred tax asset
    
    
    68,502
    
    
    
    77,868Less: Valuation allowance
    
    
    (20,434
    )
    
    
    (29,762
    )Net deferred tax asset
    
    $
    48,068
    
    
    $
    48,106
   56




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
  Expiration Year Ending June 30,
    
    Amount2007
    
    $
    32,5842008
    
    
    36,1882009
    
    
    84,7912010
    
    
    7,095Thereafter
    
    
    4,619Total NOL carryforwards
    
    $
    165,277
 6. Net Income Per Share
   Year Ended June 30,2006
    
    
    2005Net income
    
    $
    28,068
    
    
    $
    26,156Weighted average basic shares
    
    
    47,487
    
    
    
    47,055Effect of dilutive securities  options
    
    
    2,089
    
    
    
    1,934Weighted average dilutive shares
    
    
    49,576
    
    
    
    48,989Basic net income per share
    
    $
    0.59
    
    
    $
    0.56Diluted net income per share
    
    $
    0.57
    
    
    $
    0.53
  7. Stock-Based Compensation
     57




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
   Number
    
    
    
    
    
    
    Number ofof
    
    
    Exercise
    
    
    OptionsOptions
    
    
    Price
    
    
    ExercisableBalance/price at July 1, 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
    
    
    
    3,982Granted
    
    
    200
    
    
    $
    8.13Exercised
    
    
    (246
    )
    
    $
    3.00Forfeited
    
    
    
    
    
    
    N/ABalance/price at June 30, 2005
    
    
    4,136
    
    
    $
    3.00-$8.13
    
    
    
    3,829Granted
    
    
    
    
    
    
    Exercised
    
    
    (55
    )
    
    $
    3.00-$8.13Forfeited
    
    
    
    
    
    
    Balance/price at June 30, 2006
    
    
    4,081
    
    
    $
    3.00-$8.13
    
    
    
    3,848
 8. Employee Stock Purchase Plan
   9. Statutory Financial Information and Accounting Policies
  58




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
     59




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 10.
    
    Parent Company Financial Information
  June 30,2006
    
    
    2005Balance SheetsAssets:Investment in subsidiaries, at equity in net assets
    
    $
    81,938
    
    
    $
    51,713Investment in mutual fund
    
    
    
    
    
    
    10,920Cash and cash equivalents
    
    
    7,554
    
    
    
    253Deferred tax asset
    
    
    42,711
    
    
    
    45,150Other assets
    
    
    790
    
    
    
    177Foreclosed real estate held for sale
    
    
    87
    
    
    
    961Goodwill and identifiable intangible assets
    
    
    143,870
    
    
    
    112,704Amounts due from subsidiaries
    
    
    1,544
    
    
    
    7,806$
    278,494
    
    
    $
    229,684Liabilities:Notes payable
    
    $
    23,612
    
    
    $
    Other liabilities
    
    
    1,459
    
    
    
    1,355Stockholders equity
    
    
    253,423
    
    
    
    228,329$
    278,494
    
    
    $
    229,684
 Year Ended June 30,2006
    
    
    2005
    
    
    2004Statements of OperationsGains on sales of foreclosed real estate
    
    $
    3,638
    
    
    $
    755
    
    
    $
    4,147Investment income
    
    
    807
    
    
    
    1,066
    
    
    
    778Equity in income of subsidiaries, net of tax
    
    
    17,922
    
    
    
    17,197
    
    
    
    2,411Expenses
    
    
    (4,532
    )
    
    
    (4,036
    )
    
    
    (14,515
    )Income (loss) before income taxes
    
    
    17,835
    
    
    
    14,982
    
    
    
    (7,179
    )Income tax benefit
    
    
    (10,233
    )
    
    
    (11,174
    )
    
    
    (3,383
    )Net income (loss)
    
    $
    28,068
    
    
    $
    26,156
    
    
    $
    (3,796
    )
 Year Ended June 30,2006
    
    
    2005
    
    
    2004Statements of Cash FlowsOperating activities:Net income (loss)
    
    $
    28,068
    
    
    $
    26,156
    
    
    $
    (3,796
    )Equity in income of subsidiaries, net of tax
    
    
    (17,922
    )
    
    
    (17,197
    )
    
    
    (2,411
    )Depreciation and amortization
    
    
    642
    
    
    
    928
    
    
    
    430Stock-based compensation
    
    
    500
    
    
    
    332
    
    
    
    7,850Deferred income taxes
    
    
    514
    
    
    
    (1,589
    )
    
    
    (3,383
    )Gains on sales of foreclosed real estate
    
    
    (3,638
    )
    
    
    (755
    )
    
    
    (4,147
    )Change in assets and liabilities
    
    
    5,725
    
    
    
    (3,389
    )
    
    
    (2,546
    )Net cash provided by (used in) operating activities
    
    
    13,889
    
    
    
    4,486
    
    
    
    (8,003
    )Investing activities:Proceeds from sales of foreclosed real estate
    
    
    4,512
    
    
    
    1,202
    
    
    
    4,634Addition to foreclosed real estate
    
    
    
    
    
    
    (300
    )
    
    
    Sales (purchases) of investment in mutual fund
    
    
    10,920
    
    
    
    (10,920
    )
    
    
    Investment in subsidiary
    
    
    (17,173
    )
    
    
    (10,950
    )
    
    
    (5,000
    )Dividend from subsidiary
    
    
    750
    
    
    
    
    
    
    
    Acquisition
    
    
    (29,853
    )
    
    
    (4,000
    )
    
    
    (77,718
    )Net cash used in investing activities
    
    
    (30,844
    )
    
    
    (24,968
    )
    
    
    (78,084
    )Financing activities:Proceeds from borrowing
    
    
    30,000
    
    
    
    
    
    
    
    Proceeds from issuance of common stock
    
    
    223
    
    
    
    104
    
    
    
    49,364Purchase of treasury stock
    
    
    
    
    
    
    (639
    )
    
    
    Proceeds from exercise of stock options
    
    
    421
    
    
    
    740
    
    
    
    406Payments on borrowings
    
    
    (6,388
    )
    
    
    
    
    
    
    Net cash provided by financing activities
    
    
    24,256
    
    
    
    205
    
    
    
    49,770Net increase (decrease) in cash and cash equivalents
    
    $
    7,301
    
    
    $
    (20,277
    )
    
    $
    (36,317
    )
 60




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 11. Losses and Loss Adjustment Expenses Incurred and Paid
  Year Ended June 30,2006
    
    
    2005
    
    
    2004Liability for unpaid loss and loss adjustment expenses at beginning
of year/date of acquisition, gross
    
    $
    42,897
    
    
    $
    30,434
    
    
    $
    27,993Reinsurance balances recoverable
    
    
    (3,608
    )
    
    
    (12,297
    )
    
    
    (11,281
    )Liability for unpaid loss and loss adjustment expenses at beginning of
year/date of acquisition, net
    
    
    39,289
    
    
    
    18,137
    
    
    
    16,712Add: Provision for losses and loss adjustment expenses:Current year
    
    
    142,436
    
    
    
    88,068
    
    
    
    7,381Prior years
    
    
    (1,548
    )
    
    
    (356
    )
    
    
    Accretion of net risk margin/discounting as of the date of acquisition
    
    
    (43
    )
    
    
    (219
    )
    
    
    (214
    )Net loss and loss adjustment expenses incurred
    
    
    140,845
    
    
    
    87,493
    
    
    
    7,167Less: Loss and loss adjustment expense payments:Current year
    
    
    90,589
    
    
    
    53,238
    
    
    
    5,742Prior years
    
    
    28,024
    
    
    
    13,103
    
    
    
    Net loss and loss adjustment expense payments
    
    
    118,613
    
    
    
    66,341
    
    
    
    5,742Liability for unpaid loss and loss adjustment expenses at end of year, net
    
    
    61,521
    
    
    
    39,289
    
    
    
    18,137Reinsurance balances recoverable
    
    
    1,301
    
    
    
    3,608
    
    
    
    12,297Liability for unpaid loss and loss adjustment expenses at end of year,
gross
    
    $
    62,822
    
    
    $
    42,897
    
    
    $
    30,434
  12. Deferred Acquisition Costs / Deferred Ceding Commissions
  13. Notes Payable and Capitalized Lease Obligation
  61




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
   CapitalizedLeaseYear Ending June 30,
    
    Notes Payable
    
    
    Obligation
    
    
    Total2007
    
    $
    5,552
    
    
    $
    139
    
    
    $
    5,6912008
    
    
    5,552
    
    
    
    144
    
    
    
    5,6962009
    
    
    5,552
    
    
    
    131
    
    
    
    5,6832010
    
    
    6,956
    
    
    
    
    
    
    
    6,956$
    23,612
    
    
    $
    414
    
    
    $
    24,026
 14. Lease Commitments
  Year Ending June 30,
    
    Amount2007
    
    $
    10,0962008
    
    
    8,4862009
    
    
    6,2392010
    
    
    5,0532011
    
    
    2,211Thereafter
    
    
    1,776Total
    
    $
    33,861
  15. Property and Equipment
  June 30,2006
    
    
    2005Leasehold improvements
    
    $
    1,740
    
    
    $
    1,452Aircraft
    
    
    190
    
    
    
    190Furniture and equipment
    
    
    4,943
    
    
    
    3,397Capitalized lease obligation
    
    
    431
    
    
    
    Total property and equipment at cost
    
    
    7,304
    
    
    
    5,039Less: Accumulated depreciation
    
    
    (3,928
    )
    
    
    (3,077
    )Total property and equipment, net
    
    $
    3,376
    
    
    $
    1,962
 62




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##### Table of Contents



FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 16. Concentrations of Credit Risk
    17. Employee Benefit Plan
  18. Related Party Transactions
    63
    Table of Contents   FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
  19. Litigation
  20. Fair Value of Financial Instruments
     21. Segment Information
   64




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
  Real EstateInsurance
    
    
    and
    
    
    ConsolidatedYear Ended June 30, 2006
    
    Operations
    
    
    Corporate
    
    
    TotalRevenues:Premiums earned
    
    $
    206,754
    
    
    $
    
    
    
    $
    206,754Commissions and fees
    
    
    28,774
    
    
    
    
    
    
    
    28,774Transaction service fee
    
    
    4,150
    
    
    
    
    
    
    
    4,150Gains on sales of foreclosed real estate
    
    
    
    
    
    
    3,638
    
    
    
    3,638Investment income
    
    
    4,955
    
    
    
    807
    
    
    
    5,762Other gains (losses)
    
    
    (76
    )
    
    
    
    
    
    
    (76
    )Total revenues
    
    
    244,557
    
    
    
    4,445
    
    
    
    249,002Expenses:Losses and loss adjustment expenses
    
    
    140,845
    
    
    
    
    
    
    
    140,845Operating expenses
    
    
    75,773
    
    
    
    2,494
    
    
    
    78,267Stock-based compensation
    
    
    
    
    
    
    500
    
    
    
    500Depreciation and amortization
    
    
    1,463
    
    
    
    
    
    
    
    1,463Interest expense
    
    
    
    
    
    
    898
    
    
    
    898Total expenses
    
    
    218,081
    
    
    
    3,892
    
    
    
    221,973Income before income taxes
    
    $
    26,476
    
    
    $
    553
    
    
    $
    27,029Total assets at June 30, 2006
    
    $
    383,337
    
    
    $
    50,969
    
    
    $
    434,306
 Real EstateInsurance
    
    
    and
    
    
    ConsolidatedYear Ended June 30, 2005
    
    Operations
    
    
    Corporate
    
    
    TotalRevenues:Premiums earned
    
    $
    132,347
    
    
    $
    
    
    
    $
    132,347Commissions and fees
    
    
    27,151
    
    
    
    
    
    
    
    27,151Ceding commissions from reinsurer
    
    
    2,975
    
    
    
    
    
    
    
    2,975Gains on sales of foreclosed real estate
    
    
    
    
    
    
    755
    
    
    
    755Investment income
    
    
    2,287
    
    
    
    1,066
    
    
    
    3,353Other
    
    
    214
    
    
    
    
    
    
    
    214Total revenues
    
    
    164,974
    
    
    
    1,821
    
    
    
    166,795Expenses:Losses and loss adjustment expenses
    
    
    87,493
    
    
    
    
    
    
    
    87,493Operating expenses
    
    
    49,921
    
    
    
    2,775
    
    
    
    52,696Stock-based compensation
    
    
    
    
    
    
    332
    
    
    
    332Depreciation and amortization
    
    
    1,920
    
    
    
    
    
    
    
    1,920Interest expense
    
    
    
    
    
    
    351
    
    
    
    351Total expenses
    
    
    139,334
    
    
    
    3,458
    
    
    
    142,792Income (loss) before income taxes
    
    $
    25,640
    
    
    $
    (1,637
    )
    
    $
    24,003Total assets at June 30, 2005
    
    $
    272,514
    
    
    $
    58,208
    
    
    $
    330,722
 65




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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(in thousands, except per share data)
 Real EstateInsurance
    
    
    and
    
    
    ConsolidatedYear Ended June 30, 2004
    
    Operations
    
    
    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
    
    
    
    958Other
    
    
    (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 at June 30, 2004
    
    $
    215,127
    
    
    $
    70,540
    
    
    $
    285,667
 22. Selected Quarterly Financial Data (unaudited)
  QuartersFirst
    
    Second
    
    Third
    
    FourthYear Ended June 30, 2006Operating revenues
    
    $
    50,258
    
    
    $
    53,841
    
    
    $
    70,068
    
    
    $
    74,835Net income before income taxes
    
    $
    5,633
    
    
    $
    5,448
    
    
    $
    9,031
    
    
    $
    6,917Net income
    
    $
    3,713
    
    
    $
    3,800
    
    
    $
    5,864
    
    
    $
    14,691Basic net income per share
    
    $
    0.08
    
    
    $
    0.08
    
    
    $
    0.12
    
    
    $
    0.31Diluted net income per share
    
    $
    0.08
    
    
    $
    0.08
    
    
    $
    0.12
    
    
    $
    0.30Year Ended June 30, 2005Operating revenues
    
    $
    30,903
    
    
    $
    40,725
    
    
    $
    45,395
    
    
    $
    49,772Net income before income taxes
    
    $
    5,898
    
    
    $
    7,328
    
    
    $
    6,779
    
    
    $
    3,998Net income
    
    $
    3,864
    
    
    $
    4,687
    
    
    $
    4,405
    
    
    $
    13,200Basic net income per share
    
    $
    0.08
    
    
    $
    0.10
    
    
    $
    0.09
    
    
    $
    0.28Diluted net income per share
    
    $
    0.08
    
    
    $
    0.10
    
    
    $
    0.09
    
    
    $
    0.27
 66




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##### Table of Contents



Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
  
 Item 9A. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
  Internal Control over Financial Reporting
 Managements Annual Report on Internal Control Over Financial Reporting
     Changes in Internal Control over Financial Reporting
  
 Item 9B. Other Information
  67




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##### Table of Contents



PART III
 
 Item 10. Directors and Executive Officers of the Registrant
     
 Item 11. Executive Compensation
  
 Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
  
 Item 13. Certain Relationships and Related Transactions
  
 Item 14. Principal Accountant Fees and Services
  68




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##### Table of Contents



PART IV
 
 Item 15. Exhibits and Financial Statement Schedules
 (a)
    
    Financial Statements, Financial Statement Schedules and Exhibits
 (1)
    
    Consolidated Financial Statements: See Index to Consolidated Financial Statements on
Page 39.(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.
 ExhibitNumber2.1
    
    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 July 2, 1996 (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 December 15, 2003).3.1
    
    Restated Certificate of Incorporation of First Acceptance Corporation (incorporated by
reference to Exhibit 3.1 of the Companys Current Report on Form 8-K dated May 3, 2004).3.2
    
    Amended and Restated Bylaws of First Acceptance Corporation (incorporated by reference to
Exhibit 3.2 of the Companys Annual Report on Form 10-K dated September 28, 2004).4.1
    
    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).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).
 69




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##### Table of Contents



ExhibitNumber10.2
    
    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).*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 (incorporated by reference to Exhibit 10.15
of the Companys Annual Report on Form 10-K dated September 28, 2004).*
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##### Table of Contents



ExhibitNumber10.16
    
    Form of Restricted Stock Award Agreement under the Companys 2002 Long-Term Incentive Plan
(incorporated by reference to Exhibit 10.1 of the Companys Current Report on Form 8-K dated
November 3, 2004).*10.17
    
    Form of Nonqualified Stock Option Agreement under the Companys 2002 Long-Term Incentive
Plan (incorporated by reference to Exhibit 10.2 of the Companys Current Report on Form 8-K
dated November 3, 2004).*10.18
    
    First Acceptance Corporation Employee Stock Purchase Plan (incorporated by reference to
Exhibit 10.1 of the Registration Statement No. 333-121551 on Form S-8, filed December 22,
2004).10.19
    
    Summary of Compensation for Non-Employee Directors and Named Executive Officers10.20
    
    Asset Purchase Agreement dated as of January 12, 2006, by and among First Acceptance
Corporation, Acceptance Insurance Agency of Illinois, Inc., Insurance Plus Agency II, Inc.,
Yale International Insurance Agency, Inc. and Constantine Danos (incorporated by reference to
Exhibit 10.1 of the Companys Current Report on Form 8-K dated January 18, 2006)10.22
    
    Credit Agreement dated as of January 12, 2006, by and among First Acceptance Corporation,
SunTrust Bank, in its capacity as a lender and as administrative agent for the lenders, and
First Bank. (incorporated by reference to Exhibit 10.2 of the Companys Current Report on Form
8-K dated January 18, 2006)14
    
    First Acceptance Corporation Code of Business Conduct and Ethics (incorporated by reference
to Exhibit 14 of the Companys Annual Report on Form 10-K dated September 28, 2004).21
    
    Subsidiaries of First Acceptance Corporation.23.1
    
    Consent of Ernst & Young, LLP.23.2
    
    Consent of KPMG LLP.31.1
    
    Certification of Chief Executive Officer pursuant to Rule 13a-14(a).31.2
    
    Certification of Acting 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
    
    Acting 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. 71




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##### Table of Contents



SIGNATURES
  FIRST ACCEPTANCE CORPORATIONDate: September 13, 2006
    
    By
    
    /s/ Stephen J. HarrisonStephen J. HarrisonPresident and Chief Executive Officer
  Signature
    
    Title
    
    Date/s/ Stephen J. Harrison

     Stephen J. Harrison
    
    President, Chief Executive Officer, and
Director
(Principal Executive Officer)
    
    September 13, 2006/s/ Michael J. Bodayle

     Michael J. Bodayle
    
    Acting Chief Financial Officer
(Principal Financial Officer and Principal
Accounting Officer)
    
    September 13, 2006/s/ Gerald J. Ford

     Gerald J. Ford
    
    Chairman of the Board of Directors
    
    September 13, 2006/s/ Thomas M. Harrison, Jr.

     Thomas M. Harrison, Jr.
    
    Executive Vice President, Secretary and
Director
    
    September 13, 2006/s/ Rhodes R. Bobbitt

     Rhodes R. Bobbitt
    
    Director
    
    September 13, 2006/s/ Harvey B. Cash

     Harvey B. Cash
    
    Director
    
    September 13, 2006/s/ Donald J. Edwards

     Donald J. Edwards
    
    Director
    
    September 13, 2006/s/ Tom C. Nichols

     Tom C. Nichols
    
    Director
    
    September 13, 2006/s/ Lyndon L. Olson

     Lyndon L. Olson
    
    Director
    
    September 13, 2006/s/ William A. Shipp, Jr.

     William A. Shipp, Jr.
    
    Director
    
    September 13, 2006
 72