##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 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
 to
 Commission file number 000-50795
 AFFIRMATIVE INSURANCE HOLDINGS, INC.
 (Exact name of registrant as specified in its charter)
 Delaware
    
    75-2770432(State of other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)4450 Sojourn Drive, Suite 500Addison, Texas
    
    75001(Address of principal executive offices)
    
    (Zip Code)
 (972) 728-6300  (Registrants telephone number, including area code)
 Not Applicable
 (Former name, former address and former fiscal year, if changed since last report)
  þ o
  Large Accelerated Filer o
    
    Accelerated Filer þ
    
    Non-Accelerated Filer o
  o þ




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##### 



Affirmative Insurance Holdings, Inc.
Index
 Part I
    
    
    3Item 1. Financial Statements
    
    
    3Consolidated Balance Sheets
    
    
    3Consolidated Statements of Operations (Unaudited)
    
    
    4Consolidated Statements of Stockholders Equity and Comprehensive Income (Loss) (Unaudited)
    
    
    5Consolidated Statements of Cash Flows (Unaudited)
    
    
    6Notes to Consolidated Financial Statements (Unaudited)
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    20Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    26Item 4. Controls and Procedures
    
    
    27PART II
    
    
    30Item 1. Legal Proceedings
    
    
    30Item 1A. Risk Factors
    
    
    32Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    32Item 3. Defaults Upon Senior Securities
    
    
    32Item 4. Submission of Matters to a Vote of Security Holders
    
    
    32Item 5. Other information
    
    
    32Item 6. Exhibits
    
    
    33Signatures
    
    
    34Certification of Chief Executive Officer Pursuant to Section 302Certification of Chief Financial Officer Pursuant to Section 302Certification of Chief Executive Officer Pursuant to Section 906Certification of Chief Financial Officer Pursuant to Section 906
  2




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##### Table of Contents



Part I
 
 Item 1. Financial Statements
 Affirmative Insurance Holdings, Inc.
 
 Consolidated Balance Sheets
 March 31, 2006 and December 31, 2005
 March 31,
    
    
    December 31,(dollars in thousands, except share data)
    
    2006
    
    
    2005(unaudited)AssetsFixed maturities  available for sale, at fair
value (amtortized cost 2006: $230,560; 2005: $
211,087)
    
    $
    229,418
    
    
    $
    210,273Short-term investments
    
    
    
    
    
    
    477Total invested assets
    
    
    229,418
    
    
    
    210,750Cash and cash equivalents
    
    
    26,570
    
    
    
    48,037Fiduciary and restricted cash
    
    
    35,227
    
    
    
    29,689Accrued investment income
    
    
    2,231
    
    
    
    2,722Premiums and fees receivable
    
    
    98,401
    
    
    
    81,680Commissions receivable
    
    
    4,945
    
    
    
    2,144Receivable from reinsurers
    
    
    24,345
    
    
    
    28,137Deferred acquisition costs
    
    
    28,069
    
    
    
    24,453Deferred tax asset
    
    
    15,264
    
    
    
    14,866Federal income taxes receivable
    
    
    3,369
    
    
    
    6,823Property and equipment, net
    
    
    5,064
    
    
    
    4,820Goodwill
    
    
    64,590
    
    
    
    61,009Other intangible assets, net
    
    
    19,215
    
    
    
    19,607Other assets
    
    
    9,701
    
    
    
    9,388Total assets
    
    $
    566,409
    
    
    $
    544,125Liabilities and Stockholders EquityLiabilitiesReserves for losses and loss adjustment expenses
    
    
    127,911
    
    
    
    126,940Unearned premium
    
    
    111,441
    
    
    
    97,344Amounts due reinsurers
    
    
    12,262
    
    
    
    8,715Deferred revenue
    
    
    28,152
    
    
    
    27,101Notes payable
    
    
    56,702
    
    
    
    56,702Consideration due for acquisitions
    
    
    1,016
    
    
    
    1,352Other liabilities
    
    
    23,091
    
    
    
    26,009Total liabilities
    
    
    360,575
    
    
    
    344,163Commitments and contingencies (Note 8)Stockholders equityCommon stock, $0.01 par value; 75,000,000
shares authorized, 17,483,520 shares issued
and 15,432,557 shares outstanding
    
    
    175
    
    
    
    175Additional paid-in capital
    
    
    159,067
    
    
    
    158,904Treasury stock, at cost; 2,050,963 shares
    
    
    (28,746
    )
    
    
    (28,746
    )Accumulated other comprehensive loss
    
    
    (742
    )
    
    
    (529
    )Retained earnings
    
    
    76,080
    
    
    
    70,158Total stockholders equity
    
    
    205,834
    
    
    
    199,962Total liabilities and stockholders equity
    
    $
    566,409
    
    
    $
    544,125
 See accompanying Notes to Consolidated Financial Statements
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Operations (Unaudited)
 Three Months Ended March 31, 2006 and 2005
 Three months endedMarch 31,2006
    
    
    2005(dollars in thousands, except per share data)
    
    
    
    
    
    (Restated)RevenuesNet premiums earned
    
    $
    73,038
    
    
    $
    67,936Commission
income and fees (includes related parties 
2005: $(189))
    
    
    17,499
    
    
    
    20,995Net investment income
    
    
    2,060
    
    
    
    1,257Net realized gains (losses)
    
    
    (367
    )
    
    
    3Total revenues
    
    
    92,230
    
    
    
    90,191ExpensesLosses and loss adjustment expenses
    
    
    47,652
    
    
    
    44,567Selling, general and administrative expenses
    
    
    32,601
    
    
    
    31,926Depreciation and amortization
    
    
    1,060
    
    
    
    1,029Interest expense
    
    
    1,085
    
    
    
    579Total expenses
    
    
    82,398
    
    
    
    78,101Net income before income taxes and minority interest
    
    
    9,832
    
    
    
    12,090Income tax expense
    
    
    3,520
    
    
    
    4,284Minority interest, net of income taxes
    
    
    81
    
    
    
    33Net income
    
    $
    6,231
    
    
    $
    7,773Net income per common share  Basic
    
    $
    0.40
    
    
    $
    0.46Net income per common share  Diluted
    
    $
    0.40
    
    
    $
    0.45Weighted average shares outstandingBasic
    
    
    15,432,557
    
    
    
    16,845,934Diluted
    
    
    15,463,132
    
    
    
    17,119,853
 See accompanying Notes to Consolidated Financial Statements
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Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Stockholders Equity and Comprehensive Income (Loss) (Unaudited)
 Three Months Ended March 31, 2006 and 2005
 Additional
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Accumulated
Other
    
    
    TotalCommon Stock Issued
    
    
    Paid-in
    
    
    Retained
    
    
    Treasury Stock
    
    
    Comprehensive
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Earnings
    
    
    Shares
    
    
    Amount
    
    
    Income (Loss)
    
    
    Equity(dollars in thousands, except share data)Balance, December
31, 2004
    
    
    16,838,519
    
    
    $
    168
    
    
    $
    151,752
    
    
    $
    53,135
    
    
    
    
    
    
    
    
    
    
    $
    251
    
    
    $
    205,306Comprehensive
income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,773
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    7,773Other
comprehensive
loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,626
    )
    
    
    (1,626
    )Total comprehensive
income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,147Dividends ($.02 per
share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (337
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (337
    )Equity based
compensation
    
    
    14,234
    
    
    
    1
    
    
    
    224
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    225Balance, March 31,
2005 - Restated
    
    
    16,852,753
    
    
    $
    169
    
    
    $
    151,976
    
    
    $
    60,571
    
    
    
    
    
    
    $
    
    
    
    $
    (1,375
    )
    
    $
    211,341Balance, December
31, 2005
    
    
    17,483,520
    
    
    $
    175
    
    
    $
    158,904
    
    
    $
    70,158
    
    
    
    2,000,000
    
    
    $
    (28,746
    )
    
    $
    (529
    )
    
    $
    199,962Comprehensive
income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,231
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,231Other
comprehensive
loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (213
    )
    
    
    (213
    )Total comprehensive
income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,018Dividends ($.02 per
share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (309
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (309
    )Equity based
compensation
    
    
    
    
    
    
    
    
    
    
    163
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    163Balance, March 31,
2006
    
    
    17,483,520
    
    
    $
    175
    
    
    $
    159,067
    
    
    $
    76,080
    
    
    
    2,000,000
    
    
    $
    (28,746
    )
    
    $
    (742
    )
    
    $
    205,834
 See accompanying Notes to Consolidated Financial Statements
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Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Cash Flows (Unaudited)
 Three Months Ended March 31, 2006 and 2005
 Three months endedMarch 31,2006
    
    
    2005(Restated)(dollars in thousands)Cash flows from operating activitiesNet income
    
    $
    6,231
    
    
    $
    7,773Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    1,060
    
    
    
    1,029Equity based compensation
    
    
    186
    
    
    
    23Realized (gain) loss on sale of bonds
    
    
    367
    
    
    
    (3
    )Amortization of discount of premiums and discounts on investments
    
    
    366
    
    
    
    642Changes in assets and liabilities:Fiduciary and restricted cash
    
    
    (5,538
    )
    
    
    (10,963
    )Premiums and commissions receivable
    
    
    (19,522
    )
    
    
    (12,705
    )Reserves for loss and loss adjustment expenses
    
    
    971
    
    
    
    10,778Net due to/from reinsurers
    
    
    7,339
    
    
    
    (3,681
    )Receivable from affiliates
    
    
    
    
    
    
    (733
    )Deferred revenue
    
    
    1,051
    
    
    
    4,029Unearned premiums
    
    
    14,097
    
    
    
    28,872Deferred acquisition costs
    
    
    (3,616
    )
    
    
    (9,862
    )Federal income taxes receivable/payable
    
    
    3,454
    
    
    
    (1,139
    )Other
    
    
    (3,047
    )
    
    
    (3,151
    )Net cash provided by operating activities
    
    
    3,399
    
    
    
    10,909Cash flows from investing activitiesProceeds from the sale of bonds
    
    
    163,522
    
    
    
    2,746Cost of bonds acquired
    
    
    (183,250
    )
    
    
    (5,093
    )Purchases of property and equipment
    
    
    (912
    )
    
    
    (920
    )Net cash paid for acquisitions
    
    
    (3,917
    )
    
    
    (1,133
    )Net cash used in investing activities
    
    
    (24,557
    )
    
    
    (4,400
    )Cash flows from financing activitiesDividends paid
    
    
    (309
    )
    
    
    (337
    )Net cash used in financing activities
    
    
    (309
    )
    
    
    (337
    )Net increase (decrease) in cash and cash equivalents
    
    
    (21,467
    )
    
    
    6,172Cash and cash equivalents, beginning of period
    
    
    48,037
    
    
    
    24,096Cash and cash equivalents, end of period
    
    $
    26,570
    
    
    $
    30,268
 See accompanying Notes to Consolidated Financial Statements
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Notes to Consolidated Financial Statements (Unaudited)
 1.
    
    GeneralAffirmative Insurance Holdings, Inc. is an insurance holding company and is engaged in
underwriting, servicing and distributing non-standard automobile insurance policies and
related products and services to individual consumers in highly targeted geographic areas. Our
subsidiaries include two insurance companies, four underwriting agencies, five retail agencies
with 179 owned and 41 franchise retail store locations as of March 31, 2006. We offer our
products and services in 12 states, including Texas, Illinois, California and Florida. Our
growth has been achieved principally as a result of the acquisition and integration of six
retail and/or underwriting agencies in 2001and 2002. We were formerly known as Instant
Insurance Holdings, Inc., and we incorporated in Delaware on June 25, 1998.All financial information herein gives effect to the restatement described in Note 2
Restatement.We completed our initial public offering of our common stock effective July 9, 2004. We issued
4,420,000 additional shares of our common stock and Vesta Insurance Group, Inc. sold 3,750,000
shares of our common stock that they owned, at an initial public offering price of $14.00 per
share. On July 26, 2004, our underwriters exercised their option to purchase an additional
663,000 shares from us, and an additional 562,500 shares from Vesta. On June 1, 2005, we
purchased 2,000,000 of our shares of common stock from Vesta at a price of $14.00 per share.On June 14, 2005, Vesta entered into a Stock Purchase Agreement with New Affirmative LLC, for
the sale by Vesta of 5,218,228 shares of our common stock. New Affirmative was formed for the
purpose of acquiring, holding, voting and disposing of the shares of our common stock acquired
in connection with the Stock Purchase Agreement and any shares of our common stock that New
Affirmative may acquire in the future. New Affirmative is (i) 50% owned by DSC AFFM, LLC, an
entity controlled by DSC AFFM Manager LLC, the sole managing member of DSC AFFM, and Andrew G.
Bluhm, the managing member of DSC Manager, and (ii) 50% owned by Affirmative Investment LLC,
an entity owned, in part, by the Enstar Group, Inc., and controlled by Affirmative Associates
LLC, the sole managing member of Affirmative Investment, and J. Christopher Flowers, the sole
member and manager of Affirmative Associates. Simultaneously with the closing of the
transactions contemplated by the Stock Purchase Agreement: (1) DSC AFFM contributed 1,459,699
shares of our common stock which were previously acquired in open market transactions by
members of DSC AFFM and subsequently contributed to DSC AFFM, to New Affirmative and (2)
Affirmative Investment contributed 1,183,000 shares of our common stock, previously acquired
by it in open market transactions, to New Affirmative. Vesta completed the sale to New
Affirmative on August 30, 2005. As of March 31, 2006, New Affirmative owned 7,860,927 shares,
or approximately 50.9% of our outstanding common stock.2.
    
    RestatementWe have restated herein the previously issued unaudited interim consolidated financial
statements as of and for the quarter ended March 31, 2005. This restatement corrects errors
related to the consolidating elimination entries used to prepare the previously filed
financial reports. The erroneous consolidating elimination entries had no effect on reported
net income, earnings per share, invested assets or stockholders equity, but did have the
effect of materially understating gross revenues and expenses and misstating assets and
liabilities.The previously issued consolidated balance sheets as of December 31, 2004 and March 31, 2005
have also been restated to reflect the $7.2 million receivable from Vesta as receivable from
affiliates and an offsetting liability in amounts due reinsurers. The restatement had no
effect on reported net income, earnings per share, invested assets, stockholders equity or
the statement of cash flows.In addition, we determined that we should make a correction to adjust the allocation of
commission income and fees among the first three quarterly periods of 2005 to appropriately
reflect third party fees earned by our agencies. This restatement resulted in reducing
commission income and fees for the first quarter of 2005 by $345,000 before income taxes
($223,000 after income taxes) that is now included in the third quarter of 2005.
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
  Notes to Consolidated Financial Statements (Unaudited)  Continued
 All applicable amounts relating to the restatement have been reflected in the consolidated
financial statements and these notes to the consolidated financial statements.The effect of the restatement on line items of the previously reported unaudited consolidated
statements of operations for the quarter ended March 31, 2005 is presented below (dollars in
thousands):
 (Unaudited)For the Quarter endedMarch 31, 2005As PreviouslyAs Restated
    
    Reported
    
    DifferenceCommission income and fees
    
    $
    20,995
    
    
    $
    17,902
    
    
    $
    3,093Selling, general and administrative expenses
    
    
    31,926
    
    
    
    28,488
    
    
    
    3,438Income tax expense
    
    
    4,284
    
    
    
    4,406
    
    
    
    (122
    )Net income
    
    $
    7,773
    
    
    $
    7,996
    
    
    $
    (223
    )
 The effect of the restatement on line items presented in our previously reported audited
consolidated balance sheet as of December 31, 2004 is as follows (dollars in thousands):
 December 31, 2004As PreviouslyAs Restated
    
    Reported
    
    DifferencePremiums and fees receivable
    
    $
    104,361
    
    
    $
    107,411
    
    
    $
    (3,050
    )Commissions receivable
    
    
    8,429
    
    
    
    11,890
    
    
    
    (3,461
    )Due from affiliates
    
    
    7,523
    
    
    
    310
    
    
    
    7,213Total assets
    
    
    521,622
    
    
    
    520,920
    
    
    
    702Amounts due reinsurers
    
    $
    42,093
    
    
    $
    43,167
    
    
    $
    (1,074
    )Other liabilities
    
    
    26,468
    
    
    
    24,692
    
    
    
    1,776Total liabilities
    
    
    316,316
    
    
    
    315,614
    
    
    
    702Shareholders equity
    
    $
    205,306
    
    
    $
    205,306
    
    
    $
    
 The effect of the restatement on line items of the previously reported unaudited
consolidated balance sheet as of the period ended March 31, 2005 is presented below (dollars
in thousands):
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 (Unaudited)March 31, 2005As PreviouslyAs Restated
    
    Reported
    
    DifferencePremiums and fees receivable
    
    $
    119,128
    
    
    $
    131,350
    
    
    $
    (12,222
    )Commissions receivable
    
    
    6,367
    
    
    
    8,678
    
    
    
    (2,311
    )Due from affiliates
    
    
    8,256
    
    
    
    1,043
    
    
    
    7,213Total assets
    
    
    544,905
    
    
    
    552,225
    
    
    
    (7,320
    )Amounts due reinsurers
    
    $
    18,303
    
    
    $
    28,673
    
    
    $
    (10,370
    )Deferred revenue
    
    
    28,507
    
    
    
    28,076
    
    
    
    431Federal income taxes payable
    
    
    6,387
    
    
    
    6,509
    
    
    
    (122
    )Other liabilities
    
    
    24,996
    
    
    
    22,032
    
    
    
    2,964Total liabilities
    
    
    333,564
    
    
    
    340,661
    
    
    
    (7,097
    )Shareholders equity
    
    $
    211,341
    
    
    $
    211,564
    
    
    $
    (223
    )
 3.
    
    Summary of Significant Accounting PoliciesBasis of PresentationOur unaudited consolidated financial statements included herein have been prepared in
accordance with accounting principles generally accepted in the United States of America
(GAAP) and include our accounts and the accounts of our operating subsidiaries. All
intercompany accounts and transactions have been eliminated in consolidation. Certain
information and footnote disclosures normally included in financial statements prepared in
accordance with GAAP have been condensed or omitted pursuant to rules and regulations of the
Securities and Exchange Commission (SEC) for interim financial reporting. These financial
statements should be read in conjunction with our audited financial statements and notes
thereto for the year ended December 31, 2005 included in our report on Form 10-K filed with
the SEC.The interim financial data as of March 31, 2006 and 2005 is unaudited; however, in the opinion
of the Company, the interim data includes all adjustments, consisting only of normal recurring
adjustments, necessary for a fair statement of the results for the interim periods.Use of Estimates in the Preparation of the Financial StatementsOur preparation of financial statements in conformity with GAAP requires us to make estimates
and assumptions that affect our reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of our financial statements and our reported
amounts of revenues and expenses during the reporting period. Actual results could differ
materially from those estimates. These estimates and assumptions are particularly important in
determining revenue recognition, reserves for losses and loss adjustment expenses, deferred
policy acquisition costs, reinsurance receivables and impairment of assets.Treasury StockWe record treasury stock purchases under the cost method, whereby the entire cost of the
acquired stock is recorded as treasury stock. When reissued, shares of treasury stock will be
removed from the treasury stock account at the average purchase price per share of the
aggregate treasury shares held.Stock Based CompensationWe adopted SFAS 123R on January 1, 2006 using the modified prospective method and,
accordingly, prior periods have not been restated because of the adoption. As of March 31,
2006, we have recognized $163,000
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 before income taxes ($105,000 after income taxes) in
share-based payment expense under the requirements of SFAS 123R (See Note 12).As permitted by SFAS 123, until December 31, 2005, we accounted for share-based payments to
employees using APB 25s intrinsic value method and, as such, generally recognized no
compensation cost on grants of employee stock options. Had we adopted SFAS 123R in prior
periods, the impact of that standard would have approximated the impact of SFAS 123 as
described below.The following table illustrates the effect on our net income and net income per share if we
had applied SFAS 123 to stock-based compensation (in thousands, except per share amounts):
 Three months endedMarch 31,2005Net income, as reported
    
    $
    7,773Add: stock-based employee compensation expense included in
reported net income, net of related income taxes
    
    
    Deduct: total stock-based compensation expense
determined under fair value based method for all awards,
net of related income taxes
    
    
    (197
    )Net income, pro forma
    
    $
    7,576Basic earnings per share  as reported
    
    $
    0.46Basic earnings per share  pro forma
    
    $
    0.45Diluted earnings per share  as reported
    
    $
    0.45Diluted earnings per share  pro forma
    
    $
    0.44
 Segment ReportingOur business is the design, sale, underwriting and servicing of non-standard personal
automobile insurance policies. Our parent company is a holding company, with no revenues and
only interest expense on corporate debt. Our subsidiaries consist of several types of legal
entities: insurance companies, underwriting agencies, retail agencies, and a service company
where all employees are paid. Our insurance companies possess the certificates of authority
and capital necessary to transact insurance business and issue policies, but they rely on both
affiliated and unaffiliated underwriting agencies to design distribute and service those
policies. Our underwriting agencies primarily design, distribute and service policies issued
or reinsured by our insurance companies and that are distributed by our retail entities and by
independent agents.In November 2005, with a change in controlling ownership, we changed our board of directors
and, subsequently, some members of senior management including the Chief Executive Officer and
the Chief Financial Officer. The former senior management, with extensive experience in
managing underwriting agencies and retail agencies, monitored the business on the basis of
several segments consisting of an agency segment that was comprised of our underwriting and
retail agencies, an insurance segment for the two insurance companies and a corporate
segment. The current senior management has determined that with the significantly increased
retention by the insurance companies of the business produced by the underwriting agencies,
the company should be analyzed as an integrated insurance company. Given the homogeneity of
our products, the regulatory environments in which we operate, the nature of our customers and
our distribution channels, we now monitor, control and manage our business lines as an
integrated entity offering non-standard personal automobile insurance products through
multiple distribution channels. Accordingly, the
segment information previously viewed by the former management is no longer used to monitor
the company and we have no segment information to disclose. Our previously reported
historical consolidated financial results represent the integrated entity currently analyzed by
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 management, so no additional or adjusted historical disclosures are required in order to
reflect this change in managements business analysis.Recently Issued Accounting StandardsIn June 2005, the FASB issued Statement No. 154, Accounting Changes and Error Corrections
(SFAS 154), which replaces APB 20 and SFAS 3. SFAS 154 applies to all voluntary changes in
accounting principles. The statement requires that voluntary changes in accounting principles
be applied retrospectively to prior periods unless doing so is impracticable. SFAS 154 is
effective for fiscal years beginning after
December 15, 2005. We applied SFAS 154 to our presented
financial statements resulting in no impact for the quarter ending
March 31, 2006 and in Note 2
for our prior year financial statements.In November 2005, the FASB issued Staff Position (FSP) FAS115-1 and FAS 124-1, which nullifies
certain provisions of EITF Issue 03-1, The Meaning of Other-Than-Temporary Impairment and Its
Application to Certain Investments, and completely supersedes EITF Topic D-44, Recognition
of Other Than Temporary Impairment upon the Planned Sale of a Security Whose Cost Exceeds Fair
Value. This staff position addresses (1) determining when an investment should be considered
impaired, (2) determining whether an impairment should be deemed other than temporary, and (3)
measuring impairment loss. We have applied FAS 115-1 and FAS 124-1 to our presented financial
statements resulting in no for the quarter ending March 31, 2006.4.
    
    ReinsuranceThe effect of reinsurance on premiums written and earned is as follows (dollars in thousands):
 Three months ended
    
    
    Three months endedMarch 31, 2006
    
    
    March 31, 2005Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    53,788
    
    
    $
    41,600
    
    
    $
    55,168
    
    
    $
    45,011Assumed  affiliate
    
    
    
    
    
    
    
    
    
    
    11,317
    
    
    
    13,603Assumed  non affiliate
    
    
    34,961
    
    
    
    33,054
    
    
    
    38,617
    
    
    
    17,195Ceded  affiliate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (309
    )Ceded  non affiliate
    
    
    (1,691
    )
    
    
    (1,616
    )
    
    
    (992
    )
    
    
    (7,564
    )$
    87,058
    
    
    $
    73,038
    
    
    $
    104,110
    
    
    $
    67,936
 The amount of unpaid loss and loss adjustment expenses and unearned premium we would
remain liable for in the event our reinsurers are unable to meet their obligations are as
follows (dollars in thousands):
 As of March 31,
    
    
    As of December 31,2006
    
    
    2005Non affiliateLoss and loss adjustment expense
    
    $
    17,565
    
    
    $
    19,169Unearned premiums
    
    
    3,214
    
    
    
    3,137Total
    
    $
    20,779
    
    
    $
    22,306
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 For the three months ended March 31, 2006, we have ceded $2.2 million of paid losses and
$700,000 of incurred losses to various reinsurers. For the three months ended March 31, 2005,
we ceded $6.8 million of paid losses and $3.5 million of incurred losses to various
reinsurers.At March 31, 2006, we had $24.3 million receivables from reinsurers, including $17.5 million
gross recoverable from Vesta Fire. Vesta Fire is currently rated C++ (Marginal) by A.M.
Best. According to our reinsurance agreement, if Vesta Fires A.M. Best financial strength
rating remained below B+ we had the right to require Vesta Fire to provide a letter of
credit or establish a trust account to collateralize the gross
amounts due to us from Vesta Fire under the reinsurance agreement. On July 27, 2004, we
notified Vesta to establish a trust account collateralizing the amount due to us, due to the
fact that Vesta Fires A.M. Best rating was below a B+ after the consummation of our initial
public offering. We have $22.0 million currently in a trust account to collateralize the
$17.5 million gross recoverable from Vesta Fire. We also have $7.2 million included in Other
Assets that is related to a receivable due from Vesta as part of the transfer of the insurance
companies to us at December 31, 2003. The $7.2 million is not included in the previously
mentioned $17.5 million gross recoverable. At March 31, 2006, $24.5 million was included in
amounts due to reinsurers that reflects the amounts we owe to Vesta. We have $23.3 million in
securities to collateralize this payable.As of December 31, 2005 and March 31, 2006, Affirmative Insurance Company, a wholly-owned
subsidiary, had two quota share reinsurance agreements in place for active programs where the
cession ranged from 25% to 100%. In Florida, our underwriting agency, Space Coast
Underwriters, produces business on behalf of Affirmative Insurance Company, and 25% of the
business is ceded to FolksAmerica. In Georgia, Affirmative Insurance Company serves as direct
front for an unaffiliated underwriting agency to which 100% of the business is ceded to their
insurance company.Effective January 1, 2005, we entered into two quota share reinsurance agreements with Old
American County Mutual Fire Insurance Company, where we will assume 100% of the business
written through our underwriting agencies in the state of Texas.Affirmative Insurance Company, a wholly-owned subsidiary, is a party to a 100% quota share
reinsurance agreement with The Hawaiian Insurance & Guaranty Company, Ltd. (Hawaiian), which
is ultimately a wholly-owned subsidiary of Vesta. On November 4, 2004, Hawaiian was named
among a group of four other named defendants and twenty unnamed defendants in a complaint
filed in the Superior Court of the State of California for the County of Los Angeles alleging
causes of action as follows: enforcement of coverage under Hawaiians policy of an underlying
default judgment plaintiff obtained against Hawaiians former insured, who was denied a
defense in the underlying lawsuit due to his failure to timely pay the Hawaiian policy
premium; ratification and waiver of policy lapse and declaratory relief against Hawaiian;
breach of implied covenant of good faith and fair dealing against Hawaiian with the plaintiff
as the assignee of the insured; intentional misconduct as to the defendant SCJ Insurance
Services; and professional negligence as to the defendants Prompt Insurance Services, Paul
Ruelas, and Anthony David Medina. SCJ Insurance Services, Prompt Insurance Services, Paul
Ruelas, and Anthony David Medina are not affiliated with Affirmative. The plaintiff sought to
enforce an underlying default judgment obtained against Hawaiians insured on September 24,
2004 in the amount of $35,000,643 and additional bad faith damages including punitive damages
in the amount of $35,000,000. Affirmative Insurance Company, as a party to a 100% quota share
reinsurance agreement, is sharing in the defense of this matter.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 On August 8, 2005, we were served a copy of plaintiffs Second Amended Complaint, which added
a cause of action for fraud and deceit against all defendants, and a cause of action for
negligent misrepresentation against Hawaiian and SCJ Insurance Services.On January 31, 2006, the Court absolved Hawaiian and SCJ Insurance Services of all counts
filed against them in this litigation on the trial court level by virtue of court order on
motions for summary judgment that were submitted by both Hawaiian and SCJ Insurance Services.
The trial judge has denied a request by plaintiff for an interlocutory appeal of the judges
ruling on the motions for summary judgment for both Hawaiian and SCJ Insurance Services.
Defendants Prompt Insurance Services, Paul Ruelas and David
Medina remain in the litigation, and the outcome as to such defendants is uncertain. Should
plaintiff seek to appeal, Hawaiian and the other defendants thereto will vigorously contest
and exercise all available rights and remedies against any such appeal.Effective August 1, 2005, we entered into novation agreements with several unaffiliated
reinsurers who participated in a quota share reinsurance agreement in which we also
participated. Pursuant to these agreements, we were substituted in place of these reinsurers
assuming all rights, interests, liabilities and obligations related to the original quota
share reinsurance agreement. As a result of these novation agreements, our participation in
the original reinsurance agreement increased from 5% to 100% effective August 1, 2005. In
consideration for our assumption of their liabilities, these reinsurers agreed to pay us an
amount equal to their share of the liabilities under the original quota share agreement as of
July 31, 2005. We received cash in the amount of $14.2 million in relation to this novation.
The terms of this reinsurance agreement did not meet the risk transfer requirements according
to FAS 113, therefore, this contract was accounted for as deposits according to the guidelines
of SOP 98-7, Deposit Accounting for Insurance and Reinsurance Contracts that do not Transfer
Insurance Risk. Under deposit accounting, the deposit liability should be adjusted based on
the adjusted amount and timing of the cash flows. Changes in the carrying amount of the
deposit liability should be reported as income or expense as appropriate. In the first
quarter of 2006, we recognized $217,400 in income related to this novation.Effective August 1, 2005, we entered into novation agreements with several unaffiliated
reinsurers related to an assumed aggregate excess of loss reinsurance agreement for business
produced in the state of Texas by one of our underwriting agencies, written by Old American
and ceded to the reinsurers. These novation agreements eliminated excess of loss coverage
that was not necessary so these agreements had no financial impact to us.5.
    
    Related Party TransactionsWe provide various services for Vesta and its subsidiaries, including underwriting, premium
processing, and claims processing. For the three months ended March 31, the accompanying
unaudited consolidated statements of operations reflect these services as follows (dollars in
thousands):
 Three months endedMarch 31,2006
    
    
    2005Commission income
    
    $
    
    
    
    $
    (189
    )
 As of August 30, 2005, we and our subsidiaries are no longer affiliated with Vesta (See
Note 1).As part of the terms of the acquisition of Affirmative Insurance Company and Insura Property
and Casualty Insurance Company from Vesta, Vesta has indemnified us for any losses due to
uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated
reinsurers prior to December 31, 2003. As of March 31, 2006, all such unaffiliated reinsurers
had A.M. Best ratings of A or better.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 6.
    
    Purchase AcquisitionsOn March 14, 2006, we completed the acquisition of the 27% minority ownership interest of
Space Coast, LLC. We paid approximately $3.2 million to the minority owners and recorded $3.2
million in goodwill. Consequently, our current ownership interest in Space Coast is 100%.7.
    
    Notes PayableOn December 31, 2004, our newly formed trust subsidiary, Affirmative Insurance Holdings
Statutory Trust I (Trust Subsidiary I), completed a private placement of $30.0 million of 30
year floating rate trust preferred securities. Simultaneously, we borrowed $30.9 million
from Trust Subsidiary I and contributed $29.0 million to Affirmative Insurance Companys
policyholders surplus. The trust preferred securities, which can be redeemed in whole or in
part by the issuer after five years, bear an initial interest rate of 7.545 percent until
December 15, 2009, at which time the securities will adjust quarterly to the 90-day LIBOR rate
plus 360 basis points. As of March 31, 2006, the note balance was $30.9 million.On June 1, 2005, our newly formed trust subsidiary, Affirmative Insurance Holdings Statutory
Trust II (Trust Subsidiary II), completed a private placement of $25.0 million of 30 year
floating rate trust preferred securities. Simultaneously, we borrowed $25.0 million from
Trust Subsidiary II and the net proceeds from this borrowing, along with cash from operations,
were used to purchase the 2.0 million shares of our common stock as discussed in Notes 1 and
10. The trust preferred securities, which can be redeemed in whole or in part by the issuer
after five years, bear an initial interest rate of 7.792% until June 15, 2010, at which time
they will adjust quarterly to the 90-day LIBOR rate plus 355 basis points. As of March 31,
2006, the note balance was $25.8 million.As of March 31, 2006, the total note balance for Trust Subsidiaries I and II was $56.7
million.8.
    
    Commitments and Contingent LiabilitiesWe and our subsidiaries are named from time to time as defendants in various legal actions
arising in the ordinary course of our business and arising out of or related to claims made in
connection with our insurance policies, claims handling and employment related disputes. The
plaintiffs in some of these lawsuits have alleged bad faith or extra-contractual damages and
some have claimed punitive damages. We believe that the resolution of these legal actions will
not have a material adverse effect on our financial position or results of operations. For
detailed information concerning legal actions, please refer to Legal Proceedings contained
elsewhere in this report.From time to time, we and our subsidiaries are subject to random compliance audits from
federal and state authorities regarding various operations within our business that involve
collecting and remitting taxes in one form or another. Recently, two of our owned
underwriting agencies were subject to a sales and use tax audit conducted by the State of
Texas. The examiner for the State of Texas has now completed his field work and delivered a
summary of tentative audit adjustment to us. The examiners report asserts that, for the
period from January 2002 to August 2005, we should have collected and remitted approximately
$2.5 million in sales tax derived from claims services provided for Old American County Mutual
Insurance Company, an unaffiliated insurance company. We believe that these services are not
subject to sales tax, are vigorously contesting the assertions made by the state, and are
exercising all available rights and remedies available to us; however, the ultimate outcome of
this matter is uncertain. We have not made an accrual for this as of March 31, 2006 as we do
not believe this meets the requirements of FAS 5, Accounting for Contingencies.9.
    
    Credit FacilityOn August 6, 2004, we entered into a credit agreement (the Credit Agreement) with The Frost
National Bank that provides us with a senior secured credit facility. Under this credit
facility, the maximum amount available to us from time to time is $15.0 million, which may
include up to $15.0 million under a two-year
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 revolving line of credit, up to $10.0 million in
five-year term loans and up to $10.0 million in five-year stand-by letters of credit. The
borrowings under our credit facility will accrue interest based on the 90-day LIBOR rate plus
150 basis points and we will pay letter of credit fees based on an annual rate of 75 basis
points. Our obligations under the facility are guaranteed by our material operating
subsidiaries (other than our insurance companies) and are secured by a first lien security
interest on all of our assets and the assets of our material operating subsidiaries (other
than our insurance companies), including a pledge of 100% of the stock of Affirmative
Insurance Company. The facility contains certain financial covenants, which include combined
ratio, risk-based capital requirement, fixed charge coverage ratio, consolidated net worth and
consolidated net income requirements and other restrictive covenants governing distributions
and management changes. The proceeds are available to issue letters of credit securing our
obligations under reinsurance agreements, to fund
general working capital for our agency operations, capital surplus for our insurance companies
and to finance acquisition activities. During 2005, we executed letters of credit under this
credit facility of approximately $2.3 million to collateralize an assumed reinsurance contract
with certain of our reinsurers, all of which were released on December 1, 2005. Total fees
were approximately $13,000.Our Credit Agreement requires us to provide the bank with written notification and documents
related to certain events. On August 12, 2005 we entered into a First Amendment to Credit
Agreement and Waiver of Defaults to the credit facility which amended and waived certain
notice requirements of the Credit Agreement and waived all existing defaults and all events of
default related to written notice requirements related to certain acquisitions of business in
December 2004 and January, February, and July 2005, the repurchase of shares in June of 2005,
and the issuance of trust preferred securities in December of 2004 and June of 2005. As of
March 31, 2006, there were no outstanding loan amounts due under our credit facility, and we
are in compliance with all of our financial and other restrictive covenants.Under the terms of our Credit Agreement, we were required to file our Annual Report on Form
10-K on or before March 31, 2006. Frost Bank waived, for a certain period of time, our
compliance with the above covenant of the Credit Agreement, and we filed our Annual Report on
Form 10-K within the waiver period. All other terms of the Credit Agreement are unaffected by
this waiver.10.
    
    Stockholders EquityIn January 2005, we issued 6,734 shares of restricted common stock to certain members of our
Board of Directors, in lieu of cash as their annual retainer. In both February and May 2005,
we issued 7,500 shares of restricted common stock to certain members of our Board of Directors
for compensation related to services performed. In November 2005, 7,000 shares of restricted
common stock that had been issued were cancelled due to the resignation of certain board
members. We are expensing the amount to compensation expense over the service period for the
remaining issued shares. Total compensation expense in connection with restricted stock
recorded for the three months ended March 31, 2006 was approximately $23,000.On June 1, 2005, we purchased 2,000,000 shares of treasury stock from Vesta for $14.00 per
share. We recorded the purchase at cost. The purchase was funded with the proceeds from our
new trust preferred securities, as discussed in Note 7, and with cash from operations.In August and September 2005, we issued 3,657 shares of our common stock upon the exercise of
options.In November 2005, we issued 623,610 shares of our common stock to Thomas E. Mangold upon the
exercise of options. In addition, we purchased 50,963 shares of stock from Thomas E. Mangold
for $14.63 per share, which was market value on the date of the transaction.In December 2005, we issued 3,000 shares of restricted common stock to Mark E. Pape, Executive
Vice President and Chief Financial Officer, which vested immediately. Total compensation
recorded at the date of the grant was $42,480.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 11.
    
    Earnings per ShareThe provisions of FASB Statement No. 128 (SFAS 128), Earnings per Sharerequire presentation
of both basic and diluted earnings per share. A reconciliation of the numerators and
denominators of the basic and diluted earnings per share computations as required by SFAS 128
is presented below:
 Income
    
    
    Shares
    
    
    Per Share(Numerator)
    
    
    (Denominator)
    
    
    Amount(dollars in thousands, except number ofshares and per share amounts)Three months ended March 31, 2006Basic Earnings per ShareNet Income
    
    $
    6,231
    
    
    
    15,432,557
    
    
    $
    0.40Diluted Earnings per ShareNet Income
    
    $
    6,231
    
    
    
    15,432,557
    
    
    $
    0.40Effect of Dilutive Securities
    
    
    
    
    
    
    30,575
    
    
    
    $
    6,231
    
    
    
    15,463,132
    
    
    $
    0.40Three months ended March 31, 2005Basic Earnings per ShareNet Income
    
    $
    7,773
    
    
    
    16,845,934
    
    
    $
    0.46Diluted Earnings per ShareNet Income
    
    $
    7,773
    
    
    
    16,845,934
    
    
    $
    0.46Effect of Dilutive Securities
    
    
    
    
    
    
    273,919
    
    
    
    (0.01
    )$
    7,773
    
    
    
    17,119,853
    
    
    $
    0.45
 12.
    
    Stock-Based CompensationWe accounted for our stock-based compensation in accordance with FASB Statement No. 123R
(SFAS 123R), Share-Based Payment,effective January 1, 2006.In December 2004, the FASB issued Statement No. 123R (SFAS 123R), Share-Based Payment,
which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation, and
supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related
implementation guidance. SFAS 123R requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the income statement based on their fair
values. This standard was effective for public companies at the beginning of the first annual
period beginning after June 15, 2005. In March 2005, the SEC issued Staff Accounting Bulletin
107 (SAB 107) to assist preparers by simplifying some of the implementation challenges of
SFAS 123R. In particular, SAB 107 provides supplemental implementation guidance on SFAS 123R,
including guidance on valuation methods, classification of compensation expense, inventory
capitalization of share-based compensation cost, income tax effects, disclosures in
Managements Discussion and Analysis and several other issues. We applied the principles of
SAB 107 in conjunction with our adoption of SFAS 123R.SFAS 123R permits us to adopt its requirements using one of two methods:
 1.
    
    A modified prospective method in which compensation cost is recognized beginning with
the adoption date (a) based on the requirements of SFAS 123R for all share-based
compensation payments granted after the adoption date and (b) based on the requirements of
SFAS 123 for all awards granted to employees prior to the adoption date that remain
unvested on the adoption date.2.
    
    A modified retrospective method which includes the requirements of the modified
prospective method described above, but also permits entities to restate based on the
amounts previously recognized under SFAS 123 for purposes of pro forma disclosures either
(a) all periods presented or
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 (b) prior interim periods of the year of adoption.
 We adopted SFAS 123R on January 1, 2006 using the modified prospective method.As of March 31, 2006, we have recognized $163,000 before income taxes ($105,000 after income
taxes) in share-based payment expense under the requirements of SFAS 123R resulting in a negligible
impact on earnings per share.As permitted by SFAS 123, until December 31, 2005, we accounted for share-based payments to
employees using APB 25s intrinsic value method and, as such, generally recognized no
compensation cost on grants of employee stock options. Had
we adopted SFAS 123R in prior periods, the impact of that standard would have approximated the
impact of SFAS 123 as described in the disclosure of pro forma net income and earnings per
share in
Note 3.In connection with our initial public offering, on May 25, 2004, our board of directors
adopted and our stockholders approved the 2004 Stock Incentive Plan, or 2004 Plan, to enable
us to attract, retain and motivate eligible employees, directors and consultants through
equity-based compensatory awards, including stock options, stock bonus awards, restricted and
unrestricted stock awards, performance stock awards, stock appreciation rights and dividend
equivalent rights. The maximum number of shares of common stock reserved for issuance under
the 2004 Plan is 3,000,000, subject to adjustment to reflect certain corporate transactions or
changes in our capital structure.We have an 1998 Omnibus Incentive Plan (1998 Plan) under which we may grant options to
employees, directors and consultants for up to 803,169 shares of common stock. The exercise
prices are determined by the Board of Directors, but shall not be less than 100% of the fair
value on the grant date or, in the case of any employee who is deemed to own more than 10% of
the voting power of all classes of our stock, not less than 110% of the fair value. The terms
of the options are also determined by the Board of Directors, but shall never exceed ten years
or, in the case of any employee who is deemed to own more than 10% of the voting power of all
classes of our common stock, shall not exceed five years. We do not expect to grant any
further equity awards under the 1998 Plan, but intend to make all future awards under the 2004
Plan. While all awards previously granted under the 1998 Plan will remain outstanding, 1998
Plan shares will not be available for re-grant if these outstanding awards are forfeited or
cancelled.Under the 2004 Plan, the board or committee may fix the term and vesting schedule of each
stock option, but no incentive stock option will be exercisable more than ten years after the
date of grant. Vested stock options generally remain exercisable for up to three months after
a participants termination of service or up to 12 months after a participants death or
disability. Typically, the exercise price of each incentive stock option must not be less than
100% of the fair market value of our common stock on the grant date, and the exercise price of
a nonqualified stock option must not be less than 20% of the fair market value of our common
stock on the grant date. In the event that an incentive stock option is granted to a 10%
stockholder, the term of such stock option may not be more than five years and the exercise
price may not be less than 110% of the fair market value on the grant date. The exercise price
of each stock option granted under the 2004 Plan may be paid in cash or in other forms of
consideration in certain circumstances, including shares of common stock, deferred payment
arrangements or pursuant to cashless exercise programs. A stock option award may provide that
if shares of our common stock are used to pay the exercise price, an additional option will be
granted to the participant to purchase that number of shares used to pay the exercise price.
Generally, stock options are not transferable except by will or the laws of descent and
distribution, unless the board or committee provides that a nonqualified stock option may be
transferred.The fair value of
each option is estimated on the date of grant using the Black-Scholes option pricing model
using the following assumptions:
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 
 2006
    
    2005
    
    2004Weighted average risk-free interest rate: 1998 Plan
    
    
    
    
    
    
    4.5
    %
    
    
    3.8
    %Weighted average risk-free interest rate: 2004 Plan
    
    
    4.5
    %
    
    
    4.1
    %
    
    
    4.0
    %Expected term of option (in years): 1998 Plan
    
    
    
    
    
    
    5.0
    
    
    
    5.0Expected term of option (in years): 2004 Plan
    
    
    3.0
    
    
    
    6.25
    
    
    
    10.0Volatility
    
    
    25
    %
    
    
    35
    %
    
    
    30
    %Dividend yield
    
    
    0.6
    %
    
    
    0.5
    %
    
    
    0.4
    %
  Weighted
    
    
    Value ofWeighted
    
    
    Average
    
    
    UnexercisedAverage
    
    
    Remaining
    
    
    In-The-Exercise
    
    
    Contractual
    
    
    MoneyOptions
    
    
    Price
    
    
    Term (years)
    
    
    Options (000's)1998 PlanOutstanding, beginning of period
    
    
    94,545
    
    
    $
    7.59Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited
    
    
    
    
    
    
    Outstanding, end of period
    
    
    94,545
    
    
    $
    7.59
    
    
    
    1.67
    
    
    $
    531Exercisable, end of period
    
    
    94,545
    
    
    $
    7.59
    
    
    
    1.67
    
    
    $
    5312004 PlanOutstanding, beginning of period
    
    
    1,493,670
    
    
    $
    16.84Granted
    
    
    15,000
    
    
    
    14.22Exercised
    
    
    
    
    
    
    Forfeited
    
    
    (42,090
    )
    
    
    14.39Outstanding, end of period
    
    
    1,466,580
    
    
    $
    13.31
    
    
    
    9.24
    
    
    $
    Exercisable, end of period
    
    
    342,216
    
    
    
    14.89
    
    
    
    9.24
    
    
    $
    
   March 31, 2006WeightedAverageRestricted
    
    
    Grant-DateStock
    
    
    Fair ValueNonvested, beginning of period
    
    
    8,000
    
    
    $
    14.05Granted
    
    
    Vested
    
    
    (4,000
    )
    
    
    15.37Canceled or expired
    
    
    Nonvested, end of period
    
    
    4,000
    
    
    $
    12.73
 18




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 As of March 31, 2006, there was $2.2 million of total unrecognized compensation cost
related to nonvested share-based compensation which will be recognized over the remaining
requisite service period.13.
    
    Policy Acquisition CostsPolicy acquisition costs, primarily commissions, premium taxes and underwriting expenses
related to issuing a policy are deferred and charged against income ratably over the terms of
the related policies.Our components of deferred acquisition costs and the related policy acquisition cost amortized
to expense were as follows (dollars in thousands):
 Three Months EndedMarch 31,2006
    
    
    2005Beginning deferred acquisition costs (DAC)
    
    $
    24,453
    
    
    $
    19,118Additions
    
    
    28,619
    
    
    
    33,436Amortization of DAC
    
    
    (25,003
    )
    
    
    (23,574
    )Ending deferred acquisition costs
    
    $
    28,069
    
    
    $
    28,980Amortization of DAC
    
    $
    25,003
    
    
    $
    23,574Profit sharing commission expense
    
    
    1,967
    
    
    
    1,584Total policy acquisition costs
    
    $
    26,970
    
    
    $
    25,158Other selling, general and adminsistrative expenses
    
    
    5,631
    
    
    
    6,768Total selling, general and administrative expenses
    
    $
    32,601
    
    
    $
    31,926
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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
  Overview
       20




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##### Table of Contents



Gross PremiumsWritten2006
    
    
    2005Our underwriting agencies:Our retail agencies
    
    $
    33,086
    
    
    $
    42,363Independent agencies
    
    
    43,502
    
    
    
    49,602Subtotal
    
    
    76,588
    
    
    
    91,965Unaffiliated underwriting agencies
    
    
    12,150
    
    
    
    13,067Other
    
    
    11
    
    
    
    70Total
    
    $
    88,749
    
    
    $
    105,102
   Three Months EndedMarch 31, 2006Texas
    
    $
    24,427
    
    
    
    27.5
    %Illinois
    
    
    23,245
    
    
    
    26.2
    %California
    
    
    11,883
    
    
    
    13.4
    %Florida
    
    
    6,018
    
    
    
    6.8
    %Indiana
    
    
    6,612
    
    
    
    7.5
    %South Carolina
    
    
    5,865
    
    
    
    6.6
    %New Mexico
    
    
    3,415
    
    
    
    3.8
    %Michigan
    
    
    4,559
    
    
    
    5.1
    %Missouri
    
    
    2,447
    
    
    
    2.8
    %Other
    
    
    278
    
    
    
    0.3
    %Total
    
    $
    88,749
    
    
    
    100.0
    %
 21




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##### Table of Contents



Results of Operations
 Three months ended March 31,2006
    
    
    2005
    
    
    % ChangeRestatedRevenuesNet premiums earned
    
    $
    73,038
    
    
    $
    67,936
    
    
    
    7.5
    %Commission income and fees
    
    
    17,499
    
    
    
    20,995
    
    
    
    -16.7
    %Net investment income
    
    
    2,060
    
    
    
    1,257
    
    
    
    63.9
    %Net realized gains (losses)
    
    
    (367
    )
    
    
    3
    
    
    NMTotal revenues
    
    
    92,230
    
    
    
    90,191
    
    
    
    2.3
    %ExpensesLosses and loss adjustment expenses
    
    
    47,652
    
    
    
    44,567
    
    
    
    6.9
    %Selling, general and administrative expenses
    
    
    32,601
    
    
    
    31,926
    
    
    
    2.1
    %Depreciation and amortization
    
    
    1,060
    
    
    
    1,029
    
    
    
    3.0
    %Interest expense
    
    
    1,085
    
    
    
    579
    
    
    
    87.4
    %Total expenses
    
    
    82,398
    
    
    
    78,101
    
    
    
    5.5
    %Net income before income taxes and minority interest
    
    
    9,832
    
    
    
    12,090
    
    
    
    -18.7
    %Income tax expense
    
    
    3,520
    
    
    
    4,284
    
    
    
    -17.8
    %Minority interest, net of income taxes
    
    
    81
    
    
    
    33
    
    
    
    145.5
    %Net income
    
    $
    6,231
    
    
    $
    7,773
    
    
    
    -19.8
    %Net income per common share  Basic
    
    $
    0.40
    
    
    $
    0.46
    
    
    
    -13.0
    %Net income per common share  Diluted
    
    $
    0.40
    
    
    $
    0.45
    
    
    
    -11.1
    %Weighted average shares outstanding  Basic
    
    
    15,432,557
    
    
    
    16,845,934
    
    
    
    -8.4
    %Weighted average shares outstanding  Diluted
    
    
    15,463,132
    
    
    
    17,119,853
    
    
    
    -9.7
    %Operational InformationGross premiums written
    
    $
    88,749
    
    
    $
    105,102
    
    
    
    -15.6
    %Net premiums written
    
    $
    87,058
    
    
    $
    104,110
    
    
    
    -16.4
    %Percentage retained
    
    
    98.1
    %
    
    
    99.1
    %Loss Ratio
    
    
    65.2
    %
    
    
    65.6
    %Expense Ratio
    
    
    22.1
    %
    
    
    17.6
    %Combined Ratio
    
    
    87.4
    %
    
    
    83.2
    %
 Comparison of the Three Month Periods Ended March 31, 2006 and March 31, 2005
   22




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##### Table of Contents



Three Months EndedMarch 31,2006
    
    
    2005
    
    
    Variance
    
    
    Variance($)
    
    
    (%)Income on non-retained business MGA commissions
    
    
    913
    
    
    
    1,403
    
    
    
    (490
    )
    
    
    -35
    % Claims service fee income
    
    
    892
    
    
    
    3,653
    
    
    
    (2,761
    )
    
    
    -76
    %Policyholder fee income
    
    
    11,702
    
    
    
    11,822
    
    
    
    (120
    )
    
    
    -1
    %Retail  third party fees
    
    
    3,992
    
    
    
    4,117
    
    
    
    (125
    )
    
    
    -3
    %Total commission income and fees
    
    
    17,499
    
    
    
    20,995
    
    
    
    (3,496
    )
    
    
    -17
    %
    23




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Liquidity and Capital Resources
 Sources and uses of funds.
   24




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##### Table of Contents



As of
    
    
    As ofMarch 31,
    
    
    December 31,2006
    
    
    2005Total invested assets ($ in thousands)
    
    $
    229,418
    
    
    $
    210,750Tax equivalent book yield
    
    
    5.02
    %
    
    
    4.77
    %Average duration in years
    
    
    0.6
    
    
    
    3.8Average S&P rating
    
    AA+
    
    AA+
   25




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Special Note Regarding Forward-Looking Statements
  
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
  Interest rate risk.
 Credit risk.
   26




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##### Table of Contents



Effects of inflation.
 
 Item 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
    27




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Managements Remediation Initiatives
     28




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Changes in Internal Control over Financial Reporting
  29




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##### Table of Contents



PART II
 
 Item 1. Legal Proceedings
    th
 30




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##### Table of Contents



rd
 31




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##### Table of Contents



Item 1A. Risk Factors
  
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  
 Item 3. Defaults Upon Senior Securities
  
 Item 4. Submission of Matters to a Vote of Security Holders
  
 Item 5. Other information
  32




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##### Table of Contents



Item 6. Exhibits
 a)
    
    EXHIBITS3.1
    
    Amended and Restated Certificate of Incorporation of Affirmative
Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.1
to our Registration Statement on Form S-1 filed with the SEC on
March 22, 2004, File No. 333-113793).3.2
    
    Amended and Restated Bylaws of Affirmative Insurance Holdings, Inc.
(incorporated by reference to Exhibit 3.2 to our Registration
Statement on Form S-1 filed with the SEC on March 22, 2004, File No.
333-113793).4.1
    
    Form of Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to Amendment No. 3 to our Registration Statement on Form
S-1 filed with the SEC on June 14, 2004, File No. 333-113793).4.2
    
    Form of Registration Rights Agreement between Affirmative Insurance
Holdings, Inc. and Vesta Insurance Group, Inc. (incorporated by
reference to Exhibit 4.2 to Amendment No. 2 to our Registration
Statement on Form S-1 filed with the SEC on May 27, 2004, File No.
333-113793).31.1*
    
    Certification of Kevin R. Callahan, Interim Chief Executive Officer
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.31.2*
    
    Certification of Mark E. Pape, Chief Financial Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.32.1*
    
    Certification of Kevin R. Callahan, Interim Chief Executive Officer
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.32.2*
    
    Certification of Mark E. Pape, Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
 
 *
    
    Filed herewith 33




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Signatures
  Affirmative Insurance Holdings, Inc.Date: May 10, 2006/s/ Mark E. PapeBy: Mark E. PapeExecutive Vice President and Chief Financial Officer(and in his capacity as Principal Financial Officer)
 34