##### 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 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 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 þ  ̈
 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
    
    
    23Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    33Item 4. Controls and Procedures
    
    
    34PART II
    
    
    36Item 1. Legal Proceedings
    
    
    36Item 1A. Risk Factors
    
    
    37Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    37Item 3. Defaults Upon Senior Securities
    
    
    37Item 4. Submission of Matters to a Vote of Security Holders
    
    
    37Item 5. Other information
    
    
    38Item 6. Exhibits
    
    
    38Signatures
    
    
    39Fourth Amendment to Credit FacilityCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO 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
June 30, 2006 and December 31, 2005
 June 30,
    
    
    December 31,(dollars in thousands, except share data)
    
    2006
    
    
    2005(unaudited)AssetsFixed maturities  available for sale, at fair value (amortized cost 2006: $234,719; 2005: $211,087)
    
    $
    233,493
    
    
    $
    210,273Short-term investments
    
    
    251
    
    
    
    477Total invested assets
    
    
    233,744
    
    
    
    210,750Cash and cash equivalents
    
    
    25,095
    
    
    
    48,037Fiduciary and restricted cash
    
    
    32,955
    
    
    
    29,689Accrued investment income
    
    
    1,716
    
    
    
    2,722Premiums and fees receivable
    
    
    85,597
    
    
    
    81,680Commissions receivable
    
    
    5,147
    
    
    
    2,144Receivable from reinsurers
    
    
    24,312
    
    
    
    28,137Deferred acquisition costs
    
    
    26,944
    
    
    
    24,453Deferred tax asset
    
    
    13,695
    
    
    
    14,866Federal income taxes receivable
    
    
    3,772
    
    
    
    6,823Property and equipment, net
    
    
    4,980
    
    
    
    4,820Goodwill
    
    
    64,832
    
    
    
    61,009Other intangible assets, net
    
    
    18,862
    
    
    
    19,607Other assets
    
    
    13,662
    
    
    
    9,388Total assets
    
    $
    555,313
    
    
    $
    544,125Liabilities and Stockholders EquityLiabilitiesReserves for losses and loss adjustment expenses
    
    
    136,417
    
    
    
    126,940Unearned premium
    
    
    102,766
    
    
    
    97,344Amounts due reinsurers
    
    
    359
    
    
    
    8,715Deferred revenue
    
    
    27,120
    
    
    
    27,101Notes payable
    
    
    56,702
    
    
    
    56,702Consideration due for acquisitions
    
    
    1,016
    
    
    
    1,352Other liabilities
    
    
    24,456
    
    
    
    26,009Total liabilities
    
    
    348,836
    
    
    
    344,163Commitments and contingencies (Note 8)Stockholders equityCommon stock, $0.01 par value; 75,000,000 shares authorized, 17,491,745 shares issued and
15,138,382 shares outstanding at June 30, 2006; 17,483,520 issued and 15,432,557
shares outstanding at December 31, 2005
    
    
    175
    
    
    
    175Additional paid-in capital
    
    
    159,318
    
    
    
    158,904Treasury stock, at cost; 2,353,363 shares at June 30, 2006; 2,050,963 shares at December 31, 2005
    
    
    (32,880
    )
    
    
    (28,746
    )Accumulated other comprehensive loss
    
    
    (797
    )
    
    
    (529
    )Retained earnings
    
    
    80,661
    
    
    
    70,158Total stockholders equity
    
    
    206,477
    
    
    
    199,962Total liabilities and stockholders equity
    
    $
    555,313
    
    
    $
    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 and Six Months Ended June 30, 2006 and 2005
 Three months ended
    
    
    Six months endedJune 30,
    
    
    June 30,(dollars in thousands, except per share data)
    
    2006
    
    
    2005
    
    
    2006
    
    
    2005(Restated)
    
    
    
    
    
    
    (Restated)RevenuesNet premiums earned
    
    $
    73,753
    
    
    $
    77,441
    
    
    $
    146,791
    
    
    $
    145,377Commission
income and fees (includes related parties - 2005: $(189))
    
    
    14,552
    
    
    
    21,707
    
    
    
    32,051
    
    
    
    42,702Net investment income
    
    
    2,154
    
    
    
    1,353
    
    
    
    4,214
    
    
    
    2,610Net realized gains (losses)
    
    
    1
    
    
    
    3
    
    
    
    (366
    )
    
    
    6Total revenues
    
    
    90,460
    
    
    
    100,504
    
    
    
    182,690
    
    
    
    190,695ExpensesLosses and loss adjustment expenses
    
    
    47,081
    
    
    
    51,217
    
    
    
    94,733
    
    
    
    95,784Selling, general and administrative expenses
    
    
    34,194
    
    
    
    37,896
    
    
    
    66,795
    
    
    
    69,822Depreciation and amortization
    
    
    1,059
    
    
    
    993
    
    
    
    2,119
    
    
    
    2,022Interest expense
    
    
    1,086
    
    
    
    796
    
    
    
    2,171
    
    
    
    1,375Total expenses
    
    
    83,420
    
    
    
    90,902
    
    
    
    165,818
    
    
    
    169,003Net income before
income taxes and
minority interest
    
    
    7,040
    
    
    
    9,602
    
    
    
    16,872
    
    
    
    21,692Income tax expense
    
    
    2,156
    
    
    
    3,403
    
    
    
    5,676
    
    
    
    7,687Minority interest, net of income taxes
    
    
    
    
    
    
    326
    
    
    
    81
    
    
    
    359Net income
    
    $
    4,884
    
    
    $
    5,873
    
    
    $
    11,115
    
    
    $
    13,646Net income per common share  Basic
    
    $
    0.32
    
    
    $
    0.36
    
    
    $
    0.72
    
    
    $
    0.83Net income per common share  Diluted
    
    $
    0.32
    
    
    $
    0.36
    
    
    $
    0.72
    
    
    $
    0.81Weighted average shares outstandingBasic
    
    
    15,321,771
    
    
    
    16,218,769
    
    
    
    15,376,858
    
    
    
    16,530,619Diluted
    
    
    15,359,004
    
    
    
    16,434,411
    
    
    
    15,414,733
    
    
    
    16,774,473
 See accompanying Notes to Consolidated Financial Statements




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Stockholders Equity and Comprehensive Income (Loss) (Unaudited)
 Six Months Ended June 30, 2006 and 2005
 AccumulatedAdditional
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other
    
    
    TotalCommon Stock Issued
    
    
    Paid-in
    
    
    Retained
    
    
    Treasury Stock
    
    
    Comprehensive
    
    
    Stockholders(dollars in thousands, except share data)
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    Earnings
    
    
    Shares
    
    
    Amount
    
    
    Income (Loss)
    
    
    EquityBalance, December 31, 2004
    
    
    16,838,519
    
    
    $
    168
    
    
    $
    151,752
    
    
    $
    53,135
    
    
    
    
    
    
    
    
    
    
    $
    251
    
    
    $
    205,306Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,646
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,646Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (477
    )
    
    
    (477
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,169Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,000,000
    
    
    
    (28,000
    )
    
    
    
    
    
    
    (28,000
    )Dividends declared ($.02 per share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (674
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (674
    )Initial public offering costs
    
    
    
    
    
    
    
    
    
    
    (22
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22
    )Equity based compensation
    
    
    21,734
    
    
    
    1
    
    
    
    319
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    320Balance, June 30, 2005 - Restated
    
    
    16,860,253
    
    
    $
    169
    
    
    $
    152,049
    
    
    $
    66,107
    
    
    
    2,000,000
    
    
    $
    (28,000
    )
    
    $
    (226
    )
    
    $
    190,099Balance, December 31, 2005
    
    
    17,483,520
    
    
    $
    175
    
    
    $
    158,904
    
    
    $
    70,158
    
    
    
    2,050,963
    
    
    $
    (28,746
    )
    
    $
    (529
    )
    
    $
    199,962Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,115
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11,115Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (268
    )
    
    
    (268
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,847Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    302,400
    
    
    
    (4,134
    )
    
    
    
    
    
    
    (4,134
    )Dividends declared ($.02 per share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (612
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (612
    )Issuance of common stock
    
    
    8,225
    
    
    
    
    
    
    
    100
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    100Equity based compensation
    
    
    
    
    
    
    
    
    
    
    314
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    314Balance, June 30, 2006
    
    
    17,491,745
    
    
    $
    175
    
    
    $
    159,318
    
    
    $
    80,661
    
    
    
    2,353,363
    
    
    $
    (32,880
    )
    
    $
    (797
    )
    
    $
    206,477
 See accompanying Notes to Consolidated Financial Statements




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Cash Flows (Unaudited)
 Six Months Ended June 30, 2006 and 2005
 Six months endedJune 30,(dollars in thousands)
    
    2006
    
    
    2005(Restated)Cash flows from operating activitiesNet income
    
    $
    11,115
    
    
    $
    13,646Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    2,119
    
    
    
    2,022Equity based compensation
    
    
    346
    
    
    
    73Realized (gain) loss on sale of bonds
    
    
    366
    
    
    
    (6
    )Amortization of premiums and discounts on investments
    
    
    725
    
    
    
    1,274Changes in assets and liabilities:Fiduciary and restricted cash
    
    
    (3,266
    )
    
    
    (8,203
    )Premiums and commissions receivable
    
    
    (6,920
    )
    
    
    3,848Reserves for loss and loss adjustment expenses
    
    
    9,477
    
    
    
    20,038Net due to/from reinsurers
    
    
    (4,531
    )
    
    
    (5,257
    )Receivable from affiliates
    
    
    
    
    
    
    307Deferred revenue
    
    
    19
    
    
    
    4,040Unearned premiums
    
    
    5,422
    
    
    
    21,547Deferred acquisition costs
    
    
    (2,491
    )
    
    
    (8,678
    )Federal income taxes receivable/payable
    
    
    3,051
    
    
    
    (7,526
    )Other
    
    
    (3,841
    )
    
    
    (7,249
    )Net cash provided by operating activities
    
    
    11,591
    
    
    
    29,876Cash flows from investing activitiesProceeds from the sale of bonds
    
    
    229,661
    
    
    
    3,170Cost of bonds acquired
    
    
    (254,158
    )
    
    
    (7,806
    )Purchases of property and equipment
    
    
    (1,533
    )
    
    
    (2,507
    )Net cash paid for acquisitions
    
    
    (4,160
    )
    
    
    (1,142
    )Net cash used in investing activities
    
    
    (30,190
    )
    
    
    (8,285
    )Cash flows from financing activitiesProceeds from borrowings
    
    
    
    
    
    
    24,369Cost of equity financing
    
    
    
    
    
    
    (22
    )Acquisition of treasury stock
    
    
    (4,134
    )
    
    
    (28,000
    )Proceeds from issuance of common stock
    
    
    100
    
    
    
    Dividends paid
    
    
    (309
    )
    
    
    (674
    )Net cash used in financing activities
    
    
    (4,343
    )
    
    
    (4,327
    )Net increase (decrease) in cash and cash equivalents
    
    
    (22,942
    )
    
    
    17,264Cash and cash equivalents, beginning of period
    
    
    48,037
    
    
    
    24,096Cash and cash equivalents, end of period
    
    $
    25,095
    
    
    $
    41,360
 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 three insurance companies, four underwriting agencies, five retail
agencies with 170 owned stores (seven of which are located in leased
space within supermarkets owned by a major supermarket chain under an
agreement signed in late 2005) and 38 franchise retail store locations as of June 30, 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 of six retail and/or
underwriting agencies in 2001 and 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.
In May and June, 2006, we purchased 302,400 shares of our common stock in open market
purchases at an average price of $13.67 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 June 30, 2006, New Affirmative owned 7,860,927 shares,
or approximately 52.0% of our outstanding common stock.2.
    
    RestatementAs previously disclosed in our Form 10-K for the year ended December 31, 2005, we determined
that we should restate certain previously issued financial statements. Accordingly, the
consolidated financial statements herein reflect the following, previously disclosed
restatements:
 (A)
    
    The previously issued unaudited interim consolidated financial statements as of and
for the quarter and six months ended June 30, 2005 were restated to correct errors
related to the consolidating elimination entries used to prepare those 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.(B)
    
    The previously issued consolidated balance sheets as of December 31, 2004 and June
30, 2005 were 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.
 7




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 (C)
    
    We made a correction to adjust the allocation of commission income and fees among
the first three quarterly periods of 2005 to appropriately reflect the timing of third
party fees earned by our agencies. This restatement resulted in reducing commission
income and fees by $138,000 before income taxes ($89,000 after income taxes) for the
second quarter of 2005 and $483,000 before income taxes ($312,000 after income taxes) for
the six months ending June 30, 2005, resulting in an increase to commission income and
fees in the third quarter of 2005.
 All applicable amounts relating to the previously disclosed restatement have been reflected in
the consolidated financial statements and these notes to the consolidated financial
statements.
 The effect of the previously disclosed restatement on line items of the previously reported
unaudited consolidated statements of operations for the three and six months ended June 30,
2005 are presented below (dollars in thousands):
 (Unaudited)
    
    (Unaudited)For the Quarter ended
    
    For the Six Months endedJune 30, 2005
    
    June 30, 2005As Previously
    
    
    
    
    
    
    
    
    
    As PreviouslyAs Restated
    
    Reported
    
    Difference
    
    As Restated
    
    Reported
    
    DifferenceCommission income and fees
    
    $
    21,707
    
    
    $
    19,990
    
    
    $
    1,717
    
    
    $
    42,702
    
    
    $
    37,892
    
    
    $
    4,810Selling, general and administrative expenses
    
    
    37,896
    
    
    
    36,041
    
    
    
    1,855
    
    
    
    69,822
    
    
    
    64,529
    
    
    
    5,293Income tax expense
    
    
    3,403
    
    
    
    3,452
    
    
    
    (49
    )
    
    
    7,687
    
    
    
    7,858
    
    
    
    (171
    )Net income
    
    $
    5,873
    
    
    $
    5,962
    
    
    $
    (89
    )
    
    $
    13,646
    
    
    $
    13,958
    
    
    $
    (312
    )
 The effect of the previously disclosed 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
    
    
    $
    
 8




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 The effect of the previously disclosed restatement on line items presented in our
previously reported unaudited consolidated balance sheet as of June 30, 2005 is presented
below (dollars in thousands):
 (Unaudited)June 30, 2005As PreviouslyAs Restated
    
    Reported
    
    DifferencePremiums and fees receivable
    
    $
    101,383
    
    
    $
    114,345
    
    
    $
    (12,962
    )Commissions receivable
    
    
    7,559
    
    
    
    9,964
    
    
    
    (2,405
    )Federal income taxes receivable
    
    
    351
    
    
    
    180
    
    
    
    171Due from affiliates
    
    
    7,216
    
    
    
    3
    
    
    
    7,213Total assets
    
    
    528,695
    
    
    
    536,678
    
    
    
    (7,983
    )Amounts due reinsurers
    
    $
    7,481
    
    
    $
    15,187
    
    
    $
    (7,706
    )Deferred revenue
    
    
    28,518
    
    
    
    27,948
    
    
    
    570Other liabilities
    
    
    19,529
    
    
    
    20,064
    
    
    
    (535
    )Total liabilities
    
    
    338,596
    
    
    
    346,267
    
    
    
    (7,671
    )Shareholders equity
    
    $
    190,099
    
    
    $
    190,411
    
    
    $
    (312
    )
 3.
    
    Summary of Significant Accounting PoliciesBasis of PresentationOur unaudited consolidated financial statements included herein have been prepared in
accordance with U.S. generally accepted accounting principles (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 June 30, 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.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 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. For the three and
six months ended June 30, 2006, we have recognized $150,500 before income taxes ($97,000 after
income taxes) and $313,500 before income
taxes ($201,000 after income taxes), respectively, 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 ended
    
    
    Six months endedJune 30,
    
    
    June 30,2005
    
    
    2005Net income, as reported
    
    $
    5,873
    
    
    $
    13,646Add: stock-based employee compensation expense included in
reported net income, net of related income taxes
    
    
    97
    
    
    
    201Deduct: total stock-based compensation expense
determined under fair value based method for all awards,
net of related income taxes
    
    
    (193
    )
    
    
    (385
    )Net income, pro forma
    
    $
    5,777
    
    
    $
    13,462Basic earnings per share  as reported
    
    $
    0.36
    
    
    $
    0.83Basic earnings per share  pro forma
    
    $
    0.36
    
    
    $
    0.81Diluted earnings per share  as reported
    
    $
    0.36
    
    
    $
    0.81Diluted earnings per share  pro forma
    
    $
    0.35
    
    
    $
    0.80
 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
beginning January 1, 2006. 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.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 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
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.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 impact.In July 2006, FASB Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes 
An Interpretation of FASB Statement No. 109 (FIN 48), was issued. FIN 48 clarifies the
accounting for uncertainty in income taxes recognized in an enterprises financial statements
with FASB Statement No. 109, Accounting for Income Taxes. Fin 48 also prescribes a
recognition threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return, as well as
providing guidance on derecognition, classification, interest and penalties, accounting in
interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning
after December 15, 2006 with earlier application permitted as long as the enterprise has not
yet issued financial statements, including interim financial statements, in the period of
adoption. We have not yet evaluated the requirements of FIN 48 and have not yet determined if
FIN 48 will have a material impact on our future financial statements.4.
    
    ReinsuranceThe effect of reinsurance on premiums written and earned is as follows (dollars in thousands):
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 Three months ended
    
    
    Three months endedJune 30, 2006
    
    
    June 30, 2005Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    45,581
    
    
    $
    45,232
    
    
    $
    39,277
    
    
    $
    45,622Assumed  affiliate
    
    
    
    
    
    
    
    
    
    
    11,481
    
    
    
    12,686Assumed  non
affiliate
    
    
    20,150
    
    
    
    29,174
    
    
    
    23,443
    
    
    
    23,638Ceded  affiliate
    
    
    
    
    
    
    
    
    
    
    (162
    )
    
    
    (301
    )Ceded  non
affiliate
    
    
    2,389
    
    
    
    (653
    )
    
    
    (1,350
    )
    
    
    (4,204
    )$
    68,120
    
    
    $
    73,753
    
    
    $
    72,689
    
    
    $
    77,441
 Six months ended
    
    
    Six months endedJune 30, 2006
    
    
    June 30, 2005Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    99,369
    
    
    $
    86,832
    
    
    $
    94,445
    
    
    $
    90,633Assumed  affiliate
    
    
    
    
    
    
    
    
    
    
    22,798
    
    
    
    26,289Assumed  non
affiliate
    
    
    55,111
    
    
    
    62,228
    
    
    
    62,060
    
    
    
    40,832Ceded  affiliate
    
    
    
    
    
    
    
    
    
    
    (162
    )
    
    
    (610
    )Ceded  non
affiliate
    
    
    698
    
    
    
    (2,269
    )
    
    
    (2,342
    )
    
    
    (11,767
    )$
    155,178
    
    
    $
    146,791
    
    
    $
    176,799
    
    
    $
    145,377
   As of June 30,
    
    
    As of December 31,2006
    
    
    2005Non affiliateLoss and loss
adjustment expense
    
    $
    22,074
    
    
    $
    19,169Unearned premiums
    
    
    171
    
    
    
    3,137Total
    
    $
    22,245
    
    
    $
    22,306
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 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 $22.4 million currently in a trust
account to collateralize the $21.2 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 $21.2 million gross recoverable. Vestas management
has indicated that they believe that this amount has been settled, although they are unable to
demonstrate any such payment, and that they will need additional supporting documentation from
us to verify that they have not previously paid this amount in connection with settlements for
other subsequent treaty periods. We have consulted with Vestas management and agreed to
provide them with the supporting reconciliations for all inception-to-date payments from
December 31, 2003 through December 31, 2005 in order to help satisfy Vesta that this amount
has not been settled and is still outstanding. We believe that our documentation will
definitively support our position and that, as a result, Vesta will ultimately pay this
liability. Should payment not be forthcoming, we are confident that we will prevail upon
pursuing our other available options.At June 30, 2006, $23.9 million was included in reserves for losses and loss adjustment
expenses that reflects the amounts we owe to Vesta. We have $23.1 million in securities to
collateralize this payable.In May of 2006, certain of Vestas insurance companies, including Vesta Fire, redomesticated
to the state of Texas. Subsequently on June 28, 2006, an Agreed Order Appointing
Rehabilitator and Permanent Injunction was issued by the Texas Department of Insurance
(Department) whereby based upon the Departments findings, a rehabilitator was appointed,
the company and certain of their officers were enjoined from various actions, and actions
against the Vesta companies were stayed. On July 18, 2006, the Department then filed an
Application for Order of Liquidation and Requested for Expedited Hearing which remains
pending. Such order was granted on August 1, 2006 as to Vesta
Fire.As of December 31, 2005, 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 was ceded to FolksAmerica.
Effective May 1, 2006, this agreement with FolksAmerica was terminated. 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 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 (Unaudited)  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, Judge Bigelow absolved Hawaiian and SCJ Insurance Services of all
counts plaintiff 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 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. A partial dismissal without prejudice was entered as to defendant Paul Ruelas. The
outcome as to Prompt Insurance Services and David Median is uncertain. Plaintiff filed a
notice of appeal on April 18, 2006. Hawaiian and the other defendants thereto believe
plaintiffs allegations in this lawsuit are without merit and will continue to vigorously
contest the claims brought by the plaintiff, and intend to exercise all available rights and
remedies against them; however, the ultimate outcome of this matter is uncertain.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 second
quarter and first half of 2006, we recognized $175,000 and $392,000 respectively, 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 on us.5.
    
    Related Party TransactionsWe provide various services for Vesta and its subsidiaries, including underwriting, premium
processing, and claims processing. For the three and six months ended June 30, the
accompanying unaudited consolidated statements of operations reflect these services as follows
(dollars in thousands):
 Three months ended
    
    
    Six months endedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Commission income
    
    $
    
    
    
    $
    310
    
    
    $
    
    
    
    $
    121
 Effective 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 June 30, 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 (Unaudited)  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%.For the first half of 2006, we paid $721,000 in contingent purchase price adjustments related
to prior acquisitions and $225,000 for the acquisition of two retail stores.7.
    
    Notes PayableOn December 31, 2004, a newly formed trust entity, Affirmative Insurance Holdings
Statutory Trust I (Trust Entity 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 Entity 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 June 30, 2006, the note balance was $30.9 million.On June 1, 2005, a newly formed trust entity, Affirmative Insurance Holdings Statutory
Trust II (Trust Entity 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 Entity 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 June 30,
2006, the note balance was $25.8 million.As of June 30, 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 June 30, 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
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 available to us from time to time is $15.0 million, which may
include up to $15.0 million under a two-year 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.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.On August 7, 2006 we entered into a Fourth Amendment to our Credit Agreement dated July 30,
2004, as amended (Credit Agreement) with Frost National Bank which amended certain
provisions of the Credit Agreement. The Fourth Amendment extended the term to July 30, 2008,
modified certain affirmative and negative covenants, and increased the revolving commitment to
$20,000,000. This description of the terms of the Fourth Amendment does not purport to be
exhaustive and is qualified in its entirety by reference to Exhibit 10.1 to this Form 10-Q,
which is incorporated by reference.As of
June 30, 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.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 and six months ended June 30, 2006 was approximately $9,000 and
$32,000, respectively.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.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 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.In May 2006, we issued 2,925 shares of our common stock upon the exercise of options.On May 9, 2006, the board of directors approved a share repurchase program for up to $15
million of our common stock over the subsequent 12 months. From time to time, repurchases may
be made in the open market or through privately negotiated transactions at the discretion of
management based on managements assessment of market conditions and other relevant factors.
We expect to fund the purchases initially through internally available funds. In May and June
2006, we repurchased a total of 302,400 shares of our common stock at an average cost of
$13.67 per share.In June 2006, we issued 5,300 shares of our common stock upon the exercise of options.On June 30, 2006, our board of directors agreed to pay
holders of our common stock $.02 per share to be paid on
July 28, 2006. We recorded a dividend payable in the amount of
$303,000.11.
    
    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:
 17




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 Income
    
    
    Shares
    
    
    Per Share(Numerator)
    
    
    (Denominator)
    
    
    Amount(dollars in thousands, except number ofshares and per share amounts)Three months ended June 30, 2006Basic Earnings per ShareNet Income
    
    $
    4,884
    
    
    
    15,321,771
    
    
    $
    0.32Diluted Earnings per ShareNet Income
    
    $
    4,884
    
    
    
    15,321,771
    
    
    $
    0.32Effect of
Dilutive Securities
    
    
    
    
    
    
    37,234
    
    
    
    $
    4,884
    
    
    
    15,359,005
    
    
    $
    0.32Three months ended June 30, 2005Basic Earnings per ShareNet Income
    
    $
    5,873
    
    
    
    16,218,769
    
    
    $
    0.36Diluted Earnings per ShareNet Income
    
    $
    5,873
    
    
    
    16,218,769
    
    
    $
    0.36Effect of
Dilutive Securities
    
    
    
    
    
    
    215,641
    
    
    
    $
    5,873
    
    
    
    16,434,410
    
    
    $
    0.36Six months ended June 30, 2006Basic Earnings per ShareNet Income
    
    $
    11,115
    
    
    
    15,376,858
    
    
    $
    0.72Diluted Earnings per ShareNet Income
    
    $
    11,115
    
    
    
    15,376,858
    
    
    $
    0.72Effect of
Dilutive Securities
    
    
    
    
    
    
    37,875
    
    
    
    $
    11,115
    
    
    
    15,414,733
    
    
    $
    0.72Six months ended June 30, 2005Basic Earnings per ShareNet Income
    
    $
    13,646
    
    
    
    16,530,619
    
    
    $
    0.83Diluted Earnings per ShareNet Income
    
    $
    13,646
    
    
    
    16,530,619
    
    
    $
    0.83Effect of
Dilutive Securities
    
    
    
    
    
    
    243,854
    
    
    
    (0.02
    )$
    13,646
    
    
    
    16,774,473
    
    
    $
    0.81
 12.
    
    Stock-Based CompensationEffective January 1, 2006, we account for our stock-based compensation in accordance with FASB
Statement No. 123R (SFAS 123R), Share-Based Compensation.In December 2004, the FASB issued SFAS 123R, which is a revision of FASB Statement No. 123,
Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25 (APB25),
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.
 18




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
  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 (b) prior interim periods of the year of adoption.
       19




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  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
    
    
    
    
    
    
    
    
    
    
    5.0Expected term of option (in years): 2004 Plan
    
    
    3.00
    
    
    
    6.25
    
    
    
    10.0Volatility
    
    
    25
    %
    
    
    35
    %
    
    
    30
    %Dividend yield
    
    
    0.6
    %
    
    
    0.5
    %
    
    
    0.4
    %
  WeightedWeighted
    
    
    Average
    
    
    AggregateAverage
    
    
    Remaining
    
    
    IntrinsicExercise
    
    
    Contractual
    
    
    ValueThree months ended June 30, 2006
    
    Options
    
    
    Price
    
    
    Term (years)
    
    
    (000s)1998 PlanOutstanding, beginning of period
    
    
    94,675
    
    
    $
    7.59Granted
    
    
    
    
    
    
    Exercised
    
    
    (2,925
    )
    
    
    7.59Forfeited
    
    
    
    
    
    
    Outstanding, end of period
    
    
    91,750
    
    
    $
    7.59
    
    
    
    1.48
    
    
    $
    744Exercisable, end of period
    
    
    91,750
    
    
    $
    7.59
    
    
    
    1.48
    
    
    $
    7442004 PlanOutstanding, beginning of period
    
    
    1,449,180
    
    
    $
    16.91Granted
    
    
    
    
    
    
    Exercised
    
    
    (5,300
    )
    
    
    14.64Forfeited
    
    
    (82,820
    )
    
    
    15.36Outstanding, end of period
    
    
    1,361,060
    
    
    $
    17.01
    
    
    
    9.02
    
    
    $
    959Exercisable, end of period
    
    
    333,616
    
    
    $
    14.90
    
    
    
    9.01
    
    
    $
    274
 20




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 WeightedWeighted
    
    
    Average
    
    
    AggregateAverage
    
    
    Remaining
    
    
    IntrinsicExercise
    
    
    Contractual
    
    
    ValueSix months ended June 30, 2006
    
    Options
    
    
    Price
    
    
    Term (years)
    
    
    (000s)1998 PlanOutstanding, beginning of period
    
    
    94,675
    
    
    $
    7.59Granted
    
    
    
    
    
    
    Exercised
    
    
    (2,925
    )
    
    
    7.59Forfeited
    
    
    
    
    
    
    Outstanding, end of period
    
    
    91,750
    
    
    $
    7.59
    
    
    
    1.48
    
    
    $
    744Exercisable, end of period
    
    
    91,750
    
    
    $
    7.59
    
    
    
    1.48
    
    
    $
    7442004 PlanOutstanding, beginning of period
    
    
    1,493,670
    
    
    $
    16.84Granted
    
    
    15,000
    
    
    
    14.22Exercised
    
    
    (5,300
    )
    
    
    14.64Forfeited
    
    
    (142,310
    )
    
    
    14.96Outstanding, end of period
    
    
    1,361,060
    
    
    $
    17.01
    
    
    
    9.02
    
    
    $
    959Exercisable, end of period
    
    
    333,616
    
    
    $
    14.90
    
    
    
    9.01
    
    
    $
    274
   WeightedAverageRestricted
    
    
    Grant-DateThree months ended June 30, 2006
    
    Stock
    
    
    Fair ValueNonvested, beginning of period
    
    
    4,000
    
    
    $
    12.73Granted
    
    
    Vested
    
    
    (4,000
    )
    
    
    12.73Canceled or expired
    
    
    Nonvested, end of period
    
    
    
    
    
    $
    
 WeightedAverageRestricted
    
    
    Grant-DateSix months ended June 30, 2006
    
    Stock
    
    
    Fair ValueNonvested, beginning of period
    
    
    8,000
    
    
    $
    14.05Granted
    
    
    Vested
    
    
    (8,000
    )
    
    
    14.05Canceled or expired
    
    
    Nonvested, end of period
    
    
    
    
    
    $
    
 21




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued)
 As of June 30, 2006, there was $1.9 million of total unrecognized compensation cost
related to nonvested share-based compensation that will be recognized over the remaining
requisite service periods.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 policy.Our components of deferred acquisition costs and the related policy acquisition cost amortized
to expense were as follows (dollars in thousands):
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Beginning deferred acquisition costs (DAC)
    
    $
    28,069
    
    
    $
    28,980
    
    
    $
    24,453
    
    
    $
    19,118Additions
    
    
    17,536
    
    
    
    18,305
    
    
    
    40,048
    
    
    
    45,304Amortization of DAC
    
    
    (18,661
    )
    
    
    (19,489
    )
    
    
    (37,557
    )
    
    
    (36,626
    )Ending deferred acquisition costs
    
    $
    26,944
    
    
    $
    27,796
    
    
    $
    26,944
    
    
    $
    27,796
 22




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
 The following discussion and analysis of our financial condition and results of operations should
be read in conjunction with our consolidated financial statements and related notes thereto
presented in this Form 10-Q and in our annual report on Form 10-K for the year ended December 31,
2005. This discussion contains certain statements of a forward-looking nature that involve risks
and uncertainties. As a result of many factors, our actual results may differ materially from those
anticipated by such forward-looking statements.OverviewWe are an insurance holding company 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 three insurance companies,
four underwriting agencies and five retail agencies with 170 owned stores (seven of which are located in leased
space within supermarkets owned by a major supermarket chain under an
agreement signed in late 2005) and 38 franchise retail store
locations as of June 30, 2006. We offer our products and services in 12 states, including Texas,
Illinois, California and Florida. We were formerly known as Instant Insurance Holdings, Inc., and
we incorporated in Delaware on June 25, 1998.We restated our 2004 audited consolidated financial statements and our 2005 quarterly unaudited
consolidated financial statements. The restated consolidated financial statements conform to the
current presentation and reflect the correction of an error in the application of consolidating
elimination entries and the receivable from Vesta as receivable from reinsurers and an offsetting
liability in amounts due reinsurers. See Note 2 Restatement to our consolidated financial
statements for a reconciliation of previously reported amounts to the restated amounts.In addition, as previously disclosed in our Form 10-K for the year ended December 31, 2005, we made
a correction to adjust the allocation of commission income and fees among the first three quarterly
periods of 2005 to appropriately reflect the timing of third party fees earned by our agencies.
This restatement resulted in reducing commission income and fees by $138,000 before income taxes
($89,000 after income taxes) for the second quarter of 2005 and $483,000 before income taxes
($312,000 after income taxes) for the six months ending June 30, 2005, resulting in an increase to
commission income and fees in the third quarter of 2005.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 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. In May and June 2006, we repurchased a
total of 302,400 shares of our common stock in open market purchases.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 June 30, 2006, New Affirmative
owned 7,860,927 shares, or approximately 52.0% of our outstanding common stock.Our insurance companies, underwriting agencies and retail agencies primarily function as a
vertically integrated unit, capturing the premium (and associated risk) and commission and fee
revenue generated from the sale of each insurance policy. However, each of these operations also
works with unaffiliated entities on an unbundled basis,
 23




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##### Table of Contents



either functioning independently or with one or both of the other two operations. We believe that
our ability to enter into a variety of business relationships with third parties allows us to
maximize sales penetration and profitability through industry cycles better than if we employed a
single, vertically exclusive operating structure.One measurement of our performance is the level of gross premiums written. The following table
displays our gross premiums written by distribution channel for the three and six months ended June
30, 2006 and 2005 (dollars in thousands):
 Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Our underwriting agencies:Our retail agencies
    
    $
    18,699
    
    
    $
    24,648
    
    
    $
    51,785
    
    
    $
    67,011Independent agencies
    
    
    36,903
    
    
    
    36,258
    
    
    
    80,405
    
    
    
    85,860Subtotal
    
    
    55,602
    
    
    
    60,906
    
    
    
    132,190
    
    
    
    152,871Unaffiliated underwriting agencies
    
    
    10,111
    
    
    
    13,203
    
    
    
    22,261
    
    
    
    26,270Other
    
    
    18
    
    
    
    92
    
    
    
    29
    
    
    
    162Total
    
    $
    65,731
    
    
    $
    74,201
    
    
    $
    154,480
    
    
    $
    179,303
   24




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##### Table of Contents



Three Months Ended June 30,
    
    
    Six Months Ended June 30,2006
    
    
    2005
    
    
    $ Change
    
    
    % Change
    
    
    2006
    
    
    2005
    
    
    $ Change
    
    
    % ChangeTexas
    
    $
    19,273
    
    
    $
    23,441
    
    
    $
    (4,168
    )
    
    
    -17.8
    %
    
    $
    43,700
    
    
    $
    62,697
    
    
    $
    (18,997
    )
    
    
    -30.3
    %Illinois
    
    
    15,377
    
    
    
    16,940
    
    
    
    (1,563
    )
    
    
    -9.2
    %
    
    
    38,622
    
    
    
    42,447
    
    
    
    (3,825
    )
    
    
    -9.0
    %California
    
    
    9,834
    
    
    
    10,396
    
    
    
    (562
    )
    
    
    -5.4
    %
    
    
    21,717
    
    
    
    21,612
    
    
    
    105
    
    
    
    0.5
    %Florida
    
    
    3,630
    
    
    
    6,249
    
    
    
    (2,619
    )
    
    
    -41.9
    %
    
    
    9,648
    
    
    
    13,735
    
    
    
    (4,087
    )
    
    
    -29.8
    %Indiana
    
    
    4,114
    
    
    
    5,555
    
    
    
    (1,441
    )
    
    
    -25.9
    %
    
    
    10,726
    
    
    
    13,308
    
    
    
    (2,582
    )
    
    
    -19.4
    %South Carolina
    
    
    4,802
    
    
    
    4,753
    
    
    
    49
    
    
    
    1.0
    %
    
    
    10,667
    
    
    
    11,138
    
    
    
    (471
    )
    
    
    -4.2
    %New Mexico
    
    
    2,380
    
    
    
    3,165
    
    
    
    (785
    )
    
    
    -24.8
    %
    
    
    5,795
    
    
    
    6,780
    
    
    
    (985
    )
    
    
    -14.5
    %Michigan
    
    
    3,295
    
    
    
    
    
    
    
    3,295
    
    
    NM
    
    
    7,854
    
    
    
    
    
    
    
    7,854
    
    
    NMMissouri
    
    
    2,731
    
    
    
    802
    
    
    
    1,929
    
    
    
    240.5
    %
    
    
    5,178
    
    
    
    2,765
    
    
    
    2,413
    
    
    
    87.3
    %Utah
    
    
    
    
    
    
    2,581
    
    
    
    (2,581
    )
    
    NM
    
    
    
    
    
    
    5,814
    
    
    
    (5,814
    )
    
    NMOther
    
    
    295
    
    
    
    319
    
    
    
    (24
    )
    
    
    -7.5
    %
    
    
    573
    
    
    
    (993
    )
    
    
    1,566
    
    
    
    -157.7
    %Total
    
    $
    65,731
    
    
    $
    74,201
    
    
    $
    (8,470
    )
    
    
    -11.4
    %
    
    $
    154,480
    
    
    $
    179,303
    
    
    $
    (24,823
    )
    
    
    -13.8
    %
 25




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##### Table of Contents



Results of Operations
  Three months ended June 30,
    
    
    Six months ended June 30,2006
    
    
    2005
    
    
    % Change
    
    
    2006
    
    
    2005
    
    
    % ChangeRestated
    
    
    
    
    
    
    
    
    
    
    RestatedRevenuesNet premiums earned
    
    $
    73,753
    
    
    $
    77,441
    
    
    
    -4.8
    %
    
    $
    146,791
    
    
    $
    145,377
    
    
    
    1.0
    %Commission income and fees
    
    
    14,552
    
    
    
    21,707
    
    
    
    -33.0
    %
    
    
    32,051
    
    
    
    42,702
    
    
    
    -24.9
    %Net investment income
    
    
    2,154
    
    
    
    1,353
    
    
    
    59.2
    %
    
    
    4,214
    
    
    
    2,610
    
    
    
    61.5
    %Net realized gains (losses)
    
    
    1
    
    
    
    3
    
    
    
    -66.7
    %
    
    
    (366
    )
    
    
    6
    
    
    NMTotal revenues
    
    
    90,460
    
    
    
    100,504
    
    
    
    -10.0
    %
    
    
    182,690
    
    
    
    190,695
    
    
    
    -4.2
    %ExpensesLosses and loss adjustment expenses
    
    
    47,081
    
    
    
    51,217
    
    
    
    -8.1
    %
    
    
    94,733
    
    
    
    95,784
    
    
    
    -1.1
    %Selling, general and administrative expenses
    
    
    34,194
    
    
    
    37,896
    
    
    
    -9.8
    %
    
    
    66,795
    
    
    
    69,822
    
    
    
    -4.3
    %Depreciation and amortization
    
    
    1,059
    
    
    
    993
    
    
    
    6.6
    %
    
    
    2,119
    
    
    
    2,022
    
    
    
    4.8
    %Interest expense
    
    
    1,086
    
    
    
    796
    
    
    
    36.4
    %
    
    
    2,171
    
    
    
    1,375
    
    
    
    57.9
    %Total expenses
    
    
    83,420
    
    
    
    90,902
    
    
    
    -8.2
    %
    
    
    165,818
    
    
    
    169,003
    
    
    
    -1.9
    %Net income before income taxes and minority interest
    
    
    7,040
    
    
    
    9,602
    
    
    
    -26.7
    %
    
    
    16,872
    
    
    
    21,692
    
    
    
    -22.2
    %Income tax expense
    
    
    2,156
    
    
    
    3,403
    
    
    
    -36.6
    %
    
    
    5,676
    
    
    
    7,687
    
    
    
    -26.2
    %Minority interest, net of income taxes
    
    
    
    
    
    
    326
    
    
    NM
    
    
    81
    
    
    
    359
    
    
    
    -77.4
    %Net income
    
    $
    4,884
    
    
    $
    5,873
    
    
    
    -16.8
    %
    
    $
    11,115
    
    
    $
    13,646
    
    
    
    -18.5
    %Net income per common share  Basic
    
    $
    0.32
    
    
    $
    0.36
    
    
    
    -11.1
    %
    
    $
    0.72
    
    
    $
    0.83
    
    
    
    -12.2
    %Net income per common share  Diluted
    
    $
    0.32
    
    
    $
    0.36
    
    
    
    -11.1
    %
    
    $
    0.72
    
    
    $
    0.81
    
    
    
    -11.1
    %Weighted average shares outstanding  Basic
    
    
    15,321,771
    
    
    
    16,218,769
    
    
    
    -5.5
    %
    
    
    15,376,858
    
    
    
    16,530,619
    
    
    
    -7.0
    %Weighted average shares outstanding  Diluted
    
    
    15,359,004
    
    
    
    16,434,411
    
    
    
    -6.5
    %
    
    
    15,414,733
    
    
    
    16,774,473
    
    
    
    -8.1
    %Operational InformationGross premiums written
    
    $
    65,731
    
    
    $
    74,201
    
    
    
    -11.4
    %
    
    $
    154,480
    
    
    $
    179,303
    
    
    
    -13.8
    %Net premiums written (1)
    
    $
    68,120
    
    
    $
    72,689
    
    
    
    -6.3
    %
    
    $
    155,178
    
    
    $
    176,799
    
    
    
    -12.2
    %Percentage retained
    
    
    103.6
    %
    
    
    98.0
    %
    
    
    
    
    
    
    100.5
    %
    
    
    98.6
    %Loss Ratio
    
    
    63.8
    %
    
    
    66.1
    %
    
    
    
    
    
    
    64.5
    %
    
    
    65.9
    %Expense Ratio
    
    
    28.1
    %
    
    
    22.2
    %
    
    
    
    
    
    
    25.1
    %
    
    
    20.0
    %Combined Ratio
    
    
    91.9
    %
    
    
    88.3
    %
    
    
    
    
    
    
    89.6
    %
    
    
    85.9
    %
 
 (1)
    
    Includes reversal of premiums previously ceded resulting from termination of 25% quota
share reinsurance agreement with FolksAmerica for business produced by our Florida underwriting
agency, Space Coast, effective May 1, 2006. Comparison of the Three Month Periods Ended June 30, 2006 and June 30, 2005
  26




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##### Table of Contents



Three Months EndedJune 30,2006
    
    
    2005
    
    
    Variance
    
    
    Variance($)
    
    
    (%)Income on non-retained business- MGA commissions
    
    
    340
    
    
    
    2,444
    
    
    
    (2,104
    )
    
    
    -86
    %- Claims service fee income
    
    
    650
    
    
    
    3,077
    
    
    
    (2,427
    )
    
    
    -79
    %Affiliated- Policyholder fee income
    
    
    9,459
    
    
    
    11,208
    
    
    
    (1,749
    )
    
    
    -16
    %- Agency fees
    
    
    406
    
    
    
    1,180
    
    
    
    (774
    )
    
    
    -66
    %Non-affiliated income  third party- Commissions and fees
    
    
    3,589
    
    
    
    3,443
    
    
    
    146
    
    
    
    4
    %- Agency fees
    
    
    108
    
    
    
    355
    
    
    
    (247
    )
    
    
    -70
    %Total commission income and fees
    
    
    14,552
    
    
    
    21,707
    
    
    
    (7,155
    )
    
    
    -33
    %
   27




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##### Table of Contents



Three Months EndedJune 30,2006
    
    
    2005(dollars in thousands)Beginning deferred acquisition costs (DAC)
    
    $
    28,069
    
    
    $
    28,980Additions
    
    
    17,536
    
    
    
    18,305Amortization of DAC
    
    
    (18,661
    )
    
    
    (19,489
    )Ending deferred acquisition costs
    
    $
    26,944
    
    
    $
    27,796Amortization of DAC as % of Earned Premium
    
    
    25.3
    %
    
    
    25.2
    %Total policy acquisition costs (amortization of DAC)
    
    $
    18,661
    
    
    $
    19,489Other selling, general and administrative expenses
    
    
    15,533
    
    
    
    18,407Total selling, general and administrative expenses
    
    $
    34,194
    
    
    $
    37,896Total SG&A expenses as % of Earned Premium
    
    
    46.4
    %
    
    
    48.9
    %
       28




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##### Table of Contents



Comparison of the Six Month Periods Ended June 30, 2006 and June 30, 2005
      29




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##### Table of Contents



Six Months EndedJune 30,2006
    
    
    2005
    
    
    Variance
    
    
    Variance($)
    
    
    (%)Income on non-retained business- MGA commissions
    
    
    1,253
    
    
    
    3,847
    
    
    
    (2,594
    )
    
    
    -67
    %- Claims service fee income
    
    
    1,542
    
    
    
    6,730
    
    
    
    (5,188
    )
    
    
    -77
    %Affiliated- Policyholder fee income
    
    
    20,011
    
    
    
    21,584
    
    
    
    (1,573
    )
    
    
    -7
    %- Agency fees
    
    
    1,556
    
    
    
    2,626
    
    
    
    (1,070
    )
    
    
    -41
    %Non-affiliated income  third party- Commissions and fees
    
    
    7,262
    
    
    
    7,199
    
    
    
    (63
    )
    
    
    1
    %- Agency fees
    
    
    427
    
    
    
    716
    
    
    
    (289
    )
    
    
    -40
    %Total commission income and fees
    
    
    32,051
    
    
    
    42,702
    
    
    
    (10,651
    )
    
    
    -25
    %
    Six Months EndedJune 30,2006
    
    
    2005(dollars in thousands)Beginning deferred acquisition costs (DAC)
    
    $
    24,453
    
    
    $
    19,118Additions
    
    
    40,048
    
    
    
    45,304Amortization of DAC
    
    
    (37,557
    )
    
    
    (36,626
    )Ending deferred acquisition costs
    
    $
    26,944
    
    
    $
    27,796Amortization of DAC as % of Earned Premium
    
    
    25.6
    %
    
    
    25.2
    %Total policy acquisition costs (amortization of DAC)
    
    $
    37,557
    
    
    $
    36,626Other selling, general and administrative expenses
    
    
    29,238
    
    
    
    33,196Total selling, general and administrative expenses
    
    $
    66,795
    
    
    $
    69,822Total SG&A expenses as % of Earned Premium
    
    
    45.5
    %
    
    
    48.0
    %
 30




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##### Table of Contents



Liquidity and Capital Resources
 Sources and uses of funds.
   31




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##### Table of Contents



As of
    
    As ofJune 30,
    
    December 31,2006
    
    2005Total invested assets ($ in thousands)
    
    $
    233,744
    
    
    $
    210,750Tax equivalent book yield
    
    
    5.58
    %
    
    
    4.77
    %Average duration in years
    
    
    0.6
    
    
    
    3.8Average S&P rating
    
    AA
    +
    
    AA
    +
   32




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##### Table of Contents



Special Note Regarding Forward-Looking Statements
  
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
  Interest rate risk.
 Credit risk.
   33




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##### Table of Contents



Effects of inflation.
 
 Item 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
   34




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##### Table of Contents



Managements Remediation Initiatives
   35




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##### Table of Contents



Changes in Internal Control over Financial Reporting
  
 PART II
 
 Item 1. Legal Proceedings
   th
  36




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##### Table of Contents



Item 1A. Risk Factors
  
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  Maximum number of shares (or approximate dollar value)Total number of shares
    
    
    that may yet be purchasedTotal number of
    
    
    Average price paid
    
    
    purchased as part of publicly
    
    
    under the plans or programsPeriod
    
    shares purchased (1)
    
    
    per share
    
    
    announced plans of programs (2)
    
    
    (2)5/1/2006  5/31/2006
    
    
    235,500
    
    
    $
    13.29
    
    
    
    235,5006/1/2006  6/30/2006
    
    
    66,900
    
    
    $
    15.00
    
    
    
    66,900Total
    
    
    302,400
    
    
    $
    13.67
    
    
    
    302,400
    
    
    $
    10,865,971
 
 (1)
    
    The shares were repurchased in open-market transactions.(2)
    
    The share repurchase program was publicly announced on May 10, 2006. On May 9, 2006,
our board of directors approved a share repurchase program for up to $15.0 million of our
common stock over twelve months. Approximately $4.1 million has been expended since the
board approval of the repurchase plan. 
 Item 3. Defaults Upon Senior Securities
  
 Item 4. Submission of Matters to a Vote of Security Holders
   Description of Matter
    
    For
    
    Against
    
    Withheld
    
    Abstentions
    
    Nonvotes1. Election of Directors:Kevin R. Callahan
    
    
    9,475,288
    
    
    
    n/a
    
    
    
    2,828,205
    
    
    
    n/a
    
    
    
    n/aThomas C. Davis
    
    
    11,425,160
    
    
    
    n/a
    
    
    
    878,333
    
    
    
    n/a
    
    
    
    n/aNimrod T. Frazer
    
    
    11,804,594
    
    
    
    n/a
    
    
    
    498,899
    
    
    
    n/a
    
    
    
    n/aDavid L. Heller
    
    
    9,594,713
    
    
    
    n/a
    
    
    
    2,708,780
    
    
    
    n/a
    
    
    
    n/aAvshalom Y. Kalichstein
    
    
    9,471,431
    
    
    
    n/a
    
    
    
    2,832,062
    
    
    
    n/a
    
    
    
    n/aSuzanne T. Porter
    
    
    11,425,160
    
    
    
    n/a
    
    
    
    878,333
    
    
    
    n/a
    
    
    
    n/aMichael J. Ryan
    
    
    9,471,431
    
    
    
    n/a
    
    
    
    2,832,062
    
    
    
    n/a
    
    
    
    n/aPaul J. Zucconi
    
    
    11,425,160
    
    
    
    n/a
    
    
    
    878,333
    
    
    
    n/a
    
    
    
    n/a2. Amendment to 2004 Stock Incentive Plan
    
    
    10,309,186
    
    
    
    315,154
    
    
    
    n/a
    
    
    
    1,825
    
    
    
    n/a
 37




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##### Table of Contents



Item 5. Other information
  
 Item 6. Exhibits
 a) EXHIBITS
 3.1
    
    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).10.1*
    
    Fourth Amendment to Credit Facility.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 38




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##### Table of Contents



Signatures
  Affirmative Insurance Holdings, Inc.Date: August 9, 2006/s/ Mark E. PapeBy: Mark E. PapeExecutive Vice President and Chief Financial Officer
(and in his capacity as Principal Financial Officer)
 39