##### 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 September 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
  o þ 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
    
    
    24Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    37Item 4. Controls and Procedures
    
    
    39PART II
    
    
    41Item 1. Legal Proceedings
    
    
    41Item 1A. Risk Factors
    
    
    41Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    41Item 3. Defaults Upon Senior Securities
    
    
    41Item 4. Submission of Matters to a Vote of Security Holders
    
    
    41Item 5. Other information
    
    
    41Item 6. Exhibits
    
    
    42Signatures
    
    
    43Certification of Kevin R. Callahan, Interim CEO Pursuant to Section 302Certification of Mark E. Pape, CFO Pursuant to Section 302Certification of Kevin R. Callahan, Interim CEO Pursuant to Section 906Certification of Mark E. Pape, 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
 September 30, 2006 and December 31, 2005
 September 30,
    
    
    December 31,2006
    
    
    2005(dollars in thousands, except share data)
    
    (unaudited)AssetsFixed
maturities  available for sale, at fair value (amortized cost 2006: $227,077; 2005: $211,087)
    
    $
    226,414
    
    
    $
    210,273Short-term investments
    
    
    251
    
    
    
    477Total invested assets
    
    
    226,665
    
    
    
    210,750Cash and cash equivalents
    
    
    57,267
    
    
    
    48,037Fiduciary and restricted cash
    
    
    32,138
    
    
    
    29,689Accrued investment income
    
    
    2,378
    
    
    
    2,722Premiums and fees receivable
    
    
    85,611
    
    
    
    81,680Commissions receivable
    
    
    5,154
    
    
    
    2,144Receivable from reinsurers
    
    
    23,152
    
    
    
    28,137Deferred acquisition costs
    
    
    26,005
    
    
    
    24,453Deferred tax asset
    
    
    9,918
    
    
    
    14,866Federal income taxes receivable
    
    
    
    
    
    
    6,823Property and equipment, net
    
    
    6,307
    
    
    
    4,820Goodwill
    
    
    64,959
    
    
    
    61,009Other intangible assets, net
    
    
    18,508
    
    
    
    19,607Other assets
    
    
    14,575
    
    
    
    9,388Total assets
    
    $
    572,637
    
    
    $
    544,125Liabilities and Stockholders EquityLiabilitiesReserves for losses and loss adjustment expenses
    
    
    139,859
    
    
    
    126,940Unearned premium
    
    
    99,221
    
    
    
    97,344Amounts due reinsurers
    
    
    8,081
    
    
    
    8,715Deferred revenue
    
    
    25,893
    
    
    
    27,101Federal income taxes payable
    
    
    437
    
    
    
    Notes payable
    
    
    56,702
    
    
    
    56,702Consideration due for acquisitions
    
    
    1,016
    
    
    
    1,352Other liabilities
    
    
    29,818
    
    
    
    26,009Total liabilities
    
    
    361,027
    
    
    
    344,163Commitments and contingencies (Note 8)Stockholders equityCommon stock, $0.01 par value; 75,000,000 shares authorized, 17,493,849 shares issued and
15,140,486 shares outstanding at September 30, 2006; 17,483,520 issued and 15,432,557
shares outstanding at December 31, 2005
    
    
    175
    
    
    
    175Additional paid-in capital
    
    
    159,416
    
    
    
    158,904Treasury stock, at cost; 2,353,363 shares at September 30, 2006; 2,050,963 shares at
December 31, 2005
    
    
    (32,880
    )
    
    
    (28,746
    )Accumulated other comprehensive loss
    
    
    (431
    )
    
    
    (529
    )Retained earnings
    
    
    85,330
    
    
    
    70,158Total stockholders equity
    
    
    211,610
    
    
    
    199,962Total liabilities and stockholders equity
    
    $
    572,637
    
    
    $
    544,125
 See accompanying Notes to Consolidated Financial Statements
 3




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Operations (Unaudited)
 Three and Nine Months Ended September 30, 2006 and 2005
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005(dollars in thousands, except per share data)
    
    
    
    
    
    (Restated)
    
    
    
    
    
    
    (Restated)RevenuesNet premiums earned
    
    $
    71,877
    
    
    $
    77,544
    
    
    $
    218,668
    
    
    $
    222,921Commission income and fees (includes related parties -
2005: $(189))
    
    
    14,420
    
    
    
    19,721
    
    
    
    46,471
    
    
    
    62,423Net investment income
    
    
    2,233
    
    
    
    1,447
    
    
    
    6,447
    
    
    
    4,057Net realized gains (losses)
    
    
    (78
    )
    
    
    5
    
    
    
    (444
    )
    
    
    11Total revenues
    
    
    88,452
    
    
    
    98,717
    
    
    
    271,142
    
    
    
    289,412ExpensesLosses and loss adjustment expenses
    
    
    46,044
    
    
    
    47,350
    
    
    
    140,777
    
    
    
    143,134Selling, general and administrative expenses
    
    
    32,979
    
    
    
    40,097
    
    
    
    99,774
    
    
    
    109,919Depreciation and amortization
    
    
    1,094
    
    
    
    912
    
    
    
    3,213
    
    
    
    2,934Interest expense
    
    
    1,085
    
    
    
    1,124
    
    
    
    3,256
    
    
    
    2,499Total expenses
    
    
    81,202
    
    
    
    89,483
    
    
    
    247,020
    
    
    
    258,486Net income before income taxes and minority interest
    
    
    7,250
    
    
    
    9,234
    
    
    
    24,122
    
    
    
    30,926Income tax expense
    
    
    2,278
    
    
    
    3,274
    
    
    
    7,954
    
    
    
    10,961Minority interest, net of income taxes
    
    
    
    
    
    
    217
    
    
    
    81
    
    
    
    576Net income
    
    $
    4,972
    
    
    $
    5,743
    
    
    $
    16,087
    
    
    $
    19,389Net income per common share  Basic
    
    $
    0.33
    
    
    $
    0.39
    
    
    $
    1.05
    
    
    $
    1.21Net income per common share  Diluted
    
    $
    0.33
    
    
    $
    0.38
    
    
    $
    1.05
    
    
    $
    1.19Weighted average shares outstandingBasic
    
    
    15,139,571
    
    
    
    14,893,310
    
    
    
    15,296,893
    
    
    
    15,978,852Diluted
    
    
    15,186,777
    
    
    
    15,165,677
    
    
    
    15,327,137
    
    
    
    16,231,333
 See accompanying Notes to Consolidated Financial Statements
 4




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Stockholders Equity and Comprehensive Income (Loss) (Unaudited)
 Nine Months Ended September 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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,389
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,389Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,472
    )
    
    
    (1,472
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    17,917Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,000,000
    
    
    
    (28,000
    )
    
    
    
    
    
    
    (28,000
    )Dividends paid ($.02 per share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (971
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (971
    )Initial public offering costs
    
    
    
    
    
    
    
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6Equity based compensation
    
    
    65,391
    
    
    
    1
    
    
    
    1,015
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,016Balance, September 30, 2005  Restated
    
    
    16,903,910
    
    
    $
    169
    
    
    $
    152,773
    
    
    $
    71,553
    
    
    
    2,000,000
    
    
    $
    (28,000
    )
    
    $
    (1,221
    )
    
    $
    195,274Balance, December 31, 2005
    
    
    17,483,520
    
    
    $
    175
    
    
    $
    158,904
    
    
    $
    70,158
    
    
    
    2,050,963
    
    
    $
    (28,746
    )
    
    $
    (529
    )
    
    $
    199,962Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    16,087
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    16,087Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    98
    
    
    
    98Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    16,185Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    302,400
    
    
    
    (4,134
    )
    
    
    
    
    
    
    (4,134
    )Dividends paid ($.02 per share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (915
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (915
    )Issuance of common stock
    
    
    10,329
    
    
    
    
    
    
    
    116
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    116Equity based compensation
    
    
    
    
    
    
    
    
    
    
    396
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    396Balance, September 30, 2006
    
    
    17,493,849
    
    
    $
    175
    
    
    $
    159,416
    
    
    $
    85,330
    
    
    
    2,353,363
    
    
    $
    (32,880
    )
    
    $
    (431
    )
    
    $
    211,610
 See accompanying Notes to Consolidated Financial Statements
 5




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Cash Flows (Unaudited)
 Nine Months Ended September 30, 2006 and 2005
 Nine months endedSeptember 30,2006
    
    
    2005(dollars in thousands)
    
    
    
    
    
    (Restated)Cash flows from operating activitiesNet income
    
    $
    16,087
    
    
    $
    19,389Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    3,213
    
    
    
    2,934Equity based compensation
    
    
    428
    
    
    
    165Realized (gain) loss on sale of bonds
    
    
    367
    
    
    
    (11
    )Amortization of premiums and discounts on investments
    
    
    1,062
    
    
    
    1,920Changes in assets and liabilities:Fiduciary and restricted cash
    
    
    (2,449
    )
    
    
    (7,796
    )Premiums and commissions receivable
    
    
    (6,941
    )
    
    
    3,386Reserves for loss and loss adjustment expenses
    
    
    12,919
    
    
    
    31,675Net due to/from reinsurers
    
    
    4,351
    
    
    
    6,137Receivable from affiliates
    
    
    
    
    
    
    7,523Deferred revenue
    
    
    (1,208
    )
    
    
    3,623Unearned premiums
    
    
    1,877
    
    
    
    16,300Deferred acquisition costs
    
    
    (1,552
    )
    
    
    (7,639
    )Deferred tax asset/liability
    
    
    4,895
    
    
    
    662Federal income taxes receivable/payable
    
    
    7,260
    
    
    
    (7,348
    )Other
    
    
    (8,972
    )
    
    
    (13,784
    )Net cash provided by operating activities
    
    
    31,337
    
    
    
    57,136Cash flows from investing activitiesProceeds from the sale of bonds
    
    
    290,794
    
    
    
    4,393Cost of bonds acquired
    
    
    (300,081
    )
    
    
    (30,001
    )Purchases of property and equipment
    
    
    (3,601
    )
    
    
    (3,381
    )Net cash paid for acquisitions
    
    
    (4,286
    )
    
    
    (2,548
    )Net cash used in investing activities
    
    
    (17,174
    )
    
    
    (31,537
    )Cash flows from financing activitiesProceeds from borrowings
    
    
    
    
    
    
    24,369Acquisition of treasury stock
    
    
    (4,134
    )
    
    
    (28,000
    )Proceeds from issuance of common stock
    
    
    116
    
    
    
    6Dividends paid
    
    
    (915
    )
    
    
    (971
    )Net cash used in financing activities
    
    
    (4,933
    )
    
    
    (4,596
    )Net increase in cash and cash equivalents
    
    
    9,230
    
    
    
    21,003Cash and cash equivalents, beginning of period
    
    
    48,037
    
    
    
    24,096Cash and cash equivalents, end of period
    
    $
    57,267
    
    
    $
    45,099
 See accompanying Notes to Consolidated Financial Statements
 6




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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 166 owned stores (twelve of which are located in leased space within
supermarkets owned by a major supermarket chain under an agreement signed in late 2005) and 35
franchise store locations as of September 30, 2006. Our underwriting agencies utilize
approximately 3,200 independent agencies to sell the policies that they administer. In
addition, we have three unaffiliated underwriting agencies producing business for our
insurance companies through approximately 4,300 independent agencies. 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. (VIG) 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 VIG. On June 1, 2005,
we purchased 2,000,000 of our shares of common stock from VIG 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, VIG and Vesta Fire Insurance Corporation (VFIC) entered into a stock
purchase agreement with New Affirmative LLC (New Affirmative), J.C. Flowers I LP and
Delaware Street Capital Master Fund for the sale by VIG and VFIC of 5,218,228 shares of our
common stock (Stock Purchase Agreement). 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. At the time of the agreement, New Affirmative was (i)
50% owned by DSC AFFM, LLC (DSC AFFM), an entity controlled by DSC AFFM Manager LLC (DSC
Manager), 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 (Affirmative Investment), an
entity owned, in part, by the Enstar Group, Inc., and controlled by Affirmative Associates LLC
(Affirmative Associates), 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.On August 31, 2006, DSC AFFM and Affirmative Investment consummated the transactions
contemplated by a purchase agreement, dated August 4, 2006, pursuant to which DSC AFFM sold to
Affirmative Investment all of the membership units of New Affirmative owned by DSM AFFM. As a
result, Affirmative Investment now owns 100% of New Affirmative. As of September 30, 2006,
New Affirmative owned 7,860,927 shares, or approximately 51.9% 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:
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 (A)
    
    The previously issued unaudited interim consolidated financial statements as of and
for the quarter and nine months ended September 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
September 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.(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 increasing commission
income and fees by $482,000 before income taxes ($311,000 after income taxes) for the
third quarter of 2005 and reducing commission income and fees for the first and second
quarters of 2005 by $344,000 before income taxes ($222,000 after income taxes) and
$138,000 before income taxes ($89,000 after income taxes), respectively. The correction
resulted in no net impact to commission income and fees for the nine months ended
September 30, 2005.(D)
    
    The previously issued unaudited interim consolidated financial statements as of and
for the quarter and nine months ended September 30, 2005 were restated to correct an
error in recording a reduction in losses and loss adjustment expenses of $1.0 million
that were related to the August 1, 2005 novation agreements with several unaffiliated
reinsurers as described in more detail in Note 4 Reinsurance. In the third quarter of
2005, we recorded a reduction in losses and loss adjustment expenses related to
profit-sharing. This is the amount that would have increased net income before taxes in
the third quarter of 2005 if we had not completed the novation agreements. However,
subsequent to the reporting of our third quarter 2005 financial results, we determined
that the novation agreements did not meet the appropriate risk transfer requirements of
reinsurance accounting, which necessitated the application of deposit accounting to those
agreements. The required accounting treatment for the novation agreements provides that
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. Based on the actual losses settled under these
agreements in the third quarter of 2005 subsequent to the date of the novation, the
adjustment to the deposit liability (representing an increase in net income before tax)
was $143,000 in the quarter, with the remaining $859,000 previously booked remaining as a
component of the deposit liability included in reserves for losses on the September 30,
2005 consolidated balance sheet until future periods as losses are settled.
   8




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 (Unaudited)
    
    
    (Unaudited)For the Quarter ended
    
    
    For the Nine Months endedSeptember 30, 2005
    
    September 30, 2005As Previously
    
    
    
    
    
    
    
    
    
    As PreviouslyAs Restated
    
    Reported
    
    Difference
    
    As Restated
    
    Reported
    
    DifferenceCommission income and fees
    
    $
    19,721
    
    
    $
    16,819
    
    
    $
    2,902
    
    
    $
    62,423
    
    
    $
    54,711
    
    
    $
    7,712Losses and loss adjustment expenses
    
    
    47,350
    
    
    
    46,347
    
    
    
    1,003
    
    
    
    143,134
    
    
    
    142,131
    
    
    
    1,003Selling, general and administrative expenses
    
    
    40,097
    
    
    
    37,820
    
    
    
    2,277
    
    
    
    109,919
    
    
    
    102,349
    
    
    
    7,570Income tax expense
    
    
    3,274
    
    
    
    3,408
    
    
    
    (134
    )
    
    
    10,961
    
    
    
    11,266
    
    
    
    (305
    )Net income
    
    $
    5,743
    
    
    $
    5,987
    
    
    $
    (244
    )
    
    $
    19,389
    
    
    $
    19,945
    
    
    $
    (556
    )
  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
    
    
    $
    
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 (Unaudited)September 30, 2005As PreviouslyAs Restated
    
    Reported
    
    DifferencePremiums and fees receivable
    
    $
    105,219
    
    
    $
    126,143
    
    
    $
    (20,924
    )Commissions receivable
    
    
    4,185
    
    
    
    7,925
    
    
    
    (3,740
    )Other assets
    
    
    15,285
    
    
    
    8,072
    
    
    
    7,213Total assets
    
    
    544,033
    
    
    
    561,484
    
    
    
    (17,451
    )Reserves for losses, LAE and deposits
    
    $
    124,705
    
    
    $
    123,845
    
    
    $
    860Amounts due reinsurers
    
    
    12,716
    
    
    
    27,804
    
    
    
    (15,088
    )Federal income taxes payable
    
    
    178
    
    
    
    483
    
    
    
    (305
    )Other liabilities
    
    
    18,323
    
    
    
    20,685
    
    
    
    (2,362
    )Total liabilities
    
    
    348,759
    
    
    
    365,654
    
    
    
    (16,895
    )Shareholders equity
    
    $
    195,274
    
    
    $
    195,830
    
    
    $
    (556
    )
 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 September 30, 2006 and 2005 is unaudited; however, in our
opinion, 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. For the three and
nine months ended September 30,
2006, we have recognized approximately $82,000 before income taxes ($54,000 after income
taxes) and
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 approximately $396,000 before income taxes ($255,000 after income taxes),
respectively, in share-based payment expense under the requirements of SFAS 123R (See Note
12).
   Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2005Net income, as reported
    
    $
    5,743
    
    
    $
    19,389Add: stock-based employee compensation expense included in
reported net income, net of related income taxes
    
    
    54
    
    
    
    255Deduct: total stock-based compensation expense
determined under fair value based method for all awards,
net of related income taxes
    
    
    (206
    )
    
    
    (592
    )Net income, pro forma
    
    $
    5,591
    
    
    $
    19,052Basic earnings per share  as reported
    
    $
    0.39
    
    
    $
    1.21Basic earnings per share  pro forma
    
    $
    0.38
    
    
    $
    1.19Diluted earnings per share  as reported
    
    $
    0.38
    
    
    $
    1.19Diluted earnings per share  pro forma
    
    $
    0.37
    
    
    $
    1.17
 Segment Reporting
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   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.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 endedSeptember 30, 2006
    
    
    September 30, 2005Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    53,695
    
    
    $
    51,666
    
    
    $
    42,983
    
    
    $
    43,845Assumed  affiliate
    
    
    
    
    
    
    
    
    
    
    4,638
    
    
    
    7,557Assumed  non affiliate
    
    
    14,788
    
    
    
    20,362
    
    
    
    27,200
    
    
    
    28,664Ceded  affiliate
    
    
    
    
    
    
    
    
    
    
    (77
    )
    
    
    (77
    )Ceded  non affiliate
    
    
    (126
    )
    
    
    (151
    )
    
    
    (1,967
    )
    
    
    (2,445
    )$
    68,357
    
    
    $
    71,877
    
    
    $
    72,777
    
    
    $
    77,544
 Nine months ended
    
    
    Nine months endedSeptember 30, 2006
    
    
    September 30, 2005Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    153,064
    
    
    $
    138,498
    
    
    $
    137,428
    
    
    $
    134,478Assumed  affiliate
    
    
    
    
    
    
    
    
    
    
    27,436
    
    
    
    33,846Assumed  non affiliate
    
    
    69,899
    
    
    
    82,590
    
    
    
    89,257
    
    
    
    69,496Ceded  affiliate
    
    
    
    
    
    
    
    
    
    
    (239
    )
    
    
    (687
    )Ceded  non affiliate
    
    
    572
    
    
    
    (2,420
    )
    
    
    (4,306
    )
    
    
    (14,212
    )$
    223,535
    
    
    $
    218,668
    
    
    $
    249,576
    
    
    $
    222,921
   As of September 30,
    
    
    As of December 31,2006
    
    
    2005Non affiliateLoss and loss adjustment expense
    
    $
    20,696
    
    
    $
    19,169Unearned premiums
    
    
    145
    
    
    
    3,137Total
    
    $
    20,841
    
    
    $
    22,306
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 Best financial strength rating remained
below B+ we had the right to require VFIC to provide a letter of credit or establish a trust
account to collateralize the gross amounts due to us from VFIC under the reinsurance
agreement. Accordingly, on July 27, 2004, we notified Vesta to establish a trust account
collateralizing the amount due to us, due to the fact that VFICs A.M. Best rating was below a
B+ after the consummation of our initial public offering. We have $22.8 million currently
in a trust account to collateralize the $20.4 million gross recoverable from VFIC. Separately,
we include $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 $20.4 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 consulted with Vestas management
and provided 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
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 September 30, 2006, $19.8 million was included in reserves for losses and loss adjustment
expenses that reflect the amounts we owe to Vesta including Hawaiian Insurance and Guaranty,
LTD. We have $23.1 million in securities to collateralize this payable.In May of 2006, certain of Vestas insurance companies, including VFIC, 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. Such Order was granted on August 1, 2006 as
to VFIC.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 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. A partial dismissal without prejudice was entered as to defendant Paul Ruelas.
Plaintiff filed a notice of appeal on April 18, 2006. On September 22, 2006, Hawaiian moved
to stay appellate proceedings pursuant to an Order of Liquidation entered on August 21, 2006,
in the Circuit Court for the State of Hawaii. 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 three and
nine months ended September 30, 2006, we recognized $169,000 and $561,000 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 nine months ended September 30, the
accompanying unaudited consolidated statements of operations reflect these services as follows
(dollars in thousands):
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Commission income
    
    $
    
    
    
    $
    473
    
    
    $
    
    
    
    $
    594
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 We lease six of our Insure One retail stores in Chicago, Illinois from ATR Investments, LLC or
entities controlled by ATR Investments. Our newly appointed president of our retail division,
Alan T. Rasof, is the sole owner and manager of ATR Investments. These six leases have terms
ranging from 3 to 4 years and expiration dates ranging from 2007 to 2011. The leases relate
to properties with square footage ranging from approximately 1,200 to 1,800 square feet and
provide for monthly rental ranging from $2,400 to $4,750. The total rent due under the leases
during their term is approximately $860,000. In some instances, we also have engaged Captain
Management Services, Ltd. to remodel our retail store locations. Captain Management is wholly
owned by Mr. Rasof. Through the date of this filing, we have paid
Captain Management approximately $352,000 relating to
remodeling and build out services performed for 15 of our retail locations in Illinois and
Indiana. We were party to a consulting agreement with ATR Investments from June 1, 2006
through October 8, 2006 pursuant to which ATR Investments provided us with certain consulting
services, including, without limitation, marketing, management and operational services
relating to new and existing and competitor retail store locations and developing retail
location site selection criteria. Through the date of this filing, we have paid ATR
Investments and Captain Management Services an aggregate amount of $135,000 for consulting
services.6.
    
    Purchase AcquisitionsOn March 14, 2006, we completed the acquisition of the 27% minority ownership interest of
Space Coast Holdings, Inc. 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 nine months ended September 30, 2006, we have paid $779,000 in contingent purchase
price adjustments related to prior acquisitions, $225,000 for the acquisition of two retail
stores and $63,800 for the purchase of a franchise.7.
    
    Notes PayableOn December 31, 2004, our 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 September 30, 2006, the note balance was $30.9 million.On June 1, 2005, our 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 $25.8 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 September 30, 2006, the note balance was $25.8 million.As of September 30, 2006, the total note balance for Trust Entities 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
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 operations. For
detailed information concerning legal actions, please refer to Legal Proceedings contained
elsewhere in this report.Recently, two of our owned underwriting agencies were subject to a routine sales and use tax
audit conducted by the State of Texas. The examiner for the State of Texas has now completed
his audit report and delivered an audit assessment to us. The examiners report asserts that,
for the period from January 2002 to December 2005, we should have collected and remitted
approximately $2.9 million in sales tax derived from claims services performed by our
underwriting agencies for policies sold by these underwriting agencies and issued by Old
American County Mutual Insurance Company, an unaffiliated insurance company, through a
fronting arrangement. The assessment includes an additional $412,000 for accrued interest and
penalty for a total assessment of $3.3 million. 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. On October 19, 2006, we
responded to the assessment by filing petitions with the Comptroller of Public Accounts for
the State of Texas requesting a redetermination of the tax due and a hearing to present
written and oral evidence and legal arguments to contest the imposition of the asserted taxes.
As a result of the timely filing of these petitions, an administrative appeal process has
commenced and the date for payment is delayed until the completion of the appeal process.
Such appeals routinely take up to three years and much longer for complex cases. As such, the
outcome of this tax assessment will not be known for a commensurate amount of time. At this
time, we are uncertain of the probability of the outcome of our appeal. Additionally, we
cannot reasonably estimate the ultimate liability at this time. We have not made an accrual
for this as of September 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, effective July 30, 2004, which provides us with a senior secured credit
facility. On August 7, 2006 we entered into a Fourth Amendment to our Credit Agreement dated
July 30, 2004, 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. The 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 the Form 10-Q filed with the SEC on August 9, 2006. Under this credit
facility, the maximum amount available to us from time to time is $20.0 million, which may
include up to $20.0 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 credit 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 credit 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.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 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.As of September 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 nine months ended September 30, 2006 was zero and approximately
$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.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.In August 2006, we issued 2,104 share of our common stock upon the exercise of options.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:
 18




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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 September 30, 2006Basic Earnings per ShareNet Income
    
    $
    4,972
    
    
    
    15,139,571
    
    
    $
    0.33Diluted Earnings per ShareNet Income
    
    $
    4,972
    
    
    
    15,139,571
    
    
    $
    0.33Effect of Dilutive Securities
    
    
    
    
    
    
    47,206
    
    
    
    $
    4,972
    
    
    
    15,186,777
    
    
    $
    0.33Three months ended September 30, 2005Basic Earnings per ShareNet Income
    
    $
    5,743
    
    
    
    14,893,310
    
    
    $
    0.39Diluted Earnings per ShareNet Income
    
    $
    5,743
    
    
    
    14,893,310
    
    
    $
    0.39Effect of Dilutive Securities
    
    
    
    
    
    
    272,367
    
    
    
    (0.01
    )$
    5,743
    
    
    
    15,165,677
    
    
    $
    0.38Nine months ended September 30, 2006Basic Earnings per ShareNet Income
    
    $
    16,087
    
    
    
    15,296,893
    
    
    $
    1.05Diluted Earnings per ShareNet Income
    
    $
    16,087
    
    
    
    15,296,893
    
    
    $
    1.05Effect of Dilutive Securities
    
    
    
    
    
    
    30,244
    
    
    
    $
    16,087
    
    
    
    15,327,137
    
    
    $
    1.05Nine months ended September 30, 2005Basic Earnings per ShareNet Income
    
    $
    19,389
    
    
    
    15,978,852
    
    
    $
    1.21Diluted Earnings per ShareNet Income
    
    $
    19,389
    
    
    
    15,978,852
    
    
    $
    1.21Effect of Dilutive Securities
    
    
    
    
    
    
    252,481
    
    
    
    (0.02
    )$
    19,389
    
    
    
    16,231,333
    
    
    $
    1.19
 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.
 19




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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.
       20




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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 September 30, 2006
    
    Options
    
    
    Price
    
    
    Term (years)
    
    
    (000s)1998 PlanOutstanding, beginning of period
    
    
    91,774
    
    
    $
    7.59Granted
    
    
    
    
    
    
    Exercised
    
    
    (2,104
    )
    
    
    7.59Forfeited
    
    
    
    
    
    
    Outstanding, end of period
    
    
    89,670
    
    
    $
    7.59
    
    
    
    1.22
    
    
    $
    633Exercisable, end of period
    
    
    89,670
    
    
    $
    7.59
    
    
    
    1.22
    
    
    $
    6332004 PlanOutstanding, beginning of period
    
    
    1,335,102
    
    
    $
    17.08Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited
    
    
    (12,980
    )
    
    
    14.96Outstanding, end of period
    
    
    1,322,122
    
    
    $
    17.10
    
    
    
    8.77
    
    
    $
    202Exercisable, end of period
    
    
    387,336
    
    
    $
    14.77
    
    
    
    8.62
    
    
    $
    78
 21




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 WeightedWeighted
    
    
    Average
    
    
    AggregateAverage
    
    
    Remaining
    
    
    IntrinsicExercise
    
    
    Contractual
    
    
    ValueNine months ended September 30, 2006
    
    Options
    
    
    Price
    
    
    Term (years)
    
    

(000s)1998
PlanOutstanding, beginning of period
    
    
    94,699
    
    
    $
    7.59Granted
    
    
    
    
    
    
    Exercised
    
    
    (5,029
    )
    
    
    7.59Forfeited
    
    
    
    
    
    
    Outstanding, end of period
    
    
    89,670
    
    
    $
    7.59
    
    
    
    1.22
    
    
    $
    633Exercisable, end of period
    
    
    89,670
    
    
    $
    7.59
    
    
    
    1.22
    
    
    $
    6332004 PlanOutstanding, beginning of period
    
    
    1,453,428
    
    
    $
    16.92Granted
    
    
    15,000
    
    
    
    14.22Exercised
    
    
    (5,300
    )
    
    
    14.64Forfeited
    
    
    (141,006
    )
    
    
    15.06Outstanding, end of period
    
    
    1,322,122
    
    
    $
    17.10
    
    
    
    8.77
    
    
    $
    202Exercisable, end of period
    
    
    387,336
    
    
    $
    14.77
    
    
    
    8.62
    
    
    $
    78
   WeightedAverageRestricted
    
    
    Grant-DateThree months ended September 30, 2006
    
    Stock
    
    
    Fair ValueNonvested, beginning of period
    
    
    
    
    
    $
    Granted
    
    
    
    
    
    
    Vested
    
    
    
    
    
    
    Canceled or expired
    
    
    
    
    
    
    Nonvested, end of period
    
    
    
    
    
    $
    
 WeightedAverageRestricted
    
    
    Grant-DateNine months ended September 30, 2006
    
    Stock
    
    
    Fair ValueNonvested, beginning of period
    
    
    8,000
    
    
    $
    14.05Granted
    
    
    Vested
    
    
    (8,000
    )
    
    
    14.05Canceled or expired
    
    
    Nonvested, end of period
    
    
    
    
    
    $
    
 22




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)   Continued
 As of September 30, 2006, there was $1.8 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
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Beginning deferred acquisition costs (DAC)
    
    $
    26,944
    
    
    $
    27,796
    
    
    $
    24,453
    
    
    $
    19,118Additions
    
    
    17,625
    
    
    
    18,241
    
    
    
    57,672
    
    
    
    63,546Amortization of DAC
    
    
    (18,564
    )
    
    
    (19,280
    )
    
    
    (56,120
    )
    
    
    (55,907
    )Ending deferred acquisition costs
    
    $
    26,005
    
    
    $
    26,757
    
    
    $
    26,005
    
    
    $
    26,757
 14.
    
    Subsequent EventsOn October 10, 2006, we announced that Kevin R. Callahan was appointed chief executive
officer. Mr. Callahan has served as interim chief executive officer since November 2005. On
October 5, 2006, we entered into an employment agreement with Mr. Callahan. The employment
agreement has been filed as Exhibit 10.1 to the report on Form 8K filed with the SEC on
October 10, 2006.On October 10, 2006, we announced that Alan T. Rasof has joined the company as president of
our retail division effective October 10, 2006. Mr. Rasof replaces Katherine C. Nolan who has
resigned from the Company.On October 10, 2006, we announced that Charlene Barnard has been appointed to the newly
created position of Chief Marketing Officer effective October 10, 2006.On October 10, 2006, we announced that Joseph Fisher has joined the company as general counsel
effective November 1, 2006. Mr. Fisher replaces David Snyder, who has resigned from the
Company.On October 17, 2006, we announced a definitive agreement under which we will acquire 100% of
the membership units of USAgencies, L.L.C., in a fully-financed all cash transaction valued at
approximately $200 million. The transaction is subject to regulatory approval and other usual
closing conditions associated with similar transactions. As a result of this announcement,
A.M. Best has placed the financial strength rating (FSR) of B+ (Very Good) and the issuer
credit ratings (ICR) of bbb- of Affirmative Insurance Group, as well as the ICR of bb- of
our parent company, Affirmative Insurance Holdings, Inc. (Affirmative Holdings) under review
with negative implications. While it is anticipated that subsequent to the completion of the
acquisition, our combined entities will maintain favorable risk-adjusted capitalization and
operating performance relative to our current rating level, A.M. Best will need to consider
the projected high intangible financial leverage position of Affirmative Holdings.On October 16, 2006, we entered into a master services agreement with Accenture LLP under
which we will outsource substantially all of our IT operations to Accenture, including our
data center, field support and application management. The initial term of the agreement is
ten years, although it may be terminated for convenience by us at any time upon six months
notice after the first two years, subject to the payment of certain stranded costs and other
termination fees.In October 2006, we issued 37,285 shares of our common stock upon the exercise of options.
 23




---



##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
  Overview
     Restatement
  24




---



##### Table of Contents



Measurement of Performance
 The Sales Process
  25




---



##### Table of Contents



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2006
    
    
    2005
    
    
    2006
    
    
    2005Our underwriting agencies:Our retail agencies
    
    $
    19,416
    
    
    $
    25,520
    
    
    $
    71,201
    
    
    $
    92,531Independent agencies
    
    
    40,441
    
    
    
    41,184
    
    
    
    120,846
    
    
    
    127,044Subtotal
    
    
    59,857
    
    
    
    66,704
    
    
    
    192,047
    
    
    
    219,575Unaffiliated underwriting agencies
    
    
    8,614
    
    
    
    8,029
    
    
    
    30,875
    
    
    
    34,299Other
    
    
    12
    
    
    
    88
    
    
    
    41
    
    
    
    247Total
    
    $
    68,483
    
    
    $
    74,821
    
    
    $
    222,963
    
    
    $
    254,121
  26
    Table of Contents     Three Months Ended September 30,
    
    

    Nine Months Ended September 30,2006
    
    
    2005
    
    
    $ Change
    
    
    % Change
    
    
    2006
    
    
    2005
    
    
    $ Change
    
    
    % ChangeTexas
    
    $
    18,777
    
    
    $
    20,974
    
    
    $
    (2,197
    )
    
    
    -10.5
    %
    
    $
    62,477
    
    
    $
    83,671
    
    
    $
    (21,194
    )
    
    
    -25.3
    %Illinois
    
    
    15,682
    
    
    
    19,726
    
    
    
    (4,044
    )
    
    
    -20.5
    %
    
    
    54,304
    
    
    
    62,173
    
    
    
    (7,869
    )
    
    
    -12.7
    %California
    
    
    7,354
    
    
    
    6,388
    
    
    
    966
    
    
    
    15.1
    %
    
    
    29,071
    
    
    
    28,000
    
    
    
    1,071
    
    
    
    3.8
    %Florida
    
    
    5,490
    
    
    
    7,613
    
    
    
    (2,123
    )
    
    
    -27.9
    %
    
    
    15,138
    
    
    
    21,348
    
    
    
    (6,210
    )
    
    
    -29.1
    %Indiana
    
    
    3,773
    
    
    
    5,294
    
    
    
    (1,521
    )
    
    
    -28.7
    %
    
    
    14,499
    
    
    
    18,602
    
    
    
    (4,103
    )
    
    
    -22.1
    %South Carolina
    
    
    4,714
    
    
    
    4,928
    
    
    
    (214
    )
    
    
    -4.3
    %
    
    
    15,381
    
    
    
    16,066
    
    
    
    (685
    )
    
    
    -4.3
    %New Mexico
    
    
    2,500
    
    
    
    3,242
    
    
    
    (742
    )
    
    
    -22.9
    %
    
    
    8,295
    
    
    
    10,022
    
    
    
    (1,727
    )
    
    
    -17.2
    %Michigan
    
    
    5,282
    
    
    
    4,111
    
    
    
    1,171
    
    
    
    28.5
    %
    
    
    13,136
    
    
    
    4,111
    
    
    
    9,025
    
    
    
    219.5
    %Missouri
    
    
    3,639
    
    
    
    817
    
    
    
    2,822
    
    
    
    345.4
    %
    
    
    8,817
    
    
    
    3,582
    
    
    
    5,235
    
    
    
    146.1
    %Utah
    
    
    277
    
    
    
    1,435
    
    
    
    (1,158
    )
    
    
    -80.7
    %
    
    
    277
    
    
    
    7,249
    
    
    
    (6,972
    )
    
    
    -96.2
    %Other
    
    
    995
    
    
    
    293
    
    
    
    702
    
    
    
    239.6
    %
    
    
    1,568
    
    
    
    (703
    )
    
    
    2,271
    
    
    
    -323.0
    %Total
    
    $
    68,483
    
    
    $
    74,821
    
    
    $
    (6,338
    )
    
    
    -8.5
    %
    
    $
    222,963
    
    
    $
    254,121
    
    
    $
    (31,158
    )
    
    
    -12.3
    %
 Commission and Fee Income
 Commission income and fees earned by our underwriting agencies on business that is not written or
retained by us.
 Policy and agency fees earned for business written or assumed by our insurance companies both
through independent agents and our retail agencies.
 27




---



##### Table of Contents



The commissions earned on sales of unaffiliated (third-party) insurance companies products sold by
our retail agencies.
 Loss and Loss Adjustment Expense
   Selling, General and Administrative Expenses
  28




---



##### Table of Contents



Results of Operations
  Three months ended September 30,
    
    
    Nine months ended September 30,2006
    
    
    2005
    
    
    % Change
    
    
    2006
    
    
    2005
    
    
    % ChangeRestated
    
    
    
    
    
    
    
    
    
    
    RestatedRevenuesNet premiums earned
    
    $
    71,877
    
    
    $
    77,544
    
    
    
    -7.3
    %
    
    $
    218,668
    
    
    $
    222,921
    
    
    
    -1.9
    %Commission income and fees
    
    
    14,420
    
    
    
    19,721
    
    
    
    -26.9
    %
    
    
    46,471
    
    
    
    62,423
    
    
    
    -25.6
    %Net investment income
    
    
    2,233
    
    
    
    1,447
    
    
    
    54.3
    %
    
    
    6,447
    
    
    
    4,057
    
    
    
    58.9
    %Net realized gains (losses)
    
    
    (78
    )
    
    
    5
    
    
    NM
    
    
    (444
    )
    
    
    11
    
    
    NMTotal revenues
    
    
    88,452
    
    
    
    98,717
    
    
    
    -10.4
    %
    
    
    271,142
    
    
    
    289,412
    
    
    
    -6.3
    %ExpensesLosses and loss adjustment expenses
    
    
    46,044
    
    
    
    47,350
    
    
    
    -2.8
    %
    
    
    140,777
    
    
    
    143,134
    
    
    
    -1.6
    %Selling, general and administrative expenses
    
    
    32,979
    
    
    
    40,097
    
    
    
    -17.8
    %
    
    
    99,774
    
    
    
    109,919
    
    
    
    -9.2
    %Depreciation and amortization
    
    
    1,094
    
    
    
    912
    
    
    
    20.0
    %
    
    
    3,213
    
    
    
    2,934
    
    
    
    9.5
    %Interest expense
    
    
    1,085
    
    
    
    1,124
    
    
    
    -3.5
    %
    
    
    3,256
    
    
    
    2,499
    
    
    
    30.3
    %Total expenses
    
    
    81,202
    
    
    
    89,483
    
    
    
    -9.3
    %
    
    
    247,020
    
    
    
    258,486
    
    
    
    -4.4
    %Net income before income taxes and minority interest
    
    
    7,250
    
    
    
    9,234
    
    
    
    -21.5
    %
    
    
    24,122
    
    
    
    30,926
    
    
    
    -22.0
    %Income tax expense
    
    
    2,278
    
    
    
    3,274
    
    
    
    -30.4
    %
    
    
    7,954
    
    
    
    10,961
    
    
    
    -27.4
    %Minority interest, net of income taxes
    
    
    
    
    
    
    217
    
    
    NM
    
    
    81
    
    
    
    576
    
    
    
    -85.9
    %Net income
    
    $
    4,972
    
    
    $
    5,743
    
    
    
    -13.4
    %
    
    $
    16,087
    
    
    $
    19,389
    
    
    
    -17.0
    %Net income per common share  Basic
    
    $
    0.33
    
    
    $
    0.39
    
    
    
    -15.4
    %
    
    $
    1.05
    
    
    $
    1.21
    
    
    
    -13.2
    %Net income per common share  Diluted
    
    $
    0.33
    
    
    $
    0.38
    
    
    
    -13.2
    %
    
    $
    1.05
    
    
    $
    1.19
    
    
    
    -11.8
    %Weighted average shares outstanding  Basic
    
    
    15,139,571
    
    
    
    14,893,310
    
    
    
    1.7
    %
    
    
    15,296,893
    
    
    
    15,978,852
    
    
    
    -4.3
    %Weighted average shares outstanding  Diluted
    
    
    15,186,777
    
    
    
    15,165,677
    
    
    
    0.1
    %
    
    
    15,327,137
    
    
    
    16,231,333
    
    
    
    -5.6
    %Operational InformationGross premiums written
    
    $
    68,483
    
    
    $
    74,821
    
    
    
    -8.5
    %
    
    $
    222,963
    
    
    $
    254,121
    
    
    
    -12.3
    %Net premiums written (1)
    
    $
    68,357
    
    
    $
    72,777
    
    
    
    -6.1
    %
    
    $
    223,535
    
    
    $
    249,576
    
    
    
    -10.4
    %Percentage retained (1)
    
    
    99.8
    %
    
    
    97.3
    %
    
    
    
    
    
    
    100.3
    %
    
    
    98.2
    %Loss Ratio
    
    
    64.1
    %
    
    
    61.1
    %
    
    
    
    
    
    
    64.4
    %
    
    
    64.2
    %Expense Ratio
    
    
    27.3
    %
    
    
    27.5
    %
    
    
    
    
    
    
    25.8
    %
    
    
    22.6
    %Combined Ratio
    
    
    91.4
    %
    
    
    88.5
    %
    
    
    
    
    
    
    90.2
    %
    
    
    86.8
    %
 
 (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 September 30, 2006 and September 30, 2005
  29




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##### Table of Contents



Three Months EndedSeptember 30,2006
    
    
    2005
    
    
    % ChangeOur underwriting agencies
    
    $
    62,163
    
    
    $
    64,270
    
    
    
    -3.3
    %Unaffiliated underwriting agencies
    
    
    9,714
    
    
    
    13,274
    
    
    
    -26.8
    %Total net premiums earned
    
    $
    71,877
    
    
    $
    77,544
    
    
    
    -7.3
    %
  Three Months Ended 
September 30,2006
    
    
    2005
    
    
    Variance
    
    
    Variance($)
    
    
    (%)Income on non-retained business- MGA commissions
    
    $
    195
    
    
    $
    2,370
    
    
    $
    (2,175
    )
    
    
    -92
    %- Claims service fee income
    
    
    428
    
    
    
    1,601
    
    
    
    (1,173
    )
    
    
    -73
    %Affiliated- Policyholder fee income
    
    
    10,237
    
    
    
    11,772
    
    
    
    (1,535
    )
    
    
    -13
    %- Agency fees
    
    
    211
    
    
    
    1,102
    
    
    
    (891
    )
    
    
    -81
    %Non-affiliated income  third party-Commissions and fees
    
    
    3,305
    
    
    
    2,607
    
    
    
    698
    
    
    
    27
    %- Agency fees
    
    
    44
    
    
    
    269
    
    
    
    (225
    )
    
    
    -84
    %Total commission income and fees
    
    $
    14,420
    
    
    $
    19,721
    
    
    $
    (5,301
    )
    
    
    -27
    %
    30




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##### Table of Contents



Three Months EndedSeptember 30,2006
    
    
    2005Loss and loss adjustment expense ratio  current period
    
    
    68.2
    %
    
    
    69.6
    %Favorable loss ratio development  prior period business
    
    
    4.1
    %
    
    
    8.5
    %Reported loss and loss adjustment expense ratio
    
    
    64.1
    %
    
    
    61.1
    %
  Three Months EndedSeptember 30,2006
    
    
    2005(dollars in thousands)Beginning deferred acquisition costs (DAC)
    
    $
    26,944
    
    
    $
    27,796Additions
    
    
    17,625
    
    
    
    18,241Amortization of DAC
    
    
    (18,564
    )
    
    
    (19,280
    )Ending deferred acquisition costs
    
    $
    26,005
    
    
    $
    26,757Amortization of DAC as % of Earned Premium
    
    
    25.8
    %
    
    
    24.9
    %Policy acquisition costs (amortization of DAC)
    
    $
    18,564
    
    
    $
    19,280Other selling, general and administrative expenses
    
    
    14,415
    
    
    
    20,817Total selling, general and administrative expenses
    
    $
    32,979
    
    
    $
    40,097Total SG&A expenses as % of Earned Premium
    
    
    45.9
    %
    
    
    51.7
    %
 31




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##### Table of Contents



Comparison of the Nine Month Periods Ended September 30, 2006 and September 30, 2005
    Nine Months EndedSeptember 30,2006
    
    
    2005
    
    
    % ChangeOur underwriting agencies
    
    $
    188,201
    
    
    $
    179,679
    
    
    
    4.7
    %Unaffiliated underwriting agencies
    
    
    30,467
    
    
    
    43,242
    
    
    
    -29.5
    %Total net premiums earned
    
    $
    218,668
    
    
    $
    222,921
    
    
    
    -1.9
    %
 32




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##### Table of Contents



Nine Months EndedSeptember 30,2006
    
    
    2005
    
    
    Variance
    
    
    Variance($)
    
    
    (%)Income on non-retained business- MGA commissions
    
    $
    1,448
    
    
    $
    6,217
    
    
    $
    (4,769
    )
    
    
    -77
    %- Claims service fee income
    
    
    1,970
    
    
    
    8,331
    
    
    
    (6,361
    )
    
    
    -76
    %Affiliated- Policyholder fee income
    
    
    30,238
    
    
    
    33,356
    
    
    
    (3,118
    )
    
    
    -9
    %- Agency fees
    
    
    1,771
    
    
    
    3,728
    
    
    
    (1,957
    )
    
    
    -52
    %Non-affiliated income  third party-Commissions and fees
    
    
    10,573
    
    
    
    9,806
    
    
    
    767
    
    
    
    8
    %- Agency fees
    
    
    471
    
    
    
    985
    
    
    
    (514
    )
    
    
    -52
    %Total commission income and fees
    
    $
    46,471
    
    
    $
    62,423
    
    
    $
    (15,952
    )
    
    
    -26
    %
     33




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##### Table of Contents



Nine Months EndedSeptember 30,2006
    
    
    2005Loss and loss adjustment expense ratio   current period
    
    
    68.3
    %
    
    
    68.9
    %Favorable loss ratio development  prior period business
    
    
    3.9
    %
    
    
    4.7
    %Reported loss and loss adjustment expense ratio
    
    
    64.4
    %
    
    
    64.2
    %
  Nine Months EndedSeptember 30,2006
    
    
    2005(dollars in thousands)Beginning deferred acquisition costs (DAC)
    
    $
    24,453
    
    
    $
    19,118Additions
    
    
    57,672
    
    
    
    63,546Amortization of DAC
    
    
    (56,120
    )
    
    
    (55,907
    )Ending deferred acquisition costs
    
    $
    26,005
    
    
    $
    26,757Amortization of DAC as % of Earned Premium
    
    
    25.7
    %
    
    
    25.1
    %Policy acquisition costs (amortization of DAC)
    
    $
    56,120
    
    
    $
    55,907Other selling, general and administrative expenses
    
    
    43,654
    
    
    
    54,012Total selling, general and administrative expenses
    
    $
    99,774
    
    
    $
    109,919Total SG&A expenses as % of Earned Premium
    
    
    45.6
    %
    
    
    49.3
    %
  34




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##### Table of Contents



Liquidity and Capital Resources
 Sources and uses of funds.
   35




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##### Table of Contents



36




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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.
  As of
    
    As ofSeptember 30,
    
    December 31,2006
    
    2005Total invested assets ($ in thousands)
    
    $
    226,665
    
    
    $
    210,750Tax equivalent book yield
    
    
    4.76%
    
    
    
    4.77%Average duration in years
    
    
    0.8
    
    
    
    3.8Average S&P rating
    
    
    AA+
    
    
    
    AA+
 37




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##### Table of Contents



Effects of inflation.
 38




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##### Table of Contents



Item 4. Controls and Procedures
 Evaluation of Disclosure Controls and Procedures
       Managements Remediation Initiatives
  39




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##### Table of Contents



Changes in Internal Control over Financial Reporting
  40




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##### Table of Contents



PART II
 
 Item 1. Legal Proceedings
     
 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
  41




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##### Table of Contents



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 (incorporated by reference to
Exhibit 10.1 to Form 10Q filed with the SEC on August 9, 2006, File
No. 000-50795).10.2+
    
    Employment Agreement, dated October 5, 2006, between Affirmative
Insurance Holdings, Inc. and Kevin R. Callahan (incorporated by
reference to Exhibit 10.1 to the Current Report on Form 8K filed
with the SEC on October 10, 2006).10.3
    
    Purchase and Sale Agreement, dated October 3, 2006, by and among The
Equityholders of USAgencies, L.L.C. and Affirmative Insurance
Holdings, Inc. (incorporated by reference to Exhibit 2.1 to the
Current Report on Form 8K filed with the SEC on October 18, 2006).10.4
    
    Master Services Agreement, dated October 16, 2006, between
Affirmative Insurance Holdings, Inc. and Accenture LLP (incorporated
by reference to Exhibit 10.27 to the Current Report on Form 8K filed
with the SEC on October 20, 2006).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+
    
    Management contract, compensatory plan or arrangement 42




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##### Table of Contents



Signatures
  Affirmative Insurance Holdings, Inc.Date: November 9, 2006/s/ Mark E. PapeBy: Mark E. PapeExecutive Vice President and Chief Financial Officer
(and in his capacity as Principal Financial Officer)
 43