##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2007
 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  Financial Information
    
    
    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
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of
Operations
    
    
    23Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    35Item 4. Controls and Procedures
    
    
    37PART II  Other Information
    
    
    37Item 1. Legal Proceedings
    
    
    37Item 1A. Risk Factors
    
    
    39Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    39Item 3. Defaults Upon Senior Securities
    
    
    39Item 4. Submission of Matters to a Vote of Security Holders
    
    
    39Item 5. Other Information
    
    
    39Item 6. Exhibits
    
    
    40SIGNATURES
    
    
    41Certification of Kevin R. Callahan, CEO, Pursuant to Section 302Certification of Mark E. Pape, CFO, Pursuant to Section 302Certification of Kevin R. Callahan, CEO, Pursuant to Section 906Certification of Mark E. Pape, CFO, Pursuant to Section 906
  2




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##### Table of Contents



Part I  Financial Information
 
 Item 1. Financial Statements
 Affirmative Insurance Holdings, Inc.
 
 Consolidated Balance Sheets
 March 31, 2007 and December 31, 2006
 March 31,
    
    
    December 31,(dollars in thousands, except share data)
    
    2007
    
    
    2006(unaudited)AssetsFixed maturities  available for sale, at fair value (amortized cost 2007: $324,684; 2006: $220,649)
    
    $
    324,192
    
    
    $
    219,960Short-term investments
    
    
    18,512
    
    
    
    1,810Total invested assets
    
    
    342,704
    
    
    
    221,770Cash and cash equivalents
    
    
    55,933
    
    
    
    52,484Fiduciary and restricted cash
    
    
    25,214
    
    
    
    35,582Accrued investment income
    
    
    4,441
    
    
    
    1,837Premiums and fees receivable, net
    
    
    92,832
    
    
    
    78,307Premium finance receivable, net
    
    
    44,237
    
    
    
    Commissions receivable
    
    
    2,373
    
    
    
    909Receivable from reinsurers
    
    
    113,311
    
    
    
    24,795Deferred acquisition costs
    
    
    30,039
    
    
    
    23,865Deferred tax asset, net
    
    
    10,319
    
    
    
    8,880Federal income taxes receivable
    
    
    8,689
    
    
    
    7,153Investment in real property, net
    
    
    6,051
    
    
    
    Property and equipment, net
    
    
    14,150
    
    
    
    10,289Goodwill
    
    
    163,128
    
    
    
    65,288Other intangible assets, net
    
    
    27,602
    
    
    
    18,155Other assets, net of allowance for doubtful accounts of: 2007 and 2006: $7,213
    
    
    14,291
    
    
    
    7,953Total assets
    
    $
    955,314
    
    
    $
    557,267Liabilities and Stockholders EquityLiabilitiesReserves for losses and loss adjustment expenses
    
    
    239,579
    
    
    
    162,569Unearned premium
    
    
    164,347
    
    
    
    92,124Amounts due reinsurers
    
    
    4,899
    
    
    
    5,089Deferred revenue
    
    
    17,495
    
    
    
    7,877Senior secured credit facility
    
    
    199,500
    
    
    
    Notes payable
    
    
    76,946
    
    
    
    56,702Capital lease obligation
    
    
    115
    
    
    
    Consideration due for acquisitions
    
    
    1,023
    
    
    
    1,023Other liabilities
    
    
    42,711
    
    
    
    25,490Total liabilities
    
    
    746,615
    
    
    
    350,874Commitments and contingencies (Note 8)Stockholders equityCommon stock, $0.01 par value; 75,000,000 shares authorized, 17,715,211 shares issued
and 15,361,848 shares outstanding at March 31, 2007; 17,707,938 shares issued and 15,354,575 outstanding at December 31, 2006
    
    
    177
    
    
    
    177Additional paid-in capital
    
    
    161,101
    
    
    
    160,862Treasury stock, at cost; 2,353,363 shares at March 31, 2007 and December 31, 2006
    
    
    (32,880
    )
    
    
    (32,880
    )Accumulated other comprehensive loss
    
    
    (320
    )
    
    
    (448
    )Retained earnings
    
    
    80,621
    
    
    
    78,682Total stockholders equity
    
    
    208,699
    
    
    
    206,393Total liabilities and stockholders equity
    
    $
    955,314
    
    
    $
    557,267
 See accompanying Notes to Consolidated Financial Statements
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Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Operations (Unaudited)
 Three Months Ended March 31, 2007 and 2006
 Three months endedMarch 31,2007
    
    
    2006(dollars in thousands, except per share data)RevenuesNet premiums earned
    
    $
    82,770
    
    
    $
    73,038Commission income and fees
    
    
    23,383
    
    
    
    17,499Net investment income
    
    
    3,961
    
    
    
    2,060Net realized losses
    
    
    (169
    )
    
    
    (367
    )Total revenues
    
    
    109,945
    
    
    
    92,230ExpensesLosses and loss adjustment expenses
    
    
    57,952
    
    
    
    47,652Selling, general and administrative expenses
    
    
    38,625
    
    
    
    32,601Depreciation and amortization
    
    
    3,288
    
    
    
    1,060Interest expense
    
    
    6,632
    
    
    
    1,085Total expenses
    
    
    106,497
    
    
    
    82,398Income before income taxes and minority interest
    
    
    3,448
    
    
    
    9,832Income tax expense
    
    
    1,202
    
    
    
    3,520Minority interest, net of income taxes
    
    
    
    
    
    
    81Net income
    
    $
    2,246
    
    
    $
    6,231Net income per common share  Basic
    
    $
    0.15
    
    
    $
    0.40Net income per common share  Diluted
    
    $
    0.15
    
    
    $
    0.40Weighted average shares outstandingBasic
    
    
    15,358,050
    
    
    
    15,432,557Diluted
    
    
    15,467,045
    
    
    
    15,463,132
 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)
 Three Months Ended March 31, 2007 and 2006
 AccumulatedAdditional
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Other
    
    
    TotalCommon Stock Issued
    
    
    Paid-in
    
    
    Retained
    
    
    Treasury Stock
    
    
    Comprehensive
    
    
    StockholdersShares
    
    
    Amount
    
    
    Capital
    
    
    Earnings
    
    
    Shares
    
    
    Amount
    
    
    Income (Loss)
    
    
    Equity(dollars in thousands, except share data)Balance, December 31, 2005
    
    
    17,483,520
    
    
    $
    175
    
    
    $
    158,904
    
    
    $
    70,158
    
    
    
    2,050,963
    
    
    $
    (28,746
    )
    
    $
    (529
    )
    
    $
    199,962Comprehensive income:Net income
    
    

    
    
    

    
    
    

    
    
    
    6,231
    
    
    

    
    
    

    
    
    

    
    
    
    6,231Other comprehensive loss
    
    

    
    
    

    
    
    

    
    
    
    
    
    
    

    
    
    

    
    
    
    (213
    )
    
    
    (213
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6,018Dividends ($.02 per share)
    
    

    
    
    

    
    
    

    
    
    
    (309
    )
    
    

    
    
    

    
    
    

    
    
    
    (309
    )Equity based compensation
    
    

    
    
    

    
    
    
    163
    
    
    

    
    
    

    
    
    

    
    
    

    
    
    
    163Balance, March 31, 2006
    
    
    17,483,520
    
    
    $
    175
    
    
    $
    159,067
    
    
    $
    76,080
    
    
    
    2,050,963
    
    
    $
    (28,746
    )
    
    $
    (742
    )
    
    $
    205,834Balance, December 31, 2006
    
    
    17,707,938
    
    
    $
    177
    
    
    $
    160,862
    
    
    $
    78,682
    
    
    
    2,353,363
    
    
    $
    (32,880
    )
    
    $
    (448
    )
    
    $
    206,393Comprehensive income:Net income
    
    

    
    
    

    
    
    

    
    
    
    2,246
    
    
    

    
    
    

    
    
    

    
    
    
    2,246Other comprehensive income
    
    

    
    
    

    
    
    

    
    
    

    
    
    

    
    
    

    
    
    
    128
    
    
    
    128Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,374Dividends ($.02 per share)
    
    

    
    
    

    
    
    

    
    
    
    (307
    )
    
    

    
    
    

    
    
    

    
    
    
    (307
    )Issuance of restricted stock
    
    
    7,273
    
    
    

    
    
    

    
    
    

    
    
    

    
    
    

    
    
    

    
    
    
    Equity based compensation
    
    

    
    
    

    
    
    
    239
    
    
    

    
    
    

    
    
    

    
    
    

    
    
    
    239Balance, March 31, 2007
    
    
    17,715,211
    
    
    $
    177
    
    
    $
    161,101
    
    
    $
    80,621
    
    
    
    2,353,363
    
    
    $
    (32,880
    )
    
    $
    (320
    )
    
    $
    208,699
 See accompanying Notes to Consolidated Financial Statements
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Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Cash Flows (Unaudited)
 Three Months Ended March 31, 2007 and 2006
 Three months endedMarch 31,2007
    
    
    2006(dollars in thousands)Cash flows from operating activitiesNet income
    
    $
    2,246
    
    
    $
    6,231Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    3,288
    
    
    
    1,060Equity based compensation
    
    
    239
    
    
    
    186Realized loss on sale of bonds and equipment
    
    
    169
    
    
    
    367Amortization of discount of premiums and discounts on investments
    
    
    515
    
    
    
    366Amortization of debt acquisition costs
    
    
    166
    
    
    
    Changes in assets and liabilities:Fiduciary and restricted cash
    
    
    10,368
    
    
    
    (5,538
    )Premiums and commissions receivable
    
    
    (15,989
    )
    
    
    (19,522
    )Reserves for loss and loss adjustment expenses
    
    
    5,488
    
    
    
    971Net due to/from reinsurers
    
    
    (5,161
    )
    
    
    7,339Premium finance contracts, net
    
    
    (6,967
    )
    
    
    Deferred revenue
    
    
    774
    
    
    
    1,051Unearned premiums
    
    
    26,760
    
    
    
    14,097Deferred acquisition costs
    
    
    (6,174
    )
    
    
    (3,616
    )Deferred tax asset
    
    
    5,986
    
    
    
    (283
    )Federal income taxes receivable
    
    
    (1,561
    )
    
    
    3,454Other
    
    
    5,972
    
    
    
    (2,764
    )Net cash provided by operating activities
    
    
    26,119
    
    
    
    3,399Cash flows from investing activitiesProceeds from the sale of bonds
    
    
    20,928
    
    
    
    163,522Cost of bonds acquired
    
    
    (58,823
    )
    
    
    (183,250
    )Purchases of property and equipment
    
    
    (1,057
    )
    
    
    (912
    )Net cash paid for acquisitions
    
    
    (176,490
    )
    
    
    (3,917
    )Net cash used in investing activities
    
    
    (215,442
    )
    
    
    (24,557
    )Cash flows from financing activitiesPrincipal payments under capital lease obligation
    
    
    (47
    )
    
    
    Proceeds from borrowings
    
    
    200,000
    
    
    
    Payments for debt acquisition costs
    
    
    (6,368
    )
    
    
    Principal payments on senior secured credit facility
    
    
    (500
    )
    
    
    Principal payments on note payable
    
    
    (6
    )
    
    
    Dividends paid
    
    
    (307
    )
    
    
    (309
    )Net cash provided by (used in) financing activities
    
    
    192,772
    
    
    
    (309
    )Net increase (decrease) in cash and cash equivalents
    
    
    3,449
    
    
    
    (21,467
    )Cash and cash equivalents, beginning of period
    
    
    52,484
    
    
    
    48,037Cash and cash equivalents, end of period
    
    $
    55,933
    
    
    $
    26,570
 See accompanying Notes to Consolidated Financial Statements
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Notes to Consolidated Financial Statements
 1.
    
    GeneralAffirmative Insurance Holdings, Inc. is an insurance holding company engaged in underwriting,
servicing and distributing non-standard automobile insurance policies and related products and
services to individual consumers in targeted geographic areas. Our subsidiaries include five
insurance companies, four underwriting agencies, six retail agencies with 256 owned retail
locations (24 of which are located in leased space within supermarkets owned by a major
supermarket chain under an agreement signed in late 2005) and 33 franchise retail store
locations as of March 31, 2007. Our underwriting agencies utilize approximately 3,400
independent agencies to sell the policies that they administer. In addition, we have
relationships with two unaffiliated underwriting agencies producing business for our insurance
companies through approximately 4,100 independent agencies. We are currently active in
offering insurance products and services through retail stores in 10 states (Louisiana,
Illinois, Texas, Missouri, Indiana, South Carolina, Florida, Kansas, Wisconsin and Alabama)
and distributing our own insurance policies through independent agents in 9 states (Illinois,
Texas, Missouri, Indiana, South Carolina, Florida, California, Michigan and New Mexico). Our
growth has been achieved principally as a result of the acquisition and integration of retail
and/or underwriting agencies and insurance companies. We were formerly known as Instant
Insurance Holdings, Inc. and we incorporated in Delaware on June 25, 1998.On January 31, 2007, we completed the acquisition of USAgencies L.L.C. (USAgencies) in a
fully-financed all cash transaction valued at approximately $199.2 million. USAgencies is a
non-standard automobile insurance distributor and provider headquartered in Baton Rouge,
Louisiana. At the time of acquisition, it had 92 retail sales locations in Louisiana,
Illinois and Alabama selling its products directly to consumers through its owned retail
stores, virtual call centers and internet site. The acquisition gives us a leading market
position in Louisiana, the 12th largest non-standard personal automobile insurance
market. The transaction became effective as of January 1, 2007 for accounting purposes (See
Note 5).We completed the 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 it 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. VIG 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
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 of the membership units of New Affirmative owned by DSC AFFM. As a result, Affirmative
Investment now owns 100% of New Affirmative. As of March 31, 2007, New Affirmative
owned 7,860,927 shares, or approximately 51.2%, of our outstanding common stock.2.
    
    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 the audited financial statements and notes thereto for the year ended
December 31, 2006 included in the reports on the Form 10-K filed with the SEC on March 16,
2007 and the Form 8-K/A filed with the SEC on April 17, 2007.The interim financial data as of March 31, 2007 and 2006 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.Recently Issued Accounting StandardsIn February 2006, the FASB issued SFAS No. 155, Accounting for Certain Hybrid Financial
Instruments  an amendment of FASB Statements No. 133 and 140(SFAS 155), which permits the
fair value remeasurement of any hybrid financial instrument that contains an embedded
derivative that otherwise would require bifurcation under SFAS No. 133, Accounting for
Derivative Instruments and Hedging Activities(SFAS 133); clarifies which interest-only
strips and principal-only strips are not subject to the requirements of SFAS 133; establishes
a requirement to evaluate interests in securitized financial assets to identify interests that
are freestanding derivatives or hybrid financial instruments that contain an embedded
derivative requiring bifurcation and clarifies that concentrations of credit risk in the form
of subordination are not embedded derivatives. All securities acquired on or after January
1, 2007 must be accounted for in accordance with the new guidance. The adoption of SFAS 155
did not have a material impact on our consolidated financial statements.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 adopted the provisions of FIN 48 on January 1, 2007. As a result, we recognized
no additional liability or reduction in deferred tax asset for unrecognized tax benefits. We
are no longer subject to U. S. federal, state, local or non-U.S. income tax
examinations by tax authorities for years prior to 2003.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 In September 2006, the FASB issued Statement No. 157, Fair Value Measurements(SFAS 157),
which defines fair value, establishes a framework for measuring fair value in GAAP and expands
disclosures about fair value measurements. This statement applies under other accounting
pronouncements that require or permit fair value measurements, the FASB having previously
concluded in those accounting pronouncements that fair value is the relevant measurement
attribute. Accordingly, this statement does not require any new fair value measurements.
SFAS 157 is effective for financial statements issued for fiscal years beginning after
November 15, 2007, and interim periods within those fiscal years. Earlier application is
encouraged, provided that the reporting entity has not yet issued financial statements for the
fiscal year, including financial statements for an interim period within that fiscal year. We
have not evaluated the requirements of SFAS 157 and have not yet determined if SFAS 157 will
have a material impact on our future financial statements.In February 2007, the FASB issued Statement No. 159, Establishing the Fair Value Option for
Financial Assets and Liabilities(SFAS 159), which includes an amendment to FASB No. 115,
Accounting for Certain Investments in Debt and Equity Securities(SFAS 115). SFAS 159
permits entities to choose to measure many financial instruments and certain other items at
fair value. The objective is to improve financial reporting by providing entities with the
opportunity to mitigate volatility in reported earnings caused by measuring related assets and
liabilities differently without having to apply complex hedge accounting provisions. This
statement is expected to expand the use of fair value measurement, which is consistent with
the FASBs long-term measurement objectives for accounting for financial instruments. This
statement applies to all entities and most of the provisions of this statement apply only to
entities that elect the fair value option. However, the amendment to FAS 115 applies to all
entities with available-for-sale and trading securities. SFAS 159 is effective for fiscal
years beginning after November 15, 2007, with early adoption permitted for an entity that has
also elected to apply the provisions of SFAS 157, Fair Value Measurements. An entity is
prohibited from retrospectively applying SFAS 159, unless it chooses early adoption. SFAS 159
also applies to eligible items existing at November 15, 2007 (or early adoption). We have not
evaluated the requirements of SFAS 159 and have not yet determined if SFAS 159 will have a
material impact on our future financial statements.3.
    
    ReinsuranceThe effect of reinsurance on premiums written and earned is as follows (dollars in thousands):
 Three months ended
    
    
    Three months endedMarch 31, 2007
    
    
    March 31, 2006Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    123,039
    
    
    $
    98,148
    
    
    $
    53,788
    
    
    $
    41,600Assumed  affiliate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Assumed  non affiliate
    
    
    20,114
    
    
    
    18,427
    
    
    
    34,961
    
    
    
    33,054Ceded  affiliate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Ceded  non affiliate
    
    
    (41,041
    )
    
    
    (33,805
    )
    
    
    (1,691
    )
    
    
    (1,616
    )$
    102,112
    
    
    $
    82,770
    
    
    $
    87,058
    
    
    $
    73,038
 Through the acquisition of USAgencies, we acquired two additional insurance companies,
USAgencies Casualty Insurance Company (Casualty), a Louisiana-domiciled insurer, and
USAgencies Direct Insurance Company (Direct), a New York-domiciled carrier, issuing policies
in Illinois and Alabama. Casualty and Direct had entered into significant quota share
reinsurance contracts with GMAC Reinsurance (GMAC) and had been dependent upon these
reinsurance contracts in order to continue to write and finance their historical level of
insurance premiums. The quota share reinsurance contracts in existence at the time of
acquisition for Casualtys Louisiana and Directs Illinois business were originally in effect
through 2008.
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 Directs Alabama business was covered under a quota share reinsurance contract
through 2007.In connection with the completion of the acquisition of USAgencies, their reinsurance program
was re-evaluated in light of the capital structure and risk management programs of the larger
combined operations of Affirmative. As a result, terms were negotiated with GMAC and a new
quota share reinsurance agreement was made effective April 1, 2007. Concurrently, the prior
agreements were cancelled on a cut-off basis. The new quota share agreement will increase
our net retention from 30% to 75% (in Louisiana) and from 25% to 75% (in Alabama) on policies
issued by Affirmative Insurance Company (AIC), Casualty or Direct. A new catastrophe excess
of loss reinsurance contract for risks in Alabama and Louisiana has also been negotiated to
become effective April 1, 2007.Direct and Casualty have received ceding commissions from GMAC. The quota share ceding
commission rate structure varies based on loss experience. The estimates of loss experience
are continually reviewed and adjusted, and resultant adjustments to ceding commissions are
reflected in current operations.The ceding commissions recognized are reflected as a reduction of the following expenses for
the three months ended March 31, 2007:
 As of March 31,2007Selling, general and administrative expenses
    
    $
    4,551Loss adjustment expenses
    
    
    3,280Total
    
    $
    7,831
 At March 31, 2007, ceding commissions of approximately $4.7 million were allocated and
reflected as a reduction to both deferred policy acquisition costs and unearned premiums, fees
and ceding commissions in the accompanying consolidated balance sheets. Unearned ceding
commissions totaled approximately $5.5 million at March 31, 2007.The amount of recoveries pertaining to quota share reinsurance contracts that were deducted
from losses incurred during 2007 were approximately $21.8 million.The amount of unpaid loss and loss adjustment expenses and unearned premium we would remain
liable for in the event our reinsurers are unable to meet their obligations are as follows
(dollars in thousands):
 As of March 31,
    
    
    As of December 31,2007
    
    
    2006Non affiliateLoss and loss adjustment expense
    
    $
    68,685
    
    
    $
    21,590Unearned premiums
    
    
    41,363
    
    
    
    1,221Total
    
    $
    110,048
    
    
    $
    22,811
 On April 1, 2007, we exercised our option to terminate the GMAC quota share contracts.
On April 30, 2007, we received $31.0 million to settle the unearned premiums less return
ceding commissions. Taking this recovery into account, our net exposure for reinsurance
provided by GMAC at March 31, 2007 was $43.7 million.For the three months ended March 31, 2007, we ceded $21.7 million ($21.0 is related to
USAgencies) of paid losses and $25.9 million ($21.8 million is related to USAgencies) of
incurred losses to various reinsurers. For
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 the three months ended March 31, 2006, we ceded
$2.2 million of paid losses and $700,000 of incurred losses to various reinsurers.At March 31, 2007, we had $113.3 million receivables from reinsurers, including $23.1 million
gross recoverable from VFIC. Under the reinsurance agreement with VFIC, AIC had the right,
under certain circumstances, to require VFIC to provide a letter of credit or establish a
trust account to collateralize the gross amount due AIC and Insura Property and Casualty
Insurance Company (Insura) from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and
VFIC entered into a Security Fund Agreement effective September 1, 2004. On August 30, 2005
AIC received a letter from VFICs President that irrevocably confirmed VFICs duty and
obligations under the Security Fund Agreement to provide security sufficient to satisfy VFICs
gross obligations under the reinsurance agreement (the VFIC Trust). Currently the VFIC
Trust holds $23.4 million to collateralize the $23.1 million gross recoverable from VFIC. In
June, 2006, the Texas Department of Insurance placed VFIC, along with several of its
affiliates, into rehabilitation and subsequently into liquidation. Due to VFICs liquidation
status, AIC is working through certain procedures to effect its right to withdraw funds from
the VFIC Trust. AIC has been working with the Special Deputy Receiver (the SDR) and his
staff on this matter since VFIC was placed into liquidation. To date, the SDR has not taken
issue with the validity of the VFIC Trust. We are currently negotiating with the SDR the
manner in which the funds will be withdrawn from the VFIC Trust, which must then be approved
by the Special Master of the Receivership Court.At March 31, 2007, $18.0 million was included in reserves for losses and loss adjustment
expenses that reflect the amounts owed from AIC and Insura under reinsurance agreements with
the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd
(Hawaiian). Affirmative established a trust account to collateralize this payable, which
currently holds $23.0 million in securities (the AFIC Trust). The AFIC Trust has not been
drawn upon the SDR in Texas or the SDR in Hawaii. It is the expectation that the terms for
withdrawal of funds from the AFIC trust will be similar to those we expect to be agreed to in
regards to the VFIC Trust.AIC, a wholly-owned subsidiary, is a party to a 100% quota share reinsurance agreement with
Hawaiian, which is ultimately a wholly-owned subsidiary of VIG. 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 (SCJ); and professional negligence as to the defendants Prompt Insurance
Services, Paul Ruelas, and Anthony David Medina. SCJ, 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.On August 8, 2005, plaintiff served a copy of its 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.On January 31, 2006, Judge Bigelow absolved Hawaiian and SCJ 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. 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.On October 2, 2006, The Court of Appeal of the State of California, Second Appellate District,
Division Five, granted the stay order requested by Hawaiian. On December 11, 2006, the court
modified its October 2, 2006
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 stay order by lifting it as to SCJ, causing the suit to proceed
with SCJ as the sole defendant. Hawaiian filed a status update with the court on March 7,
2007 indicating that the liquidation proceeding for Hawaiian remained pending and in full
force and effect. On March 15, 2007, plaintiff moved the Court of Appeal to lift the stay and
that motion was denied. On March 27, 2007, plaintiff filed a petition with the Supreme Court
of California for review of the Court of Appeals order denying plaintiffs motion to lift the
stay, and this petition is currently pending. 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 first
quarter of 2007 and 2006, we recognized $107,900 and $217,400, respectively, in income related
to this novation.4.
    
    Premium Finance ReceivablesFinance receivables, which are secured by unearned premiums from the underlying insurance
policies, consisted of the following at March 31, 2007:
 March 31,2007Premium finance contracts
    
    $
    48,923Unearned finance charges
    
    
    (4,136
    )Allowance for credit losses
    
    
    (550
    )Finance receivables,net
    
    $
    44,237
 The original term of a substantial portion of a premium finance contract is five months,
although premium finance contracts are generally no longer than twelve months. Our experience
is that a substantial portion of the insurance coverage and related finance receivables cancel
before contractual maturity dates.5.
    
    AcquisitionsOn January 31, 2007, we completed the acquisition of USAgencies in a fully-financed all cash
transaction valued at approximately $199.2 million. USAgencies is a non-standard personal
automobile insurance provider headquartered in Baton Rouge, Louisiana. At the time of
acquisition, it had 92 retail sales locations in Louisiana, Illinois and Alabama selling its
products directly to consumers through its owned retail stores,
virtual call centers and internet site. In 2006, USAgencies had gross written premiums of
approximately $177.1 million, an increase of 12.6% from 2005 gross written premiums of $157.3
million. The purchase of USAgencies was financed through $200.0 million in borrowings under a
$220.0 million senior secured credit facility that was entered into concurrently with the
completion of the acquisition. The acquisition gives us a leading market position in
Louisiana, the 12th largest non-standard automobile insurance market. For
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 accounting purposes, the transaction was effective as of January 1, 2007, so our reported
results for the first quarter of 2007 include USAgencies first quarter 2007 operating
results, as adjusted to reflect purchase accounting treatment. The transaction was reported
on our Form 8-K filed on February 6, 2007 and our Form 8-K/A filed on April 17, 2007.The total estimated cost of the acquisition of USAgencies was as follows (dollars in
thousands):
 Purchase price paid to sellers
    
    $
    176,305Purchase price paid to escrow account
    
    
    20,000Transaction costs paid to third parties on behalf of sellers
    
    
    2,820Acquisition costs paid directly to third parties
    
    
    1,512Total estimated purchase price, before imputed interest
    
    
    200,637Less: adjustment to reduce cost of acquisition for interest imputed
from the acquisition date to the closing date
    
    
    (1,470
    )Estimated cost of acquisition
    
    $
    199,167
 The estimated fair values and useful lives of assets acquired and liabilities assumed are
based on preliminary management estimates and are subject to final valuation adjustments which
may cause the amount ultimately recorded as goodwill and other intangible assets to be
different from that shown on the accompanying Consolidated Balance Sheets. The Company is
undertaking a valuation study to determine the allocation of the total purchase price to the
various assets acquired and liabilities assumed, including estimated fair values of certain
assets and liabilities which are being determined with the assistance of an independent
valuation specialist. The final purchase price allocations may result in different
allocations for tangible and intangible assets than presented in these accompanying
Consolidated Balance Sheets, and those differences could be material.The following table summarizes the preliminary purchase price adjustments based on
managements preliminary assessment of fair values of the assets acquired and the liabilities
assumed at the date of acquisition (dollars in thousands):
 Net tangible assets acquired
    
    $
    88,124Amortizable intangible assets acquired, at preliminary estimates of fair value:Non-compete agreement (2 year straight-line amortization)
    
    
    1,000Customer relationships (approximate 3 year amortization period)
    
    
    4,700Trademark and trade name (3 year straight-line amortization)
    
    
    3,900Leases
(approximate half year amortization period)
    
    
    200Non-amortizable intangible asset acquired, at preliminary estimates of fair value:State licenses
    
    
    1,700Adjustment to deferred taxes for preliminary purchase
allocation adjustments
    
    
    1,775Goodwill
    
    
    97,768Estimated net assets acquired
    
    $
    199,167
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 Included in the preliminary purchase price allocation are intangible assets subject to
amortization totaling $9.8 million. As of March 31, 2007, such intangible assets had a
carrying value of $8.0 million, less accumulated amortization of $1.8 million. Estimated
amortization expenses related to the USAgencies acquisition for 2007 and future years is as
follows (dollars in thousands):
 2007
    
    $
    5,0952008
    
    
    2,8902009
    
    
    1,7002010
    
    
    115Total
    
    $
    9,800
 In conjunction with the acquisition of USAgencies, cash and cash equivalents were used in the
acquisition as follows (dollars in thousands):
 Fair value of tangible assets
excluding cash and cash equivalents
    
    $
    222,186Fair value of intangible assets acquired
    
    
    109,268Capitalized direct expenses
    
    
    1,512Liabilities assumed
    
    
    (156,548
    )Cash and cash equivalents used
    
    $
    176,418
 On March 14, 2006, we completed the acquisition of the 27% minority ownership interest of
Space Coast Holdings, Inc (Space Coast). 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 three months ended March 31, 2007, we paid $72,000 in contingent purchase price
adjustments related to prior acquisitions. For the three months ended March 31, 2006, we paid
$143,000 in contingent purchase price adjustments related to prior acquisitions and $225,000
for the purchase of two retail stores.6.
    
    Notes PayableOn December 31, 2004, our newly formed trust subsidiary, 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 AIC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% until December 15, 2009, at which time
the securities will adjust quarterly to the 90-day LIBOR rate plus 3.6 percentage points. As
of March 31, 2007, the note balance was $30.9 million.On June 1, 2005, our newly formed trust subsidiary, 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
9. 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 3.6 percentage points. As of March 31, 2007, the note
balance was $25.8 million.On March 29, 2005, USAgencies issued $20.0 million of floating rate subordinated notes with a
stated maturity of March 15, 2035. We are required to make interest-only payments on a
quarterly basis at the rate of the 3-month LIBOR plus 395 basis points (9.31% as of March 31,
2007). The variable interest rate will not exceed 12.50% through March 2010, with no limit
thereafter. The notes are redeemable in whole or in part anytime
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 after March 15, 2010. Prior
to March 15, 2010, the notes may only be redeemed in whole or in part subject to certain
specific restrictions and prepayment penalties pursuant to the indenture agreement.7.
    
    Senior Credit FacilityOn January 31, 2007, we entered into a $220.0 million senior secured credit facility (the
Facility) provided by a syndicate of lenders, including Credit Suisse, Cayman Islands
Branch, as Administrative Agent and Collateral Agent that provides for a $200.0 million senior
term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing
capacity. On March 8, 2007, we added The Frost National Bank, N.A. to the Facility when we
received approval of the First Amendment to the Facility and executed a joinder agreement
whereby Frost became the provider of an initial revolving credit commitment of $15.0 million.
The revolving portion of the Facility includes an option to increase the $20.0 million
principal amount of revolving loans available thereunder by up to an additional $20.0 million
and a $2.0 million sublimit for letters of credit. 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 AIC. The facility contains certain financial covenants, which include capital
expenditure limitations, minimum interest coverage requirements, maximum leverage ratio
requirements, minimum risk-based capital requirements, maximum combined ratio limitations,
minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well
as other restrictive covenants. In connection with entering into the
Facility, we incurred $6.4 million in deferred debt acquisition
costs that is being amortized over the seven year term of the
Facility.Concurrently with entering into the Facility, the Company borrowed $200.0 million (the
Borrowing) under the term loan portion of the Facility to finance our acquisition of
USAgencies and to pay related costs and expenses. The principal amount of the Borrowing is
payable in quarterly installments of $500,000, with the remaining balance due on the seventh
anniversary of the closing of the Facility. Beginning in 2008, we are also required to make
additional annual principal payments that are to be calculated based upon our financial
performance during the preceding fiscal year. In addition, certain events, such as the sale
of material assets or the issuance of significant new equity, necessitate additional required
principal repayments.The interest rate shall be determined at the beginning of each interest period based on the
Alternative Base Rate (ABR) or the Adjusted LIBOR Rate as defined in the credit agreement.
The ABR is the greater of (a) the prime rate plus 2.50% or (b) the federal funds rate
plus 3.00%. The Adjusted LIBOR Rate is the 1, 2, 3 or 6 month LIBOR plus a margin of 3.50%.
For the initial 60 day interest period ending March 30, 2007, interest was determined by the
credit agreement at the ABR of 10.75% (8.25% prime rate plus 2.50%). At the beginning of
each subsequent interest period, the rate is the ABR unless the Company
elects to use the Adjusted LIBOR Rate by notifying the lender prior to the effective interest
period. The Company will choose the lower interest rate for each subsequent interest period.
Based on March 31, 2007 interest rates, the Adjusted LIBOR Rate
is 8.82%, as determined by
using the 1 month LIBOR rate plus a margin of 3.50%. The Company notified the lender prior to
the March 31, 2007 interest period of its election to use the Adjusted LIBOR Rate for the
current interest period.As of March 31, 2007, we have no borrowings under the revolving portion of the Facility.In connection with the closing of the Facility on that date, we terminated our existing Credit
Agreement with The Frost National Bank dated July 30, 2004, as amended (the Prior Credit
Agreement). At the time of the termination of the Prior Credit Agreement , there were no
borrowings or other amounts outstanding under the
Prior Credit Agreement. As of December 31, 2006, there were no outstanding loan amounts due
under the Prior Credit Agreement, and we were in compliance with all of our financial and
other restrictive covenants.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
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 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.In December 2003 InsureOne Independent Agency, LLC (InsureOne), American Agencies General
Agency, Inc. and Affirmative Insurance Holdings, Inc. brought action in the Circuit Court of
Cook County, Illinois to enforce non-compete and non-solicitation agreements entered into with
James Hallberg, the former president of InsureOne, a wholly-owned subsidiary, and eight former
employees of InsureOne and two of Hallbergs family trusts. The court entered interim orders
prohibiting all defendants, including Hallberg, from hiring any employees of InsureOne or of
plaintiffs other underwriting agencies.On November 9, 2005 upon the close of plaintiffs side of the case, the court ruled that the
following counts from Plaintiffs 5th Amended Verified Complaint would remain in
the case to be considered until the close of trial: 1) breach of contract by James P.
Hallberg; 2) breach of contract by James P. Hallberg Gift Trust and Patricia L. Hallberg Gift
Trust; and 3) breach of contract by William Hallberg.James Hallbergs currently pending counterclaims include breach of contract, fraud, and breach
of fiduciary duty. The Hallberg family gift trusts have also asserted a single counterclaim
that alleges fraud and breach of fiduciary duty in relation to the purchase of that same 20%
minority interest in InsureOne in 2003. We are vigorously contesting the counterclaims and
are exercising all available rights and remedies.We are seeking between $15.0 and $23.0 million in damages for lost profits and diminution in value.
James Hallberg and the Hallberg family gift trust are seeking combined damages of $4,530,482.
The bench trial of this matter has concluded. The court is expected to render judgment
during the first half of 2007.Affirmative Insurance Holdings, Inc. and Affirmative Property Holdings, Inc. brought action
against Business Risk Technology, Inc. and Steven M. Repetti (BRT) in the Circuit Court of
the 17th Judicial Circuit, Broward County, Florida on January 6, 2006 for
fraudulent inducement, breach of contract, breach of the covenant of good faith and fair
dealing, and for declaratory and supplemental relief arising from the defendants wrongful
conduct and contractual breaches. The details of such allegations are set forth in the
petition. This action involves our enforcement of certain rights under a software license
agreement we entered with BRT wherein BRT agreed to develop and provide us with a complete,
turnkey software system for use by our various affiliates. Among the requested relief, we are
seeking declaratory relief, a return of confidential and proprietary information, monetary
damages, attorneys fees, reasonable pre-judgment and post-judgment interest, and any other
relief the Court deems just. On April 27, 2006, BRT counterclaimed for breach of contract,
unjust enrichment, fraud, unfair and deceptive trade practices and libel. Subsequently, the
court dismissed the unfair and deceptive trade practices and libel claims without prejudice
and provided BRT with leave to amend its complaint in ten (10) days; however, BRT did not
amend. Mediation has been ordered by the court to occur before September 27, 2007. Parties
have been ordered to be ready for trial in October 2007. We are vigorously prosecuting the
claims against the defendants and are exercising all available rights and remedies against
them.On December 21, 2005, Donna Villegas brought suit against Affirmative Insurance Holdings, Inc.
in the United States District Court for the Northern District of Texas, Dallas Division, under
the Family and Medical Leave Act (FMLA) for retaliation. Specifically, Plaintiff claims that
Affirmative retaliated against her in violation of 29 U.S.C. § 2615(a) for requesting and
taking intermittent FMLA leave by allegedly demoting her and ultimately terminating her
employment. A bench trial took place the week April 2, 2007, at which time
plaintiff quantified her damages of approximately $270,000 in back and front pay, in addition
to seeking liquidated damages under FMLA , attorneys fees and interest. Judgment is expected
to be rendered by the court within the second quarter of 2007. We believe plaintiffs
allegations in this lawsuit are without merit and will continue to vigorously contest the
claims brought by plaintiff, and intend to exercise all available rights and remedies;
however, the ultimate outcome of this matter is uncertain.On October 18, 2002, the named plaintiff Nickey Marsh filed suit in the Fourth Judicial
District Court of Louisiana against USAgencies alleging that certain adjustments to the actual
cash value of his total loss
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Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 automobile claim were improper. An amending petition, filed on
October 24, 2003, made class action allegations, and sought class-wide compensatory damages,
attorneys fees and punitive damages of $5,000 per claimant. The parties conducted class
certification discovery, and statistics prepared from discovery estimates indicate that
approximately 2,700 to 4,000 such claims may exist. The contested adjustments to actual cash
value were approximately $50 to $100 per claim. After a class certification hearing in
February of 2006, a judgment was rendered on August 7, 2006 certifying the class. USAgencies
continues to contest the class certification, and has filed an appellate brief with the
Louisiana Second Circuit Court of Appeal arguing against the same. Briefing and oral argument
in the appellate court are complete, and a decision is pending. Pursuant to the terms of the
Acquisition Agreement between the Company and USAgencies, the selling parties are bound to
indemnify the Company from any and all losses attendant to claims arising out of the Marsh
litigation out of a sum placed into escrow specifically for such purpose (the Marsh
Litigation Reserve). The Acquisition Agreement provides that the Marsh Litigation Reserve
shall not exceed the amount placed into escrow, and that upon the final resolution of the
Marsh litigation by (i) a court order that is final and nonappealable or (ii) a binding
settlement agreement and (b) the determination of all amounts to be paid with respect to Marsh
litigation (the Marsh Payments), the amount constituting the Marsh Payments shall be paid
out of the Marsh Litigation Reserve to the Company either (i) in accordance with a joint
written instruction by the Company and the Seller or (ii) pursuant to a court order or
judgment that is final and nonappealable sent to the escrow agent by the Company or the
Seller, and any portion of the Marsh Litigation Reserve not so required to be paid to the
Company shall be promptly paid by the escrow agent to the Seller. We believe plaintiffs
allegations in this lawsuit are without merit and will continue to vigorously contest the
claims brought by the plaintiffs, and intend to exercise all available rights and remedies
against them; however, the ultimate outcome of this matter is uncertain, and, although we
believe it is unlikely, it is nevertheless possible that the aggregate amount payable at the
conclusion of the Marsh litigation may exceed the Marsh Litigation Reserve, and the Seller may
not have the financial ability to indemnify the Company for any losses in excess of said
reserve.On December 8, 2006, Michael V. Clegg, APLC, brought suit for damages for alleged breach of
contract against USAgencies Insurance Company [sic] (USAgencies), a subsidiary of the
Registrant, in the Nineteenth Judicial District Court of Louisiana. Plaintiff alleges that
USAgencies breached a contract with Mr. Cleggs law firm purportedly granting the firm
exclusive rights to serve as counsel for USAgencies in the State of Louisiana for a period of
two (2) years commencing on December 15, 2005 and ending December 15, 2007. USAgencies has
answered timely denying the substance of the claims. The parties have agreed to bifurcate the
liability and damage portions of this matter. USAgencies has filed a Peremptory Exception of
No Cause Action on grounds that a client can terminate the attorney-client relationship at any
time, limiting the attorneys recovery to quantum meruit, regardless of the type of agreement
that the parties may have entered into. We believe plaintiffs allegations in this lawsuit
are without merit and will continue to vigorously contest the claims brought by plaintiff, and
intend to exercise all available rights and remedies against him; however, the ultimate
outcome of this matter is uncertain.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 a 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
 17




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 reasonably estimate
the ultimate liability at this time. We have not made an accrual for this as of March 31,
2007 as we do not believe this meets the requirements of FAS 5, Accounting for Contingencies.9.
    
    Stockholders EquityIn 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 $15.0
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 funded the purchases 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 shares of our common stock upon the exercise of options.In October 2006, we issued 70,000 shares of restricted stock to Kevin R. Callahan, Chief
Executive Officer, which vests ratably over five years. Total compensation recorded for the
three months ended March 31, 2007 was approximately $52,000.In October 2006, we issued 37,285 shares of our common stock upon the exercise of options.In November 2006, we issued 20,000 shares of restricted stock to Joseph G. Fisher, Senior Vice
President and General Counsel, which vests ratably over five years. Total compensation
recorded for the three months ended March 31, 2007 was approximately $17,000.In November 2006, we issued 25,000 shares of restricted stock to Robert A. Bondi, Executive
Vice President and Chief Operating Officer, which vests ratably over five years. Total
compensation recorded for the three months ended March 31, 2007 was approximately $20,000.In November 2006, we issued 61,804 shares of our common stock upon the exercise of options.In February 2007, we issued 7,273 shares of restricted stock to Robert A. Bondi, Executive
Vice President and Chief Operating Officer that vests ratably over five years. Total
compensation expense recorded for this issuance for the three months ended March 31, 2007 was
approximately $2,000.10.
    
    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




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 Income
    
    
    Shares
    
    
    Per Share(Numerator)
    
    
    (Denominator)
    
    
    Amount(dollars in thousands, except number ofshares and per share amounts)Three months ended March 31, 2007Basic Earnings per ShareNet Income
    
    $
    2,246
    
    
    
    15,358,050
    
    
    $
    0.15Diluted Earnings per ShareNet Income
    
    $
    2,246
    
    
    
    15,358,050
    
    
    $
    0.15Effect of Dilutive Securities
    
    
    
    
    
    
    108,995
    
    
    
    $
    2,246
    
    
    
    15,467,045
    
    
    $
    0.15Three months ended March 31, 2006Basic Earnings per ShareNet Income
    
    $
    6,231
    
    
    
    15,432,557
    
    
    $
    0.40Diluted Earnings per ShareNet Income
    
    $
    6,231
    
    
    
    15,432,557
    
    
    $
    0.40Effect of Dilutive Securities
    
    
    
    
    
    
    30,575
    
    
    
    $
    6,231
    
    
    
    15,463,132
    
    
    $
    0.40
 11.
    
    Stock-Based CompensationEffective January 1, 2006, we account for our stock-based compensation in accordance with FASB
Statement No. 123R (SFAS 123R), Share-Based Payment.For the three months ended March 31, 2007 and 2006, we have recognized $148,000 before income
taxes ($96,200 after income taxes) and $163,000 before income taxes ($105,000 after income
taxes), respectively, in share-based compensation expense under the requirements of SFAS 123R
resulting in a negligible impact on earnings per share.As permitted by SFAS 123R, we used the modified Black-Scholes model to estimate the value of
employee stock options on the date of grant that used the assumptions noted below. The
risk-free rate for periods within the contractual life of the options is based on the U.S.
Treasury yield curve in effect at the time of grant. The expected term of each option is
based on our estimate that all individuals granted stock options would have an average holding
period of two years after the vesting before any of the vested options are exercised. We
expect all grantees to exercise their options within two years after each individual tranches
vesting date within the single option grant. Expected volatilities are based on historical
volatilities of our common stock. The dividend yield was based on expected dividends at the
time of grant.
 Three months endedMarch 31,2007

    
    2006Weighted average risk-free interest rate: 1998 Plan
    
    
    
    
    
    
    Weighted average risk-free interest rate: 2004 Plan
    
    
    4.5
    %
    
    
    4.5
    %Expected term of option (in years): 1998 Plan
    
    
    5.0
    
    
    
    5.0Expected term of option (in years): 2004 Plan
    
    
    5.0
    
    
    
    3.0Volatility
    
    
    25
    %
    
    
    25
    %Dividend yield
    
    
    0.5
    %
    
    
    0.6
    %
 19




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 A summary of activity under the 1998 and 2004 Plans for the three months ended March 31,
2007 and 2006 is as follows:
 For the three months ended March 31, 2007WeightedWeighted
    
    
    Average
    
    
    AggregateAverage
    
    
    Remaining
    
    
    IntrinsicExercise
    
    
    Contractual
    
    
    ValueOptions
    
    
    Price
    
    
    Term (years)
    
    
    (000's)1998 PlanOutstanding, beginning of period
    
    
    58,461
    
    
    $
    7.59Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited
    
    
    
    
    
    
    Outstanding, end of period
    
    
    58,461
    
    
    $
    7.59
    
    
    
    0.72
    
    
    $
    568Exercisable, end of period
    
    
    58,461
    
    
    $
    7.59
    
    
    
    0.72
    
    
    $
    5682004 PlanOutstanding, beginning of period
    
    
    1,936,080
    
    
    $
    19.01Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited
    
    
    (105,000
    )
    
    
    20.03Outstanding, end of period
    
    
    1,831,080
    
    
    $
    18.95
    
    
    
    8.87
    
    
    $
    2,202Exercisable, end of period
    
    
    454,904
    
    
    $
    15.90
    
    
    
    8.37
    
    
    $
    949
 For the three months ended March 31, 2006WeightedWeighted
    
    
    Average
    
    
    AggregateAverage
    
    
    Remaining
    
    
    IntrinsicExercise
    
    
    Contractual
    
    
    ValueOptions
    
    
    Price
    
    
    Term (years)
    
    
    (000's)1998 PlanOutstanding, beginning of period
    
    
    94,675
    
    
    $
    7.59Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited
    
    
    
    
    
    
    Outstanding, end of period
    
    
    94,675
    
    
    $
    7.59
    
    
    
    1.68
    
    
    $
    532Exercisable, end of period
    
    
    94,675
    
    
    $
    7.59
    
    
    
    1.68
    
    
    $
    5322004 PlanOutstanding, beginning of period
    
    
    1,453,428
    
    
    $
    16.92Granted
    
    
    15,000
    
    
    
    14.22Exercised
    
    
    
    
    
    
    Forfeited
    
    
    (45,206
    )
    
    
    14.54Outstanding, end of period
    
    
    1,423,222
    
    
    $
    16.97
    
    
    
    9.24
    
    
    $
    Exercisable, end of period
    
    
    341,116
    
    
    $
    14.89
    
    
    
    9.24
    
    
    $
    
  20




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 A summary of activity for our nonvested restricted stock grants for the three months ended
March 31, 2007 and 2006 is as follows:
 For the three months ended March 31,2007
    
    
    2006Weighted
    
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    
    AverageRestricted
    
    
    Grant-Date
    
    
    Restricted
    
    
    Grant-DateStock
    
    
    Fair Value
    
    
    Stock
    
    
    Fair ValueNonvested, beginning of period
    
    
    115,000
    
    
    $
    15.44
    
    
    
    8,000
    
    
    $
    14.05Granted
    
    
    7,273
    
    
    
    16.50
    
    
    
    
    
    
    
    Vested
    
    
    
    
    
    
    
    
    
    
    (4,000
    )
    
    
    15.37Canceled or expired
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Nonvested, end of period
    
    
    122,273
    
    
    $
    15.50
    
    
    
    4,000
    
    
    $
    12.73
 As of March 31, 2007, there was $2.7 million of total unrecognized compensation cost
related to nonvested option compensation expense and $1.8 million of unrecognized compensation
cost for nonvested restricted stock compensation expense that will be recognized over the
remaining requisite service period. As of March 31, 2006, there was $2.2 million of total
unrecognized compensation cost related to nonvested option compensation expense that will be
recognized over the remaining requisite service period and $8,000 of unrecognized compensation
cost for nonvested restricted stock compensation expense that will be recognized over the
remaining requisite service period.12.
    
    Policy Acquisition CostsPolicy acquisition costs, primarily commissions, premium taxes and underwriting expenses
related to issuing a policy are deferred and charged against income ratably over the terms of
the related policies.Our components of deferred acquisition costs and the related policy acquisition cost amortized
to expense were as follows (dollars in thousands):
 Three Months EndedMarch 31,2007
    
    
    2006Beginning deferred acquisition costs (DAC)
    
    $
    23,865
    
    
    $
    24,453Additions
    
    
    25,411
    
    
    
    22,513Amortization of DAC
    
    
    (19,237
    )
    
    
    (18,897
    )Ending deferred acquisition costs
    
    $
    30,039
    
    
    $
    28,069
 13.
    
    Subsequent EventsEffective April 30, 2007, we entered into an interest rate swap with a notional amount of
$50.0 million that has been designated as a hedge of variable cash flows associated with that
portion of the senior secured credit
facility (See Note 7). This derivative instrument requires quarterly settlements whereby we
pay a fixed rate of 4.993% and receive a three month LIBOR rate, reset every three months.
The derivative expires on April 30, 2011.We have designated this derivative instrument as a cash flow hedge in accordance with
Statement of Financial Accounting Standards No. 133 (SFAS 133), Accounting for Derivative
Instruments and Hedging Activities,
 21




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements  Continued
 as subsequently amended by SFAS 138, Accounting for
Certain Derivative Instruments and Certain Hedging Activities an amendment of SFAS 133. The
credit risk associated with this contract is limited to the uncollected interest payments and
the fair market value of the derivative to the extent it has become favorable to us.On April 17, 2007, we filed with the SEC a report on Form 8-K/A that included as exhibits (i)
audited financial statements for USAgencies for the years ended December 31, 2006, 2005 and
2004 and (ii) pro forma financial information.
 22




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##### Table of Contents



Item 2.
Managements Discussion and Analysis of Financial Condition and Results of Operations.
    Overview
      23




---



##### Table of Contents



Measurement of Performance
 The Sales Process
     Three months endedMarch 31,2007
    
    
    2006Gross Premiums Written By:Our underwriting agencies:Our retail agencies
    
    $
    79,817
    
    
    $
    33,086Independent agencies
    
    
    51,946
    
    
    
    43,502Subtotal
    
    
    131,763
    
    
    
    76,588Unaffiliated underwriting agencies
    
    
    11,392
    
    
    
    12,150Other
    
    
    (2
    )
    
    
    11Total
    
    $
    143,153
    
    
    $
    88,749
 24




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##### Table of Contents



Three Months Ended March 31,2007
    
    
    2006Louisiana *
    
    $
    44,285
    
    
    $
    Illinois*
    
    
    22,055
    
    
    
    23,245Texas
    
    
    21,877
    
    
    
    24,427California
    
    
    10,846
    
    
    
    11,883Michigan
    
    
    9,430
    
    
    
    4,559Florida
    
    
    8,921
    
    
    
    6,018Alabama*
    
    
    6,785
    
    
    
    Missouri
    
    
    6,689
    
    
    
    2,447Indiana
    
    
    5,173
    
    
    
    6,612South Carolina
    
    
    4,617
    
    
    
    5,865New Mexico
    
    
    1,931
    
    
    
    3,415Arizona
    
    
    323
    
    
    
    105Georgia
    
    
    117
    
    
    
    178Utah
    
    
    106
    
    
    
    (13
    )Other
    
    
    (2
    )
    
    
    8Total
    
    $
    143,153
    
    
    $
    88,749
 
 *
    
    States in which USAgencies operates. 25




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##### Table of Contents



Commission Income and Fees
 Commission income and fees earned by our underwriting agencies on business that is not written or
retained by us.
 Policy, installment, premium finance and agency fees are earned for business written or assumed by
our insurance companies both through independent agents and our retail agencies.
 The commissions earned on sales of
unaffiliated (third-party) companies products sold by our retail
agencies.
 Losses and Loss Adjustment Expenses
 26




---



##### Table of Contents



Selling, General and Administrative Expenses.
  Consolidation Process.
 27




---



##### Table of Contents



Results of Operations
  Three months ended March 31,2007
    
    
    2006
    
    
    % ChangeRevenuesNet premiums earned
    
    $
    82,770
    
    
    $
    73,038
    
    
    
    13.3
    %Commission income and fees
    
    
    23,383
    
    
    
    17,499
    
    
    
    33.6
    %Net investment income
    
    
    3,961
    
    
    
    2,060
    
    
    
    92.3
    %Net realized losses
    
    
    (169
    )
    
    
    (367
    )
    
    
    -54.0
    %Total revenues
    
    
    109,945
    
    
    
    92,230
    
    
    
    19.2
    %ExpensesLosses and loss adjustment expenses
    
    
    57,952
    
    
    
    47,652
    
    
    
    21.6
    %Selling, general and administrative expenses
    
    
    38,625
    
    
    
    32,601
    
    
    
    18.5
    %Depreciation and amortization
    
    
    3,288
    
    
    
    1,060
    
    
    
    210.2
    %Interest expense
    
    
    6,632
    
    
    
    1,085
    
    
    
    511.2
    %Total expenses
    
    
    106,497
    
    
    
    82,398
    
    
    
    29.2
    %Net income before income taxes and minority interest
    
    
    3,448
    
    
    
    9,832
    
    
    
    -64.9
    %Income tax expense
    
    
    1,202
    
    
    
    3,520
    
    
    
    -65.9
    %Minority interest, net of income taxes
    
    
    
    
    
    
    81
    
    
    NMNet income
    
    $
    2,246
    
    
    $
    6,231
    
    
    
    -64.0
    %Net income per common share  Basic
    
    $
    0.15
    
    
    $
    0.40
    
    
    
    -62.5
    %Net income per common share  Diluted
    
    $
    0.15
    
    
    $
    0.40
    
    
    
    -62.5
    %Weighted average shares outstanding  Basic
    
    
    15,358,050
    
    
    
    15,432,557Weighted average shares outstanding  Diluted
    
    
    15,467,045
    
    
    
    15,463,132Operational InformationGross premiums written
    
    $
    143,153
    
    
    $
    88,749
    
    
    
    61.3
    %Net premiums written
    
    $
    102,112
    
    
    $
    87,058
    
    
    
    17.3
    %Percentage retained
    
    
    71.3
    %
    
    
    98.1
    %Loss Ratio
    
    
    70.0
    %
    
    
    65.2
    %Expense Ratio
    
    
    22.4
    %
    
    
    22.1
    %Combined Ratio
    
    
    92.4
    %
    
    
    87.4
    %
 Comparison of the Three Month Periods Ended March 31, 2007 and March 31, 2006
   28




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##### Table of Contents



Three Months EndedMarch 31,2007
    
    
    2006
    
    
    % ChangeOur underwriting agencies
    
    $
    72,711
    
    
    $
    62,395
    
    
    
    16.5
    %Unaffiliated underwriting agencies
    
    
    10,059
    
    
    
    10,643
    
    
    
    -5.5
    %Total net premiums earned
    
    $
    82,770
    
    
    $
    73,038
    
    
    
    13.3
    %
  Three Months EndedMarch 31,2007
    
    
    2006
    
    
    Variance
    
    
    Variance($)
    
    
    (%)Income on non-retained business- MGA commissions
    
    $
    409
    
    
    $
    913
    
    
    $
    (504
    )
    
    
    -55
    %- Claims service fee income
    
    
    511
    
    
    
    892
    
    
    
    (381
    )
    
    
    -43
    %Affiliated- Policyholder fee income
    
    
    9,792
    
    
    
    10,557
    
    
    
    (765
    )
    
    
    -7
    %- Premium finance fees and interest
    
    
    5,798
    
    
    
    
    
    
    
    5,798
    
    
    NM- Agency fees
    
    
    409
    
    
    
    1,145
    
    
    
    (736
    )
    
    
    -64
    %Non-affiliated income  third party-Commissions and fees
    
    
    5,977
    
    
    
    3,673
    
    
    
    2,304
    
    
    
    63
    %- Agency fees
    
    
    487
    
    
    
    319
    
    
    
    168
    
    
    
    53
    %Total commission income and fees
    
    $
    23,383
    
    
    $
    17,499
    
    
    $
    5,884
    
    
    
    34
    %
    29




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##### Table of Contents



Three Months EndedMarch 31,2007
    
    2006Loss and loss adjustment expense ratio   current period
    
    
    72.0
    %
    
    
    68.5
    %Favorable loss ratio development  prior period business
    
    
    -2.0
    %
    
    
    -3.3
    %Reported loss and loss adjustment expense ratio
    
    
    70.0
    %
    
    
    65.2
    %
  30




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##### Table of Contents



Three Months EndedMarch 31,2007
    
    
    2006(dollars in thousands)Beginning deferred acquisition costs (DAC)
    
    $
    23,865
    
    
    $
    24,453Additions
    
    
    25,411
    
    
    
    22,513Amortization of DAC
    
    
    (19,237
    )
    
    
    (18,897
    )Ending DAC
    
    $
    30,039
    
    
    $
    28,069Amortization of DAC as % of Earned Premium
    
    
    23.2
    %
    
    
    25.9
    %Policy acquisition costs (amortization of DAC)
    
    $
    19,237
    
    
    $
    18,897Other selling, general and administrative expenses
    
    
    19,388
    
    
    
    13,704Total selling, general and administrative expenses
    
    $
    38,625
    
    
    $
    32,601Total SG&A expenses as % of Earned Premium
    
    
    46.7
    %
    
    
    44.6
    %
    31




---



##### Table of Contents



Three Months EndedMarch 31,2007
    
    
    2006Selling, general and administrative expenses
    
    $
    38,625
    
    
    $
    32,601Depreciation and amortization
    
    
    3,288
    
    
    
    1,060Less: commission income and fees
    
    
    (23,383
    )
    
    
    (17,499
    )Total expenses, net of commission income and fees (dividend)
    
    $
    18,530
    
    
    $
    16,162Net premiums earned (divisor)
    
    $
    82,770
    
    
    $
    73,038Expense ratio
    
    
    22.4
    %
    
    
    22.1
    %
      Liquidity and Capital Resources
 Sources and uses of funds.
  32




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##### Table of Contents



33




---



##### Table of Contents



Senior secured credit facility.
   34




---



##### Table of Contents



Special Note Regarding Forward-Looking Statements
  
 Item 3.
Quantitative and Qualitative Disclosures About Market Risk.
  Interest rate risk.
 Credit risk.
  35




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##### Table of Contents



As of
    
    
    As ofMarch 31,
    
    
    December 31,2007
    
    
    2006Total invested assets ($ in thousands)
    
    $
    342,704
    
    
    $
    221,770Tax equivalent book yield
    
    
    5.43%
    
    
    
    5.33%Average duration in years
    
    
    1.5
    
    
    
    1.0Average S&P rating
    
    AA+
    
    
    AA+
      Effects of inflation.
 36




---



##### Table of Contents



Item 4.
Controls and Procedures.
 Evaluation of Disclosure Controls and Procedures
   Changes in Internal Control over Financial Reporting
   
 PART II  Other Information
 
 Item 1.
Legal Proceedings.
   37




---



##### Table of Contents



th
   th
    38




---



##### Table of Contents



Item 1A. Risk Factors.
  
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
  
 Item 3. Defaults Upon Senior Securities.
  
 Item 4. Submission of Matters to a Vote of Security Holders.
  
 Item 5. Other Information.
  39




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##### Table of Contents



Item 6. Exhibits.
 a) Exhibits
 2.1
    
    Purchase and Sale
Agreement, dated
October 3, 2006 and
effective as of October
12, 2006, by and among
the equityholders of
USAgencies, L.L.C. and
Affirmative Insurance
Holdings, Inc.
(incorporated by
reference to Exhibit
2.1 to our Current
Report on Form 8-K
filed with the SEC on
October 18, 2006, File
No. 000-50795).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
    
    $220,000,000 Credit Agreement, dated as
of January 31, 2007, among Affirmative
Insurance Holdings, Inc. as Borrower,
the Lenders party thereto, Credit
Suisse, Cayman Islands Branch as
Administrative Agent and Collateral
Agent and Credit Suisse Securities
(USA) LLC, as Sole Bookrunner and Sole
Lead Arranger (incorporated by
reference to Exhibit 10.32 to our
Annual Report on Form 10-K filed with
the SEC on March 16, 2007, File No.
000-50795).10.2
    
    First Amendment to Credit Agreement and
Guarantee and Collateral Agreement,
dated as of March 8, 2007, among
Affirmative Insurance Holdings, Inc. as
Borrower, the lenders party thereto,
Credit Suisse, Cayman Islands Branch,
as Administrative Agent, Collateral
Agent, Outgoing Issuing Bank and
Outgoing Swingline Lender and The Frost
National Bank as Incoming Issuing Bank
and Incoming Swingline Lender
(incorporated by reference to Exhibit
10.33 to our Annual Report on Form 10-K
filed with the SEC on March 16, 2007,
File No. 000-50795).10.3
    
    Consent to Assignment, dated January
10, 2007, and effective as of December
1, 2006, among Affirmative Property
Holdings, Inc., KR Callahan & Company,
LLC and 227 West Monroe Street, Inc.
with respect to that certain Assignment
of Lease, dated as of November 30,
2006, and effective December 1, 2006,
between Affirmative Property Holdings,
Inc. and KR Callahan & Company, LLC
(incorporated by reference to Exhibit
10.34 to our Annual Report on Form 10-K
filed with the SEC on March 16, 2007,
File No. 000-50795).10.4
    
    Lease, dated as of May 8, 2006, between
KR Callahan & Company, LLC, as tenant,
and 227 West Monroe Street, Inc., as
landlord (incorporated by reference to
Exhibit 10.35 to our Annual Report on
Form 10-K filed with the SEC on March
16, 2007, File No. 000-50795).31.1*
    
    Certification of Kevin R. Callahan,
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, 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 40




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##### Table of Contents



SIGNATURES
  Affirmative Insurance Holdings, Inc.Date: May 10, 2007/s/ Mark E. PapeBy: Mark E. PapeExecutive Vice President and Chief Financial Officer(and in his capacity as Principal Financial Officer)
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