##### 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, 2005
 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 þ




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Affirmative Insurance Holdings, Inc.
Index
 PagePart I
    
    Financial InformationItem 1.
    
    Financial Statements (unaudited)Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004
    
    
    1Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2005 and 2004
    
    
    2Consolidated
Statements of Stockholders Equity and Comprehensive Income for
the Nine Months Ended September 30, 2005 and 2004
    
    
    3Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004
    
    
    4Notes to Consolidated Financial Statements
    
    
    5Item 2.
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    19Item 3.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    31Item 4.
    
    Controls and Procedures
    
    
    32Part II
    
    Other InformationItem 1.
    
    Legal Proceedings
    
    
    33Item 2.
    
    Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    34Item 3.
    
    Defaults Upon Senior Securities
    
    
    34Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    34Item 5.
    
    Other Information
    
    
    34Item 6.
    
    Exhibits
    
    
    35Signatures
    
    
    36Second Amendment to Credit Agreement and Waiver of DefaultsSeparation Agreement and General ReleaseCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906




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##### Table of Contents



Part I
 
 Item 1. Financial Statements
 Affirmative Insurance Holdings, Inc.
 
 Consolidated Balance Sheets  (Unaudited)
 September 30, 2005 and December 31, 2004
 September 30,
    
    
    December 31,(dollars in thousands, except share data)
    
    2005
    
    
    2004AssetsFixed maturities  available for sale, at fair value (amortized cost 2005: $180,654; 2004: $157,296)
    
    $
    178,776
    
    
    $
    157,666Short-term investments
    
    
    480
    
    
    
    1,995179,256
    
    
    
    159,661Cash and cash equivalents
    
    
    45,099
    
    
    
    24,096Fiduciary and restricted cash
    
    
    24,063
    
    
    
    16,267Accrued investment income
    
    
    2,306
    
    
    
    1,979Premiums and fees receivable (includes related parties - 2004: $30,980)
    
    
    126,143
    
    
    
    107,411Commissions receivable (includes related parties - 2004: $5,136)
    
    
    7,925
    
    
    
    11,890Receivable from reinsurers (includes related parties - 2004: $28,873)
    
    
    39,889
    
    
    
    75,403Deferred acquisition costs
    
    
    26,757
    
    
    
    19,118Receivable from affiliates
    
    
    
    
    
    
    310Deferred tax asset
    
    
    6,768
    
    
    
    6,637Property and equipment, net
    
    
    7,496
    
    
    
    6,485Goodwill
    
    
    69,614
    
    
    
    67,430Other intangible assets, net
    
    
    18,096
    
    
    
    18,361Other assets
    
    
    8,072
    
    
    
    5,872Total assets
    
    $
    561,484
    
    
    $
    520,920Liabilities and Stockholders EquityLiabilitiesReserves for losses and loss adjustment expenses (includes related parties - 2004: $23,037)
    
    
    123,845
    
    
    
    93,030Unearned premium (includes related parties - 2004: $16,921)
    
    
    106,995
    
    
    
    90,695Amounts due reinsurers (includes related parties - 2004: $9,640)
    
    
    27,804
    
    
    
    43,167Deferred revenue
    
    
    28,101
    
    
    
    24,478Federal income taxes payable
    
    
    483
    
    
    
    7,526Notes payable
    
    
    56,702
    
    
    
    30,928Consideration due for acquisitions
    
    
    1,039
    
    
    
    1,098Other liabilities
    
    
    20,685
    
    
    
    24,692Total liabilities
    
    
    365,654
    
    
    
    315,614Commitments and contingencies (Note 6)Stockholders equityCommon stock, $0.01 par value; 75,000,000 shares authorized, 16,903,910 shares issued, 14,903,910 shares
outstanding at September 30, 2005 and 16,838,519 shares issued and outstanding at December 31, 2004
    
    
    169
    
    
    
    168Additional paid-in capital
    
    
    152,773
    
    
    
    151,752Treasury stock, at cost; 2,000,000 shares at September 30, 2005
    
    
    (28,000
    )
    
    
    Accumulated other comprehensive (loss) income
    
    
    (1,221
    )
    
    
    251Retained earnings
    
    
    72,109
    
    
    
    53,135Total stockholders equity
    
    
    195,830
    
    
    
    205,306Total liabilities and stockholders equity
    
    $
    561,484
    
    
    $
    520,920
 1




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Operations  (Unaudited)
 Three and Nine Months Ended September 30, 2005 and 2004
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,(dollars in thousands, except per share data)
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004RevenuesNet premiums earned
    
    $
    77,544
    
    
    $
    50,328
    
    
    $
    222,921
    
    
    $
    141,276Commission
income (includes related parties  three months, 2005: $473; 2004: $1,022; nine months, 2005: $594; 2004: $2,577)
    
    
    2,791
    
    
    
    6,850
    
    
    
    10,232
    
    
    
    26,050Fee income
    
    
    13,331
    
    
    
    13,243
    
    
    
    40,522
    
    
    
    40,560Claims processing fees
    
    
    697
    
    
    
    1,343
    
    
    
    3,957
    
    
    
    2,698Net investment income
    
    
    1,447
    
    
    
    799
    
    
    
    4,057
    
    
    
    1,389Realized gains (losses)
    
    
    5
    
    
    
    11
    
    
    
    11
    
    
    
    (9
    )Total revenues
    
    
    95,815
    
    
    
    72,574
    
    
    
    281,700
    
    
    
    211,964ExpensesLosses and loss adjustment expenses
    
    
    46,347
    
    
    
    35,468
    
    
    
    142,131
    
    
    
    95,325Policy acquisition expenses
    
    
    11,880
    
    
    
    15,109
    
    
    
    40,049
    
    
    
    41,382Employee compensation and benefits
    
    
    15,909
    
    
    
    7,193
    
    
    
    38,852
    
    
    
    28,102Depreciation and amortization
    
    
    912
    
    
    
    1,166
    
    
    
    2,934
    
    
    
    3,011Operating expenses
    
    
    10,031
    
    
    
    2,929
    
    
    
    23,448
    
    
    
    12,033Interest expense
    
    
    1,124
    
    
    
    135
    
    
    
    2,499
    
    
    
    526Total expenses
    
    
    86,203
    
    
    
    62,000
    
    
    
    249,913
    
    
    
    180,379Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    9,612
    
    
    
    10,574
    
    
    
    31,787
    
    
    
    31,585Income tax expense
    
    
    3,408
    
    
    
    4,150
    
    
    
    11,266
    
    
    
    11,668Minority interest, net of income taxes
    
    
    217
    
    
    
    274
    
    
    
    576
    
    
    
    581Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    
    
    
    
    173
    
    
    
    
    
    
    
    596Net income
    
    $
    5,987
    
    
    $
    5,977
    
    
    $
    19,945
    
    
    $
    18,740Net income per common share  Basic
    
    $
    0.40
    
    
    $
    0.38
    
    
    $
    1.25
    
    
    $
    1.43Net income per common share  Diluted
    
    $
    0.39
    
    
    $
    0.37
    
    
    $
    1.23
    
    
    $
    1.42Weighted average shares outstandingBasic
    
    
    14,893,310
    
    
    
    15,931,171
    
    
    
    15,978,852
    
    
    
    13,072,295Diluted
    
    
    15,165,677
    
    
    
    16,181,166
    
    
    
    16,231,333
    
    
    
    13,237,835
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Stockholders Equity and Comprehensive Income  (Unaudited)
 Nine Months Ended September 30, 2005 and 2004
 AccumulatedAdditional
    
    
    
    
    
    
    
    
    
    
    Other
    
    
    TotalCommon Stock Issued
    
    
    
    
    
    
    Paid-in
    
    
    Retained
    
    
    Treasury
    
    
    Comprehensive
    
    
    StockholdersShares
    
    
    Amount
    
    
    Warrants
    
    
    Capital
    
    
    Earnings
    
    
    Stock
    
    
    Income (Loss)
    
    
    Equity(dollars in thousands, except share data)Balance, December 31, 2003
    
    
    11,557,215
    
    
    $
    116
    
    
    $
    157
    
    
    $
    84,074
    
    
    $
    29,039
    
    
    
    
    
    
    $
    (9
    )
    
    $
    113,377Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,740
    
    
    
    
    
    
    
    
    
    
    
    18,740Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    459
    
    
    
    459Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,199Issuance of common stock
    
    
    5,278,505
    
    
    
    52
    
    
    
    (157
    )
    
    
    67,715
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    67,610Balance, September 30, 2004
    
    
    16,835,720
    
    
    $
    168
    
    
    $
    
    
    
    $
    151,789
    
    
    $
    47,779
    
    
    $
    
    
    
    $
    450
    
    
    $
    200,186Balance, December 31, 2004
    
    
    16,838,519
    
    
    $
    168
    
    
    $
    
    
    
    $
    151,752
    
    
    $
    53,135
    
    
    $
    
    
    
    $
    251
    
    
    $
    205,306Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    19,945
    
    
    
    
    
    
    
    
    
    
    
    19,945Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,472
    )
    
    
    (1,472
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,473Purchase of treasury stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (28,000
    )
    
    
    
    
    
    
    (28,000
    )Dividends ($.02 per share)
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (971
    )
    
    
    
    
    
    
    
    
    
    
    (971
    )Issuance of common stock, net
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6Equity based compensation
    
    
    65,391
    
    
    
    1
    
    
    
    
    
    
    
    1,015
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,016Balance, September 30, 2005
    
    
    16,903,910
    
    
    $
    169
    
    
    $
    
    
    
    $
    152,773
    
    
    $
    72,109
    
    
    $
    (28,000
    )
    
    $
    (1,221
    )
    
    $
    195,830
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Cash Flows  (Unaudited)
 Nine Months Ended September 30, 2005 and 2004
 Nine months endedSeptember 30,2005
    
    
    2004(dollars in thousands)Cash flows from operating activitiesNet income
    
    $
    19,945
    
    
    $
    18,740Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    2,934
    
    
    
    3,011Undistributed equity in unconsolidated subsidiaries
    
    
    
    
    
    
    596Equity based compensation
    
    
    165
    
    
    
    Realized (gains) losses
    
    
    (11
    )
    
    
    9Amortization of discount on investment
    
    
    1,920
    
    
    
    Changes in assets and liabilities:Fiduciary and restricted cash
    
    
    (7,796
    )
    
    
    (8,522
    )Premiums, fees and commissions receivable
    
    
    (14,767
    )
    
    
    (55,382
    )Reserves for loss and loss expenses
    
    
    30,815
    
    
    
    45,363Amounts due to / from reinsurers
    
    
    20,151
    
    
    
    13,032Receivable from affiliates
    
    
    310
    
    
    
    (194
    )Deferred revenue
    
    
    3,623
    
    
    
    7,734Unearned premiums
    
    
    16,300
    
    
    
    24,499Deferred acquisition costs
    
    
    (7,639
    )
    
    
    (3,504
    )Federal income taxes payable
    
    
    (7,043
    )
    
    
    (849
    )Other
    
    
    (1,771
    )
    
    
    (1,258
    )Net cash provided by operating activities
    
    
    57,136
    
    
    
    43,275Cash flows from investing activitiesProceeds from the sale of bonds
    
    
    4,393
    
    
    
    15,726Cost of bonds acquired
    
    
    (30,001
    )
    
    
    (88,215
    )Purchases of property and equipment
    
    
    (3,381
    )
    
    
    (3,002
    )Net cash paid for acquisitions
    
    
    (2,548
    )
    
    
    (3,110
    )Net cash used in investing activities
    
    
    (31,537
    )
    
    
    (78,601
    )Cash flows from financing activitiesPrincipal payments under capital lease obligation
    
    
    
    
    
    
    (341
    )Proceeds from borrowings
    
    
    24,369
    
    
    
    Repayments of borrowings
    
    
    
    
    
    
    (10,020
    )Proceeds from issuance of common stock, net
    
    
    6
    
    
    
    67,510Acquisition of treasury stock
    
    
    (28,000
    )
    
    
    Dividends paid
    
    
    (971
    )
    
    
    Net cash (used in) provided by financing activities
    
    
    (4,596
    )
    
    
    57,149Net increase in cash and cash equivalents
    
    
    21,003
    
    
    
    21,823Cash and cash equivalents, beginning of period
    
    
    24,096
    
    
    
    15,358Cash and cash equivalents, end of period
    
    $
    45,099
    
    
    $
    37,181
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Notes to Consolidated Financial Statements (Unaudited)
 1.
    
    GeneralAffirmative Insurance Holdings, Inc., (we, us, our) is an insurance holding company and is
engaged in underwriting, servicing and distributing non-standard automobile insurance policies
and related products and services to individual consumers in highly targeted geographic areas.
Our subsidiaries include two insurance companies, four underwriting agencies, five retail
agencies with 181 owned and 45 franchise retail store locations as of September 30, 2005. As of
the date of this filing, we offer our products and services in 12 states, including Texas,
Illinois, California and Florida. We were formerly known as Instant Insurance Holdings, Inc.,
and we incorporated in Delaware on June 25, 1998.As a result of a series of transactions commencing on December 21, 2000, Vesta Insurance Group,
Inc. and its subsidiaries (Vesta) owned approximately 98.1% of our issued and outstanding
common stock at June 30, 2004, which were acquired from former stockholders and the purchase of
new common stock directly from us.We completed our initial public offering of our common stock effective July 9, 2004. We issued
4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common
stock that they owned, at an initial public offering price of $14.00 per share. On July 26,
2004, our underwriters exercised their option to purchase an additional 663,000 shares from us,
and an additional 562,500 shares from Vesta. On June 1, 2005, we purchased 2,000,000 of our
 shares of common stock from Vesta at a price of $14.00 per share.On June 14, 2005, Vesta entered into a Stock Purchase Agreement with New Affirmative LLC (New
Affirmative), related to the sale of 5,218,228 shares of our common stock. New Affirmative was
formed for the purpose of acquiring, holding, voting and disposing of the shares of the
Companys Common Stock acquired in connection with the Stock Purchase Agreement and any shares
of the Companys Common Stock that New Affirmative may acquire in the future. New Affirmative is
(i) 50% owned by DSC AFFM, LLC, a Delaware limited liability company (DSC AFFM), an entity
controlled by DSC AFFM Manager LLC, a Delaware limited liability company and sole managing
member of DSC AFFM (DSC Manager), and Andrew G. Bluhm, the managing member of DSC Manager, and
(ii) 50% owned by Affirmative Investment LLC, a Delaware limited liability company (Affirmative
Investment), an entity controlled by Affirmative Associates LLC, a Delaware limited liability
company and the sole managing member of Affirmative Investment (Affirmative Associates), 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 the Companys 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 the Companys Common
Stock, previously acquired by it in open market transactions, to New Affirmative. The Vesta /
New Affirmative transaction was subject to customary closing conditions and regulatory approval
by the Illinois Department of Financial and Professional Regulation  Division of Insurance and
other required filings. Vesta completed the sale to New Affirmative on August 30, 2005. New
Affirmative now owns approximately 7,860,927 shares of our common stock, or 52.7%.2.
    
    Summary of Significant Accounting PoliciesBasis of PresentationOur unaudited consolidated financial statements included herein have been prepared in accordance
with accounting principles generally accepted in the United States of America (GAAP) and
include our accounts and the accounts of our operating subsidiaries. All intercompany accounts
and transactions have been eliminated in consolidation. Certain information and footnote
disclosures normally included in financial statements prepared in accordance with GAAP have been
condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission
(SEC) for interim financial reporting. These financial statements should be read in
conjunction with our audited financial statements and notes thereto for the year ended December
31, 2004 included in our report on Form 10-K filed with the SEC.
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##### Table of Contents



The interim financial data as of September 30, 2005 and 2004 is unaudited; however, in the
opinion of the Company, the interim data includes all adjustments, consisting only of normal
recurring adjustments, necessary
for a fair statement of the results for the interim periods.ReclassificationCertain previously reported amounts have been reclassified in order to conform to current year
presentation. Such reclassification had no effects on net income or stockholders equity.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. Upon reissuance, the cost of treasury shares held
will be reduced by the average purchase price per share of the aggregate treasury shares held.Stock Based CompensationIn December 2002, the FASB issued SFAS No. 148 (SFAS 148), Accounting for Stock-Based
CompensationTransition and Disclosure.This statement provides alternative methods of
transition for a voluntary change to the fair value based method of accounting for stock-based
employee compensation. It also amends the disclosure requirements of SFAS No. 123 (SFAS 123),
Accounting for Stock-Based Compensationto require prominent disclosures in both annual and
interim financial statements about the method of accounting for stock-based employee
compensation and the effect of the method on reported results. We have elected to continue to
apply APB Opinion No. 25 (APB 25) Accounting for Stock Issued to Employeesand related
interpretations in accounting for stock options.The following table illustrates the effect on our net income and net income per share if we had
applied SFAS 123 to stock-based compensation (in thousands, except per share amounts):
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Net income, as reported
    
    $
    5,987
    
    
    $
    5,977
    
    
    $
    19,945
    
    
    $
    18,740Add: stock-based employee compensation expense included in
reported net income, net of related income taxes
    
    
    
    
    
    
    18
    
    
    
    
    
    
    
    18Deduct: total stock-based compensation expense
determined under fair value based method for all awards,
net of related income taxes
    
    
    (206
    )
    
    
    (144
    )
    
    
    (592
    )
    
    
    (190
    )Net income, pro forma
    
    $
    5,781
    
    
    $
    5,851
    
    
    $
    19,353
    
    
    $
    18,568Basic earnings per share  as reported
    
    $
    0.40
    
    
    $
    0.38
    
    
    $
    1.25
    
    
    $
    1.43Basic earnings per share  pro forma
    
    $
    0.39
    
    
    $
    0.37
    
    
    $
    1.21
    
    
    $
    1.42Diluted earnings per share  as reported
    
    $
    0.39
    
    
    $
    0.37
    
    
    $
    1.23
    
    
    $
    1.42Diluted earnings per share  pro forma
    
    $
    0.38
    
    
    $
    0.36
    
    
    $
    1.19
    
    
    $
    1.40
 6




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##### Table of Contents



Recently Issued Accounting StandardsIn March 2004, the Emerging Issues Task Force (EITF) of the FASB reached a consensus on Issue
03-1, The Meaning of Other-Than Temporary Impairment and Its Application to Certain Investments.
EITF 03-1 provides guidance with respect to the meaning of other-than temporary impairment and
its application to investments classified as either available-for-sale or held-to-maturity under
SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities,and investments
accounted for under the cost method or the equity method. In September 2004, the FASB issued a
Staff Position, FSP EITF 03-1-1, delaying the effective date for the measurement and recognition
guidance included in EITF 03-1, and also issued an exposure draft, FSP EITF 03-1a, which
proposes guidance relating to debt securities that are impaired because of interest rate and/or
sector spread increases. The delay in the effective date for the measurement and recognition
guidance of EITF 03-1 did not suspend existing requirements for assessing whether investment
impairments are other-than-temporary. We do not anticipate that this will have a material impact
on our financial statements.In December 2004, the FASB issued SFAS No. 123R (SFAS 123R), Share-Based Compensation,which
is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation,and supersedes
APB Opinion No. 25, Accounting for Stock Issued to Employees,and its related implementation
guidance. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains
employee services in share-based payment transactions. This statement requires a public entity
to measure the cost of employee services received in exchange for an award of equity instruments
based on the grant-date, as defined in SFAS 123R, fair value of the award (with limited
exceptions). That cost will be recognized over the period during which an employee is required
to provide service in exchange for the award, the requisite service period. No compensation cost
is recognized for equity instruments for which employees do not render the requisite service.
SFAS 123R is effective for public entities that do not file as small business issuers as of the
beginning of the first interim or annual reporting period that begins after December 31, 2005.
We anticipate adopting the provisions of SFAS 123R in January 2006. We are currently evaluating
the requirements and the potential impact of SFAS 123R and have not yet determined if SFAS 123R
will have a material impact on our future Statements of Operation.3.
    
    ReinsuranceThe effect of reinsurance on premiums written and earned is as follows (dollars in thousands):
 Three months ended
    
    
    Three months endedSeptember 30, 2005
    
    
    September 30, 2004Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    42,983
    
    
    $
    43,845
    
    
    $
    50,970
    
    
    $
    41,245Assumed  affiliate
    
    
    4,638
    
    
    
    7,557
    
    
    
    15,791
    
    
    
    11,063Assumed  non
affiliate
    
    
    27,200
    
    
    
    28,664
    
    
    
    9,264
    
    
    
    15,255Ceded  affiliate
    
    
    (77
    )
    
    
    (77
    )
    
    
    (1,072
    )
    
    
    (2,214
    )Ceded  non affiliate
    
    
    (1,967
    )
    
    
    (2,445
    )
    
    
    (4,631
    )
    
    
    (15,021
    )$
    72,777
    
    
    $
    77,544
    
    
    $
    70,322
    
    
    $
    50,328
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Nine months ended
    
    
    Nine months endedSeptember 30, 2005
    
    
    September 30, 2004Written
    
    
    Earned
    
    
    Written
    
    
    EarnedDirect
    
    $
    137,428
    
    
    $
    134,478
    
    
    $
    143,819
    
    
    $
    111,776Assumed  affiliate
    
    
    27,436
    
    
    
    33,846
    
    
    
    60,697
    
    
    
    71,491Assumed  non
affiliate
    
    
    89,257
    
    
    
    69,496
    
    
    
    17,811
    
    
    
    15,939Ceded  affiliate
    
    
    (239
    )
    
    
    (687
    )
    
    
    (4,096
    )
    
    
    (17,860
    )Ceded  non affiliate
    
    
    (4,306
    )
    
    
    (14,212
    )
    
    
    (59,651
    )
    
    
    (40,070
    )$
    249,576
    
    
    $
    222,921
    
    
    $
    158,580
    
    
    $
    141,276
 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 September 30,
    
    
    As of December 31,2005
    
    
    2004AffiliateLoss and loss
adjustment expense
    
    $
    
    
    
    $
    23,815Unearned premiums
    
    
    
    
    
    
    656Total
    
    $
    
    
    
    $
    24,471Non affiliateLoss and loss
adjustment expense
    
    $
    31,240
    
    
    $
    18,087Unearned premiums
    
    
    3,832
    
    
    
    13,530Total
    
    $
    35,072
    
    
    $
    31,617
 For the three and nine months ended, September 30, 2005, we have ceded $3.8 million and
$15.0 million of paid losses and ($1.0) million and $4.0 million of incurred losses to various
reinsurers, respectively. For the three and nine months ended September 30, 2004, we have ceded
$8.3 million and $29.0 million of paid losses and $15.9 and $39.3 million of incurred losses to
various reinsurers, respectively.Effective December 31, 2004, we terminated two ceded quota share reinsurance agreements with
unaffiliated reinsurers on a run-off basis for business written through our underwriting
agencies in the states of Illinois, Indiana, Missouri, New Mexico and South Carolina. Effective
December 31, 2004, we terminated two quota share reinsurance agreements with Old American County
Mutual Fire Insurance Company on a run-off basis, where we had assumed business written through
our underwriting agencies in the state of Texas.Effective January 1, 2005, we entered into two quota share reinsurance agreements with Old
American County Mutual Fire Insurance Company, where we will assume 100% of the business written
through our underwriting agencies in the state of Texas.Effective May 1, 2004, we entered into a quota share reinsurance agreement with an unaffiliated
reinsurer to cede 25% of the business written through our Florida underwriting agency. This
contract continues in force until terminated by us or our reinsurer at any April 30 with not less
than 90 days prior notice. Effective May 1, 2005, we amended this agreement and will continue
ceding 25% of the business written through our Florida underwriting agency to the unaffiliated
reinsurer at substantially the same terms and conditions. The reinsurance under this agreement is
provided by Folksamerica, which is rated A by A.M. Best.All of our quota share reinsurance agreements contain provisions for sliding scale commissions,
under which the commission paid to us varies with the loss ratio results under each contract.
The effect of this feature in the quota
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##### Table of Contents



share reinsurance agreements is to limit the reinsurers aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company.
These features also have the effect of reducing the amount of protection relative to the quota
share amount of premiums ceded by us. Before entering into these reinsurance agreements, and
based on our prior operating history, we concluded that each agreement met the risk transfer
test of SFAS No. 113 (SFAS 113) Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contractsas the reinsurers assume significant risk and have a reasonable
possibility of significant loss.On November 4, 2004, The Hawaiian Insurance & Guaranty Company, Ltd. (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. The plaintiff is seeking 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, our wholly-owned subsidiary, is a party to a 100% quota share
reinsurance agreement with Hawaiian and is sharing in the defense of this matter. Hawaiian is
ultimately a wholly-owned subsidiary of Vesta Insurance Group, Inc., which is no longer a
beneficial owner of our outstanding common stock at September 30, 2005 (See Note 1). The other
named defendants, SCJ Insurance Services, Prompt Insurance Services, Paul Ruelas, and Anthony
David Medina, are unaffiliated persons to Affirmative.Mediation was held on June 16, 2005, but concluded with no settlement. On July 20, 2005 and
pursuant to Section 998 of the California Code of Civil Procedure, Hawaiian offered to resolve
this matter in favor of the plaintiff for the sum of $1,000,010 with both parties to bear their
own fees and cost of suit. Pursuant to the terms of our quota share arrangement with Hawaiian,
we recorded $500,010 loss reserve for this matter at June 30, 2005.On August 8, 2005, we were served a copy of Plaintiffs Second Amended Complaint, which adds 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.This matter is currently proceeding through pre-trial discovery and depositions of pertinent
witnesses. Most depositions have been completed and Hawaiian has filed a motion for summary
judgment / summary adjudication of issues which is set for hearing on December 2, 2005. The
parties have agreed to participate in a mediation, which is currently being scheduled for late November 2005. A jury trial is set for February 6, 2006. We believe these allegations are
without merit and are vigorously contesting the claims brought by the plaintiff; 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 participate.
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 of the original quota share agreement as of July
31, 2005.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. During the nine months ended September 30, 2005, we had executed
letters of credit under our credit facility of approximately $2.3 million with these reinsurers,
all of which were still outstanding as of September 30, 2005 (See Note 7). We are currently in
the process of requesting that the letters of credit discussed above be released due to these
novation agreements.
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As of August 1, 2005, we recorded the following amounts related to this novation (dollars in
thousands):
 As of August 1,2005AssetsPremiums and fees receivable
    
    $
    12,698Receivable from reinsurer
    
    
    1,799DAC
    
    
    149$
    14,646LiabilitiesLoss and loss adjustment expense
    
    $
    11,130Unearned premium
    
    
    596Other liabilities
    
    
    2,920$
    14,646
 4.
    
    Related Party TransactionsWe provide various services for Vesta and its subsidiaries, including underwriting, premium
processing, and claims processing. For the 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 30,2005
    
    2004
    
    2005
    
    2004Commission income
    
    $
    473
    
    
    $
    1,022
    
    
    $
    594
    
    
    $
    2,577
 As of August 30, 2005, we and our subsidiaries are no longer affiliated with Vesta (See
Note 1).In addition, we have presented, in the accompanying consolidated balance sheets, the following
amounts related to contracts with Vesta and its subsidiaries (dollars in thousands):
 September 30,
    
    
    December 31,2005
    
    
    2004AssetsPremiums and fees receivable
    
    $
    
    
    
    $
    30,980Commissions receivable
    
    
    
    
    
    
    5,136Receivable from reinsurer
    
    
    
    
    
    
    28,873Receivable from affiliates
    
    
    
    
    
    
    310$
    
    
    
    $
    65,299LiabilitiesLoss and loss adjustment expense
    
    $
    
    
    
    $
    23,037Unearned premium
    
    
    
    
    
    
    16,921Amounts due reinsurers
    
    
    
    
    
    
    9,640$
    
    
    
    $
    49,598
 As part of the terms of the acquisition of Affirmative Insurance Company and Insura
Property and Casualty Insurance Company from Vesta, Vesta has indemnified us for any losses due
to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated
reinsurers prior to December 31, 2003. As of September 30, 2005, all such unaffiliated
reinsurers had A.M. Best ratings of A or better.
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##### Table of Contents



5.
    
    Notes PayableOn June 1, 2005, our newly formed trust subsidiary, Affirmative Insurance Holdings Statutory
Trust II (Trust Subsidiary II), completed a private placement of $25.0 million of 30 year
floating rate trust preferred securities. Simultaneously, we borrowed $25.0 million from Trust
Subsidiary II and the net proceeds from this borrowing, along with cash from operations, were
used to purchase the 2.0 million shares of our common stock as discussed in Note 8. 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.6.
    
    Commitments and ContingenciesWe and our subsidiaries are named from time to time as defendants in various legal actions
arising in the ordinary course of our business and arising out of or related to claims made in
connection with our insurance policies, claims handling and employment related disputes. The
plaintiffs in some of these lawsuits have alleged bad faith or extra-contractual damages and
some have claimed punitive damages. We believe that the resolution of these legal actions will
not have a material adverse effect on our financial position or results of operations.James Hallberg, the former president of InsureOne, our wholly-owned subsidiary, is a defendant,
along with three other former employees of InsureOne and two of Hallbergs family trusts, in an
action we brought in the Circuit Court of Cook County, Illinois in December 2003 to enforce
non-compete and non-solicitation agreements entered into with those employees. The court entered
an interim order prohibiting all the individual defendants, including Hallberg, from hiring any
employees of InsureOne or one of our other underwriting agencies. The order is still in effect
in the Illinois action until the conclusion of the trial of the Illinois action, which began
August 9, 2005. On May 17, 2004, Hallberg filed a counterclaim in the Illinois case seeking
unspecified compensatory damages, specific performance, attorneys fees and court costs based on
causes of action for breach of contract, fraud, negligent misrepresentation and breach of
fiduciary duty in connection with Vestas original acquisition of the InsureOne business in
2002, the claimants employment with InsureOne and our purchase of the 20% minority interest in
InsureOne in 2003. We filed a motion to dismiss these counterclaims, which was granted in part
and denied in part. Hallberg subsequently filed amended counterclaims based on causes of action
for breach of contract, fraud, and breach of fiduciary duty, which were most recently amended on
July 12, 2005. The Hallberg family 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. This claim had previously been brought by the Hallberg
family trusts in the United States District Court for the Northern District of Illinois pursuant
to Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.
The Hallberg family trusts voluntarily dismissed that federal action, after the court had
granted our motion to dismiss, in order to assert their claim in the Illinois state court
litigation as a counterclaim. We have answered those counterclaims, and believe the
counterclaims are without merit. We are vigorously contesting the counterclaims and are
exercising all rights and remedies available to us.On May 6, 2004, the former minority owners of our InsureOne retail agency, including the two
Hallberg family trust defendants and Hallberg, in his capacity as trustee of one of his family
trusts, filed a complaint in the United States District Court for the Northern District of
Illinois alleging causes of action against us and three of our executive officers under Section
10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, as well as
causes of action for fraudulent misrepresentation, negligent misrepresentation and breach of
fiduciary duty in connection with our purchase of the plaintiffs 20% minority interest in this
retail agency in 2003. The plaintiffs sought damages equal to the difference between the amount
paid for the 20% interest and the courts determination of the value of this interest, plus
attorneys fees and court costs. Defendants filed a motion to dismiss this case, which was
granted by the Court on March 8, 2005. The Courts March 8, 2005 Order dismissed all claims
without prejudice and granted plaintiffs 20 days from the date of the order to attempt to
replead their claims. On May 2, 2005, plaintiffs filed a motion to voluntarily dismiss this
matter without prejudice, which was granted by the Court. As indicated above, two of the
Hallberg family trusts have now brought this claim as a counterclaim in the Illinois state
action. Thus, the only current action pending is the action in the Illinois state court.
Plaintiffs may still bring these claims in federal court at a later date, or alternatively, the
plaintiffs may file the state law claims in state court. We believe that the allegations are
without merit and are vigorously contesting the claims brought by the Plaintiffs, however, the
ultimate outcome of this matter is uncertain.
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On May 10, 2005, Instant Auto Insurance Agency of Texas, Inc., now known as A-Affordable
Insurance Agency, Inc. (A-Affordable), was named as a defendant in an action in the Chancery
Court of Cook County, Illinois for breach of contract and an accounting (record review) brought
in connection with an Asset Purchase and Sale Agreement between the former and current owners of
certain assets of A-Affordable. The defendants motion to dismiss for improper venue, answer
and counterclaim are all on file with the Court, as is the plaintiffs motions to withdraw as
counsel for plaintiffs. In an August 11, 2005 preliminary hearing, the Court determined that the
plaintiffs motion to withdraw would be heard on August 29, 2005 at a pre-calendared status
conference. The Court indicated that it would allow the plaintiffs between 2-4 weeks to obtain
replacement counsel, and if they fail to do so by the deadline, the Court would consider
dismissing the case. On August 29, 2005, the Court allowed Robert F. Coleman & Associates to
withdraw as counsel for plaintiffs. On September 19, 2005, Kevin M. Flynn & Associates filed a
motion for leave to withdraw as counsel for plaintiffs. On October 12, 2005, the Court granted
Flynns motion to withdraw as counsel for plaintiffs. Plaintiffs currently do not have legal
counsel. The Court also ordered plaintiffs to respond to defendants motion to dismiss by
November 2, 2005 or the plaintiffs case may be dismissed for want of prosecution. As of
November 10, 2005, plaintiffs have failed to comply with the Court order to
respond. The Court has set a status conference on November 28, 2005. No substantive proceedings
have occurred in the case. We believe that the allegations are without merit and are vigorously
contesting the claims brought by the Plaintiffs and exercising all available rights and remedies
against them, including the filing of a counterclaim; however, the ultimate outcome of this
matter is uncertain.We are the subject of a purported class action in Florida wherein the complaint alleges that we
have engaged in a scheme and common course of conduct to charge policy holders premiums for PIP
[Personal Injury Protection] coverage and then to void the policy when the policy holder
attempted to make a claim for benefits under the policy by claiming material misrepresentation
in the application or lack of cooperation by the insured. Included in the allegations are
claims for breach of contract; breach of fiduciary duty; breach of obligation of good faith,
fair dealing and commercial reasonableness; unfair and deceptive acts or practices; and civil
conspiracy. Plaintiffs seek certification of the case as a class action, as well as an
unspecified amount of compensatory and benefit damages, attorneys fees, litigation costs, and
any other relief the Court deems proper. The action is pending in the Circuit Court of the
15th Judicial Circuit in and for Palm Beach County, Florida. This matter, filed
August 29, 2005, is still in the early procedural stages, and as of the date of this
publication, the class had not been certified. We believe these allegations are without merit,
are vigorously contesting the claims brought by the plaintiffs, and are exercising all available
rights and remedies against them; however, the ultimate outcome of this matter is uncertain.On November 4, 2004, The Hawaiian Insurance & Guaranty Company, Ltd. (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. The plaintiff is seeking 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, our wholly-owned subsidiary, is a party to a 100% quota share
reinsurance agreement with Hawaiian and is sharing in the defense of this matter. Hawaiian is
ultimately a wholly-owned subsidiary of Vesta Insurance Group, Inc., which is no longer a
beneficial owner of our outstanding common stock at September 30, 2005 (See Note 1). The other
named defendants, SCJ Insurance Services, Prompt Insurance Services, Paul Ruelas, and Anthony
David Medina, are unaffiliated persons to Affirmative.Mediation was held on June 16, 2005, but concluded with no settlement. On July 20, 2005
and pursuant to Section 998 of the California Code of Civil Procedure, Hawaiian offered to
resolve this matter in favor of the plaintiff for the sum of $1,000,010 with both parties to bear
their own fees and cost of suit. Pursuant to the terms of our quota share arrangement with
Hawaiian, we recorded $500,010 loss reserve for this matter at June 30, 2005.
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##### Table of Contents



On August 8, 2005, we were served a copy of Plaintiffs Second Amended Complaint, which
adds 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.This matter is currently proceeding through pre-trial discovery and depositions of pertinent
witnesses. Most depositions have been completed and Hawaiian has filed a motion for summary
judgment / summary adjudication of issues which is set for hearing on December 2, 2005. The
parties have agreed to participate in a mediation, which is currently being scheduled for late
November 2005. A jury trial is set for February 6, 2006. We believe these allegations are
without merit and are vigorously contesting the claims brought by the plaintiff; however, the
ultimate outcome of this matter is uncertain.7.
    
    Credit FacilityOn August 6, 2004, we entered into a senior secured credit facility with The Frost National
Bank. Under this credit facility, the maximum amount available to us from time to time is $15.0
million, which may include up to $15.0 million under a two-year revolving line of credit, up to
$10.0 million in five-year term loans and up to $10.0 million in five-year stand-by letters of
credit. The borrowings under our credit facility will accrue interest based on the 90-day LIBOR
rate plus 150 basis points and we will pay letter of credit fees based on an annual rate of 75
basis points. Our obligations under the facility are guaranteed by our material operating
subsidiaries (other than our insurance companies) and are secured by a first lien security
interest on all of our assets and the assets of our material operating subsidiaries (other than
our insurance companies), including a pledge of 100% of the stock of Affirmative Insurance
Company. The facility contains certain financial covenants, which include combined ratio,
risk-based capital requirement, fixed charge coverage ratio, consolidated net worth and
consolidated net income requirements and other restrictive covenants governing distributions and
management changes. The proceeds are available to issue letters of credit securing our
obligations under reinsurance agreements, to fund general working capital for our agency
operations, capital surplus for our insurance
companies and to finance acquisition activities. During the nine months ended September 30,
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
still outstanding as of September 30, 2005 (See Note 3). Total fees were approximately $13,000.Our Credit Agreement requires us to provide the bank with written notification and documents
related to certain events. On August 12, 2005 we entered into a First Amendment to Credit
Agreement and Waiver of Defaults to the credit facility which amended and waived certain notice
requirements of the Credit Agreement and waived all existing defaults and all events of default
related to written notice requirements related to certain acquisitions of business in December
2004 and January, February, and July 2005, the repurchase of shares in June of 2005, and the
issuance of trust preferred securities in December of 2004 and June of 2005. As of September
30, 2005, 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.8.
    
    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. We recorded prepaid expense for these grants of
approximately $319,000 at the date of the grant and are amortizing the amount to compensation
expense over the service period. Total compensation expense recorded for the three and nine
months ended September 30, 2005 was approximately $53,000 and $126,000, respectively.On June 1, 2005, we purchased 2,000,000 million 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 5, and with cash from operations.
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##### Table of Contents



In July 2005, we issued 40,000 shares of restricted common stock to Timothy A. Bienek, Executive
Vice President and Chief Financial Officer, which vest over three years. We recorded prepaid
expense for these grants of approximately $697,000 at the date of the grant and are amortizing
the amount to compensation expense over the service period, or three years. Total compensation
expense recorded for the three and nine months ended September 30, 2005 was approximately
$39,000.In August and September 2005, we issued 3,657 shares of our common stock due to the exercise of
options.9.
    
    Earnings per ShareThe provisions of SFAS No. 128 (SFAS 128) Earnings per Sharerequire presentation of both
basic and diluted earnings per share. A reconciliation of the numerators and denominators of the
basic and diluted earnings per share computations as required by SFAS 128 is presented below:
 Income
    
    
    Shares
    
    
    Per Share(Numerator)
    
    
    (Denominator)
    
    
    Amount(dollars in thousands, except per share amounts)Three months ended September 30, 2005Basic Earnings per ShareNet Income
    
    $
    5,987
    
    
    
    14,893,310
    
    
    $
    0.40Diluted Earnings per ShareNet Income
    
    $
    5,987
    
    
    
    14,893,310
    
    
    $
    0.40Effect of Dilutive Securities
    
    
    
    
    
    
    272,367
    
    
    
    (0.01
    )$
    5,987
    
    
    
    15,165,677
    
    
    $
    0.39Three months ended September 30, 2004Basic Earnings per ShareNet Income
    
    $
    5,977
    
    
    
    15,931,171
    
    
    $
    0.38Diluted Earnings per ShareNet Income
    
    $
    5,977
    
    
    
    15,931,171
    
    
    $
    0.38Effect of Dilutive Securities
    
    
    
    
    
    
    249,995
    
    
    
    (0.01
    )$
    5,977
    
    
    
    16,181,166
    
    
    $
    0.37Nine months ended September 30, 2005Basic Earnings per ShareNet Income
    
    $
    19,945
    
    
    
    15,978,852
    
    
    $
    1.25Diluted Earnings per ShareNet Income
    
    $
    19,945
    
    
    
    15,978,852
    
    
    $
    1.25Effect of Dilutive Securities
    
    
    
    
    
    
    252,481
    
    
    
    (0.02
    )$
    19,945
    
    
    
    16,231,333
    
    
    $
    1.23Nine months ended September 30, 2004Basic Earnings per ShareNet Income
    
    $
    18,740
    
    
    
    13,072,295
    
    
    $
    1.43Diluted Earnings per ShareNet Income
    
    $
    18,740
    
    
    
    13,072,295
    
    
    $
    1.43Effect of Dilutive Securities
    
    
    
    
    
    
    165,540
    
    
    
    (0.01
    )$
    18,740
    
    
    
    13,237,835
    
    
    $
    1.42
 14




---



##### Table of Contents



10.
    
    Segment InformationIn June 1997, the FASB issued SFAS No. 131 (SFAS 131) Disclosures about Segments of an
Enterprise and Related Information. SFAS 131 defines an operating segment as a component of an
enterprise if it meets the following criteria: (1) it engages in business activities from which
it may earn revenue and incur expenses; (2) whose operating results are regularly reviewed by
the enterprises chief operating decision maker; and (3) for which discrete financial
information is available.We have reflected the requirements of SFAS 131 for the three and nine months ended September 30,
2005 and 2004 in the following tables for our three operating segments: agency segment,
insurance segment, and corporate segment.Our agency segment is comprised of our underwriting agencies and our retail agencies. Our
underwriting agencies primarily design, distribute and service policies issued or reinsured by
our insurance companies or another unaffiliated insurance company. In our insurance segment, we
issue non-standard personal automobile
insurance policies through our two Illinois-domiciled insurance company subsidiaries. Our
insurance companies possess the certificates of authority and capital necessary to transact
insurance business and issue policies, but they rely on both affiliated and unaffiliated
underwriting agencies to design, distribute and service those policies. Our corporate segment is
comprised of investor relations costs, directors and officers insurance, directors fees and
travel costs, as well as interest expense.
 15




---



##### Table of Contents



Agency
    
    
    Insurance
    
    
    Corporate
    
    
    
    
    
    
    AffirmativeThree months ended September 30, 2005
    
    Segment
    
    
    Segment
    
    
    Segment
    
    
    Eliminations
    
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    77,544
    
    
    $
    
    
    
    $
    
    
    
    $
    77,544Commission income
    
    
    23,514
    
    
    
    
    
    
    
    
    
    
    
    (20,723
    )
    
    
    2,791Fee income
    
    
    10,831
    
    
    
    6,679
    
    
    
    
    
    
    
    (4,179
    )
    
    
    13,331Claims processing fees
    
    
    7,901
    
    
    
    
    
    
    
    
    
    
    
    (7,204
    )
    
    
    697Investment income
    
    
    48
    
    
    
    1,399
    
    
    
    
    
    
    
    
    
    
    
    1,447Realized gains
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    5Total revenues
    
    
    42,299
    
    
    
    85,622
    
    
    
    
    
    
    
    (32,106
    )
    
    
    95,815Expenses:Losses and loss adjustment expenses
incurred
    
    
    
    
    
    
    46,347
    
    
    
    
    
    
    
    
    
    
    
    46,347Policy acquisition expenses
    
    
    7,565
    
    
    
    31,705
    
    
    
    
    
    
    
    (27,390
    )
    
    
    11,880Employee compensation and benefits
    
    
    16,063
    
    
    
    198
    
    
    
    
    
    
    
    (352
    )
    
    
    15,909Depreciation and amortization
    
    
    912
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    912Operating expenses
    
    
    12,773
    
    
    
    1,316
    
    
    
    306
    
    
    
    (4,364
    )
    
    
    10,031Interest expense
    
    
    
    
    
    
    
    
    
    
    1,124
    
    
    
    
    
    
    
    1,124Total expenses
    
    
    37,313
    
    
    
    79,566
    
    
    
    1,430
    
    
    
    (32,106
    )
    
    
    86,203Net income (loss) before income taxes,
minority interest and equity interest
    
    
    4,986
    
    
    
    6,056
    
    
    
    (1,430
    )
    
    
    
    
    
    
    9,612Income tax expense (benefit)
    
    
    1,768
    
    
    
    2,146
    
    
    
    (506
    )
    
    
    
    
    
    
    3,408Minority interest, net of tax
    
    
    217
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    217Net income (loss)
    
    $
    3,001
    
    
    $
    3,910
    
    
    $
    (924
    )
    
    $
    
    
    
    $
    5,987Total assets
    
    $
    142,694
    
    
    $
    407,650
    
    
    $
    11,140
    
    
    $
    
    
    
    $
    561,484
 Agency
    
    
    Insurance
    
    
    Corporate
    
    
    
    
    
    
    AffirmativeThree months ended September 30, 2004
    
    Segment
    
    
    Segment
    
    
    Segment
    
    
    Eliminations
    
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    50,328
    
    
    $
    
    
    
    $
    
    
    
    $
    50,328Commission income
    
    
    24,582
    
    
    
    
    
    
    
    
    
    
    
    (17,732
    )
    
    
    6,850Fee income
    
    
    10,299
    
    
    
    7,000
    
    
    
    
    
    
    
    (4,056
    )
    
    
    13,243Claims processing fees
    
    
    7,274
    
    
    
    
    
    
    
    
    
    
    
    (5,931
    )
    
    
    1,343Investment income
    
    
    23
    
    
    
    776
    
    
    
    
    
    
    
    
    
    
    
    799Realized gains (losses)
    
    
    2
    
    
    
    9
    
    
    
    
    
    
    
    
    
    
    
    11Total revenues
    
    
    42,180
    
    
    
    58,113
    
    
    
    
    
    
    
    (27,719
    )
    
    
    72,574Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    35,468
    
    
    
    
    
    
    
    
    
    
    
    35,468Policy acquisition expenses
    
    
    7,136
    
    
    
    18,191
    
    
    
    
    
    
    
    (10,218
    )
    
    
    15,109Employee compensation and benefits
    
    
    14,214
    
    
    
    
    
    
    
    
    
    
    
    (7,021
    )
    
    
    7,193Depreciation and amortization
    
    
    1,166
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,166Operating expenses
    
    
    12,696
    
    
    
    447
    
    
    
    266
    
    
    
    (10,480
    )
    
    
    2,929Interest expense
    
    
    
    
    
    
    
    
    
    
    135
    
    
    
    
    
    
    
    135Total expenses
    
    
    35,212
    
    
    
    54,106
    
    
    
    401
    
    
    
    (27,719
    )
    
    
    62,000Net income (loss) before income taxes,
minority interest and equity interest
    
    
    6,968
    
    
    
    4,007
    
    
    
    (401
    )
    
    
    
    
    
    
    10,574Income tax expense (benefit)
    
    
    2,743
    
    
    
    1,559
    
    
    
    (152
    )
    
    
    
    
    
    
    4,150Minority interest, net of tax
    
    
    274
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    274Equity interest in unconsolidated
subsidiaries, net of tax
    
    
    
    
    
    
    
    
    
    
    173
    
    
    
    
    
    
    
    173Net income (loss)
    
    $
    3,951
    
    
    $
    2,448
    
    
    $
    (422
    )
    
    $
    
    
    
    $
    5,977Total assets
    
    $
    218,180
    
    
    $
    299,618
    
    
    $
    12,908
    
    
    $
    
    
    
    $
    530,706
 16




---



##### Table of Contents



Agency
    
    
    Insurance
    
    
    Corporate
    
    
    
    
    
    
    AffirmativeNine months ended September 30, 2005
    
    Segment
    
    
    Segment
    
    
    Segment
    
    
    Eliminations
    
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    222,921
    
    
    $
    
    
    
    $
    
    
    
    $
    222,921Commission income
    
    
    75,163
    
    
    
    
    
    
    
    
    
    
    
    (64,931
    )
    
    
    10,232Fee income
    
    
    32,584
    
    
    
    19,924
    
    
    
    
    
    
    
    (11,986
    )
    
    
    40,522Claims processing fees
    
    
    23,495
    
    
    
    
    
    
    
    
    
    
    
    (19,538
    )
    
    
    3,957Investment income
    
    
    139
    
    
    
    3,918
    
    
    
    
    
    
    
    
    
    
    
    4,057Realized gains
    
    
    11
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    11Total revenues
    
    
    131,392
    
    
    
    246,763
    
    
    
    
    
    
    
    (96,455
    )
    
    
    281,700Expenses:Losses and loss adjustment expenses
incurred
    
    
    
    
    
    
    142,131
    
    
    
    
    
    
    
    
    
    
    
    142,131Policy acquisition expenses
    
    
    20,977
    
    
    
    84,337
    
    
    
    
    
    
    
    (65,265
    )
    
    
    40,049Employee compensation and benefits
    
    
    48,391
    
    
    
    552
    
    
    
    
    
    
    
    (10,091
    )
    
    
    38,852Depreciation and amortization
    
    
    2,928
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    2,934Operating expenses
    
    
    39,852
    
    
    
    3,516
    
    
    
    1,179
    
    
    
    (21,099
    )
    
    
    23,448Interest expense
    
    
    
    
    
    
    
    
    
    
    2,499
    
    
    
    
    
    
    
    2,499Total expenses
    
    
    112,148
    
    
    
    230,542
    
    
    
    3,678
    
    
    
    (96,455
    )
    
    
    249,913Net income (loss) before income taxes,
minority interest and equity interest
    
    
    19,244
    
    
    
    16,221
    
    
    
    (3,678
    )
    
    
    
    
    
    
    31,787Income tax expense (benefit)
    
    
    6,820
    
    
    
    5,749
    
    
    
    (1,303
    )
    
    
    
    
    
    
    11,266Minority interest, net of tax
    
    
    576
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    576Net income (loss)
    
    $
    11,848
    
    
    $
    10,472
    
    
    $
    (2,375
    )
    
    $
    
    
    
    $
    19,945
 Agency
    
    
    Insurance
    
    
    Corporate
    
    
    
    
    
    
    AffirmativeNine months ended September 30, 2004
    
    Segment
    
    
    Segment
    
    
    Segment
    
    
    Eliminations
    
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    141,276
    
    
    $
    
    
    
    $
    
    
    
    $
    141,276Commission income
    
    
    71,938
    
    
    
    
    
    
    
    
    
    
    
    (45,888
    )
    
    
    26,050Fee income
    
    
    32,457
    
    
    
    21,217
    
    
    
    
    
    
    
    (13,114
    )
    
    
    40,560Claims processing fees
    
    
    20,627
    
    
    
    
    
    
    
    
    
    
    
    (17,929
    )
    
    
    2,698Investment income
    
    
    58
    
    
    
    1,331
    
    
    
    
    
    
    
    
    
    
    
    1,389Realized gains (losses)
    
    
    3
    
    
    
    (12
    )
    
    
    
    
    
    
    
    
    
    
    (9
    )Total revenues
    
    
    125,083
    
    
    
    163,812
    
    
    
    
    
    
    
    (76,931
    )
    
    
    211,964Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    95,325
    
    
    
    
    
    
    
    
    
    
    
    95,325Policy acquisition expenses
    
    
    21,526
    
    
    
    55,711
    
    
    
    
    
    
    
    (35,855
    )
    
    
    41,382Employee compensation and benefits
    
    
    43,170
    
    
    
    
    
    
    
    
    
    
    
    (15,068
    )
    
    
    28,102Depreciation and amortization
    
    
    3,011
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,011Operating expenses
    
    
    35,938
    
    
    
    1,837
    
    
    
    266
    
    
    
    (26,008
    )
    
    
    12,033Interest expense
    
    
    
    
    
    
    
    
    
    
    526
    
    
    
    
    
    
    
    526Total expenses
    
    
    103,645
    
    
    
    152,873
    
    
    
    792
    
    
    
    (76,931
    )
    
    
    180,379Net income (loss) before income taxes,
minority interest and equity interest
    
    
    21,438
    
    
    
    10,939
    
    
    
    (792
    )
    
    
    
    
    
    
    31,585Income tax expense (benefit)
    
    
    7,920
    
    
    
    4,040
    
    
    
    (292
    )
    
    
    
    
    
    
    11,668Minority interest, net of tax
    
    
    581
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    581Equity interest in unconsolidated
subsidiaries, net of tax
    
    
    
    
    
    
    
    
    
    
    596
    
    
    
    
    
    
    
    596Net income (loss)
    
    $
    12,937
    
    
    $
    6,899
    
    
    $
    (1,096
    )
    
    $
    
    
    
    $
    18,740
 17




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##### Table of Contents



11.
    
    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 policy acquisition costs and the related policy acquisition costs
amortized to expense were as follows (dollars in thousands):
 Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004Beginning Deferred Acquisition Costs
    
    $
    27,796
    
    
    $
    12,560
    
    
    $
    19,118
    
    
    $
    14,371Additions
    
    
    30,666
    
    
    
    23,506
    
    
    
    91,976
    
    
    
    59,215Amortization expense
    
    
    (31,705
    )
    
    
    (18,191
    )
    
    
    (84,337
    )
    
    
    (55,711
    )Ending Deferred Acquisition Costs
    
    $
    26,757
    
    
    $
    17,875
    
    
    $
    26,757
    
    
    $
    17,875
 We report our consolidated policy acquisition expense in our Statements of Operations in
the following captions: policy acquisition expenses, operating expenses and employee
compensation and benefits.
 12.
    
    Subsequent EventsOn October 7, 2005, we announced the appointment of Katherine C. Nolan as President, Retail
Division, succeeding George M. Daly, who has resigned from the Company effective November 30,
2005. Ms. Nolan
remains an executive vice president of Affirmative Insurance Holdings, Inc.On October 28, 2005 and pursuant to Section 14(f) of the Securities Exchange Act of 1934 and
Rule 14f-1 thereunder, the Company filed with the SEC a Schedule 14f-1 (Information Statement)
regarding a planned change of majority of the directors of its board. Consistent with such
filing, ten days from the date of mailing of the Information Statement, Lucius E. Burch, III,
Mark E. Pape and Mark E. Watson, resigned as directors of the Company. Messrs Thomas E.
Mangold, Thomas C. Davis and Paul Z. Zucconi and Ms. Suzanne T. Porter remained as directors of
the Company after such resignations and pursuant to a resolution of the Board, increased the
members of the board from seven to nine and filled the five resulting vacancies on the Board by
appointing the following five individuals who, following inquiry by the Board, were designated
by New Affirmative: Kevin R. Callahan, Nimrod T. Frazer, David L. Heller, Avshalom Y.
Kalichstein and Michael J. Ryan.On November 14, 2005, we announced the resignation of
Thomas E. Mangold as chairman, chief executive officer and president,
effective November 13, 2005. Our board appointed Kevin R.
Callahan as interim chairman and chief executive officer effective
November 15, 2005, while a search is conducted for
Mr. Mangold's permanent replacement.
 18




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
  Overview
       19




---



##### Table of Contents



Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,2005
    
    
    2004
    
    
    2005
    
    
    2004(Unaudited in thousands)
    
    
    (Unaudited in thousands)Our underwriting agencies:Our retail stores
    
    $
    25,427
    
    
    $
    30,982
    
    
    $
    90,771
    
    
    $
    96,025Independent agencies
    
    
    42,999
    
    
    
    46,571
    
    
    
    125,944
    
    
    
    141,983Unaffiliated underwriting
agencies
    
    
    11,785
    
    
    
    26,962
    
    
    
    53,428
    
    
    
    82,153Total
    
    $
    80,211
    
    
    $
    104,515
    
    
    $
    270,143
    
    
    $
    320,161
   Results of Operations
  20




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##### Table of Contents



Three months ended
    
    
    Nine months endedSeptember 30,
    
    
    September 30,(Unaudited in thousands)
    
    2005
    
    
    2004
    
    
    2005
    
    
    2004Total Revenues:Agency segment
    
    $
    42,299
    
    
    $
    42,180
    
    
    $
    131,392
    
    
    $
    125,083Insurance segment
    
    
    85,622
    
    
    
    58,113
    
    
    
    246,763
    
    
    
    163,812Corporate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Eliminations
    
    
    (32,106
    )
    
    
    (27,719
    )
    
    
    (96,455
    )
    
    
    (76,931
    )Total
    
    $
    95,815
    
    
    $
    72,574
    
    
    $
    281,700
    
    
    $
    211,964Total Expenses:Agency segment
    
    $
    37,313
    
    
    $
    35,212
    
    
    $
    112,148
    
    
    $
    103,645Insurance segment
    
    
    79,566
    
    
    
    54,106
    
    
    
    230,542
    
    
    
    152,873Corporate
    
    
    1,430
    
    
    
    401
    
    
    
    3,678
    
    
    
    792Eliminations
    
    
    (32,106
    )
    
    
    (27,719
    )
    
    
    (96,455
    )
    
    
    (76,931
    )Total
    
    $
    86,203
    
    
    $
    62,000
    
    
    $
    249,913
    
    
    $
    180,379Pretax Income:Agency segment
    
    $
    4,986
    
    
    $
    6,968
    
    
    $
    19,244
    
    
    $
    21,438Insurance segment
    
    
    6,056
    
    
    
    4,007
    
    
    
    16,221
    
    
    
    10,939Corporate
    
    
    (1,430
    )
    
    
    (401
    )
    
    
    (3,678
    )
    
    
    (792
    )Total
    
    $
    9,612
    
    
    $
    10,574
    
    
    $
    31,787
    
    
    $
    31,585
 Comparison of the Three Months Ended September 30, 2005 to September 30, 2004
 Consolidated.
     21




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##### Table of Contents



Agency segment.
 Three months endedSeptember 30,2005
    
    
    2004(Unaudited in millions)Commissions
    
    $
    23.5
    
    
    $
    24.6Policy and other fees
    
    
    10.8
    
    
    
    10.3Claims processing fees
    
    
    7.9
    
    
    
    7.3Other
    
    
    0.1
    
    
    
    Total
    
    $
    42.3
    
    
    $
    42.2
        22




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##### Table of Contents




    
    Policy acquisition expenses, comprised solely of commission expenses in our agency
segment, for the three months ended September 30, 2005 were $7.6 million, an increase of
$429,000, or 6.0%, as compared to $7.1 million for the same period in 2004. The increase
was principally due to the acquisition of our Michigan underwriting agency in July 2005 as
well as an increase in average commission rate to 17.6% from 15.2% during the same period
of the prior year, partially offset by decreases in total controlled premium in other
underwriting agencies. The increase in average commission rate was primarily caused by a
higher proportion of our premiums written in markets where we pay higher commission rates.
    
    Employee compensation and benefit expenses for the three months ended September 30,
2005 were $16.1 million, an increase of $1.8 million, or 13.0%, as compared to $14.2
million for the same period in 2004. The increase in employee compensation and benefit
expenses was principally due to the increased headcount to 1,221 for the three months
ended September 30, 2005 as compared to 1,123 for the same period in 2004, principally
related to the July 2005 Michigan acquisition, which added 27 employees, and the December
2004 Fed USA acquisition, which added 91 employees, partially offset by natural attrition.
    
    Depreciation and amortization expenses for the three months ended September 30, 2005
were $912,000, a decrease of $254,000, or 21.8%, as compared to $1.2 million for the same
period in 2004. The decrease in depreciation and amortization expenses was principally due
to the acceleration of amortization and depreciation of certain software assets in 2004 to
match their estimated remaining lives, in anticipation of replacing these systems with a
new operating system in 2005.
    
    Operating expenses for the three months ended September 30, 2005 were $12.8 million,
an increase of $77,000, or .6%, as compared to $12.7 million for the same period of 2004.
The increase in operating expenses was principally due to increased payments of allocated
loss adjustment expenses of $877,000. The increase in allocated loss adjustment expense
payments was a result of changes in contractual terms where our payment of allocated loss
adjustment expenses is included in all of our claims administration contracts starting in
2004, where previously our payment of allocated loss adjustment expenses was only included
in some of our contracts. In addition, professional fees increased $854,000 over the prior
period due to increased fees related to complying with the Sarbanes-Oxley Act and
increased audit fees, as well as increased professional fees. Rent expense also increased
$403,000 due to expansion and acquisition of our Michigan underwriting agency. These
increases were offset by a decrease of $445,000 in advertising, $597,000 in licenses,
taxes and fees and other expenses, which was primarily attributable to miscellaneous
write-offs, reductions in bank service charges and other miscellaneous expenses, as well
as $1.0 million increase in expenses allocated to our Insurance segment in 2005.
  Insurance company segment.
   23




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##### Table of Contents



Corporate and other segment.
 Comparison of the Nine Months Ended September 30, 2005 to September 30, 2004
 Consolidated.
  24




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##### Table of Contents



Agency segment.
 Nine months endedSeptember 30,2005
    
    
    2004(Unaudited in millions)Commissions
    
    $
    75.2
    
    
    $
    71.9Policy and other fees
    
    
    32.6
    
    
    
    32.5Claims processing fees
    
    
    23.5
    
    
    
    20.6Investment income
    
    
    0.1
    
    
    
    0.1Total
    
    $
    131.4
    
    
    $
    125.1
      25




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##### Table of Contents




    
    Policy acquisition expenses, comprised solely of commission expenses in our agency
segment, for the nine months ended September 30, 2005 were $21.0 million, a decrease of
$549,000, or 2.6%, as compared to $21.5 million for the same period in 2004. The decrease
was principally due to the decrease in Total Controlled Premium and partially offset by an
increase in average commission rate to 16.6% from 15.1% during the same period of the
prior year. The increase in average commission rate was primarily caused by a higher
proportion of our premiums written in markets where we pay higher commission rates.
    
    Employee compensation and benefit expenses for the nine months ended September 30,
2005 were $48.4 million, an increase of $5.2 million, or 12.1%, as compared to $43.2
million for the same period in 2004. The increase in employee compensation and benefit
expenses was principally due to increased headcount to 1,221 at September 30, 2005 as
compared to 1,123 for the same period in 2004, principally related to the December 2004
Fed USA acquisition, which added 91 employees, offset by natural attrition.
    
    Depreciation and amortization expenses for the nine months ended September 30, 2005
were $2.9 million, a decrease of $83,000, or 2.8%, as compared to $3.0 million for the
same period in 2004. The decreases in depreciation and amortization expenses were
principally due to the acceleration of amortization and depreciation of certain software
assets to match their estimated remaining lives, in anticipation of replacing these
systems with a new operating system in 2005, offset by increases in software and hardware
purchases.
    
    Operating expenses for the nine months ended September 30, 2005 were $39.9 million,
an increase of $3.9 million, or 10.9%, as compared to $35.9 million for the same period in
2004. The increase in operating expenses was principally due to additional payments of
allocated loss adjustment expenses of $3.2 million,
as compared to the same period in the prior year. The increase in allocated loss adjustment
expense payments is a result of changes in contractual terms where our payment of allocated
loss adjustment expenses is included in all of our claims administration contracts starting
in 2004, where previously our payment of allocated loss adjustment expenses was only
included in some of our contracts. We also increased advertising expenditures $597,000 over
the same period in the prior year as we continued expansion of our retail branding.
Professional fees increased $1.8 million over the same period in the prior year due to
increased audit fees, fees associated with the Sarbanes-Oxley Act and increased professional
fees. Rent expense increased $873,000 due to expansion of existing facilities and
acquisition of our Michigan underwriting agency. These increases were partially offset by a
decrease of $750,000 in licenses, taxes and fees and $1.2 million in other expenses, which
was primarily attributable to reductions in bank service charges and other miscellaneous
expenses, as well as $2.7 million increase in expenses allocated to our Insurance segment in
2005.
  Insurance company segment.
 26




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##### Table of Contents



Corporate and other segment.
 27




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##### Table of Contents



Liquidity and Capital Resources
 Sources and uses of funds.
       28




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##### Table of Contents



As ofSeptember 30,
    
    December 31,($ in thousands)
    
    2005
    
    2004Invested assets
    
    $
    179,256
    
    
    $
    159,661Tax equivalent book yield
    
    
    4.24
    %
    
    
    4.03
    %Average duration in years
    
    
    3.8
    
    
    
    3.8Average S&P rating
    
    AA+
    
    
    AA+
   Initial public offering.
 Credit facility.
 29




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##### Table of Contents



Trust Preferred Securities.
 New Accounting Pronouncements
 The Meaning of Other-Than Temporary Impairment and Its Application to Certain Investments. Accounting for Certain Investments in Debt and Equity Securities,
 Share-Based Compensation, Accounting for Stock-Based Compensation, Accounting for Stock Issued to Employees,
 30




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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.
   31




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##### Table of Contents



Effects of inflation.
 
 Item 4. Controls and Procedures
   32




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##### Table of Contents



PART II
 
 Item 1. Legal Proceedings
     33




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##### Table of Contents



th
 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  Total
    
    
    
    
    
    
    Total Number of
    
    
    Maximum NumberNumber of
    
    
    
    
    
    
    Shares purchased as
    
    
    of Shares that mayShares
    
    
    Average
    
    
    part of Publicly
    
    
    yet be PurchasedPurchased
    
    
    Price Paid
    
    
    Announced Plans or
    
    
    under the Plans orPeriod
    
    (1)
    
    
    Per Share
    
    
    Programs
    
    
    Programs6/1/2005 - 6/1/2005
    
    
    2,000,000
    
    
    $
    14.00
    
    
    
    2,000,000
    
    
    
    
 
 (1)
    
    Under a share repurchase program announced on May 19, 2005, we were
authorized to repurchase up to $28.0 million of our common stock from Vesta. 
 Item 3. Defaults Upon Senior Securities
  
 Item 4. Submission of Matters to a Vote of Security Holders
  
 Item 5. Other information
  34




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##### Table of Contents



Item 6. Exhibits
 a)
    
    EXHIBITS3.1
    
    Amended and Restated Certificate of Incorporation of Affirmative Insurance Holdings, Inc.
(incorporated by reference to Exhibit 3.1 to our Registration Statement on Form S-1 filed with the
SEC on March 22, 2004, File No. 333-113793).3.2
    
    Amended and Restated Bylaws of Affirmative Insurance Holdings, Inc. (incorporated by reference to
Exhibit 3.2 to our Registration Statement on Form S-1 filed with the SEC on March 22, 2004, File
No. 333-113793).4.1
    
    Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to
our Registration Statement on Form S-1 filed with the SEC on June 14, 2004, File No. 333-113793).4.2
    
    Form of Registration Rights Agreement between Affirmative Insurance Holdings, Inc. and Vesta
Insurance Group, Inc. (incorporated by reference to Exhibit 4.2 to Amendment No. 2 to our
Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).10.1
    
    Form of Restricted Stock Agreement (incorporated by reference to Exhibit 10.2 to our Current
Report on Form 8-K filed with the SEC on July 22, 2005, File No. 000-50795). +10.2
    
    Form of Change of Control Agreement (incorporated by reference to Exhibit 10.1 to our Current
Report on Form 8-K filed with the SEC on July 22, 2005, File No. 000-50795). +10.3
    
    First Amendment to Credit Agreement and Waiver of Defaults between Affirmative Insurance Holdings,
Inc. and the Frost National Bank dated August 12, 2005 (incorporated by reference to Exhibit 10.3
of our Quarterly Report on Form 10-Q filed with the SEC on August 15, 2005, File No. 000-50795).*10.4
    
    Second Amendment to Credit Agreement and Waiver of Defaults between Affirmative Insurance
Holdings, Inc. and the Frost National Bank dated September 30, 2005.*10.5
    
    Separation Agreement and General Release (including Supplemental General Release Agreement
attached as Exhibit A) (incorporated by reference to Exhibit 10.1 of our Current Report on Form
8-K filed with the SEC on October 13, 2005, File No. 000-50795).*31.1
    
    Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.*31.2
    
    Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.*32.1
    
    Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*32.2
    
    Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 *
    
    Filed herewith+
    
    Management contract, compensatory plan or arrangement. 35




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##### Table of Contents



Signatures
  Affirmative Insurance Holdings, Inc.Date: November 14, 2005/s/ Timothy A. BienekBy: Timothy A. BienekExecutive Vice President and Chief Financial Officer(and in his capacity as Principal Financial Officer)
 36




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##### Table of Contents



EXHIBITS INDEX
 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
    
    Form of Restricted Stock Agreement (incorporated by reference to Exhibit 10.2 to our Current
Report on Form 8-K filed with the SEC on July 22, 2005, File No. 000-50795). +10.2
    
    Form of Change of Control Agreement (incorporated by reference to Exhibit 10.1 to our Current
Report on Form 8-K filed with the SEC on July 22, 2005, File No. 000-50795). +10.3
    
    First Amendment to Credit Agreement and Waiver of Defaults between Affirmative Insurance Holdings,
Inc. and the Frost National Bank dated August 12, 2005 (incorporated by reference to Exhibit 10.3
of our Quarterly Report on Form 10-Q filed with the SEC on August 15, 2005, File No. 000-50795).*10.4
    
    Second Amendment to Credit Agreement and Waiver of Defaults between Affirmative Insurance
Holdings, Inc. and the Frost National Bank dated September 30, 2005.*10.5
    
    Separation Agreement and General Release (including Supplemental General Release Agreement
attached as Exhibit A) (incorporated by reference to Exhibit 10.1 of our Current Report on Form
8-K filed with the SEC on October 13, 2005, File No. 000-50795).*31.1
    
    Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.*31.2
    
    Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.*32.1
    
    Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*32.2
    
    Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 *
    
    Filed herewith+
    
    Management contract, compensatory plan or arrangement. 37