##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549
 FORM 10-Q
 (Mark One)
 þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 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




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Affirmative Insurance Holdings, Inc.
 Index
 PagePart I Financial InformationItem 1. Financial Statements (unaudited)Consolidated Balance Sheets as of June 30, 2005 and December 31, 2004
    
    
    1Consolidated Statements of Operations for the Three and Six Months Ended June 30, 2005 and 2004
    
    
    2Consolidated Statements of Stockholders Equity and Comprehensive Income
for the Six Months Ended June 30, 2005 and 2004
    
    
    3Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2005 and 2004
    
    
    4Notes to Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    27Item 4. Controls and Procedures
    
    
    28Part II Other InformationItem 1. Legal Proceedings
    
    
    29Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    30Item 3. Defaults Upon Senior Securities
    
    
    30Item 4. Submission of Matters to a Vote of Security Holders
    
    
    30Item 5. Other Information
    
    
    30Item 6. Exhibits
    
    
    31Signatures
    
    
    31Amended Credit FacilityCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906




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##### Table of Contents



Part I
 
 Item 1. Financial Statements
 Affirmative Insurance Holdings, Inc.
 
 Consolidated Balance Sheets  (Unaudited)
 June 30, 2005 and December 31, 2004
 June 30,
    
    December 31,(dollars in thousands, except share data)
    
    2005
    
    2004AssetsFixed maturities  available for sale, at fair value (amortized cost 2005: $162,653; 2004: $157,296)
    
    $
    162,307
    
    
    $
    157,666Short-term investments
    
    
    
    
    
    
    1,995162,307
    
    
    
    159,661Cash and cash equivalents
    
    
    41,360
    
    
    
    24,096Fiduciary and restricted cash
    
    
    24,470
    
    
    
    16,267Accrued investment income
    
    
    2,098
    
    
    
    1,979Premiums and fees receivable (includes related parties - 2005: $20,130; 2004: $30,980)
    
    
    114,345
    
    
    
    107,411Commissions
receivable (includes related parties  2005: $3,261; 2004: $5,136)
    
    
    9,964
    
    
    
    11,890Receivable from reinsurers (includes related parties  2005: $14,815; 2004: $28,873)
    
    
    46,048
    
    
    
    75,403Deferred acquisition costs
    
    
    27,796
    
    
    
    19,118Receivable from affiliates
    
    
    3
    
    
    
    310Deferred tax asset
    
    
    7,568
    
    
    
    6,637Federal income tax receivable
    
    
    180
    
    
    
    Property and equipment, net
    
    
    7,349
    
    
    
    6,485Goodwill
    
    
    68,530
    
    
    
    67,430Other intangible assets, net
    
    
    17,976
    
    
    
    18,361Other assets
    
    
    6,684
    
    
    
    5,872Total assets
    
    $
    536,678
    
    
    $
    520,920Liabilities and Stockholders EquityLiabilitiesReserves for
losses and loss adjustment expenses (includes related parties 
2005: $23,679; 2004: $23,037)
    
    
    113,068
    
    
    
    93,030Unearned premium (includes related parties  2005: $13,430; 2004: $16,921)
    
    
    112,242
    
    
    
    90,695Amounts due reinsurers (includes related parties  2005: $4,565; 2004: $9,640)
    
    
    15,187
    
    
    
    43,167Deferred revenue
    
    
    27,948
    
    
    
    24,478Federal income taxes payable
    
    
    
    
    
    
    7,526Notes payable
    
    
    56,702
    
    
    
    30,928Consideration due for acquisitions
    
    
    1,056
    
    
    
    1,098Other liabilities
    
    
    20,064
    
    
    
    24,692Total liabilities
    
    
    346,267
    
    
    
    315,614Commitments and contingencies (Note 6)Stockholders equityCommon stock, $0.01 par value; 75,000,000 shares authorized, 14,860,253 and 16,838,519 shares
outstanding at June 30, 2005 and December 31, 2004, respectively
    
    
    169
    
    
    
    168Additional paid-in capital
    
    
    152,049
    
    
    
    151,752Treasury stock, at cost; 2,000,000 and 0 shares at June 30, 2005 and December 31, 2004, respectively
    
    
    (28,000
    )
    
    
    Accumulated other comprehensive (loss) income
    
    
    (226
    )
    
    
    251Retained earnings
    
    
    66,419
    
    
    
    53,135Total stockholders equity
    
    
    190,411
    
    
    
    205,306Total liabilities and stockholders equity
    
    $
    536,678
    
    
    $
    520,920
 1




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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Operations  (Unaudited)
 Three and Six Months Ended June 30, 2005 and 2004
 Three months ended
    
    Six months endedJune 30,
    
    June 30,(dollars in thousands, except per share data)
    
    2005
    
    2004
    
    2005
    
    2004RevenuesNet premiums earned
    
    $
    77,441
    
    
    $
    43,738
    
    
    $
    145,377
    
    
    $
    90,948Commission
income (includes related parties  three months, 2005: $310; 2004: $138; six months, 2005: $121; 2004: $787)
    
    
    3,633
    
    
    
    8,276
    
    
    
    7,441
    
    
    
    19,200Fee income
    
    
    13,563
    
    
    
    13,826
    
    
    
    27,191
    
    
    
    27,317Claims processing fees
    
    
    2,794
    
    
    
    1,009
    
    
    
    3,260
    
    
    
    1,355Net investment income
    
    
    1,353
    
    
    
    363
    
    
    
    2,610
    
    
    
    590Realized gains (losses)
    
    
    3
    
    
    
    (3
    )
    
    
    6
    
    
    
    (20
    )Total revenues
    
    
    98,787
    
    
    
    67,209
    
    
    
    185,885
    
    
    
    139,390ExpensesLosses and loss adjustment expenses
    
    
    51,217
    
    
    
    28,149
    
    
    
    95,784
    
    
    
    59,857Policy acquisition expenses
    
    
    13,666
    
    
    
    13,620
    
    
    
    28,169
    
    
    
    26,273Employee compensation and benefits
    
    
    13,584
    
    
    
    10,230
    
    
    
    22,943
    
    
    
    20,909Depreciation and amortization
    
    
    993
    
    
    
    961
    
    
    
    2,022
    
    
    
    1,845Operating expenses
    
    
    8,791
    
    
    
    4,821
    
    
    
    13,417
    
    
    
    9,104Interest expense
    
    
    796
    
    
    
    174
    
    
    
    1,375

    
    
    
    391Total expenses
    
    
    89,047
    
    
    
    57,955
    
    
    
    163,710
    
    
    
    118,379Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    9,740
    
    
    
    9,254
    
    
    
    22,175
    
    
    
    21,011Income tax expense
    
    
    3,452
    
    
    
    3,311
    
    
    
    7,858
    
    
    
    7,518Minority interest, net of income taxes
    
    
    326
    
    
    
    212
    
    
    
    359
    
    
    
    307Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    
    
    
    
    250
    
    
    
    
    
    
    
    423Net income
    
    $
    5,962
    
    
    $
    5,481
    
    
    $
    13,958
    
    
    $
    12,763Net income per common share  Basic
    
    $
    0.37
    
    
    $
    0.47
    
    
    $
    0.84
    
    
    $
    1.10Net income per common share  Diluted
    
    $

    0.36
    
    
    $
    0.47
    
    
    $
    0.83
    
    
    $
    1.09Weighted average shares outstandingBasic
    
    
    16,218,769
    
    
    
    11,671,883
    
    
    
    16,530,619
    
    
    
    11,627,149Diluted
    
    
    16,434,410
    
    
    
    11,770,892
    
    
    
    16,774,473
    
    
    
    11,735,771
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated
Statements of Stockholders Equity and Comprehensive Income  (Unaudited)
 Six Months Ended June 30, 2005 and 2004
 AccumulatedAdditional
    
    
    
    
    
    
    
    
    
    Other
    
    TotalCommon Stock
    
    
    
    
    
    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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,763
    
    
    
    
    
    
    
    
    
    
    
    12,763Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (675
    )
    
    
    (675
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,088Issuance of common stock
    
    
    114,668
    
    
    
    1
    
    
    
    (157
    )
    
    
    1,156
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,000Balance, June 30, 2004
    
    
    11,671,883
    
    
    $
    117
    
    
    $
    
    
    
    $
    85,230
    
    
    $
    41,802
    
    
    $
    
    
    
    $
    (684
    )
    
    $
    126,465Balance, December 31, 2004
    
    
    16,838,519
    
    
    $
    168
    
    
    $
    
    
    
    $
    151,752
    
    
    $
    53,135
    
    
    $
    
    
    
    $
    251
    
    
    $
    205,306Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,958
    
    
    
    
    
    
    
    
    
    
    
    13,958Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (477
    )
    
    
    (477
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,481Purchase of treasury stock
    
    
    (2,000,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (28,000
    )
    
    
    
    
    
    
    (28,000
    )Dividends
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (674
    )
    
    
    
    
    
    
    
    
    
    
    (674
    )Initial public offering costs
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22
    )Equity based compensation
    
    
    21,734
    
    
    
    1
    
    
    
    
    
    
    
    319
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    320Balance, June 30, 2005
    
    
    14,860,253
    
    
    $
    169
    
    
    $
    
    
    
    $
    152,049
    
    
    $
    66,419
    
    
    $
    (28,000
    )
    
    $
    (226
    )
    
    $
    190,411
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##### Table of Contents



Affirmative Insurance Holdings, Inc.
 
 Consolidated Statements of Cash Flows  (Unaudited)
 Six Months Ended June 30, 2005 and 2004
 Six months endedJune 30,2005
    
    2004(dollars in thousands)Cash flows from operating activitiesNet income
    
    $
    13,958
    
    
    $
    12,763Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    2,022
    
    
    
    1,845Undistributed equity in unconsolidated subsidiaries
    
    
    
    
    
    
    423Equity based compensation
    
    
    73
    
    
    
    Realized (gains) losses
    
    
    (6
    )
    
    
    20Amortization of discount on investment
    
    
    1,274
    
    
    
    Changes in assets and liabilities:Fiduciary and restricted cash
    
    
    (8,203
    )
    
    
    (2,971
    )Premiums, fees and commissions receivable
    
    
    (5,008
    )
    
    
    (47,383
    )Reserves for loss and loss expenses
    
    
    20,038
    
    
    
    28,907Amounts due reinsurers
    
    
    1,375
    
    
    
    9,140Receivable from affiliates
    
    
    307
    
    
    
    (438
    )Deferred revenue
    
    
    3,470
    
    
    
    5,525Unearned premiums
    
    
    21,547
    
    
    
    14,659Deferred acquisition costs
    
    
    (8,678
    )
    
    
    1,811Federal income taxes payable
    
    
    (7,526
    )
    
    
    5,570Other
    
    
    (4,067
    )
    
    
    9,825Net cash provided by operating activities
    
    
    30,576
    
    
    
    39,696Cash flows from investing activitiesProceeds from the sale of bonds
    
    
    3,170
    
    
    
    4,278Cost of bonds acquired
    
    
    (8,506
    )
    
    
    (12,491
    )Purchases of property and equipment
    
    
    (2,507
    )
    
    
    (1,840
    )Net cash paid for acquisitions
    
    
    (1,142
    )
    
    
    (1,946
    )Net cash used in investing activities
    
    
    (8,985
    )
    
    
    (11,999
    )Cash flows from financing activitiesPrincipal payments under capital lease obligation
    
    
    
    
    
    
    (341
    )Proceeds from borrowings
    
    
    24,369
    
    
    
    Repayments of borrowings
    
    
    
    
    
    
    (4,195
    )Proceeds from issuance of common stock
    
    
    
    
    
    
    927Initial public offering costs
    
    
    (22
    )
    
    
    Acquisition of treasury stock
    
    
    (28,000
    )
    
    
    Dividends paid
    
    
    (674
    )
    
    
    Net cash used in financing activities
    
    
    (4,327
    )
    
    
    (3,609
    )Net increase in cash and cash equivalents
    
    
    17,264
    
    
    
    24,088Cash and cash equivalents, beginning of period
    
    
    24,096
    
    
    
    15,358Cash and cash equivalents, end of period
    
    $
    41,360
    
    
    $
    39,446
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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 183 owned and 46 franchise retail store locations as of June 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. As of June 30, 2005, Vesta
beneficially owned approximately 35.1% of our outstanding common stock.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 is
owned equally between J.C. Flowers I LP and Delaware Street Capital Master Fund, LP, who
currently owns a combined total of 2,642,699 shares of our common stock, or 17.8%. This
transaction is subject to customary closing conditions and regulatory approval by the Illinois
Department of Financial and Professional Regulation  Division of Insurance and other required
filings. If this transaction is approved and closed, New Affirmative will own approximately
52.9% of our outstanding common stock.2.
    
    Summary of Significant Accounting PoliciesBasis of PresentationOur unaudited consolidated financial statements included herein have been prepared in accordance
with accounting principles generally accepted in the United States of America (GAAP) and
include our accounts and the accounts of our operating subsidiaries. All significant
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 for the year
ended December 31, 2004 included in our report on Form 10-K filed with the SEC.The interim financial data as of June 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.
 5




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##### Table of Contents



Use of Estimates in the Preparation of the Financial StatementsOur preparation of financial statements in conformity with accounting principles generally
accepted in the United States of America 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 costs of the
acquired stock is recorded as treasury stock. Upon reissuance, the cost of treasury shares held
is 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
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004Net income, as reported
    
    $
    5,962
    
    
    $
    5,481
    
    
    $
    13,958
    
    
    $
    12,763Deduct: total stock-based compensation expense
determined under fair value based method for all awards,
net of related income taxes
    
    
    (193
    )
    
    
    (24
    )
    
    
    (385
    )
    
    
    (46
    )Net income, pro forma
    
    $
    5,769
    
    
    $
    5,457
    
    
    $
    13,573
    
    
    $
    12,717Basic earnings per share  as reported
    
    $
    0.37
    
    
    $
    0.47
    
    
    $
    0.84
    
    
    $
    1.10Basic earnings per share  pro forma
    
    $
    0.36
    
    
    $
    0.47
    
    
    $
    0.82
    
    
    $
    1.09Diluted earnings per share  as reported
    
    $
    0.36
    
    
    $
    0.47
    
    
    $
    0.83
    
    
    $
    1.09Diluted earnings per share  pro forma
    
    $
    0.35
    
    
    $
    0.46
    
    
    $
    0.81
    
    
    $
    1.08
 Recently Issued Accounting Standards
 The Meaning of Other-Than Temporary Impairment and Its Application to Certain Investments. Accounting for Certain Investments in Debt and Equity Securities,
 6




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##### Table of Contents



Share-Based Compensation, Accounting for Stock-Based Compensation, Accounting for Stock Issued to Employees,
 3.
    
    ReinsuranceThe effect of reinsurance on premiums written and earned is as follows (dollars in thousands):
 Three months ended
    
    Three months endedJune 30, 2005
    
    June 30, 2004Written
    
    Earned
    
    Written
    
    EarnedDirect
    
    $
    39,277
    
    
    $
    45,622
    
    
    $
    41,237
    
    
    $
    37,792Assumed  affiliate
    
    
    11,481
    
    
    
    12,686
    
    
    
    22,514
    
    
    
    35,717Assumed  non affiliate
    
    
    23,443
    
    
    
    23,638
    
    
    
    2,795
    
    
    
    1,980Ceded  affiliate
    
    
    (162
    )
    
    
    (301
    )
    
    
    (2,765
    )
    
    
    (14,476
    )Ceded  non affiliate
    
    
    (1,350
    )
    
    
    (4,204
    )
    
    
    (21,804
    )
    
    
    (17,275
    )$
    72,689
    
    
    $
    77,441
    
    
    $
    41,977
    
    
    $
    43,738
 Six months ended
    
    Six months endedJune 30, 2005
    
    June 30, 2004Written
    
    Earned
    
    Written
    
    EarnedDirect
    
    $
    94,445
    
    
    $
    90,633
    
    
    $
    92,849
    
    
    $
    70,531Assumed  affiliate
    
    
    22,798
    
    
    
    26,289
    
    
    
    44,906
    
    
    
    60,428Assumed  non affiliate
    
    
    62,060
    
    
    
    40,832
    
    
    
    8,547
    
    
    
    684Ceded  affiliate
    
    
    (162
    )
    
    
    (610
    )
    
    
    (3,024
    )
    
    
    (15,646
    )Ceded  non affiliate
    
    
    (2,342
    )
    
    
    (11,767
    )
    
    
    (55,020
    )
    
    
    (25,049
    )$
    176,799
    
    
    $
    145,377
    
    
    $
    88,258
    
    
    $
    90,948
 7




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##### Table of Contents



As of June 30,
    
    As of December 31,2005
    
    2004AffiliateLoss and loss adjustment expense
    
    $
    19,864
    
    
    $
    23,815Unearned premiums
    
    
    192
    
    
    
    656Total
    
    $
    20,056
    
    
    $
    24,471Non affiliateLoss and loss adjustment expense
    
    $
    14,944
    
    
    $
    18,087Unearned premiums
    
    
    4,121
    
    
    
    13,530Total
    
    $
    19,065
    
    
    $
    31,617
      Accounting and Reporting for Reinsurance of Short-Duration and
Long-Duration Contracts
  8




---



##### Table of Contents



4.
    
    Related Party TransactionsWe provide various services for Vesta and its subsidiaries, including underwriting, premium
processing, and claims processing. For the three and six months ended June 30, the accompanying
unaudited consolidated statements of operations reflect these services as follows (dollars in
thousands):
 Three months ended
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004Commission income
    
    $
    310
    
    
    $
    138
    
    
    $
    121
    
    
    $
    787
  9




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##### Table of Contents



June 30,
    
    December 31,2005
    
    2004AssetsPremiums and fees receivable
    
    $
    20,130
    
    
    $
    30,980Commissions receivable
    
    
    3,261
    
    
    
    5,136Receivable from reinsurer
    
    
    14,815
    
    
    
    28,873Receivable from affiliates
    
    
    3
    
    
    
    310$
    38,209
    
    
    $
    65,299LiabilitiesLoss and loss adjustment expense
    
    $
    23,679
    
    
    $
    23,037Unearned premium
    
    
    13,430
    
    
    
    16,921Amounts due reinsurers
    
    
    4,565
    
    
    
    9,640$
    41,674
    
    
    $
    49,598
  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.The former president of InsureOne, a wholly-owned subsidiary, James Hallberg, is a defendant,
along with eight former employees of InsureOne and two of Hallbergs family trusts, in actions
we brought in the Circuit Court of Cook County, Illinois in December 2003 and in the United
States District Court for the Eastern District of Missouri in February 2004 to enforce
non-compete and non-solicitation agreements entered into with those employees. Both courts
entered interim orders prohibiting all defendants, including Hallberg, from hiring any employees
of InsureOne or one of our other underwriting agencies. The order expired in the Missouri action
in November of 2004, but 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, the former president of InsureOne 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
 10




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##### Table of Contents



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. In the Missouri action, the parties
filed a joint motion for voluntary dismissal which was granted by the Court without prejudice
and provided for the right of each party to re-file.On May 6, 2004, the former minority owners of our InsureOne retail agency, including InsureOnes
former president 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, that 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.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.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.Affirmative Insurance Company, a 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, which beneficially
owned approximately 35.1% of our outstanding common stock at June 30,
2005. The other named defendants SCJ Insurance Services, Prompt Insurance Services, Paul Ruelas,
and Anthony David Medina are unaffiliated persons to Affirmative.This matter is currently proceeding through pre-trial discovery and depositions of pertinent
witnesses in preparation for a February 6, 2006 trial date. 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
(see Note 11 for further detail). Hawaiian and the other defendants thereto believe these
allegations are without merit and are vigorously contesting the claims brought by the plaintiffs
and exercising all available rights and remedies against them; however, the ultimate outcome of
this matter is uncertain.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 is on
file with the Court, as is the plaintiffs motion to withdraw as
counsel. 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. If the
plaintiffs hire replacement counsel, it is projected that the Court
will make a ruling on the defendants motion to dismiss for
improper venue by mid-to-late October. If the defendants motion
to dismiss for improper venue is successful, the case will be dismissed, but the Plaintiffs
will be entitled to re-file the case in Texas. No substantive proceedings have occurred in the
case. We believe that the allegations are
without merit and are
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##### Table of Contents



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.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 six months ended June 30, 2005, we executed letters of credit under this credit
facility of approximately $2.3 million to collateralize a loss corridor position with certain of
our reinsurers, all of which were still outstanding as of June 30, 2005. Total fees were
approximately $13,000. As of June 30, 2005, there were no outstanding loan amounts due under our
credit facility, and we are in compliance with all of our financial covenants.Our Credit Agreement requires us to provide the bank with
written notification and documents related to certain events. As of June 30, 2005, we were not in compliance with these covenants which thereby created technical defaults under the Credit Agreement. 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 2005.8.
    
    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 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 six
months ended June 30, 2005 was approximately $50,000 and $73,000, 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.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:
 12




---



##### Table of Contents



Income
    
    Shares
    
    Per Share(Numerator)
    
    (Denominator)
    
    Amount(dollars in thousands, except number ofshares and per share amounts)Three months ended June 30, 2005Basic Earnings per ShareNet Income
    
    $
    5,962
    
    
    
    16,218,769
    
    
    $
    0.37Diluted Earnings per ShareNet Income
    

    $
    5,962
    
    
    
    16,218,769
    
    
    $
    0.37Effect of Dilutive Securities
    
    
    
    
    
    
    215,641
    
    
    
    (0.01
    )$
    5,962
    
    
    
    16,434,410
    
    
    $
    0.36Three months ended June 30, 2004Basic Earnings per ShareNet Income
    
    $
    5,481
    
    
    
    11,671,883
    
    
    $
    0.47Diluted Earnings per ShareNet Income
    
    $
    5,481
    
    
    
    11,671,883
    
    
    $
    0.47Effect of Dilutive Securities
    
    
    
    
    
    
    99,009
    
    
    
    $
    5,481
    
    
    
    11,770,892
    
    
    $
    0.47Six months ended June 30, 2005Basic Earnings per ShareNet Income
    
    $
    13,958
    
    
    
    16,530,619
    
    
    $
    0.84Diluted Earnings per ShareNet Income
    
    $
    13,958
    
    
    
    16,530,619
    
    
    $
    0.84Effect of Dilutive Securities
    
    
    
    
    
    
    243,854
    
    
    
    (0.01
    )$
    13,958
    
    
    
    16,774,473
    
    
    $
    0.83Six months ended June 30, 2004Basic Earnings per ShareNet Income
    
    $
    12,763
    
    
    
    11,627,149
    
    
    $
    1.10Diluted Earnings per ShareNet Income
    
    $
    12,763
    
    
    
    11,627,149
    
    
    $
    1.10Effect of Dilutive Securities
    
    
    
    
    
    
    108,622
    
    
    
    (0.01
    )$
    12,763
    
    
    
    11,735,771
    
    
    $
    1.09
 10. Segment Information
 Disclosures about Segments of an
Enterprise and Related Information
   13




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##### Table of Contents



Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeThree months ended June 30, 2005
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    77,441
    
    
    $
    
    
    
    $
    
    
    
    $
    77,441Commission income
    
    
    22,351
    
    
    
    
    
    
    
    
    
    
    
    (18,718
    )
    
    
    3,633Fee income
    
    
    10,906
    
    
    
    6,319
    
    
    
    
    
    
    
    (3,662
    )
    
    
    13,563Claims processing fees
    
    
    8,075
    
    
    
    
    
    
    
    
    
    
    
    (5,281
    )
    
    
    2,794Investment income
    
    
    45
    
    
    
    1,308
    
    
    
    
    
    
    
    
    
    
    
    1,353Realized gains
    
    
    3
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3Total revenues
    
    
    41,380
    
    
    
    85,068
    
    
    
    
    
    
    
    (27,661
    )
    
    
    98,787Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    51,217
    
    
    
    
    
    
    
    
    
    
    
    51,217Policy acquisition expenses
    
    
    5,872
    
    
    
    27,474
    
    
    
    
    
    
    
    (19,680
    )
    
    
    13,666Employee compensation and benefits
    
    
    15,716
    
    
    
    207
    
    
    
    
    
    
    
    (2,339
    )
    
    
    13,584Depreciation and amortization
    
    
    987
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    993Operating expenses
    
    
    12,737
    
    
    
    1,187
    
    
    
    509
    
    
    
    (5,642
    )
    
    
    8,791Interest expense
    
    
    
    
    
    
    
    
    
    
    796
    
    
    
    
    
    
    
    796Total expenses
    
    
    35,312
    
    
    
    80,091
    
    
    
    1,305
    
    
    
    (27,661
    )
    
    
    89,047Net income (loss) before income taxes,
minority interest and equity interest
    
    
    6,068
    
    
    
    4,977
    
    
    
    (1,305
    )
    
    
    
    
    
    
    9,740Income tax expense (benefit)
    
    
    2,150
    
    
    
    1,764
    
    
    
    (462
    )
    
    
    
    
    
    
    3,452Minority interest, net of tax
    
    
    326
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    326Net income (loss)
    
    $
    3,592
    
    
    $
    3,213
    
    
    $
    (843
    )
    
    $
    
    
    
    $
    5,962Total assets
    
    $
    141,415
    
    
    $
    391,930
    
    
    $
    3,333
    
    
    $
    
    
    
    $
    536,678
 Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeThree months ended June 30, 2004
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    43,738
    
    
    $
    
    
    
    $
    
    
    
    $
    43,738Commission income
    
    
    21,956
    
    
    
    
    
    
    
    
    
    
    
    (13,680
    )
    
    
    8,276Fee income
    
    
    11,244
    
    
    
    7,114
    
    
    
    
    
    
    
    (4,532
    )
    
    
    13,826Claims processing fees
    
    
    7,128
    
    
    
    
    
    
    
    
    
    
    
    (6,119
    )
    
    
    1,009Investment income
    
    
    17
    
    
    
    346
    
    
    
    
    
    
    
    
    
    
    
    363Realized gains (losses)
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Total revenues
    
    
    40,345
    
    
    
    51,195
    
    
    
    
    
    
    
    (24,331
    )
    
    
    67,209Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    28,149
    
    
    
    
    
    
    
    
    
    
    
    28,149Policy acquisition expenses
    
    
    6,355
    
    
    
    19,494
    
    
    
    
    
    
    
    (12,229
    )
    
    
    13,620Employee compensation and benefits
    
    
    14,289
    
    
    
    
    
    
    
    
    
    
    
    (4,059
    )
    
    
    10,230Depreciation and amortization
    
    
    961
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    961Operating expenses
    
    
    12,361
    
    
    
    503
    
    
    
    
    
    
    
    (8,043
    )
    
    
    4,821Interest expense
    
    
    
    
    
    
    
    
    
    
    174
    
    
    
    
    
    
    
    174Total expenses
    
    
    33,966
    
    
    
    48,146
    
    
    
    174
    
    
    
    (24,331
    )
    
    
    57,955Net income (loss) before income taxes,
minority interest and equity interest
    
    
    6,379
    
    
    
    3,049
    
    
    
    (174
    )
    
    
    
    
    
    
    9,254Income tax expense (benefit)
    
    
    2,282
    
    
    
    1,091
    
    
    
    (62
    )
    
    
    
    
    
    
    3,311Minority interest, net of tax
    
    
    212
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    212Equity interest in unconsolidated subsidiaries, net of tax
    
    
    
    
    
    
    
    
    
    
    250
    
    
    
    
    
    
    
    250Net income (loss)
    
    $
    3,885
    
    
    $
    1,958
    
    
    $
    (362
    )
    
    $
    
    
    
    $
    5,481Total assets
    
    $
    151,006
    
    
    $
    267,950
    
    
    $
    2,984
    
    
    $
    
    
    
    $
    421,940
 14




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##### Table of Contents



Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeSix months ended June 30, 2005
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    145,377
    
    
    $
    
    
    
    $
    
    
    
    $
    145,377Commission income
    
    
    51,649
    
    
    
    
    
    
    
    
    
    
    
    (44,208
    )
    
    
    7,441Fee income
    
    
    21,753
    
    
    
    13,245
    
    
    
    
    
    
    
    (7,807
    )
    
    
    27,191Claims processing fees
    
    
    15,594
    
    
    
    
    
    
    
    
    
    
    

    (12,334
    )
    
    
    3,260Investment income
    
    
    91
    
    
    
    2,519
    
    
    
    
    
    
    
    
    
    
    
    2,610Realized gains
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    6Total revenues
    
    
    89,093
    
    
    
    161,141
    
    
    
    
    
    
    
    (64,349
    )
    
    
    185,885Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    95,784
    
    
    
    
    
    
    
    
    
    
    
    95,784Policy acquisition expenses
    
    
    13,412
    
    
    
    52,632
    
    
    
    
    
    
    
    (37,875
    )
    
    
    28,169Employee compensation and benefits
    
    
    32,328
    
    
    
    354
    
    
    
    
    
    
    
    (9,739
    )
    
    
    22,943Depreciation and amortization
    
    
    2,016
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    2,022Operating expenses
    
    
    27,079
    
    
    
    2,200
    
    
    
    873
    
    
    
    (16,735
    )
    
    
    13,417Interest expense
    
    
    
    
    
    
    
    
    
    
    1,375
    
    
    
    
    
    
    
    1,375Total expenses
    
    
    74,835
    
    
    
    150,976
    
    
    
    2,248
    
    
    
    (64,349
    )
    
    
    163,710Net income (loss) before income taxes,
minority interest and equity interest
    
    
    14,258
    
    
    
    10,165
    
    
    
    (2,248
    )
    
    
    
    
    
    
    22,175Income tax expense (benefit)
    
    
    5,052
    
    
    
    3,603
    
    
    
    (797
    )
    
    
    
    
    
    
    7,858Minority interest, net of tax
    
    
    359
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    359Net income (loss)
    
    $
    8,847
    
    
    $
    6,562
    
    
    $
    (1,451
    )
    
    $
    
    
    
    $
    13,958Total assets
    
    $
    141,415
    
    
    $
    391,930
    
    
    $
    3,333
    
    
    $
    
    
    
    $
    536,678
 Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeSix months ended June 30, 2004
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    90,948
    
    
    $
    
    
    
    $
    
    
    
    $
    90,948Commission income
    
    
    47,356
    
    
    
    
    
    
    
    
    
    
    
    (28,156
    )
    
    
    19,200Fee income
    
    
    22,158
    
    
    
    14,217
    
    
    
    
    
    
    
    (9,058
    )
    
    
    27,317Claims processing fees
    
    
    13,353
    
    
    
    
    
    
    
    
    
    
    
    (11,998
    )
    
    
    1,355Investment income
    
    
    35
    
    
    
    555
    
    
    
    
    
    
    
    
    
    
    
    590Realized gains (losses)
    
    
    1
    
    
    
    (21
    )
    
    
    
    
    
    
    
    
    
    
    (20
    )Total revenues
    
    
    82,903
    
    
    
    105,699
    
    
    
    
    
    
    
    (49,212
    )
    
    
    139,390Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    59,857
    
    
    
    
    
    
    
    
    
    
    
    59,857Policy acquisition expenses
    
    
    14,390
    
    
    
    37,520
    
    
    
    
    
    
    
    (25,637
    )
    
    
    26,273Employee compensation and benefits
    
    
    28,956
    
    
    
    
    
    
    
    
    
    
    
    (8,047
    )
    
    
    20,909Depreciation and amortization
    
    
    1,845
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,845Operating expenses
    
    
    23,242
    
    
    
    1,390
    
    
    
    
    
    
    
    (15,528
    )
    
    
    9,104Interest expense
    
    
    
    
    
    
    
    
    
    
    391
    
    
    
    
    
    
    
    391Total expenses
    
    
    68,433
    
    
    
    98,767
    
    
    
    391
    
    
    
    (49,212
    )
    
    
    118,379Net income (loss) before income taxes,
minority interest and equity interest
    
    
    14,470
    
    
    
    6,932
    
    
    
    (391
    )
    
    
    
    
    
    
    21,011Income tax expense (benefit)
    
    
    5,177
    
    
    
    2,481
    
    
    
    (140
    )
    
    
    
    
    
    
    7,518Minority interest, net of tax
    
    
    307
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    307Equity interest in unconsolidated subsidiaries, net of tax
    
    
    
    
    
    
    
    
    
    
    423
    
    
    
    
    
    
    
    423Net income (loss)
    
    $
    8,986
    
    
    $
    4,451
    
    
    $
    (674
    )
    
    $
    
    
    
    $
    12,763Total assets
    
    $
    151,006
    
    
    $
    267,950
    
    
    $
    2,984
    
    
    $
    
    
    
    $
    421,940
 15




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##### Table of Contents



11. Subsequent Events
     16




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
  Overview
     Three months ended
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004(Unaudited in thousands)
    
    (Unaudited in thousands)Our underwriting agencies:Our retail stores
    
    $
    24,330
    
    
    $
    27,457
    
    
    $
    65,344
    
    
    $
    65,043Independent agencies
    
    
    35,879
    
    
    
    41,476
    
    
    
    82,945
    
    
    
    95,412Unaffiliated underwriting agencies
    
    
    16,368
    
    
    
    27,913
    
    
    
    41,643
    
    
    
    55,191Total
    
    $
    76,577
    
    
    $
    96,846
    
    
    $
    189,932
    
    
    $
    215,646
  17




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##### Table of Contents



Results of Operations
  Three months ended
    
    Six months endedJune 30,
    
    June 30,2005
    
    2004
    
    2005
    
    2004(Unaudited in thousands)Total Revenues:Agency segment
    
    $
    41,380
    
    
    $
    40,345
    
    
    $
    89,093
    
    
    $
    82,903Insurance segment
    
    
    85,068
    
    
    
    51,195
    
    
    
    161,141
    
    
    
    105,699Corporate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Eliminations
    
    
    (27,661
    )
    
    
    (24,331
    )
    
    
    (64,349
    )
    
    
    (49,212
    )Total
    
    $
    98,787
    
    
    $
    67,209
    
    
    $
    185,885
    
    
    $
    139,390Total Expenses:Agency segment
    
    $
    35,312
    
    
    $
    33,966
    
    
    $
    74,835
    
    
    $
    68,433Insurance segment
    
    
    80,091
    
    
    
    48,146
    
    
    
    150,976
    
    
    
    98,767Corporate
    
    
    1,305
    
    
    
    174
    
    
    
    2,248
    
    
    
    391Eliminations
    
    
    (27,661
    )
    
    
    (24,331
    )
    
    
    (64,349
    )
    
    
    (49,212
    )Total
    
    $
    89,047
    
    
    $
    57,955
    
    
    $
    163,710
    
    
    $
    118,379Pretax Income:Agency segment
    
    $
    6,068
    
    
    $
    6,379
    
    
    $
    14,258
    
    
    $
    14,470Insurance segment
    
    
    4,977
    
    
    
    3,049
    
    
    
    10,165
    
    
    
    6,932Corporate
    
    
    (1,305
    )
    
    
    (174
    )
    
    
    (2,248
    )
    
    
    (391
    )Total
    
    $
    9,740
    
    
    $
    9,254
    
    
    $
    22,175
    
    
    $
    21,011
 Comparison of the Three Months Ended June 30, 2005 to June 30, 2004
 Consolidated.
  18




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##### Table of Contents



Agency segment.
 Three months endedJune 30,2005
    
    2004(Unaudited in millions)Commissions
    
    $
    22.4
    
    
    $
    22.0Policy and other fees
    
    
    10.9
    
    
    
    11.2Claims processing fees
    
    
    8.1
    
    
    
    7.1Total
    
    $
    41.4
    
    
    $
    40.3
     19




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##### Table of Contents




    
    Policy acquisition expenses, comprised solely of commission expenses in our agency
segment, for the three months ended June 30, 2005 were $5.9 million, a decrease of
$483,000, or 7.6%, as compared to $6.4 million for the same period in 2004. The decrease
was principally due to the decrease in Total Controlled Premium partially offset by an
increase in average commission rate to 16.4% from 15.3% during 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 three months ended June 30, 2005
were $15.7 million, an increase of $1.4 million, or 10.0%, as compared to $14.3 million
for the same period in 2004. The increase in employee compensation and benefit expenses
was principally due to the increased headcount to 1,202 for the three months ended June
30, 2005 as compared to 1,137 for the same period in 2004, principally related to the
December 2004 Fed USA acquisition, which added 89 employees, offset by
natural attrition.
 
    
    Depreciation and amortization expenses for the three months ended June 30, 2005 were
$987,000, an increase of $26,000, or 2.7%, as compared to $961,000 for the same period in
2004. The increases in depreciation and amortization expenses were principally due to
increases in software and hardware purchases as well as 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 the second half of
2005.
 
    
    Operating expenses for the three months ended June 30, 2005 were $12.7 million, an
increase of $376,000, or 3.0%, as compared to $12.4 million for the same period of 2004.
The increase in operating expenses was principally due to increased payments of allocated
loss adjustment expenses of $1.0 million. 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 $603,000 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.
These increases were offset by a decrease of $1.1million 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.
  Insurance company segment.
 20




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Corporate and other segment.
 Comparison of the Six Months Ended June 30, 2005 to June 30, 2004
 Consolidated.
  21




---



##### Table of Contents



Agency segment.
 Six months endedJune 30,2005
    
    2004(Unaudited in millions)Commissions
    
    $
    51.6
    
    
    $
    47.4Policy and other fees
    
    
    21.8
    
    
    
    22.2Claims processing fees
    
    
    15.6
    
    
    
    13.3Investment income
    
    
    0.1
    
    
    
    0.0Total
    
    $
    89.1
    
    
    $
    82.9
    22




---



##### Table of Contents




    
    Policy acquisition expenses, comprised solely of commission expenses in our agency
segment, for the six months ended June 30, 2005 were $13.4 million, a decrease of
$978,000, or 6.8%, as compared to $14.4 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 16.1% 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 six months ended June 30, 2005
were $32.3 million, an increase of $3.4 million, or 11.6%, as compared to $29.0 million
for the same period in 2004. The increase in employee compensation and benefit expenses
was principally due to increased headcount to 1,202 at June 30, 2005 as compared to 1,137
for the same period in 2004, principally related to the December 2004 Fed USA acquisition,
which added 89 employees, offset by natural attrition.
 
    
    Depreciation and amortization expenses for the six months ended June 30, 2005 were
$2.0 million, an increase of $171,000, or 9.3%, as compared to $1.8 million for the same
period in 2004. The increases in depreciation and amortization expenses were principally
due to increases in software and hardware purchases as well as 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
the second half of 2005.
 
    
    Operating expenses for the six months ended June 30, 2005 were $27.1 million, an
increase of $3.8 million, or 16.5%, as compared to $23.2 million for the same period in
2004. The increase in operating expenses was principally due to additional payments of
allocated loss adjustment expenses of $2.4 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 $1.0 million over the same period
in the prior year as we continued expansion of our retail branding. Professional fees
increased $1.0 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. These
increases were partially offset by a decrease of $1.2 million 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.
  23




---



##### Table of Contents



Insurance company segment.
      Corporate and other segment.
 Liquidity and Capital Resources
 Sources and uses of funds.
 24




---



##### Table of Contents



25




---



##### Table of Contents



As ofJune 30,
    
    December 31,2005
    
    2004($ in thousands)Invested assets
    
    $
    162,307
    
    
    $
    159,661Tax equivalent book yield
    
    
    4.12
    %
    
    
    4.03
    %Average duration in years
    
    
    4.0
    
    
    
    3.8Average S&P rating
    
    
    AA+
    
    
    
    AA+
   Initial public offering.
 Credit facility.
  Trust Preferred Securities.
 26




---



##### Table of Contents



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,
 Special Note Regarding Forward-Looking Statements
  
 Item 3. Quantitative and Qualitative Disclosures About Market Risk
  Interest rate risk.
 27




---



##### Table of Contents



Credit risk.
    Effects of inflation.
 
 Item 4. Controls and Procedures
  28




---



##### Table of Contents



PART II
 
 Item 1. Legal Proceedings
    29




---



##### Table of Contents



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 of
    
    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
   Description of Matter
    
    For
    
    Against
    
    Withheld
    
    Abstentions
    
    Nonvotes1. Election of Directors:Lucius E. Burch, III
    
    
    16,299,725
    
    
    
    n/a
    
    
    
    66,666
    
    
    
    n/a
    
    
    
    n/aThomas C. Davis
    
    
    16,299,725
    
    
    
    n/a
    
    
    
    66,666
    
    
    
    n/a
    
    
    
    n/aThomas E. Mangold
    
    
    16,046,670
    
    
    
    n/a
    
    
    
    319,721
    
    
    
    n/a
    
    
    
    n/aMark E. Pape
    
    
    16,355,991
    
    
    
    n/a
    
    
    
    10,400
    
    
    
    n/a
    
    
    
    n/aSuzanne T. Porter
    
    
    16,355,891
    
    
    
    n/a
    
    
    
    10,500
    
    
    
    n/a
    
    
    
    n/aMark E. Watson, Jr.
    
    
    16,299,725
    
    
    
    n/a
    
    
    
    66,666
    
    
    
    n/a
    
    
    
    n/aPaul J. Zucconi
    
    
    16,355,991
    
    
    
    n/a
    
    
    
    10,400
    
    
    
    n/a
    
    
    
    n/a2. Ratification of the appointment of
PricewaterhouseCoopers LLP as the
Companys independent auditors for
the fiscal year ending 2005
    
    
    16,364,791
    
    
    
    1,600
    
    
    
    n/a
    
    
    
    n/a
    
    
    
    n/a
 
 Item 5. Other information
  30




---



##### Table of Contents



Item 6. Exhibits
 a) EXHIBITS
 3.1
    
    Amended and Restated Certificate of Incorporation of Affirmative Insurance Holdings, Inc.
(incorporated by reference to Exhibit 3.1 to our Registration Statement on Form S-1 filed with the
SEC on March 22, 2004, File No. 333-113793).3.2
    
    Amended and Restated Bylaws of Affirmative Insurance Holdings, Inc. (incorporated by reference to
Exhibit 3.2 to our Registration Statement on Form S-1 filed with the SEC on March 22, 2004, File
No. 333-113793).4.1
    
    Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 3 to
our Registration Statement on Form S-1 filed with the SEC on June 14, 2004, File No. 333-113793).4.2
    
    Form of Registration Rights Agreement between Affirmative Insurance Holdings, Inc. and Vesta
Insurance Group, Inc. (incorporated by reference to Exhibit 4.2 to Amendment No. 2 to our
Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).10.1
    
    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.*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++
    
    Management contract, compensatory plan or arrangement 
 Signatures
  Affirmative Insurance Holdings, Inc.Date: August 15, 2005/s/ Timothy A. BienekBy: Timothy A. BienekExecutive Vice President and Chief Financial Officer(and in his capacity as Principal Financial Officer)
 31