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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 2004 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(State of other jurisdiction of
incorporation or organization)
    
    75-2770432(I.R.S. Employer
Identification No.)4450 Sojourn Drive, Suite 500
Addison, Texas(Address of principal executive offices)
    
    75001(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) Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. x Yes o No Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act):
o Yes x No Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. The number of shares outstanding of the registrants common stock,
$.01 par value, as of November 8, 2004
16,835,720




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Affirmative Insurance Holdings, Inc.
Index PagePart I Financial InformationItem 1.
Financial Statements (unaudited)Consolidated Balance Sheets as of September 30, 2004 and December 31, 2003
    
    
    1Consolidated Statements of Operations for the Three Months Ended September 30, 2004 and 2003
    
    
    2Consolidated Statements of Operations for the Nine Months Ended September 30, 2004 and 2003
    
    
    2Consolidated Statements of Stockholders Equity and Comprehensive Income
for the Nine Months Ended September 30, 2004 and 2003
    
    
    3Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2004 and 2003
    
    
    4Notes to Consolidated Financial Statements
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3. Quantatative and Qualitative Disclosures About Market Risk
    
    
    24Item 4. Control Procedures
    
    
    24Part II Other InformationItem 1. Legal Proceedings
    
    
    25Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    25Item 3. Defaults Upon Senior Securities
    
    
    25Item 4. Submission of Matters to a Vote of Security Holders
    
    
    25Item 5. Other Information
    
    
    25Item 6. Exhibits
    
    
    26Signatures
    
    
    26Credit FacilityCertification of CEO Pursuant to Section 302Certification of the CFO Pursuant to Section 302Certification of CEO & 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, 2004 and December 31, 2003
 September 30,
    
    December 31,2004
    
    2003(dollars in thousands, exceptshare data)AssetsFixed
maturities - available for sale, at fair value (amortized cost 2004: $116,444; 2003: $6,623)
    
    $
    117,119
    
    
    $
    6,610Short-term investments
    
    
    3,981Other invested assets
    
    
    
    
    
    
    928121,100
    
    
    
    7,538Cash and cash equivalents
    
    
    37,181
    
    
    
    15,358Fiduciary and restricted cash
    
    
    17,989
    
    
    
    9,467Accrued investment income
    
    
    1,262
    
    
    
    47Premiums and fees receivable (includes related parties - 2004: $25,271; 2003: $35,458)
    
    
    115,440
    
    
    
    75,596Commissions
receivable (includes related parties - 2004: $3,584; 2003: $2,340)
    
    
    7,855
    
    
    
    7,043Receivable from reinsurers (includes related parties - 2004: $44,801; 2003: $87,584)
    
    
    112,828
    
    
    
    94,526Deferred acquisition costs
    
    
    17,875
    
    
    
    14,371Receivable from affiliates
    
    
    108
    
    
    
    Deferred tax asset
    
    
    4,207
    
    
    
    Property and equipment, net
    
    
    7,068
    
    
    
    6,519Goodwill
    
    
    65,579
    
    
    
    65,010Other intangible assets, net
    
    
    14,043
    
    
    
    14,586Other assets
    
    
    8,171
    
    
    
    4,518Total assets
    
    $
    530,706
    
    
    $
    314,579Liabilities and Stockholders EquityLiabilitiesReserves for losses and loss adjustment expenses
    
    
    103,870
    
    
    
    58,507Unearned premium (includes related parties - 2004: $23,289; 2003: $35,458)
    
    
    95,725
    
    
    
    71,226Amounts due
reinsurers (includes related parties -  2004: $42,220; 2003: $15,664)
    
    
    70,967
    
    
    
    19,633Payable to affiliates
    
    
    
    
    
    
    86Deferred revenue
    
    
    23,185
    
    
    
    15,451Federal income taxes payable
    
    
    6,838
    
    
    
    7,687Deferred income taxes
    
    
    
    
    
    
    1,254Notes payable
    
    
    
    
    
    
    10,020Consideration due for acquisitions
    
    
    1,149
    
    
    
    4,275Other liabilities
    
    
    28,786
    
    
    
    13,063Total liabilities
    
    
    330,520
    
    
    
    201,202Commitments and contingencies (Note 5)Stockholders equityCommon stock, $0.01 par value; 75,000,000 shares authorized, 16,835,720 shares issued
and outstanding at September 30, 2004; 40,000,000 shares authorized; 11,557,215
shares issued and outstanding at December 31, 2003
    
    
    168
    
    
    
    116Warrants
    
    
    
    
    
    
    157Additional paid-in capital
    
    
    151,789
    
    
    
    84,074Accumulated
other comprehensive income (loss)
    
    
    450
    
    
    
    (9
    )Retained earnings
    
    
    47,779
    
    
    
    29,039Total stockholders equity
    
    
    200,186
    
    
    
    113,377Total liabilities and stockholders equity
    
    $
    530,706
    
    
    $
    314,579
 See accompanying Notes to Consolidated Financial Statements 1




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Affirmative Insurance Holdings, Inc. 
 Consolidated Statements of Operations  (Unaudited)
Three Months Ended September 30, 2004 and 2003
Nine Months Ended September 30, 2004 and 2003
 Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands, except per share data)RevenuesNet premiums earned
    
    $
    50,328
    
    
    $
    
    
    
    $
    141,276
    
    
    $
    Commission
income (includes related parties - three months, 2004: $1,022;
2003: $8,372, nine months, 2004: $2,577; 2003: $19,650)
    
    
    6,850
    
    
    
    11,741
    
    
    
    26,050
    
    
    
    36,669Fee income
(includes related parties - three months, 2003: $3,992, nine months,
2003: $10,706)
    
    
    13,243
    
    
    
    9,774
    
    
    
    40,560
    
    
    
    30,055Claims
processing fees (includes related parties - three months, 2003: $2,266,
nine months, 2003: $6,271)
    
    
    1,343
    
    
    
    2,536
    
    
    
    2,698
    
    
    
    7,920Net investment income
    
    
    799
    
    
    
    46
    
    
    
    1,389
    
    
    
    148Realized gains (losses)
    
    
    11
    
    
    
    16
    
    
    
    (9
    )
    
    
    451Total revenues
    
    
    72,574
    
    
    
    24,113
    
    
    
    211,964
    
    
    
    75,243ExpensesLosses and loss adjustment expenses
    
    
    35,468
    
    
    
    
    
    
    
    95,325
    
    
    
    Policy acquisition expenses
    
    
    15,109
    
    
    
    3,967
    
    
    
    41,382
    
    
    
    12,220Employee compensation and benefits
    
    
    7,193
    
    
    
    8,729
    
    
    
    28,102
    
    
    
    27,006Depreciation and amortization
    
    
    1,166
    
    
    
    784
    
    
    
    3,011
    
    
    
    2,466Operating expenses
    
    
    2,929
    
    
    
    4,272
    
    
    
    12,033
    
    
    
    12,323Interest expense
    
    
    135
    
    
    
    239
    
    
    
    526
    
    
    
    609Total expenses
    
    
    62,000
    
    
    
    17,991
    
    
    
    180,379
    
    
    
    54,624Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    10,574
    
    
    
    6,122
    
    
    
    31,585
    
    
    
    20,619Income tax expense
    
    
    4,150
    
    
    
    2,189
    
    
    
    11,668
    
    
    
    7,372Minority interest, net of income taxes
    
    
    274
    
    
    
    89
    
    
    
    581
    
    
    
    345Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    173
    
    
    
    174
    
    
    
    596
    
    
    
    174Net income
    
    $
    5,977
    
    
    $
    3,670
    
    
    $
    18,740
    
    
    $
    12,728Net income
per common share - Basic
    
    $
    0.38
    
    
    $
    0.36
    
    
    $
    1.43
    
    
    $
    1.26Net income
per common share - Diluted
    
    $
    0.37
    
    
    $
    0.36
    
    
    $
    1.42
    
    
    $
    1.26
 See accompanying Notes to Consolidated Financial Statements 2




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Affirmative Insurance Holdings, Inc. 
 Consolidated Statements of Stockholders Equity and Comprehensive Income  (Unaudited)
Nine Months Ended September 30, 2004 and 2003
 AccumulatedCommon Stock
    
    
    
    
    
    Additional
    
    
    
    
    
    Other
    
    TotalPaid-in
    
    Retained
    
    Comprehensive
    
    Stockholders'Shares
    
    Amount
    
    Warrants
    
    Capital
    
    Earnings
    
    Income (Loss)
    
    Equity(dollars in thousands, except share data)Balance, December 31, 2002
    
    
    10,031,615
    
    
    $
    100
    

    
    $
    157
    
    
    $
    67,745
    
    
    $
    9,982
    
    
    $
    363
    
    
    $
    78,347Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,728
    
    
    
    
    
    
    
    12,728Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (333
    )
    
    
    (333
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,395Issuance of common stock
    
    
    53,615
    
    
    
    1
    
    
    
    
    
    
    
    407
    
    
    
    
    
    
    
    
    
    
    
    408Balance, September 30, 2003
    
    
    10,085,230
    
    
    $
    101
    
    
    $
    157
    
    
    $
    68,152
    
    
    $
    22,710
    
    
    $
    30
    
    
    $
    91,150Balance,
September 31, 2003
    
    
    11,557,215
    
    
    $
    116
    
    
    $
    157
    
    
    $
    84,074
    
    
    $
    29,039
    
    
    $
    (9
    )
    
    $
    113,377Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    18,740
    
    
    
    
    
    
    
    18,740Other comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    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
    
    
    $
    200,186
 See accompanying Notes to Consolidated Financial Statements 3




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##### Table of Contents



Affirmative Insurance Holdings, Inc. 
 Consolidated Statements of Cash Flows  (Unaudited)
Nine Months Ended September 30, 2004 and 2003
 Nine months endedSeptember 30,2004
    
    2003(dollars in thousands)Cash flows from operating activitiesNet income
    
    $
    18,740
    
    
    $
    12,728Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    3,011
    
    
    
    2,466Undistributed equity in unconsolidated subsidiaries
    
    
    596
    
    
    
    174Realized (gain) loss on sale of bonds
    
    
    9
    
    
    
    (451
    )Changes in assets and liabilities:Fiduciary and restricted cash
    
    
    (8,522
    )
    
    
    2,672Premiums and commissions receivable
    
    
    (55,382
    )
    
    
    17,920Reserves for loss and loss expenses
    
    
    45,363
    
    
    
    (3,426
    )Amounts due reinsurers
    
    
    13,032
    
    
    
    (20,012
    )Receivable from affiliates
    
    
    (194
    )
    
    
    20,078Deferred revenue
    
    
    7,734
    
    
    
    2,773Unearned premiums
    
    
    24,499
    
    
    
    (6,937
    )Deferred acquisition costs
    
    
    (3,504
    )
    
    
    Other
    
    
    4,193
    
    
    
    (2,953
    )Net cash provided by
operating activities
    
    
    49,575
    
    
    
    25,032Cash flows from investing activitiesProceeds from the sale of bonds
    
    
    15,726
    
    
    
    5,047Cost of bonds acquired
    
    
    (94,515
    )
    
    
    (5,754
    )Purchases of property and equipment
    
    
    (3,002
    )
    
    
    (1,702
    )Net cash paid for acquisitions
    
    
    (3,110
    )
    
    
    (15,019
    )Net cash used in investing activities
    
    
    (84,901
    )
    
    
    (17,428
    )Cash flows from financing activitiesPrincipal payments under capital lease obligation
    
    
    (341
    )
    
    
    (149
    )Principal payments on note payable
    
    
    (10,020
    )
    
    
    (3,968
    )Proceeds from issuance of common stock
    
    
    67,510
    
    
    
    408Net cash provided by (used in) financing
activities
    
    
    57,149
    
    
    
    (3,709
    )Net increase in cash and cash equivalents
    
    
    21,823
    
    
    
    3,895Cash and cash equivalents, beginning of period
    
    
    15,358
    
    
    
    2,260Cash and cash equivalents, end of period
    
    $
    37,181
    
    
    $
    6,155
 See accompanying Notes to Consolidated Financial Statements 4




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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 and
four retail agencies with 146 retail store locations as of September 30,
2004. We offer our products and services in 11 states, including Texas,
Illinois, California and Florida. Our growth has been achieved principally
as a result of the acquisition and integration of six retail and/or
underwriting agencies in 2001 and 2002. We were formerly known as Instant
Insurance Holdings, Inc., and we incorporated in Delaware on June 25, 1998.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. At the conclusion of
these transactions, Vesta owned approximately 42.6% of our issued and
outstanding capital stock.2.
    
    Basis 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, 2003 included in our initial
public offering prospectus filed with the SEC.The interim financial data as of September 30, 2004 and for the nine months
ended September 30, 2004 and 2003 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.We purchased certain operations from Vesta in 2002 and 2003 that are
accounted for herein, at historical cost, in a manner similar to a pooling
of interest. Therefore, the results of these operations are included in the
historical results for all periods presented.Supplemental Cash Flow InformationDuring the first quarter of 2004, we received $35.6 million in fixed income
securities from Vesta in lieu of cash, to settle the collection of premiums
and fees, receivables from reinsurers, exchange of other invested assets,
and miscellaneous inter-company balances.Stock SplitOn May 25, 2004 we completed a stock split of 13.17 shares per one share of
common stock affected through a stock dividend. All references to common
shares, share prices, per share amounts, and stock plans have been restated
retroactively in this report for our stock split.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 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.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): 5




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##### Table of Contents



Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    5,977
    
    
    $
    3,670
    
    
    $
    18,740
    
    
    $
    12,728Add: stock-based employee compensation expense included in
reported net income, net of related income taxes
    
    
    18
    
    
    
    
    
    
    
    18
    
    
    
    Deduct: total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related income taxes
    
    
    (144
    )
    
    
    (62
    )
    
    
    (190
    )
    
    
    (187
    )Net income, pro forma
    
    $
    5,851
    
    
    $
    3,608
    
    
    $
    18,568
    
    
    $
    12,541Basic
earnings per share - as reported
    
    $
    0.38
    
    
    $
    0.36
    
    
    $
    1.43
    
    
    $
    1.26Basic
earnings per share - pro forma
    
    $
    0.37
    
    
    $
    0.36
    
    
    $
    1.42
    
    
    $
    1.24Diluted
earnings per share - as reported
    
    $
    0.37
    
    
    $
    0.36
    
    
    $
    1.42
    
    
    $
    1.26Diluted
earnings per share - pro forma
    
    $
    0.36
    
    
    $
    0.36
    
    
    $
    1.40
    
    
    $
    1.24
  Recently Issued Accounting StandardsIn January 2003, the FASB issued Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities. FIN 46 states that if a
business enterprise is the primary beneficiary of a variable interest
entity, the assets, liabilities and results of the activities of the
variable interest entity should be included in the consolidated financial
statements of the business enterprise. This Interpretation explains how to
identify variable interest entities and how an enterprise assesses its
interests in a variable interest entity to decide whether to consolidate
that entity. FIN 46 also requires existing unconsolidated variable interest
entities to be consolidated by their primary beneficiaries if the entities
do not effectively disperse risks among parties involved. Variable interest
entities that effectively disperse risks will not be consolidated unless a
single party holds an interest or combination of interests that effectively
recombines risks that were previously dispersed. Due to significant
implementation concerns, the FASB modified the wording of FIN 46 and issued
FIN 46R in December 2003. FIN 46R deferred the effective date for the
provisions of FIN 46 to pre-existing entities other than Special Purpose
Entities (SPEs) until financial statements are issued for periods ending
after March 15, 2004. SPEs are subject to the provisions of either FIN 46
or FIN 46R as of December 15, 2003. Our adoption of FIN 46 and FIN 46R did
not have a material impact on our consolidated financial position or
consolidated results of operations.In 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.3.
    
    ReinsuranceThe effect of reinsurance on premiums written and earned is as follows
(dollars in thousands): Three months ended
    
    Three months endedSeptember 30, 2004
    
    September 30, 2003Written
    
    Earned
    
    Written
    
    EarnedDirect
    
    $
    50,970
    
    
    $
    41,245
    
    
    $
    27,226
    
    
    $
    30,078Assumed - affiliate
    
    
    15,791
    
    
    
    11,063
    
    
    
    
    
    
    
    Assumed - non affiliate
    
    
    9,264
    
    
    
    15,255
    
    
    
    
    
    
    
    Ceded - affiliate
    
    
    (1,072
    )
    
    
    (2,214
    )
    
    
    (27,226
    )
    
    
    (30,078
    )Ceded - non affiliate
    
    
    (4,631
    )
    
    
    (15,021
    )
    
    
    
    
    
    
    $
    70,322
    
    
    $
    50,328
    
    
    $
    
    
    
    $
    
 6




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##### Table of Contents



Nine months ended
    
    Nine months endedSeptember 30, 2004
    
    September 30, 2003Written
    
    Earned
    
    Written
    
    EarnedDirect
    
    $
    143,819
    
    
    $
    111,776
    
    
    $
    88,884
    
    
    $
    95,808Assumed - affiliate
    
    
    60,697
    
    
    
    71,491
    
    
    
    
    
    
    
    Assumed - non affiliate
    
    
    17,811
    
    
    
    15,939
    
    
    
    
    
    
    
    Ceded - affiliate
    
    
    (4,096
    )
    
    
    (17,860
    )
    
    
    (88,884
    )
    
    
    (95,808
    )Ceded - non affiliate
    
    
    (59,651
    )
    
    
    (40,070
    )
    
    
    
    
    
    
    $
    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 30,2004AffiliateLoss and loss adjustment expense
    
    $
    33,421Unearned premiums
    
    
    3,108Total
    
    $
    36,529Non affiliateLoss and loss adjustment expense
    
    $
    21,008Unearned premiums
    
    
    19,566Total
    
    $
    40,574
  As of and for the nine months ended, September 30, 2004, we have ceded
$29.0 million of paid losses and $39.3 million of incurred losses to
various reinsurers.Effective January 1, 2004, we entered into two quota share reinsurance
agreements with unaffiliated reinsurers with variable cession percentages,
which provided us with an option to cede less of the business produced by
our underwriting agencies to these reinsurers in the last two quarters of
2004.  
    Illinois, Indiana, Missouri.This agreement covers all
business written through our underwriting agencies in these states
from January 1, 2004 and continues in force until terminated by us
or our reinsurers at any December 31 with not less than 90 days
prior notice. We ceded 60.0% of gross premiums written for the first
six months of 2004, and effective July 1, 2004, we have reduced the
amount of business we cede to our reinsurers on all business written
through our underwriting agencies in these states from 60.0% to
20.0% for the second half of 2004. We have provided notification of
our intent to terminate this agreement on December 31, 2004 on a
cut-off basis, meaning the reinsurers retain the liability for all
losses occurring prior to December 31, 2004 related to this
agreement and the ceded unearned premium for unexpired policies in
force is returned to us. This agreement contains a loss corridor
where the company remains liable for 100% of the losses between a
loss ratio of 72.0% and 77.0%. This agreement also contains a
provision that limits reinsurers liability to a loss ratio of
100.0%. The effect of these features in this agreement 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. While we do not receive
pro rata protection relative to the amount of premiums ceded, the
amount of such protection is significant, as determined in
accordance with guidance under both statutory accounting practices
and GAAP. The reinsurance under this agreement is provided by
Hannover Re, which reinsures 50% of the premiums we cede, Swiss Re,
which reinsures 20.83% of the premiums we cede, and AXA Re, which
reinsures 29.17% of the premiums we cede. Hannover Re, Swiss Re, and
AXA Re are rated A, A+, and A-, respectively, by A.M. Best.
    New Mexico and South Carolina.This agreement covers substantially all of our
business written through our underwriting agencies in these states from January
1, 2004 and continues in force until terminated by us or our reinsurers at any
December 31 with not less than 90 days prior notice. We ceded 75.0% of gross
premiums written in the first six months of 2004, and effective July 1, 2004,
we have reduced the amount of business we cede to our reinsurers on all
business written through our underwriting agencies in these states from 75.0%
to 30.0% for the second half of 2004. We have provided notification of our
intent to terminate this agreement on December 31, 2004 on a cut-off basis.
The reinsurance under this agreement is provided by Chubb Re, which reinsures
86.7% of the premiums we cede, and AXA Re which reinsures 13.3% of the premiums
we cede. Chubb Re and AXA Re are rated A++ and A- respectively, by A.M.
Best. 7




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##### Table of Contents



We have entered into a quota share reinsurance agreement effective January
1, 2004 under which we will assume a portion of the business produced by
our Texas-based A-Affordable underwriting agency and written by Old
American County Mutual Fire Insurance Company. We assumed 25.0% of the
gross premiums written in the first six months of 2004 and effective July
1, 2004 we have increased our participation on business produced by our
Texas-based A-Affordable underwriting agency from 25.0% to 70.0% for the
second half of 2004.Effective May 1, 2004, we entered into a quota share reinsurance agreement
with an unaffiliated reinsurer to cede 25.0% of the business written
through our Florida underwriting agency. This contract continues in force
until terminated by us or our reinsurers at any April 30 with not less than
90 days prior notice. We can terminate this agreement on April 30, 2005 on
a cut-off basis. The reinsurance under this agreement is provided by
Folksamerica, which reinsures 100% of all premiums we cede. Folksamerica
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 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-Durantion and
Long-Duration Contractsas the reinsurers assume significant risk and have
a reasonable possibility of significant loss.  4.
    
    Related Party Transactions  We provide various services for Vesta and its subsidiaries, including
underwriting, premium processing, and claims processing. For the three
months and nine months ended September 30, the accompanying unaudited
consolidated statements of operations reflect these services as follows
(dollars in thousands): Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Commission income
    
    $
    1,022
    
    
    $
    8,372
    
    
    $
    2,577
    
    
    $
    19,650Fee income
    
    
    
    
    
    
    3,992
    
    
    
    
    
    
    
    10,706Claims processing fees
    
    
    
    
    
    
    2,266
    
    
    
    
    
    
    
    6,271$
    1,022
    
    
    $
    14,630
    
    
    $
    2,577
    
    
    $
    36,627
  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 31,2004
    
    2003AssetsPremiums and fees receivable
    
    $
    25,271
    
    
    $
    35,458Commissions receivable
    
    
    3,584
    
    
    
    2,340Receivable from reinsurer
    
    
    44,801
    
    
    
    87,584Receivable from affiliates
    
    
    108
    
    
    
    $
    73,764
    
    
    $
    125,382LiabilitiesUnearned premium
    
    $
    23,289
    
    
    $
    35,458Amounts due reinsurers
    
    
    42,220
    
    
    
    15,664Payable to affiliates
    
    
    
    
    
    
    86$
    65,509
    
    
    $
    51,208
  As part of the terms of the acquisition of Affirmative Insurance Company and
Insura, 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, 2004, all such
unaffiliated reinsurers had A.M. Best ratings of A- or better.Prior to May 2003, we leased office space from a minority shareholder of
InsureOne Independent Agency, LLC. Total rent paid to the minority
shareholder for the nine months ended September 30, 2003 was $682,000. 8




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##### Table of Contents



5.
    
    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.We are the subject of a purported class action in South Carolina alleging
that we have improperly denied coverage for losses resulting from the
operation of insured vehicles by undisclosed permissive use drivers. The
non-standard personal automobile policies in question were issued by a
subsidiary of Vesta and were sold through Drivers Choice, one of our
underwriting agencies. The plaintiff seeks injunctive relief and contract
reformation, as well as an unspecified amount of compensatory and punitive
damages, costs and interest based on claims for breach of contract, bad
faith, fraud and negligence. This matter is still in the early procedural
stages and as of the date of this report the class had not been certified.
Although we are vigorously defending this lawsuit, the ultimate outcome of
this case is uncertain.On May 6, 2004, the former minority owners of our InsureOne retail agency,
including InsureOnes former president, 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 seek 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. InsureOne filed a
motion to dismiss this case, and we anticipate that no other substantive
action will occur until the Court rules on the motion to dismiss. We
believe this complaint is without merit, and we are vigorously contesting
the claims brought by the plaintiffs and are exercising all available rights
and remedies against them.InsureOnes former president is also a defendant, along with eight former
employees of InsureOne, 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 have entered interim orders prohibiting the defendants from hiring
any employees of InsureOne or one of our other underwriting agencies. These
orders are presently in effect until November 2004, when the trial in the
Illinois case of our claims for permanent injunctive relief and an
undetermined amount of compensatory and punitive damages was originally
scheduled; provided however, a hearing has been scheduled for November 2004
to determine a new trial date, which is expected to be set either in
December 2004 or January 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. InsureOne filed a motion to dismiss the counterclaim,
and that motion is pending before the Court. We believe the counterclaim is
without merit. We are vigorously contesting the counterclaim and are
exercising all rights and remedies available to us.6.
    
    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 initially
accrue interest at an annual rate of LIBOR plus 1.50% and we will pay letter
of credit fees based on an initial annual rate of 0.75%. 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. Currently, we have not borrowed against our
facility. As of September 30, 2004, we are in compliance with all of our
financial and other restrictive covenants.7.
    
    Stockholders EquityOn March 12, 2004, we issued 35,216 shares of our common stock to E.B. Lyon,
III, a minority stockholder, at a purchase price of $9.76 per share, for aggregate consideration of
$343,809 in cash.On March 12, 2004, we issued 39,944 shares of our common stock to LBL
Partners, Ltd., a minority stockholder, at a purchase price of $9.76 per share, for aggregate
consideration of $389,967 in cash.On March 12, 2004, we issued 19,623 shares of our common stock to Thomas E.
Mangold, our Chief Executive Officer, at a purchase price of $9.76 per
share, for aggregate consideration of $191,576 in cash. We believe that the
fair value of our common stock issued to Mr. Mangold was higher than our
historical carrying value we assigned to our shares of common stock for this
transaction. In light of our proposed public offering, we used a projected
public valuation model to determine the estimated fair value of the common
shares issued to Mr. Mangold. Based on the projections, we recorded $73,000
of compensation expense in March 2004.On March 12, 2004, we issued 19,886 shares of our common stock to Vesta
Insurance Group, Inc. in connection with the exercise of warrants, with an
exercise price of $0.08 per share, which were originally purchased by Vesta
in 2000. 9




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##### Table of Contents



On March 12, 2004 we filed an Amendment and Restated Certificate of
Incorporation increasing the number of shares of authorized common stock
from 40 million to 75 million.On July 9, 2004, we completed our initial public offering of our common
stock. 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 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. Our net proceeds from the offering
were $65.3 million, after deducting our estimated offering expenses. We
contributed $64.3 million of the net proceeds to our insurance companies in
order to increase their statutory surplus. This additional capital allowed
us to reduce our reinsurance purchases and retain more gross premiums. The
remaining $1.0 million of net proceeds were held for general corporate
purposes. At the conclusion of these transactions, Vesta owned
approximately 42.6% of our issued and outstanding capital stock.On September 28, 2004, we issued 80,837 shares of our common stock to Vesta
Insurance Group, Inc. in connection with the exercise of options, with an
exercise price of $7.59 per share, which we originally issued to Vesta on
June 30, 2000.8.
    
    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 number ofshares and per share amounts)Three 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
    
    
    $
    0.37Three months ended September 30, 2003Basic Earnings per ShareNet Income
    
    $
    3,670
    
    
    
    10,085,230
    
    
    $
    0.36Diluted Earnings per ShareNet Income
    
    $
    3,670
    
    
    
    10,085,230
    
    
    $
    0.36Effect of Dilutive Securities
    
    
    
    
    
    
    19,887
    
    
    
    $
    3,670
    
    
    
    10,105,117
    
    
    $
    0.36Nine 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
    
    
    $
    1.42Nine months ended September 30, 2003Basic Earnings per ShareNet Income
    
    $
    12,728
    
    
    
    10,076,589
    
    
    $
    1.26Diluted Earnings per ShareNet Income
    
    $
    12,728
    
    
    
    10,076,589
    
    
    $
    1.26Effect of Dilutive Securities
    
    
    
    
    
    
    19,887
    
    
    
    $
    12,728
    
    
    
    10,096,476
    
    
    $
    1.26
  Options to purchase 847,008 shares of common stock at prices ranging from
$7.59 to $9.49 were outstanding at September 30, 2003 but were not included
in the computation of diluted earnings per share for the three months and
nine months ended September 30, 2003, because the inclusion would result in
an anti-dilutive effect in periods where the option exercise price exceeded
the average estimated market price per share for the period. 10




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##### Table of Contents



9.
    
    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 months and nine
months ended September 30, 2004 and 2003 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. Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeThree months ended September 30, 2004
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)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
    
    
    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
 11




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##### Table of Contents



Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeThree months ended September 30, 2003
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Commission income
    
    
    18,660
    
    
    
    
    
    
    
    
    
    
    
    (6,919
    )
    
    
    11,741Fee income
    
    
    9,746
    
    
    
    2,404
    
    
    
    
    
    
    
    (2,376
    )
    
    
    9,774Claims processing fees
    
    
    6,211
    
    
    
    
    
    
    
    
    
    
    
    (3,675
    )
    
    
    2,536Investment income
    
    
    6
    
    
    
    40
    
    
    
    
    
    
    
    
    
    
    
    46Realized gains (losses)
    
    
    (8
    )
    
    
    24
    
    
    
    
    
    
    
    
    
    
    
    16Total revenues
    
    
    34,615
    
    
    
    2,468
    
    
    
    
    
    
    
    (12,970
    )
    
    
    24,113Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Policy acquisition expenses
    
    
    5,981
    
    
    
    
    
    
    
    
    
    
    
    (2,014
    )
    
    
    3,967Employee compensation and benefits
    
    
    13,705
    
    
    
    
    
    
    
    
    
    
    
    (4,976
    )
    
    
    8,729Depreciation and amortization
    
    
    784
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    784Operating expenses
    
    
    10,377
    
    
    
    (125
    )
    
    
    
    
    
    
    (5,980
    )
    
    
    4,272Interest expense
    
    
    
    
    
    
    
    
    
    
    239
    
    
    
    
    
    
    
    239Total expenses
    
    
    30,847
    
    
    
    (125
    )
    
    
    239
    
    
    
    (12,970
    )
    
    
    17,991Net income (loss) before income taxes,
minority interest and equity interest
    
    
    3,768
    
    
    
    2,593
    
    
    
    (239
    )
    
    
    
    
    
    
    6,122Income tax expense (benefit)
    
    
    1,347
    
    
    
    927
    
    
    
    (85
    )
    
    
    
    
    
    
    2,189Minority interest, net of tax
    
    
    89
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    89Equity interest in unconsolidated subsidiaries, net of tax
    
    
    
    
    
    
    
    
    
    
    174
    
    
    
    
    
    
    
    174Net income (loss)
    
    $
    2,332
    
    
    $
    1,666
    
    
    $
    (328
    )
    
    
    
    
    
    $
    3,670Total assets
    
    $
    130,515
    
    
    $
    135,381
    
    
    $
    4,087
    
    
    $
    
    
    
    $
    269,983
 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
 12




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##### Table of Contents



Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeNine months ended September 30, 2003
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Commission income
    
    
    58,182
    
    
    
    
    
    
    
    
    
    
    
    (21,513
    )
    
    
    36,669Fee income
    
    
    29,908
    
    
    
    7,178
    
    
    
    
    
    
    
    (7,031
    )
    
    
    30,055Claims processing fees
    
    
    19,276
    
    
    
    
    
    
    
    
    
    
    
    (11,356
    )
    
    
    7,920Investment income
    
    
    29
    
    
    
    119
    
    
    
    
    
    
    
    
    
    
    
    148Realized gains (losses)
    
    
    (6
    )
    
    
    457
    
    
    
    
    
    
    
    
    
    
    
    451Total revenues
    
    
    107,389
    
    
    
    7,754
    
    
    
    
    
    
    
    (39,900
    )
    
    
    75,243Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Policy acquisition expenses
    
    
    18,818
    
    
    
    
    
    
    
    
    
    
    
    (6,598
    )
    
    
    12,220Employee compensation and benefits
    
    
    42,533
    
    
    
    
    
    
    
    
    
    
    
    (15,527
    )
    
    
    27,006Depreciation and amortization
    
    
    2,466
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,466Operating expenses
    
    
    30,509
    
    
    
    (411
    )
    
    
    
    
    
    
    (17,775
    )
    
    
    12,323Interest expense
    
    
    
    
    
    
    
    
    
    
    609
    
    
    
    
    
    
    
    609Total expenses
    
    
    94,326
    
    
    
    (411
    )
    
    
    609
    
    
    
    (39,900
    )
    
    
    54,624Net income (loss) before income taxes,
minority interest and equity interest
    
    
    13,063
    
    
    
    8,165
    
    
    
    (609
    )
    
    
    
    
    
    
    20,619Income tax expense (benefit)
    
    
    4,670
    

    
    
    2,920
    
    
    
    (218
    )
    
    
    
    
    
    
    7,372Minority interest, net of tax
    
    
    345
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    345Equity interest in unconsolidated subsidiaries, net of tax
    
    
    
    
    
    
    
    
    
    
    174
    
    
    
    
    
    
    
    174Net income (loss)
    
    $
    8,048
    
    
    $
    5,245
    
    
    $
    (565
    )
    
    $
    
    
    
    $
    12,728
 13




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##### Table of Contents



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations The following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our unaudited consolidated
financial statements and related notes thereto presented in this Form 10-Q and
our annual consolidated financial statements and the related notes as filed
with the Securities and Exchange Commission in our Registration Statement on
Form S-1, File No. 333-113793. This discussion contains certain statements of a
forward-looking nature that involve risks and uncertainties. As a result of
many factors, our actual results may differ materially from those anticipated
by such forward-looking statements. Overview We are an insurance holding company engaged in underwriting, servicing and
distributing non-standard automobile insurance policies and related products
and services to individual consumers in highly targeted geographic areas. Our
subsidiaries include two insurance companies, four underwriting agencies and
four retail agencies with 146 retail store locations. We offer our products and
services in 11 states, including Texas, Illinois, California and Florida. Our insurance companies, underwriting agencies and retail agencies often
function as a vertically integrated unit, capturing the premium (and associated
risk) and commission and fee revenue generated from the sale of each insurance
policy. However, each of these operations also works with unaffiliated entities
on an unbundled basis, either functioning independently or with one or both of
the other two operations. We believe that our ability to enter into a variety
of business relationships with third parties allows us to maximize sales
penetration and profitability through industry cycles better than if we
employed a single, vertically integrated operating structure. Prior to January 1, 2004, our consolidated revenues were derived principally
from commissions and fees, investment income and investment gains and losses.
Prior to January 1, 2004, our consolidated expenses consisted primarily of
expenses associated with underwriting activities, agents commissions and
operations. Beginning January 1, 2004, our consolidated revenues also include
net premiums earned and net investment income and our consolidated expenses
also include losses, loss adjustment expenses and policy acquisition costs. We
measure the total gross premiums written from which we derive commissions by
our underwriting agencies or premiums by our insurance companies as our Total
Controlled Premium. We report consolidated financial information in three
business segments: our agency segment, our insurance company segment and our
corporate segment. Discussion and Analysis Provided For periods prior to December 31, 2003, we managed Vestas non-standard
personal automobile insurance business, or the NSA Business, and Vesta reported
the financial results of this business in a separate financial reporting
segment. The historical financial results of the NSA Business have been
included in footnotes to Vestas financial statements, which are not included
in this report. Accordingly, we are also providing supplemental financial
information related to the NSA Business derived from these footnotes, all of
which has been supplied to us by Vesta. Results of Operations The following table summarizes our historical results of operations by
reporting segment. For more detailed information concerning the components of
revenues and expenses by segment, please refer to Note 9 to our consolidated
financial statements included in this report. Three months ended
    
    Nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(Unaudited in thousands)Total Revenues:Agency segment
    
    $
    42,180
    
    
    $
    34,615
    
    
    $
    125,083
    
    
    $
    107,389Insurance segment
    
    
    58,113
    
    
    
    2,468
    
    
    
    163,812
    
    
    
    7,754Corporate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Eliminations
    
    
    (27,719
    )
    
    
    (12,970
    )
    
    
    (76,931
    )
    
    
    (39,900
    )Total
    
    $
    72,574
    
    
    $
    24,113
    
    
    $
    211,964
    
    
    $
    75,243Total Expenses:Agency segment
    
    $
    35,212
    
    
    $
    30,847
    
    
    $
    103,645
    
    
    $
    94,326Insurance segment
    
    
    54,106
    
    
    
    (125
    )
    
    
    152,873
    
    
    
    (411
    )Corporate
    
    
    401
    
    
    
    239
    
    
    
    792
    
    
    
    609Eliminations
    
    
    (27,719
    )
    
    
    (12,970
    )
    
    
    (76,931
    )
    
    
    (39,900
    )Total
    
    $
    62,000
    
    
    $
    17,991
    
    
    $
    180,379
    
    
    $
    54,624Pretax Income:Agency segment
    
    $
    6,968
    
    
    $
    3,768
    
    
    $
    21,438
    
    
    $
    13,063Insurance segment
    
    
    4,007
    
    
    
    2,593
    
    
    
    10,939
    
    
    
    8,165Corporate
    
    
    (401
    )
    
    
    (239
    )
    
    
    (792
    )
    
    
    (609
    )Total
    
    $
    10,574
    
    
    $
    6,122
    
    
    $
    31,585
    
    
    $
    20,619
 14




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##### Table of Contents



Comparison of the Three Months Ended September 30, 2004 to September 30, 2003 Consolidated.The following table displays our Total Controlled Premium by
distribution channel for the three months ended September 30, 2004 and 2003: Three months endedSeptember 30,2004
    
    2003(Unaudited in thousands)Our underwriting agencies:Our retail stores
    
    $
    30,982
    
    
    $
    28,968Independent agencies
    
    
    46,571
    
    
    
    39,095Unaffiliated underwriting agencies
    
    
    26,962
    
    
    
    27,055Total
    
    $
    104,515
    
    
    $
    95,118
 Total Controlled Premium for the three months ended September 30, 2004 was
$104.5 million, an increase of $9.4 million, or 9.9%, as compared to $95.1
million for the same period in 2003. The increase is primarily due to
increased appointments of independent agents by our underwriting agencies, an
unearned premium transfer related to the purchase of renewal rights of a New
Mexico book of business and increases in both our retail agents and locations
and partially offset by a decrease in premiums produced by unaffiliated
underwriting agencies due to the reduction in premium volume from a cancelled
program. Total revenues for the three months ended September 30, 2004 were $72.6
million, an increase of $48.5 million, or 201.0%, as compared to total revenues
of $24.1 million for the same period in 2003. Total expenses for the three months ended September 30, 2004 were $62.0
million, an increase of $44.0 million, or 244.6%, as compared to total expenses
of $18.0 million for the same period in 2003. Pretax income for the three months ended September 30, 2004 was $10.6 million,
an increase of $4.5 million, or 72.7%, as compared to pretax income of $6.1
million for the same period in 2003. Income tax expense for the three months ended September 30, 2004 was $4.2
million, or an effective rate of 39.2%, as compared to income tax expense of
$2.2 million, or an effective rate of 35.8% for the same period in 2003. The
increase in income tax expense is primarily related to increases in state
income taxes due to Affirmative falling below 80% ownership in July 2004 and
therefore leaving Vestas federal and state consolidation group. For the three months ended September 30, 2004, minority interest net of income
taxes was $274,000 as compared to $89,000 for the same period in 2003. Agency segment.Total revenues for the three months ended September 30, 2004
were $42.2 million, an increase of $7.6 million, or 21.9%, as compared to total
revenues of $34.6 million for the same period in 2003. Revenues for the three months ended September 30, 2004 and 2003 were generated
primarily through commissions, policy fees and claims processing fees, as
follows: Three months endedSeptember 30,2004
    
    2003(Unaudited in millions)Commissions
    
    $
    24.6
    
    
    $
    18.7Policy and other fees
    
    
    10.3
    
    
    
    9.7Claims processing fees
    
    
    7.3
    
    
    
    6.2Total
    
    $
    42.2
    
    
    $
    34.6
 For the three months ended September 30, 2004, gross premiums written produced
by our underwriting agencies were $77.6 million, an increase of $9.5 million,
or 13.9%, as compared to $68.1 million for the same period in 2003. The
principal reasons for the increase in gross premiums written were a $2.0
million unearned premium transfer related to the purchase of renewal rights of
a New Mexico book of business, continued growth from our Florida underwriting
agency, which had increased gross premiums written of $2.1 million as compared
to the same period in 2003, principally driven by the expansion of a current
product into new territories as well as a $3.5 million increase in gross
premiums written by our Texas underwriting agencies as compared to the same
period in 2003 due to additional appointments of independent agents. Commissions for the three months ended September 30, 2004 were $24.6 million,
an increase of $5.9 million, or 31.7%, as compared to commissions of $18.7
million for the same period in 2003. We earned commissions in both our
underwriting agencies and retail agencies. Commissions for our underwriting
agencies, which include both provisional and profit-sharing commissions, for
the three months ended September 30, 2004 were $23.0 million, an increase of
$5.9 million, or 34.8%, as compared to $17.0 million for the same period in
2003. 15




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##### Table of Contents



Provisional commissions for our underwriting agencies for the three months
ended September 30, 2004 were $20.2 million, an increase of $4.3 million, or
26.8%, as compared to $16.0 million for the same period in 2003. The increase
in provisional commissions was principally due to increased written premium
volume compared to the same period in 2003 as well as increases in commission
rates, which is eliminated in consolidation, caused by our insurance companies
increased retention of premiums starting July 1, 2004. Profit sharing commissions for our underwriting agencies for the three months
ended September 30, 2004 were $2.8 million, an increase of $1.7 million, as
compared to $1.1 million for the same period in 2003. The increase in profit
sharing commissions was principally a result of continued favorable loss ratio
development for business produced by our underwriting agencies as compared to
loss ratios recorded as of the beginning of the period. Commissions related to our retail agencies sales of unaffiliated insurance
companies products were $1.6 million for the three months ended September 30,
2004, a decrease of $19,000, or 1.2%, as compared to $1.6 million for the same
period in 2003, primarily due to the sale of Instant Auto Insurance Agency, in
June 2003. Policy and other fees for the three months ended September 30, 2004 were $10.3
million, an increase of $553,000, or 5.7%, as compared to $9.7 million for the
same period in 2003. The increase in policy fees was primarily due to the
increased production volume over the same period in 2003. Claims processing fees for the three months ended September 30, 2004 were $7.3
million, an increase of $1.1 million, or 17.1%, as compared to $6.2 million for
the same period in 2003, principally due to an increase in the amount of gross
premiums earned on business that our underwriting agencies produced. Total expenses for the three months ended September 30, 2004 were $35.2
million, an increase of $4.4 million, or 14.2%, as compared to total expenses
of $30.8 million for the same period in 2003.  
    
    Policy acquisition expenses, comprised solely of commission expenses
in our agency segment, for the three months ended September 30, 2004
were $7.1 million, an increase of $1.2 million, or 19.3%, as compared
to $6.0 million for the same period in 2003, principally due to the
increase in premiums written and slightly offset by a decline in
average commission rate to 15.2% from 15.3% during the prior year.
The decrease in average commission rate was primarily caused by a
higher proportion of our premiums written in markets where we pay
lower commission rates.
    
    Employee compensation and benefit expenses for the three months ended
September 30, 2004 were $14.2 million, an increase of $509,000, or
3.7%, as compared to $13.7 million for the same period in 2003. The
increase in employee compensation and benefit expenses was principally
due to increased headcount for the three months ended September 30,
2004 as compared to the same period in 2003.
    
    Depreciation and amortization expenses for the three months ended
September 30, 2004 were $1.2 million, an increase of $382,000, or
48.7%, as compared to $784,000 for the same period in 2003. The
increases in depreciation and amortization expenses were principally
due to increases in software and hardware purchases as well as the
acceleration of certain software assets to match their newly estimated
remaining lives.
    
    Operating expenses for the three months ended September 30, 2004 were
$12.7 million, an increase of $2.3 million, or 22.3%, as compared to
$10.4 million for the same period in 2003. The change in operating
expenses was primarily a result of increases in premium related
expenses of $918,000 due to the $9.5 million increase in premium
volume produced by our underwriting agencies, a $283,000 increase in
advertising expenditures primarily due to the continued expansion of
our retail branding, a $536,000 increase in professional fees
primarily due to ongoing litigation efforts as well as a $119,000
increase in license and fees due primarily to increased franchise tax
expenses. Pretax income for the three months ended September 30, 2004 was $7.0 million,
an increase of $3.2 million, or 84.9%, as compared to pretax income of $3.8
million for the same period in 2003. The pretax margin for the three months
ended September 30, 2004 was 16.5%, an increase from the 10.9% pre-tax margin
recorded in the same period in 2003. Insurance company segment.Total revenues for the three months ended
September 30, 2004 were $58.1 million, an increase of $55.6 million, as
compared to total revenues of $2.5 million for the same period in 2003. The
increase in total revenues was principally due to our retention of gross
premiums written by our insurance
companies following the termination of the reinsurance agreements with Vesta,
which allowed us to start assuming premiums and losses that were previously
ceded to Vesta Fire beginning January 1, 2004. Net investment income for the three months ended September 30, 2004 was
$776,000, an increase of $736,000 from net investment income of $40,000 for the
same period in 2003. The increase is primarily due to the increase in the size
of our investment portfolio due to the following; capital contributions into
our insurance subsidiaries after our initial public offering, the settlement of
the December 2003 reinsurance transaction with Vesta and operating cash flows,
which increased our investment portfolio to $121.1 million as of September 30,
2004 as compared to $7.5 million as of December 31, 2003. Net realized capital
gains for the three months ended September 30, 2004 were $9,000, compared to
net realized capital gains of $24,000 for the same period in 2003. Loss and loss adjustment expenses for the three months ended September 30,
2004, were $35.5 million compared to zero for the same period in 2003. Our loss
and loss adjustment expense ratio for the three months ended September 30, 2004
was 61.9%. The increase in loss and loss adjustment expenses was due to our
termination of the reinsurance agreements with Vesta. Policy acquisition and operating expenses for the three months ended September
30, 2004 were $18.6 million compared to negative $125,000 for the same period
in 2003. The increase in policy acquisition and operating expenses was due to
our termination of the reinsurance agreements with Vesta. Our expense ratio for
the three months ended September 30, 2004 was 32.5%. The negative expense
recorded for the three months ended September 30, 2003 is a result of our
insurance companies receiving ceding commissions in an amount greater than
their policy acquisition and operating expenses. Pretax income for the three months ended September 30, 2004 was $4.0 million,
an increase of $1.4 million, or 54.5%, as compared to $2.6 million for the same
period in 2003. The increase in pretax income was principally a result of the
profitability of the business being retained starting January 1, 2004 as
compared to the policy fees retained in the insurance segment in the prior
year. Our combined ratio for the three months ended September 30, 2004 was
94.4%. 16




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##### Table of Contents



Corporate and other segment.Operating expense for the three months ended
September 30, 2004 was $266,000 as compared to zero for the same period in
2003. Operating expenses include investor relations costs, directors and
officers insurance as well as directors fees and travel expenses. Interest
expense for the three months ended September 30, 2004 was $135,000, as compared
to interest expense of $239,000 for the same period in 2003. The interest
expense primarily represents interest payments on a note payable related to the
Harbor Insurance Group, Inc. acquisition, which began in January 2003 when the
final determination of the contingent payments was made. This note was paid
off in September 2004. Comparison of the Nine Months Ended September 30, 2004 to September 30, 2003 Consolidated.The following table displays our Total Controlled Premium by
distribution channel for the nine months ended September 30, 2004 and 2003: Nine months endedSeptember 30,2004
    
    2003(Unaudited in thousands)Our underwriting agencies:Our retail stores
    
    $
    96,025
    
    
    $
    92,298Independent agencies
    
    
    141,983
    
    
    
    122,298Unaffiliated underwriting agencies
    
    
    82,153
    
    
    
    87,574Total
    
    $
    320,161
    
    
    $
    302,170
 Total Controlled Premium for the nine months ended September 30, 2004 was
$320.2 million, an increase of $18.0 million, or 6.0%, as compared to $302.2
million for the same period in 2003. The increase is primarily due to
increased appointments of independent agents by our underwriting agencies, an
unearned premium transfer related to the purchase of renewal rights of a New
Mexico book of business and increases in both our retail agents and locations,
and partially offset by a decrease in premiums produced by unaffiliated
underwriting agencies due to declining premium volume from a program in runoff. Total revenues for the nine months ended September 30, 2004 were $212.0
million, an increase of $136.7 million, or 181.7%, as compared to total
revenues of $75.2 million for the same period in 2003. Total expenses for the nine months ended September 30, 2004 were $180.4
million, an increase of $125.8 million, or 230.2%, as compared to total
expenses of $54.6 million for the same period in 2003. Pretax income for the nine months ended September 30, 2004 was $31.6 million,
an increase of $11.0 million, or 53.2%, as compared to pretax income of $20.6
million for the same period in 2003. Income tax expense for the nine months ended September 30, 2004 was $11.7
million, or an effective rate of 36.9%, as compared to income tax expense of
$7.4 million, or an effective rate of 35.8% for the same period in 2003. The
increase in income tax expense is primarily related to increases in state
income taxes due to Affirmative falling below 80% ownership in July 2004 and
therefore leaving Vestas federal and state consolidation group. For the nine months ended September 30, 2004, minority interest net of income
taxes was $581,000 as compared to $345,000 for the same period in 2003. Agency segment.Total revenues for the nine months ended September 30, 2004
were $125.1 million, an increase of $17.7 million, or 16.5%, as compared to
total revenues of $107.4 million for the same period in 2003. Revenues for the nine months ended September 30, 2004 and 2003 were generated
primarily through commissions, policy fees and claims processing fees, as
follows: Nine months endedSeptember 30,2004
    
    2003(Unaudited in millions)Commissions
    
    
    71.9
    
    
    $
    58.2Policy and other fees
    
    
    32.5
    
    
    
    29.9Claims processing fees
    
    
    20.6
    
    
    
    19.3Other
    
    
    0.1
    
    
    
    Total
    
    $
    125.1
    
    
    $
    107.4
 For the nine months ended September 30, 2004, gross premiums written produced
by our underwriting agencies were $238.0 million, an increase of $23.4 million,
or 10.9%, as compared to $214.6 million for the same period in 2003. The
principal reasons for the increase in gross premiums written were due to our
Florida underwriting agency, which had increased gross premiums written of
$11.5 million as compared to the same period in 2003, principally driven by the
expansion of a current product into new territories, a $7.1 million increase in
gross premiums written by our Texas underwriting agencies as compared to the 17




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##### Table of Contents



same period in 2003 due to additional appointments of independent agents and
increases in both retail agents and locations and an unearned premium transfer
of $2.0 million related to the purchase of renewal rights of a New Mexico book
of business. Commissions for the nine months ended September 30, 2004 were $71.9 million, an
increase of $13.8 million, or 23.6%, as compared to commissions of $58.2
million for the same period in 2003. We earned commissions in both our
underwriting agencies and retail agencies. Commissions for our underwriting
agencies, which include both provisional and profit-sharing commissions, for
the nine months ended September 30, 2004 were $66.9 million, an increase of
$13.8 million, or 26.1%, as compared to $51.0 million for the same period in
2003. Provisional commissions for our underwriting agencies for the nine months ended
September 30, 2004 were $59.4 million, an increase of $8.4 million, or 16.6%,
as compared to $53.0 million for the same period in 2003. The increase in
provisional commissions was
principally due to increased written premium volume compared to the same period
in 2003, as well as increases in commission rates, which is eliminated in
consolidation, caused by our insurance companies increased retention of
premiums starting July 1, 2004. Profit sharing commissions for our underwriting agencies for the nine months
ended September 30, 2004 were $7.4 million, an increase of $5.4 million, as
compared to $2.0 million for the same period in 2003. The increase in profit
sharing commissions was principally a result of continued favorable loss ratio
development for business produced by our underwriting agencies as compared to
loss ratios recorded as of the beginning of the period. Commissions related to our retail agencies sales of unaffiliated insurance
companies products were $5.1 million for the nine months ended September 30,
2004, a decrease of $69,000, or 1.3%, as compared to $5.1 million for the same
period in 2003, primarily due to the sale of Instant Auto Insurance Agency in
June 2003. Policy and other fees for the nine months ended September 30, 2004 were $32.5
million, an increase of $2.5 million, or 8.5%, as compared to $29.9 million for
the same period in 2003. The increase in policy fees was principally due to the
increased production volume over the same period in 2003. Claims processing fees for the nine months ended September 30, 2004 were $20.6
million, an increase of $1.4, or 7.0%, as compared to $19.3 million for the
same period in 2003, principally due to an increase in the amount of gross
premiums earned on business that our underwriting agencies produced. Total expenses for the nine months ended September 30, 2004 were $103.6
million, an increase of $9.3 million, or 9.9%, as compared to total expenses of
$94.3 million for the same period in 2003.  
    
    Policy acquisition expenses, comprised solely of commission expenses
in our agency segment, for the nine months ended September 30, 2004
were $21.5 million, an increase of $2.7 million, or 14.4%, as compared
to $18.8 million for the same period in 2003, principally due to the
increase in premiums written and slightly offset by a decline in
average commission rate to 15.1% from 15.4% during the prior year.
The decrease in rate was primarily caused by a higher proportion of
our premiums written in markets where we pay lower commission rates.
    
    Employee compensation and benefit expenses for the nine months ended
September 30, 2004 were $43.2 million, an increase of $637,000, or
1.5%, as compared to workforce expense of $42.5 million for the same
period in 2003. The increase in employee compensation and benefit
expenses was principally due to increased medical costs associated
with our self funded medical plans as well as slight increases in
salaries, severance expense and other miscellaneous amounts compared
to the same period in 2003.
    
    Depreciation and amortization expenses for the nine months ended
September 30, 2004 were $3.0 million, an increase of $545,000, or
22.1%, as compared to $2.5 million for the same period in 2003. The
increases in depreciation and amortization expenses were principally
due to increases in software and hardware purchases.
    
    Operating expenses for the nine months ended September 30, 2004 were
$35.9 million, an increase of $5.4 million, or 17.8%, as compared to
$30.5 million for the same period in 2003. The change in operating
expenses was primarily a result of increases in premium related
expenses of $1.9 million due to the increased premium volume produced
by our underwriting agencies, a $1.4 million increase in advertising
expenditures primarily due to the continued expansion of our retail
branding, a $1.4 million increase in professional fees primarily due
to current litigation efforts as well as a $668,000 increase in
license and fees due primarily to increased franchise tax expenses. Pretax income for the nine months ended September 30, 2004 was $21.4 million,
an increase of $8.4 million, or 64.1%, as compared to pretax income of $13.1
million for the same period in 2003. The pretax margin for the nine months
ended September 30, 2004 was 17.1%, an increase from the 12.2% pre-tax margin
recorded in the same period in 2003. Insurance company segment.Total revenues for the nine months ended
September 30, 2004 were $163.8 million, an increase of $156.0 million, as
compared to total revenues of $7.8 million for the same period in 2003. The
increase in total revenues was principally due to our retention of gross
premiums written in our
insurance companies following the termination of the reinsurance agreements
with Vesta, which allowed us to start assuming premiums and losses that were
previously ceded to Vesta Fire beginning January 1, 2004. Net investment income for the nine months ended September 30, 2004 was $1.3
million, an increase of $1.2 million from net investment income of $119,000 for
the same period in 2003. The increase is primarily due to the increase in the
size of our investment portfolio due to the following; capital contributions
into our insurance subsidiaries after our initial public offering, the
settlement of the December 2003 reinsurance transaction with Vesta and
operating cash flows, which increased our investment portfolio to $121.1
million as of September 30, 2004 as compared to $7.5 million as of December 31,
2003. Net realized capital losses for the nine months ended September 30, 2004
were $12,000, compared to net realized capital gains of $457,000 for the same
period in 2003. Loss and loss adjustment expenses for the nine months ended September 30, 2004,
were $95.3 million compared to zero for the same period in 2003. Our loss and
loss adjustment expense ratio for the nine months ended September 30, 2004 was
58.7%. The increase in loss and loss adjustment expenses was due to our
termination of the reinsurance agreements with Vesta. 18




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Policy acquisition and operating expenses for the nine months ended September
30, 2004 were $57.5 million compared to negative $411,000 for the same period
in 2003. The increase in policy acquisition and operating expenses was due to
our termination of the reinsurance agreements with Vesta. Our expense
ratio for the nine months ended September 30, 2004 was 35.4%. The negative expense
recorded for the nine months ended September 30, 2003 is a result of our
insurance companies receiving ceding commissions in an amount greater than
their policy acquisition and operating expenses. Pretax income for the nine months ended September 30, 2004 was $10.9 million,
an increase of $2.8 million, or 340%, as compared to $8.2 million for the same
period in 2003. The increase in pretax income was principally a result of the
profitability of the business being retained starting January 1, 2004 as
compared to the policy fees retained in the insurance segment in the prior
year. Our combined ratio for the nine months ended September 30, 2004 was
94.1%. Corporate and other segment.Operating expense for the nine months ended
September 30, 2004 was $266,000 as compared to zero for the same period in
2003. Operating expenses include investor relations costs, directors and
officers insurance as well as directors fees and travel expenses. Interest
expense for the nine months ended September 30, 2004 was $526,000, as compared
to interest expense of $609,000 for the same period in 2003. The interest
expense primarily represents interest payments on a note payable related to the
Harbor Insurance Group, Inc. acquisition, which began in January 2003 when the
final determination of the contingent payments was made. This note was paid
off in September 2004. Liquidity and Capital Resources Sources and uses of funds.We are a holding company with no business
operations of our own. Consequently, our ability to pay dividends to
stockholders, meet our debt payment obligations and pay our taxes and
administrative expenses is largely dependent on dividends or other
distributions from our subsidiaries, including our insurance company
subsidiaries. There are no restrictions on the payment of dividends by our non-insurance
company subsidiaries other than state corporate laws regarding solvency. As a
result, our non-insurance company subsidiaries generate revenues, profits and
net cash flows that are generally unrestricted as to their availability for the
payment of dividends, and we expect to use those revenues to service our
corporate financial obligations, such as debt service and stockholder
dividends. As of September 30, 2004, we had $9.6 million of cash and invested
assets at the holding company level and $2.7 million of cash and invested
assets at our non-insurance company subsidiaries. State insurance laws restrict the ability of our insurance company subsidiaries
to declare stockholder dividends. These subsidiaries may not make an
extraordinary dividend until 30 days after the applicable commissioner of
insurance has received notice of the intended dividend and has not objected in
such time or until the commissioner has approved the payment of the
extraordinary dividend within the 30-day period. An extraordinary dividend is
defined as any dividend or distribution of cash or other property whose fair
market value, together with that of other dividends and distributions made
within the preceding 12 months, exceeds the greater of 10.0% of the insurance
companys surplus as of the preceding December 31 or the insurance companys
net income for the 12-month period ending the preceding December 31, in each
case determined in accordance with statutory accounting practices. In addition,
an insurance companys remaining surplus after payment of a dividend or other
distribution to stockholder affiliates must be both reasonable in relation to
its outstanding liabilities and adequate to its financial needs. In 2004, our
insurance companies may pay up to $3.7 million in ordinary dividends without
prior regulatory approval, although we do not anticipate that our insurance
company subsidiaries will pay dividends in the foreseeable future because we
intend to reduce our reinsurance purchases and seek stronger financial strength
ratings for our insurance company subsidiaries, both of which will require that
the statutory surplus of our insurance company subsidiaries be increased. The National Association of Insurance Commissioners model law for risk-based
capital provides formulas to determine the amount of capital that an insurance
company needs to ensure that it has an acceptable expectation of not becoming
financially impaired. At September 30, 2004, the capital ratios of both of our
insurance companies substantially exceeded the risk-based capital requirements.
As of September 30, 2004, the capital ratios of both of our insurance companies
exceeded the highest level for regulatory action under the risk-based capital
guidelines. On July 12, 2004, A.M. Best Co. upgraded the financial strength ratings of our
insurance subsidiaries, Affirmative Insurance Company and Insura, to B+ (Very
Good) from B (Fair). The ratings of our insurance companies were removed from
review and assigned a stable outlook. Our rating of B+
(Very Good) is the sixth highest of 15 rating levels. Our operating subsidiaries primary sources of funds are premiums received,
commission and fee income, investment income and the proceeds from the sale and
maturity of investments. Funds are used to pay claims and operating expenses,
to purchase investments and to pay dividends to our holding company. Net cash provided by
operating activities was $49.6 million for the nine months
ended September 30, 2004, as compared to net cash provided by operating
activities of $25.0 million for the same period in 2003. The increase in cash
flow generated from operations was principally due to the collection of certain
amounts due from Vesta Fire in connection with the December 31, 2003
reinsurance restructuring agreement, collections from other reinsurers,
increases in other liabilities, as well as increases in our net income. Net cash used in investing activities was $84.9 million for the nine months
ended September 30, 2004, as compared to net cash used in investing activities
of $17.4 million for the same period in 2003. The increase in cash used in
investing activities was primarily due to increases in bonds acquired by our
insurance companies due to increased cash flow following our December 31, 2003
reinsurance restructuring agreement with Vesta as well as our $64.3 million
capitalization into our insurance companies following our initial public
offering, offset in part by a reduction in our cash paid for acquisitions according to
agreed upon payment schedules. During the first quarter of 2004, we received
$35.6 million in fixed income securities from Vesta, in lieu of cash, to settle
the collection of premiums and fees, receivables from reinsurers, exchanges of
other invested assets and miscellaneous inter-company balances. 19




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##### Table of Contents



We invest our insurance portfolio funds in highly rated fixed income
securities. Our portfolio is managed by an outside investment advisor on an
active basis in compliance with investment policies promulgated by us.
Information about our investment portfolio is as follows: As ofSeptember 30,
    
    December 31,2004
    
    2003Tax equivalent book yield
    
    
    3.99
    %
    
    
    2.54
    %Average duration in years
    
    
    3.9
    
    
    
    3.3Average S&P rating
    
    AA+
    
    AAA
 Net cash provided by
financing activities was $57.1 million for the nine months
ended September 30, 2004, as compared to net cash used in financing activities
of $3.7 million for the same period in 2003. The increase in cash provided by
financing activities was primarily related to the completion of our initial
public offering of our common stock effective July 9, 2004 in which we raised
net proceeds of $65.3 million, as well as other issuances of our common stock
in March 2004. These increases were offset by additional principal payments
applied to our note payable from 2003 to 2004. We believe that existing cash and investment balances, as well as new cash
flows generated from operations, and available borrowings under our credit facility, will be adequate to meet our capital and
liquidity needs during the 12-month period following the date of our initial
public offering at both the holding company and insurance company levels. We do
not currently know of any events that could cause a material increase or
decrease in our long-term liquidity needs. If such events materialize, we will
identify the source and disclose our plan of action to remedy any deficiency. Initial public offering.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 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. Our net proceeds
from the offering were $65.3 million, after deducting our offering
expenses. We contributed $64.3 million of the net proceeds to our insurance
companies in order to increase their statutory surplus. This additional
capital will permit us to reduce our reinsurance purchases and retain more
gross premiums over time. The remaining $1.0 million of net proceeds we
received will be used for general corporate purposes. At the conclusion of
these transactions, Vesta owned approximately 42.6% of our issued and
outstanding capital stock. Credit facility.On 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 initially accrue
interest at an annual rate of LIBOR plus 1.50% and we will pay letter of credit
fees based on an initial annual rate of 0.75%. 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 acquisitions activities. Currently, we have not borrowed
against our facility. As of September 30, 2004, we are in compliance with all
of our financial and other restrictive covenants. New Accounting Pronouncements In January 2003, the FASB issued Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities. FIN 46 states that if a business
enterprise is the primary beneficiary of a variable interest entity, the
assets, liabilities and results of the activities of the variable interest
entity should be included in the consolidated financial statements of the
business enterprise. This Interpretation explains how to identify variable
interest entities and how an enterprise assesses its interests in a variable
interest entity to decide whether to consolidate that entity. FIN 46 also
requires existing unconsolidated variable interest entities to be consolidated
by their primary beneficiaries if the entities do not effectively disperse
risks among parties involved. Variable interest entities that effectively
disperse risks will not be consolidated unless a single party holds an interest
or combination of interests that effectively recombines risks that were
previously dispersed. Due to significant implementation concerns, the FASB
modified the wording of FIN 46 and issued FIN 46R in December 2003. FIN 46R
deferred the effective date for the provisions of FIN 46 to pre-existing
entities other than Special Purpose Entities (SPEs) until financial
statements are issued for periods ending after March 15, 2004. SPEs are
subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003.
Our adoption of FIN 46 and FIN 46R did not have a material impact on our
consolidated financial position or consolidated results of operations. In 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. Special Note Regarding Forward-Looking Statements Any statement contained in this report which is not a historical fact, or which
might otherwise be considered an opinion or projection concerning the Company
or its business, whether express or implied, is meant as and should be
considered a forward-looking statement as that term is defined in the Private
Securities Litigation Reform Act of 1996. Forward-looking statements are based
on assumptions and opinions concerning a variety of known and unknown risks,
including but not necessarily limited to changes in market conditions, natural
disasters and other catastrophic events, increased competition, changes in
availability and cost of reinsurance, changes in governmental regulations, and
general economic conditions, as well as other risks more completely described
in our filings with the Securities and Exchange Commission. If any of these
assumptions or opinions prove incorrect, any forward-looking statements made on
the basis of such assumptions or opinions may also prove materially incorrect
in one or more respects. 20




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Unaudited Pro Forma Financial Information The following unaudited pro forma financial information is intended to provide
information about how the transfer to us by Vesta of all economic interest in
the NSA Business beginning January 1, 2004 may have affected our historical
financial statements if the results of the NSA Business had been combined for
the periods presented. Because the NSA Business is not associated with any
single legal entity, it does not have historical balance sheets reflecting a
separate investment portfolio and stockholders equity, nor does it have
complete statements of operations reflecting investment income, investments
gains and losses and income taxes. We have made pro forma adjustments to our
historical consolidated statements of operations for the underwriting results
of the NSA Business. The following unaudited pro forma financial information
does not necessarily reflect the results of operations that may have actually
resulted had the transactions described occurred as of the dates indicated, nor
should the following unaudited pro forma information be taken as necessarily
indicative of our future results of operations. Three Months Ended September 30, 2003Affirmative
    
    Pro Forma
    
    AffirmativeHistorical
    
    Adjustments
    
    Pro FormaAs Reported (1)
    
    and Eliminations (2)
    
    Combined(in thousands, except per share data)RevenuesNet premiums earned
    
    $
    
    
    
    $
    43,343
    
    
    $
    43,343Commissions and fees
    
    
    24,051
    
    
    
    (9,337
    )
    
    
    14,714Net investment income (3)
    
    
    46
    
    
    
    
    
    
    
    46Realized losses (3)
    
    
    16
    
    
    
    
    
    
    
    16Other
    
    
    
    
    
    
    667
    
    
    
    667Total revenues
    
    
    24,113
    
    
    
    34,673
    
    
    
    58,786ExpensesLosses and loss adjustment expenses
    
    
    
    
    
    
    29,821
    
    
    
    29,821Policy acquisition and operating expenses
    
    
    17,752
    
    
    
    5,086
    
    
    
    22,838Interest expense
    
    
    239
    
    
    
    
    
    
    
    239Total expenses
    
    
    17,991
    
    
    
    34,907
    
    
    
    52,898Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    6,122
    
    
    
    (234
    )
    
    
    5,888Income tax expense (4)
    
    
    2,189
    
    
    
    (84
    )
    
    
    2,105Minority interest, net of income taxes
    
    
    89
    
    
    
    
    
    
    
    89Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    174
    
    
    
    
    
    
    
    174Net income
    
    $
    3,670
    
    
    $
    (150
    )
    
    $
    3,520Net income
per common share - Basic
    
    $
    0.36
    
    
    $
    (0.01
    )
    
    $
    0.35Net income
per common share - Diluted
    
    $
    0.36
    
    
    $
    (0.01
    )
    
    $
    0.35
 21




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##### Table of Contents



Nine Months Ended September 30, 2003Affirmative
    
    Pro Forma
    
    AffirmativeHistorical
    
    Adjustments
    
    Pro FormaAs Reported (1)
    
    and Eliminations (2)
    
    Combined(in thousands, except per share data)RevenuesNet premiums earned
    
    $
    
    
    
    $
    123,809
    
    
    $
    123,809Commissions and fees
    
    
    74,644
    
    
    
    (22,864
    )
    
    
    51,780Net investment income (3)
    
    
    148
    
    
    
    
    
    
    
    148Realized gains (3)
    
    
    451
    
    
    
    
    
    
    
    451Other
    
    
    
    
    
    
    2,352
    
    
    
    2,352Total revenues
    
    
    75,243
    
    
    
    103,297
    
    
    
    178,540ExpensesLosses and loss adjustment expenses
    
    
    
    
    
    
    84,925
    
    
    
    84,925Policy acquisition and operating expenses
    
    
    54,015
    
    
    
    18,308
    
    
    
    72,323Interest expense
    
    
    609
    
    
    
    
    
    
    
    609Total expenses
    
    
    54,624
    
    
    
    103,233
    
    
    
    157,857Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    20,619
    
    
    
    64
    
    
    
    20,683Income tax expense (4)
    
    
    7,372
    
    
    
    21
    
    
    
    7,393Minority interest, net of income taxes
    
    
    345
    
    
    
    
    
    
    
    345Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    174
    
    
    
    
    
    
    
    174Net income
    
    $
    12,728
    
    
    $
    43
    
    
    $
    12,771Net income
per common share - Basic
    
    $
    1.26
    
    
    $
    0.01
    
    
    $
    1.27Net income
per common share - Diluted
    
    $
    1.26
    
    
    $
    0.00
    
    
    $
    1.26
  (1)
    
    Effective December 31, 2003, we acquired 100% of the stock of two
insurance companies  Affirmative Insurance Company and Insura  from
Vesta, in exchange for shares of our common stock. We accounted for our
acquisitions of the insurance companies at Vestas historical carrying
values as transfers of net assets between entities under common control
in accordance with SFAS No. 141. The acquisition was accounted for as a
pooling of interests. Accordingly, our historical financial information
shown above reflect our
historical results of operations and the results of Affirmative Insurance
Company and Insura on a combined basis, as if this transaction had been
consummated prior to the periods presented. Prior to December 31, 2003,
Vesta reinsured 100% of the NSA Business written by Affirmative Insurance
Company and Insura. As a result of this reinsurance agreement, our
historical statements of operations do not include the underwriting
results of the NSA Business written by our insurance companies, but only
certain revenues, primarily policy fees that were not ceded to Vesta.(2)
    
    Reflects pro forma adjustments to include the underwriting results of
the NSA Business, including the portion written or assumed by our
consolidated insurance companies that we historically ceded to Vesta, as
well as other revenues and expenses associated with the NSA Business
that were earned or incurred by other Vesta insurance company
subsidiaries that we do not consolidate, after eliminating commissions
and fees and associated expenses paid to us by those other
unconsolidated companies(3)
    
    Reflects the historical results of the investment portfolios of
Affirmative Insurance Company and Insura that we acquired effective
December 31, 2003.(4)
    
    Because the NSA Business is not associated with any single legal
entity, it does not have complete statements of operations reflecting
income taxes, therefore income taxes were assumed. 22




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##### Table of Contents



The following unaudited pro forma financial information is presented for our
business segments and is intended to provide information about how the transfer
to us of the future economic interest in the NSA Business effective December
31, 2003 may have affected our historical statements of operations of these
business segments if the results of this business had been combined for the
periods presented. Three Months Ended September 30, 2003Insurance
    
    
    
    
    
    
    
    
    
    ConsolidatedAgency
    
    Company
    
    Corporate
    
    Pro Forma
    
    Pro FormaSegment (1)
    
    Segment (2)
    
    Segment (1)
    
    Eliminations (3)
    
    Total(in thousands)RevenuesNet premiums earned
    
    $
    
    
    
    $
    43,343
    
    
    $
    
    
    
    $
    
    
    
    $
    43,343Commissions and fees
    
    
    34,617
    
    
    
    5,747
    
    
    
    
    
    
    
    (25,650
    )
    
    
    14,714Net investment income (4)
    
    
    6
    
    
    
    40
    
    
    
    
    
    
    
    
    
    
    
    46Realized gains (losses) (4)
    
    
    (8
    )
    
    
    24
    
    
    
    
    
    
    
    
    
    
    
    16Other
    
    
    
    
    
    
    667
    
    
    
    
    
    
    
    
    
    
    
    667Total revenues
    
    
    34,615
    
    
    
    49,821
    
    
    
    
    
    
    
    (25,650
    )
    
    
    58,786ExpensesLosses and loss adjustment expenses
    
    
    
    
    
    
    29,821
    
    
    
    
    
    
    
    
    
    
    
    29,821Policy acquisition and operating expenses
    
    
    30,847
    
    
    
    17,641
    
    
    
    
    
    
    
    (25,650
    )
    
    
    22,838Interest expense
    
    
    
    
    
    
    
    
    
    
    239
    
    
    
    
    
    
    
    239Total expenses
    
    
    30,847
    
    
    
    47,462
    
    
    
    239
    
    
    
    (25,650
    )
    
    
    52,898Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    3,768
    
    
    
    2,359
    
    
    
    (239
    )
    
    
    
    
    
    
    5,888Income tax expense
    
    
    1,347
    
    
    
    843
    
    
    
    (85
    )
    
    
    
    
    
    
    2,105Minority interest, net of income taxes
    
    
    89
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    89Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    
    
    
    
    
    
    
    
    174
    
    
    
    
    
    
    
    174Net income
    
    $
    2,332
    
    
    $
    1,516
    
    
    $
    (328
    )
    
    $
    
    
    
    $
    3,520
 Nine Months Ended September 30, 2003Insurance
    
    
    
    
    
    
    
    
    
    ConsolidatedAgency
    
    Company
    
    Corporate
    
    Pro Forma
    
    Pro FormaSegment (1)
    
    Segment (2)
    
    Segment (1)
    
    Eliminations (3)
    
    Total(in thousands)RevenuesNet premiums earned
    
    $
    
    
    
    $
    123,809
    
    
    $
    
    
    
    $
    
    
    
    $
    123,809Commissions and fees
    
    
    107,366
    
    
    
    16,380
    
    
    
    
    
    
    
    (71,966
    )
    
    
    51,780Net investment income (4)
    
    
    29
    
    
    
    119
    
    
    
    
    
    
    
    
    
    
    
    148Realized gains (4)
    
    
    (6
    )
    
    
    457
    
    
    
    
    
    
    
    
    
    
    
    451Other
    
    
    
    
    
    
    2,352
    
    
    
    
    
    
    
    
    
    
    
    2,352Total revenues
    
    
    107,389
    
    
    
    143,117
    
    
    
    
    
    
    
    (71,966
    )
    
    
    178,540ExpensesLosses and loss adjustment expenses
    
    
    
    
    
    
    84,925
    
    
    
    
    
    
    
    
    
    
    
    84,925Policy acquisition and operating expenses
    
    
    94,326
    
    
    
    49,963
    
    
    
    
    
    
    
    (71,966
    )
    
    
    72,323Interest expense
    
    
    
    
    
    
    
    
    
    
    609
    
    
    
    
    
    
    
    609Total expenses
    
    
    94,326
    
    
    
    134,888
    
    
    
    609
    
    
    
    (71,966
    )
    
    
    157,857Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    13,063
    
    
    
    8,229
    
    
    
    (609
    )
    
    
    
    
    
    
    20,683Income tax expense
    
    
    4,670
    
    
    
    2,941
    
    
    
    (218
    )
    
    
    
    
    
    
    7,393Minority interest, net of income taxes
    
    
    345
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    345Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    
    
    
    
    
    
    
    
    174
    
    
    
    
    
    
    
    174Net income
    
    $
    8,048
    
    
    $
    5,288
    
    
    $
    (565
    )
    
    $
    
    
    
    $
    12,771
 23




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##### Table of Contents



1)
    
    The unaudited pro forma statement of operations information for the
agency segment and the corporate segment has been derived from our
historical business segment information presented in the financial
statements included in this report.2)
    
    The unaudited pro forma statement of operations information for the
insurance segment has been derived from our historical business segment
information presented in the financial statements included in this
report. The pro forma adjustments reflect the results of the NSA
Business as reported by Vesta in the segment footnote of Vestas
financial statements, including 100% of the net premium earned by Vesta
on non-standard personal automobile insurance policies during 2003 as
well as policy fees and other revenues and expenses that were earned or
incurred by Vestas insurance company subsidiaries other than
Affirmative Insurance Company and Insura during 2003.3)
    
    The commissions and fees paid to our underwriting agencies by our
consolidated insurance companies and the other Vesta insurance
subsidiaries whose results have been included on a pro forma basis, and
the associated expenses, are eliminated in pro forma eliminations.4)
    
    The net investment income and realized gains reflected in the
unaudited pro forma statements of operations reflect the historical
results of the investment portfolios of Affirmative Insurance Company
and Insura that we acquired on December 31, 2003. 
 Item 3. Quantitative and Qualitative Disclosures About Market Risk We believe that interest rate risk and credit risk are the two types of market
risk to which we are principally exposed. Interest rate risk.Our investment portfolio consists principally of
investment-grade, fixed income securities, all of which are classified as
available for sale. Accordingly, the primary market risk exposure to our debt
securities is interest rate risk. In general the fair market value of a
portfolio of fixed income securities increases or decreases inversely with
changes in market interest rates, while net investment income realized from
future investments in fixed income securities increases or decreases along with
interest rates. In addition, some of our fixed income securities have call or
prepayment options. This could subject us to reinvestment risk should interest
rates fall and issuers call their securities and we reinvest at lower interest
rates. We attempt to mitigate this interest rate risk by investing in
securities with varied maturity dates and by managing the duration of our
investment portfolio to a defined range of three to four years. The fair value
of our fixed income securities as of September 30, 2004 was $121.1 million. The
effective duration of the portfolio as of September 30, 2004 was 3.9 years.
Should the market interest rates increase 1.0%, our fixed income investment
portfolio would be expected to decline in market value by 3.9%, or $4.7
million, representing the effective duration multiplied by the change in market
interest rates. Conversely, a 1.0% decline in interest rates would result in a
3.9%, or $4.7 million, increase in the market value of our fixed income
investment portfolio. Credit risk.An additional exposure to our fixed income securities portfolio
is credit risk. We attempt to manage our credit risk by investing only in
investment grade securities and limiting our exposure to a single issuer. As of
September 30, 2004, our fixed income investments were invested in the
following: U.S. Treasury securities  5.1%, mortgage-backed securities 
7.6%, corporate securities  20.3%, and municipal securities  67.0%. As of
September 30, 2004, all of our fixed income securities were rated investment
grade by nationally recognized statistical rating organizations. We are subject to credit risks with respect to our reinsurers. Although a
reinsurer is liable for losses to the extent of the coverage which it assumes,
our reinsurance contracts do not discharge our insurance companies from primary
liability to each policyholder for the full amount of the applicable policy,
and consequently our insurance companies remain obligated to pay claims in
accordance with the terms of the policies regardless of whether a reinsurer
fulfills or defaults on its obligations under the related reinsurance
agreement. In order to mitigate credit risk to reinsurance companies, we
attempt to select financially strong reinsurers with an A.M. Best rating of
A- or better and continue to evaluate their financial condition. At September 30, 2004, we had a total of $112.8 million of receivables from
reinsurers, of which $44.8 million was due from Vesta Fire. Our reinsurance
agreements with Vesta Fire allow us and Vesta Fire to offset amounts due to one
another under these agreements. At September 30, 2004, we owed
Vesta Fire $42.2
million under a quota share reinsurance agreement. Vesta Fire is currently
rated B (Fair) by A.M. Best. According to our reinsurance agreement, if
Vesta Fires A.M. Best financial strength rating remained below B+ after the
consummation of our initial public offering, we had the right to require Vesta
Fire to provide a letter of credit or establish a trust account to
collateralize the net amount due to us from Vesta Fire under these reinsurance
agreements. We anticipate the reinsurance recoverable due from Vesta Fire to
decline over time as the loss and loss adjustment expenses that were ceded
related to the non-standard automobile business written by us prior to December
31, 2003 are paid. On July 27, 2004, we notified Vesta to establish a trust
account collateralizing the net amount due to us, due to the fact that Vesta
Fires A.M. Best rating was below a B+ after the consummation of our initial
public offering. As of September 30, 2004, Vesta has fully collateralized the
net amount due to us. As part of the terms of the acquisition of Affirmative Insurance Company and
Insura, 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, 2004, all such
unaffiliated reinsurers had A.M. Best ratings of A- or better. Effects of inflation.We do not believe that inflation has a material effect
on our results of operations, except for the effect that inflation may have on
interest rates and claims costs. The effects of inflation are considered in
pricing and estimating reserves for unpaid claims and claim expenses. The
actual effects of inflation on our results are not known until claims are
ultimately settled. In addition to general price inflation, we are exposed to a
persisting long-term upward trend in the cost of judicial awards for damages.
We attempt to mitigate the effects of inflation in our pricing and establishing
of loss and loss adjustment expense reserves. 
 Item 4. Controls and Procedures We carried out an evaluation, under the supervision and with the participation
of our principal executive officer and principal financial officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures as of September 30, 2004 pursuant to Rule 13a-15 of the Securities
and Exchange Act of 1934, as amended. Based on this evaluation, our principal
executive officer and principal financial officer concluded that as of
September 30, 2004 our disclosure controls and procedures are effective.
Disclosure controls and procedures are controls and procedures designed to
ensure that information required to be disclosed in our reports filed or
submitted under the Securities Exchange Act of 1934 is recorded, processed,
summarized and reported within the time period specified in the SECs rules and
forms and include controls and procedures designed to ensure that information
we are required to disclose in such reports is accumulated and communicated to
management, including our Chief Executive Officer and Chief Financial Officer,
as appropriate to allow timely decisions regarding required disclosure. There have been no significant changes in our internal controls over financial
reporting that occurred during our last fiscal quarter that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting. 24




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##### Table of Contents



PART II 
 Item 1. Legal Proceedings
 We 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. We are the subject of a purported class action in South Carolina alleging that
we have improperly denied coverage for losses resulting from the operation of
insured vehicles by undisclosed permissive use drivers. The non-standard
personal automobile policies in question were issued by a subsidiary of Vesta
and were sold through Drivers Choice, one of our underwriting agencies. The
plaintiff seeks injunctive relief and contract reformation, as well as an
unspecified amount of compensatory and punitive damages, costs and interest
based on claims for breach of contract, bad faith, fraud and negligence. This
matter is still in the early procedural stages and as of the date of this
report the class had not been certified. Although we are vigorously defending
this lawsuit, the ultimate outcome of this case is uncertain. On May 6, 2004, the former minority owners of our InsureOne retail agency,
including InsureOnes former president, 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 seek 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. InsureOne filed a motion to dismiss this
case, and we anticipate that no other substantive action will occur until the
Court rules on the motion to dismiss. We believe this complaint is without
merit, and we are vigorously contesting the claims brought by the plaintiffs
and are exercising all available rights and remedies against them. InsureOnes former president is also a defendant, along with eight former
employees of InsureOne, 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 have
entered interim orders prohibiting the defendants from hiring any employees of
InsureOne or one of our other underwriting agencies. These orders are
presently in effect until November 2004, when the trial in the Illinois case of
our claims for permanent injunctive relief and an undetermined amount of
compensatory and punitive damages was originally scheduled; provided however, a
hearing has been scheduled for November 2004 to determine a new trial date,
which is expected to be set either in December 2004 or January 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. InsureOne filed a motion to dismiss the
counterclaim, and that motion is pending before the Court. We believe the
counterclaim is without merit. We are vigorously contesting the counterclaim
and are exercising all rights and remedies available to us. 
 Item 2. Unregistered Sales of Equity Securities and Use of Proceeds None. 
 Item 3. Defaults Upon Senior Securities None. 
 Item 4. Submission of Matters to a Vote of Security Holders None. 
 Item 5. Other information None. 25




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##### Table of Contents



Item 6. Exhibits a) EXHIBITS  3.1
    
    Amended and Restated Certificate of Incorporation of Affirmative
Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.1 to our
Registration Statement on Form S-1 filed with the SEC on March 22, 2004,
File No. 333-113793).3.2
    
    Amended and Restated Bylaws of Affirmative Insurance Holdings, Inc.
(incorporated by reference to Exhibit 3.2 to our Registration Statement on
Form S-1 filed with the SEC on March 22, 2004, File No. 333-113793).4.1
    
    Form of Common Stock Certificate (incorporated by reference to Exhibit
4.1 to Amendment No. 3 to our Registration Statement on Form S-1 filed
with the SEC on June 14, 2004, File No. 333-113793).4.2
    
    Form of Registration Rights Agreement between Affirmative Insurance
Holdings, Inc. and Vesta Insurance Group, Inc. (incorporated by reference
to Exhibit 4.2 to Amendment No. 2 to our Registration Statement on Form
S-1 filed with the SEC on May 27, 2004, File No. 333-113793).*10.1
    
    Credit Facility between Affirmative Insurance Holdings, Inc. and The Frost National Bank.*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
    
    Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*
    
    Filed herewith 
 Signatures Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized. Affirmative Insurance Holdings, Inc.Date: November 15, 2004/s/ Timothy A. BienekBy: Timothy A. BienekExecutive Vice President andChief Financial Officer(and in his capacity as Principal Financial Officer)
 26