##### Table of Contents



UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended June 30, 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
    
    75-2770432(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)4450 Sojourn Drive, Suite 500Addison, Texas
    
    75001(Address of principal executive offices)
    
    (Zip Code)
 (972) 728-6300(Registrants telephone number, including area code) Not
Applicable(Former name, former address and former fiscal year, if changed since last report) 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. o Yes x 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 August 11, 2004
16,754,883




---



Affirmative Insurance Holdings, Inc.
Index Part I
    
    Financial Information
    
    PageItem 1.
    
    Financial StatementsConsolidated Balance Sheets as of June 30, 2004 (unaudited) and December 31, 2003
    
    
    1Consolidated Statements of Operations for the Three Months Ended June 30, 2004 and 2003
    
    
    2Consolidated Statements of Operations for the Six Months Ended June 30, 2004 and 2003
    
    
    2Consolidated Statements of Stockholders Equity and Comprehensive Income
for the Six Months Ended June 30, 2004 and 2003
    
    
    3Consolidated Statements of Cash Flows for the Six Months Ended June 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.
    
    Quantitative and Qualitative Disclosures About Market Risk
    
    
    23Item 4.
    
    Control Procedures
    
    
    23Part II
    
    Other InformationItem 1.
    
    Legal Proceedings
    
    
    24Item 2.
    
    Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    24Item 3.
    
    Defaults Upon Senior Securities
    
    
    24Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    24Item 5.
    
    Other Information
    
    
    24Item 6.
    
    Exhibits and Reports on Form 8-K
    
    
    25Signatures
    
    
    25Certification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO & CFO Pursuant to Section 906




---



##### Table of Contents



Part I 
 Item 1. Financial Statements
 Affirmative Insurance Holdings, Inc.
 
 Consolidated Balance
Sheets
June 30, 2004 and December 31, 2003
 June 30,
    
    December 31,2004
    
    2003(Unaudited)(dollars in thousands, exceptshare data)AssetsFixed maturities  available for sale, at
fair value (amortized cost 2004: $54,416, 2003: $6,623)
    
    $
    53,346
    
    
    $
    6,610Other invested assets
    
    
    
    
    
    
    92853,346
    
    
    
    7,538Cash and cash equivalents
    
    
    39,446
    
    
    
    15,358Fiduciary and restricted cash
    
    
    12,438
    
    
    
    9,467Accrued investment income
    
    
    692
    
    
    
    47Premiums and
fees receivable (includes related parties  2004: $37,866; 2003: $35,458)
    
    
    108,382
    
    
    
    75,596Commissions receivable (includes related parties  2004: $1,873; 2003: $2,340)
    
    
    6,914
    
    
    
    7,043Receivable from reinsurers (includes related parties  2004: $49,359; 2003: $87,584)
    
    
    96,005
    
    
    
    94,526Deferred acquisition costs
    
    
    12,560
    
    
    
    14,371Receivable from affiliates
    
    
    352
    
    
    
    Property and equipment, net
    
    
    6,884
    
    
    
    6,519Goodwill
    
    
    65,262
    
    
    
    65,010Other intangible assets, net
    
    
    14,228
    
    
    
    14,586Other assets
    
    
    5,431
    
    
    
    4,518Total assets
    
    $
    421,940
    
    
    $
    314,579Liabilities and Stockholders EquityLiabilitiesReserves for losses and loss adjustment expenses
    
    
    87,414
    
    
    
    58,507Unearned premium (includes related parties  2004: $20,882; 2003: $35,458)
    
    
    85,885
    
    
    
    71,226Amounts due reinsurers (includes related parties   2004: ($3,909); 2003: $15,664)
    
    
    50,252
    
    
    
    19,633Payable to affiliates
    
    
    
    
    
    
    86Deferred revenue
    
    
    20,976
    
    
    
    15,451Federal income taxes payable
    
    
    13,257
    
    
    
    7,687Deferred income taxes
    
    
    1,616
    
    
    
    1,254Notes payable
    
    
    5,825
    
    
    
    10,020Consideration due for acquisitions
    
    
    2,592
    
    
    
    4,275Other liabilities
    
    
    27,658
    
    
    
    13,063Total liabilities
    
    
    295,475
    
    
    
    201,202Commitments and contingencies (Note 5)Stockholders equityCommon stock, $0.01 par value; 75,000,000 shares authorized, 11,671,883
shares issued
and outstanding at June 30, 2004; 40,000,000 shares authorized; 11,557,215
shares issued and outstanding at December 31, 2003
    
    
    117
    
    
    
    116Warrants
    
    
    
    
    
    
    157Additional paid-in capital
    
    
    85,230
    
    
    
    84,074Accumulated other comprehensive loss
    
    
    (684
    )
    
    
    (9
    )Retained earnings
    
    
    41,802
    
    
    
    29,039Total stockholders equity
    
    
    126,465
    
    
    
    113,377Total liabilities and stockholders equity
    
    $
    421,940
    
    
    $
    314,579
 See accompanying Notes to Consolidated Financial Statements 1




---



##### Table of Contents



Affirmative Insurance Holdings, Inc. 
 Consolidated Statements of Operations  (Unaudited)
 Three Months Ended June 30, 2004 and 2003
 Six Months Ended June 30, 2004 and 2003
 Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(dollars in thousands, except per share data)RevenuesNet premiums earned
    
    $
    43,738
    
    
    $
    
    
    
    $
    90,948
    
    
    $
    Commission
income (includes related parties  three months, 2004: $138; 2003: $5,898, six months, 2004: $787; 2003: $11,278)
    
    
    8,276
    
    
    
    11,165
    
    
    
    19,200
    
    
    
    24,928Fee income (includes related parties   three months, 2003: $4,101, six months,
2003: $6,714)
    
    
    13,826
    
    
    
    9,610
    
    
    
    27,317
    
    
    
    20,281Claims processing fees (includes related parties  three months, 2003: $2,328,
six months, 2003: $4,005)
    
    
    1,009
    
    
    
    2,582
    
    
    
    1,355
    
    
    
    5,384Net investment income
    
    
    363
    
    
    
    52
    
    
    
    590
    
    
    
    102Realized gains (losses)
    
    
    (3
    )
    
    
    (9
    )
    
    
    (20
    )
    
    
    435Total revenues
    
    
    67,209
    
    
    
    23,400
    
    
    
    139,390
    
    
    
    51,130ExpensesLosses and loss adjustment expenses
    
    
    28,149
    
    
    
    
    
    
    
    59,857
    
    
    
    Policy acquisition expenses
    
    
    13,620
    
    
    
    3,653
    
    
    
    26,273
    
    
    
    8,253Employee compensation and benefits
    
    
    10,230
    
    
    
    8,961
    
    
    
    20,909
    
    
    
    18,277Depreciation and amortization
    
    
    961
    
    
    
    911
    
    
    
    1,845
    
    
    
    1,682Operating expenses
    
    
    4,821
    
    
    
    4,004
    
    
    
    9,104
    
    
    
    8,051Interest expense
    
    
    174
    
    
    
    265
    
    
    
    391
    
    
    
    370Total expenses
    
    
    57,955
    
    
    
    17,794
    
    
    
    118,379
    
    
    
    36,633Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    9,254
    
    
    
    5,606
    
    
    
    21,011
    
    
    
    14,497Income tax expense
    
    
    3,311
    
    
    
    2,004
    
    
    
    7,518
    
    
    
    5,183Minority interest, net of income taxes
    
    
    212
    
    
    
    10
    
    
    
    307
    
    
    
    256Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    250
    
    
    
    
    
    
    
    423
    
    
    
    Net income
    
    $
    5,481
    
    
    $
    3,592
    
    
    $
    12,763
    
    
    $
    9,058Net income per common share  Basic
    
    $
    0.47
    
    
    $
    0.36
    
    
    $
    1.10
    
    
    $
    0.90Net income per common share  Diluted
    
    $
    0.47
    
    
    $
    0.36
    
    
    $
    1.09
    
    
    $
    0.90
 See accompanying Notes to Consolidated Financial Statements 2




---



##### Table of Contents



Affirmative Insurance Holdings, Inc. 
 Consolidated Statements of Stockholders Equity and Comprehensive Income  (Unaudited)
 Six Months Ended June 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
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    9,058
    
    
    
    
    
    
    
    9,058Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (289
    )
    
    
    (289
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    8,769Issuance of common stock
    
    
    53,615
    
    
    
    1
    
    
    
    
    
    
    
    407
    
    
    
    
    
    
    
    
    
    
    
    408Balance, June 30, 2003
    
    
    10,085,230
    
    
    $
    101
    
    
    $
    157
    
    
    $
    68,152
    
    
    $
    19,040
    
    
    $
    74
    
    
    $
    87,524Balance, December 31, 2003
    
    
    11,557,215
    
    
    $
    116
    
    
    $
    157
    
    
    $
    84,074
    
    
    $
    29,039
    
    
    $
    (9
    )
    
    $
    113,377Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,763
    
    
    
    
    
    
    
    12,763Other comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (675
    )
    
    
    (675
    )Total comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    12,088Issuance of common stock
    
    
    114,668
    
    
    
    1
    
    
    
    (157
    )
    
    
    1,156
    
    
    
    
    
    
    
    
    
    
    
    1,000Balance, June 30, 2004
    
    
    11,671,883
    
    
    $
    117
    
    
    $
    
    
    
    $
    85,230
    
    
    $
    41,802
    
    
    $
    (684
    )
    
    $
    126,465
 See accompanying Notes to Consolidated Financial Statements 3




---



##### Table of Contents



Affirmative Insurance Holdings, Inc. 
 Consolidated Statements of Cash Flows  (Unaudited)
 Six Months Ended June 30, 2004 and 2003
 Six months endedJune 30,2004
    
    2003(dollars in thousands)Cash flows from operating activitiesNet income
    
    $
    12,763
    
    
    $
    9,058Adjustments to reconcile net income to net cash provided by
operating activities:Depreciation and amortization
    
    
    1,845
    
    
    
    1,682Undistributed equity in unconsolidated subsidiaries
    
    
    423
    
    
    
    Realized (gain) loss on sale of bonds
    
    
    20
    
    
    
    (435
    )Changes in assets and liabilities:Fiduciary and restricted cash
    
    
    (2,971
    )
    
    
    5,881Premiums and commissions receivable
    
    
    (47,383
    )
    
    
    3,772Reserves for loss and loss expenses
    
    
    28,907
    
    
    
    (1,978
    )Amounts due reinsurers
    
    
    9,140
    
    
    
    (14,278
    )Receivable from affiliates
    
    
    (438
    )
    
    
    19,212Deferred revenue
    
    
    5,525
    
    
    
    264Unearned premiums
    
    
    14,659
    
    
    
    (4,086
    )Deferred acquisition costs
    
    
    1,811
    
    
    
    Other
    
    
    19,595
    
    
    
    658Net cash provided by operating activities
    
    
    43,896
    
    
    
    19,750Cash flows from investing activitiesProceeds from the sale of bonds
    
    
    4,278
    
    
    
    4,822Cost of bonds acquired
    
    
    (16,691
    )
    
    
    (5,452
    )Purchases of property and equipment
    
    
    (1,840
    )
    
    
    (974
    )Net cash paid for acquisitions
    
    
    (1,946
    )
    
    
    (7,892
    )Net cash used in investing activities
    
    
    (16,199
    )
    
    
    (9,496
    )Cash flows from financing activitiesPrincipal payments under capital lease obligation
    
    
    (341
    )
    
    
    (99
    )Principal payments on note payable
    
    
    (4,195
    )
    
    
    (2,856
    )Proceeds from issuance of common stock
    
    
    927
    
    
    
    407Net cash used in financing activities
    
    
    (3,609
    )
    
    
    (2,548
    )Net increase in cash and cash equivalents
    
    
    24,088
    
    
    
    7,706Cash and cash equivalents, beginning of period
    
    
    15,358
    
    
    
    1,599Cash and cash equivalents, end of period
    
    $
    39,446
    
    
    $
    9,305
 See accompanying Notes to Consolidated Financial Statements 4




---



##### 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 144 retail store locations as of June 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 such
rules and regulations 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 Securities and Exchange
Commission.The interim financial data as of June 30, 2004 and for the six months ended
June 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 123 to 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 25 and
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




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income, as reported
    
    $
    5,481
    
    
    $
    3,592
    
    
    $
    12,763
    
    
    $
    9,058Add: stock-based employee compensation expense included in
reported net income, net of related income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Deduct: total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related income taxes
    
    
    (24
    )
    
    
    (62
    )
    
    
    (49
    )
    
    
    (125
    )Net income, pro forma
    
    $
    5,457
    
    
    $
    3,530
    
    
    $
    12,714
    
    
    $
    8,933Basic earnings per share  as reported
    
    $
    0.47
    
    
    $
    0.36
    
    
    $
    1.10
    
    
    $
    0.90Basic earnings per share  pro forma
    
    $
    0.47
    
    
    $
    0.35
    
    
    $
    1.09
    
    
    $
    0.89Diluted earnings per share  as reported
    
    $
    0.47
    
    
    $
    0.36
    
    
    $
    1.09
    
    
    $
    0.90Diluted earnings per share  pro forma
    
    $
    0.46
    
    
    $
    0.35
    
    
    $
    1.08
    
    
    $
    0.89
  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.3.
    
    ReinsuranceThe effect of reinsurance on premiums written and earned is as follows
(dollars in thousands): Three months ended
    
    Three months endedJune 30, 2004
    
    June 30, 2003Written
    
    Earned
    
    Written
    
    EarnedDirect
    
    $
    41,237
    
    
    $
    37,792
    
    
    $
    26,086
    
    
    $
    32,590Assumed  affiliate
    
    
    22,514
    
    
    
    35,717
    
    
    
    
    
    
    
    Assumed  non affiliate
    
    
    2,795
    
    
    
    1,980
    
    
    
    
    
    
    
    Ceded  affiliate
    
    
    (2,765
    )
    
    
    (14,476
    )
    
    
    (26,086
    )
    
    
    (32,590
    )Ceded  non affiliate
    
    
    (21,804
    )
    
    
    (17,275
    )
    
    
    
    
    
    
    $
    41,977
    
    
    $
    43,738
    
    
    $
    
    
    
    $
    
 Six months ended
    
    Six months endedJune 30, 2004
    
    June 30, 2003Written
    
    Earned
    
    Written
    
    EarnedDirect
    
    $
    92,849
    
    
    $
    70,531
    
    
    $
    61,658
    
    
    $
    65,730Assumed  affiliate
    
    
    44,906
    
    
    
    60,428
    
    
    
    
    
    
    
    Assumed  non affiliate
    
    
    8,547
    
    
    
    684
    
    
    
    
    
    
    
    Ceded  affiliate
    
    
    (3,024
    )
    
    
    (15,646
    )
    
    
    (61,658
    )
    
    
    (65,730
    )Ceded  non affiliate
    
    
    (55,020
    )
    
    
    (25,049
    )
    
    
    
    
    
    
    $
    88,258
    
    
    $
    90,948
    
    
    $
    
    
    
    $
    
 6




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued  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 June 30,2004AffiliateLoss and loss adjustment expense
    
    $
    42,648Unearned premiums
    
    
    3,010Total
    
    $
    45,658Non affiliateLoss and loss adjustment expense
    
    $
    13,875Unearned premiums
    
    
    29,971Total
    
    $
    43,846
  As of and for the six months ended, June 30, 2004, we have ceded $20.7
million of paid losses and $23.4 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 provide 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 will 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 can 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 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 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 will 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 can 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.  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. 7




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued  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 as the reinsurers assume significant risk and
have a reasonable possibility of significant loss.4.
    
    Related Party TransactionsWe provide various services for Vesta and its subsidiaries, including
underwriting, premium processing, and claims processing. For the three
months and six months ended June 30, the accompanying unaudited consolidated
statements of operations reflect these services as follows (dollars in
thousands): Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Commission income
    
    $
    138
    
    
    $
    5,898
    
    
    $
    787
    
    
    $
    11,278Fee income
    
    
    
    
    
    
    4,101
    
    
    
    
    
    
    
    6,714Claims processing fees
    
    
    
    
    
    
    2,328
    
    
    
    
    
    
    
    4,005$
    138
    
    
    $
    12,327
    
    
    $
    787
    
    
    $
    21,997
  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): June 30,
    
    December 31,2004
    
    2003AssetsPremiums and fees receivable
    
    $
    37,866
    
    
    $
    35,458Commissions receivable
    
    
    1,873
    
    
    
    2,340Receivable from reinsurer
    
    
    49,359
    
    
    
    87,584Receivable from affiliates
    
    
    352
    
    
    
    $
    89,450
    
    
    $
    125,382LiabilitiesUnearned premium
    
    $
    20,882
    
    
    $
    35,458Amounts due reinsurers
    
    
    (3,909
    )
    
    
    15,664Payable to affiliates
    
    
    
    
    
    
    86$
    16,973
    
    
    $
    51,208
  As part of the terms of the acquisition of Affirmative Insurance Company and
Insura Property and Casualty Company (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 June 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 three months and six months ended June 30, 2003 was
$171,000 and $682,000.5.
    
    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. 8




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued  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 in effect until September 2004, when the trial in the Illinois
case of our claims for permanent injunctive relief and an undetermined
amount of compensatory and punitive damages is scheduled. 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.
    
    Stockholders EquityOn March 12, 2004, we issued 35,216 shares of our common stock to E.B. Lyon,
III 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. 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.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.7.
    
    Earnings per ShareThe provisions of SFAS No. 128 (SFAS 128), Earnings per Share, require
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: 9




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued Income
    
    Shares
    
    Per Share(Numerator)
    
    (Denominator)
    
    Amount(dollars in thousands, except number ofshares and per share amounts)Three months ended June 30, 2004Basic Earnings per ShareNet Income
    
    $
    5,481
    
    
    
    11,671,883
    
    
    $
    0.47Diluted Earnings per ShareNet Income
    
    $
    5,481
    
    
    
    11,671,883
    
    
    $
    0.47Effect of Dilutive Securities
    
    
    
    
    
    
    99,009
    
    
    
    $
    5,481
    
    
    
    11,770,892
    
    
    $
    0.47Three months ended June 30, 2003Basic Earnings per ShareNet Income
    
    $
    3,592
    
    
    
    10,085,230
    
    
    $
    0.36Diluted Earnings per ShareNet Income
    
    $
    3,592
    
    
    
    10,085,230
    
    
    $
    0.36Effect of Dilutive Securities
    
    
    
    
    
    
    19,887
    
    
    
    $
    3,592
    
    
    
    10,105,117
    
    
    $
    0.36Six months ended June 30, 2004Basic Earnings per ShareNet Income
    
    $
    12,763
    
    
    
    11,627,149
    
    
    $
    1.10Diluted Earnings per ShareNet Income
    
    $
    12,763
    
    
    
    11,627,149
    
    
    $
    1.10Effect of Dilutive Securities
    
    
    
    
    
    
    108,622
    
    
    
    (0.01
    )$
    12,763
    
    
    
    11,735,771
    
    
    $
    1.09Six months ended June 30, 2003Basic Earnings per ShareNet Income
    
    $
    9,058
    
    
    
    10,072,197
    
    
    $
    0.90Diluted Earnings per ShareNet Income
    
    $
    9,058
    
    
    
    10,072,197
    
    
    $
    0.90Effect of Dilutive Securities
    
    
    
    
    
    
    19,887
    
    
    
    $
    9,058
    
    
    
    10,092,084
    
    
    $
    0.90
  Options to purchase 847,008 shares of common stock at prices ranging from
$7.59 to $9.49 were outstanding at June 30, 2003 but were not included in
the computation of diluted earnings per share for the three months and six
months ended June 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.8.
    
    Segment InformationIn June 1997, the FASB issued SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information(SFAS 131). 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 six
months ended June 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. 10




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeThree months ended June 30, 2004
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Net premiums earned
    
    $
    
    
    
    $
    43,738
    
    
    $
    
    
    
    $
    
    
    
    $
    43,738Commission income
    
    
    21,956
    
    
    
    
    
    
    
    
    
    
    
    (13,680
    )
    
    
    8,276Fee income
    
    
    11,244
    
    
    
    7,114
    
    
    
    
    
    
    
    (4,532
    )
    
    
    13,826Claims processing fees
    
    
    7,128
    
    
    
    
    
    
    
    
    
    
    
    (6,119
    )
    
    
    1,009Investment income
    
    
    17
    
    
    
    346
    
    
    
    
    
    
    
    
    
    
    
    363Realized losses
    
    
    
    
    
    
    (3
    )
    
    
    
    
    
    
    
    
    
    
    (3
    )Total revenues
    
    
    40,345
    
    
    
    51,195
    
    
    
    
    
    
    
    (24,331
    )
    
    
    67,209Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    28,149
    
    
    
    
    
    
    
    
    
    
    
    28,149Policy acquisition expenses
    
    
    6,355
    
    
    
    19,494
    
    
    
    
    
    
    
    (12,229
    )
    
    
    13,620Employee compensation and benefits
    
    
    14,289
    
    
    
    
    
    
    
    
    
    
    
    (4,059
    )
    
    
    10,230Depreciation and amortization
    
    
    961
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    961Operating expenses
    
    
    12,361
    
    
    
    503
    
    
    
    
    
    
    
    (8,043
    )
    
    
    4,821Interest expense
    
    
    
    
    
    
    
    
    
    
    174
    
    
    
    
    
    
    
    174Total expenses
    
    
    33,966
    
    
    
    48,146
    
    
    
    174
    
    
    
    (24,331
    )
    
    
    57,955Net income (loss) before income taxes,
minority interest and equity interest
    
    
    6,379
    
    
    
    3,049
    
    
    
    (174
    )
    
    
    
    
    
    
    9,254Income tax expense (benefit)
    
    
    2,282
    
    
    
    1,091
    
    
    
    (62
    )
    
    
    
    
    
    
    3,311Minority interest, net of tax
    
    
    212
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    212Equity interest in unconsolidated
subsidiaries, net of tax
    
    
    
    
    
    
    
    
    
    
    250
    
    
    
    
    
    
    
    250Net income (loss)
    
    $
    3,885
    
    
    $
    1,958
    
    
    $
    (362
    )
    
    $
    
    
    
    $
    5,481Total assets
    
    $
    151,006
    
    
    $
    267,950
    
    
    $
    2,984
    
    
    $
    
    
    
    $
    421,940
 Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeThree months ended June 30, 2003
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Commission income
    
    
    17,576
    
    
    
    
    
    
    
    
    
    
    
    (6,411
    )
    
    
    11,165Fee income
    
    
    9,561
    
    
    
    2,341
    
    
    
    
    
    
    
    (2,292
    )
    
    
    9,610Claims processing fees
    
    
    6,435
    
    
    
    
    
    
    
    
    
    
    
    (3,853
    )
    
    
    2,582Investment income
    
    
    12
    
    
    
    40
    
    
    
    
    
    
    
    
    
    
    
    52Realized gains (losses)
    
    
    1
    
    
    
    (10
    )
    
    
    
    
    
    
    
    
    
    
    (9
    )Total revenues
    
    
    33,585
    
    
    
    2,371
    
    
    
    
    
    
    
    (12,556
    )
    
    
    23,400Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Policy acquisition expenses
    
    
    5,609
    
    
    
    
    
    
    
    
    
    
    
    (1,956
    )
    
    
    3,653Employee compensation and benefits
    
    
    13,832
    
    
    
    
    
    
    
    
    
    
    
    (4,871
    )
    
    
    8,961Depreciation and amortization
    
    
    911
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    911Operating expenses
    
    
    9,843
    
    
    
    (110
    )
    
    
    
    
    
    
    (5,729
    )
    
    
    4,004Interest expense
    
    
    
    
    
    
    
    
    
    
    265
    
    
    
    
    
    
    
    265Total expenses
    
    
    30,195
    
    
    
    (110
    )
    
    
    265
    
    
    
    (12,556
    )
    
    
    17,794Net income (loss) before income taxes,
minority interest and equity interest
    
    
    3,390
    
    
    
    2,481
    
    
    
    (265
    )
    
    
    
    
    
    
    5,606Income tax expense (benefit)
    
    
    1,212
    
    
    
    887
    
    
    
    (95
    )
    
    
    
    
    
    
    2,004Minority interest, net of tax
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10Equity
interest in unconsolidated subsidiaries,
net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    2,168
    
    
    $
    1,594
    
    
    $
    (170
    )
    
    
    
    
    
    $
    3,592Total assets
    
    $
    142,154
    
    
    $
    169,281
    
    
    $
    1,512
    
    
    $
    
    
    
    $
    312,947
 11




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeSix months ended June 30, 2004
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    90,948
    
    
    $
    
    
    
    $
    
    
    
    $
    90,948Commission income
    
    
    47,356
    
    
    
    
    
    
    
    
    
    
    
    (28,156
    )
    
    
    19,200Fee income
    
    
    22,158
    
    
    
    14,217
    
    
    
    
    
    
    
    (9,058
    )
    
    
    27,317Claims processing fees
    
    
    13,353
    
    
    
    
    
    
    
    
    
    
    
    (11,998
    )
    
    
    1,355Investment income
    
    
    35
    
    
    
    555
    
    
    
    
    
    
    
    
    
    
    
    590Realized gains (losses)
    
    
    1
    
    
    
    (21
    )
    
    
    
    
    
    
    
    
    
    
    (20
    )Total revenues
    
    
    82,903
    
    
    
    105,699
    
    
    
    
    
    
    
    (49,212
    )
    
    
    139,390Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    59,857
    
    
    
    
    
    
    
    
    
    
    
    59,857Policy acquisition expenses
    
    
    14,390
    
    
    
    37,520
    
    
    
    
    
    
    
    (25,637
    )
    
    
    26,273Employee compensation and benefits
    
    
    28,956
    
    
    
    
    
    
    
    
    
    
    
    (8,047
    )
    
    
    20,909Depreciation and amortization
    
    
    1,845
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,845Operating expenses
    
    
    23,242
    
    
    
    1,390
    
    
    
    
    
    
    
    (15,528
    )
    
    
    9,104Interest expense
    
    
    
    
    
    
    
    
    
    
    391
    
    
    
    
    
    
    
    391Total expenses
    
    
    68,433
    
    
    
    98,767
    
    
    
    391
    
    
    
    (49,212
    )
    
    
    118,379Net income (loss) before income taxes,
minority interest and equity interest
    
    
    14,470
    
    
    
    6,932
    
    
    
    (391
    )
    
    
    
    
    
    
    21,011Income tax expense (benefit)
    
    
    5,177
    
    
    
    2,481
    
    
    
    (140
    )
    
    
    
    
    
    
    7,518Minority interest, net of tax
    
    
    307
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    307Equity interest in unconsolidated
subsidiaries, net of tax
    
    
    
    
    
    
    
    
    
    
    423
    
    
    
    
    
    
    
    423Net income (loss)
    
    $
    8,986
    
    
    $
    4,451
    
    
    $
    (674
    )
    
    $
    
    
    
    $
    12,763Total assets
    
    $
    151,006
    
    
    $
    267,950
    
    
    $
    2,984
    
    
    $
    
    
    
    $
    421,940
 Agency
    
    Insurance
    
    Corporate
    
    
    
    
    
    AffirmativeSix months ended June 30, 2003
    
    Segment
    
    Segment
    
    Segment
    
    Eliminations
    
    Consolidated(dollars in thousands)Revenues:Net premiums earned
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Commission income
    
    
    39,522
    
    
    
    
    
    
    
    
    
    
    
    (14,594
    )
    
    
    24,928Fee income
    
    
    20,162
    
    
    
    4,774
    
    
    
    
    
    
    
    (4,655
    )
    
    
    20,281Claims processing fees
    
    
    13,065
    
    
    
    
    
    
    
    
    
    
    
    (7,681
    )
    
    
    5,384Investment income
    
    
    23
    
    
    
    79
    
    
    
    
    
    
    
    
    
    
    
    102Realized gains
    
    
    2
    
    
    
    433
    
    
    
    
    
    
    
    
    
    
    
    435Total revenues
    
    
    72,774
    
    
    
    5,286
    
    
    
    
    
    
    
    (26,930
    )
    
    
    51,130Expenses:Losses and loss adjustment expenses incurred
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Policy acquisition expenses
    
    
    12,837
    
    
    
    
    
    
    
    
    
    
    
    (4,584
    )
    
    
    8,253Employee compensation and benefits
    
    
    28,828
    
    
    
    
    
    
    
    
    
    
    
    (10,551
    )
    
    
    18,277Depreciation and amortization
    
    
    1,682
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,682Operating expenses
    
    
    20,132
    
    
    
    (286
    )
    
    
    
    
    
    
    (11,795
    )
    
    
    8,051Interest expense
    
    
    
    
    
    
    
    
    
    
    370
    
    
    
    
    
    
    
    370Total expenses
    
    
    63,479
    
    
    
    (286
    )
    
    
    370
    
    
    
    (26,930
    )
    
    
    36,633Net income (loss) before income taxes,
minority interest and equity interest
    
    
    9,295
    
    
    
    5,572
    
    
    
    (370
    )
    
    
    
    
    
    
    14,497Income tax expense (benefit)
    
    
    3,323
    
    
    
    1,993
    
    
    
    (133
    )
    
    
    
    
    
    
    5,183Minority interest, net of tax
    
    
    256
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    256Equity interest in unconsolidated subsidiaries,
net of tax
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income (loss)
    
    $
    5,716
    
    
    $
    3,579
    
    
    $
    (237
    )
    
    $
    
    
    
    $
    9,058Total assets
    
    $
    142,154
    
    
    $
    169,281
    
    
    $
    1,512
    
    
    $
    
    
    
    $
    312,947
 12




---



##### Table of Contents



Affirmative Insurance Holdings, Inc.
Notes to Consolidated Financial Statements (Unaudited)  Continued  9.
    
    Subsequent EventsEffective July 1, 2004, per our reinsurance agreements, we amended the
amounts of premiums we cede to unaffiliated reinsurers or assume from an
unaffiliated insurance company on business produced by certain of our
underwriting agencies. We reduced the amount of business we will cede to
our reinsurers on all business produced through our underwriting agencies in
Illinois, Indiana and Missouri from 60.0% to 20.0% for the second half of
2004. We reduced the amount of business we cede to our reinsurers on all
business produced through our underwriting agencies in New Mexico and South
Carolina from 75.0% to 30.0% for the second half of 2004. We increased the
amount of business we assume from an unaffiliated insurance company on
business produced by our Texas-based A-Affordable underwriting agency from
25.0% to 70.0% for the second half of 2004.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 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 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.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.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
acquisition activities. 13




---



##### 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
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 144 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 and other 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 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 8 to our consolidated
financial statements included in this report. Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003(Unaudited in thousands)Total Revenues:Agency segment
    
    $
    40,345
    
    
    $
    33,585
    
    
    $
    82,903
    
    
    $
    72,774Insurance segment
    
    
    51,195
    
    
    
    2,371
    
    
    
    105,699
    
    
    
    5,286Corporate
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Eliminations
    
    
    (24,331
    )
    
    
    (12,556
    )
    
    
    (49,212
    )
    
    
    (26,930
    )Total
    
    $
    67,209
    
    
    $
    23,400
    
    
    $
    139,390
    
    
    $
    51,130Total Expenses:Agency segment
    
    $
    33,966
    
    
    $
    30,195
    
    
    $
    68,433
    
    
    $
    63,479Insurance segment
    
    
    48,146
    
    
    
    (110
    )
    
    
    98,767
    
    
    
    (286
    )Corporate
    
    
    174
    
    
    
    265
    
    
    
    391
    
    
    
    370Eliminations
    
    
    (24,331
    )
    
    
    (12,556
    )
    
    
    (49,212
    )
    
    
    (26,930
    )Total
    
    $
    57,955
    
    
    $
    17,794
    
    
    $
    118,379
    
    
    $
    36,633Pretax Income:Agency segment
    
    $
    6,379
    
    
    $
    3,390
    
    
    $
    14,470
    
    
    $
    9,295Insurance segment
    
    
    3,049
    
    
    
    2,481
    
    
    
    6,932
    
    
    
    5,572Corporate
    
    
    (174
    )
    
    
    (265
    )
    
    
    (391
    )
    
    
    (370
    )Total
    
    $
    9,254
    
    
    $
    5,606
    
    
    $
    21,011
    
    
    $
    14,497
 14




---



##### Table of Contents



Comparison of the Three Months Ended June 30, 2004 to June 30, 2003 Consolidated.The following table displays our Total Controlled Premium by
distribution channel for the three months ended June 30, 2004 and 2003: Three months endedJune 30,2004
    
    2003(Unaudited in thousands)Our underwriting agencies:Our retail stores
    
    $
    27,457
    
    
    $
    25,642Independent agencies
    
    
    41,476
    
    
    
    36,184Unaffiliated underwriting agencies
    
    
    27,913
    
    
    
    28,096Total
    
    $
    96,846
    
    
    $
    89,922
 Total Controlled Premium for the three months ended June 30, 2004 was $96.8
million, an increase of $6.9 million, or 7.7%, as compared to $89.9 million for
the same period in 2003. The increase is primarily due to increased
appointments of independent agents by our underwriting agencies 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 June 30, 2004 were $67.2 million, an
increase of $43.8 million, or 187.2%, as compared to total revenues of $23.4
million for the same period in 2003. Total expenses for the three months ended June 30, 2004 were $58.0 million, an
increase of $40.2 million, or 225.7%, as compared to total expenses of $17.8
million for the same period in 2003. Pretax income for the three months ended June 30, 2004 was $9.3 million, an
increase of $3.6 million, or 65.1%, as compared to pretax income of $5.6
million for the same period in 2003. Income tax expense for the three months ended June 30, 2004 was $3.3 million,
or an effective rate of 35.8%, as compared to income tax expense of $2.0
million, or an effective rate of 35.8% for the same period in 2003. For the three months ended June 30, 2004, minority interest net of income taxes
was $212,000 as compared to $10,000 for the same period in 2003. Agency segment.Total revenues for the three months ended June 30, 2004 were
$40.3 million, an increase of $6.8 million, or 20.1%, as compared to total
revenues of $33.6 million for the same period in 2003. Revenues for the three months ended June 30, 2004 and 2003 were generated
primarily through commissions, policy fees and claims processing fees, as
follows: Three months endedJune 30,2004
    
    2003(Unaudited in millions)Commissions
    
    $
    22.0
    
    
    $
    17.6Policy and other fees
    
    
    11.2
    
    
    
    9.6Claims processing fees
    
    
    7.1
    
    
    
    6.4Total
    
    $
    40.3
    
    
    $
    33.6
 For the three months ended June 30, 2004, gross premiums written produced by
our underwriting agencies were $68.9 million, an increase of $7.1 million, or
11.5%, as compared to $61.8 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 $3.3 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 $3.3 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 and
increases in both retail agents and locations. Commissions for the three months ended June 30, 2004 were $22.0 million, an
increase of $4.4 million, or 24.9%, as compared to commissions of $17.6 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 June 30, 2004 were $20.3 million, an increase of $4.4 million, or 27.4%,
as compared to $15.9 million for the same period in 2003. Provisional commissions for our underwriting agencies for the three months
ended June 30, 2004 were $17.6 million, an increase of $2.5 million, or 16.6%,
as compared to $15.1 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. 15




---



##### Table of Contents



Profit sharing commissions for our underwriting agencies for the three months
ended June 30, 2004 were $2.7 million, an increase of $1.9 million, as compared
to $815,000 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 $1.7 million for the three months ended June 30, 2004,
an increase of $23,000, or 1.4%, as compared to $1.7 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 June 30, 2004 were $11.2
million, an increase of $1.7 million, or 17.6%, as compared to $9.6 million for
the same period in 2003. The increase in policy fees was primarily due to the
increased premium volume over the same period in 2003 and increases in the rate
per policy charged by our Texas retail agency. Claims processing fees for the three months ended June 30, 2004 were $7.1
million, an increase of $700,000, or 10.8%, as compared to $6.4 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 June 30, 2004 were $34.0 million, an
increase of $3.8million, or 12.5%, as compared to total expenses of $30.2
million for the same period in 2003.  
    
    Policy acquisition expenses, comprised solely of commission expenses
in our agency segment, for the three months ended June 30, 2004 were
$6.4 million, an increase of $746,000, or 13.3%, as compared to $5.6
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 15.3% from 15.5% 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
June 30, 2004 were $14.3 million, an increase of $457,000, or 3.3%, as
compared to $13.8 million for the same period in 2003. The increase in
employee compensation and benefit expenses was principally due to
$324,000 of accrued severance recorded for the transition of certain
accounting functions from our Chicago office to our Addison office.
    
    Depreciation and amortization expenses for the three months ended June
30, 2004 were $961,000, an increase of $50,000, or 5.5%, as compared
to $911,000 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 three months ended June 30, 2004 were $12.4
million, an increase of $2.5 million, or 25.6%, as compared to $9.8
million for the same period in 2003. The change in operating expenses
was primarily a result of increases in premium related expenses of
$680,000 due to the $7.1 million increase in premium volume produced
by our underwriting agencies, a $480,000 increase in advertising
expenditures primarily due to the continued expansion of our retail
branding, a $536,000 increase in professional fees primarily due to
current year litigation efforts as well as a $427,000 increase in
license and fees due primarily to increased franchise tax expenses. Pretax income for the three months ended June 30, 2004 was $6.4 million, an
increase of $3.0 million, or 88.2%, as compared to pretax income of $3.4
million for the same period in 2003. The pretax margin for the three months
ended June 30, 2004 was 15.8%, an increase from the 10.1% pre-tax margin
recorded in the same period in 2003. Insurance company segment.Total revenues for the three months ended June
30, 2004 were $51.2 million, an increase of $48.8 million, as compared to total
revenues of $2.4 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 June 30, 2004 was $346,000, an
increase of $306,000 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 following the settlement of the December 2003 reinsurance
transaction with Vesta and operating cash flows, which increased our investment
portfolio to $53.3 million as of June 30, 2004 as compared to $7.5 million as
of December 31, 2003. Net realized capital losses for the three months ended
June 30, 2004 were $3,000, compared to net realized capital losses of $10,000
for the same period in 2003. Loss and loss adjustment expenses for the three months ended June 30, 2004,
were $28.1 million compared to zero for the same period in 2003. Our loss and
loss adjustment expense ratio for the three months ended June 30, 2004 was
55.4%. 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 June 30,
2004 were $20.0 million compared to negative $110,000 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 June 30, 2004 was 39.3%. The negative expense recorded for
the three months ended June 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 June 30, 2004 was $3.0 million, an
increase of $568,000, or 22.9%, as compared to $2.5 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 June 30, 2004 was 94.7%. Corporate and other segment.Interest expense for the three months ended
June 30, 2004 was $174,000, as compared to interest expense of $265,000 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. 16




---



##### Table of Contents



Comparison of the Six Months Ended June 30, 2004 to June 30, 2003 Consolidated.The following table displays our Total Controlled Premium by
distribution channel for the six months ended June 30, 2004 and 2003: Six months endedJune 30,2004
    
    2003(Unaudited in thousands)Our underwriting agencies:Our retail stores
    
    $
    65,043
    
    
    $
    63,329Independent agencies
    
    
    95,412
    
    
    
    83,203Unaffiliated underwriting agencies
    
    
    55,191
    
    
    
    60,519Total
    
    $
    215,646
    
    
    $
    207,051
 Total Controlled Premium for the six months ended June 30, 2004 was $215.6
million, an increase of $8.6 million, or 4.2%, as compared to $207.1 million
for the same period in 2003. The increase is primarily due to increased
appointments of independent agents by our underwriting agencies 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 six months ended June 30, 2004 were $139.4 million, an
increase of $88.3 million, or 172.6%, as compared to total revenues of $51.1
million for the same period in 2003. Total expenses for the six months ended June 30, 2004 were $118.4 million, an
increase of $81.7 million, or 223.1%, as compared to total expenses of $36.6
million for the same period in 2003. Pretax income for the six months ended June 30, 2004 was $21.0 million, an
increase of $6.5 million, or 44.9%, as compared to pretax income of $14.5
million for the same period in 2003. Income tax expense for the six months ended June 30, 2004 was $7.5 million, or
an effective rate of 35.8%, as compared to income tax expense of $5.2 million,
or an effective rate of 35.8% for the same period in 2003. For the six months ended June 30, 2004, minority interest net of income taxes
was $307,000 as compared to $256,000 for the same period in 2003. Agency segment.Total revenues for the six months ended June 30, 2004 were
$82.9 million, an increase of $10.1 million, or 13.9%, as compared to total
revenues of $72.8 million for the same period in 2003. Revenues for the six months ended June 30, 2004 and 2003 were generated
primarily through commissions, policy fees and claims processing fees, as
follows: June 30,2004
    
    2003(Unaudited in millions)Commissions
    
    
    47.4
    
    
    $
    39.6Policy and other fees
    
    
    22.2
    
    
    
    20.2Claims processing fees
    
    
    13.3
    
    
    
    13.0Total
    
    $
    82.9
    
    
    $
    72.8
 For the six months ended June 30, 2004, gross premiums written produced by our
underwriting agencies were $160.5 million, an increase of $13.9 million, or
9.5%, as compared to $146.5 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 $9.4 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 $4.1 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 and
increases in both retail agents and locations. Commissions for the six months ended June 30, 2004 were $47.4 million, an
increase of $7.8 million, or 19.8%, as compared to commissions of $39.6 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 six months
ended June 30, 2004 were $43.9 million, an increase of $7.9 million, or 21.9%,
as compared to $36.0 million for the same period in 2003. Provisional commissions for our underwriting agencies for the six months ended
June 30, 2004 were $39.2 million, an increase of $4.2 million, or 11.9%, as
compared to $35.0 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. 17




---



##### Table of Contents



Profit sharing commissions for our underwriting agencies for the six months
ended June 30, 2004 were $4.7 million, an increase of $3.7 million, as compared
to $948,000 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 $3.5 million for the six months ended June 30, 2004, a
decrease of $49,000, or 1.4%, as compared to $3.5 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 six months ended June 30, 2004 were $22.2
million, an increase of $2.0 million, or 9.9%, as compared to $20.2 million for
the same period in 2003. The increase in policy fees was principally due to the
increased premium volume over the same period in 2003 and increases in the rate
per policy charged by our Texas retail agency. Claims processing fees for the six months ended June 30, 2004 were $13.3
million, an increase of $288,000, or 2.2%, as compared to $13.0 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 six months ended June 30, 2004 were $68.4 million, an
increase of $5.0 million, or 7.8%, as compared to total expenses of $63.5
million for the same period in 2003.  
    
    Policy acquisition expenses, comprised solely of commission expenses
in our agency segment, for the six months ended June 30, 2004 were
$14.4 million, an increase of $1.6 million, or 12.1%, as compared to
$12.8 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 six months ended
June 30, 2004 were $29.0 million, an increase of $128,000, or 0.4%, as
compared to workforce expense of $28.8 million for the same period in
2003. The increase in employee compensation and benefit expenses was
principally due to $324,000 of accrued severance recorded for the
transition of certain accounting functions from our Chicago office to
our Addison office recorded in the second quarter.
    
    Depreciation and amortization expenses for the six months ended June
30, 2004 were $1.8 million, an increase of $163,000, or 9.7%, as
compared to $1.7 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 six months ended June 30, 2004 were $23.2
million, an increase of $3.1 million, or 15.4%, as compared to $20.1
million for the same period in 2003. The change in operating expenses
was primarily a result of increases in premium related expenses of
$1.0 million due to the $13.9 million increase in premium volume
produced by our underwriting agencies, a $1.1 million increase in
advertising expenditures primarily due to the continued expansion of
our retail branding, a $751,000 increase in professional fees
primarily due to current year litigation efforts as well as a $573,000
increase in license and fees due primarily to increased franchise tax
expenses, offset by decreases in other miscellaneous expenses. Pretax income for the six months ended June 30, 2004 was $14.5 million, an
increase of $5.2 million, or 55.7%, as compared to pretax income of $9.3
million for the same period in 2003. The pretax margin for the six months ended
June 30, 2004 was 17.5%, an increase from the 12.8% pre-tax margin recorded in
the same period in 2003. Insurance company segment.Total revenues for the six months ended June 30,
2004 were $105.7 million, an increase of $100.4 million, as compared to total
revenues of $5.3 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 six months ended June 30, 2004 was $555,000, an
increase of $476,000 from net investment income of $79,000 for the same period
in 2003. The increase is primarily due to the increase in the size of our
investment portfolio following the settlement of the December 2003 reinsurance
transaction with Vesta and operating cash flows. Net realized capital losses
for the six months ended June 30, 2004 were $21,000, compared to net realized
capital gains of $433,000 for the same period in 2003. Loss and loss adjustment expenses for the six months ended June 30, 2004, were
$59.9 million compared to zero for the same period in 2003. Our loss and loss
adjustment expense ratio for the six months ended June 30, 2004 was 56.9%. 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 six months ended June 30,
2004 were $38.9 million compared to negative $286,000 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
six months ended June 30, 2004 was 37.0%. The negative expense recorded for the
six months ended June 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 six months ended June 30, 2004 was $6.9 million, an
increase of $1.4 million, or 24.4%, as compared to $5.6 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 six months ended June 30, 2004 was 93.9%. Corporate and other segment.Interest expense for the six months ended June
30, 2004 was $391,000, as compared to interest expense of $370,000 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. 18




---



##### Table of Contents



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 June 30, 2004, we had $94,000 of cash and invested assets at
the holding company level and $17.1 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 June 30, 2004, the capital ratios of both of our
insurance companies substantially exceeded the risk-based capital requirements.
As of June 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 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 $43.9 million for the six months
ended June 30, 2004, as compared to net cash provided by operating activities
of $19.7 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 $16.2 million for the six months
ended June 30, 2004, as compared to net cash used in investing activities of
$9.5 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, offset 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. Net cash used in financing activities was $3.6 million for the six months ended
June 30, 2004, as compared to net cash used in financing activities of $2.5
million for the same period in 2003. The increase in cash used in financing
activities was principally caused by additional principal payments applied to
our note payable from 2003 to 2004, offset in part by an increase in proceeds
from issuances of our common stock in March 2004. We believe that existing cash and investment balances, as well as new cash
flows generated from operations, 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 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 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. New 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. 19




---



##### Table of Contents



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. 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. 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 June 30, 2003Affirmative
    
    Pro Forma
    
    AffirmativeHistorical
    
    Adjustments
    
    Pro FormaAs Reported(1)
    
    and Eliminations(2)
    
    Combined(in thousands, except per share data)RevenuesNet premiums earned
    
    $
    
    
    
    $
    41,795
    
    
    $
    41,795Commissions and fees
    
    
    23,357
    
    
    
    (6,935
    )
    
    
    16,422Net investment income (3)
    
    
    52
    
    
    
    
    
    
    
    52Realized losses (3)
    
    
    (9
    )
    
    
    
    
    
    
    (9
    )Other
    
    
    
    
    
    
    773
    
    
    
    773Total revenues
    
    
    23,400
    
    
    
    35,633
    
    
    
    59,033ExpensesLosses and loss adjustment expenses
    
    
    
    
    
    
    28,592
    
    
    
    28,592Policy acquisition and operating expenses
    
    
    17,529
    
    
    
    7,149
    
    
    
    24,678Interest expense
    
    
    265
    
    
    
    
    
    
    
    265Total expenses
    
    
    17,794
    
    
    
    35,741
    
    
    
    53,535Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    5,606
    
    
    
    (108
    )
    
    
    5,498Income tax expense (4)
    
    
    2,004
    
    
    
    (39
    )
    
    
    1,965Minority interest, net of income taxes
    
    
    10
    
    
    
    
    
    
    
    10Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    
    
    
    
    
    
    
    
    Net income
    
    $
    3,592
    
    
    $
    (69
    )
    
    $
    3,523Net income per common share  Basic
    
    $
    0.36
    
    
    $
    (0.01
    )
    
    $
    0.35Net income per common share  Diluted
    
    $
    0.36
    
    
    $
    (0.01
    )
    
    $
    0.35
 20




---



##### Table of Contents



Six Months Ended June 30, 2003Affirmative
    
    Pro Forma
    
    AffirmativeHistorical
    
    Adjustments
    
    Pro FormaAs Reported(1)
    
    and Eliminations(2)
    
    Combined(in thousands, except per share data)RevenuesNet premiums earned
    
    $
    
    
    
    $
    80,466
    
    
    $
    80,466Commissions and fees
    
    
    50,593
    
    
    
    (13,527
    )
    
    
    37,066Net investment income (3)
    
    
    102
    
    
    
    
    
    
    
    102Realized gains (3)
    
    
    435
    
    
    
    
    
    
    
    435Other
    
    
    
    
    
    
    1,685
    
    
    
    1,685Total revenues
    
    
    51,130
    
    
    
    68,624
    
    
    
    119,754ExpensesLosses and loss adjustment expenses
    
    
    
    
    
    
    55,104
    
    
    
    55,104Policy acquisition and operating expenses
    
    
    36,263
    
    
    
    13,222
    
    
    
    49,485Interest expense
    
    
    370
    
    
    
    
    
    
    
    370Total expenses
    
    
    36,633
    
    
    
    68,326
    
    
    
    104,959Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    14,497
    
    
    
    298
    
    
    
    14,795Income tax expense (4)
    
    
    5,183
    
    
    
    105
    
    
    
    5,288Minority interest, net of income taxes
    
    
    256
    
    
    
    
    
    
    
    256Equity interest in unconsolidated subsidiaries,
net of income taxes
    
    
    
    
    
    
    
    
    
    
    Net income
    
    $
    9,058
    
    
    $
    193
    
    
    $
    9,251Net income per common share  Basic
    
    $
    0.90
    
    
    $
    0.02
    
    
    $
    0.92Net income per common share  Diluted
    
    $
    0.90
    
    
    $
    0.02
    
    
    $
    0.92
  (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. 21




---



##### 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 June 30, 2003Insurance
    
    
    
    
    
    
    
    
    
    ConsolidatedAgency
    
    Company
    
    Corporate
    
    Pro Forma
    
    Pro FormaSegment(1)
    
    Segment(2)
    
    Segment(1)
    
    Eliminations(3)
    
    Total(in thousands)RevenuesNet premiums earned
    
    $
    
    
    
    $
    41,795
    
    
    $
    
    
    
    $
    
    
    
    $
    41,795Commissions and fees
    
    
    33,572
    
    
    
    5,549
    
    
    
    
    
    
    
    (22,699
    )
    
    
    16,422Net investment income (4)
    
    
    12
    
    
    
    40
    
    
    
    
    
    
    
    
    
    
    
    52Realized gains (losses) (4)
    
    
    1
    
    
    
    (10
    )
    
    
    
    
    
    
    
    
    
    
    (9
    )Other
    
    
    
    
    
    
    773
    
    
    
    
    
    
    
    
    
    
    
    773Total revenues
    
    
    33,585
    
    
    
    48,147
    
    
    
    
    
    
    
    (22,699
    )
    
    
    59,033ExpensesLosses and loss adjustment expenses
    
    
    
    
    
    
    28,592
    
    
    
    
    
    
    
    
    
    
    
    28,592Policy acquisition and operating expenses
    
    
    30,195
    
    
    
    17,182
    
    
    
    
    
    
    
    (22,699
    )
    
    
    24,678Interest expense
    
    
    
    
    
    
    
    
    
    
    265
    
    
    
    
    
    
    
    265Total expenses
    
    
    30,195
    
    
    
    45,774
    
    
    
    265
    
    
    
    (22,699
    )
    
    
    53,535Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    3,390
    
    
    
    2,373
    
    
    
    (265
    )
    
    
    
    
    
    
    5,498Income tax expense
    
    
    1,212
    
    
    
    848
    
    
    
    (95
    )
    
    
    
    
    
    
    1,965Minority interest, net of income taxes
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10Equity interest in unconsolidated subsidiaries, net of income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income
    
    $
    2,168
    
    
    $
    1,525
    
    
    $
    (170
    )
    
    $
    
    
    
    $
    3,523
 Six Months Ended June 30, 2003Insurance
    
    
    
    
    
    
    
    
    
    ConsolidatedAgency
    
    Company
    
    Corporate
    
    Pro Forma
    
    Pro FormaSegment(1)
    
    Segment(2)
    
    Segment(1)
    
    Eliminations(3)
    
    Total(in thousands)RevenuesNet premiums earned
    
    $
    
    
    
    $
    80,466
    
    
    $
    
    
    
    $
    
    
    
    $
    80,466Commissions and fees
    
    
    72,749
    
    
    
    10,633
    
    
    
    
    
    
    
    (46,316
    )
    
    
    37,066Net investment income (4)
    
    
    23
    
    
    
    79
    
    
    
    
    
    
    
    
    
    
    
    102Realized gains (4)
    
    
    2
    
    
    
    433
    
    
    
    
    
    
    
    
    
    
    
    435Other
    
    
    
    
    
    
    1,685
    
    
    
    
    
    
    
    
    
    
    
    1,685Total revenues
    
    
    72,774
    
    
    
    93,296
    
    
    
    
    
    
    
    (46,316
    )
    
    
    119,754ExpensesLosses and loss adjustment expenses
    
    
    
    
    
    
    55,104
    
    
    
    
    
    
    
    
    
    
    
    55,104Policy acquisition and operating expenses
    
    
    63,479
    
    
    
    32,322
    
    
    
    
    
    
    
    (46,316
    )
    
    
    49,485Interest expense
    
    
    
    
    
    
    
    
    
    
    370
    
    
    
    
    
    
    
    370Total expenses
    
    
    63,479
    
    
    
    87,426
    
    
    
    370
    
    
    
    (46,316
    )
    
    
    104,959Net income before income taxes, minority interest
and equity interest in unconsolidated subsidiaries
    
    
    9,295
    
    
    
    5,870
    
    
    
    (370
    )
    
    
    
    
    
    
    14,795Income tax expense
    
    
    3,323
    
    
    
    2,098
    
    
    
    (133
    )
    
    
    
    
    
    
    5,288Minority interest, net of income taxes
    
    
    256
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    256Equity interest in unconsolidated subsidiaries,
net of income taxes
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Net income
    
    $
    5,716
    
    
    $
    3,772
    
    
    $
    (237
    )
    
    $
    
    
    
    $
    9,251
 22




---



##### 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 June 30, 2004 was $53.3 million. The
effective duration of the portfolio as of June 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 $2.1 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
$2.1 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
June 30, 2004, our fixed income investments were invested in the following:
U.S. Treasury securities  11.6%, mortgage-backed securities  4.0%, municipal
securities  27.9% and corporate securities  56.5%. As of June 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 June 30, 2004, we had a total of $96.0 million of receivables from
reinsurers, of which $49.4 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 June 30, 2004, we owed Vesta Fire $30.6
million under a quota share reinsurance agreement. Vesta Fire is currently
rated B (Fair) by A.M. Best. If Vesta Fires A.M. Best financial strength
rating remained below B+ after the consummation of our initial public
offering, we would have 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 in the amount of $18.7 million, 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 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 June 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 June 30, 2004. Based on this evaluation, our principal
executive officer and principal financial officer concluded that our disclosure
controls and procedures are effective in timely alerting them to material
information concerning Affirmative and its consolidated subsidiaries required
to be included in our periodic SEC reports. 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. 23




---



##### 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 in
effect until September 2004, when the trial in the Illinois case of our claims
for permanent injunctive relief and an undetermined amount of compensatory and
punitive damages is scheduled. 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. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities We completed an initial public offering of our common stock pursuant to a
Registration Statement on Form S-1, File No. 333-113793, which was declared
effective by the SEC on July 9, 2004. Piper Jaffray acted as lead manager and
sole book-runner and William Blair & Company, Sandler ONeill & Partners, L.P.
and Raymond James served as co-managers. 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. At the conclusion
of these transactions, Vesta owned approximately 42.6% of our issued and
outstanding capital stock. We received gross proceeds of $71.2 million and net
proceeds of $65.3 million from the initial public offering of our common stock.
We contributed $64.3 million of our net proceeds to our insurance company
subsidiaries, Affirmative Insurance Company and Insura, in order to increase
their statutory surplus and allow us to reduce our reinsurance purchases and
retain more gross premiums written over time. The remaining $1.0 million of
net proceeds was retained for general corporate purposes. 
 Item 3. Defaults Upon Senior Securities None. 
 Item 4. Submission of Matters to a Vote of Security Holders None. 
 Item 5. Other information None. 24




---



##### Table of Contents



Item 6. Exhibits and Reports on Form 8-K  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).*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 herewithb)
    
    Reports onForm 8-K.None. 
 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: August 11, 2004/s/ Timothy A. BienekBy: Timothy A. BienekExecutive Vice President and Chief Financial Officer(and in his capacity as Principal Financial Officer)
 25