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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 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: 000-50360 DIRECT GENERAL CORPORATION   Tennessee
    
    62-1564496(State or other jurisdiction of
    
    (I.R.S. Employer Identification No.)incorporation or organization)1281 Murfreesboro Road, Nashville, TN
    
    37217(Address of principal executive offices)
    
    (Zip Code)
 (615) 399-0600
(Registrants telephone number, including area code) 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.
      Yes
þ No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).       Yes o No þ Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date: 22,268,757 shares of common
stock, no par value, at May 12, 2004.




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TABLE OF CONTENTS  PART IFINANCIAL INFORMATIONCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSCONDENSED CONSOLIDATED BALANCE SHEETSCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSPART II  OTHER INFORMATIONSIGNATURESEX-31.1  SECTION 302 CERTIFICATION OF THE CEOEX-31.2  SECTION 906 CERTIFICATION OF THE CFOEX-32.1  SECTION 906 CERTIFICATON OF THE CEOEX-32.2  SECTION 906 CERTIFICATION OF THE CFO    Table of Contents  
 PART IFINANCIAL INFORMATION Item 1. Financial Statements. DIRECT GENERAL CORPORATION AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
 Three Months Ended March 31,2004
    
    2003(In thousands, except per share amounts)RevenuesPremiums earned
    
    $
    83,007
    
    
    $
    47,675Finance income
    
    
    12,761
    
    
    
    11,227Commission and service fee income
    
    
    13,495
    
    
    
    8,499Net investment income
    
    
    2,276
    
    
    
    1,381Net realized gains on securities and other
    
    
    69
    
    
    
    266Total revenues
    
    
    111,608
    
    
    
    69,048ExpensesInsurance losses and loss adjustment expenses
    
    
    60,825
    
    
    
    34,798Selling, general and administrative costs
    
    
    25,240
    
    
    
    17,331Interest expense
    
    
    1,352
    
    
    
    1,567Total expenses
    
    
    87,417
    
    
    
    53,696Income before income taxes
    
    
    24,191
    
    
    
    15,352Income tax expense
    
    
    9,173
    
    
    
    5,542Net income
    
    
    15,018
    
    
    
    9,810Preferred stock dividends  Series B
    
    
    
    
    
    
    140Net income available to common shareholders
    
    $
    15,018
    
    
    $
    9,670Earnings per ShareBasic earnings per common share
    
    $
    0.70
    
    
    $
    0.80Diluted earnings per common share
    
    $
    0.67
    
    
    $
    0.56
 See notes to condensed consolidated financial statements. 2




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DIRECT GENERAL CORPORATION AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)March 31,
    
    December 31,2004
    
    2003(In thousands)AssetsInvestments:Debt securities available-for-sale at fair value (amortized cost $280,690 and
$263,929, at March 31, 2004 and December 31, 2003, respectively)
    
    $
    285,375
    
    
    $
    264,998Short-term investments
    
    
    1,631
    
    
    
    1,322Total investments
    
    
    287,006
    
    
    
    266,320Cash and cash equivalents
    
    
    117,789
    
    
    
    87,342Finance receivables, net
    
    
    253,784
    
    
    
    201,271Reinsurance balances receivable
    
    
    65,086
    
    
    
    57,472Prepaid reinsurance premiums
    
    
    56,088
    
    
    
    56,397Deferred policy acquisition costs
    
    
    12,099
    
    
    
    11,432Deferred income taxes
    
    
    18,975
    
    
    
    18,539Property and equipment
    
    
    14,185
    
    
    
    13,775Goodwill, net
    
    
    22,188
    
    
    
    20,840Other assets
    
    
    27,293
    
    
    
    17,766Total assets
    
    $
    874,493
    
    
    $
    751,154Liabilities and Shareholders EquityLoss and loss adjustment expense reserves
    
    $
    113,332
    
    
    $
    112,618Unearned premiums
    
    
    267,301
    
    
    
    213,250Reinsurance balances payable and funds held
    
    
    68,544
    
    
    
    62,223Accounts payable and accrued expenses
    
    
    12,463
    
    
    
    13,105Income taxes payable
    
    
    9,964
    
    
    
    2,369Notes payable
    
    
    176,819
    
    
    
    148,946Capital lease obligations
    
    
    4,279
    
    
    
    4,556Payable for securities
    
    
    8,680
    
    
    
    Other liabilities
    
    
    18,778
    
    
    
    16,692Total liabilities
    
    
    680,160
    
    
    
    573,759Shareholders equityPreferred stock, no par; authorized shares  10,000.0; no shares issued
    
    
    
    
    
    
    Common stock, no par; authorized shares  100,000.0; issued shares  21,657.7
and 21,350.6 at March 31, 2004 and December 31, 2003, respectively
    
    
    92,278
    
    
    
    91,853Retained earnings
    
    
    99,892
    
    
    
    85,735Accumulated other comprehensive income (loss):Net unrealized appreciation on investment securities
    
    
    3,046
    
    
    
    695Net loss on cash flow hedge
    
    
    (883
    )
    
    
    (888
    )Total shareholders equity
    
    
    194,333
    
    
    
    177,395Total liabilities and shareholders equity
    
    $
    874,493
    
    
    $
    751,154
 See notes to condensed consolidated financial statements. 3




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DIRECT GENERAL CORPORATION AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
 Three Months Ended March 31,2004
    
    2003(In thousands)Operating activitiesNet income
    
    $
    15,018
    
    
    $
    9,810Adjustments to reconcile net income to net cash provided by operating activities:Net realized gains on securities and other
    
    
    (69
    )
    
    
    (266
    )Depreciation and amortization
    
    
    1,331
    
    
    
    1,160Deferred income taxes
    
    
    (1,983
    )
    
    
    (2,543
    )Changes in operating assets and liabilities:Finance receivables
    
    
    (52,513
    )
    
    
    (50,477
    )Reinsurance balances receivable
    
    
    (7,614
    )
    
    
    5,004Prepaid reinsurance premiums
    
    
    309
    
    
    
    (24,656
    )Deferred policy acquisition costs
    
    
    (667
    )
    
    
    (2,069
    )Income taxes recoverable/payable
    
    
    7,595
    
    
    
    2,543Loss and loss adjustment expense reserves
    
    
    714
    
    
    
    5,098Unearned premiums
    
    
    54,051
    
    
    
    52,865Reinsurance balances payable and funds held
    
    
    6,321
    
    
    
    16,508Accounts payable and accrued expenses
    
    
    (690
    )
    
    
    (462
    )Other
    
    
    (4,608
    )
    
    
    8,436Net cash provided by operating activities
    
    
    17,195
    
    
    
    20,951Investing activitiesProceeds from sales and maturities of debt securities available-for-sale
    
    
    54,504
    
    
    
    8,481Purchase of debt securities available-for-sale
    
    
    (67,775
    )
    
    
    (23,955
    )Payable for securities
    
    
    8,680
    
    
    
    Net purchases of short-term investments
    
    
    (309
    )
    
    
    (2,000
    )Purchase of property and equipment, net
    
    
    (1,678
    )
    
    
    (678
    )Purchase of life insurance company
    
    
    (7,330
    )
    
    
    Net cash used in investing activities
    
    
    (13,908
    )
    
    
    (18,152
    )Financing activitiesIssuances of common stock
    
    
    425
    
    
    
    Proceeds from borrowings
    
    
    28,000
    
    
    
    10,000Payment of principal on borrowings
    
    
    (404
    )
    
    
    (1,754
    )Payment of stock dividends
    
    
    (861
    )
    
    
    (140
    )Net cash provided by financing activities
    
    
    27,160
    
    
    
    8,106Net increase in cash and cash equivalents
    
    
    30,447
    
    
    
    10,905Cash and cash equivalents at beginning of period
    
    
    87,342
    
    
    
    87,027Cash and cash equivalents at end of period
    
    $
    117,789
    
    
    $
    97,932
 See notes to condensed consolidated financial statements. 4




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DIRECT GENERAL CORPORATION AND SUBSIDIARIES 
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
 1. Nature of Operations Direct General Corporation, headquartered in Nashville, Tennessee, is a
financial services holding company whose principal operating subsidiaries
provide non-standard personal automobile insurance, term life insurance,
premium finance and other consumer products and services primarily on a direct
basis throughout most of the southeastern United States. Direct General
Corporation owns four property/casualty insurance companies, two life/health
insurance companies, two premium finance companies, twelve insurance agencies,
two administrative service companies and one company that provides
non-insurance consumer products and services. 2. Basis of Presentation The unaudited consolidated financial statements included herein have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission. Certain information and footnote disclosures normally included in
financial statements prepared in accordance with accounting principles
generally accepted in the United States (GAAP) have been condensed or omitted
pursuant to such rules and regulations. The consolidated financial statements
reflect all normal recurring adjustments which were, in the opinion of
management, necessary for a fair statement of the results for the interim
periods presented. The results of operations for the period ended March 31,
2004 are not necessarily indicative of the results expected for the full year.
These unaudited consolidated financial statements and the notes thereto should
be read in conjunction with the Companys audited financial statements and
accompanying notes included in the Companys Annual Report on Form 10-K for the
year ended December 31, 2003. Effective August 11, 2003, the Company effected a stock split pursuant to
which each outstanding share of the Companys common stock became 12 new shares
of common stock. The Company has adjusted all share and per share amounts in
the accompanying financial statements to reflect the 12 for 1 split. 3. Acquisitions On January 30, 2004, the Company acquired an inactive life insurance
company for a total purchase price of $7.3 million of which approximately $1.3
million was attributable to goodwill. The assets of this life insurance
company consist of licenses to conduct life and/or accident and health
insurance business in 43 states and the District of Columbia and debt
securities. 4. Secondary Offering On March 23, 2004, the Company completed a secondary offering whereby
selling shareholders sold 3,314,015 shares of the Companys common stock. As
result of the exercise of the over-allotment option by the underwriters of the
secondary offering, the Company issued and sold an additional 497,102 common
shares in April 2004, which resulted in net proceeds to the Company (after
deducting issuance costs) of approximately $16.0 million. 5. Earnings Per Share The following table sets forth the computation of basic and diluted
earnings per share: Three Months Ended March 31,2004
    
    2003(In thousands, except per share amounts)Numerator:Net income available to common
shareholders
    
    $
    15,018
    
    
    $
    9,670Dividends paid to preferred shareholders
    
    
    
    
    
    
    260Income for purposes of computing
diluted earnings per common share
    
    $
    15,018
    
    
    $
    9,930Denominator:Weighted average common shares outstanding
    
    
    21,503.0
    
    
    
    12,119.1Dilutive stock options
    
    
    834.1
    
    
    
    310.7Dilutive preferred stock
    
    
    
    
    
    
    5,264.0Weighted average common shares
outstanding for purposes of computing
diluted earnings per common share
    
    
    22,337.1
    
    
    
    17,693.8Basic earnings per common share
    
    $
    0.70
    
    
    $
    0.80Diluted earnings per common share
    
    $
    0.67
    
    
    $
    0.56
 5




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6. Stock Options The Company follows the provisions of Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, to account for its
stock option activity in the financial statements. The Company granted all
employee stock options currently outstanding at an exercise price equal to the
market price at the date of grant and, therefore, under APB 25, no compensation
expense is recorded. The Company follows the disclosure provisions of
Statement of Financial Accounting Standards (SFAS) 123, Accounting for
Stock-Based Compensation. If the Company had elected to recognize stock compensation expense based
on the fair value of stock options at the grant date, as prescribed by SFAS
123, net income available to common shareholders and basic and diluted earnings
per share would have been reported as presented in the following table. Three Months Ended March 31,2004
    
    2003(In thousands, except per share amounts)Net income available to common
shareholders, as reported
    
    $
    15,018
    
    
    $
    9,670Deduct: Total stock-based employee
compensation expense determined
under the fair value based method,
net of related tax effects
    
    
    (252
    )
    
    
    (19
    )Net income available to common
shareholders, pro forma
    
    $
    14,766
    
    
    $
    9,651Income for purposes of computing
diluted earnings per share common,
as reported
    
    $
    15,018
    
    
    $
    9,930Deduct: Total stock-based employee
compensation expense determined
under the fair value based method,
net of related tax effects
    
    
    (252
    )
    
    
    (19
    )Income for purposes of computing
diluted earnings per share common,
pro forma
    
    $
    14,766
    
    
    $
    9,911Earnings per shareBasic  as reported
    
    $
    0.70
    
    
    $
    0.80Basic  pro forma
    
    $
    0.69
    
    
    $
    0.80Diluted  as reported
    
    $
    0.67
    
    
    $
    0.56Diluted  pro forma
    
    $
    0.66
    
    
    $
    0.56
 7. Recent Accounting Pronouncements The Company continually evaluates the impact of new accounting
pronouncements and based on this analysis, the Company does not expect recently
issued accounting standards to have a material impact on the Companys results
of operations, financial condition, or cash flows. 6




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Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations. This Managements Discussion and Analysis of Financial Condition and
Results of Operations should be read in conjunction with the Companys
discussion presented under the caption Managements Discussion and Analysis of
Financial Condition and Results of Operations that is available in the Annual
Report onForm 10-Kfor the year ended December 31, 2003 filed with the
Securities and Exchange Commission. Overview We are a provider of non-standard personal automobile insurance, premium
finance and other insurance and non-insurance products and services. Our
operations are concentrated in the southeastern part of the United States. Our
business model integrates our insurance, premium finance and agency
subsidiaries under one organization. Our model also emphasizes the
distribution of our products and services through neighborhood sales offices
staffed by salaried employee-agents as opposed to commissioned agents. The
expansion of our neighborhood sales offices in selected states includes the use
of independent insurance agencies, which we generally have options to acquire
in the future. Measurement of Results We evaluate our operations by monitoring key measures of growth and
profitability. We measure our growth by examining our gross revenues, which is
comprised of gross premiums written and revenues from all other sources
produced through our distribution system. We generally measure our operating
results by examining our net income, return on equity, and our loss, expense
and combined ratios. In addition, we evaluate our performance by comparing the
level of our ancillary income to premiums earned and to operating expenses.
The following provides further explanation of the key measures that we use to
evaluate our results: Gross Premiums Written. Gross premiums written is the sum of direct
premiums written and assumed premiums written. Direct premiums written is the
sum of the total policy premiums, net of cancellations, associated with
policies underwritten and issued by our insurance subsidiaries. Assumed
premiums written is the sum of total premiums associated with the insurance
risk transferred to us by other insurance companies pursuant to reinsurance
contracts. We use gross premiums written, which excludes the impact of
premiums ceded to reinsurers, as a measure of the underlying growth of our
insurance business from period to period. Net Premiums Written.Net premiums written is the sum of direct premiums
written and assumed premiums written less ceded premiums written. Ceded
premiums written is the portion of our direct and assumed premiums that we
transfer to our reinsurers in accordance with the terms of our reinsurance
contracts based upon the risks they accept. We use net premiums written,
primarily in relation to gross premiums written, to measure the amount of
business retained after cessions to reinsurers. Gross Revenues (a non-GAAP financial measure).Gross revenues are the sum
of gross premiums written plus all other revenues (finance income, commission
and service fee income, net investment income, and net realized gains (losses)
on securities). We use gross revenues as the primary measure of the underlying
growth of our revenue streams from period to period. Gross revenues are
reconciled to total revenues in the Managements Discussion and Analysis of
Financial Condition and Results of Operations  Results of Operations. Loss Ratio. Loss ratio is the ratio (expressed as a percentage) of losses
and loss adjustment expenses incurred to premiums earned and measures the
underwriting profitability of a companys insurance business. Loss ratio
generally is measured on both a gross (direct and assumed) and net (gross less
ceded) basis. We use the gross loss ratio as a measure of the overall
underwriting profitability of the insurance business we write and to assess the
adequacy of our pricing. Our net loss ratio is meaningful in evaluating our
financial results, which are net of ceded reinsurance, as reflected in our
consolidated financial statements. Our loss ratios are generally calculated in
the same way for GAAP and statutory accounting purposes. Expense Ratio. Expense ratio is the ratio (expressed as a percentage) of
net operating expenses to premiums earned and measures a companys operational
efficiency in producing, underwriting and administering its insurance business.
For statutory accounting purposes, operating expenses of an insurance company
exclude investment expenses, and are reduced by other income. There is no such
industry definition for determining an expense ratio for GAAP purposes. As a
result, we apply the statutory definition to calculate our expense ratio on a
GAAP basis. We reduce our operating expenses by ancillary income (excluding
net investment income and realized gains (losses) on securities) to calculate
our net operating expenses. Due to our historically high levels of
reinsurance, we calculate our expense ratio on both a gross basis (before the
effect of ceded reinsurance) and a net basis (after the effect of ceded
reinsurance). Although the net basis is meaningful in evaluating our financial
results that are net of ceded reinsurance, as reflected in our consolidated
financial statements, we believe that the gross expense ratio more accurately
reflects the operational efficiency of the underlying business and is a better
measure of future trends. 7




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Combined Ratio. Combined ratio is the sum of the loss ratio and the
expense ratio and measures a companys overall underwriting profit. If the
combined ratio is at or above 100, an insurance company cannot be profitable
without investment income (and may not be profitable if investment income is
insufficient). We use the GAAP combined ratio in evaluating our overall
underwriting profitability and as a measure for comparison of our profitability
relative to the profitability of our competitors. Ancillary Income Measures.We have developed measures of our ability to
generate ancillary income (finance income and commission and service fee
income) that reflect the differences between our business model and those used
by our competitors. We measure our ancillary income as a percentage of
premiums earned and as a percentage of our operating expenses. We believe that
most of our competitors only achieve point of sale contact through an
independent agent and are therefore typically unable to generate significant
amounts of ancillary income. Results of Operations The table below summarizes certain operating results and key measures we
use in monitoring and evaluating our operations. The information provided is
intended to summarize and supplement information contained in our consolidated
financial statements and to assist the reader in gaining a better understanding
of our results of operations. Three Months EndedMarch 31,%($ in millions)
    
    2004
    
    2003
    
    Change(Unaudited)Selected Financial DataGross premiums written
    
    $
    169.0
    
    
    $
    140.6
    
    
    
    20.2Ancillary income
    
    
    26.3
    
    
    
    19.6
    
    
    
    34.2Net investment income and realized capital gains
    
    
    2.3
    
    
    
    1.7
    
    
    
    35.3Gross revenues
    
    $
    197.6
    
    
    $
    161.9
    
    
    
    22.1Ceded premiums written
    
    
    (31.7
    )
    
    
    (64.7
    )
    
    
    (51.0
    )Change in net unearned premiums
    
    
    (54.3
    )
    
    
    (28.2
    )
    
    
    92.6Total revenues
    
    $
    111.6
    
    
    $
    69.0
    
    
    
    61.7Net income
    
    $
    15.0
    
    
    $
    9.8
    
    
    
    53.1Key Financial RatiosLoss ratio  net
    
    
    73.3
    %
    
    
    73.0
    %Expense ratio  net
    
    
    0.4
    %
    
    
    (1.7
    %)Combined ratio  net
    
    
    73.7
    %
    
    
    71.3
    %Ancillary income to net operating expenses
    
    
    98.7
    %
    
    
    104.4
    %
  Overview of Operating Results Net income increased 53.1% to $15.0 million or $0.67 per share, on a
diluted basis, for the three months ended March 31, 2004, as compared to net
income of $9.8 million or $0.56 per share, on a diluted basis, in the first
quarter of 2003. For the quarter, gross premiums written increased 20.2%
fueled by substantial growth in our renewal business and modest growth in new
business. Total revenues increased 61.7% driven by a significant increase in
net premiums earned due to the growth in gross premiums and an increase in the
percentage of business retained. During the quarter, we continued to realize
the benefits from the Cash Register agency network that was acquired in
November 2003 by retaining the commission income on the sale of ancillary
insurance products and converting the cost structure from a commission-based
structure to the largely fixed cost structure provided by our business model.
The Cash Register agency offices generated additional commission and
administrative fee income of $1.6 million and term life insurance sales of $0.2
million for us. We also recognized a $2.6 million reduction in operating costs
associated with the Cash Register business as compared to the first quarter of
2003. 8




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Revenues  Premiums The following table presents our gross premiums written in our major
markets and provides a summary of gross, ceded and net premiums written and
earned for the periods presented: Three Months EndedMarch 31,%($ in millions)
    
    2004
    
    2003
    
    Change(Unaudited)Gross premiums writtenFlorida
    
    $
    83.9
    
    
    $
    70.9
    
    
    
    18.3Tennessee
    
    
    23.4
    
    
    
    20.9
    
    
    
    12.0Georgia
    
    
    12.3
    
    
    
    11.9
    
    
    
    3.4Louisiana
    
    
    12.5
    
    
    
    10.5
    
    
    
    19.0Mississippi
    
    
    10.1
    
    
    
    8.4
    
    
    
    20.2Texas
    
    
    7.0
    
    
    
    1.8
    
    
    
    288.9All other states
    
    
    19.8
    
    
    
    16.2
    
    
    
    22.2Gross premiums written
    
    $
    169.0
    
    
    $
    140.6
    
    
    
    20.2Ceded premiums written
    
    
    (31.7
    )
    
    
    (64.7
    )
    
    
    (51.0
    )Net premiums written
    
    $
    137.3
    
    
    $
    75.9
    
    
    
    80.9Gross premiums earned
    
    $
    115.0
    
    
    $
    87.8
    
    
    
    31.0Ceded premiums earned
    
    
    (32.0
    )
    
    
    (40.1
    )
    
    
    (20.2
    )Net premiums earned
    
    $
    83.0
    
    
    $
    47.7
    
    
    
    74.0Net premiums written to gross premiums written
    
    
    81.2
    %
    
    
    54.0
    %Gross premiums earned to gross premiums written
    
    
    68.0
    %
    
    
    62.4
    %Net premiums earned to net premiums written
    
    
    60.5
    %
    
    
    62.8
    %
 Gross premiums written increased $28.4 million or 20.2% for the three
months ended March 31, 2004 compared to the first quarter of 2003. The increase
in gross premiums written reflected increases of approximately $23.2 million in
our existing states and $5.2 million in our expansion state, Texas. The
premium growth in our existing states was driven by increases in renewal
policies in Florida, Arkansas and South Carolina and new business policies in
Tennessee, Mississippi and South Carolina. There was minimal impact from rate
increases in our existing states. Gross written premiums from the sale of our
core non-standard automobile insurance business increased 19.4% to $163.0
million while gross premiums written from the sale of our term life insurance
business increased 46.3% to $6.0 million as compared to the first quarter of
2003. Gross premiums earned, a function of gross premiums written over the
current and prior periods, increased 31.0% to $115.0 million in first quarter
of 2004 versus the same period in 2003. Gross premiums written in Texas continue to increase and are in line with
our expectations to produce approximately $40 million for the year. We expect
to begin our initial advertising campaign in Texas in the third quarter of
2004, which is likely to involve the co-branding of Direct and the Texas
independent agency network that we have an option to acquire the assets of at
the end of 2004. The growth in net premiums written and earned is a function of gross
premiums written and earned less ceded premiums written and earned. The
increased capitalization of our insurance subsidiaries enabled us to retain
more business and, as a result, the ratio of net premiums written to gross
premiums written increased to 81.2% during the first quarter of 2004 as
compared to 54.0% in the first quarter of 2003. We expect to retain 80% to 90%
of our gross premiums written in 2004.  Ancillary Income Ancillary income for the three months ended March 31, 2004 increased 34.2%
to $26.3 million compared to the corresponding period in 2003. Approximately
$1.6 million of this increase was due to an increase in commission and service
fee income on products sold by the Cash Register agency offices, which were
acquired in the fourth quarter of 2003. During the first quarter of 2004, the
penetration in the sales of ancillary insurance products increased, while
premium finance income grew largely as a result of an increase in average
finance receivables outstanding. The increase in finance income will not
correspond proportionately with the increase in premiums earned since, in
Texas, we are currently only issuing one-month policies and are not financing
premiums. The ratio of ancillary income to gross premiums earned was 22.9% and
22.3% for the first quarter of 2004 and 2003, 9




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respectively, while the ratio of ancillary income to operating expenses
decreased to 98.7% in the 2004 period from 104.4% in the 2003 period. Because
operating expenses are net of ceded reinsurance commissions received and we
have been reducing our level of reinsurance, our net operating expenses have
increased resulting in a lower ratio of ancillary income to operating expenses.  Net Investment Income Net investment income was $2.3 million for the three months ended March
31, 2004 compared to $1.4 million for the first quarter of 2003. The increase
was due primarily to an increase in average invested assets partially offset by
a decrease in investment yields. Average invested assets increased 95.5% to
$265.7 million in the first quarter of 2004 from $135.2 million in the first
quarter of 2003; however, the average investment yield decreased to 3.5% in the
first quarter of 2004 from 4.3% in the corresponding period in 2003.  Realized Gains on Securities and Other We realized gross gains of $0.2 million and gross losses of $0.2 million
on the sale of securities for the three months ended March 31, 2004.
Comparatively, we realized gross gains on debt securities of $0.3 million and
no gross losses for the comparable period in 2003. There was no impact on
realized losses attributable to adjustments for other than temporary impairment
of securities still held during these periods. In the first quarter of 2004, we also realized gross gains of $0.5 million
and gross losses of $0.8 million on closed contracts in our trading portfolio.
The trading portfolio primarily consists of futures contracts, swaps, and other
derivative instruments. This represents a speculative investment and does not
represent a hedge; accordingly, all open contracts are marked to market with
the change in market values included in net realized gains on securities and
other in our consolidated statement of operations. During the quarter, the
market value on open contracts increased by $0.3 million, which was included in
net realized gains on securities and other. As of March 31, 2004, we had open
contracts with gross unrealized gains of $0.2 million and gross unrealized
losses of $0.1 million.  Expenses  Insurance Losses and Loss Adjustment Expenses Insurance losses and loss adjustment expenses increased to $60.8 million
for the three months ended March 31, 2004 from $34.8 million for the same
period in 2003. Net loss ratios for the first quarter of 2004 and 2003 were
73.3% and 73.0%, respectively. The Companys quarterly analysis of reserves
resulted in a slight increase to prior year reserves, which increased the net
loss ratio by 0.4 points in the first quarter of 2004. During the first
quarter of 2003, the Company recognized $0.8 million of favorable development
on prior years reserves, which reduced the net loss ratio by 1.7 points. The
net loss ratios, excluding the impact of the adjustments to prior years
reserves, were 72.9% and 74.7% for the three months ended March 31, 2004 and
2003, respectively. The impact of catastrophic losses in both the first
quarter of 2004 and 2003 was minimal. Overall, our countrywide frequency and severity trends were relatively
flat for the current quarter. We have been closely monitoring increases in
claims frequency, particularly in the personal injury protection coverage in
the Miami, Florida market over the past few quarters. We increased rates for
personal injury protection coverages and have been actively challenging those
claims believed to be fraudulent. As a result of these efforts, coupled with a
substantial reduction in new business in the Miami, Florida market, we have
began to experience an improvement in the loss trends for the personal injury
protection coverage in Florida. The loss ratio for our Texas business
continues to be slightly better than our countrywide average for our existing
states.  Operating Expenses Operating expenses increased 40.7% to $26.6 million for the three months
ended March 31, 2004, compared to $18.9 million for the same period of 2003.
This increase in operating expenses was substantially lower than the 61.6%
increase in total revenues primarily as a result of the reduction in operating
costs associated with the acquisition of Cash Register agency offices in
Florida. Operating expenses for the quarter reflected a $2.6 million reduction
in selling, general and administrative costs associated with the Cash Register
business as the cost structure for this business was converted from a variable
structure with commissioned independent agents to the largely fixed cost
structure provided by our business model. The increase in operating costs
compared to the first quarter of 2003 was driven by a reduction in ceded
reinsurance commissions received of $5.4 million and a $4.9 million increase in
other operating costs primarily associated with our growth in Texas and
increased premium volumes in our existing states. 10




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##### Table of Contents



Income Taxes Our effective tax rates were 37.9% and 36.1% for the three-month periods
ended March 31, 2004 and 2003, respectively. The increase in our effective tax
rate is primarily due to an increase in state income taxes and a reduction in
tax-exempt interest. Financial Condition  Liquidity and Capital Resources  Sources and Uses of Funds We are organized as a holding company system with all of our operations
being conducted by our wholly-owned insurance, premium finance, agency,
administrative and consumer product subsidiaries. Accordingly, Direct General
Corporation receives cash through loans from banks, issuance of equity
securities, subsidiary dividends and other transactions. We may use the
proceeds from these sources to contribute to the capital of our insurance
subsidiaries and premium finance company in order to support premium growth, to
repurchase our common stock, to retire our outstanding indebtedness, to pay
interest, dividends, and taxes, and for other business purposes. Our operating subsidiaries primary sources of funds are premiums
received, finance income, commission and service fee income, investment income,
borrowings under credit facilities and proceeds from the sale and redemption of
investments. Funds are used to pay claims and operating expenses, to pay
interest and principal repayments under the terms of our indebtedness for
borrowed money, to purchase investments and to pay dividends to Direct General
Corporation. We had positive cash flow from operations of approximately $17.2
million and $21.0 million in the first three months of 2004 and 2003,
respectively. We expect our cash flows to be positive in both the short-term
and reasonably foreseeable future.  Financing and Capital During the first quarter of 2004, one of our insurance subsidiaries
purchased an inactive life insurance company for a total purchase price of $7.3
million. The life company has licenses in 43 states and the District of
Columbia and we plan to sell our life insurance product in North Carolina,
Texas and future expansion states through this entity. We also invested an
additional $5.5 million in our insurance subsidiaries to support premium growth
and the increased retention of the business. During the first quarter of 2004,
we paid a common stock dividend totaling $0.9 million. As of March 31, 2004, the maximum aggregate amount available under our
revolving credit agreement used to support our premium finance operations was
$190.0 million and the amount outstanding was $176.0 million. . Based on
communications with our lenders, we expect to renew this facility for an
additional two-year period when the facility matures on June 30, 2004. We do
not expect any material changes in the underlying terms of the agreement. In April 2004, we sold an additional 497,102 shares of common stock and
received net proceeds of $16.0 million after offering expenses in conjunction
with a secondary offering. The proceeds from this offering will be used to
further capitalize our insurance subsidiaries and for general corporate
purposes.  Reinsurance The
increased capitalization of our insurance subsidiaries enabled us to
reduce our quota share cession percentage. As a result, we ceded 18.8% of our
gross premiums written to reinsurers in the three months ended March 31, 2004
as compared to 46.0% in the first quarter of 2003. Our quota share reinsurance
agreement for 2004 also provides for adjustments to the cession percentage
during the year. We plan to cede between 10% and 20% of our gross premiums
written to reinsurers during 2004.  Investments Debt securities. Our investment portfolio primarily consists of debt
securities, all classified as available-for-sale and carried at market value
with unrealized gains and losses reported in our financial statements as a
separate component of shareholders equity on an after-tax basis. As of March
31, 2004, our investment portfolio of $285.4 million included $4.7 million in
net unrealized gains. The effective duration of our investment portfolio was
4.1 years at March 31, 2004. 11




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The following table shows the composition by our internal industry
classification of the amortized cost, gross unrealized gains, gross unrealized
losses and fair value of debt securities available-for-sale as of March 31,
2004: Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    Fair($ in millions)
    
    Cost
    
    Gains
    
    Losses
    
    ValueU.S. Treasury securities and
obligations of U.S. government
corporations and agencies
    
    $
    61.9
    
    
    $
    0.6
    
    
    $
    0.2
    
    
    $
    62.3Obligations of states and
political subdivisions
    
    
    50.7
    
    
    
    2.0
    
    
    
    0.1
    
    
    
    52.6Corporate debt securitiesBanks and financial institutions
    
    
    53.0
    
    
    
    1.1
    
    
    
    0.1
    
    
    
    54.0Credit cards and auto loans
    
    
    59.7
    
    
    
    0.5
    
    
    
    0.2
    
    
    
    60.0Industrial
    
    
    34.8
    
    
    
    0.7
    
    
    
    0.1
    
    
    
    35.4Telecommunications
    
    
    12.1
    
    
    
    0.3
    
    
    
    
    
    
    
    12.4Utilities and Electric Services
    
    
    8.5
    
    
    
    0.2
    
    
    
    
    
    
    
    8.7Corporate debt securities
    
    
    168.1
    
    
    
    2.8
    
    
    
    0.4
    
    
    
    170.5Total
    
    $
    280.7
    
    
    $
    5.4
    
    
    $
    0.7
    
    
    $
    285.4
 The amortized cost and fair value of debt securities available-for-sale as
of March 31, 2004, by contractual maturity, is shown below: ($ in millions)
    
    Amortized Cost
    
    Fair ValueYears to maturity:One or less
    
    $
    7.3
    
    
    $
    7.3After one through five
    
    
    140.5
    
    
    
    142.5After five through ten
    
    
    99.5
    
    
    
    101.9After ten
    
    
    33.4
    
    
    
    33.7Total
    
    $
    280.7
    
    
    $
    285.4
 The Securities Valuation Office of the National Association of Insurance
Commissioners (NAIC) evaluates the bond investments of insurers for
regulatory reporting purposes and assigns securities to one of six investment
categories called NAIC designations. The NAIC designations parallel the
credit ratings of the Nationally Recognized Statistical Rating Organizations
for marketable bonds. NAIC designations 1 and 2 include bonds considered to be
investment grade, rated BBB- or higher by Standard & Poors (S&P). NAIC
designations 3 through 6 include bonds considered below investment grade, rated
BB+ or lower by S&P. All of the debt securities in our portfolio were rated
investment grade by the NAIC and S&P as of March 31, 2004. Investment grade
securities generally bear lower yields and lower degrees of risk than those
that are unrated or are rated non-investment grade. The quality distribution of our investment portfolio as of March 31, 2004
was as follows: ($ in millions)NAICRating
    
    S&P Rating
    
    Amortized Cost
    
    Fair Value
    
    % of Fair Value1
    
    AAA
    
    $
    124.5
    
    
    $
    126.2
    
    
    
    44.2
    %1
    
    AA
    
    
    29.4
    
    
    
    30.5
    
    
    
    10.7
    %1
    
    
    A
    
    
    
    61.8
    
    
    
    63.0
    
    
    
    22.1
    %2
    
    BBB
    
    
    33.1
    
    
    
    33.6
    
    
    
    11.8
    %1
    
    Agency
    
    
    31.9
    
    
    
    32.1
    
    
    
    11.2
    %$
    280.7
    
    
    $
    285.4
    
    
    
    100.0
    %
 We evaluate the risk versus reward tradeoffs of investment opportunities,
measuring their effects on the stability, diversity, overall quality and
liquidity of our investment portfolio. The primary market risk exposure to our
debt securities portfolio is interest rate risk, which is limited by managing
duration to a defined range of three to four years. Interest rate risk
includes the risk from movements in the underlying market rate and in credit
spreads of the respective sectors of debt securities held in our portfolio.
The fair value of our fixed maturity portfolio is directly impacted by changes
in market interest rates. 12




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The following table provides information about our investments that are
sensitive to interest rate risk and provides estimates of expected changes in
fair value based upon a 100 basis-point increase and decrease in market
interest rates as of March 31, 2004: -100 Basis Point
    
    
    
    
    
    +100 Basis Point($ in millions)
    
    Change
    
    Fair Value
    
    ChangeDebt securities, available for sale
    
    $
    297.2
    
    
    $
    285.4
    
    
    $
    273.5
 Short-term investments.We have a managed trading account with a
commodities trading company and, as of March 31, 2004, the total fair value of
open trades in this account was a $0.1 million loss, which represents less than
1% of our entire investment portfolio. We invest in commodities, primarily
cattle futures and swaps. U.S. Treasury securities of $1.7 million, included
in short-term investments and cash of $1.0 million, included in cash and cash
equivalents, are held as collateral for this account. We recognized net
realized losses of $0.3 million on closed contracts and a $0.3 million gain on
open contracts during the first quarter of 2004. Because this is a speculative
investment and not a hedge, both the realized gains on closed contracts and the
change in the fair value of open contracts are reported as net realized gains
on securities and other in our consolidated statement of operations. Cash and cash equivalents. Our balance in cash and cash equivalents was
$117.8 million as of as of March 31, 2004, which was approximately 35% higher
than the balance of cash held at December 31, 2003. The increase was primarily
attributable to the seasonality of the business. Forward-Looking Statements This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. All statements made in the
report, other than statements of historical fact, are forward-looking
statements. You can identify these statements from our use of the words may,
should, could, potential, continue, plan, forecast, estimate,
project, believe, intend, anticipate, expect, target, is likely,
will, or the negative of these terms, and similar expressions. These
statements are made pursuant to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. These forward-looking statements may
include, among other things:  
    
    statements and assumptions relating to future growth, earnings,
earnings per share and other financial performance measures, as well
as managements short-term and long-term performance goals;
    
    statements relating to the anticipated effects on results of
operations or financial condition from recent and expected
developments or events;
    
    statements relating to our business and growth strategies; and
    
    any other statements or assumptions that are not historical facts. We believe that our expectations are based on reasonable assumptions.
However, these forward-looking statements involve known and unknown risks,
uncertainties and other important factors that could cause our actual results,
performance or achievements, or industry results, to differ materially from our
expectations of future results, performance or achievements expressed or
implied by these forward-looking statements. In addition, our past results of
operations do not necessarily indicate our future results. We discuss these
and other uncertainties in the Business  Risks Related to our Business
section of the Annual Report on Form 10-K for the year ended December 31, 2003
filed with the Securities and Exchange Commission on March 4, 2004. You should not place undue reliance on any forward-looking statements.
These statements speak only as of the date of this report. Except as otherwise
required by applicable laws, we undertake no obligation to publicly update or
revise any forward-looking statements or the risk factors described in this
report, whether as a result of new information, future events, changed
circumstances or any other reason after the date of this report. Item 3. Quantitative and Qualitative Disclosures About Market Risk. Please see the caption Financial Condition  Liquidity and Capital
Resources in Part I  FINANCIAL INFORMATION, Item 2. Managements Discussion
and Analysis of Financial Condition and Results of Operations of this report
for a description of our quantitative and qualitative disclosures about market
risks. 13




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Item 4. Controls and Procedures. Our management, with the participation of our chief executive officer and
chief financial officer, has evaluated the effectiveness of the design and
operation of our disclosure controls and procedures (as defined in Exchange Act
Rule 13a-15(e)) as of the end of the period covered by this report. Based on
that evaluation, the chief executive officer and chief financial officer have
concluded that our disclosure controls and procedures are effective to ensure
that material information relating to us and our consolidated subsidiaries is
made known to such officers by others within these entities, particularly
during the period this report was prepared, in order to allow timely decisions
regarding required disclosure. There have not been any changes in our internal
control over financial reporting during the period covered by this report that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting. 14




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PART II  OTHER INFORMATION Item 1. Legal Proceedings. We and our subsidiaries are named from time to time as defendants in
various legal actions that are incidental to our business and arise out of or
are related to claims made in connection with our insurance policies, claims
handling, premium finance agreements and other contracts, and employment
related disputes. The plaintiffs in some of these lawsuits have alleged bad
faith or extracontractual 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. During 2003, we entered into a voluntary settlement agreement regarding
all aspects of two proposed class actions filed in Tennessee state courts
alleging, among other things, that certain business practices relating to our
premium finance and insurance operations were unlawful. The settlement became
final on June 9, 2003. Out of over 1.1 million settlement class members to whom
notices of the settlement were sent, approximately 130 persons gave notice that
they elected not to participate in the settlement (opt-out). None of the
class members objected to the settlement. The Tennessee court has determined
that the majority of the purported opt-out notices were timely and properly
submitted. The majority of the opt-out class members are represented by a
single law firm, which recently filed a multi-plaintiff lawsuit against us and
several of our subsidiaries in Holmes County, Mississippi. This lawsuit is in
the early procedural stages, and the ultimate outcome of this case is
uncertain. We intend to vigorously defend this lawsuit. William C. Adair, Jr., our Chairman, Chief Executive Officer and President
has been named as a defendant in a lawsuit filed in Tennessee state court in
November 2003. The complaint alleges that Mr. Adair induced the plaintiff to
market a Health Plan, that Mr. Adair made certain misrepresentations to the
plaintiff and that Mr. Adair breached a contract that resulted in a loss of
commissions to the plaintiff. Based on these allegations, plaintiff is seeking
compensatory damages and an unspecified amount of punitive damages. We are not
named as a defendant in this lawsuit; however, the plaintiff has recently filed
a motion to name one of our subsidiary companies, Direct General Insurance
Company, as a defendant. This lawsuit against Mr. Adair is still in the early
procedural stages, and the ultimate outcome of this case is uncertain. If we
or any of our subsidiaries are named as a defendant in this lawsuit, we will
vigorously defend against any claims. In addition to legal actions that are incidental to our business, one or
more of our subsidiaries has been named as a defendant in a number of currently
pending putative class action lawsuits. Please see the caption Business 
Legal Proceeding included in our Annual Report on Form 10-K for the year ended
December 31, 2003 filed with the Commission on March 9, 2004 for a description
of these legal actions. Item 6. Exhibits and Reports on Form 8-K. (a) List of exhibits: 31.1
    
    Rule 13a-14(a) Certifications of CEO (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002).31.2
    
    Rule 13a-14(a) Certifications of CFO (pursuant to Section 302 of the Sarbanes-Oxley Act of 2002).32.1
    
    Rule 1350 Certifications of CEO (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).32.2
    
    Rule 1350 Certifications of CFO (pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).
 (b) Reports of Form 8-K: (i)
    
    Current Report on Form 8-K filed on February 11, 2004
to report earnings for the quarter ended December 31, 2003.
 15




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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. DIRECT GENERAL CORPORATION
(Registrant)May 14, 2004
Date
    
    By:  /s/ William C. Adair, Jr.
(Signature)Name:  William C. Adair, Jr.
Title:  Chairman, Chief Executive Officer and PresidentMay 14, 2004
Date
    
    By:  /s/ Barry D. Elkins
(Signature)Name:  Barry D. Elkins
Title:  Senior Vice President and Chief Financial Officer
 16