##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q (Mark One) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended September 30, 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  þ   No  o Indicate the number of shares outstanding of each of the issuers classes
of common stock, as of the latest practicable date: 22,360,046 shares of common
stock, no par value, at November 8, 2004.




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TABLE OF CONTENTS  PART IFINANCIAL INFORMATIONItem 1. Financial StatementsCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONSCONDENSED CONSOLIDATED BALANCE SHEETSCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWSNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTSItem 2. Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3. Quantitative and Qualitative Disclosures About Market RiskItem 4. Controls and ProceduresPART II OTHER INFORMATIONItem 1. Legal ProceedingsItem 6. Exhibits and Reports on Form 8-KSIGNATURESEX-31.1 SECTION 302 CERTIFICATION OF THE CEOEX-31.2 SECTION 302 CERTIFICATION OF THE CFOEX-32.1 SECTION 906 CERTIFICATION 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
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(In thousands  except per share amounts)RevenuesPremiums earned
    
    $
    97,318
    
    
    $
    58,366
    
    
    $
    273,622
    
    
    $
    159,817Finance income
    
    
    11,695
    
    
    
    11,246
    
    
    
    37,158
    
    
    
    33,693Commission and service fee income
    
    
    11,874
    
    
    
    8,287
    
    
    
    37,349
    
    
    
    24,285Net investment income
    
    
    2,789
    
    
    
    1,681
    
    
    
    7,686
    
    
    
    4,612Net realized gains on securities and other
    
    
    86
    
    
    
    1,512
    
    
    
    146
    
    
    
    3,433Total revenues
    
    
    123,762
    
    
    
    81,092
    
    
    
    355,961
    
    
    
    225,840ExpensesInsurance losses and loss adjustment expenses
    
    
    71,765
    
    
    
    43,189
    
    
    
    200,852
    
    
    
    118,178Selling, general and administrative costs
    
    
    28,393
    
    
    
    18,423
    
    
    
    78,781
    
    
    
    53,405Interest expense
    
    
    1,257
    
    
    
    1,562
    
    
    
    4,148
    
    
    
    4,934Total expenses
    
    
    101,415
    
    
    
    63,174
    
    
    
    283,781
    
    
    
    176,517Income before income taxes
    
    
    22,347
    
    
    
    17,918
    
    
    
    72,180
    
    
    
    49,323Income tax expense
    
    
    7,999
    
    
    
    6,182
    
    
    
    26,796
    
    
    
    17,643Net income
    
    
    14,348
    
    
    
    11,736
    
    
    
    45,384
    
    
    
    31,680Preferred stock dividends  Series B
    
    
    
    
    
    
    64
    
    
    
    
    
    
    
    345Net income available to common shareholders
    
    $
    14,348
    
    
    $
    11,672
    
    
    $
    45,384
    
    
    $
    31,335Earnings per ShareBasic earnings per common share
    
    $
    0.64
    
    
    $
    0.70
    
    
    $
    2.06
    
    
    $
    2.29Diluted earnings per common share
    
    $
    0.63
    
    
    $
    0.58
    
    
    $
    2.00
    
    
    $
    1.70
 See notes to condensed consolidated financial statements. 2




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DIRECT GENERAL CORPORATION AND SUBSIDIARIES 
 CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)September 30,
    
    December 31,2004
    
    2003(In thousands)AssetsInvestments:Debt securities available-for-sale at fair value
(amortized cost $311,266 and $263,929 at September 30,
2004 and December 31, 2003, respectively)
    
    $
    312,287
    
    
    $
    264,998Short-term investments
    
    
    1,661
    
    
    
    1,322Total investments
    
    
    313,948
    
    
    
    266,320Cash and cash equivalents
    
    
    88,613
    
    
    
    87,342Finance receivables, net
    
    
    224,600
    
    
    
    201,271Reinsurance balances receivable
    
    
    48,395
    
    
    
    57,472Prepaid reinsurance premiums
    
    
    40,287
    
    
    
    56,397Deferred policy acquisition costs
    
    
    12,053
    
    
    
    11,432Income taxes recoverable
    
    
    2,535
    
    
    
    Deferred income taxes
    
    
    21,817
    
    
    
    18,539Property and equipment
    
    
    15,694
    
    
    
    13,775Goodwill, net
    
    
    22,188
    
    
    
    20,840Other assets
    
    
    24,842
    
    
    
    17,766Total assets
    
    $
    814,972
    
    
    $
    751,154Liabilities and Shareholders EquityLoss and loss adjustment expense reserves
    
    $
    120,186
    
    
    $
    112,618Unearned premiums
    
    
    236,100
    
    
    
    213,250Reinsurance balances payable and funds held
    
    
    45,569
    
    
    
    62,223Accounts payable and accrued expenses
    
    
    12,653
    
    
    
    13,105Income taxes payable
    
    
    
    
    
    
    2,369Notes payable
    
    
    146,559
    
    
    
    148,946Capital lease obligations
    
    
    3,833
    
    
    
    4,556Other liabilities
    
    
    12,312
    
    
    
    16,692Total liabilities
    
    
    577,212
    
    
    
    573,759Shareholders equityCommon stock, no par; authorized shares  100,000.0;
issued shares  22,360.0 and 21,350.6 at September 30,
2004 and December 31, 2003, respectively
    
    
    108,884
    
    
    
    91,853Retained earnings
    
    
    128,471
    
    
    
    85,735Additional Paid-in Capital
    
    
    196
    
    
    
    Accumulated other comprehensive income (loss):Net unrealized appreciation on investment securities
    
    
    663
    
    
    
    695Net loss on cash flow hedge
    
    
    (454
    )
    
    
    (888
    )Total shareholders equity
    
    
    237,760
    
    
    
    177,395Total liabilities and shareholders equity
    
    $
    814,972
    
    
    $
    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)
 Nine Months Ended September 30,2004
    
    2003(In thousands)Operating activitiesNet income
    
    $
    45,384
    
    
    $
    31,680Adjustments to reconcile net income to net cash provided by operating activities:Net realized gains on securities and other
    
    
    (146
    )
    
    
    (3,433
    )Depreciation and amortization
    
    
    4,170
    
    
    
    3,323Deferred income taxes
    
    
    (3,495
    )
    
    
    (5,119
    )Changes in operating assets and liabilities:Finance receivables
    
    
    (23,329
    )
    
    
    (36,888
    )Reinsurance balances receivable
    
    
    9,077
    
    
    
    (4,789
    )Prepaid reinsurance premiums
    
    
    16,110
    
    
    
    (5,838
    )Deferred policy acquisition costs
    
    
    (621
    )
    
    
    (2,595
    )Income taxes recoverable/payable
    
    
    (4,904
    )
    
    
    (678
    )Loss and loss adjustment expense reserves
    
    
    7,568
    
    
    
    18,891Unearned premiums
    
    
    22,850
    
    
    
    43,953Reinsurance balances payable and funds held
    
    
    (16,654
    )
    
    
    7,290Accounts payable and accrued expenses
    
    
    (500
    )
    
    
    (510
    )Other
    
    
    (7,538
    )
    
    
    (6,631
    )Net cash provided by operating activities
    
    
    47,972
    
    
    
    38,656Investing activitiesProceeds from sales and maturities of debt securities available-for-sale
    
    
    100,308
    
    
    
    72,833Purchase of debt securities available-for-sale
    
    
    (144,712
    )
    
    
    (199,236
    )Payable for securities
    
    
    
    
    
    
    50,542Net (sales) purchases of short-term investments
    
    
    (339
    )
    
    
    1,003Purchase of property and equipment, net
    
    
    (5,901
    )
    
    
    (2,998
    )Purchase of life insurance company
    
    
    (7,330
    )
    
    
    Net cash used in investing activities
    
    
    (57,974
    )
    
    
    (77,856
    )Financing activitiesIssuances of common stock
    
    
    17,031
    
    
    
    72,493Net (payment) proceeds from borrowings
    
    
    (1,872
    )
    
    
    27,676Payment of principal on borrowings
    
    
    (1,238
    )
    
    
    (11,382
    )Payment on stock dividends
    
    
    (2,648
    )
    
    
    (345
    )Purchase of treasury stock
    
    
    
    
    
    
    (33
    )Net cash provided by financing activities
    
    
    11,273
    
    
    
    88,409Net increase in cash and cash equivalents
    
    
    1,271
    
    
    
    49,209Cash and cash equivalents at beginning of period
    
    
    87,342
    
    
    
    87,027Cash and cash equivalents at end of period
    
    $
    88,613
    
    
    $
    136,236
 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, thirteen insurance
agencies, two administrative service companies and one company that provides
non-insurance consumer products and services. 2. Basis of Presentation The unaudited condensed 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 unaudited condensed
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
three and nine months ended September 30, 2004 are not necessarily indicative
of the results that may be expected for the full year. These unaudited
condensed 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 consisted of licenses to conduct life and/or accident and health
insurance business in 43 states and the District of Columbia and debt
securities. In October 2004, the Company gave notice of its intention to exercise the
option to purchase certain assets of All American General Agency, Inc., a
non-standard automobile insurance agency in Texas operating primarily under the
name AMCO. The effective date of the acquisition is expected to be on or about
December 31, 2004. The assets being acquired include customer records and
renewal rights and the operating assets of approximately 65 sales offices used
to conduct their automobile insurance agency business. 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 a
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. Notes Payable The Company maintains a revolving credit facility with a consortium of
banks to fund the working capital of the Companys premium finance operations.
On July 1, 2004, the Company renewed its $190 million revolving credit facility
under substantially similar terms and extended its maturity for an additional
three-year period to June 30, 2007. As of September 30, 2004, the amount
outstanding under the facility was $146.0 million. 5




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6. Earnings Per Share The following table sets forth the computation of basic and diluted
earnings per share: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share amounts)Numerator:Net income available to common shareholders
    
    $
    14,348
    
    
    $
    11,672
    
    
    $
    45,384
    
    
    $
    31,335Dividends paid to preferred shareholders
    
    
    
    
    
    
    118
    
    
    
    
    
    
    
    639Income for purposes of computing diluted
earnings per common share
    
    $
    14,348
    
    
    $
    11,790
    
    
    $
    45,384
    
    
    $
    31,974Denominator:Weighted average common shares outstanding
    
    
    22,352.1
    
    
    
    16,734.9
    
    
    
    22,032.6
    
    
    
    13,674.6Dilutive stock options
    
    
    420.7
    
    
    
    710.1
    
    
    
    620.8
    
    
    
    668.2Dilutive warrants
    
    
    
    
    
    
    81.5
    
    
    
    
    
    
    
    135.6Dilutive preferred stock
    
    
    
    
    
    
    2,632.0
    
    
    
    
    
    
    
    4,377.0Weighted average common shares outstanding
for purposes of computing diluted earnings
per common share
    
    
    22,772.8
    
    
    
    20,158.5
    
    
    
    22,653.4
    
    
    
    18,855.4Basic earnings per common share
    
    $
    0.64
    
    
    $
    0.70
    
    
    $
    2.06
    
    
    $
    2.29Diluted earnings per common share
    
    $
    0.63
    
    
    $
    0.58
    
    
    $
    2.00
    
    
    $
    1.70
 7. 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 generally
grants employee stock options 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 disclosed in the following table in
accordance with SFAS 148, Accounting for Stock-Based Compensation-Transition
and Disclosure: Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share amounts)Net income
available to
common
shareholders, as
reported
    
    $
    14,348
    
    
    $
    11,672
    
    
    $
    45,384
    
    
    $
    31,335Deduct: Total
stock-based
employee
compensation
expense
determined under
the fair value
based method,
net of related
tax effects
    
    
    (219
    )
    
    
    (114
    )
    
    
    (659
    )
    
    
    (144
    )Net income
available to
common
shareholders,
pro forma
    
    $
    14,129
    
    
    $
    11,558
    
    
    $
    44,725
    
    
    $
    31,191Income for
purposes of
computing
diluted earnings
per share
common, as
reported
    
    $
    14,348
    
    
    $
    11,790
    
    
    $
    45,384
    
    
    $
    31,974Deduct: Total
stock-based
employee
compensation
expense
determined under
the fair value
based method,
net of related
tax effects
    
    
    (219
    )
    
    
    (114
    )
    
    
    (659
    )
    
    
    (144
    )Income for
purposes of
computing
diluted earnings
per share
common, pro
forma
    
    $
    14,129
    
    
    $
    11,676
    
    
    $
    44,725
    
    
    $
    31,830
 6




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Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003(In thousands, except per share amounts)Earnings per shareBasic  as reported
    
    $
    0.64
    
    
    $
    0.70
    
    
    $
    2.06
    
    
    $
    2.29Basic  pro forma
    
    $
    0.63
    
    
    $
    0.69
    
    
    $
    2.03
    
    
    $
    2.28Diluted  as reported
    
    $
    0.63
    
    
    $
    0.58
    
    
    $
    2.00
    
    
    $
    1.70Diluted  pro forma
    
    $
    0.62
    
    
    $
    0.58
    
    
    $
    1.97
    
    
    $
    1.69
 8. 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. 7




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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 ancillary income (finance income and commission
and service fee income) and net investment income (excluding 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. 8




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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. (Unaudited)
    
    (Unaudited)Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,($ in millions)
    
    2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    % ChangeSelected Financial DataGross premiums written
    
    $
    106.9
    
    
    $
    103.7
    
    
    
    3.1
    
    
    $
    377.7
    
    
    $
    332.2
    
    
    
    13.7Ancillary income
    
    
    23.6
    
    
    
    19.5
    
    
    
    21.0
    
    
    
    74.5
    
    
    
    58.0
    
    
    
    28.4Net investment income
    
    
    2.8
    
    
    
    1.7
    
    
    
    64.7
    
    
    
    7.7
    
    
    
    4.6
    
    
    
    67.4Gross revenues
    
    $
    133.3
    
    
    $
    124.9
    
    
    
    6.7
    
    
    $
    459.9
    
    
    $
    394.8
    
    
    
    16.5Ceded premiums written
    
    
    (17.5
    )
    
    
    (29.7
    )
    
    
    (41.1
    )
    
    
    (65.1
    )
    
    
    (134.3
    )
    
    
    (51.5
    )Change in net unearned premiums
    
    
    7.9
    
    
    
    (15.6
    )
    
    
    (150.6
    )
    
    
    (38.9
    )
    
    
    (38.1
    )
    
    
    2.1Net realized gains on investments
    
    
    0.1
    
    
    
    1.5
    
    
    
    (93.3
    )
    
    
    0.1
    
    
    
    3.4
    
    
    
    (97.1
    )Total revenues
    
    $
    123.8
    
    
    $
    81.1
    
    
    
    52.7
    
    
    $
    356.0
    
    
    $
    225.8
    
    
    
    57.7Net income
    
    $
    14.3
    
    
    $
    11.7
    
    
    
    22.2
    
    
    $
    45.4
    
    
    $
    31.7
    
    
    
    43.2Key Financial RatiosLoss ratio  net
    
    
    73.7
    %
    
    
    74.0
    %
    
    
    
    
    
    
    73.4
    %
    
    
    73.9
    %Expense ratio  net
    
    
    6.2
    %
    
    
    0.8
    %
    
    
    
    
    
    
    3.1
    %
    
    
    0.2
    %Combined ratio  net
    
    
    79.9
    %
    
    
    74.8
    %
    
    
    
    
    
    
    76.5
    %
    
    
    74.1
    %Ancillary income to gross premiums earned
    
    
    19.8
    %
    
    
    19.1
    %
    
    
    
    
    
    
    21.0
    %
    
    
    20.1
    %Ancillary income to net operating expenses
    
    
    79.5
    %
    
    
    97.5
    %
    
    
    
    
    
    
    89.8
    %
    
    
    99.5
    %
 Overview of Operating Results Net income increased 22.2% to $14.3 million or $0.63 per share, on a
diluted basis, for the three months ended September 30, 2004 and 43.2% to $45.4
million or $2.00 per share, on a diluted basis, for the nine months ended
September 30, 2004 compared to the same periods in 2003. The increase in net
income during the quarter, was primarily attributable to continued growth in
premiums written and earned, and growth in ancillary income, which were
partially offset by an increase in operating expenses. Total revenues
increased 52.7% to $123.8 million in the current quarter and operating expenses
increased 48.5% to $29.7 million. The loss ratio for the quarter improved
slightly to 73.7% from 74.0% in the prior year quarter, even though losses for
the current quarter included hurricane losses of $2.3 million or approximately
2.4 points. Gross revenues increased 6.7% and 16.5% for the three and nine
months ended September 30, 2004, respectively, compared to the same periods in
2003. Net realized gains, after tax, were $0.1 million for both the three
months and nine months ended September 30, 2004, but were $1.0 million and $2.2
million or $0.05 and $0.12 per diluted share for the three and nine months
ended September 30, 2003, respectively. 9




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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: (Unaudited)
    
    (Unaudited)Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,($ in millions)
    
    2004
    
    2003
    
    % Change
    
    2004
    
    2003
    
    % ChangeGross premiums writtenFlorida
    
    $
    53.2
    
    
    $
    53.3
    
    
    
    (0.2
    )
    
    $
    189.3
    
    
    $
    170.9
    
    
    
    10.8Tennessee
    
    
    14.6
    
    
    
    15.0
    
    
    
    (2.7
    )
    
    
    51.6
    
    
    
    49.1
    
    
    
    5.1Georgia
    
    
    6.7
    
    
    
    7.3
    
    
    
    (8.2
    )
    
    
    25.7
    
    
    
    24.2
    
    
    
    6.2Louisiana
    
    
    7.6
    
    
    
    7.7
    
    
    
    (1.3
    )
    
    
    26.2
    
    
    
    24.0
    
    
    
    9.2Texas
    
    
    7.8
    
    
    
    4.7
    
    
    
    66.0
    
    
    
    22.8
    
    
    
    10.1
    
    
    
    125.7Mississippi
    
    
    5.0
    
    
    
    4.8
    
    
    
    4.2
    
    
    
    20.1
    
    
    
    17.2
    
    
    
    16.9All other states
    
    
    12.0
    
    
    
    10.9
    
    
    
    10.1
    
    
    
    42.0
    
    
    
    36.7
    
    
    
    14.4Gross premiums written
    
    $
    106.9
    
    
    $
    103.7
    
    
    
    3.1
    
    
    $
    377.7
    
    
    $
    332.2
    
    
    
    13.7Ceded premiums written
    
    
    (17.5
    )
    
    
    (29.7
    )
    
    
    (41.1
    )
    
    
    (65.1
    )
    
    
    (134.3
    )
    
    
    (51.5
    )Net premiums written
    
    $
    89.4
    
    
    $
    74.0
    
    
    
    20.8
    
    
    $
    312.6
    
    
    $
    197.9
    
    
    
    58.0Gross premiums earned
    
    $
    119.4
    
    
    $
    102.1
    
    
    
    16.9
    
    
    $
    354.8
    
    
    $
    288.3
    
    
    
    23.1Ceded premiums earned
    
    
    (22.1
    )
    
    
    (43.7
    )
    
    
    (49.4
    )
    
    
    (81.2
    )
    
    
    (128.5
    )
    
    
    (36.8
    )Net premiums earned
    
    $
    97.3
    
    
    $
    58.4
    
    
    
    66.6
    
    
    $
    273.6
    
    
    $
    159.8
    
    
    
    71.2Net premiums written to gross premiums written
    
    
    83.6
    %
    
    
    71.4
    %
    
    
    
    
    
    
    82.8
    %
    
    
    59.6
    %Gross premiums earned to gross premiums written
    
    
    111.7
    %
    
    
    98.5
    %
    
    
    
    
    
    
    93.9
    %
    
    
    86.8
    %Net premiums earned to net premiums written
    
    
    108.8
    %
    
    
    78.9
    %
    
    
    
    
    
    
    87.5
    %
    
    
    80.7
    %
 Gross premiums written increased $3.2 million or 3.1% and $45.5 million or
13.7% for the three and nine months ended September 30, 2004, respectively,
compared to the same periods in 2003. Gross written premiums from the sale of
our core non-standard automobile insurance business increased 2.4% and 12.9%
for the three and nine month periods ended September 30, 2004, respectively,
while gross premiums written from the sale of our term life insurance business
increased 22.2% to $4.4 million and 39.6% to $14.1 million for the first three
and nine months of 2004, respectively. Gross premiums earned, a function of
gross premiums written over the current and prior periods, increased 16.9% and
23.1% in the three and nine months ended September 30, 2004, respectively, as
compared to the same periods in 2003. The increase in gross premiums written primarily reflected growth in our
expansion state of Texas while gross premiums written in our existing states
were flat overall. We have exercised our option to acquire the assets of
approximately 65 sales offices in Texas from All American General Agency, Inc.
(AMCO). In August, we began a limited advertising campaign in Texas, which
initially involved the co-branding of Direct and AMCO. Co-branding with the
AMCO name did not produce the level of new business that we expected. We
believe that this was generally due to AMCOs poor brand name recognition
resulting from a lack of advertising in recent years. As a result, we have made
the decision to shift from co-branding to a focus on branding the Direct name,
through both television and yellow page advertising. We are also developing
additional sales offices in areas of Texas not currently served by the AMCO
agency and expect to commence operations in our initial sales offices in
Missouri and Virginia during the fourth quarter. The premium growth in our existing states was impacted by the hurricanes
that disrupted normal business operations in Florida and other states.
Approximately 110 of our sales offices were closed for a day or more during the
quarter, which we estimate resulted in a $2.4 to $2.8 million reduction in
gross premiums written. In addition, many of our Florida customers experienced
unexpected financial demands that slowed insurance purchases. We have not seen
much downward pressure on rates by our competitors. However, in many of our
remaining existing states, our growth has leveled off and we are seeing
increased competition primarily in the form of increased advertising. In
response, we made adjustments to our premium finance payment plans in several
states in October and plan revisions to our advertising campaigns in order to
attract more business. The growth in net premiums written and earned is a function of gross
premiums written and earned less ceded premiums written and earned. The ratio
of net premiums written to gross premiums written increased to 83.6% and 82.8%
for the three and nine months ended September 30, 2004. Comparatively, this
ratio was only 71.4% and 59.6% for the corresponding periods in 2003, 10




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which was prior to the infusion of additional capital into our insurance
subsidiaries from the proceeds raised in our initial public offering in the
third quarter of 2003. We expect to retain approximately 85% of our gross
premiums written in 2004. For 2005, we expect to slightly increase our
retention to approximately 88%. Ancillary Income Ancillary income for the three and nine months ended September 30, 2004
was $23.6 million and $74.5 million, respectively, which represents an increase
of 21.0% and 28.4%, respectively, compared to the corresponding periods in
2003. Commission and service fee income on products sold by the Cash Register
agency offices, which were acquired in the fourth quarter of 2003, represented
approximately $1.4 million and $4.6 million of the increase over the prior year
quarter and year to date, respectively. In response to the multiple hurricanes
that occurred during the third quarter of 2004, all insurance companies and
premium finance companies were ordered by the Florida Department of Financial
Services to grant an extension of the grace period until October 15th for any
Florida customers whose payments were due between August 10th and October 15th.
As a result of these orders, no additional late or cancellation fees could be
charged during this period, which reduced our finance income by approximately
$1.0 million in the quarter. The ratio of ancillary income to gross premiums earned was 19.8% and 19.1%
for the third quarter of 2004 and 2003, respectively, while the ratio of
ancillary income to operating expenses decreased to 79.5% in the 2004 period
from 97.5% in the 2003 period. For the nine months ended September 30, 2004
and 2003, the ratio of ancillary income to gross premiums earned was 21.0% and
20.1%, respectively, and the ratio of ancillary income to operating expenses
was 89.8% and 99.5%, respectively. The increase in ancillary income as a
percentage of gross premiums earned is largely attributable to the increase in
ancillary income produced by the Cash Register offices. The decline in the
ratio of ancillary income to operating expenses is primarily associated with
the increased retention of the business. 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. In addition, the reduction in
finance income related to the extended grace periods in Florida reduced the
ratio of ancillary income to operating expenses by 3.4 points and 1.3 points,
for the three and nine months ended September 30, 2004. Net Investment Income Net investment income increased to $2.8 million from $1.7 million for the
three months ended September 30, 2004 compared to the same period of 2003. The
increase in investment income was due primarily to an increase in average
invested assets. For the nine months ended September 30, 2004, net investment
income increased to $7.7 million from $4.6 million in the corresponding period
in 2003. The year to date increase in investment income was consistent with
the 65.7% increase in average invested assets to $288.9 million in the first
nine months of 2004 from $174.3 million in the first nine months of 2003. The
return on the portfolio for the nine months ended September 30, 2004 and 2003
was 3.6% and 3.9%, respectively. Realized Gains (Losses) on Securities Net realized gains on securities were insignificant for the three months
ended September 30, 2004 as compared to net realized gains of $0.4 million in
the corresponding period in 2003. We realized gross gains of $0.1 million and
$0.3 million and gross losses of $0.1 million and $0.8 million on the sale of
securities for the three and nine month periods ended September 30, 2004,
respectively. The majority of these gains and losses were attributable to the
sale of selected securities in favor of securities that offered more attractive
yields and income potential. Comparatively, we realized gross gains of $0.6
million and $2.5 million for the three and nine month periods ended September
30, 2003, respectively, offset by gross realized losses of $0.2 million for
both periods. The prior year to date gross gains were primarily attributable
to the sale of certain securities as we repositioned our bond portfolio based
on our investment guidelines for changes in market conditions and other
factors. There was no impact on realized losses attributable to adjustments
for other than temporary impairment of securities still held during these
periods. In the three and nine month periods ended September 30, 2004, we also
realized gross gains of $0.8 million and $2.3 million and gross losses of $0.3
million and $2.0 million, respectively, 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.
For the three and nine months ended September 30, 2004, the market value on
open contracts decreased by $0.4 million and increased by $0.3 million,
respectively, which was included in net realized gains on securities and other.
As of September 30, 2004, we had open contracts with gross unrealized gains of
$0.1 million and gross unrealized losses of $0.1 million. 11




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Expenses Insurance Losses and Loss Adjustment Expenses Insurance losses and loss adjustment expenses increased to $71.8 million
for the three months ended September 30, 2004 from $43.2 million for the same
period in 2003. Net loss ratios for the third quarter of 2004 and 2003 were
73.7% and 74.0%, respectively. During the quarter, we recognized catastrophe
losses totaling $2.3 million associated with the four hurricanes that struck
Florida and the Southeastern United States. The impact of weather related
losses in the third quarter of 2003 was minimal. The Companys quarterly
analysis of reserves resulted in an increase to the reserves for prior accident
quarters of $0.9 million or 0.9 points in the third quarter of 2004, which was
primarily associated with the personal injury protection coverage in Florida.
In comparison, the loss ratio for the third quarter of 2003 was increased by
approximately 0.4 points of adverse reserve development. For the nine months ended September 30, 2004, insurance losses and loss
adjustment expenses increased to $200.9 million from $118.2 million in the
corresponding 2003 period and the net loss ratios were 73.4% and 73.9%,
respectively. The impact of weather related losses in both the first nine
months of 2004 and 2003 was approximately 0.8 points on the respective loss
ratios. Our 2004 year to date loss ratio was adversely impacted by
approximately 1.5 points due to the strengthening of prior year reserves. The
majority of this strengthening centered on an increase in the frequency and
severity trends for the personal injury protection coverage, particularly in
the Miami, Florida market, where we continue to experience high levels of
fraudulent activity. For the nine months ended September 30, 2003, the loss
ratio included approximately 0.2 points of favorable development on prior
years reserves. The accident year loss ratio, which excludes the impact of
prior year reserve development, improved to 71.9% in 2004 from 74.1% in 2003,
primarily as a result of a modestly higher level of premiums earned per
exposure on both the personal injury protection and physical damage coverages.
Overall, we have seen a small improvement in severity trends that were
partially offset by a minor increase in claims frequency. Over the past several quarters, we adjusted premium rates and increased
the involvement of our special investigations unit in an attempt to combat the
continued fraud problems in the Miami market, which represents approximately 5%
of our total Florida premium volume. While the rate increases we implemented
have resulted in a reduction in exposures in this market, we are still not
satisfied with the level of losses on new business. As a result, our sales
offices in the Miami market are no longer accepting applications for new
business. We will, however, continue to service our profitable renewal book of
business out of these offices. Operating Expenses Operating expenses increased 48.5% to $29.7 million for the three months
ended September 30, 2004, compared to $20.0 million for the same period of
2003. The increase in operating costs compared to the third quarter of 2003
was driven by a reduction in ceded reinsurance commissions received of $3.7
million and a $6.0 million increase in other operating costs primarily
associated with our growth and expansion, increased employee health and
corporate insurance costs, increased advertising costs, and increased
professional services costs related to the implementation of the Sarbanes-Oxley
Act, all of which were partially offset by a reduction in the operating costs
of the Cash Register agency offices in Florida. For the nine months ended September 30, 2004, operating expenses increased
42.2% to $82.9 million from $58.3 million in the comparable period in 2003.
The increase in operating expenses was primarily attributable to a $14.6
million reduction in ceded reinsurance commissions received and a $10.0 million
increase in other operating costs associated with increased premium volumes and
expansion including approximately $4.7 million of net expenses attributable to
our growth in Texas. We also experienced higher levels of employee health
costs, corporate insurance costs, and professional services costs related to
the implementation of the Sarbanes-Oxley Act, which were partially offset by an
overall reduction in operating costs for the Cash Register agency offices. Income Taxes Our effective tax rates were 35.8% and 34.5% for the three month periods
ended September 30, 2004 and 2003, respectively. The effective tax rates for
the nine months ended September 30, 2004 and 2003 were 37.1% and 35.8%,
respectively. The increase in our effective tax rate over the corresponding
periods in the prior year was 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 12




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##### Table of Contents



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 $48.0
million and $38.7 million for the nine months ended September 30, 2004 and
2003, respectively. We expect our cash flows from operations to be positive in
both the short-term and reasonably foreseeable future. Financing and Capital During the first nine months of 2004, we received $17.0 million from the
issuance of common stock including approximately $16.0 million from the sale of
497,102 shares sold in our secondary stock offering. The remaining proceeds
were primarily associated with common stock issued to employees in conjunction
with their exercise of common stock options. During the three and nine months ended September 30, 2004, we paid common
stock dividends of $0.9 million and $2.6 million, respectively. Comparatively,
we did not pay common stock dividends prior to our initial public offering of
common stock in 2003, but did pay preferred stock dividends of $0.1 million and
$0.3 million for the three and nine months ended September 30, 2003. All of
the preferred shares outstanding were converted to common shares in conjunction
with the initial public offering. As of September 30, 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 $146.0 million. This facility
matures on June 30, 2007. We believe that we will be able to increase the size
of this facility as necessary in order to meet the working capital needs of our
finance operations. Reinsurance The
increased capitalization of our insurance subsidiaries enabled us to
reduce our quota share cession percentage. As a result, we ceded 16.4% of our
gross premiums written to reinsurers in the three months ended September 30,
2004 as compared to 28.6% in the third quarter of 2003. For the first nine
months of 2004, we ceded 17.2% of our gross premiums written to reinsurers as
compared to 40.4% for the corresponding period in 2003. We plan to cede
approximately 15% and 12% of our gross premiums written to reinsurers during
2004 and 2005, respectively. 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
September 30, 2004, our investment portfolio of $312.3 million included $1.0
million in net unrealized gains. The effective duration of our investment
portfolio was 4.1 years at September 30, 2004. 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 September 30,
2004: Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    Fair($ in millions)
    
    Cost
    
    Gains
    
    Losses
    
    ValueU.S. Treasury securities and
obligations of U.S. government
corporations and agencies
    
    $
    52.9
    
    
    $
    0.3
    
    
    $
    0.5
    
    
    $
    52.7Obligations of states and
political subdivisions
    
    
    50.0
    
    
    
    1.5
    
    
    
    0.1
    
    
    
    51.4Corporate debt securitiesBanks and financial institutions
    
    
    58.6
    
    
    
    0.5
    
    
    
    0.5
    
    
    
    58.6Credit cards and auto loans
    
    
    80.7
    
    
    
    0.2
    
    
    
    0.7
    
    
    
    80.2Industrial
    
    
    36.7
    
    
    
    0.4
    
    
    
    0.3
    
    
    
    36.8
 13




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##### Table of Contents



Gross
    
    GrossAmortized
    
    Unrealized
    
    Unrealized
    
    Fair($ in millions)
    
    Cost
    
    Gains
    
    Losses
    
    ValueInsurance
    
    
    8.0
    
    
    
    0.1
    
    
    
    0.1
    
    
    
    8.0Telecommunications
    
    
    11.4
    
    
    
    0.2
    
    
    
    0.1
    
    
    
    11.5Utilities and electric services
    
    
    13.0
    
    
    
    0.2
    
    
    
    0.1
    
    
    
    13.1Corporate debt securities
    
    
    208.4
    
    
    
    1.6
    
    
    
    1.8
    
    
    
    208.2Total
    
    $
    311.3
    
    
    $
    3.4
    
    
    $
    2.4
    
    
    $
    312.3
 The amortized cost and fair value of debt securities available-for-sale as
of September 30, 2004, by contractual maturity, is shown below: ($ in millions)
    
    Amortized Cost
    
    Fair ValueYears to maturity:One or less
    
    $
    6.0
    
    
    $
    6.0After one through five
    
    
    163.7
    
    
    
    163.7After five through ten
    
    
    99.0
    
    
    
    100.1After ten
    
    
    42.6
    
    
    
    42.5Total
    
    $
    311.3
    
    
    $
    312.3
 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 September 30, 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 September 30,
2004 was as follows: ($ in millions)NAIC
    
    S&P
    
    AmortizedRating
    
    Rating
    
    Cost
    
    Fair Value
    
    %1
    
    AAA
    
    $
    126.3
    
    
    $
    126.3
    
    
    
    40.5
    %1
    
    AA
    
    
    34.8
    
    
    
    35.4
    
    
    
    11.3
    %1
    
    A
    
    
    78.9
    
    
    
    79.2
    
    
    
    25.4
    %2
    
    BBB
    
    
    36.1
    
    
    
    36.3
    
    
    
    11.6
    %1
    
    Agency
    
    
    35.2
    
    
    
    35.1
    
    
    
    11.2
    %$
    311.3
    
    
    $
    312.3
    
    
    
    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. 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 September 30, 2004: -100 Basis Point
    
    
    
    
    
    +100 Basis Point($ in millions)
    
    Change
    
    Fair Value
    
    ChangeDebt securities, available-for-sale
    
    $
    325.0
    
    
    $
    312.3
    
    
    $
    299.6
 Short-term investments.We have a managed trading account with a
commodities trading company and, as of September 30, 2004, the total fair value
of open trades in this account was slightly negative. 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 $1.6 million,
included in cash and cash equivalents, are held as collateral for this account.
We recognized net realized gains of $0.5 million on closed contracts and a
decrease in net unrealized gains of $0.4 million on open contracts for the
third 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 (losses) on
securities and other in our consolidated statement of operations. 14




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Cash and cash equivalents. Our balance in cash and cash equivalents was
$88.6 million as of September 30, 2004, which was approximately 1.5% higher
than the balance of cash held at December 31, 2003. 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 9, 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. 
 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 quarterly 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. 15




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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 determined that
the majority of the purported opt-out notices were timely and properly
submitted. The majority of the opt-out class members were represented by a
single law firm, which filed a multi-plaintiff lawsuit against us. During the
third quarter of 2004, we entered into a voluntary settlement agreement
regarding all aspects of the opt-out lawsuit. The settlement did not have a
material effect on our results for the third quarter of 2004. 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. For descriptions of these legal
actions, please see the caption Business  Legal Proceeding included in our
Annual Report on Form 10-K for the year ended December 31, 2003 (Form 10-K)
filed with the Securities and Exchange Commission (SEC) on March 9, 2004 and
our periodic reports filed with the SEC under the Securities Exchange Act of
1934 since the filing of our Form 10-K. 
 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 on Form 8-K:  (i)
    
    Current Report on Form 8-K filed on August 4, 2004 to
report earnings for the quarter ended June 30, 2004 (Item 12.
Results of Operations and Financial Condition). 16




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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)November 8, 2004
    
    By:
    
    /s/ William C. Adair, Jr.Date
    
    
    
    (Signature)Name: William C. Adair, Jr.Title: Chairman, Chief Executive Officer and PresidentNovember 8, 2004
    
    By:
    
    /s/ Barry D. ElkinsDate
    
    
    
    (Signature)Name: Barry D. ElkinsTitle: Senior Vice President and Chief Financial Officer
 17