UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

For the transition period from
to
Commission file number 000-50795

AFFIRMATIVE INSURANCE HOLDINGS, INC.

(972) 728-6300
(Registrant’s telephone number, including area code)

Not Applicable
(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act): o Yes x No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

The number of shares outstanding of the registrant’s common stock,
$.01 par value, as of November 8, 2004
16,835,720

Affirmative Insurance Holdings, Inc.
Index

Part I

See accompanying Notes to Consolidated Financial Statements

1

Affirmative Insurance Holdings, Inc.

See accompanying Notes to Consolidated Financial Statements

2

Affirmative Insurance Holdings, Inc.

See accompanying Notes to Consolidated Financial Statements

3

Affirmative Insurance Holdings, Inc.

See accompanying Notes to Consolidated Financial Statements

4

Affirmative Insurance Holdings, Inc.

1.		General
		Affirmative Insurance Holdings, Inc., (“we”, “us”, “our”) is an insurance holding company and is engaged in underwriting, servicing and distributing non-standard automobile insurance policies and related products and services to individual consumers in highly targeted geographic areas. Our subsidiaries include two insurance companies, four underwriting agencies and four retail agencies with 146 retail store locations as of September 30, 2004. We offer our products and services in 11 states, including Texas, Illinois, California and Florida. Our growth has been achieved principally as a result of the acquisition and integration of six retail and/or underwriting agencies in 2001 and 2002. We were formerly known as Instant Insurance Holdings, Inc., and we incorporated in Delaware on June 25, 1998.
		As a result of a series of transactions commencing on December 21, 2000, Vesta Insurance Group, Inc. and its subsidiaries (“Vesta”) owned approximately 98.1% of our issued and outstanding common stock at June 30, 2004, which were acquired from former stockholders and the purchase of new common stock directly from us.
		We completed our initial public offering of our common stock effective July 9, 2004. We issued 4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14.00 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from Vesta. At the conclusion of these transactions, Vesta owned approximately 42.6% of our issued and outstanding capital stock.
2.		Basis of Presentation
		Our unaudited consolidated financial statements included herein have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and include our accounts and the accounts of our operating subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial reporting. These financial statements should be read in conjunction with our audited financial statements for the year ended December 31, 2003 included in our initial public offering prospectus filed with the SEC.
		The interim financial data as of September 30, 2004 and for the nine months ended September 30, 2004 and 2003 is unaudited; however, in the opinion of the Company, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods.
		We purchased certain operations from Vesta in 2002 and 2003 that are accounted for herein, at historical cost, in a manner similar to a pooling of interest. Therefore, the results of these operations are included in the historical results for all periods presented.
		Supplemental Cash Flow Information
		During the first quarter of 2004, we received $35.6 million in fixed income securities from Vesta in lieu of cash, to settle the collection of premiums and fees, receivables from reinsurers, exchange of other invested assets, and miscellaneous inter-company balances.
		Stock Split
		On May 25, 2004 we completed a stock split of 13.17 shares per one share of common stock affected through a stock dividend. All references to common shares, share prices, per share amounts, and stock plans have been restated retroactively in this report for our stock split.
		Reclassification
		Certain previously reported amounts have been reclassified in order to conform to current year presentation. Such reclassification had no effects on net income or stockholders’ equity.
		Use of Estimates in the Preparation of the Financial Statements
		Our preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect our reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of our financial statements and our reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. These estimates and assumptions are particularly important in determining revenue recognition, reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables and impairment of assets.
		Stock Based Compensation
		In December 2002, the FASB issued SFAS No. 148 (“SFAS 148”), Accounting for Stock-Based Compensation — Transition and Disclosure. This statement provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure requirements of SFAS No. 123 (“SFAS 123”), Accounting for Stock-Based Compensation to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method on reported results. We have elected to continue to apply APB Opinion No. 25 (“APB 25”) Accounting for Stock Issued to Employees and related interpretations in accounting for stock options.
		The following table illustrates the effect on our net income and net income per share if we had applied SFAS 123 to stock-based compensation (in thousands, except per share amounts):

5

		Recently Issued Accounting Standards
		In January 2003, the FASB issued Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. FIN 46 states that if a business enterprise is the primary beneficiary of a variable interest entity, the assets, liabilities and results of the activities of the variable interest entity should be included in the consolidated financial statements of the business enterprise. This Interpretation explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to decide whether to consolidate that entity. FIN 46 also requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. Due to significant implementation concerns, the FASB modified the wording of FIN 46 and issued FIN 46R in December 2003. FIN 46R deferred the effective date for the provisions of FIN 46 to pre-existing entities other than Special Purpose Entities (“SPEs”) until financial statements are issued for periods ending after March 15, 2004. SPEs are subject to the provisions of either FIN 46 or FIN 46R as of December 15, 2003. Our adoption of FIN 46 and FIN 46R did not have a material impact on our consolidated financial position or consolidated results of operations.
		In March 2004, the Emerging Issues Task Force (“EITF”) of the FASB reached a consensus on Issue 03-1, The Meaning of Other-Than Temporary Impairment and Its Application to Certain Investments. EITF 03-1 provides guidance with respect to the meaning of other-than temporary impairment and its application to investments classified as either available-for-sale or held-to-maturity under SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities, and investments accounted for under the cost method or the equity method. In September 2004, the FASB issued a Staff Position, FSP EITF 03-1-1, delaying the effective date for the measurement and recognition guidance included in EITF 03-1, and also issued an exposure draft, FSP EITF 03-1a, which proposes guidance relating to debt securities that are impaired because of interest rate and/or sector spread increases. The delay in the effective date for the measurement and recognition guidance of EITF 03-1 did not suspend existing requirements for assessing whether investment impairments are other-than-temporary.
3.		Reinsurance
		The effect of reinsurance on premiums written and earned is as follows (dollars in thousands):

6

The amount of unpaid loss and loss adjustment expenses and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations are as follows (dollars in thousands):

		As of and for the nine months ended, September 30, 2004, we have ceded $29.0 million of paid losses and $39.3 million of incurred losses to various reinsurers.
		Effective January 1, 2004, we entered into two quota share reinsurance agreements with unaffiliated reinsurers with variable cession percentages, which provided us with an option to cede less of the business produced by our underwriting agencies to these reinsurers in the last two quarters of 2004.

•

Illinois, Indiana, Missouri. This agreement covers all business written through our underwriting agencies in these states from January 1, 2004 and continues in force until termina