UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2005

OR

For the transition period from

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. þ 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 þ 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 May 12, 2005
16,852,753

Affirmative Insurance Holdings, Inc.
Index

Part I

1

Affirmative Insurance Holdings, Inc.

2

Affirmative Insurance Holdings, Inc.

3

Affirmative Insurance Holdings, Inc.

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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, five retail agencies with 183 owned and 42 franchise retail store locations as of March 31, 2005. 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 31, 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. As of March 31, 2005, Vesta beneficially owned approximately 42.8% 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, 2004 included in our report on Form 10-K filed with the SEC.

The interim financial data as of March 31, 2005 and 2004 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.

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.

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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):

Recently Issued Accounting Standards

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. We do not anticipate that this will have a material impact on our financials, as our investment portfolio is primarily comprised of ‘A’ rated bonds.

In December 2004, the FASB issued SFAS No. 123R (“SFAS 123R”), Share-Based Compensation, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and its related implementation guidance. SFAS 123R focuses primarily on accounting for transactions in which an entity obtains employee services in share-based payment transactions. This statement requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award (with limited exceptions). That cost will be recognized over the period during which an employee is required to provide service in exchange for the award, the requisite service period. No compensation cost is recognized for equity instruments for which employees do not render the requisite service. SFAS 123R is effective for public entities that do not file as small business issuers as of the beginning of the first interim or annual reporting period that begins after December 31, 2005. We anticipate adopting the provisions of SFAS 123R in January 2006. We are currently evaluating the requirements and the potential impact of SFAS 123R and have not yet determined if SFAS 123R will have a material impact on our future operations.

3. Reinsurance

The effect of reinsurance on premiums written and earned is as follows (dollars in thousands):

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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 three months ended, March 31, 2005, we have ceded $6.8 million of paid losses and $3.5 million of incurred losses to various reinsurers.

Effective December 31, 2004, we terminated two ceded quota share reinsurance agreements with unaffiliated reinsurers on a run-off basis for business written through our underwriting agencies in the states of Illinois, Indiana, Missouri, New Mexico and South Carolina. Effective December 31, 2004, we terminated two quota share reinsurance agreements with Old American County Mutual Fire Insurance Company on a run-off basis, where we had assumed business written through our underwriting agencies in the state of Texas.

Effective January 1, 2005, we entered into two quota share reinsurance agreements with Old American County Mutual Fire Insurance Company, where we will assume 100% of the business written through our underwriting agencies in the state of Texas.

Effective May 1, 2004, we entered into a quota share reinsurance agreement with an unaffiliated reinsurer to cede 25% of the business written through our Florida underwriting agency. This contract continues in force until terminated by us or our reinsurer at any April 30 with not less than 90 days prior notice. Effective May 1, 2005, we have amended this agreement and will continue ceding 25% of the business written through our Florida underwriting agency to the unaffiliated reinsurer at substantially the same terms and conditions. The reinsurance under this agreement is provided by Folksamerica, which reinsures 100% of the premium we cede. Folksamerica is rated “A” by A.M. Best.

All of our quota share reinsurance agreements contain provisions for sliding scale commissions, under which the commission paid to us varies with the loss ratio results under each contract. The effect of this feature in the quota share reinsurance agreements is to limit the reinsurers aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by us. Before entering into these reinsurance agreements, and based on our prior operating history, we concluded that each agreement met the risk transfer test of SFAS No. 113 (“SFAS 113”) Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts as the reinsurers assume significant risk and have a reasonable possibility of significant loss.

On November 4, 2004, The Hawaiian Insurance & Guaranty Company, Ltd. (“Hawaiian”) was named among a group of four other named defendants and twenty unnamed defendants in a complaint filed in the Superior Court of the State of California for the County of Los Angeles alleging causes of action as follows: enforcement of coverage under Hawaiian’s policy of an underlying default judgment plaintiff obtained against Hawaiian’s former insured, who was denied a defense in the underlying lawsuit due to his failure to pay the Hawaiian policy premium; ratification and waiver of policy lapse and declaratory relief against Hawaiian; breach of implied covenant of good faith and fair dealing against Hawaiian with the plaintiff as the assignee of the insured; intentional misconduct as to the defendant SCJ Insurance Services; and professional negligence as to the defendants Prompt Insurance Services, Paul Ruelas, and Anthony David Medina. The plaintiff is seeking to enforce an underlying default judgment obtained against Hawaiian’s insured on September 24, 2004 in the amount of $35,000,643 and additional bad faith damages including punitive damages in the amount of $35,000,000.

Affirmative Insurance Company, a wholly-owned subsidiary of Affirmative Insurance Holdings, Inc. (“Affirmative), is a party to a 100% quota share reinsurance agreement with Hawaiian and is sharing in the defense of this matter. Hawaiian is ultimately a wholly-owned subsidiary of Vesta Insurance Group, Inc. which is a 42.9% stockholder of Affirmative. The other named defendants, SCJ Insurance Services, Prompt Insurance Services, Paul Ruelas, and Anthony David Medina, are unaffiliated persons to Affirmative.

This matter is currently proceeding through pre-trial discovery and depositions of pertinent witnesses in preparation for a September 6, 2005 trial date. Hawaiian and the other defendants thereto believe these allegations are without merit and are vigorously contesting the claims brought by the plaintiffs and exercising all available rights and remedies against them; however, the ultimate outcome of this matter is uncertain.

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4. Related Party Transactions

We provide various services for Vesta and its subsidiaries, including underwriting, premium processing, and claims processing. For the three months ended March 31, the accompanying unaudited consolidated statements of operations reflect these services as follows (dollars in thousands):

In addition, we have presented, in the accompanying consolidated balance sheets, the following amounts related to contracts with Vesta and its subsidiaries (dollars in thousands):