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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2009

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission file number 000-50795

 

 

LOGO

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   75-2770432

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

4450 Sojourn Drive, Suite 500

Addison, Texas

  75001
(Address of principal executive offices)   (Zip Code)

(972) 728-6300

(Registrant’s telephone number, including area code)

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ¨    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   ¨    Accelerated filer   x
Non-accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  ¨    Yes    No  x

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 4, 2009: 15,415,358

 

 

 


Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC.

NINE MONTHS ENDED SEPTEMBER 30, 2009

INDEX TO FORM 10-Q

 

PART I – FINANCIAL INFORMATION

   3

Item 1. Financial Statements

   3

Consolidated Balance Sheets – September 30, 2009 and December 31, 2008

   3

Consolidated Statements of Income (Loss) – Three and Nine Months Ended September 30, 2009 and 2008

   4

Consolidated Statements of Stockholders’ Equity – Nine Months Ended September  30, 2009 and 2008

   5

Consolidated Statements of Comprehensive Income (Loss) – Three and Nine Months Ended September  30, 2009 and 2008

   5

Consolidated Statements of Cash Flows – Nine Months Ended September 30, 2009 and 2008

   6

Notes to Consolidated Financial Statements

   7

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

   21

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   32

Item 4. Controls and Procedures

   34

PART II – OTHER INFORMATION

   35

Item 1. Legal Proceedings

   35

Item 1A. Risk Factors

   35

Item 6. Exhibits

   35

SIGNATURES

   36

 

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Table of Contents

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

     September 30,
2009
    December 31,
2008
 
     (Unaudited)        

Assets

    

Investment securities, at fair value

    

Trading securities

   $ 37,694      $ 40,155   

Available-for-sale securities

     229,447        218,988   

Cash and cash equivalents

     53,369        66,513   

Fiduciary and restricted cash

     14,022        20,109   

Accrued investment income

     3,473        3,106   

Premiums and fees receivable, net

     64,124        57,805   

Premium finance receivable, net

     47,153        40,987   

Commissions receivable

     2,063        1,840   

Receivable from reinsurers

     42,064        63,331   

Deferred acquisition costs

     24,425        21,993   

Deferred tax assets

     21,173        16,459   

Federal income taxes receivable

     —          1,316   

Investment in real property, net

     5,761        5,848   

Property and equipment (net of accumulated depreciation of $31,963 and $25,550 for 2009 and 2008)

     41,189        42,143   

Goodwill

     163,570        163,650   

Other intangible assets, net

     16,863        17,255   

Prepaid expenses

     6,468        8,967   

Other assets (net of allowance for doubtful accounts of $7,213 for 2009 and 2008)

     14,231        11,586   
                

Total assets

   $ 787,089      $ 802,051   
                

Liabilities and Stockholders’ Equity

    

Liabilities:

    

Reserves for losses, loss adjustment expenses and deposits

   $ 197,253      $ 204,637   

Unearned premium

     117,383        109,097   

Amounts due reinsurers

     3,207        5,146   

Deferred revenue

     10,301        5,943   

Senior secured credit facility

     110,150        136,677   

Notes payable

     76,895        76,909   

Federal income taxes payable

     1,237        —     

Other liabilities

     49,830        47,159   
                

Total liabilities

     566,256        585,568   
                

Stockholders’ equity:

    

Common stock, $0.01 par value; 75,000,000 shares authorized, 17,768,721 shares issued and 15,415,358 shares outstanding at September 30, 2009 and December 31, 2008

     178        178   

Additional paid-in capital

     164,470        163,707   

Treasury stock, at cost (2,353,363 shares at September 30, 2009 and December 31, 2008)

     (32,880     (32,880

Accumulated other comprehensive income (loss)

     3,343        (1,849

Retained earnings

     85,722        87,327   
                

Total stockholders’ equity

     220,833        216,483   
                

Total liabilities and stockholders’ equity

   $ 787,089      $ 802,051   
                

See accompanying Notes to Consolidated Financial Statements

 

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Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(in thousands, except per share data)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
     (Unaudited)  

Revenues

        

Net premiums earned

   $ 88,561      $ 87,511      $ 276,006      $ 275,902   

Commission income and fees

     20,024        18,446        60,474        58,646   

Net investment income

     2,399        2,952        7,284        10,982   

Net realized gains (losses)

     17        (52     604        55   

Other income

     512        —          1,049        —     
                                

Total revenues

     111,513        108,857        345,417        345,585   
                                

Expenses

        

Losses and loss adjustment expenses

     70,293        70,576        221,860        212,154   

Selling, general and administrative expenses

     38,092        37,758        117,728        107,762   

Depreciation and amortization

     2,341        2,836        7,131        7,556   
                                

Total expenses

     110,726        111,170        346,719        327,472   
                                

Operating income (loss)

     787        (2,313     (1,302     18,113   

Gain on extinguishment of debt

     —          —          19,434        —     

Loss on interest rate swaps

     926        —          5,872        —     

Interest expense

     6,425        4,305        17,143        14,136   

Other intangible assets impairment

     —          212        —          212   
                                

Income (loss) from continuing operations before income tax expense

     (6,564     (6,830     (4,883     3,765   

Income tax benefit

     (3,172     (3,380     (4,634     (681
                                

Income (loss) from continuing operations

     (3,392     (3,450     (249     4,446   

Discontinued operations (Note 14)

        

Loss from operations (including loss on disposal of $961)

     (47     (678     (1,835     (1,969

Other intangible assets impairment

     —          (4,397     —          (4,397

Income tax benefit

     (17     (1,908     (479     (2,272
                                

Loss from discontinued operations

     (30     (3,167     (1,356     (4,094
                                

Net income (loss)

   $ (3,422   $ (6,617   $ (1,605   $ 352   
                                

Basic income (loss) per common share:

        

Continuing operations

   $ (0.22   $ (0.22   $ (0.01   $ 0.29   

Discontinued operations

     (0.00     (0.21     (0.09     (0.27
                                

Net income (loss)

   $ (0.22   $ (0.43   $ (0.10   $ 0.02   
                                

Diluted income (loss) per common share:

        

Continuing operations

   $ (0.22   $ (0.22   $ (0.01   $ 0.29   

Discontinued operations

     (0.00     (0.21     (0.09     (0.27
                                

Net income (loss)

   $ (0.22   $ (0.43   $ (0.10   $ 0.02   
                                

Weighted average common shares outstanding:

        

Basic

     15,415        15,415        15,415        15,415   
                                

Diluted

     15,415        15,415        15,415        15,415   
                                

Dividends declared per common share

   $ —        $ 0.02      $ —        $ 0.06   
                                

See accompanying Notes to Consolidated Financial Statements

 

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Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands, except share data)

 

     Nine Months Ended September 30,  
     2009     2008  
     Shares    Amounts     Shares    Amounts  
     (Unaudited)  

Common stock

          

Balance at beginning of year and end of period

   17,768,721    $ 178      17,768,721    $ 178   
                      

Additional paid-in capital

          

Balance at beginning of year

        163,707           162,603   

Stock-based compensation expense

        763           789   
                      

Balance at end of period

        164,470           163,392   
                      

Retained earnings

          

Balance at beginning of year

        87,327           87,122   

Net income (loss)

        (1,605        352   

Dividends declared

        —             (925
                      

Balance at end of period

        85,722           86,549   
                      

Treasury stock

          

Balance at beginning of year and end of period

   2,353,363      (32,880   2,353,363      (32,880
              

Accumulated other comprehensive income (loss)

          

Balance at beginning of year, net of tax

        (1,849        22   

Unrealized gain (loss) on available-for-sale investment securities, net of tax

        1,334           (7,999

Unrealized gain on cash flow hedges, net of tax

        3,858           126   
                      

Balance at end of period, net of tax

        3,343           (7,851
                      

Total stockholders’ equity

   15,415,358    $ 220,833      15,415,358    $ 209,388   
                          

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  
     (Unaudited)  

Net income (loss)

   $ (3,422   $ (6,617   $ (1,605   $ 352   

Other comprehensive income (loss):

        

Unrealized gain (loss) on available-for-sale investment securities, net of tax

     656        (5,625     1,334        (7,999

Unrealized gain (loss) on cash flow hedges, net of tax

     —          (329     3,858        126   
                                

Other comprehensive income (loss), net

     656        (5,954     5,192        (7,873
                                

Total comprehensive income (loss)

   $ (2,766   $ (12,571   $ 3,587      $ (7,521
                                

See accompanying Notes to Consolidated Financial Statements

 

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AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Nine Months Ended
September 30,
 
     2009     2008  
     (Unaudited)  

Cash flows from operating activities

    

Net income (loss)

   $ (1,605   $ 352   

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

    

Depreciation and amortization of intangible assets

     7,164        7,648   

Stock-based compensation expense

     848        789   

Amortization of debt issuance and modification costs

     577        1,006   

Amortization of debt discount

     3,960        —     

Realized gains from sales of available-for-sale securities

     (230     (43

Realized gain on trading securities

     (44     —     

Other income

     (1,049     —     

(Gain) loss on disposal of assets (including sale of business)

     631        (8

Amortization of premiums on investments, net

     2,501        1,894   

Provision for doubtful premiums receivable

     749        395   

Other intangible assets impairment

     —          4,609   

Gain on extinguishment of debt

     (19,434     —     

Loss on interest rate swaps

     5,872        —     

Change in operating assets and liabilities:

    

Fiduciary and restricted cash

     6,087        (5,923

Premiums, fees and commissions receivable

     (7,291     6,932   

Reserves for losses and loss adjustment expenses

     (7,384     (13,510

Amounts due from reinsurers

     19,328        4,531   

Premium finance receivable, net (related to our insurance premiums)

     (5,255     (1,583

Deferred revenue

     4,358        (470

Unearned premium

     8,286        (10,142

Deferred acquisition costs

     (2,432     1,796   

Deferred tax assets

     (7,510     (3,434

Federal income taxes receivable (payable)

     2,553        3,563   

Other

     (608     (2,343
                

Net cash provided by (used in) operating activities

     10,072        (3,941
                

Cash flows from investing activities

    

Proceeds from sales of available-for-sale securities

     19,237        100,266   

Proceeds from maturities of available-for-sale securities

     57,717        53,576   

Proceeds from sales of trading securities

     2,505        —     

Purchases of available-for-sale securities

     (87,631     (64,743

Premium finance receivable, net (related to third-party insurance premiums)

     (911     (5,584

Purchases of property and equipment

     (6,070     (16,465

Proceeds from insurance recoveries

     600        —     

Net cash paid for acquisitions

     (60     (188

Proceeds from sale of business

     250        —     
                

Net cash provided by (used in) investing activities

     (14,363     66,862   
                

Cash flows from financing activities

    

Principal payments on senior secured credit facility

     (6,321     (59,941

Debt modification costs paid

     (2,532     —     

Dividends paid

     —          (925
                

Net cash used in financing activities

     (8,853     (60,866
                

Net increase (decrease) in cash and cash equivalents

     (13,144     2,055   

Cash and cash equivalents at beginning of year

     66,513        44,048   
                

Cash and cash equivalents at end of period

   $ 53,369      $ 46,103   
                

Supplemental disclosure of cash flow information:

    

Cash paid for interest

   $ 12,569      $ 13,825   

Cash paid for income taxes

     774        368   

See accompanying Notes to Consolidated Financial Statements

 

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AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

 

1. General

Affirmative Insurance Holdings, Inc. (“Affirmative” or “the Company”) , formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware in June 1998 and completed an initial public offering of its common stock in July 2004. In this report, the terms “we,” “us”, “management,” or “our,” refer to Affirmative Insurance Holdings, Inc. and all entities included in our consolidated financial statements. We are a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic markets. Non-standard personal automobile insurance policies provide coverage to drivers who find it difficult to obtain insurance from standard automobile insurance companies due to their lack of prior insurance, age, driving record, limited financial resources or other factors. Non-standard personal automobile insurance policies generally require higher premiums than standard automobile insurance policies for comparable coverage. We are currently active in offering insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas, and Wisconsin) and distributing our own insurance policies through independent agents or brokers in 11 states (Louisiana, Texas, Illinois, Alabama, California, Michigan, Florida, Missouri, Indiana, South Carolina, and New Mexico).

 

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements of the Company. In the opinion of management, all adjustments necessary for a fair presentation have been included and are of a normal recurring nature. Interim results are not necessarily indicative of the results that may be expected for the year. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2008 included in our Annual Report on Form 10-K.

The consolidated balance sheet at December 31, 2008 was derived from the audited financial statements at that date but does not include all of the information and notes required by GAAP.

Certain prior year amounts have been reclassified to conform to the current presentation and for discontinued operations.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the 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, valuation of assets, and deferred income taxes.

Recently Issued Accounting Standards

Effective July 1, 2009, The Financial Accounting Standards Board (FASB) issued the Accounting Standards Codification (ASC or Codification), which superseded all existing non-SEC accounting and reporting standards under U.S. GAAP and became the single official source for U.S. authoritative GAAP combined with guidance issued by the U.S. Securities and Exchange Commission (SEC), and is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The FASB no longer issues new standards in the form of Statements of Financial Accounting Standards (SFAS), FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, amendments to the Codification are made by issuing “Accounting Standards Updates”. The Codification did not change existing GAAP. Accordingly, the issuance of the codification did not impact the Company’s consolidated results of operations or financial condition.

Two FASB standards issued in June 2009, SFAS No. 166, Accounting for Transfers of Financial Assets – An Amendment of FASB Statement No. 140 (SFAS 166); and SFAS No. 167, Amendments to FASB Interpretation No. 46(R) (SFAS 167) have not been added to the Codification as of September 30, 2009, and are not effective as of that date without the ability to early adopt.

        SFAS 167 eliminates Interpretation 46(R)’s exceptions to consolidating qualifying special-purpose entities, contains new criteria for determining the primary beneficiary, and increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a variable interest entity. SFAS 167 also contains a new requirement that any term, transaction, or arrangement that does not have a substantive effect on an entity’s status as a variable interest entity, a company’s power over a variable interest entity, or a company’s obligation to absorb losses or its right to receive benefits of an entity must be disregarded in applying Interpretation 46(R)’s provisions. The elimination of the qualifying special-purpose entity concept and its consolidation exceptions means more entities will be subject to consolidation assessments and reassessments. SFAS 167 will be effective for the fiscal year beginning January 1, 2010. The Company is currently assessing the potential impacts, if any, on the consolidated results of operations and financial condition.

 

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SFAS 166 eliminates the concept of a qualifying special-purpose entity, creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifies other sale-accounting criteria, and changes the initial measurement of a transferor’s interest in transferred financial assets. SFAS 166 will be effective for fiscal years beginning after November 15, 2009. The Company is currently assessing the potential impacts, if any, on the consolidated results of operations and financial condition.

In May 2009, the FASB issued authoritative guidance establishing general standards for the accounting and reporting of subsequent events that occur between the balance sheet date and issuance of financial statements. It should not result in significant changes in the subsequent events that an entity reports, either through recognition or disclosure in its financial statements. This guidance requires companies to recognize the effects, if material, of subsequent events in the financial statements if the subsequent event provides additional evidence about conditions that existed as of the balance sheet date. Beginning in financial reporting periods ending after June 15, 2009, companies must also disclose the date through which subsequent events have been evaluated and the nature of any nonrecognized subsequent events. Nonrecognized subsequent events include events that provide evidence about conditions that did not exist as of the balance sheet date, but which are of such a nature that they must be disclosed to keep the financial statements from being misleading. This disclosure should alert all users of financial statements that an entity has not evaluated subsequent events after that date in the set of financial statements being presented. The Company adopted this standard in the second quarter of 2009 and it had no material impact on the consolidated results of operations or financial condition. Management evaluated subsequent events for recognition or disclosure through November 9, 2009.

On January 1, 2009, the Company adopted authoritative guidance issued by the FASB that amended and expanded the disclosure requirements to provide users of financial statements with enhanced disclosures about an entity’s derivative and hedging activities thereby improving the transparency of financial reporting. This standard requires qualitative disclosure about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit risk related contingent features in derivative agreements. The adoption of this standard did not have a material impact on the Company’s consolidated results of operations or financial condition.

In April 2009, the FASB issued authoritative guidance that requires fair value disclosures in both interim as well as annual financial statements in order to provide more timely information about the effects of current market conditions on financial instruments. The Company adopted this guidance in the second quarter of 2009, the impact of which related only to disclosures of the Company’s debt and did not have a material impact on the Company’s consolidated financial statements.

In the second quarter of 2009, the Company adopted authoritative guidance issued by the FASB that amended the other-than-temporary impairment guidance for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments in the financial statements. This guidance did not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. Adoption of this guidance did not have a material impact on the Company’s consolidated results of operations or financial condition.

In the second quarter of 2009, the Company adopted authoritative guidance issued by the FASB on estimating fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying circumstances that may indicate that a transaction is not orderly. Adoption of this guidance did not have a material impact on the Company’s consolidated results of operations or financial condition.

On January 1, 2009, the Company adopted authoritative guidance issued by the FASB on fair value measurement for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Adoption of the new guidance did not have a material impact on the Company’s consolidated results of operations or financial condition.

In August, the FASB issued authoritative guidance on measuring the fair value of liabilities and clarifies that the quoted price for an identical liability, when traded as an asset in an active market, is also a Level 1 measurement, the highest priority in the fair value hierarchy, when no adjustment to the quoted price is required. This guidance is effective for interim and annual periods beginning after August 27, 2009. The Company does not anticipate any revisions in valuation techniques to be considered necessary as a result of adopting this guidance in the fourth quarter of 2009.

 

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3. Goodwill and Other Intangible Assets

The Company completed its annual goodwill and indefinite lived intangible asset impairment analyses as of September 30, 2009. The Company reports under a single reporting segment and, as such, the goodwill analysis is measured under one reporting unit. Consistent with prior assessments, the fair value of the Company’s reporting unit was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Based upon the results of the assessment, the Company concluded that the carrying values of goodwill and other intangible assets were not impaired as of September 30, 2009. As of September 30, 2008, the Company concluded that the carrying value of other intangible assets related to the Company’s Florida operations exceeded their fair value, resulting in an impairment loss of $4.4 million for indefinite lived other intangible assets and $0.2 million for amortizing other intangible assets.

 

4. Trading Investment Securities

The amortized cost, realized losses and estimated fair value of our trading securities were as follows (in thousands):

 

     Amortized
Cost
   Total Realized
Losses
    Fair
Value

September 30, 2009

   $ 48,790    $ (11,096   $ 37,694

December 31, 2008

     51,295      (11,140     40,155

Our trading investment securities consist solely of auction-rate tax-exempt securities. Generally, the interest rates for these securities are determined by bidding every 7, 28 or 35 days. When there are more sellers than buyers, an auction fails and bondholders that want to sell are unable to sell the securities. Auctions for these securities began to fail in early 2008 and investment banks stopped committing capital to the auctions. Issuers remain obligated to pay interest and principal when due when an auction fails. Rates at failed auctions are set at a level established in the terms of the debt.

In August 2008, our broker announced settlements in principle with each of the Division of Enforcement of the U.S. Securities and Exchange Commission (SEC), the New York Attorney General and other state agencies to purchase all of its clients’ auction-rate securities at par and several other items, including fines. In October 2008, our broker filed a prospectus with the SEC, which published a legally-binding offer to all authorized holders of auction-rate securities in our broker’s accounts (“the settlement”). The time frames that our broker has set for buybacks have different start dates based upon the individual client’s size, which is determined by each client’s balance of investments held at our broker. For the majority of our auction-rate holdings, the buybacks are expected to occur between July 2010 and two years thereafter. In November 2008, the Company elected to participate in our broker’s offer to purchase our auction-rate securities at par. In November 2008, we classified our portfolio of auction-rate securities as trading. At September 30, 2009 and December 31, 2008, the fair value of the settlement was $10.7 million and $9.6 million, respectively, which is recorded in other assets with changes in fair value recorded in other income.

 

5. Available-for-Sale Investment Securities

Our available-for-sale investment portfolio consists of fixed-income securities carried at fair value with unrealized gains and losses reported in our financial statements as a separate component of stockholders’ equity on an after-tax basis. The Investment Committee periodically reviews investment portfolio results and evaluates strategies to maximize yields, to match maturity durations with anticipated needs, and to maintain compliance with investment guidelines.

 

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The amortized cost, gross unrealized gains (losses), and estimated fair value of our investments at September 30, 2009, and December 31, 2008, are as follows (in thousands):

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value

September 30, 2009

          

U.S. Treasury and government agencies

   $ 14,531    $ 308    $ —        $ 14,839

Residential mortgage-backed securities

     4,601      380      —          4,981

States and political subdivisions

     141,258      3,148      (38     144,368

Corporate debt securities

     63,913      1,381      (35     65,259
                            

Total

   $ 224,303    $ 5,217    $ (73   $ 229,447
                            

December 31, 2008

          

U.S. Treasury and government agencies

   $ 28,482    $ 416    $ (107   $ 28,791

Residential mortgage-backed securities

     5,829      337      —          6,166

States and political subdivisions

     180,601      2,712      (237     183,076

Corporate debt securities

     986      —        (31     955
                            

Total

   $ 215,898    $ 3,465    $ (375   $ 218,988
                            

Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. Our amortized cost and estimated fair value of fixed-income securities at September 30, 2009 by contractual maturity are as follows (in thousands):

 

     Amortized
Cost
   Fair Value

Due in one year or less

   $ 83,842    $ 84,700

Due after one year through five years

     126,475      130,170

Due after five years through ten years

     6,515      6,734

Due after ten years

     2,870      2,862

Mortgage-backed securities

     4,601      4,981
             

Total

   $ 224,303    $ 229,447
             

At September 30, 2009, we owned approximately $25.7 million of pre-refunded municipal bonds. These pre-refunded municipal bonds have contractual maturities in excess of ten years. However, due to pre-refunding, these securities will be called by the issuer generally within three years or less. Pre-refunded municipal bonds are created when municipalities issue new debt to refinance debt issued when interest rates were higher. Once the refinancing is completed, the issuer uses the proceeds to purchase U.S. Treasury securities and places these securities in an escrow account. These proceeds are then used to pay interest and principal on the original debt until the bond is called.

Our amortized cost and estimated fair value of pre-refunded municipal bonds at September 30, 2009 by contractual maturity are as follows (in thousands):

 

     Amortized
Cost
   Fair Value

Due in one year or less

   $ 10,007    $ 10,191

Due after one year through five years

     10,197      10,477

Due after five years through ten years

     2,073      2,207

Due after ten years

     2,870      2,862
             

Total

   $ 25,147    $ 25,737
             

Proceeds from sales, maturities, and principal receipts of available-for-sale investment securities were $77.0 million, of which proceeds from investments sold prior to maturity were $19.3 million, and proceeds from investment maturities were $57.7 million for the nine months ended September 30, 2009.

 

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Gross realized gains and losses on investments for the nine months ended September 30, 2009, are summarized as follows (in thousands):

 

Gross gains

   $ 251   

Gross losses

     (21
        

Total

   $ 230   
        

The following tables show our investments with fair value and gross unrealized losses, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2009 and December 31, 2008 (in thousands):

 

     September 30, 2009  
     Less Than Twelve
Months
    Twelve Months
or Greater
     Total  
     Fair
Value
   Gross
Unrealized
Losses
    Fair
Value
   Gross
Unrealized
Losses
     Fair
Value
   Gross
Unrealized
Losses
 

States and political subdivisions

   $ 3,950    $ (6   $ 1,047    $ (32    $ 4,997    $ (38

Corporate debt securities

     7,536      (35     —        —           7,536      (35
                                              

Total

   $ 11,486    $ (41   $ 1,047    $ (32    $ 12,533    $ (73
                                              

 

     December 31, 2008  
     Less Than Twelve
Months
    Twelve Months
or Greater
     Total  
     Fair
Value
   Gross
Unrealized
Losses
    Fair
Value
   Gross
Unrealized
Losses
     Fair
Value
   Gross
Unrealized
Losses
 

U.S. Treasury and government agencies

   $ 6,861    $ (107   $ —      $ —         $ 6,861    $ (107

States and political subdivisions

     22,241      (214     940      (23      23,181      (237

Corporate debt securities

     954      (31     —        —           954      (31
                                              

Total

   $ 30,056    $ (352   $ 940    $ (23    $ 30,996    $ (375
                                              

At September 30, 2009, our portfolio contained approximately 21 individual investment securities that are in an unrealized loss position.

The unrealized losses at September 30, 2009 were attributable to changes in market interest rates since the securities were purchased. Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. This analysis requires management to consider various factors, which include (1) duration and magnitude of the decline in value, (2) the financial condition of the issuer or issuers, (3) structure of the security and (4) the Company’s intent to sell the security or whether its more likely than not that the Company would be required to sell the security before its anticipated recovery in market value. At September 30, 2009, management performed its quarterly analysis of all securities with an unrealized loss and concluded no individual securities were other-than-temporarily impaired.

 

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6. Reinsurance

In the ordinary course of business, we place reinsurance with other insurance companies in order to provide greater diversification of our business and limit the potential for losses arising from large risks. In addition, we assume reinsurance from other insurance companies.

The effect of reinsurance on premiums written and earned and loss and loss adjustment expenses was as follows (in thousands):

 

     Three Months Ended September 30,  
     2009     2008  
     Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
    Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
 

Direct

   $ 71,636      $ 71,930      $ 57,944      $ 75,581      $ 84,185      $ 63,746   

Reinsurance assumed

     19,789        17,311        13,344        13,834        14,335        11,655   

Reinsurance ceded

     (862     (680     (995     (10,689     (11,009     (4,825
                                                

Total

   $ 90,563      $ 88,561      $ 70,293      $ 78,726      $ 87,511      $ 70,576   
                                                

 

     Nine Months Ended September 30,  
     2009     2008  
     Written
Premium
   Earned
Premium
    Loss and
Loss
Adjustment
Expenses
    Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
 

Direct

   $ 224,367    $ 226,913      $ 186,732      $ 254,380      $ 265,677      $ 199,913   

Reinsurance assumed

     61,526      51,084        38,441        45,424        44,391        36,478   

Reinsurance ceded

     8,331      (1,991     (3,313     (34,604     (34,166     (24,237
                                               

Total

   $ 294,224    $ 276,006      $ 221,860      $ 265,200      $ 275,902      $ 212,154   
                                               

Under certain of our reinsurance transactions, we receive ceding commissions. The ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations. Effective January 1, 2009, we terminated our quota share reinsurance contract on a cut-off basis and received $10.5 million of returned unearned premiums, net of $2.6 million returned ceding commissions. In 2008, ceding commissions recognized as a reduction of selling, general and administrative expense were $2.5 million and $8.1 million for the three months and nine months ended September 30, 2008, respectively.

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

 

     September 30,
2009
   December 31,
2008

Losses and loss adjustment expense reserves

   $ 32,444    $ 40,667

Unearned premium reserve

     715      11,037
             

Total

   $ 33,159    $ 51,704
             

Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), our wholly-owned subsidiaries, Affirmative Insurance Company (AIC) and Insura Property and Casualty Insurance Company (Insura), had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize gross amounts due from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement effective September 2004. In August 2005, AIC received a letter from VFIC’s President that irrevocably confirmed VFIC’s duty and obligation under the Security Fund Agreement to provide security sufficient to satisfy VFIC’s gross obligations under the reinsurance agreement (the VFIC Trust). At September 30, 2009, the VFIC Trust held $17.4 million (after cumulative withdrawals of $7.6 million through September 30, 2009), consisting of $12.6 million of a U.S. Treasury money market account and $4.8 million of corporate bonds rated BBB or higher, to collateralize the $14.3 million gross recoverable from VFIC.

At September 30, 2009, net amounts owed by AIC and Insura under reinsurance agreements with the VIG-affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian) were $13.2 million. Affirmative established a trust account to collateralize this payable, which currently holds $22.4 million (including accrued interest) in securities (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through September 2009.

 

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The Michigan Catastrophic Claims Association (MCCA) is a reinsurance facility that covers no-fault medical losses above a specific retention amount. For policies effective from July 1, 2009 to June 30, 2010, the required retention is $0.5 million. As a writer of personal automobile policies in the state of Michigan, we cede premiums and claims to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders. Our ceded premiums written to the MCCA were $0.7 million and $0.4 million for the three months ended September 30, 2009 and 2008, respectively, and $1.5 million for the nine months ended September 30, 2009 and 2008.

We have an assumed reinsurance agreement with a Texas county mutual insurance company (the county mutual), whereby we assume 100% of the policies issued by the county mutual for business produced by our owned MGAs. The county mutual does not retain any of this business and there are no loss limits other than the underlying policy limits. The county mutual reinsurance agreement may be terminated by either party upon prior written notice of not less than 90 days. In the event of such termination, the MGA agrees to produce automobile insurance business in the State of Texas solely for the benefit of the county mutual for a period of ten years. The county mutual reinsurance agreement automatically terminates on January 1, 2014. Assumed written premiums from the county mutual were $19.8 million and $13.8 million for the three months ended September 30, 2009 and 2008, and $61.5 million and $45.4 million for the nine months ended September 30, 2009 and 2008, respectively.

 

7. Premium Finance Receivables, Net

Finance receivables (issued for policies by both the Company and third-party insurance carriers) are secured by unearned premiums from the underlying insurance policies and consisted of the following at September 30, 2009 and December 31, 2008 (in thousands):

 

     September 30,
2009
    December 31,
2008
 

Premium finance contracts

   $ 50,276      $ 43,657   

Unearned finance charges

     (2,643     (2,265

Allowance for credit losses

     (480     (405
                

Total

   $ 47,153      $ 40,987   
                

 

8. Deferred Policy Acquisition Costs

Policy acquisition costs, consisting of primarily commission, advertising, premium taxes, underwriting and agency expenses, are deferred and charged against income ratably over the terms of the related policies. The components of deferred policy acquisition costs and the related policy acquisition expenses amortized to expense were as follows (in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  

Beginning balance

   $ 24,732      $ 24,691      $ 21,993      $ 24,536   

Additions

     18,740        18,153        59,517        54,595   

Amortization

     (19,047     (20,104     (57,085     (56,391
                                

Ending balance

   $ 24,425      $ 22,740      $ 24,425      $ 22,740   
                                

 

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9. Senior Secured Credit Facility

On March 27, 2009, we entered into an amendment to the senior secured credit facility. The amendment included the following changes:

 

   

The leverage ratio covenant calculation was changed to include only amounts borrowed under the facility. In addition, the quarterly requirements were changed for the remaining term of the facility;

 

   

The interest coverage ratio covenant calculation was changed to include only interest expense paid in cash. In addition, the quarterly requirements were changed for the remaining term of the facility;

 

   

The combined ratio covenant was replaced with a loss ratio covenant;

 

   

The fixed charge coverage ratio was changed to include only interest expense paid in cash. In addition, the annual requirements were changed for the remaining term of the facility;

 

   

The consolidated net worth covenant calculation was changed to a covenant that excludes goodwill and includes subordinated debt;

 

   

Asset sales are now allowed for transactions with less than 80% of cash proceeds. Financing is limited to $5.0 million per transaction and $10.0 million in the aggregate;

 

   

A sale and leaseback transaction of capitalized technology assets is allowed for up to $30.0 million;

 

   

The pricing under the agreement was changed as follows:

 

   

A LIBOR floor of 3.0% was established; and

 

   

Pricing depends on the amount of the leverage ratio. If the leverage ratio is greater than 2.0, the pricing is LIBOR plus 6.25%. If the leverage ratio is greater than 1.5 and less than or equal to 2.0, the pricing is LIBOR plus 6.00%. If the leverage ratio is less than or equal to 1.5, the pricing is LIBOR plus 5.75%;

 

   

Common stock dividends are permitted only if the leverage ratio is less than or equal to 1.5;

 

   

The annual excess cash flow payment was changed to 50 percent of non-regulated cash flow and 75 percent of dividends paid from regulated insurance companies; and

 

   

The revolving facility was reduced from $20.0 million to $10.0 million.

In accordance with ASC 470-50 Debt-Modifications and Extinguishments, the Company evaluated the present value of the cash flows under the terms of the amended credit agreement to determine if they were at least 10 percent different from the present value of the remaining cash flows under the terms of the original credit agreement. It was determined that the terms were substantially different and therefore should be accounted for as a debt extinguishment. The amended debt agreement was recorded at fair value, which was determined to be $112.5 million, with the discount to be amortized as interest expense over the remaining life of the note using the effective interest method. In addition, $1.8 million of new debt issuance costs were incurred, which were capitalized and will be amortized to interest expense over the term of the amended credit agreement.

We recorded a $19.4 million pretax, non-cash gain on extinguishment of debt as a result of this transaction, which is included in a separate line item in the accompanying consolidated statement of income (loss) for the nine months ended September 30, 2009. The $19.4 million debt extinguishment gain resulted from a $24.2 million discount representing the difference between the carrying value of the original credit agreement and the fair value of the new modified credit agreement, net of $0.7 million of term lender consent fees and the write-off of $4.1 million of deferred debt issuance costs relating to the original credit agreement. As of September 30, 2009, the principal balance of the senior secured credit facility was $130.4 million.

 

10. Income Taxes

The provision for income taxes for the three and nine months ended September 30, 2009 and 2008 consisted of the following (in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  

Current tax expense (benefit)

   $ 2,223      $ (400   $ 3,312      $ 482   

Deferred tax expense (benefit)

     (5,412     (4,888     (8,425     (3,435
                                

Net income tax expense (benefit)

   $ (3,189   $ (5,288   $ (5,113   $ (2,953
                                

 

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The effective tax rate on income differs from the federal statutory tax rate of 35% for the following reasons (in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  

Income (loss) from continuing operations before income tax expense (benefit)

   $ (6,564   $ (6,830   $ (4,883   $ 3,765   

Loss from discontinued operations before income tax benefit

     (47     (5,075     (1,835     (6,366
                                

Loss before income tax benefit

   $ (6,611   $ (11,905   $ (6,718   $ (2,601
                                

Tax provision computed at the federal statutory income tax rate

     (2,314     (4,166     (2,351     (910

Increases (reductions) in tax resulting from:

        

Tax-exempt interest

     (345     (597     (1,165     (2,138

State income taxes

     (197     (733     (85     (69

Capital loss valuation allowance

     —          —          (1,008     —     

Other

     (333     208        (504     164   
                                
   $ (3,189   $ (5,288   $ (5,113   $ (2,953
                                

Effective tax rate

     48.2     44.4     76.1     113.5
                                

The capital loss valuation allowance was reversed in the second quarter of 2009 due to management’s assessment that it is more likely than not that the capital loss carryforwards will be utilized.

 

11. Legal and Regulatory Proceedings

We and our subsidiaries are named from time to time as parties in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies and claims handling. We believe that the resolution of these legal actions will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, the ultimate outcome of these matters is uncertain.

In September 2009, plaintiff Toni Hollinger filed a putative class action in the U.S. District Court for the Eastern District of Texas against several county mutual insurance companies and reinsurance companies, including Affirmative Insurance Company. The complaint alleges that defendants engaged in unfair discrimination and violated the Texas Insurance Code by charging different policy fees for the same class and hazard of insurance written through county mutual insurance companies. The Company believes that this claim lacks merit and intends to defend itself vigorously.

In November 2008, James Lambie filed an arbitration demand with the American Arbitration Association against Affirmative Insurance Holdings, Inc. seeking payment of up to $1.2 million pursuant to an Earn-Out Contingency Agreement entered into with Lambie in conjunction with the Company’s purchase of Drivers Choice Insurance Services, LLC from Lambie and others. An arbitration hearing was held on August 20-21, 2009. On October 22, 2009, the arbitrator entered a final, binding award in favor of the Company.

In December 2003, InsureOne Independent Agency, LLC (InsureOne), American Agencies General Agency, Inc. and Affirmative Insurance Holdings, Inc. brought action in the Circuit Court of Cook County, Illinois to enforce non-compete and non-solicitation agreements entered into with James Hallberg, the former president of InsureOne, a wholly-owned subsidiary, and eight former employees of InsureOne and two of Hallberg’s family trusts. On November 21, 2008, the Court entered a Memorandum Order and Judgment, which was amended on January 20, 2009, entering judgment in favor of InsureOne Independent Agency, LLC, American Agencies General Agency, Inc. and Affirmative Insurance Holdings, Inc., awarding us $7.7 million, plus reasonable attorneys’ fees and costs. The Court also entered judgment in favor of James Hallberg on a counterclaim, awarding him $130,168, plus attorneys’ fees and costs, for which we established a liability. The parties each filed post-judgment motions, which the Court denied on September 3, 2009. This matter is now on appeal.

From time to time, we and our subsidiaries are subject to random compliance audits from federal and state authorities regarding various operations within our business that involve collecting and remitting taxes in one form or another. In 2006, two of our owned underwriting agencies were subject to a sales and use tax audit conducted by the State of Texas. The examiner for the State of Texas completed his audit report and delivered an audit assessment, for the period from January 2002 to December 2005, asserting that we should have collected and remitted approximately $2.9 million in sales tax derived from claims services performed by our underwriting agencies for policies sold by these underwriting agencies and issued by an affiliated county mutual insurance company through a fronting arrangement. Our insurance companies reinsured 100% of these policies. The assessment included an additional $0.4 million for accrued interest and penalty for a total assessment of $3.3 million. We believe that these services are not

 

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subject to sales tax and are vigorously contesting the assertions made by the state and exercising all available rights and remedies available to us. In October 2006, we responded to the assessment by filing petitions with the Comptroller of Public Accounts for the State of Texas requesting a re-determination of the tax due. In June 2009, the Comptroller responded to our petition, disputing the validity of positions set forth in our October 2006 petitions. We are now pursuing discovery from the Comptroller’s office and intend to present written and oral evidence and legal arguments to contest the imposition of the asserted taxes. Pending the administrative hearing process, the date for any potential payment is delayed and the final outcome of this tax assessment will not be known for some time. Due to the uncertainty surrounding the ultimate outcome of this matter, no liability has been recorded as of September 30, 2009.

 

12. Net Income (Loss) Per Common Share

Net income (loss) per common share is based on the weighted average number of shares outstanding. Diluted weighted average shares is calculated by adjusting basic weighted average shares outstanding by all potentially dilutive stock options and restricted stock. Stock options outstanding of 1,601,339 for the three and nine months ended September 30, 2009, and 1,727,531 for the three and nine months ended September 30, 2008, were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price of our common stock and thus the inclusion would have been antidilutive.

The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for the three and nine months ended September 30, 2009 and 2008 (in thousands, except per share amounts):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
     2009     2008     2009     2008

Numerator:

        

Income (loss) from continuing operations

   $ (3,392   $ (3,450   $ (249   $ 4,446
                              

Denominator:

        

Weighted average basic shares

        

Weighted average common shares outstanding

     15,415        15,415        15,415        15,415
                              

Weighted average diluted shares

        

Weighted average common shares outstanding

     15,415        15,415        15,415        15,415

Effect of dilutive stock options

     —          —          —          —  
                              

Total weighted average diluted shares

     15,415        15,415        15,415        15,415
                              

Basic income (loss) per common share from continuing operations:

   $ (0.22   $ (0.22   $ (0.01   $ 0.29
                              

Diluted income (loss) per common share from continuing operations:

   $ (0.22   $ (0.22   $ (0.01   $ 0.29
                              

 

13. Fair Value of Financial Instruments

The Company utilizes a hierarchy of valuation techniques for the disclosure of fair value estimates based on whether the significant inputs into the valuation are observable. In determining the level of hierarchy in which the estimate is disclosed, the highest priority is given to unadjusted quoted prices in active markets and the lowest priority to unobservable inputs that reflect the Company’s significant market assumptions. The Company measures certain assets and liabilities at fair value on a recurring basis, including investment securities classified as available-for-sale or trading, cash equivalents, other receivables and interest rate swaps. Following is a brief description of the type of valuation information that qualifies a financial asset for each level:

Level 1 — Unadjusted quoted market prices for identical assets or liabilities in active markets which are accessible by the Company.

Level 2 — Observable prices in active markets for similar assets or liabilities. Prices for identical or similar assets or liabilities in markets that are not active. Directly observable market inputs for substantially the full term of the asset or liability, e.g., interest rates and yield curves at commonly quoted intervals, volatilities, prepayment speeds, default rates, and credit spreads. Market inputs that are not directly observable but are derived from or corroborated by observable market data.

Level 3 — Unobservable inputs based on the Company’s own judgment as to assumptions a market participant would use, including inputs derived from extrapolation and interpolation that are not corroborated by observable market data.

The Company evaluates the various types of financial assets and liabilities to determine the appropriate fair value hierarchy based upon trading activity and the observability of market inputs. The Company employs control processes to validate the reasonableness of the fair value estimates of its assets and liabilities, including those estimates based on prices and quotes obtained from independent third-party sources. The Company’s procedures generally include, but are not limited to, initial and on going evaluation of methodologies used by independent third-parties and monthly analytical reviews of the prices against current pricing trends and statistics.

 

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Where possible, the Company utilizes quoted market prices to measure fair value. For assets and liabilities that have quoted market prices in active markets, the Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. When quoted market prices in active markets are unavailable, the Company determines fair values based on independent external valuation information, which utilizes various models and valuation techniques based on a range of inputs including pricing models, quoted market price of publicly traded securities with similar duration and yield, time value, yield curve, prepayment speeds, default rates and discounted cash flow. In most cases, these estimates are determined based on independent third-party valuation information, and the amounts are disclosed as Level 2 or Level 3 of the fair value hierarchy depending on the level of observable market inputs.

Financial assets and financial liabilities measured at fair value on a recurring basis

The following table provides information as of September 30, 2009 about the Company’s financial assets and liabilities measured at fair value on a recurring basis:

 

     September 30,
2009
   Quoted
Prices in
Active
Markets
(Level 1)
   Significant
Other
Observable
Inputs
(Level 2)
   Significant
Unobservable
Inputs
(Level 3)

Assets:

           

U.S. Treasury and government agencies

   $ 14,839    $ 14,839    $ —      $ —  

Residential mortgage-backed securities

     4,981      —        4,981      —  

States and political subdivisions

     144,368      —        144,368      —  

Corporate debt securities

     65,259      65,259      —        —  

Auction-rate tax-exempt securities

     37,694      —        —        37,694
                           

Total investment securities

     267,141      80,098      149,349      37,694

Cash and cash equivalents

     53,369      53,369      —        —  

Fiduciary and restricted cash

     14,022      14,022      —        —  

Other receivables (other assets)

     10,696      —        —        10,696
                           

Total assets

   $ 345,228    $ 147,489    $ 149,349    $ 48,390
                           

Liabilities:

           

Interest rate swaps (other liabilities)

   $ 4,589    $ —      $ —      $ 4,589
                           

Total liabilities

   $ 4,589    $ —      $ —      $ 4,589
                           

Level 1 Financial assets

Financial assets classified as Level 1 in the fair value hierarchy include U.S. Government bonds and certain government agencies securities, corporate bonds, and cash or cash equivalents. U.S. Government bonds and corporate bonds are traded on a daily basis and the Company estimates the fair value of these securities using unadjusted quoted market prices. Cash and cash equivalents primarily consist of highly liquid money market funds, which are reflected within Level 1 of the fair value hierarchy.

Level 2 Financial assets

Financial assets classified as Level 2 in the fair value hierarchy include mortgage-backed securities, tax-exempt securities, and certain auction-rate tax-exempt securities that have auctions on a regular basis that do not fail. The fair value of these securities is determined based on observable market inputs provided by independent third-party pricing services and the Company discloses the fair values of these investments in Level 2 of the fair value hierarchy. To date, the Company has not experienced a circumstance where it has determined that an adjustment is required to a quote or price received from independent third-party pricing sources. To the extent the Company determines that a price or quote is inconsistent with actual trading activity observed in that investment or similar investments, the Company would determine a fair value using this observable market information and disclose the occurrence of this circumstance. All of the fair values of securities disclosed in Level 2 are estimated based on independent third-party pricing services.

 

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Level 3 Financial assets and liabilities

The Company’s Level 3 financial assets include certain illiquid auction-rate tax-exempt securities. Observable market inputs for certain auction-rate tax-exempt securities that have experienced failed auctions as a result of liquidity issues in the global credit and capital market are not readily available. The fair value of these securities is estimated using third-party valuation sources.

The Company’s Level 3 financial assets also include other receivables related to a settlement agreement entered into during November 2008 with our broker to liquidate certain of our auction-rate tax-exempt securities. Under the terms of the agreement, our broker will purchase our eligible auction-rate tax-exempt securities for full par value on or prior to June 30, 2012. As of September 30, 2009, we held $48.8 million, at amortized cost, and $37.7 million fair value of auction-rate tax-exempt securities that are eligible for such settlement. We have elected to record the settlement as a financial asset at fair value in accordance with ASC 825-10 Financial Instruments – Overall [SFAS No. 159, Establishing the Fair Value Option for Financial Assets and Liabilities]. The fair value of this agreement was estimated by third-party valuation sources to be $10.7 million and is included in other assets in Level 3 of the fair value hierarchy.

The Company’s Level 3 financial liabilities are interest rate swaps. The fair value of these swaps are determined by quotes from brokers that are not considered binding.

Fair value measurements for assets in category Level 3 for the three months ended September 30, 2009 were as follows (in thousands):

 

     Fair Value
Measurements Using
Significant
Unobservable Inputs
(Level 3)
Auction-Rate
Tax-Exempt Securities
    Fair Value
Measurements Using
Significant
Unobservable Inputs
(Level 3)
Other Assets

Balance at July 1, 2009

   $ 39,253      $ 10,184

Transfers in and/or out of Level 3

     —          —  

Total gains or (losses) (realized/unrealized):

    

Included in earnings

     (354     512

Included in other comprehensive income

     —          —  

Purchases, issuances, and settlements

     (1,205     —  
              

Balance at September 30, 2009

   $ 37,694      $ 10,696
              

Fair value measurements for liabilities in category Level 3 for the three months ended September 30, 2009 were as follows (in thousands):

 

     Fair Value Measurements
Using Significant
Unobservable Inputs
(Level 3)
Interest Rate Swaps
 

Balance at July 1, 2009

   $ 4,555   

Transfers into Level 3

     —     

Total losses (realized/unrealized):

  

Included in earnings

     926   

Included in other comprehensive income

     —     

Purchases, issuances, and settlements

     (892
        

Balance at September 30, 2009

   $ 4,589   
        

 

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Fair value measurements for assets in category Level 3 for the nine months ended September 30, 2009 were as follows (in thousands):

 

     Fair Value
Measurements Using
Significant
Unobservable Inputs
(Level 3)
Auction-Rate
Tax-Exempt Securities
    Fair Value
Measurements Using
Significant
Unobservable Inputs
(Level 3)
Other Assets

Balance at January 1, 2009

   $ 39,130      $ 9,647

Transfers in and/or out of Level 3

     —          —  

Total gains (realized/unrealized):

    

Included in earnings

     44        1,049

Included in other comprehensive income

     —          —  

Purchases, issuances, and settlements

     (1,480     —  
              

Balance at September 30, 2009

   $ 37,694      $ 10,696
              

Fair value measurements for liabilities in category Level 3 for the nine months ended September 30, 2009 were as follows (in thousands):

 

     Fair Value Measurements
Using Significant
Unobservable Inputs
(Level 3)
Interest Rate Swaps
 

Balance at January 1, 2009

   $ 5,935   

Transfers into Level 3

     —     

Total gains or (losses) (realized/unrealized):

  

Included in earnings

     5,872   

Included in other comprehensive income

     (5,935

Purchases, issuances, and settlements

     (1,283
        

Balance at September 30, 2009

   $ 4,589   
        

Derivative financial instruments are reported at fair value on the consolidated balance sheet. Our current derivative instruments consist of two interest rate swaps entered into in 2007 and 2008, with an aggregate notional amount of $115.0 million outstanding at September 30, 2009, previously designated as hedges against the variability of cash flows associated with that portion of the senior secured credit facility. The interest rate swap liability is recorded in other liabilities on the consolidated balance sheet.

Historically, our interest rate swaps qualified as cash flow hedges for hedge accounting. Accordingly, we recorded changes in fair value of the interest rate swaps in accumulated other comprehensive income (loss), net of tax. The credit risk associated with these swap agreements is limited to the uncollected interest payments due from counterparties. As of September 30, 2009, counterparty credit risk was minimal.

On March 27, 2009, we entered into an amendment to the senior secured credit facility, which was considered an extinguishment of debt. As a result, the previously hedged interest payments will not occur. Therefore, the amount recorded in accumulated other comprehensive loss through March 27, 2009 was reclassified to earnings as loss on interest rate swaps. Subsequent to March 27, 2009, we record changes in the fair value of the derivative instruments in earnings, as gain or loss on interest rate swaps.

 

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Gains and losses (realized and unrealized) for Level 3 assets and liabilities included in earnings for the nine months ended September 30, 2009, are reported in net investment income, other income and loss on interest rate swaps as follows:

 

     Net Investment
Income
   Other
Income
   Loss on
Interest Rate
Swaps
 

Assets

        

Total gains (losses) realized in earnings

   $ 44    $ 1,049    $ —     

Liabilities

        

Total gains (losses) realized in earnings

     —        —        (5,872
                      

Total for the period ended September 30, 2009

   $ 44    $ 1,049    $ (5,872
                      

Fair values represent our best estimates and may not be substantiated by comparisons to independent markets and, in many cases, could not be realized in immediate settlement of the instruments. The following financial liabilities are not required to be recorded at fair value, but their fair value is being disclosed.

Notes payable — The fair value of the notes payable were determined using a third-party valuation source is estimated to be $24.9 million with a carrying value of $76.9 million at September 30, 2009.

Senior secured credit facility — The fair value of the senior secured credit facility was determined using a third-party valuation source is estimated to be $98.0 million with a carrying value of $110.2 million at September 30, 2009.

Certain nonfinancial assets and nonfinancial liabilities have not been disclosed at their fair values. Therefore, the aggregate fair value amounts presented do not purport to represent our underlying value.

 

14. Discontinued Operations

On June 24, 2009, the Company sold all of its retail stores and its franchise business in Florida effective May 31, 2009. The results of operations of the sold business have been classified as discontinued operations in the consolidated statements of income. Cash flows related to discontinued operations have been combined with cash flows from continuing operations within each category of cash flows.

The aggregate sales price increased by $0.2 million to $4.2 million in the third quarter upon the failure by the purchaser to make a scheduled prepayment of $0.2 million. This also increased the secured 10% note to the principal amount of $2.9 million payable over five years. The sales price also included cash at closing of $0.3 million as well as a deferred payment of $1.0 million, subject to certain adjustments, due within 18 months of closing, which may be converted to a secured note at the purchaser’s option. Due to the uncertainty surrounding the financial viability of the debtor, the note and deferred payment have been recorded with no estimated net realizable value.

The summarized statements of loss from discontinued operations were as follows (in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  

Revenue (including loss on disposal)

   $ (20   $ 644      $ 569      $ 1,954   

Pretax loss from discontinued operations

     (47     (678     (1,835     (1,969

Other intangible assets impairment

     —          (4,397     —          (4,397

Income tax (benefit)

     (17     (1,908     (479     (2,272
                                

Loss from discontinued operations

   $ (30   $ (3,167   $ (1,356   $ (4,094
                                

We assigned store operating leases to the purchaser, but remain contingently liable on five store leases in the event of default by the assignee. These five stores have future lease related payments totaling approximately $0.4 million through August 2012. We believe the likelihood of a liability being triggered under these leases is remote, and, therefore, no liability has been accrued for these lease obligations as of September 30, 2009.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

OVERVIEW

We are a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic markets. Non-standard personal automobile insurance policies provide coverage to drivers who find it difficult to obtain insurance from standard automobile insurance companies due to their lack of prior insurance, age, driving record, limited financial resources or other factors. Non-standard personal automobile insurance policies generally require higher premiums than standard automobile insurance policies for comparable coverage.

As of September 30, 2009, our subsidiaries included insurance companies licensed to write policies in 40 states, underwriting agencies, and retail agencies with 203 owned stores and relationships with two unaffiliated underwriting agencies. We are currently active in offering insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas, and Wisconsin) and distributing our own insurance policies through 9,200 independent agents or brokers in 11 states (Louisiana, Texas, Illinois, Alabama, California, Michigan, Florida, Missouri, Indiana, South Carolina, and New Mexico).

We believe that the delivery of non-standard personal automobile insurance policies to individual consumers requires the interaction of four basic operations, each with a specialized function:

 

   

Insurance companies, which possess the regulatory authority and capital necessary to issue insurance policies;

 

   

Underwriting agencies, which supply centralized infrastructure and personnel required to design and service insurance policies that are distributed through retail agencies;

 

   

Retail agencies, which provide multiple points of sale under established local brands with personnel licensed and trained to sell insurance policies and ancillary products to individual consumers; and

 

   

Premium finance companies, which provide financing alternatives to individual customers of our retail agencies.

Our four operating components often function as a vertically integrated unit, capturing the premium and associated risk and commission income and fees generated from the sale of an insurance policy. There are other instances, however, when each of our operations functions with unaffiliated entities on an unbundled basis, either independently or with one or two of the other operations. For example, our retail stores earn commission income and fees from sales of non-standard automobile insurance policies issued by third-party insurance carriers.

We believe that our ability to enter into a variety of business relationships with third-parties allows us to maximize sales penetration and profitability through industry cycles better than if we employed a single, vertically integrated operating structure.

CRITICAL ACCOUNTING POLICIES

There have been no changes of critical accounting policies since December 31, 2008.

The Company completed its annual goodwill and indefinite lived intangible asset impairment analyses as of September 30, 2009. The Company reports under a single reporting segment and, as such, the goodwill analysis is measured under one reporting unit. Consistent with prior assessments, the fair value of the Company’s reporting unit was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Based upon the results of the assessment, the Company concluded that the carrying values of goodwill and other intangible assets were not impaired as of September 30, 2009. As of September 30, 2008, the Company concluded that the carrying value of other intangible assets related to the Company’s Florida operations exceeded their fair value, resulting in an impairment loss of $4.4 million for indefinite lived other intangible assets and $0.2 million for amortizing other intangible assets.

Key inputs in our valuation model are projected cash flows, future inflationary trends, future tax rates, and the risk-adjusted discount rate. The risk-adjusted discount rate was developed using a capital asset pricing model to estimate our weighted-average cost of capital. The relative mix of capital between debt and equity was estimated at approximately 34 percent based on observed industry averages.

Based on the valuation model results, management concluded that goodwill was not impaired as the fair value of the Company exceeded its carrying value. Further, the fair value obtained from the discounted cash flow model was subject to a stress test by decreasing forecasted cash flows by 15%, and at the same time increasing the discount rate by 100 basis points to 15.4%. The indicated stress value was sufficient to cover the book value of the Company.

 

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RECENTLY ISSUED ACCOUNTING STANDARDS

Effective July 1, 2009, The Financial Accounting Standards Board (FASB) issued the Accounting Standards Codification (ASC or Codification), which superseded all existing non-SEC accounting and reporting standards under U.S. GAAP and became the single official source for U.S. authoritative GAAP combined with guidance issued by the U.S. Securities and Exchange Commission (SEC), and is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The FASB no longer issues new standards in the form of Statements of Financial Accounting Standards (SFAS), FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, amendments to the Codification are made by issuing “Accounting Standards Updates”. The Codification did not change existing GAAP. Accordingly, the issuance of the codification did not impact the Company’s consolidated results of operations or financial condition.

Two FASB standards issued in June 2009, SFAS No. 166, Accounting for Transfers of Financial Assets – An Amendment of FASB Statement No. 140 (SFAS 166); and SFAS No. 167, Amendments to FASB Interpretation No. 46(R) (SFAS 167) have not been added to the Codification as of September 30, 2009, and are not effective as of that date without the ability to early adopt.

SFAS 167 eliminates Interpretation 46(R)’s exceptions to consolidating qualifying special-purpose entities, contains new criteria for determining the primary beneficiary, and increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a variable interest entity. SFAS 167 also contains a new requirement that any term, transaction, or arrangement that does not have a substantive effect on an entity’s status as a variable interest entity, a company’s power over a variable interest entity, or a company’s obligation to absorb losses or its right to receive benefits of an entity must be disregarded in applying Interpretation 46(R)’s provisions. The elimination of the qualifying special-purpose entity concept and its consolidation exceptions means more entities will be subject to consolidation assessments and reassessments. SFAS 167 will be effective for the fiscal year beginning January 1, 2010. The Company is currently assessing the potential impacts, if any, on the consolidated results of operations and financial condition.

SFAS 166 eliminates the concept of a qualifying special-purpose entity, creates more stringent conditions for reporting a transfer of a portion of a financial asset as a sale, clarifies other sale-accounting criteria, and changes the initial measurement of a transferor’s interest in transferred financial assets. SFAS 166 will be effective for fiscal years beginning after November 15, 2009. The Company is currently assessing the potential impacts, if any, on the consolidated results of operations and financial condition.

In May 2009, the FASB issued authoritative guidance establishing general standards for the accounting and reporting of subsequent events that occur between the balance sheet date and issuance of financial statements. It should not result in significant changes in the subsequent events that an entity reports, either through recognition or disclosure in its financial statements. This guidance requires companies to recognize the effects, if material, of subsequent events in the financial statements if the subsequent event provides additional evidence about conditions that existed as of the balance sheet date. Beginning in financial reporting periods ending after June 15, 2009, companies must also disclose the date through which subsequent events have been evaluated and the nature of any nonrecognized subsequent events. Nonrecognized subsequent events include events that provide evidence about conditions that did not exist as of the balance sheet date, but which are of such a nature that they must be disclosed to keep the financial statements from being misleading. This disclosure should alert all users of financial statements that an entity has not evaluated subsequent events after that date in the set of financial statements being presented. The Company adopted this standard in the second quarter of 2009 and it had no material impact on the consolidated results of operations or financial condition. Management evaluated subsequent events for recognition or disclosure through November 9, 2009.

On January 1, 2009, the Company adopted authoritative guidance issued by the FASB that amended and expanded the disclosure requirements to provide users of financial statements with enhanced disclosures about an entity’s derivative and hedging activities thereby improving the transparency of financial reporting. This standard requires qualitative disclosure about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of and gains and losses on derivative instruments, and disclosures about credit risk related contingent features in derivative agreements. The adoption of this standard did not have a material impact on the Company’s consolidated results of operations or financial condition.

In April 2009, the FASB issued authoritative guidance that requires fair value disclosures in both interim as well as annual financial statements in order to provide more timely information about the effects of current market conditions on financial instruments. The Company adopted this guidance in the second quarter of 2009, the impact of which related only to disclosures of the Company’s debt and did not have a material impact on the Company’s consolidated financial statements.

In the second quarter of 2009, the Company adopted authoritative guidance issued by the FASB that amended the other-than-temporary impairment guidance for debt securities to make the guidance more operational and to improve the presentation and disclosure of other-than-temporary impairments in the financial statements. This guidance did not amend existing recognition and measurement guidance related to other-than-temporary impairments of equity securities. Adoption of this guidance did not have a material impact on the Company’s consolidated results of operations or financial condition.

In the second quarter of 2009, the Company adopted authoritative guidance issued by the FASB on estimating fair value when the volume and level of activity for the asset or liability have significantly decreased and identifying circumstances that may indicate that a transaction is not orderly. Adoption of this guidance did not have a material impact on the Company’s consolidated results of operations or financial condition.

On January 1, 2009, the Company adopted authoritative guidance issued by the FASB on fair value measurement for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Adoption of the new guidance did not have a material impact on the Company’s consolidated results of operations or financial condition.

In August, the FASB issued authoritative guidance on measuring the fair value of liabilities and clarifies that the quoted price for an identical liability, when traded as an asset in an active market, is also a Level 1 measurement, the highest priority in the fair value hierarchy, when no adjustment to the quoted price is required. This guidance is effective for interim and annual periods beginning after August 27, 2009. The Company does not anticipate any revisions in valuation techniques to be considered necessary as a result of adopting this guidance in the fourth quarter of 2009.

 

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MEASUREMENT OF PERFORMANCE

We are an insurance holding company engaged in the underwriting, servicing and distribution of non-standard personal automobile insurance policies and related products and services. We distribute our products through three distinct distribution channels: our retail stores, independent agents and unaffiliated underwriting agencies. We generate earned premiums and fees from policyholders through the sale of our insurance products. In addition, through our retail stores, we sell insurance policies of third-party insurers and other products or services of unaffiliated third-party providers and thereby earn commission income from those third-party providers and insurers and fees from the customers.

As part of our corporate strategy, we treat our retail stores as independent agents, encouraging them to sell to their individual customers whatever products are most appropriate for and affordable to those customers. We believe that this offers our retail customers the best combination of service and value, developing stronger customer loyalty and improving customer retention. In practice, this means that in our retail stores, the relative proportion of the sales of our own insurance products as compared to the sales of the third-party policies will vary depending upon the competitiveness of our insurance products in the marketplace during the period. This reflects our intention of maintaining the margins in our insurance company subsidiaries, even at the cost of business lost to third-party carriers.

In the independent agency distribution channel and the unaffiliated underwriting agency distribution channel, the effect of competitive conditions is the same as in our retail store distribution channel. As in our retail stores, independent agents (either working directly with us or through unaffiliated underwriting agencies) not only offer our products but also offer their customers a selection of products by third-party carriers. Therefore, our insurance products must be competitive in pricing, features, commission rates and ease of sale or the independent agents will sell the products of those third parties instead of our products. We believe that we are generally competitive in the markets we serve, and we constantly evaluate our products relative to those of other carriers.

Premiums. One measurement of our performance is the level of gross premiums written and a second measurement is the relative proportion of premiums written through our three distribution channels. The following table displays our gross premiums written and assumed by distribution channel for the three and nine months ended September 30, 2009 and 2008 (in thousands):

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008

Our underwriting agencies:

           

Retail agencies

   $ 50,742    $ 54,082    $ 163,445    $ 180,787

Independent agencies

     34,833      28,905      102,955      95,713
                           

Subtotal

     85,575      82,987      266,400      276,500

Unaffiliated underwriting agencies

     5,850      6,428      19,493      23,304
                           

Total

   $ 91,425    $ 89,415    $ 285,893    $ 299,804
                           

Total gross premiums written for the three months ended September 30, 2009 increased $2.0 million, or 2.2%, compared with the prior year primarily due to the expansion of independent agency relationships. Total gross premiums written for the nine months ended September 30, 2009 decreased $13.9 million, or 4.6%, compared with the prior year primarily due to macroeconomic factors. In our retail distribution channel, gross premiums written consist of premiums written for our affiliated insurance carriers’ products only and do not include premiums written for third-party insurance carriers in our retail and franchised stores. We earn only commission income and fees in our retail distribution channel for sales of third-party insurance policies. Gross premiums written in our retail distribution channel for the three and nine months ended September 30, 2009, decreased $3.3 million and $17.3 million, or 6.2% and 9.6%, respectively, when compared with the prior year. These declines were primarily due to the negative macroeconomic environment.

In our independent agency distribution channel, gross premiums written for the three and nine months ended September 30, 2009 increased $5.9 million and $7.2 million, respectively, or 20.5% and 7.6%, respectively, compared with the prior year. This increase was primarily due to the expansion of independent agency relationships.

Gross premiums written by our unaffiliated underwriting agencies for the three and nine months ended September 30, 2009 decreased $0.6 million and $3.8 million, respectively, or 9.0% and 16.4%, respectively, compared with the prior year. For strategic reasons, we have chosen to reduce our emphasis on growth in the unaffiliated underwriting agencies distribution channel.

In the third quarter of 2009, we began to implement changes in pricing to improve our premium production levels and profitability. The states of Illinois, Indiana, Michigan and South Carolina are targeted for these changes. We expect it to take about one year before the full benefits from these actions are realized.

 

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The following table displays our gross premiums written and assumed by state for the three and nine months ended September 30, 2009 and 2008 (in thousands):

 

     Three Months Ended
September 30,
   Nine Months Ended
September 30,
     2009    2008    2009    2008

Louisiana

   $ 36,087    $ 33,774    $ 108,543    $ 107,583

Texas

     20,396      15,003      64,217      50,212

Illinois

     8,916      11,903      31,269      41,434

Alabama

     7,324      6,945      22,729      21,932

California

     5,788      6,308      19,272      22,905

Michigan

     5,709      3,850      14,326      13,175

Indiana

     2,136      2,255      7,295      7,814

Missouri

     2,058      1,750      7,109      7,884

Florida

     1,136      4,813      4,934      16,287

South Carolina

     1,082      1,825      3,772      7,322

New Mexico

     728      869      2,207      2,856

Other

     65      120      220      400
                           

Total

   $ 91,425    $ 89,415    $ 285,893    $ 299,804
                           

The following table displays our net premiums written by distribution channel for the three and nine months ended September 30, 2009 and 2008 (in thousands):

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2009     2008     2009     2008  

Our underwriting agencies:

        

Retail agencies – gross premiums written

   $ 50,742      $ 54,082      $ 163,445      $ 180,787   

Ceded reinsurance

     —          (10,179     10,286        (32,354
                                

Subtotal retail agencies net premiums written

     50,742        43,903        173,731        148,433   
                                

Independent agencies – gross premiums written

     34,833        28,905        102,955        95,713   

Ceded reinsurance

     (651     (402     (1,304     (1,541
                                

Subtotal independent agencies net premiums written

     34,182        28,503        101,651        94,172   
                                

Unaffiliated underwriting agencies – gross premiums written

     5,850        6,428        19,493        23,304   

Ceded reinsurance

     (32     (58     (121     (181
                                

Subtotal unaffiliated underwriting agencies net premiums written

     5,818        6,370        19,372        23,123   
                                

Catastrophe and contingent coverages with various reinsurers

     (179     (50     (530     (528
                                

Total net premiums written

   $ 90,563      $ 78,726      $ 294,224      $ 265,200   
                                

Total net premiums written for the three months ended September 30, 2009 increased $11.8 million, or 15.0%, compared with the prior year quarter. Total net premiums written for the nine months ended September 30, 2009 increased $29.0 million, or 10.9%, compared with the prior year period. The increase was primarily due to lower ceded reinsurance for our Louisiana and Alabama businesses. Effective January 1, 2009, we terminated our quota share reinsurance contract on a cut-off basis and $10.5 million of ceded unearned premium was returned.

RESULTS OF OPERATIONS

We had a loss from continuing operations of $3.4 million and $0.2 million for the three and nine months ended September 30, 2009, respectively, compared with a loss from continuing operations of $3.5 million for the three months ended September 30, 2008 and income from continuing operations of $4.4 million for the nine months ended September 30, 2008. Significant items impacting the current year to date results were:

 

   

net pretax gain on extinguishment of debt of $19.4 million in the first quarter of 2009;

 

   

unfavorable development on reserve estimates for prior accident years of $11.0 million in the second quarter of 2009;

 

   

net contingent commission expense related to prior period development of $1.0 million and $3.3 million for the three and nine months ended September 30, 2009, respectively;

 

   

an accrual of $1.0 million for severance payments to be made to a former executive in the second quarter of 2009; and

 

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loss on interest rate swaps of $0.9 million and $5.9 million for the three and nine months ended September 30, 2009, respectively, associated with the discontinuation of hedge accounting for the interest rate swaps.

Comparison of the Three Months Ended September 30, 2009 to the Three Months Ended September 30, 2008

Total revenues for the three months ended September 30, 2009 increased $2.7 million, or 2.4%, compared with the three months ended September 30, 2008. The increase was primarily due to increased commission and fees revenue as well as reduced reinsurance in 2009.

The largest component of revenue is net premiums earned on our insurance policies. Net premiums earned for the current quarter increased $1.1 million, or 1.2%, compared with the prior year quarter. Since insurance premiums are earned over the service period of the policies, the revenue in the current quarter includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. Net premiums earned during the current quarter on policies sold through our affiliated underwriting agencies (including retail and independent agencies) increased by $2.2 million, or 2.8%. This increase is primarily due to the termination of our quota-share reinsurance agreement for Louisiana and Alabama business. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $1.2 million, or 15.7%, compared with the prior year quarter.

The following table sets forth net premiums earned by distribution channel for the current quarter and the prior year quarter (in thousands):

 

     Three Months Ended
September 30,
     2009    2008

Our underwriting agencies

   $ 82,260    $ 80,039

Unaffiliated underwriting agencies

     6,301      7,472
             

Total net premiums earned

   $ 88,561    $ 87,511
             

Commission Income and Fees. Another measurement of our performance is the relative level of production of commission income and fees. Commission income and fees consist of (a) policy, installment, premium finance and agency fees earned for business written or assumed by our insurance companies both through independent agents and our retail agencies and (b) the commission, premium finance and agency fee income earned on sales of unaffiliated, third-party companies’ insurance policies or other products sold by our retail agencies. These various types of commission income and fees are impacted in different ways by the decisions we make in pursuing our corporate strategy.

Policy, installment, premium finance and agency fees are earned for business written or assumed by our insurance companies both through independent agents and our retail agencies. Policy, installment and agency fees are fees charged to the customers in connection with their purchase of coverage from our insurance company subsidiaries. Generally, we can increase or decrease agency and installment fees subject to limited regulatory restrictions, but policy fees and interest rates must be approved by the applicable state’s department of insurance. Premium finance fees are financing fees earned by our premium finance subsidiaries, and consist of interest and origination fees on premiums that customers choose to finance.

Commissions, premium finance and agency fees are earned on sales of unaffiliated (third-party) companies’ products sold by our retail agencies. As described above, in our owned stores, there can be a shift in the relative proportion of the sales of third-party insurance products as compared to sales of our own carriers’ products due to the relative competitiveness of our insurance products that could result in an increase in our commission income and fees from non-affiliated third-party insurers. We negotiate commission rates with the various third-party carriers whose products we agree to sell in our retail stores. As a result, the level of third-party commission income will also vary depending upon the mix by carrier of third-party products that are sold. In addition, we earn fees from the sales of other products and services such as auto club memberships, bond cards and tax preparation services offered by unaffiliated companies.

 

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The following sets forth the components of consolidated commission income and fees earned for the current quarter and the prior year quarter (in thousands):

 

     Three Months Ended
September 30,
 
     2009    2008  

Policyholder fees

   $ 9,604    $ 10,253   

Premium finance revenue

     5,597      4,593   

Commissions and fees

     3,445      2,650   

Agency fees

     1,133      1,036   

Other, net

     245      (86
               

Total commission income and fees

   $ 20,024    $ 18,446   
               

Total commission income and fees increased $1.6 million, or 8.6%, compared with the prior year quarter. Policyholder fees have decreased due to the lower volume of premiums written in states where we collect policyholder fees. We have experienced a steady increase in premium finance revenue since December 2007 when we began financing third-party premiums. Commissions and fees increased as a result of a revised rate structure in 2009 and more of our retail customers choosing third-party products due to the soft market conditions.

Net Investment Income and Other Income. Net investment income for the current quarter decreased $0.6 million, or 18.7%, compared with the prior year quarter. The decrease was primarily due to a reduction in yields and an 8.0% decrease in total average invested assets to $272.2 million during the current quarter from $296.0 million during the prior year quarter. The average investment yield was 2.5% (3.9% on a taxable equivalent basis) in the current quarter, compared with 3.1% (4.8% on taxable equivalent basis) in the prior year quarter.

As of September 30, 2009, we held $48.8 million, at amortized cost, and $37.7 million fair value of auction-rate tax-exempt securities. Generally, the interest rates for these securities are determined by bidding every 7, 28 or 35 days. When there are more sellers than buyers, an auction fails and bondholders that want to sell are unable to sell the securities. Auctions for these securities began to fail in late January 2008. Issuers remain obligated to pay interest and principal when due when an auction fails. Rates at failed auctions are set at a level established in the terms of the debt. In February 2008, investment banks stopped committing capital to the auctions and there have been widespread auctions failures since that time.

In August 2008, our broker announced settlements in principle with each of the Division Enforcement of the U.S. Securities and Exchange Commission (SEC), the New York Attorney General and other state agencies to purchase all of its clients’ auction-rate securities at par and several other items, including fines. In October 2008, our broker filed a prospectus with the SEC, which published a legally-binding offer to all authorized holders of auction-rate securities in our broker’s accounts (“the settlement”). The majority of our auction-rate securities qualify under the terms of the settlement. The time frames that our broker has set for buybacks have different start dates based upon the individual client’s size, which is determined by each client’s balance of investments held at our broker. For the majority of our auction-rate holdings, the buybacks are expected to occur between July 2010 and two years thereafter. In November 2008, the Company elected to participate in our broker’s offer to purchase our auction-rate securities at par. We classify our portfolio of auction-rate securities as trading and as of the quarter ended September 30, 2009, recorded a realized loss of $0.4 million for the change in fair value since June 30, 2009. As of September 30, 2009, the fair value of the settlement was $10.7 million, which we reported in other assets with the increase in fair value of $0.5 million during the three months ended September 30, 2009, reported in other income.

Losses and Loss Adjustment Expenses. Since the largest expenses of an insurance company are the losses and loss adjustment expenses, another measurement of our insurance carriers’ performance is the level of such expenses, specifically as a ratio to earned premiums. Our losses and loss adjustment expenses are a blend of the specific estimated and actual costs of providing the coverage contracted by the purchasers of our insurance policies. We maintain reserves to cover our estimated ultimate liability for losses and related loss adjustment expenses for both reported and unreported claims on the insurance policies issued by our insurance companies. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity and other variable factors such as inflation. Due to the inherent uncertainty of estimating reserves, reserve estimates can be expected to vary from period to period. To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and loss adjustment expenses and incur a charge to earnings in the period during which such reserves are increased. We have a limited history in establishing reserves and the historic development of our reserves for losses and loss adjustment expenses is not necessarily indicative of future trends in the development of these amounts.

Losses and loss adjustment expenses for the current quarter decreased $0.3 million, or 0.4 %, compared with the prior year quarter. The percentage of losses and loss adjustment expense to net premiums earned (the loss ratio) was 79.4% in the current quarter, compared with 80.6% in the prior year quarter. The decline was primarily due to hurricane losses and prior period adverse development in 2008. Excluding these items, the loss ratio for the current quarter increased to 79.4% from 75.5%. The increase in the loss ratio for the current

 

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quarter ended September 30, 2009 compared to the prior year quarter, excluding noted items, was due to the increase of the current period loss ratio to 76.4% for the nine months ended September 30, 2009 from 75.0% for the six months ended June 30, 2009. This increase was primarily due to increased loss frequency from our Florida and Texas businesses.

The Florida losses were primarily the result of our decision to push the full coverage product in Florida in 2007 in response to the Personal Injury Protection (PIP) sunset in that state on October 1, 2007 and the development recorded in the second quarter primarily was for 2008. Inadequate pricing and product management produced significantly higher losses than anticipated. We have drastically reduced the production of this product by restricting writings by agent, territory and coverage based on where significant loss ratio swings occurred.

In the third quarter of 2009, we undertook a study to assess how we carry out our claims administration activities. Through this review, we identified specific actions to achieve organizational efficiencies and reduce our loss and loss adjustment expenses. We have started to implement these steps in the fourth quarter of 2009 and expect these actions to have a significant impact on mitigating our loss and loss adjustment expenses. We expect it to take about one year before the full benefits from these actions are realized.

The following table displays the impact of loss development related to prior periods’ business on our loss ratio for the current quarter and the prior year quarter:

 

 

     Three Months Ended
September 30,
 
     2009     2008  

Loss ratio – current quarter

   79.4   75.5

Hurricane losses

   —        2.2   

Adverse loss ratio development – prior period business

   —        2.9   
            

Reported loss ratio

   79.4   80.6
            

Selling, General and Administrative Expenses. Another measurement of our performance that addresses our overall efficiency is the level of selling, general and administrative expenses. We recognize that our customers are primarily motivated by low prices. As a result, we strive to keep our costs as low as possible to be able to keep our prices affordable and thus to maximize our sales while still maintaining profitability. Our selling, general and administrative expenses include not only the cost of acquiring the insurance policies through our insurance carriers (the amortization of the deferred acquisition costs) and managing our insurance carriers and the retail stores, but also the costs of the holding company. The largest component of selling, general and administrative expenses is personnel costs, including payroll, benefits and accrued bonus expenses.

Selling, general and administrative expenses increased $0.3 million, or 0.9%, compared with the prior year quarter. This increase was primarily related to a reduction in ceding commission of $2.5 million due to the termination of the Louisiana and Alabama quota-share agreement and contingent commissions related to prior period development of $1.0 million. These increases were offset by cost reduction initiatives implemented by management.

In July 2009, we suspended matching contributions to the 401(k) plan. This action is expected to decrease selling, general and administrative expenses by approximately $1.0 million annually. We are also in the process of implementing the following organizational changes by the end of 2009 including:

 

   

consolidating insurance operations into one location;

 

   

consolidating agency and claims operations; and

 

   

conducting a general business unit review to identify and implement additional expense savings opportunities.

We believe that the cumulative effect of all of the actions outlined above, including the sale of the Florida retail operations and the suspension of the 401(k) matching contributions, should produce expense savings of at least $10.0 million annually and the elimination of approximately 150 jobs.

Deferred policy acquisition costs represent the deferral of expenses that we incur in acquiring new business or renewing existing business. Policy acquisition costs, consisting of primarily commission, advertising, premium taxes, underwriting and retail agency expenses, are initially deferred and then charged against income ratably over the terms of the related policies through amortization of the deferred policy acquisition costs. Thus, the amortization of deferred acquisition costs is correlated with earned premium and the ratio of amortization of deferred acquisition costs to earned premium in an accounting period is another measurement of performance.

 

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The following table sets forth the impact that amortization of deferred acquisition costs had on selling, general and administrative expenses and the change in deferred acquisition costs (in thousands):

 

     Three Months Ended
September 30,
 
     2009     2008  

Amortization of deferred acquisition costs

   $ 19,047      $ 20,104   

Other selling, general and administrative expenses

     19,045        17,654   
                

Total selling, general and administrative expenses

   $ 38,092      $ 37,758   
                

Total as a percentage of net premiums earned

     43.0     43.1
                

Beginning deferred acquisition costs

   $ 24,732      $ 24,691   

Additions

     18,740        18,153   

Amortization

     (19,047     (20,104
                

Ending deferred acquisition costs

   $ 24,425      $ 22,740   
                

Amortization of deferred acquisition costs as a percentage of net premiums earned

     21.5     23.0
                

During 2006, we developed a comprehensive implementation plan and supporting business case to consolidate and transform our primary business applications onto a new strategic platform. This plan encompasses consolidating and migrating our multiple claims, point-of-sale and policy administration systems onto single strategic platforms, as well as deploying new premium finance, reporting and business analytics capabilities. For all components of this systems transformation plan, we have selected a software package that we will configure and integrate to meet our unique needs. We believe this systems transformation will position us to realize significant strategic benefits including: systemic pricing advantage in our marketplace via consolidated and streamlined systems and operations; faster product time to market; additional retail revenue via premium financing; improved claims and underwriting performance via increased automated application of best practice processing rules; a platform to simplify and hasten post-merger and acquisition integration-reducing integration costs and accelerating synergies realization; and improved customer focus and retention. Through September 30, 2009, we have capitalized $40.7 million of costs related to the transformation. The agency management and premium finance systems were fully implemented in the first quarter of 2008. The insurance systems began to be implemented in June 2008 with the claims system implemented to support all of our operations except for our Louisiana and Alabama operations in the last six months of 2008. We are in the process of converting all remaining open claims from the legacy system to the new system (with the exception of Louisiana and Alabama). Through the third quarter of 2009, the new point-of-sale and policy administration system was implemented in Texas, Illinois, Indiana and South Carolina. For the new policy administration system implementation, we plan to operate the legacy systems through the policies’ renewal dates when they will be converted to the new system. This will result in additional operating expense until the legacy systems can be retired.

Depreciation and Amortization. Depreciation and amortization expenses for the current quarter decreased $0.5 million, or 17.5%, compared with the prior year quarter. Depreciation expense increased by $0.1 million, or 5.6%, primarily due to the implementation of the insurance systems mentioned above. Amortization expense decreased by $0.6 million, or 82.3%, for the current quarter primarily as a result of lower amortization expense related to the purchase of USAgencies.

Loss on Interest Rate Swaps. Loss on interest rate swaps for the current quarter was $0.9 million. The modification of the senior credit facility effective March 27, 2009 resulted in the interest rate swaps becoming ineffective as cash flow hedges and are therefore carried at fair value. The loss relates to the impact on the determination of fair value associated with the general decline in short term interest rates implied in the current forward yield curve.

Interest Expense. Interest expense for the current quarter increased $2.1 million, or 49.2%, compared with the prior year quarter. This increase reflects the amortization of loan discount of $1.9 million resulting from the modification of the senior credit facility as well as the increased interest rate, which was partially offset by a lower loan balance due to principal reductions.

Income Taxes. Income tax benefit for the current quarter was $3.2 million, or an effective rate of 48.2%, as compared with income tax benefit of $5.3 million, or an effective rate of 44.4%, for the prior year quarter.

Discontinued Operations. In June 2009, the Company sold all of its retail stores and its franchise business in Florida effective May 31, 2009. The results of operations of the sold business have been classified as discontinued operations in the consolidated statements of income. The sale of these stores is expected to improve pretax income in the range of $1.0 million to $1.5 million annually.

The aggregate sales price increased by $0.2 million to $4.2 million in the third quarter upon the failure by the purchaser to make a scheduled prepayment of $0.2 million. This also increased the secured 10% note to the principal amount of $2.9 million payable over five years. The sales price also included cash at closing of $0.3 million as well as a deferred payment of $1.0 million, subject to certain adjustments, due within 18 months of closing, which may be converted to a secured note at the purchaser’s option. Due to the uncertainty surrounding the financial viability of the debtor, the note and deferred payment have been recorded with no estimated net realizable value.

 

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We assigned store operating leases to the purchaser, but remain contingently liable on five store leases in the event of default by the assignee. These five stores have future lease related payments totaling approximately $0.4 million through August 2012. We believe the likelihood of a liability being triggered under these leases is remote, and therefore no liability has been accrued for these lease obligations as of September 30, 2009.

Comparison of the Nine Months Ended September 30, 2009 to the Nine Months Ended September 30, 2008

Total revenues for the nine months ended September 30, 2009 decreased $0.2 million, or 0.1%, compared with the nine months ended September 30, 2008. The decrease was primarily due to a decrease in net investment income, partially offset by increases in commission income and fees and other income.

The largest component of revenue is net premiums earned on insurance policies issued by our five affiliated insurance carriers. Net premiums earned for the current period increased $0.1 million, or 0.04%, compared with the prior year period. Since insurance premiums are earned over the service period of the policies, the revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods. Net premiums earned during the current period on policies sold through our affiliated underwriting agencies (including retail and independent agencies) increased by $5.7 million, or 2.3%. This increase is primarily due to the increase in retention on the Louisiana and Alabama business with the termination of our quota-share reinsurance agreement, which was partially offset by the macroeconomic environment and soft market conditions. Net premiums earned on insurance products sold through the unaffiliated underwriting agencies distribution channel decreased by $5.6 million, or 22.6%, compared with the prior year period.

The following table sets forth net premiums earned by distribution channel for the current period and the prior year period (in thousands):

 

     Nine Months Ended
September 30,
     2009    2008

Our underwriting agencies

   $ 256,733    $ 250,990

Unaffiliated underwriting agencies

     19,273      24,912
             

Total net premiums earned

   $ 276,006    $ 275,902
             

Commission Income and Fees.

The following sets forth the components of consolidated commission income and fees earned for the current period and the prior year period (in thousands):

 

     Nine Months Ended
September 30,
     2009    2008

Policyholder fees

   $ 29,251    $ 32,690

Premium finance revenue

     16,627      14,311

Commissions and fees

     10,155      7,864

Agency fees

     3,753      3,496

Other, net

     688      285
             

Total commission income and fees

   $ 60,474    $ 58,646
             

Commission income and fees increased $1.8 million, or 3.1%, compared with the prior year period. Policyholder fees have decreased due to the lower volume of premiums written in states where we collect policyholder fees. We have experienced a steady increase in premium finance revenue since December 2007 when we began financing third-party premiums. Commissions and fees increased as a result of a revised rate structure in 2009 and more of our retail customers choosing third-party products due to the soft market conditions. Agency fees increased due to additional fees that we began collecting in April 2008.

Net Investment Income and Other Income. Net investment income for the current period decreased $3.7 million, or 33.7%, compared with the prior year period. The decrease was primarily due to a reduction in yields and a 12.0% decrease in total average invested assets to $270.1 million during the current period from $306.8 million during the prior year period. The average investment yield was 2.6% (4.0% on a taxable equivalent basis) in the current period, compared with 3.7% (5.7% on taxable equivalent basis) in the prior year period.

 

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Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for the current period increased $9.7 million, or 4.6%, compared with the prior year period. The percentage of losses and loss adjustment expense to net premiums earned (the loss ratio) was 80.4% in the current period, compared with 76.9% in the prior year period. The increase in the loss ratio for the nine months ended September 30, 2009 compared to the prior year period was due to increased losses from unfavorable development on reserve estimates for prior accident years of $11.1 million primarily due to $5.6 million for our Florida business, $3.7 million for our Michigan business, and $1.8 million for our Louisiana business.

The Michigan losses were the result of prior accident year development exceeding original estimates. The Florida losses were the result of our decision to push the full coverage product in Florida in 2007 in response to the Personal Injury Protection (PIP) sunset in that state on October 1, 2007 and the development recorded in the second quarter primarily was for 2008. Inadequate pricing and product management produced significantly higher losses than anticipated. We have drastically reduced the production of this product by restricting writings by agent, territory and coverage based on where significant loss ratio swings occurred. Excluding Florida in the current period, the loss ratio was 74.3%.

The following table displays the impact of loss development related to prior periods’ business on our loss ratio for the current period and the prior year period:

 

     Nine Months Ended
September 30,
 
     2009     2008  

Loss ratio – current period

   76.4   74.7

Hurricane losses

   —        0.7   

Adverse loss ratio development – prior period business

   4.0      1.5   
            

Reported loss ratio

   80.4   76.9
            

Selling, General and Administrative Expenses. The largest component of selling, general and administrative expenses is personnel costs, including payroll, benefits and accrued bonus expenses. Selling, general and administrative expenses increased $10.0 million, or 9.2%, compared with the prior year period. This increase was primarily related to no longer receiving ceding commissions and a return of ceding commission of $2.6 million due to the termination of the Louisiana and Alabama quota share agreement in 2009; contingent commissions related to prior period development of $3.3 million; and a severance charge of $1.3 million. These increases were partially offset by cost reduction initiatives implemented by management.

The following table sets forth the impact that amortization of deferred acquisition costs had on selling, general and administrative expenses and the change in deferred acquisition costs (in thousands):

 

     Nine Months Ended
September 30,
 
     2009     2008  

Amortization of deferred acquisition costs

   $ 57,085      $ 56,391   

Other selling, general and administrative expenses

     60,643        51,371   
                

Total selling, general and administrative expenses

   $ 117,728      $ 107,762   
                

Total as a percentage of net premiums earned

     42.7     39.1
                

Beginning deferred acquisition costs

   $ 21,993      $ 24,536   

Additions

     59,517        54,595   

Amortization

     (57,085     (56,391
                

Ending deferred acquisition costs

   $ 24,425      $ 22,740   
                

Amortization of deferred acquisition costs as a percentage of net premiums earned

     20.7     20.4
                

Depreciation and Amortization. Depreciation and amortization expenses for the current period decreased $0.4 million, or 5.6%, compared with the prior year period. Depreciation expense increased by $1.5 million, or 29.2%, primarily due to the implementation of the insurance systems mentioned above and amortization expense decreased by $1.9 million, or 81.1%, for the current period primarily as a result of decreasing amortization related to the purchase of USAgencies.

Gain on Extinguishment of Debt. We evaluated the present value of the cash flows under the terms of the amended credit agreement to determine if they were at least 10 percent different from the present value of the remaining cash flows under the terms of the original credit agreement. It was determined that the terms were substantially different and therefore should be accounted for as a debt extinguishment. The amended debt agreement was recorded at fair value, which was determined to be $112.5 million, with the discount to

 

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be amortized as interest expense over the remaining life of the note using the effective interest method. In addition, $1.8 million of new debt issuance costs were incurred, which were capitalized and are being amortized to interest expense over the term of the amended credit agreement.

We recorded a $19.4 million pretax, non-cash gain on extinguishment of debt as a result of this transaction, which is included in a separate line item in the accompanying consolidated statement of income for the nine months ended September 30, 2009. The $19.4 million debt extinguishment gain resulted from a $24.2 million discount representing the difference between the carrying value of the original credit agreement and the fair value of the new modified credit agreement, net of $0.7 million of term lender consent fees and the write-off of $4.1 million of deferred debt issuance costs relating to the original credit agreement.

Loss on Interest Rate Swaps. Loss on interest rate swaps for the current period was $5.9 million. The modification of the senior credit facility effective March 27, 2009 resulted in the interest rate swaps becoming ineffective as cash flow hedges and are therefore carried at fair value. The loss relates to the impact on the determination of fair value associated with the general decline in short term interest rates implied in the current forward yield curve.

On March 27, 2009, we entered into an amendment to the senior secured credit facility, which was considered an extinguishment of debt under ASC 470-50. As a result, the previously hedged interest payments will not occur. Therefore, the amount recorded in accumulated other comprehensive loss through March 27, 2009 was reclassified to earnings as loss on interest rate swaps. Subsequent to March 27, 2009, we record changes in the fair value of the derivative instruments in earnings, as gain or loss on interest rate swaps.

Interest Expense. Interest expense for the current period increased $3.0 million, or 21.3%, compared with the prior period. This increase reflects the amortization of loan discount of $4.0 million resulting from the modification of the senior credit facility as well as the increased interest rate, which was partially offset by a lower loan balance due to principal reductions.

Income Taxes. Income tax benefit for the current period was $5.1 million, or an effective rate of 76.1%, as compared with income tax benefit of $3.0 million, or an effective rate of 113.5%, for the prior year period. The lower effective tax rate for the current period was primarily due to the higher level of tax-exempt income in 2008 partially offset by the reversal of a $1.0 million valuation allowance in 2009 resulting from management’s assessment that it is more likely than not that capital loss carryforwards will be utilized.

Discontinued Operations. On June 24, 2009, the Company sold all of its retail stores and its franchise business in Florida effective May 31, 2009. The results of operations of the sold business have been classified as discontinued operations in the consolidated statements of income.

LIQUIDITY AND CAPITAL RESOURCES

Sources and uses of funds. We are a holding company with no business operations of our own. Consequently, our ability to pay dividends to stockholders, meet our debt payment obligations and pay our taxes and administrative expenses is largely dependent on dividends or other distributions from our subsidiaries.

The payment of dividends by our non-insurance company subsidiaries are restricted under the terms of the amendment to the senior secured credit facility. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally used to service our corporate financial obligations, such as debt service under the terms of the amendment to the senior secured credit facility. As of September 30, 2009, we had $9.8 million of cash and equivalents at the holding company level and $14.8 million of cash and cash equivalents at our non-insurance company subsidiaries.

State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of September 30, 2009, our insurance companies could not pay ordinary dividends to us without prior regulatory approval due to a negative unassigned surplus position. However, as mentioned previously, our nonregulated entities provide adequate cash flow to fund their own operations. In February 2009, we obtained approval from the New York Department of Insurance for one of our insurance subsidiaries to retire one million shares of its stock for $2.9 million and approved payment of an extraordinary dividend for $0.1 million.

The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At September 30, 2009, each of our insurance subsidiaries maintained a risk-based capital level that was in excess of the amount that would require any corrective actions.

 

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Our operating subsidiaries’ primary sources of funds are premiums received, commission and fee income, investment income and the proceeds from the sale and maturity of investments. Funds are used to pay claims and operating expenses, to purchase investments and to pay dividends to our holding company.

We believe that existing cash and investment balances, as well as new cash flows generated from operations and available borrowings under our other credit facilities, will be adequate to meet our capital and liquidity needs during the 12-month period following the date of this report at both the holding company and insurance company levels. We do not currently know of any events that could cause a material increase or decrease in our long-term liquidity needs other than the debt service requirements of the senior secured credit facility.

Senior secured credit facility. On March 27, 2009, we entered into an amendment to the facility. The amendment included the following changes:

 

   

The leverage ratio covenant calculation was changed to include only amounts borrowed under the facility. In addition, the quarterly requirements were changed for the remaining term of the facility;

 

   

The interest coverage ratio covenant calculation was changed to include only interest expense paid in cash. In addition, the quarterly requirements were changed for the remaining term of the facility;

 

   

The combined ratio covenant was replaced with a loss ratio covenant;

 

   

The fixed charge coverage ratio was changed to include only interest expense paid in cash. In addition, the annual requirements were changed for the remaining term of the facility;

 

   

The consolidated net worth covenant calculation was changed to a covenant that excludes goodwill and includes subordinated debt;

 

   

Asset sales are now allowed for transactions with less than 80% of cash proceeds. Financing is limited to $5.0 million per transaction and $10.0 million in the aggregate;

 

   

A sale and leaseback transaction of capitalized technology assets is allowed for up to $30.0 million;

 

   

The pricing under the agreement was changed as follows:

 

   

A LIBOR floor of 3.0% was established.

 

   

Pricing depends on the amount of the leverage ratio. If the leverage ratio is greater than 2.0, the pricing is LIBOR plus 6.25%. If the leverage ratio is greater than 1.5 and less than or equal to 2.0, the pricing is LIBOR plus 6.00%. If the leverage ratio is less than or equal to 1.5, the pricing is LIBOR plus 5.75%;

 

   

Common stock dividends are permitted only if the leverage ratio is less than or equal to 1.5;

 

   

The annual excess cash flow payment was changed to 50 percent of non-regulated cash flow and 75 percent of dividends paid from regulated insurance companies; and

 

   

The revolving facility was reduced from $20.0 million to $10.0 million.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We are principally exposed to two types of market risk: interest rate risk and credit risk.

Interest rate risk. Our investment portfolio consists of investment-grade, fixed-income securities classified as available-for-sale investment securities and auction-rate tax-exempt securities classified as trading. Accordingly, the primary market risk exposure to our debt securities is interest rate risk. In general, the fair market value of a portfolio of fixed-income securities increases or decreases inversely with changes in market interest rates, while net investment income realized from future investments in fixed-income securities increases or decreases along with interest rates. In addition, some of our fixed-income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall and issuers call their securities and we reinvest at lower interest rates. We attempt to mitigate this interest rate risk by investing in securities with varied maturity dates and by managing the duration of our investment portfolio to a defined range of less than three years. The fair value of our fixed-income securities as of September 30, 2009 was $267.1 million. The effective average duration of the portfolio as of September 30, 2009 was 1.48 years. If market interest rates increase 1.0%, our fixed-income investment portfolio would be expected to decline in market value by 1.48%, or $4.0 million, representing the effective average duration multiplied by the change in market interest rates. Conversely, a 1.0% decline in interest rates would result in a 1.48%, or $4.0 million, increase in the market value of our fixed-income investment portfolio.

Our senior secured credit facility is also subject to interest rate risk. During the first quarter of 2009, we entered into an amendment that changed the pricing to be tiered based on the leverage ratio and includes a LIBOR floor of 3.0%. The interest rate is floating based on LIBOR plus increments tied to the Company’s leverage ratio. If the leverage ratio is greater than 2.0, the pricing is LIBOR plus 6.25%. If the leverage ratio is greater than 1.5 and less than or equal to 2.0, the pricing is LIBOR plus 6.00%. If the leverage ratio is less than or equal to 1.5, the pricing is LIBOR plus 5.75%.

 

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Derivative financial instruments are reported at fair value on the consolidated balance sheet. Our current derivative instruments consist of two interest rate swaps entered into in 2007 and 2008, with an aggregate notional amount of $115.0 million outstanding at September 30, 2009. One swap instrument has a notional amount outstanding of $50.0 million that requires quarterly settlements whereby we pay a fixed rate of 4.993% and receive a three-month LIBOR rate. The second interest rate swap has a notional amount of $65.0 million outstanding, for which we pay a fixed rate of 3.031% and receive a three-month LIBOR rate. The interest rate swaps were previously designated as hedges against the variability of cash flows associated with that portion of the senior secured credit facility.

Credit risk. An additional exposure to our fixed-income securities portfolio is credit risk. We attempt to manage our credit risk by investing only in investment-grade securities and limiting our exposure to a single issuer. At September 30, 2009, our fixed-income investments were invested in the following: U.S. Treasury and government agencies securities 5.5%, corporate debt securities 24.4%, resident mortgaged-backed securities 1.9% and states and political subdivisions securities 68.2%. At September 30, 2009, all of our fixed-income securities were rated “A” or better by nationally recognized statistical rating organizations. The average quality of our portfolio was “AA” at September 30, 2009.

We invest our insurance portfolio funds in highly-rated, fixed-income securities. Information about our investment portfolio is as follows ($ in thousands):

 

     September 30,
2009
    December 31,
2008
 

Total invested assets

   $ 267,141      $ 259,143   

Tax-equivalent book yield

     4.42     4.75

Average duration in years

     1.48        1.58   

Average S&P rating

     AA        AA   

We are subject to credit risks with respect to our reinsurers. Although a reinsurer is liable for losses to the extent of the coverage which it assumes, our reinsurance contracts do not discharge our insurance companies from primary liability to each policyholder for the full amount of the applicable policy, and consequently our insurance companies remain obligated to pay claims in accordance with the terms of the policies regardless of whether a reinsurer fulfills or defaults on its obligations under the related reinsurance agreement. In order to mitigate credit risk to reinsurance companies, we attempt to select financially strong reinsurers with an A.M. Best rating of “A-” or better and continue to evaluate their financial condition.

The table below presents the total amount of receivables due from reinsurance as of September 30, 2009 and December 31, 2008, respectively (in thousands):

 

     September 30,
2009
   December 31,
2008

Michigan Catastrophic Claims Association

   $ 17,492    $ 15,989

Vesta Insurance Group

     14,302      14,223

Quota-share reinsurer for Louisiana and Alabama business

     6,363      28,951

Other

     3,907      4,168
             

Total reinsurance recoverable

   $ 42,064    $ 63,331
             

Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), our wholly-owned subsidiaries, Affirmative Insurance Company (AIC) and Insura Property and Casualty Insurance Company (Insura), had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize gross amounts due from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement effective September 2004. In August 2005, AIC received a letter from VFIC’s President that irrevocably confirmed VFIC’s duty and obligation under the Security Fund Agreement to provide security sufficient to satisfy VFIC’s gross obligations under the reinsurance agreement (the VFIC Trust). At September 30, 2009, the VFIC Trust held $17.4 million consisting of $12.6 million of a U.S. Treasury money market account and $4.8 million of corporate bonds rated BBB or higher (after cumulative withdrawals of $7.6 million through September 30, 2009), to collateralize the $14.3 million gross recoverable from VFIC.

At September 30, 2009, net amounts owed by AIC and Insura under reinsurance agreements with the VIG-affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian) were $13.2 million. Affirmative established a trust account to collateralize this payable, which currently holds $22.4 million (including accrued interest) in securities (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through September 2009.

As part of the terms of the acquisition of AIC and Insura, VIG has indemnified us for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of September 30, 2009, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better.

 

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Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 (Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the United States Securities and Exchange Commission rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our Disclosure Committee and management, including the principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rules 13a-15(b) and 15d-15(b). Based upon this evaluation, the principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective as of September 30, 2009.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings

See Note 11 of Notes to Consolidated Financial Statements, “Legal and Regulatory Proceedings.”

 

Item 1A. Risk Factors

There are no material changes to those risk factors previously disclosed in Item 1A to Part I of our Form 10-K for the fiscal year ended December 31, 2008.

 

Item 6. Exhibits

 

  31.1 Certification of Kevin R. Callahan, Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

  31.2 Certification of Michael J. McClure, Chief Financial Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

  32.1 Certification of Kevin R. Callahan, Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

  32.2 Certification of Michael J. McClure, Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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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.

 

    Affirmative Insurance Holdings, Inc.
Date: November 9, 2009    
   

/s/ Michael J. McClure

  By:   Michael J. McClure
    Executive Vice President and Chief Financial Officer
    (and in his capacity as Principal Financial Officer)

 

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