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EX-31.2 - CERTIFICATION OF MICHAEL J. MCCLURE, CHIEF FINANCIAL OFFICER - AFFIRMATIVE INSURANCE HOLDINGS INCdex312.htm
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EX-32.1 - CERTIFICATION OF KEVIN R. CALLAHAN, CHIEF EXECUTIVE OFFICER - AFFIRMATIVE INSURANCE HOLDINGS INCdex321.htm
EX-32.2 - CERTIFICATION OF MICHAEL J. MCCLURE, CHIEF FINANCIAL OFFICER - AFFIRMATIVE INSURANCE HOLDINGS INCdex322.htm
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 June 30, 2010

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

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 August 16, 2010: 15,415,358

 

 

 

 


Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC.

SIX MONTHS ENDED JUNE 30, 2010

INDEX TO FORM 10-Q

 

PART I – FINANCIAL INFORMATION

   3

Item 1. Financial Statements

   3

Consolidated Balance Sheets – June 30, 2010 and December 31, 2009

   3

Consolidated Statements of Income (Loss) – Three and Six Months Ended June 30, 2010 and 2009

   4

Consolidated Statements of Stockholders’ Equity – Six Months Ended June 30, 2010 and 2009

   5

Consolidated Statements of Comprehensive Income (Loss) – Three and Six Months Ended June  30, 2010 and 2009

   5

Consolidated Statements of Cash Flows – Six Months Ended June 30, 2010 and 2009

   6

Notes to Consolidated Financial Statements

   7

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

   20

Item 3. Quantitative and Qualitative Disclosures About Market Risk

   29

Item 4. Controls and Procedures

   30

PART II – OTHER INFORMATION

   32

Item 1. Legal Proceedings

   32

Item 1A. Risk Factors

   32

Item 6. Exhibits

   32

SIGNATURES

   33

 

2


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)

 

     June 30,
2010
    December 31,
2009
 
     (Unaudited)        

Assets

    

Investment securities, at fair value

    

Trading securities

   $ 12,166      $ 37,416   

Available-for-sale securities

     220,898        213,656   

Cash and cash equivalents

     81,918        60,928   

Fiduciary and restricted cash

     6,888        15,004   

Accrued investment income

     1,882        2,823   

Premiums and fees receivable, net

     54,477        63,344   

Premium finance receivable, net

     44,447        40,825   

Commissions receivable

     2,013        1,362   

Receivable from reinsurers

     41,877        42,082   

Deferred acquisition costs

     24,276        24,230   

Federal income taxes receivable

     3,083        3,326   

Investment in real property, net

     9,792        5,831   

Property and equipment (net of accumulated depreciation of $37,808 for 2010 and $33,581 for 2009)

     40,314        41,984   

Goodwill

     163,570        163,570   

Other intangible assets (net of accumulated amortization of $12,919 for 2010 and $12,765 for 2009)

     16,598        16,752   

Prepaid expenses

     6,047        5,750   

Other assets, (net of allowance for doubtful accounts of $7,213 for 2010 and 2009) (Includes other receivables of $3,199 at June 30, 2010 and $8,830 at December 31, 2009)

     5,454        12,397   
                

Total assets

   $ 735,700      $ 751,280   
                

Liabilities and Stockholders’ Equity

    

Liabilities:

    

Reserves for losses and loss adjustment expenses

   $ 183,425      $ 193,647   

Unearned premium

     108,309        109,361   

Amounts due to reinsurers

     4,465        4,037   

Deferred revenue

     8,639        10,190   

Capital lease obligation

     27,611        —     

Senior secured credit facility

     97,661        111,506   

Notes payable

     76,882        76,891   

Deferred tax liability

     11,457        10,820   

Other liabilities (Includes swap of $2,800 at June 30, 2010 and $4,108 at December 31, 2009)

     51,058        51,473   
                

Total liabilities

     569,507        567,925   
                

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 June 30, 2010 and December 31, 2009

     178        178   

Additional paid-in capital

     165,138        164,752   

Treasury stock, at cost (2,353,363 shares at June 30, 2010 and December 31, 2009)

     (32,880     (32,880

Accumulated other comprehensive income

     886        2,859   

Retained earnings

     32,871        48,446   
                

Total stockholders’ equity

     166,193        183,355   
                

Total liabilities and stockholders’ equity

   $ 735,700      $ 751,280   
                

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
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  
     (Unaudited)  

Revenues

        

Net premiums earned

   $ 96,415      $ 94,221      $ 189,137      $ 187,445   

Commission income and fees

     22,265        19,879        45,860        40,451   

Net investment income

     1,116        2,416        2,575        4,885   

Net realized gains

     3,525        2,592        7,180        589   

Other income (loss)

     (3,220     (2,061     (5,033     537   
                                

Total revenues

     120,101        117,047        239,719        233,907   
                                

Expenses

        

Losses and loss adjustment expenses

     80,887        81,890        151,912        151,568   

Selling, general and administrative expenses

     42,547        39,516        85,086        79,636   

Depreciation and amortization

     2,383        2,397        4,815        4,790   
                                

Total expenses

     125,817        123,803        241,813        235,994   
                                

Operating income (loss)

     (5,716     (6,756     (2,094     (2,087

Gain on extinguishment of debt

     —          —          —          19,434   

Loss on interest rate swaps

     89        516        610        4,946   

Interest expense

     5,916        6,576        12,036        10,718   
                                

Income (loss) from continuing operations before income tax expense

     (11,721     (13,848     (14,740     1,683   

Income tax expense (benefit)

     390        (5,821     835        (1,462
                                

Income (loss) from continuing operations

     (12,111     (8,027     (15,575     3,145   

Discontinued operations

        

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

     —          (1,322     —          (1,789

Income tax benefit

     —          (344     —          (462
                                

Loss from discontinued operations

     —          (978     —          (1,327
                                

Net income (loss)

   $ (12,111   $ (9,005   $ (15,575   $ 1,818   
                                

Basic income (loss) per common share:

        

Continuing operations

   $ (0.79   $ (0.52   $ (1.01   $ 0.21   

Discontinued operations

     —          (0.06     —          (0.09
                                

Net income (loss)

   $ (0.79   $ (0.58   $ (1.01   $ 0.12   
                                

Diluted income (loss) per common share:

        

Continuing operations

   $ (0.79   $ (0.52   $ (1.01   $ 0.21   

Discontinued operations

     —          (0.06     —          (0.09
                                

Net income (loss)

   $ (0.79   $ (0.58   $ (1.01   $ 0.12   
                                

Weighted average common shares outstanding:

        

Basic

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

Diluted

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

See accompanying Notes to Consolidated Financial Statements

 

4


Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands, except share data)

 

     Six Months Ended June 30,  
     2010     2009  
     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

        164,752           163,707   

Stock-based compensation expense

        386           516   
                      

Balance at end of period

        165,138           164,223   
                      

Retained earnings

          

Balance at beginning of year

        48,446           87,327   

Net income (loss)

        (15,575        1,818   
                      

Balance at end of period

        32,871           89,145   
                      

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

        2,859           (1,849

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

        (1,973        678   

Gain on cash flow hedges transferred to earnings, net of tax

        —             3,858   
                      

Balance at end of period, net of tax

        886           2,687   
                      

Total stockholders’ equity

      $ 166,193         $ 223,353   
                      

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  
     (Unaudited)  

Net income (loss)

   $ (12,111   $ (9,005   $ (15,575   $ 1,818   

Other comprehensive income (loss):

        

Unrealized gain (loss) arising during period, net of tax

     (64     155        (617     802   

Reclassification adjustment for gains included in net income, net of tax

     (163     —          (1,356     (124

Unrealized gain on cash flow hedges, net of tax

     —          —          —          3,858   
                                

Other comprehensive income (loss), net

     (227     155        (1,973     4,536   
                                

Total comprehensive income (loss)

   $ (12,338   $ (8,850   $ (17,548   $ 6,354   
                                

See accompanying Notes to Consolidated Financial Statements

 

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Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Six Months Ended
June 30,
 
     2010     2009  
     (Unaudited)  

Cash flows from operating activities

    

Net income (loss)

   $ (15,575   $ 1,818   

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

    

Depreciation and amortization

     4,815        4,823   

Stock-based compensation expense

     544        553   

Amortization of debt issuance and modification costs

     254        434   

Amortization of debt discount

     3,448        2,065   

Net realized gains from sales of available-for-sale securities

     (1,356     (191

Realized gain on trading securities

     (5,825     (398

Fair value (gain) loss on settlement rights for auction-rate securities

     5,631        (537

Loss on disposal of assets (including sale of business)

     1        962   

Amortization of premiums on investments, net

     1,604        1,645   

Provision for doubtful receivables

     226        528   

Gain on extinguishment of debt

     —          (19,434

Loss on interest rate swaps

     610        4,946   

Change in operating assets and liabilities:

    

Fiduciary and restricted cash

     8,116        3,548   

Premiums, fees and commissions receivable

     7,990        (5,272

Reserves for losses and loss adjustment expenses

     (10,222     (1,085

Amounts due from reinsurers

     633        16,040   

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

     (6,480     (2,373

Deferred revenue

     (1,551     2,942   

Unearned premium

     (1,052     5,919   

Deferred acquisition costs

     (46     (2,739

Deferred tax liability

     637        (2,087

Federal income taxes receivable

     243        232   

Other

     (3,684     3,394   
                

Net cash provided by (used in) operating activities

     (11,039     15,733   
                

Cash flows from investing activities

    

Proceeds from sales of available-for-sale securities

     77,040        6,810   

Proceeds from maturities of available-for-sale securities

     37,856        36,989   

Proceeds from sales of trading securities

     31,075        1,300   

Purchases of available-for-sale securities

     (120,093     (63,241

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

     2,858        (1,346

Purchases of property and equipment

     (3,006     (3,981

Proceeds from sale of business

     —          250   

Improvements to investment in real property

     (4,019     —     
                

Net cash provided by (used in) investing activities

     21,711        (23,219
                

Cash flows from financing activities

    

Proceeds from financing under capital lease obligation

     28,189        —     

Principal payments under capital lease obligation

     (578     —     

Principal payments on senior secured credit facility

     (17,293     (5,986

Debt issuance costs paid

     —          (2,532
                

Net cash provided by (used in) financing activities

     10,318        (8,518
                

Net increase (decrease) in cash and cash equivalents

     20,990        (16,004

Cash and cash equivalents at beginning of year

     60,928        66,513   
                

Cash and cash equivalents at end of period

   $ 81,918      $ 50,509   
                

Supplemental disclosure of cash flow information:

    

Cash paid for interest

   $ 8,315      $ 8,214   

Cash paid for income taxes

     313        1,832   

See accompanying Notes to Consolidated Financial Statements

 

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Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

 

1. General

Affirmative Insurance Holdings, Inc., formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware in June 1998. The Company is a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic areas. The Company currently offers insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas and Wisconsin) as well as through 9,400 independent agents or brokers in 10 states (Louisiana, Texas, Illinois, Alabama, California, Michigan, 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, 2009 included in the Company’s Annual Report on Form 10-K.

The consolidated balance sheet at December 31, 2009 was derived from the audited financial statements at that date, but does not include all of the information and notes required by GAAP. All material intercompany transactions and balances have been eliminated in consolidation.

Certain prior year amounts have been reclassified to conform to the current presentation.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires the Company 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

ASU 2009-17 amended the standards for determining whether to consolidate a variable interest entity. These new standards amended the evaluation criteria to identify the primary beneficiary of a variable interest entity and require ongoing reassessment of whether an enterprise is the primary beneficiary of the variable interest entity. The provisions of the new standards are effective for annual reporting periods beginning after November 15, 2009 and interim periods within those fiscal years. The adoption of this new standard effective January 1, 2010 did not impact the Company’s consolidated financial position, results of operations or cash flows.

ASU 2009-16 eliminated 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. The provisions of the new standards are effective for fiscal years beginning after November 15, 2009. The adoption of the new standard effective January 1, 2010 did not impact the Company’s consolidated financial position, results of operations or cash flows.

ASU 2010-06 requires additional disclosures about fair value measurements, including transfers in and out of Levels 1 and 2 and activity in Level 3 on a gross basis, and clarifies certain other existing disclosure requirements including level of disaggregation and disclosures around inputs and valuation techniques. The provisions of the new standards are effective for interim or annual reporting periods beginning after December 15, 2009, except for the additional Level 3 disclosures which will become effective for fiscal years beginning after December 15, 2010. These standards are disclosure only in nature and do not change accounting requirements. Accordingly, adoption of the new standard had no impact on the Company’s consolidated financial position, results of operations or cash flows.

 

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3. Trading Investment Securities

The Company’s trading investment securities consist solely of auction-rate tax-exempt securities, which are carried at fair value with realized gains and losses reported in current period earnings. The Company had redemptions of $23.7 million and $31.1 million, at par, during the three and six months ended June 30, 2010.

The amortized cost, net realized losses and estimated fair value of the Company’s trading securities portfolio at June 30, 2010 and December 31, 2009, were as follows (in thousands):

 

     Amortized
Cost
   Net Realized
Losses
    Fair
Value

June 30, 2010

   $ 15,365    $ (3,199   $ 12,166

December 31, 2009

   $ 46,440    $ (9,024   $ 37,416

In October 2008, the Company’s broker filed a prospectus with the Securities and Exchange Commission (SEC), which published a legally-binding offer to all authorized holders of auction-rate securities to purchase all eligible securities at par (“the settlement”). The time frames set by the Company’s broker 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 the Company’s broker. In November 2008, the Company elected to participate in its broker’s offer to purchase the Company’s auction-rate securities at par and classified its portfolio of auction-rate securities as trading. The settlement agreement requires the Company’s broker to purchase eligible securities at par, at any time during a two-year period beginning June 30, 2010. All auction-rate securities held at June 30, 2010 are eligible for buyback under the settlement agreements. At June 30, 2010 and December 31, 2009, the fair value of the settlement was $3.2 million and $8.8 million, respectively, which is recorded in other assets in the consolidated balance sheets with changes in fair value recorded in other income in the consolidated statement of income (loss).

 

4. Available-for-Sale Investment Securities

The Company’s available-for-sale investment securities are carried at fair value with unrealized gains and losses, net of income taxes, reported in accumulated other comprehensive income, a separate component of stockholders’ equity. Gains and losses realized on the disposition of investment securities are determined on the specific-identification basis and credited or charged to income. 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.

The amortized cost, gross unrealized gains (losses), and estimated fair value of the Company’s available-for-sale securities at June 30, 2010, and December 31, 2009, were as follows (in thousands):

 

     Amortized
Cost
   Gross
Unrealized
Gains
   Gross
Unrealized
Losses
    Fair Value

June 30, 2010

          

U.S. Treasury and government agencies

   $ 31,209    $ 215    $ (26   $ 31,398

Residential mortgage-backed securities

     3,733      361      —          4,094

States and political subdivisions

     28,852      488      (4     29,336

Corporate debt securities

     126,594      1,564      (173     127,985

FDIC-insured certificates of deposit

     28,085      —        —          28,085
                            

Total

   $ 218,473    $ 2,628    $ (203   $ 220,898
                            

December 31, 2009

          

U.S. Treasury and government agencies

   $ 24,529    $ 212    $ (99   $ 24,642

Residential mortgage-backed securities

     4,342      322      —          4,664

States and political subdivisions

     117,659      2,667      (21     120,305

Corporate debt securities

     62,728      1,346      (29     64,045
                            

Total

   $ 209,258    $ 4,547    $ (149   $ 213,656
                            

 

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Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. The Company’s amortized cost and estimated fair values of fixed-income securities at June 30, 2010 by contractual maturity were as follows (in thousands):

 

     Amortized
Cost
   Fair Value

Due in one year or less

   $ 54,626    $ 55,046

Due after one year through five years

     156,270      157,851

Due after five years through ten years

     3,844      3,907

Residential mortgage-backed securities

     3,733      4,094
             

Total

   $ 218,473    $ 220,898
             

At June 30, 2010, the Company owned approximately $1.2 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.

The Company’s amortized cost and estimated fair value of pre-refunded municipal bonds at June 30, 2010 by contractual maturity were as follows (in thousands):

 

     Amortized
Cost
   Fair Value

Due in one year or less

   $ 1,001    $ 1,002

Due after one year through five years

     163      166
             

Total

   $ 1,164    $ 1,168
             

Gross realized gains and losses on available-for-sale investments for the six months ended June 30 were as follows (in thousands):

 

     2010     2009

Gross gains

   $ 1,397      $ 191

Gross losses

     (41     —  
              

Total

   $ 1,356      $ 191
              

The following table summarizes the Company’s available-for-sale securities in an unrealized loss position at June 30, 2010, and December 31, 2009, the fair value and amount of gross unrealized losses, aggregated by investment category and length of time those securities have been continuously in an unrealized loss position (in thousands):

 

     June 30, 2010  
     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

   $ 18,170    $ (26   $ —      $ —        $ 18,170    $ (26

States and political subdivisions

     284      (2     750      (2     1,034      (4

Corporate debt securities

     29,852      (173     —        —          29,852      (173
                                             

Total

   $ 48,306    $ (201   $ 750    $ (2   $ 49,056    $ (203
                                             

 

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     December 31, 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
 

U.S. Treasury and government agencies

   $ 10,930    $ (99   $ —      $ —        $ 10,930    $ (99

States and political subdivisions

     2,605      (12     745      (9     3,350      (21

Corporate debt securities

     5,168      (29     —        —          5,168      (29
                                             

Total

   $ 18,703    $ (140   $ 745    $ (9   $ 19,448    $ (149
                                             

The Company’s portfolio contains approximately 41 individual investment securities that are in an unrealized loss position as of June 30, 2010.

The unrealized losses at June 30, 2010 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 June 30, 2010, management performed its quarterly analysis of all securities with an unrealized loss and concluded no individual securities were other-than-temporarily impaired.

 

5. Reinsurance

In the ordinary course of business, the Company places reinsurance with other insurance companies in order to provide greater diversification of its business and limit the potential for losses arising from large risks. In addition, the Company assumes reinsurance from other insurance companies.

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

 

     Three Months Ended June 30,  
     2010     2009  
     Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
    Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
 

Direct

   $ 58,662      $ 78,541      $ 66,277      $ 63,311      $ 77,152      $ 70,384   

Reinsurance assumed

     14,299        19,010        16,639        18,996        17,693        13,044   

Reinsurance ceded

     (238     (1,136     (2,029     (514     (624     (1,538
                                                

Total

   $ 72,723      $ 96,415      $ 80,887      $ 81,793      $ 94,221      $ 81,890   
                                                
     Six Months Ended June 30,  
     2010     2009  
     Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
    Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
 

Direct

   $ 156,403      $ 153,664      $ 123,217      $ 152,731      $ 154,982      $ 128,788   

Reinsurance assumed

     33,640        37,936        33,111        41,737        33,773        25,098   

Reinsurance ceded

     (2,449     (2,463     (4,416     9,193        (1,310     (2,318
                                                

Total

   $ 187,594      $ 189,137      $ 151,912      $ 203,661      $ 187,445      $ 151,568   
                                                

 

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Under certain of the Company’s reinsurance transactions, the Company has received 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. The ceding commissions recognized were reflected as a reduction (increase) of the following expenses (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010    2009     2010    2009  

Selling, general and administrative expenses

   $ 1    $ (623   $ 10    $ (2,987

Loss adjustment expenses

     19      143        35      332   
                              

Total

   $ 20    $ (480   $ 45    $ (2,655
                              

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

 

     June 30,
2010
   December 31,
2009

Losses and loss adjustment expense reserves

   $ 33,660    $ 32,447

Unearned premium reserve

     1,082      1,096
             

Total

   $ 34,742    $ 33,543
             

The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. For policies effective 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, the Company cedes 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. The Company’s ceded premiums written to the MCCA were $0.2 million and $0.3 million for the three months ended June 30, 2010 and 2009, and $2.2 million and $0.8 million for the six months ended June 30, 2010 and 2009, respectively.

At June 30, 2010, the Company’s total receivables from reinsurers were $41.9 million, consisting of $21.8 million receivable from the MCCA, $1.5 million from a quota-share reinsurer (rated A- by A.M. Best) for business reinsured in Louisiana and Alabama, $13.9 million net receivable (net of $2.5 million payable) from subsidiaries of Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC) and $4.7 million receivables from other reinsurers. Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), the Company’s 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 June 30, 2010, the VFIC Trust held $16.8 million (after cumulative withdrawals of $8.5 million through June 30, 2010), consisting of $11.9 million of a U.S. Treasury money market account and $4.9 million of corporate bonds rated BBB or higher, to collateralize the $13.9 million net recoverable from VFIC.

The Company assumes reinsurance from a Texas county mutual insurance company (the county mutual) whereby the Company has assumed 100% of the policies issued by the county mutual for business produced by the Company’s owned managing general agents (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 on any annual anniversary upon prior written notice of not less than 90 days. AIC has established a trust to secure the Company’s obligation under this reinsurance contract with a balance of $47.0 million as of June 30, 2010.

At June 30, 2010, $11.1 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $21.6 million in securities (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through June 2010, and the Special Deputy Receiver in Hawaii had cumulative withdrawals from the AIC Trust of $1.7 million through June 2010.

 

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6. Premium Finance Receivables, Net

Premium finance receivables (related to policies of both the Company and third-party carriers) are secured by unearned premiums from the underlying insurance policies and consisted of the following at June 30, 2010 and December 31, 2009 (in thousands):

 

     June 30,
2010
    December 31,
2009
 

Premium finance contracts

   $ 47,219      $ 43,473   

Unearned finance charges

     (2,287     (2,216

Allowance for credit losses

     (485     (432
                

Total

   $ 44,447      $ 40,825   
                

 

7. Deferred Policy Acquisition Costs

Policy acquisition costs, consisting of primarily commissions, 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 amortization expense were as follows (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  

Beginning balance

   $ 28,945      $ 25,807      $ 24,230      $ 21,993   

Additions

     17,742        19,084        42,744        40,974   

Amortization

     (22,411     (20,159     (42,698     (38,235
                                

Ending balance

   $ 24,276      $ 24,732      $ 24,276      $ 24,732   
                                

 

8. Debt

The Company’s long-term debt instruments and balances outstanding at June 30, 2010 and December 31, 2009 were as follows (in thousands):

 

     2010    2009

Notes payable due 2035

   $ 30,928    $ 30,928

Notes payable due 2035

     25,774      25,774

Notes payable due 2035

     20,180      20,189
             

Total notes payable

     76,882      76,891

Senior secured credit facility

     97,661      111,506
             

Total long-term debt

   $ 174,543    $ 188,397
             

The $30.9 million notes payable bear an initial interest rate of 7.545% until March 15, 2010, at which time the securities adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of June 30, 2010 was 4.14%.

The $25.8 million notes payable due 2035 bear an initial interest rate of 7.792% until June 15, 2010, at which time they adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of June 30, 2010 was 4.09%.

The $20.2 million notes payable due 2035 bear an interest rate of the three-month LIBOR rate plus 3.95% not exceeding 12.50% through March 2010 with no limit thereafter. The interest rate as of June 30, 2010 was 4.49%.

The pricing under the senior secured credit facility is currently subject to a LIBOR floor of 3.00% plus 6.25%, and is tiered based on the Company’s leverage ratio. The interest rate as of June 30, 2010 was 9.25%.

During the first six months of 2010, the Company made its scheduled quarterly payments of $0.6 million and additional payments of $16.7 million on the senior secured credit facility. As of June 30, 2010, the principal balance of the senior secured credit facility was $112.7 million. The revolving portion of the facility expired in January 2010. As of June 30, 2010, the Company was in compliance with all of its financial and other covenants for the senior secured credit facility.

 

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9. Capital Lease Obligation

In May 2010, the Company entered into a capital lease obligation related to certain computer software, software licenses, and hardware used in the Company’s insurance operations. The Company received cash proceeds from the financing in the amount of $28.2 million. As required by the lease agreements, the Company purchased $28.2 million of FDIC-insured certificates of deposit held in brokerage accounts and pledged as collateral against all of the Company’s obligations under the lease. The dollar amount of collateral pledged is set to decline over the term of the lease as the Company makes the scheduled lease payments. The lease term is 60 months with monthly rental payments totaling approximately $0.6 million. At the end of the initial term, the Company will have the right to purchase the software for a nominal fee, after which all rights, title and interest would transfer to the Company. The Company’s capital lease obligation was $27.6 million at June 30, 2010.

Property under capital lease at June 30, 2010 and December 31, 2009 were as follows (in thousands):

 

     2010    2009
     Cost    Accumulated
Depreciation
    Net    Cost    Accumulated
Depreciation
   Net

Computer software, software licenses and hardware

   $ 28,189    $ (1,648   $ 26,541    $ —      $ —      $ —  
                                          

Lease expense for property under capital lease was as follows (in thousands):

 

Lease expense for the six months ended June 30:

  

2010

   $ 823

Estimated future lease payments for the years ending December 31:

  

2010

   $ 2,807

2011

     6,736

2012

     6,736

2013

     6,736

2014

     6,736

2015

     3,368
      

Total estimated future lease payments

     33,119

Less: Amount representing interest

     5,508
      

Present value of future lease payments

   $ 27,611
      

 

10. Income Taxes

The provision for income taxes for the three and six months ended June 30, 2010 and 2009 consisted of the following (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010    2009     2010    2009  

Current tax expense

   $ 77    $ 1,610      $ 198    $ 1,088   

Deferred tax expense (benefit)

     313      (7,775     637      (3,012
                              

Net income tax expense (benefit)

   $ 390    $ (6,165   $ 835    $ (1,924
                              

 

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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
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  

Loss before income tax expense (benefit)

   $ (11,721   $ (15,170   $ (14,740   $ (106

Tax provision computed at the federal statutory income tax rate

     (4,103     (5,310     (5,159     (37

Increases (reductions) in tax resulting from:

        

Tax-exempt interest

     (93     (393     (309     (821

State income taxes

     81        24        65        112   

Valuation allowance

     4,467        (1,008     6,156        (1,008

Other

     38        522        82        (170
                                

Income tax expense (benefit)

   $ 390      $ (6,165   $ 835      $ (1,924
                                

Effective tax rate

     (3.3 )%      40.6     (5.7 )%      1,815.1
                                

Net deferred tax assets prior to recognition of the valuation allowance were $27.0 million and $20.8 million at June 30, 2010 and December 31, 2009, respectively. In assessing the realizability of its deferred tax assets, the Company considered whether it was more likely than not that its deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, the Company began recording a valuation allowance against deferred taxes in December 2009. As of June 30, 2010, the valuation allowance was $38.5 million.

In August 2010, the Company received a Revenue Agents Report for the 2006 Internal Revenue Service (IRS) audit. The IRS had one proposed adjustment related to the loss reserve deductions for 2006, which the Company plans to appeal.

 

11. Legal and Regulatory Proceedings

The Company and its subsidiaries are named from time to time as parties in various legal actions arising in the ordinary course of the Company’s business and arising out of or related to claims made in connection with the Company’s insurance policies and claims handling. The Company believes 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 August 2009, plaintiff Sunrise Business Resources, Inc. (Sunrise) filed suit against Affirmative Insurance Company in the Superior Court for the State of California, County of Los Angeles. Sunrise alleges that it is due approximately $722,000 in deferred compensation arising out of a Claims Administration Agreement between itself and Hawaiian Insurance & Guaranty Company (HIG). AIC, along with other third-party reinsurance companies, were parties to Quota Share Reinsurance Contracts with HIG during 2004 through June 30, 2006. Affirmative removed the action to the U.S. District Court for the Central District of California. On July 23, 2010, the Court entered a final dismissal order pursuant to the parties’ settlement.

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. On August 5, 2010, the Court issued an order dismissing plaintiff’s claims for lack of subject matter jurisdiction.

In October 2009, plaintiff Dalton Johnson filed a putative class action in Palm Beach County, Florida against Affirmative Insurance Company. The complaint alleges that Affirmative failed to apply a statutorily-permitted fee schedule for hospital emergency care and services enacted into law in January 2008, thereby exhausting prematurely the PIP benefits available to Affirmative’s insureds. Plaintiff filed an amended complaint in March 2010, which was dismissed with prejudice on May 14, 2010. On June 4, 2010, plaintiff filed a notice of appeal of the dismissal. The Company believes that this claim lacks merit and intends to defend itself vigorously.

In January 2010, the Circuit Court of Cook County, Illinois granted plaintiff Valerie Thomas leave to amend her complaint to assert a putative class action against Affirmative Insurance Company. The complaint alleges that Affirmative failed to provide a statutory 5% premium discount to insureds who had anti-theft devices installed as standard equipment on their vehicles even when the insureds did not disclose the existence of such devices to Affirmative. The case has been consolidated with several identical class actions against other defendant insurance companies. On June 14, 2010, the court dismissed plaintiff’s breach of contract count, but

 

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denied Affirmative’s motion to dismiss as to all remaining counts. On July 19, 2010, Affirmative filed its answer to the amended complaint. The parties will proceed to discovery. The Company believes that this claim lacks merit and intends to defend itself vigorously.

From time to time, the Company and its subsidiaries are subject to random compliance audits from federal and state authorities regarding various operations within its business that involve collecting and remitting taxes in one form or another. In 2006, two of the Company’s wholly-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 the Company should have collected and remitted approximately $2.9 million in sales tax derived from claims services performed by the Company’s underwriting agencies for policies sold by these underwriting agencies and issued by a county mutual insurance company through a fronting arrangement. The Company’s 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. The Company believes that these services are not subject to sales tax and are vigorously contesting the assertions made by the state and exercising all available rights and remedies available to the Company. In October 2006, the Company 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 the Company’s petition, disputing the validity of positions set forth in the Company’s October 2006 petitions. On July 20, 2010, the Comptroller served the Company with its responses to the Company’s discovery requests. The Company is reviewing the Comptroller’s discovery responses and the Company intends 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 June 30, 2010.

 

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 1,260,900 and 1,724,531 for the three and six months ended June 30, 2010 and 2009, respectively, 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 the common stock and thus the inclusion would have been anti-dilutive.

The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for the three and six months ended June 30, 2010 and 2009 (in thousands, except per share amounts):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
     2010     2009     2010     2009

Numerator:

        

Income (loss) from continuing operations

   $ (12,111   $ (8,027   $ (15,575   $ 3,145
                              

Denominator:

        

Weighted average common shares outstanding

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

Weighted average diluted shares

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

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

   $ (0.79   $ (0.52   $ (1.01   $ 0.21
                              

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

   $ (0.79   $ (0.52   $ (1.01   $ 0.21
                              

 

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.

 

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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 ongoing evaluation of methodologies used by independent third-parties and monthly analytical reviews of the prices against current pricing trends and statistics.

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 prices 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 June 30, 2010 about the Company’s financial assets and liabilities measured at fair value on a recurring basis:

 

     June 30,
2010
   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

   $ 31,398    $ 31,398    $ —      $ —  

Residential mortgage-backed securities

     4,094      —        4,094      —  

States and political subdivisions

     29,336      —        29,336      —  

Corporate debt securities

     127,985      127,985      —        —  

FDIC-insured certificates of deposit

     28,085      —        28,085      —  

Auction-rate tax-exempt securities

     12,166      —        —        12,166
                           

Total investment securities

     233,064      159,383      61,515      12,166

Cash and cash equivalents

     81,918      81,918      —        —  

Fiduciary and restricted cash

     6,888      6,888      —        —  

Other receivables (other assets)

     3,199      —        —        3,199
                           

Total assets

   $ 325,069    $ 248,189    $ 61,515    $ 15,365
                           

Liabilities:

           

Interest rate swaps (other liabilities)

   $ 2,800    $ —      $ —      $ 2,800
                           

Total liabilities

   $ 2,800    $ —      $ —      $ 2,800
                           

 

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The following table provides information as of December 31, 2009 about the Company’s financial assets and liabilities measured at fair value on a recurring basis:

 

     December 31,
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

   $ 24,642    $ 24,642    $ —      $ —  

Residential mortgage-backed securities

     4,664      —        4,664      —  

States and political subdivisions

     120,305      —        120,305      —  

Corporate debt securities

     64,045      64,045      —        —  

Auction-rate tax-exempt securities

     37,416      —        —        37,416
                           

Total investment securities

     251,072      88,687      124,969      37,416

Cash and cash equivalents

     60,928      60,928      —        —  

Fiduciary and restricted cash

     15,004      15,004      —        —  

Other receivables (other assets)

     8,830      —        —        8,830
                           

Total assets

   $ 335,834    $ 164,619    $ 124,969    $ 46,246
                           

Liabilities:

           

Interest rate swaps (other liabilities)

   $ 4,108    $ —      $ —      $ 4,108
                           

Total liabilities

   $ 4,108    $ —      $ —      $ 4,108
                           

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.

Level 3 Financial assets and liabilities

The Company’s Level 3 financial assets include 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 with the Company’s broker to liquidate certain of the Company’s auction-rate tax-exempt securities. The settlement agreement requires the Company’s broker to purchase eligible securities at par, at any time during a two-year period beginning June 30, 2010. As of June 30, 2010, the Company held $15.4 million, at amortized cost, and $12.2 million fair value of auction-rate tax-exempt securities that are eligible for such settlement. The Company elected to record the settlement as a financial asset at fair value in accordance with ASC 825-10 Financial Instruments – Overall. The fair value of this agreement was estimated by third-party valuation sources to be $3.2 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.

 

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Fair value measurements for assets in category Level 3 for the three months ended June 30, 2010 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 April 1, 2010

   $ 32,503      $ 6,491   

Transfers in and/or out of Level 3

     —          —     

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

    

Included in earnings

     3,363        (3,292

Included in other comprehensive income

     —          —     

Settlements

     (23,700     —     
                

Balance at June 30, 2010

   $ 12,166      $ 3,199   
                

Fair value measurements for liabilities in category Level 3 for the three months ended June 30, 2010 were as follows (in thousands):

 

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

Balance at April 1, 2010

   $ 3,592   

Transfers into Level 3

     —     

Total losses included in earnings

     89   

Settlements

     (881
        

Balance at June 30, 2010

   $ 2,800   
        

The Company did not have any significant transfers between Levels 1 and 2 during the period ended June 30, 2010.

Fair value measurements for assets in category Level 3 for the six months ended June 30, 2010 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, 2010

   $ 37,416      $ 8,830   

Transfers in and/or out of Level 3

     —          —     

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

    

Included in earnings

     5,825        (5,631

Included in other comprehensive income

     —          —     

Settlements

     (31,075     —     
                

Balance at June 30, 2010

   $ 12,166      $ 3,199   
                

 

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Fair value measurements for liabilities in category Level 3 for the six months ended June 30, 2010 were as follows (in thousands):

 

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

Balance at January 1, 2010

   $ 4,108   

Transfers into Level 3

     —     

Total losses included in earnings

     610   

Settlements

     (1,918
        

Balance at June 30, 2010

   $ 2,800   
        

Derivative financial instruments are reported at fair value on the consolidated balance sheet. The Company’s current derivative instruments consist of two interest rate swaps with an aggregate notional amount of $90 million outstanding at June 30, 2010, 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. The credit risk associated with these swap agreements is limited to the uncollected interest payments due from counterparties. As of June 30, 2010, counterparty credit risk was minimal.

Gains and losses (realized and unrealized) for Level 3 assets and liabilities included in earnings for the period ended June 30, 2010, are reported in net investment income, other income and loss on interest rate swaps as follows:

 

     Net  Investment
Income
   Other
Income(Loss)
    Loss on
Interest Rate
Swaps
 

Assets

       

Total gains (losses) realized in earnings

   $ 5,825    $ (5,631   $ —     

Liabilities

       

Total gains (losses) realized in earnings

     —        —          (610
                       

Total for the period ended June 30, 2010

   $ 5,825    $ (5,631   $ (610
                       

Fair values represent the Company’s 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 values of the notes payable were determined using a third-party valuation source and were estimated to be $21.4 million in the aggregate with a total carrying value of $76.9 million at June 30, 2010.

Senior secured credit facility — The fair value of the senior secured credit facility was determined using a third-party valuation source and was estimated to be $84.3 million with a carrying value of $97.7 million at June 30, 2010.

 

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 (loss). Cash flows related to discontinued operations have been combined with cash flows from continuing operations within each category of cash flows.

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

 

     Three Months Ended
June  30,
    Six Months Ended
June  30,
 
     2010    2009     2010    2009  

Revenue (including loss on disposal)

   $ —      $ (460   $ —      $ 601   

Pretax loss from discontinued operations

     —        (1,322     —        (1,789

Income tax benefit

     —        (344     —        (462
                              

Loss from discontinued operations

   $ —      $ (978   $ —      $ (1,327
                              

 

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Table of Contents
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 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 June 30, 2010, our subsidiaries included insurance companies licensed to write insurance policies in 40 states, underwriting agencies, and retail agencies with 205 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 9,400 independent agents or brokers in 10 states (Louisiana, Texas, Illinois, Alabama, California, Michigan, Missouri, Indiana, South Carolina, and New Mexico). In February 2010, we notified the Florida Insurance Commissioner of our intent to discontinue writing new and renewal policies in the state of Florida. We began issuing notices of non-renewal to insureds beginning on May 17, 2010.

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, 2009.

RECENTLY ISSUED ACCOUNTING STANDARDS

Refer to Note 2 to the unaudited Consolidated Financial Statements for a discussion of certain accounting standards that have been adopted during 2010 and certain accounting standards which we have not yet been required to adopt and may be applicable to the Company’s future Consolidated Financial Statements.

MEASUREMENT OF PERFORMANCE

We are an insurance holding company engaged in the underwriting, servicing and distributing 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.

 

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Table of Contents

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 by distribution channel for the three and six months ended June 30, 2010 and 2009 (in thousands):

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2010    2009    2010    2009

Our underwriting agencies:

           

Retail agencies

   $ 39,156    $ 46,324    $ 97,109    $ 112,707

Independent agencies

     28,723      29,827      81,730      68,122
                           

Subtotal

     67,879      76,151      178,839      180,829

Unaffiliated underwriting agencies

     5,082      6,156      11,204      13,639
                           

Total

   $ 72,961    $ 82,307    $ 190,043    $ 194,468
                           

Total gross premiums written for the three and six months ended June 30, 2010 decreased $9.3 million and $4.4 million, respectively, or 11.4% and 2.3%, respectively, compared with the prior year primarily due to a decline in production from our retail distribution channel. 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 stores. We earn 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 six months ended June 30, 2010, decreased $7.2 million and $15.6 million, or 15.5% and 13.8%, respectively, when compared with the prior year. This decrease was due to more of our retail customers choosing third-party products due to soft market conditions.

In our independent agency distribution channel, gross premiums written for the three months ended June 30, 2010 decreased $1.1 million, or 3.7%, compared with the prior year period, and gross premiums written for the six months ended June 30, 2010 increased $13.6 million, or 20.0%, compared with the prior year period. The increase was due to an initiative to target the expansion of some of our independent agent relationships.

Gross premiums written by our unaffiliated underwriting agencies for the three and six months ended June 30, 2010 decreased $1.1 million and $2.4 million, respectively, or 17.4% and 17.9%, respectively, compared with the prior year. The following table displays our gross premiums written and assumed by state for the three and six months ended June 30, 2010 and 2009 (in thousands):

 

     Three Months Ended
June 30,
   Six Months Ended
June 30,
     2010    2009    2010    2009

Louisiana

   $ 29,491    $ 31,026    $ 74,047    $ 72,456

Texas

     14,693      19,757      34,587      43,821

Illinois

     9,379      8,705      21,247      22,353

Alabama

     5,766      5,989      15,694      15,405

California

     5,043      6,089      11,110      13,483

Michigan

     2,864      3,121      19,798      8,618

Indiana

     2,222      1,697      5,284      5,158

South Carolina

     1,363      1,413      2,914      2,690

Missouri

     1,012      1,961      2,880      5,051

Florida

     611      1,859      1,333      3,798

New Mexico

     479      623      1,056      1,479

Other

     38      67      93      156
                           

Total

   $ 72,961    $ 82,307    $ 190,043    $ 194,468
                           

 

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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, South Carolina and Texas were targeted for these changes. We expect it to take about one year before the full benefits from these actions are realized.

The following table displays our net premiums written by distribution channel for the three and six months ended June 30, 2010 and 2009 (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2010     2009     2010     2009  

Our underwriting agencies:

        

Retail agencies – gross premiums written

   $ 39,156      $ 46,324      $ 97,109      $ 112,707   

Ceded reinsurance

     —          —          —          10,286   
                                

Subtotal retail agencies net premiums written

     39,156        46,324        97,109        122,993   
                                

Independent agencies – gross premiums written

     28,723        29,827        81,730        68,122   

Ceded reinsurance

     (156     (302     (2,158     (652
                                

Subtotal independent agencies net premiums written

     28,567        29,525        79,572        67,470   
                                

Unaffiliated underwriting agencies – gross premiums written

     5,082        6,156        11,204        13,639   

Ceded reinsurance

     (23     (36     (55     (85
                                

Subtotal unaffiliated underwriting agencies net premiums written

     5,059        6,120        11,149        13,554   
                                

Catastrophe and contingent coverages with various reinsurers

     (59     (176     (236     (356
                                

Total net premiums written

   $ 72,723      $ 81,793      $ 187,594      $ 203,661   
                                

Total net premiums written for the three months ended June 30, 2010 decreased $9.1 million, or 11.1%, compared with the prior year quarter. Total net premiums written for the six months ended June 30, 2010 decreased $16.1 million, or 7.9%, compared with the prior year period. The decrease was primarily due to the termination of our quota share reinsurance contract for our Louisiana and Alabama business on a cut-off basis effective January 1, 2009 and the resulting return of $10.5 million of ceded unearned premium.

RESULTS OF OPERATIONS

We had a net loss from continuing operations of $12.1 million and $8.0 million for the three months ended June 30, 2010, and 2009, respectively. We had a net loss from continuing operations of $15.6 million for the six months ended June 30, 2010, compared with net income from continuing operations of $3.1 million for the comparable period in 2009. Significant items impacting the six months ended June 30, 2009 results were a net pretax gain on extinguishment of debt of $19.4 million, which was partially offset by unfavorable prior year loss development of $11.0 million and loss on interest rate swaps of $4.9 million associated with the discontinuation of hedge accounting. Significant items impacting the six months ended June 30, 2010 results were unfavorable loss development of $9.0 million.

Comparison of the Three Months Ended June 30, 2010 to the Three Months Ended June 30, 2009

Total revenues for the three months ended June 30, 2010 increased $3.1 million, or 2.6%, compared with the three months ended June 30, 2009. The increase was primarily due to increases in net premiums earned, commission income and fees and net realized gains, partially offset by decreases in net investment income and other income.

The largest component of revenue is net premiums earned on insurance policies. Net premiums earned for the current quarter increased $2.2 million, or 2.3%, 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 $2.9 million, or 3.3%. This increase is primarily due to continued expansion of the independent agent distribution channel, 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 $0.7 million, or 11.0%, compared with the prior year quarter.

 

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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
June  30,
     2010    2009

Our underwriting agencies

   $ 90,665    $ 87,761

Unaffiliated underwriting agencies

     5,750      6,460
             

Total net premiums earned

   $ 96,415    $ 94,221
             

Commission Income and Fees. Another measurement of our performance is the relative level of production of commission income and fees. Commission income and fees consists 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 fees, installment fees, and interest rates subject to limited regulatory restrictions, but policy fees 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 origination and servicing fees as well as interest on premiums that customers choose to finance.

Commissions, premium finance and agency fees are earned on sales of 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.

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
June  30,
     2010    2009

Policyholder fees

   $ 11,263    $ 9,942

Premium finance revenue

     5,926      5,462

Commissions and fees

     3,925      3,195

Agency fees

     1,151      1,102

Other, net

     —        178
             

Total commission income and fees

   $ 22,265    $ 19,879
             

Commission income and fees increased $2.4 million, or 12.0%, compared with the prior year quarter. Policyholder fees have increased due to an increase in managing general agents’ fee income due to a change in the mix of business. 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 more of our retail customers chose third-party products due to the soft market conditions.

Net Investment Income and Other Income (Loss). Net investment income for the current quarter decreased $1.3 million, or 53.8%, compared with the prior year quarter. The decrease was primarily due to a reduction in yields and a 17.1% decrease in total average invested assets to $222.9 million during the current quarter from $268.8 million during the prior year quarter. The average investment yield was 2.3% (2.6% on a taxable equivalent basis) in the current quarter, compared with 3.1% (4.1% on taxable equivalent basis) in the prior year quarter. In addition, investment income for our investment in real estate declined $0.5 million for the three months ended June 30, 2010, compared with the prior year quarter. This decrease is due to improvements we are making to the property for a new long-term lease, which is expected to commence in the third quarter of 2010.

 

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Table of Contents

In the first quarter of 2010, we began to reposition our investment portfolio by decreasing our tax-exempt investments. The purpose of the repositioning is to monetize the tax-exempt portion of the investments and to decrease our municipal credit exposure. The repositioning was completed in the second quarter of 2010. As a result of the repositioning, we sold $23.0 million of available-for-sale securities during the three-month period ended June 30, 2010, for a net realized gain of $0.2 million.

As of June 30, 2010, we held $15.4 million, at amortized cost, and $12.2 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 October 2008, our broker filed a prospectus with the SEC, which published a legally-binding offer to all authorized holders of auction-rate securities to purchase all eligible securities at par (“the settlement”). The time frames set by our broker 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. In November 2008, we elected to participate in our broker’s offer to purchase our auction-rate securities at par and classified our portfolio of auction-rate securities as trading. The settlement agreement requires our broker to purchase eligible securities at par, at any time during a two-year period beginning June 30, 2010. All auction-rate securities held at June 30, 2010 are eligible for buyback under the settlement agreements. At June 30, 2010 and December 31, 2009, the fair value of the settlement was $3.2 million and $8.8 million, respectively, which is recorded in other assets in the consolidated balance sheets with changes in fair value recorded in other income (loss) in the consolidated statements of income (loss). The Company had redemptions of auction rate securities, at par, of $23.7 million and realized gains of $3.3 million during the second quarter.

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, changes in the mix of business/limits 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. The claim initiatives that we started in the second half of 2009 shortened the claims payment cycle and have reduced the number of claims outstanding. The acceleration of payment patterns has necessitated increased use of judgment by management to account for the deviation in trends. 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. 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 $1.0 million, or 1.2%, compared with the prior year quarter. The percentage of losses and loss adjustment expense to net premiums earned (the loss ratio) was 74.6% in the current quarter, compared with 75.2% in the prior year quarter. The decrease in the current quarter loss ratio was primarily due to pricing increases in Texas and Michigan. For the three months ended June 30, 2010, the adverse loss development of $9.0 million for the prior period was primarily due to unfavorable development from our 2009 Texas and Michigan businesses. In the three months ended June 30, 2009, we recorded adverse loss development of $11.0 million primarily related to our Florida, Michigan and Louisiana businesses.

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
June 30,
 
     2010     2009  

Loss ratio – current quarter

   74.6   75.2

Adverse loss ratio development – prior period business

   9.3      11.7   
            

Reported loss ratio

   83.9   86.9
            

Selling, General and Administrative Expenses. Another measurement of our performance that addresses our overall efficiency is the level of selling, general and administrative (SG&A) 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 SG&A 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 SG&A expenses is personnel costs, including payroll, benefits and accrued bonus expenses. SG&A expenses increased $3.0 million, or 7.7%, compared with the prior year quarter primarily related to an increase in amortization of policy acquisition costs due to increased independent agent sales volumes and a reallocation of expenses

 

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from loss adjustment expense to more accurately reflect claim handling costs. If the new allocation methodology was in place in the second quarter of 2009, SG&A expenses would have been higher by $1.8 million. Excluding these items, SG&A expenses declined $1.1 million for the three months ended June 30, 2010, compared with the prior year.

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. Through June 30, 2010, the new point-of-sale and policy administration system was implemented in Illinois, Indiana, Michigan, Missouri, South Carolina and Texas. 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.

In July 2009, we suspended matching contributions to the 401(k) plan. This action is expected to decrease SG&A expenses by approximately $1.0 million annually. We are also in the process of implementing or have completed the following organizational changes including:

 

   

consolidating insurance, 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.

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.

Amortization of deferred policy acquisition costs is a major component of SG&A expenses. The following table sets forth the impact that amortization of deferred acquisition costs had on SG&A expenses and the change in deferred acquisition costs (in thousands):

 

     Three Months Ended
June 30,
 
     2010     2009  

Amortization of deferred acquisition costs

   $ 22,411      $ 20,159   

Other selling, general and administrative expenses

     20,136        19,357   
                

Total selling, general and administrative expenses

   $ 42,547      $ 39,516   
                

Total as a percentage of net premiums earned

     44.1     41.9
                

Beginning deferred acquisition costs

   $ 28,945      $ 25,807   

Additions

     17,742        19,084   

Amortization

     (22,411     (20,159
                

Ending deferred acquisition costs

   $ 24,276      $ 24,732   
                

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

     23.2     21.4
                

Depreciation and Amortization. Depreciation and amortization expenses for the current quarter were consistent with the prior year quarter.

Loss on Interest Rate Swaps. Loss on interest rate swaps for the three months ended June 30, 2010 decreased $0.4 million, or 82.8%, compared with the same period in the prior year. The amendment of the senior credit facility in March 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 decline in short-term interest rates implied in the forward yield curve.

Interest Expense. Interest expense for the current quarter decreased $0.7 million, or 10.0%, compared with the prior quarter. This decrease was due to a decrease in the average debt outstanding, partially offset by the amortization of debt discount of $1.7 million in the current quarter.

Income Taxes. Income tax expense for the current quarter was $0.4 million as compared with an income tax benefit of $6.2 million for the same period in the prior year. The income tax expense for the three months ended June 30, 2010 was primarily due to an increase in the deferred tax liability related to goodwill and state tax expense.

 

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Our net deferred tax assets prior to recognition of valuation allowance were $27.0 million and $20.8 million at June 30, 2010 and December 31, 2009, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, we began recording a valuation allowance against deferred taxes in December 2009. As of June 30, 2010, the valuation allowance was $38.5 million.

Comparison of the Six Months Ended June 30, 2010 to the Six Months Ended June 30, 2009

Total revenues for the six months ended June 30, 2010 increased $5.8 million, or 2.5%, compared with the six months ended June 30, 2009. The increase was primarily due to increases in net realized gains, commission income and fees and net premiums earned, partially offset by decreases in other income and net investment income.

The largest component of revenue is net premiums earned on insurance policies. Net premiums earned for the current period increased $1.7 million, or 0.9%, 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 $3.0 million, or 1.7%. 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 $1.3 million, or 10.1%, 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):

 

     Six Months Ended
June  30,
     2010    2009

Our underwriting agencies

   $ 177,472    $ 174,473

Unaffiliated underwriting agencies

     11,665      12,972
             

Total net premiums earned

   $ 189,137    $ 187,445
             

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):

 

     Six Months Ended
June  30,
     2010    2009

Policyholder fees

   $ 23,416    $ 19,647

Premium finance revenue

     11,696      11,030

Commissions and fees

     8,213      6,710

Agency fees

     2,533      2,621

Other, net

     2      443
             

Total commission income and fees

   $ 45,860    $ 40,451
             

Commission income and fees increased $5.4 million, or 13.4%, compared with the prior year period. Policyholder fees have increased due to an increase in managing general agents’ fee income due to a change in the mix of business. 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 more of our retail customers choosing third-party products due to the soft market conditions.

Net Investment Income and Other Income (Loss). Net investment income for the current period decreased $2.3 million, or 47.3%, compared with the prior year period. The decrease was primarily due to a reduction in yields and an 11.8% decrease in total average invested assets to $235.1 million during the current period from $266.6 million during the prior year period. The average investment yield was 2.4% (2.9% on a taxable equivalent basis) in the current period, compared with 3.1% (4.2% on taxable equivalent basis) in the prior year period. In addition, investment income for our investment in real estate declined $1.0 million for the six months ended June 30, 2010, compared with the prior year period. This decrease is due to improvements we are making to the property for a new long-term lease, which is expected to commence in the third quarter of 2010.

 

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In the first quarter of 2010, we began to reposition our investment portfolio by decreasing our tax-exempt investments. The purpose of the repositioning is to monetize the tax-exempt portion of the investments and to decrease our municipal credit exposure. The repositioning was completed in the second quarter of 2010. As a result of the repositioning, we sold $77.0 million of available-for-sale securities during the six-month period ended June 30, 2010, for a net realized gain of $1.4 million.

For the six-month period ended June 30, 2010, other income includes $0.6 million related to a settlement received from legal proceedings.

Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for the current period increased $0.3 million, or 0.2%, compared with the prior year period. The percentage of losses and loss adjustment expense to net premiums earned (the loss ratio) was 75.5% in the current period, compared with 75.0% in the prior year period. The increase in the current period loss ratio was primarily due to a change in mix due to growth in Texas and Michigan which have higher loss ratios than our average. For the six months ended June 30, 2010, the adverse loss development of $9.0 million for the prior period accident year was primarily due to unfavorable development from our 2009 Texas and Michigan businesses. In the first six months ended June 30, 2009, we recorded adverse loss development of $11.0 million primarily related to our Florida, Michigan and Louisiana businesses.

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:

 

     Six Months Ended
June 30,
 
     2010     2009  

Loss ratio – current period

   75.5   75.0

Adverse loss ratio development – prior period business

   4.8      5.9   
            

Reported loss ratio

   80.3   80.9
            

Selling, General and Administrative Expenses. The largest component of SG&A expenses is personnel costs, including payroll, benefits and accrued bonus expenses. SG&A increased $5.5 million, or 6.8%, compared with the prior year period. This increase was primarily related to an increase in amortization of policy acquisition costs due to higher independent agent sales volumes and a reallocation of expenses from loss adjustment expense to more accurately reflect claim handling costs. If the new allocation methodology was in place in the first six months of 2009, SG&A expenses would have been higher by $3.5 million. Excluding these items, SG&A expenses declined $2.5 million for the six months ended June 30, 2010, compared with the prior year.

The following table sets forth the impact that amortization of deferred acquisition costs had on SG&A expenses and the change in deferred acquisition costs (in thousands):

 

     Six Months Ended
June 30,
 
     2010     2009  

Amortization of deferred acquisition costs

   $ 42,698      $ 38,235   

Other selling, general and administrative expenses

     42,388        41,401   
                

Total selling, general and administrative expenses

   $ 85,086      $ 79,636   
                

Total as a percentage of net premiums earned

     45.0     42.5
                

Beginning deferred acquisition costs

   $ 24,230      $ 21,993   

Additions

     42,744        40,974   

Amortization

     (42,698     (38,235
                

Ending deferred acquisition costs

   $ 24,276      $ 24,732   
                

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

     22.6     20.4
                

Depreciation and Amortization. Depreciation and amortization expenses for the current period were consistent with the prior year period.

Gain on Extinguishment of Debt. In March 2009, we entered into an amendment of our senior secured credit facility. 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 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.

 

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We recorded a $19.4 million pretax, non-cash gain on extinguishment of debt as a result of this transaction. 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 decreased $4.3 million, or 87.7%, compared with the prior year period. The amendment of the senior credit facility in March 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 decline in short-term interest rates implied in the forward yield curve.

Interest Expense. Interest expense for the current period increased $1.3 million, or 12.3%, compared with the prior period. This increase was due to higher interest rates on the senior secured credit facility and the amortization of debt discount of $3.4 million in the current period, partially offset by a decrease in the average debt outstanding.

Income Taxes. Income tax expense for the current period was $0.8 million, as compared with an income tax benefit of $1.9 million, for the prior year period. The income tax expense for the current period was primarily due to an increase in the deferred tax liability related to goodwill and state tax expense.

Our net deferred tax assets prior to recognition of valuation allowance were $27.0 million and $20.8 million at June 30, 2010 and December 31, 2009, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, we began recording a valuation allowance against deferred taxes in December 2009. As of June 30, 2010, the valuation allowance was $38.5 million.

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.

There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends and we have and expect to continue to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of June 30, 2010, we had $2.8 million of cash and equivalents at the holding company level and $18.0 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 June 30, 2010, 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 June 30, 2010, each of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions on our part.

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.

 

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In May 2010, the Company entered into a capital lease obligation related to certain computer software, software licenses, and hardware currently used by and on the books of Affirmative Insurance Company and received cash from the financing in the amount of $28.2 million. As required by the lease agreements, the Company purchased $28.2 million of FDIC-insured certificates of deposit with the lease financing proceeds. These investments are pledged as collateral against the Company’s lease obligation and are scheduled to decrease as the Company makes the scheduled lease payments. The lease term is 60 months with monthly rental payments totaling approximately $0.6 million.

We believe that existing cash and investment balances, as well as cash flows generated from operations, will be adequate to meet our liquidity needs, planned capital expenditures and the debt service requirements of the senior secured credit facility and notes payable, 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.

Senior secured credit facility. At June 30, 2010, we were in compliance with all of our financial and other covenants.

 

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 June 30, 2010 was $233.1 million. The effective average duration of the portfolio as of June 30, 2010 was 2.79 years. If market interest rates increase 1.0%, our fixed-income investment portfolio would be expected to decline in market value by 2.79%, or $6.5 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 2.79%, or $6.5 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%.

Derivative financial instruments are reported at fair value on the consolidated balance sheet. Our current derivative instruments consist of two interest rate swaps with an aggregate notional amount of $90.0 million outstanding at June 30, 2010. 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 $40.0 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.

Our notes payable are also subject to interest rate risk. The $30.9 million notes payable bear an initial interest rate of 7.545% until March 15, 2010, at which time the securities adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of June 30, 2010 was 4.14%. The $25.8 million notes payable bear an initial interest rate of 7.792% until June 15, 2010, at which time they will adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of June 30, 2010 was 4.09%. The $20.2 million notes payable bear an interest rate of the three-month LIBOR rate plus 3.95% not exceeding 12.50% through March 2010 with no limit thereafter. The interest rate as of June 30, 2010 was 4.49%.

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 June 30, 2010, our fixed-income investments were invested in the following: U.S. Treasury and government agencies securities 13.5%, corporate debt securities 54.9%, residential mortgage-backed securities 1.8%, states and political subdivisions securities 17.8% and FDIC-insured certificates of deposit 12.0%.

 

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

 

     June 30,
2010
    December 31,
2009
 

Total invested assets

   $ 233,064      $ 251,072   

Tax-equivalent book yield

     2.90     4.00

Average duration in years

     2.79        1.50   

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 June 30, 2010 and December 31, 2009, respectively (in thousands):

 

     June 30,
2010
   December  31,
2009

Michigan Catastrophic Claims Association

   $ 21,846    $ 18,452

Vesta Insurance Group

     13,859      14,691

Quota-share reinsurer for Louisiana and Alabama business

     1,526      3,955

Other

     4,646      4,984
             

Total reinsurance receivable

   $ 41,877    $ 42,082
             

Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), Affirmative Insurance Company (AIC) had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize the gross amount due AIC and Insura Property and Casualty Insurance Company from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement effective September 1, 2004. On August 30, 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 June 30, 2010, the VFIC Trust held $16.8 million (after cumulative withdrawals of $8.5 million through June 30, 2010), consisting of $11.9 million of a U.S. Treasury money market account and $4.9 million of corporate bonds rated BBB or higher, to collateralize the $13.9 million net recoverable from VFIC.

At June 30, 2010, $11.1 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $21.6 million in securities (the AIC Trust). The Special Deputy Receiver (SDR) in Texas or the SDR in Hawaii drew down the AIC Trust $0.4 million through June 2010, and the Special Deputy Receiver in Hawaii had cumulative withdrawals from the AIC Trust of $1.7 million through June 2010.

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 June 30, 2010, all such unaffiliated reinsurers had A.M. Best ratings of “A” or better.

 

Item 4. Controls and Procedures

The Company’s management performed an evaluation under the supervision and with the participation of the Company’s principal executive officer and the principal financial officer, and completed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e)), as adopted by the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934, as amended (the Exchange Act) as of June 30, 2010. Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures.

 

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Based on that evaluation, the Company’s principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were effective.

As previously reported in our Form 10-K for the year ended December 31, 2009, management concluded that our disclosure controls and procedures were not effective because of a material weakness with respect to the preparation and review of the income tax provision.

Subsequently, during the first quarter of 2010, we implemented enhancements to our internal controls over financial reporting to ensure proper presentation and review of the income tax provision. We believe the controls have been effective during the three and six months ended June 30, 2010.

There were no other changes in internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during our most recent fiscal quarter 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 10 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, 2009.

 

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: August 16, 2010    
   

/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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