UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

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

AFFIRMATIVE INSURANCE HOLDINGS, INC.

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

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

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

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

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

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

Affirmative Insurance Holdings, Inc.
Index

Part I

See accompanying Notes to Consolidated Financial Statements

1

Affirmative Insurance Holdings, Inc.

See accompanying Notes to Consolidated Financial Statements

2

Affirmative Insurance Holdings, Inc.

See accompanying Notes to Consolidated Financial Statements

3

Affirmative Insurance Holdings, Inc.

See accompanying Notes to Consolidated Financial Statements

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Affirmative Insurance Holdings, Inc.

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

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

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

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

	•	Illinois, Indiana, Missouri. This agreement covers all business written through our underwriting agencies in these states from January 1, 2004 and continues in force until terminated by us or our reinsurers at any December 31 with not less than 90 days’ prior notice. We ceded 60.0% of gross premiums written for the first six months of 2004, and effective July 1, 2004, we have reduced the amount of business we cede to our reinsurers on all business written through our underwriting agencies in these states from 60.0% to 20.0% for the second half of 2004. We have provided notification of our intent to terminate this agreement on December 31, 2004 on a cut-off basis, meaning the reinsurers retain the liability for all losses occurring prior to December 31, 2004 related to this agreement and the ceded unearned premium for unexpired policies in force is returned to us. This agreement contains a loss corridor where the company remains liable for 100% of the losses between a loss ratio of 72.0% and 77.0%. This agreement also contains a provision that limits reinsurers liability to a loss ratio of 100.0%. The effect of these features in this agreement is to limit the reinsurers aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by us. While we do not receive pro rata protection relative to the amount of premiums ceded, the amount of such protection is significant, as determined in accordance with guidance under both statutory accounting practices and GAAP. The reinsurance under this agreement is provided by Hannover Re, which reinsures 50% of the premiums we cede, Swiss Re, which reinsures 20.83% of the premiums we cede, and AXA Re, which reinsures 29.17% of the premiums we cede. Hannover Re, Swiss Re, and AXA Re are rated “A”, “A+”, and “A-”, respectively, by A.M. Best.
	•	New Mexico and South Carolina. This agreement covers substantially all of our business written through our underwriting agencies in these states from January 1, 2004 and continues in force until terminated by us or our reinsurers at any December 31 with not less than 90 days’ prior notice. We ceded 75.0% of gross premiums written in the first six months of 2004, and effective July 1, 2004, we have reduced the amount of business we cede to our reinsurers on all business written through our underwriting agencies in these states from 75.0% to 30.0% for the second half of 2004. We have provided notification of our intent to terminate this agreement on December 31, 2004 on a cut-off basis. The reinsurance under this agreement is provided by Chubb Re, which reinsures 86.7% of the premiums we cede, and AXA Re which reinsures 13.3% of the premiums we cede. Chubb Re and AXA Re are rated “A++” and “A-” respectively, by A.M. Best.

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		We have entered into a quota share reinsurance agreement effective January 1, 2004 under which we will assume a portion of the business produced by our Texas-based A-Affordable underwriting agency and written by Old American County Mutual Fire Insurance Company. We assumed 25.0% of the gross premiums written in the first six months of 2004 and effective July 1, 2004 we have increased our participation on business produced by our Texas-based A-Affordable underwriting agency from 25.0% to 70.0% for the second half of 2004.
		Effective May 1, 2004, we entered into a quota share reinsurance agreement with an unaffiliated reinsurer to cede 25.0% of the business written through our Florida underwriting agency. This contract continues in force until terminated by us or our reinsurers at any April 30 with not less than 90 days prior notice. We can terminate this agreement on April 30, 2005 on a cut-off basis. The reinsurance under this agreement is provided by Folksamerica, which reinsures 100% of all premiums we cede. Folksamerica is rated “A” by A.M. Best.
		All of our quota share reinsurance agreements contain provisions for sliding scale commissions, under which the commission paid to us varies with the loss ratio results under each contract. The effect of this feature in the quota share reinsurance agreements is to limit the reinsurers aggregate exposure to loss and thereby reduce the ultimate cost to us as the ceding company. These features also have the effect of reducing the amount of protection relative to the quota share amount of premiums ceded by us. Before entering into these reinsurance agreements, and based on our prior operating history, we concluded that each agreement met the risk transfer test of SFAS No. 113 (“SFAS 113”) Accounting and Reporting for Reinsurance of Short-Durantion and Long-Duration Contracts as the reinsurers assume significant risk and have a reasonable possibility of significant loss.

4.

Related Party Transactions

We provide various services for Vesta and its subsidiaries, including underwriting, premium processing, and claims processing. For the three months and nine months ended September 30, the accompanying unaudited consolidated statements of operations reflect these services as follows (dollars in thousands):

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

		As part of the terms of the acquisition of Affirmative Insurance Company and Insura, Vesta has indemnified us for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of September 30, 2004, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better.
		Prior to May 2003, we leased office space from a minority shareholder of InsureOne Independent Agency, LLC. Total rent paid to the minority shareholder for the nine months ended September 30, 2003 was $682,000.

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5.		Commitments and Contingencies
		We and our subsidiaries are named from time to time as defendants in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies, claims handling and employment related disputes. The plaintiffs in some of these lawsuits have alleged bad faith or extra-contractual damages and some have claimed punitive damages. We believe that the resolution of these legal actions will not have a material adverse effect on our financial position or results of operations.
		We are the subject of a purported class action in South Carolina alleging that we have improperly denied coverage for losses resulting from the operation of insured vehicles by undisclosed “permissive use drivers”. The non-standard personal automobile policies in question were issued by a subsidiary of Vesta and were sold through Driver’s Choice, one of our underwriting agencies. The plaintiff seeks injunctive relief and contract reformation, as well as an unspecified amount of compensatory and punitive damages, costs and interest based on claims for breach of contract, bad faith, fraud and negligence. This matter is still in the early procedural stages and as of the date of this report the class had not been certified. Although we are vigorously defending this lawsuit, the ultimate outcome of this case is uncertain.
		On May 6, 2004, the former minority owners of our InsureOne retail agency, including InsureOne’s former president, filed a complaint in the United States District Court for the Northern District of Illinois alleging causes of action against us and three of our executive officers under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, as well as causes of action for fraudulent misrepresentation, negligent misrepresentation and breach of fiduciary duty in connection with our purchase of the plaintiffs’ 20% minority interest in this retail agency in 2003. The plaintiffs seek damages equal to the difference between the amount paid for the 20% interest and the court’s determination of the value of this interest, plus attorneys’ fees and court costs. InsureOne filed a motion to dismiss this case, and we anticipate that no other substantive action will occur until the Court rules on the motion to dismiss. We believe this complaint is without merit, and we are vigorously contesting the claims brought by the plaintiffs and are exercising all available rights and remedies against them.
		InsureOne’s former president is also a defendant, along with eight former employees of InsureOne, in actions we brought in the Circuit Court of Cook County, Illinois in December 2003 and in the United States District Court for the Eastern District of Missouri in February 2004 to enforce non-compete and non-solicitation agreements entered into with those employees. Both courts have entered interim orders prohibiting the defendants from hiring any employees of InsureOne or one of our other underwriting agencies. These orders are presently in effect until November 2004, when the trial in the Illinois case of our claims for permanent injunctive relief and an undetermined amount of compensatory and punitive damages was originally scheduled; provided however, a hearing has been scheduled for November 2004 to determine a new trial date, which is expected to be set either in December 2004 or January 2005. On May 17, 2004, the former president of InsureOne filed a counterclaim in the Illinois case seeking unspecified compensatory damages, specific performance, attorneys’ fees and court costs based on causes of action for breach of contract, fraud, negligent misrepresentation and breach of fiduciary duty in connection with Vesta’s original acquisition of the InsureOne business in 2002, the claimant’s employment with InsureOne and our purchase of the 20% minority interest in InsureOne in 2003. InsureOne filed a motion to dismiss the counterclaim, and that motion is pending before the Court. We believe the counterclaim is without merit. We are vigorously contesting the counterclaim and are exercising all rights and remedies available to us.
6.		Credit Facility
		On August 6, 2004, we entered into a senior secured credit facility with The Frost National Bank. Under this credit facility, the maximum amount available to us from time to time is $15.0 million, which may include up to $15.0 million under a two-year revolving line of credit, up to $10.0 million in five-year term loans and up to $10.0 million in five-year stand-by letters of credit. The borrowings under our credit facility will initially accrue interest at an annual rate of LIBOR plus 1.50% and we will pay letter of credit fees based on an initial annual rate of 0.75%. Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of Affirmative Insurance Company. The facility contains certain financial covenants, which include combined ratio, risk-based capital requirement, fixed charge coverage ratio, consolidated net worth and consolidated net income requirements and other restrictive covenants governing distributions and management changes. The proceeds are available to issue letters of credit securing our obligations under reinsurance agreements, to fund general working capital for our agency operations, capital surplus for our insurance companies and to finance acquisition activities. Currently, we have not borrowed against our facility. As of September 30, 2004, we are in compliance with all of our financial and other restrictive covenants.
7.		Stockholders’ Equity
		On March 12, 2004, we issued 35,216 shares of our common stock to E.B. Lyon, III, a minority stockholder, at a purchase price of $9.76 per share, for aggregate consideration of $343,809 in cash.
		On March 12, 2004, we issued 39,944 shares of our common stock to LBL Partners, Ltd., a minority stockholder, at a purchase price of $9.76 per share, for aggregate consideration of $389,967 in cash.
		On March 12, 2004, we issued 19,623 shares of our common stock to Thomas E. Mangold, our Chief Executive Officer, at a purchase price of $9.76 per share, for aggregate consideration of $191,576 in cash. We believe that the fair value of our common stock issued to Mr. Mangold was higher than our historical carrying value we assigned to our shares of common stock for this transaction. In light of our proposed public offering, we used a projected public valuation model to determine the estimated fair value of the common shares issued to Mr. Mangold. Based on the projections, we recorded $73,000 of compensation expense in March 2004.
		On March 12, 2004, we issued 19,886 shares of our common stock to Vesta Insurance Group, Inc. in connection with the exercise of warrants, with an exercise price of $0.08 per share, which were originally purchased by Vesta in 2000.

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		On March 12, 2004 we filed an Amendment and Restated Certificate of Incorporation increasing the number of shares of authorized common stock from 40 million to 75 million.
		On July 9, 2004, we completed our initial public offering of our common stock. We issued 4,420,000 additional shares of our common stock and Vesta sold 3,750,000 shares of our common stock that they owned, at an initial public offering price of $14 per share. On July 26, 2004, our underwriters exercised their option to purchase an additional 663,000 shares from us, and an additional 562,500 shares from Vesta. Our net proceeds from the offering were $65.3 million, after deducting our estimated offering expenses. We contributed $64.3 million of the net proceeds to our insurance companies in order to increase their statutory surplus. This additional capital allowed us to reduce our reinsurance purchases and retain more gross premiums. The remaining $1.0 million of net proceeds were held for general corporate purposes. At the conclusion of these transactions, Vesta owned approximately 42.6% of our issued and outstanding capital stock.
		On September 28, 2004, we issued 80,837 shares of our common stock to Vesta Insurance Group, Inc. in connection with the exercise of options, with an exercise price of $7.59 per share, which we originally issued to Vesta on June 30, 2000.
8.		Earnings per Share
		The provisions of SFAS No. 128 (“SFAS 128”) Earnings per Share require presentation of both basic and diluted earnings per share. A reconciliation of the numerators and denominators of the basic and diluted earnings per share computations as required by SFAS 128 is presented below:

		Options to purchase 847,008 shares of common stock at prices ranging from $7.59 to $9.49 were outstanding at September 30, 2003 but were not included in the computation of diluted earnings per share for the three months and nine months ended September 30, 2003, because the inclusion would result in an anti-dilutive effect in periods where the option exercise price exceeded the average estimated market price per share for the period.

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9.		Segment Information
		In June 1997, the FASB issued SFAS No. 131 (“SFAS 131”) Disclosures about Segments of an Enterprise and Related Information. SFAS 131 defines an operating segment as a component of an enterprise if it meets the following criteria: (1) it engages in business activities from which it may earn revenue and incur expenses; (2) whose operating results are regularly reviewed by the enterprise’s chief operating decision maker; and (3) for which discrete financial information is available.
		We have reflected the requirements of SFAS 131 for the three months and nine months ended September 30, 2004 and 2003 in the following tables for our three operating segments: agency segment, insurance segment, and corporate segment.
		Our agency segment is comprised of our underwriting agencies and our retail agencies. Our underwriting agencies primarily design, distribute and service policies issued or reinsured by our insurance companies or another unaffiliated insurance company. In our insurance segment, we issue non-standard personal automobile insurance policies through our two Illinois-domiciled insurance company subsidiaries. Our insurance companies possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both affiliated and unaffiliated underwriting agencies to design, distribute and service those policies.

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