UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

Annual Report Pursuant to Section 13 or 15 (d) of
The Securities Exchange Act of 1934

GAINSCO, INC.

Securities registered pursuant to Section 12(b) of the Act:

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 þ No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained herein, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. þ

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).

Yes o No þ

The aggregate market value of the registrant’s Common Stock ($.10 par value), the registrant’s only class of voting or non-voting common equity stock, held by non-affiliates of the registrant (19,289,597 shares) as of the close of the business on June 30, 2004 was $13,502,718 (based on the closing sale price of $0.70 per share on that date on the OTC Bulletin Board).

As of March 25, 2005, there were 61,084,960 shares of the registrant’s Common Stock ($.10 par value) outstanding.

Incorporation by Reference

Portions of the Company’s Proxy Statement for its Annual Meeting of Shareholders to be held on May 11, 2005 are incorporated by reference herein in response to Items 10, 11, 12, 13 and 14 of Part III of Form 10-K.

TABLE OF CONTENTS

(i)

PART I

ITEM 1. BUSINESS

General Description

     GAINSCO, INC. (“GNAC”) is a holding company that provides administrative and financial services for its wholly owned subsidiaries. The term “Company” as used in this document includes GNAC and its subsidiaries unless the context otherwise requires. GNAC was incorporated in Texas on October 11, 1978. It completed its initial public offering on November 14, 1986.

     The Company is a property and casualty insurance company concentrating its efforts on the nonstandard personal automobile market as it continues to exit from the commercial insurance business. The Company’s insurance operations for 2004 were conducted through two insurance companies: General Agents Insurance Company of America, Inc. (“General Agents”), an Oklahoma corporation, and MGA Insurance Company, Inc. (“MGA”), a Texas corporation.

     At December 31, 2004 the Company was approved to write insurance in 39 states and the District of Columbia on a non-admitted basis and in 44 states and the District of Columbia on an admitted basis. The Company markets its nonstandard personal auto line of insurance on an admitted basis through over 1,800 non-affiliated retail agencies in Arizona, Florida, Nevada and Texas and through a non-affiliated general agency in California. Approximately 90% of the Company’s gross premiums written during 2004 resulted from risks located in Florida.

     The Company’s only line of insurance currently being written is nonstandard personal auto and it is written on classes of risks which are not generally insured by many of the standard companies. The strategy of the Company is to identify various classes of risks where it can price its coverages profitably and competitively. For a description of the product lines presently written by the Company, see “Product Lines.” The Company sets its premiums by applying judgment after consideration of statistical analysis, the risks involved and the competition.

Recent Developments

Nonstandard Personal Auto Line

     The Company only writes nonstandard personal auto insurance and has no plans to write any other lines of insurance. This business has been profitable in recent periods, due in large part to favorable market conditions. The Company’s current vision is to grow that business strategically to establish a broader, more geographically diversified earnings base by expanding into new states and markets to achieve growth with diversification of risk.

     During its recent transition period, (described below under “2005 Recapitalization”), the Company limited its growth by maintaining a ratio of net premiums written to surplus (“leverage”) of approximately 1 to 1, which is below the level at which some competitors operate. The recently completed capital restructuring (discussed in detail below) has permitted management to change its focus to seek opportunities to grow premiums written while diversifying risk.

     The Company limited its business to Florida until the fourth quarter of 2003, when it began writing policies in Texas. In 2004, the Company began writing policies in Arizona and Nevada and initiated a California program with a non-affiliated managing general agency as well. The Company experienced significant growth in premiums written during the first two months of 2005, and management currently expects continuing growth in premiums written and an increase in the Company’s leverage. Significant growth could enable the Company to increase its profitability, if it is able to achieve that growth with favorable profit margins, but it also has the potential to cause material and adverse effects on the Company’s financial condition and results if not profitably written.

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     This growth strategy necessarily entails increased operational risks and other challenges that are greater than and different from those to which the Company has previously been subject in writing nonstandard personal automobile insurance. These new risks and challenges include, but are not limited to, the following:

	•	competitive conditions for the Company’s product have intensified recently, and further pressures on pricing are anticipated;
	•	generally, new business initially produces higher loss ratios than more seasoned in-force business, and this factor could be magnified to the extent that the Company enters multiple new states and market areas within a short period of time. Furthermore, it amplifies the importance of the Company’s ability to assess any new trends accurately and respond effectively;
	•	pricing decisions in new states and markets, involving different claims environments, distribution sources and customer demographics, will be made without the same level of experience and data that is available in existing markets;
	•	the Company’s expected growth will require additional personnel resources (including management personnel), relationships with agents and vendors with whom the Company has not previously done business, and additional dependence on operating systems and technology. The Company will face substantial challenges in maintaining adequate customer service and retaining business, particularly because of the additional complexity of operating in multiple states and time zones; and
	•	if the Company grows significantly or if adverse underwriting results occur, additional capital may be required, and such capital may not be available on favorable or acceptable terms. The ability of the Company to maintain sufficient capital and perform successfully will be important factors in determinations of its A. M. Best rating, and that rating could have a significant influence on its marketing initiatives.

     The Company’s ability to manage the foregoing risks and challenges, as well as potentially declining market conditions and possible unforeseen developments affecting its business, will determine in large part whether the Company’s strategy for profitable growth can be implemented successfully. There is no assurance that the Company will be able to achieve the objectives of its growth strategy.

2005 Recapitalization

     Introduction. On January 21, 2005, the Company consummated a recapitalization pursuant to agreements that it entered into on August 27, 2004 and that were approved by GNAC’s shareholders on January 18, 2005. The agreements were with Goff Moore Strategic Partners, L.P. (“GMSP”), then holder of the Company’s Series A and Series C Preferred Stock and approximately 5% of the outstanding Common Stock; Robert W. Stallings, the Chairman of the Board and then holder of the Company’s Series B Preferred Stock; and First Western Capital, LLC, a limited liability company (“First Western”) owned by James R. Reis. The recapitalization substantially reduced, as well as extended, the Company’s existing Preferred Stock redemption obligations and resulted in cash proceeds to the Company of approximately $8.7 million (before an estimated $2.2 million in transaction costs and approximately $3.4 million used to redeem the Series C Preferred Stock). The events leading up to, and the transactions constituting, the recapitalization are described below.

     1999 GMSP Transaction. On October 4, 1999 and in conclusion of a strategic alternatives review process that the Board of Directors initiated in 1998 to seek out additional ways to maximize shareholder value (including the possible sale of the Company), the Company sold to GMSP, for an aggregate purchase price of $31,620,000, (i) 31,620 shares of Series A Preferred Stock (stated value $1,000 per share), which were convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share (subject to adjustment for certain events), (ii) the Series A Warrant (which expired unexercised on October 4, 2004) to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise price of $6.375 per share and (iii) the Series B Warrant expiring October 4, 2006

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to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise of $8.50 per share. At closing, the Company and its insurance company subsidiaries entered into investment management agreements with GMSP, pursuant to which GMSP managed their respective investment portfolios. In the securities purchase agreement entered into between GMSP and the Company for the 1999 GMSP transaction, the Company agreed to nominate John C. Goff and another individual selected by GMSP, and to use its best efforts to cause them to be elected to the Board.

     Background of 2001 Transactions with GMSP and Mr. Stallings. In early 2001 it became apparent to management that the Company’s insurance company subsidiaries had suffered more unexpected severe claims development in the fourth quarter of 2000 than originally thought, largely due to runoff from the commercial trucking lines that the Company announced on November 9, 2000 that it had determined to cease writing. As a result the Company was not in compliance with two covenants in its bank credit agreement, and, if the situation were not quickly addressed through the raising of additional equity capital, the Company faced the possibility of a qualified opinion from its auditors on the year ended December 31, 2000 and a downgrade of its A.M. Best rating, which at the time was A-. Under these circumstances the Company approached GMSP for financial assistance. GMSP in turn introduced the Company to Mr. Stallings with whom GMSP has previously had a successful relationship through its investment in Pilgrim Capital Corporation.

     To evaluate the proposals and negotiate with GMSP and Mr. Stallings, the Board appointed a Special Committee of disinterested, independent directors. The Special Committee considered with its financial advisor the alternatives that might be available to the Company, and ultimately the Special Committee concluded that the alternatives most likely to succeed within the short time available would be transactions with GMSP and Mr. Stallings. GMSP’s willingness to invest additional capital in the Company at this critical time was among other things conditioned upon the Company’s agreeing to redeem the Series A Preferred Stock on January 1, 2006.

     2001 GMSP Transaction. On March 23, 2001, the Company consummated another transaction with GMSP pursuant to which, among other things, the Company issued 3,000 shares of its newly created Series C Preferred Stock (stated value of $1,000 per share) to GMSP in exchange for an aggregate purchase price of $3 million in cash. The annual dividend rate on the Series C Preferred Stock was 10% until March 23, 2004 and 20% thereafter. The Series C Preferred Stock was redeemable at the Company’s option after March 23, 2006 and at GMSP’s option after March 23, 2007 at a price of $1,000 per share plus accrued and unpaid dividends. The Series C Preferred Stock was not convertible into Common Stock.

     The agreement with GMSP in connection with the 2001 GMSP transaction was conditioned upon the following changes in the securities acquired by GMSP in the 1999 transaction: (i) the exercise prices of the Series A Warrant and the Series B Warrant held by GMSP were reduced to $2.25 per share and $2.5875 per share, respectively (each of these warrants provided for the purchase of 1,550,000 shares of Common Stock); and (ii) the Series A Preferred Stock was called for redemption by the Company so that on January 1, 2006 the Company would have become obligated to pay $1,000 per share for 31,620 shares ($31.6 million) to the holder to the extent that it could legally do so and, to the extent it could do so, the Company was obligated to pay quarterly an amount equal to 8% interest per annum on any unpaid balance.

     The 2001 agreement with GMSP also provided an opportunity to convert the Company’s illiquid investments with a cost of $4.2 million to cash as of November 2002. In February 2002 and with GMSP’s consent, the Company exercised its option to require GMSP purchase the illiquid investments for approximately $2.1 million.

     2001 Transactions with Robert W. Stallings On March 23, 2001, the Company sold to Robert W. Stallings for $3 million in cash 3,000 shares of its newly created Series B Preferred Stock (stated value of $1,000 per share) and a warrant expiring March 23, 2006 to purchase an aggregate of 1,050,000 shares of Common Stock at $2.25 per share. The annual dividend provisions and the redemption provisions of the Series B Preferred Stock are the same as those for the Series C Preferred Stock. The Series B Preferred Stock was convertible into 1,333,333 shares of

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Common Stock at $2.25 per share. Mr. Stallings also entered into a consulting agreement pursuant to which he provided consulting services to the Company’s insurance subsidiaries for $300,000 per annum. In the securities purchase agreement entered into between Mr. Stallings and the Company for this transaction, the Company agreed to nominate Mr. Stallings, and use its best efforts to cause him to be elected to the Board.

     Preferred Stock in Relation to Capital Base. At December 31, 2004, the capital base (total assets less total liabilities) of the Company was $46,546,545 and consisted of Shareholders’ Equity of $12,854,545 and three series of Redeemable Preferred Stock (the Series A Preferred Stock, the Series B Preferred Stock and the Series C Preferred Stock), which were classified as mezzanine financing in the aggregate amount of $33,692,000. At December 31, 2004, there was $3,928,000 of unaccreted discount on Redeemable Preferred Stock that remained in Shareholders’ Equity. At December 31, 2004, the per common share Shareholders’ Equity was approximately $0.61, including unaccreted discount on Redeemable Preferred Stock of $0.19; less such unaccreted discount, the per common share Shareholders’ Equity was approximately $0.42 per common share. The aggregate redemption value at December 31, 2004 of the Preferred Stock was $37,620,000 stated value.

     Obligation to Redeem Series A Preferred Stock on January 1, 2006. On March 23, 2001, in satisfaction of a condition to the closing of the sale of $3,000,000 of Series C Preferred Stock to GMSP, the Company called the Series A Preferred Stock for redemption so that on January 1, 2006 the Company would be obligated to pay $31,620,000 to GMSP, subject to certain conditions. To the extent that the Company was restricted from redeeming the Series A Preferred Stock because of the conditions, the Company would be obligated to pay quarterly an amount equal to 8% interest per annum on any unpaid balance.

     Obligation to Redeem Series B and Series C Preferred Stock on March 23, 2007. The Series B and Series C Preferred Stock would become redeemable at the option of the holders commencing March 23, 2007 for the aggregate liquidation amount of $6,000,000 plus accrued dividends, subject to conditions similar to those conditions on the Company’s obligation to redeem the Series A Preferred Stock.

     Background of the Recapitalization. On May 19, 2003 the Board appointed a Special Committee of disinterested, independent directors which was authorized to review any proposal submitted for any investment in a business venture by the Company in which any holder of Preferred Stock or other affiliate was a co-investor or otherwise financially interested. At the time the Company was considering entering the financial services business by acquiring a company already in that business. Since the Company did not have the necessary capital for such a transaction, the Company considered obtaining the necessary capital by entering into a joint arrangement with the holders of its Preferred Stock who could have provided necessary capital. Negotiations for such a transaction never developed to the point that management brought it to the Special Committee for its consideration.

     On November 17, 2003 the Board discussed how the writing of additional private passenger automobile insurance policies to provide the possibility of expanded premium and investment income would require the commitment of additional capital in the insurance subsidiaries, but that the taking of dividends out of the insurance company subsidiaries to satisfy dividend obligations to the Preferred Stock would limit these growth opportunities. There was also discussed an opportunity to enter into a potentially long-term exclusive relationship with a general agency in another state that, if it could be properly arranged and executed, possibly could lead to significant growth in premiums written. The Board then discussed the possibility of recapitalizing some or all of the Series A, B and C Preferred Stock in order to ease pressures on the Company’s capital structure and its A.M. Best rating. See “A.M. Best Rating” below. At this Board meeting the mandate of the Special Committee was expanded to authorize and empower the Special Committee to review and evaluate any recapitalization proposal made by any holder of Preferred Stock or other affiliate, and to take all action that in its judgment may be necessary or appropriate in order to evaluate, negotiate, approve or reject any transaction arising out of any such recapitalization proposal. The Special Committee was also granted the authority to engage such investment bankers, counsel and other advisors necessary to help the Special Committee evaluate any recapitalization proposal. The membership

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of the Compensation Committee and the Special Committee overlapped and, when it became apparent that the recapitalization would require arrangements for the compensation of individual officers and directors, the Special Committee began to meet with the Compensation Committee. On August 27, 2004 after 44 meetings, often with its counsel and financial advisors, the Special Committee approved the recapitalization agreements which are described below, and the Compensation Committee approved the related employment arrangements. The Special Committee received a fairness opinion from an independent investment banking firm to the effect that the consideration to be received by the Company in the recapitalization was fair, from a financial point of view, to the holders of the Common Stock other than those affiliated with GMSP, First Western and Mr. Stallings. Later on August 27, 2004 the full Board met and approved the recapitalization agreements and related employment agreements, in each case subject to shareholder approval.

     Recapitalization Transactions. In the recapitalization which closed on January 21, 2005, of the 31,620 shares of Series A Preferred Stock held by GMSP and called in 2001 for redemption on January 1, 2006 at a redemption price of approximately $31.6 million, 13,500 shares (redemption value of $13.5 million) were exchanged for 19,125,612 shares of Common Stock. The remaining 18,120 shares of Series A Preferred Stock (which had been called for redemption in 2006 and have a redemption value of approximately $18.1 million) became redeemable at the option of the holders on January 1, 2011, and became entitled to receive cash dividends at the rate of 6% per annum until January 1, 2006 and 10% per annum thereafter until redemption. Those remaining 18,120 shares of Series A Preferred Stock remain convertible into 3,552,941 shares of Common Stock at $5.10 per share, continue to be entitled to vote on an as-converted basis, and remain redeemable at the option of the Company commencing June 30, 2005 at a price equal to stated value plus accrued dividends. The Company received an option to purchase all of the Series C Preferred Stock from GMSP, which the Company exercised on January 21, 2005 as part of the recapitalization for approximately $3.4 million from the proceeds of the sale of Common Stock in the recapitalization. The expiration date of GMSP’s Series B Warrant to purchase 1,550,000 shares of Common Stock for $2.5875 per share was extended to January 1, 2011. The investment management agreements of the Company and its insurance company subsidiaries with GMSP were terminated, as were the agreements entered into between the Company and GMSP in connection with their 1999 and 2001 transactions.

     Also as part of the recapitalization, (i) Mr. Stallings acquired 13,459,741 shares of Common Stock in exchange for $4,629,042 cash, his 3,000 shares of outstanding Series B Preferred Stock and his warrant expiring March 23, 2006 to purchase 1,050,000 shares of Common Stock for $2.25 per share, and (ii) First Western acquired 6,729,871 shares of Common Stock in exchange for $4,037,922 in cash. The purchase price of these shares was $0.60 per share.

     As a result of the recapitalization, the number of shares of Common Stock outstanding increased from 21,169,736 previously to 61,084,960 after closing of the recapitalization. GMSP now owns approximately 33% of the outstanding Common Stock, Mr. Stallings owns approximately 22% and First Western owns approximately 11%.

     In conjunction with the recapitalization, Mr. Stallings became executive Chairman of the Board of the Company, and Mr. Reis became Executive Vice President of the Company with responsibility for risk management. Mr. Stallings’ agreements entered into with the Company in the 2001 transactions were terminated, as was First Western’s consulting agreement with a subsidiary of the Company. Mr. Anderson remains as the Company’s President and Chief Executive Officer.

     The recapitalization agreements with GMSP, First Western and Mr. Stallings provide that, at least until January 21, 2007, the Company will (i) continue to be registered under Section 12(g) of the Securities Exchange Act of 1934 and file reports on Forms 10-K, 10-Q and 8-K (or their equivalents) and proxy statements with the Securities and Exchange Commission and (ii) observe and comply with many of the corporate governance rules promulgated by the New York Stock Exchange (even though the Common Stock is not listed there).

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     In its recapitalization agreement, GMSP further agreed that at least until January 21, 2007, it would not purchase or otherwise acquire additional shares of Common Stock if thereafter it would beneficially own more than 37.5% of the voting stock (excluding the shares of Series A Preferred Stock entitled to vote on matters submitted to the holders of Common Stock) and that GMSP would not be deemed collectively to own more than 37.5% of the voting stock solely by reason of the acquisition of Common Stock (i) by Mr. Goff pursuant to any existing or future Company incentive stock plans or (ii) pursuant to the conversion of shares of Series A Preferred Stock or the exercise of the Series B Warrant. Additionally, GMSP agreed that during this two year period it would vote the shares of Series A Preferred Stock in respect of each matter submitted to the holders of the Common Stock in proportion to the vote of all shares of Common Stock voted on such matter such that the vote of the shares of Series A Preferred Stock will have no effect on the outcome of any proposal submitted to the holders of the Common Stock. During this two-year period GMSP also is entitled to designate Mr. Goff to serve on the Board for so long as GMSP beneficially owns at least 20% of the voting stock.

     The recapitalization agreements with First Western and Mr. Stallings provide that, at least until January 21, 2007, neither of them will purchase or otherwise acquire additional shares of Common Stock if thereafter they would together beneficially own more than 37.5% of the voting stock (provided that they will not be deemed collectively to own more than 37.5% of the voting stock solely by reason of the acquisition of Common Stock by Messrs. Reis and Stallings pursuant to any of the existing or future incentive stock plans). Mr. Stalling’s recapitalization agreement provides that he shall be nominated to the Board for two years after closing and for so long thereafter as he beneficially owns at least 20% of the Common Stock. First Western’s recapitalization agreement provides that during this two year period and for so long thereafter as it owns at least 10% of the voting stock and in the event Mr. Stallings ceases to be a director, First Western may designate another individual (including Mr. Reis) to serve on the Board.

Net Operating Loss Carryforwards

     As a result of losses in prior years, as of December 31, 2004 the Company has net operating loss carryforwards for tax purposes aggregating $72,200,837. These net operating loss carryforwards of $1,124,708, $22,806,147, $33,950,174, $13,686,532 and $633,276, if not utilized, will expire in 2018, 2020, 2021, 2022 and 2023, respectively. The tax benefit of the net operating loss carryforwards is $24,548,285, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $72,200,837.

     In certain circumstances, Section 382 of the Internal Revenue Code may apply to materially limit the amount of the Company’s taxable income that may be offset in a tax year by the Company’s net operating losses carried forward from prior years (the “§ 382 Limitation”). The annual § 382 Limitation generally is an amount equal to the value of the Company (immediately before an “ownership change”) multiplied by the long-term tax-exempt rate for the month in which the change occurs (e.g., 4.27% if the ownership change occurred in March 2005). This annual limitation would apply to all years to which the net operating losses can be carried forward.

     In general, the application of Section 382 is triggered by an increase of more than 50% in the ownership of all of the Company’s currently issued and outstanding stock (determined on the basis of value) by one or more “5% shareholders” during the applicable “testing period” (usually the three year period ending on the date on which a transaction is tested for an ownership change). The determination of whether an ownership change has occurred under Section 382 is made by aggregating the increases in percentage ownership for each 5% shareholder whose percentage ownership (by value) has increased during the testing period. For this purpose, all stock owned by persons who own less than 5% of the Company’s stock is generally treated as stock owned by a single 5% shareholder.

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     In general, a 5% shareholder is any person who owns 5% or more of the stock (by value) of the Company at any time during the testing period. The determination of whether an ownership change has occurred is made by the Company as of each “testing date.” For this purpose, a testing date generally is triggered whenever there is an “owner shift” involving any change in the respective stock ownership of the Company and such change affects the percentage of stock owned (by value) by any person who is a 5% shareholder before or after such change. A testing date also may be triggered by the Company’s issuance of options in certain limited circumstances. Examples of owner shifts that may trigger testing dates include a purchase or disposition of Company stock by a 5% shareholder, an issuance, redemption or recapitalization of Company stock that affects the percentage of stock owned (by value) by a 5% shareholder, and certain corporate reorganizations that affect the percentage of stock owned (by value) by a 5% shareholder.

     The Company believes that the recapitalization transactions described elsewhere in this Report did not trigger a limitation on the Company’s ability to utilize its loss carryforwards for federal income tax purposes. The recapitalization transactions did, however, result in a substantial ownership shift. Future transactions in Company stock by the Company or others could affect the Company’s ability to utilize the net operating loss carryforwards.

Accounting for Preferred Stock

     In May 2003, the Financial Accounting Standards Board (“FASB”) issued Statement No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity” (SFAS 150). This statement does not have an impact on the current accounting by the Company as all of the Company’s series of Preferred Stock are not considered “mandatory redeemable financial instruments” based on SFAS 150’s definition, and therefore are not subject to the accounting treatment under paragraph 9 of SFAS 150. All three series of Preferred Stock are currently classified as temporary equity pursuant to SEC ASR 268 and EITF Topic No. D-98. Rule 5-02.28 of SEC Regulation S-X requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date; (2) at the option of the holder; or (3) upon the occurrence of an event that is not solely within the control of the issuer.

Product Lines

     The Company’s principal products previously served certain nonstandard markets within the commercial lines and personal lines. On February 7, 2002, the Company announced its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results. In the first quarter of 2002 nonstandard personal auto became the only line of insurance marketed by the Company. The following table sets forth for nonstandard personal auto and all of the remaining lines that are in runoff (“Runoff lines”) gross premiums written (before ceding any amounts to reinsurers), percentage of gross premiums written for the periods indicated and the number of policies in force at the end of each period.

Nonstandard Personal Auto The Company only writes in the nonstandard personal auto market. These risks are written with policy liability limits not in excess of $40,000. Severe weather conditions generally result in higher incidences of automobile accidents and increases in the number of claims filed as well as the compensation sought by claimants. Due to the geographic concentration of the Company’s insureds (particularly near coastlines), the Company could be exposed to disproportionately high losses related to individual hurricanes and other severe weather conditions.

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Runoff Lines The Company announced on February 7, 2002 its decision to discontinue writing commercial lines insurance business due to continued adverse claims development and unprofitable results. The commercial lines of insurance previously written by the Company included:

     Commercial Auto The commercial auto coverage underwritten by the Company included risks associated with local haulers of specialized freight, tradespersons’ vehicles and trucking companies.

     Garage The Company’s garage product line included garage liability, garage keepers’ legal liability and dealers’ open lot coverages. The Company targeted its coverage to used car dealers, recreational vehicle dealers, automobile repair shops and wrecker/towing risks.

     General Liability The Company underwrote general liability insurance for businesses such as car washes, janitorial services, small contractors, apartment buildings, rental dwellings and retail stores.

     Property The Company underwrote commercial property coverages that included fire, extended coverage and vandalism on commercial establishments packaged with its liability product or on a monoline basis.

     Specialty Lines The Company underwrote and managed programs in professional liability for lawyers, real estate agents, educators and other general professions, as well as directors and officers liability.

     Umbrella The Company wrote personal umbrella risks which did not have access to the preferred markets.

     Property The Company wrote nonstandard dwelling fire risks.

Reinsurance

     The Company may purchase reinsurance in order to reduce its liability on individual risks and to protect against catastrophe claims. A reinsurance transaction takes place when an insurance company transfers, or “cedes,” to another insurer a portion or all of its exposure. The reinsurer assumes the exposure in return for a portion or the entire premium. The ceding of insurance does not legally discharge the insurer from its primary liability for the full amount of the policies, and the ceding company is required to pay the claim if the reinsurer fails to meet its obligations under the reinsurance agreement.

Commercial Lines

     Prior to 1999 and again beginning in 2001, the Company wrote commercial casualty policy limits up to $1,000,000. For policies with an effective date occurring from 1995 through 1998 and policies with an effective date occurring during 2001 or 2002, the Company has first excess casualty reinsurance for 100% of casualty claims exceeding $500,000 up to the $1,000,000 limits, resulting in a maximum net claim retention per risk of $500,000 for such policies. During 1999 and 2000, the Company wrote commercial casualty policy limits up to $5,000,000. For policies with an effective date occurring in 1999 or 2000, the Company has first excess casualty reinsurance for 100% of casualty claims exceeding $500,000 up to $1,000,000 and second excess casualty reinsurance for 100% of casualty claims exceeding $1,000,000 up to the $5,000,000 limits, resulting in a maximum net claim retention per risk of $500,000. The Company has facultative reinsurance for policy limits written in excess of the limits reinsured under the excess casualty agreements.

     Effective December 31, 2000, the Company entered into a quota share reinsurance agreement whereby the Company ceded 100% of its commercial auto liability unearned premiums and 50% of all other commercial business unearned premiums at December 31, 2000 to a non-affiliated reinsurer. For policies with an effective date

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of January 1, 2001 through December 31, 2001, the Company entered into a quota share reinsurance agreement whereby the Company ceded 20% of its commercial business to a non-affiliated reinsurer. Also effective December 31, 2000, the Company entered into a reserve reinsurance cover agreement with a non-affiliated reinsurer. This agreement reinsures the Company’s ultimate net aggregate liability in excess of $32,500,000 up to an aggregate limit of $89,650,000 for net commercial auto liability losses and loss adjustment expense incurred but unpaid as of December 31, 2000. The Company established a reinsurance balance receivable and a liability for funds held under reinsurance agreements for the reserves transferred at December 31, 2000. Also in connection with this agreement, the Company was required to maintain assets in a trust fund with a fair value at least equal to the funds held liability. The trust fund was established during the third quarter of 2001 and at December 31, 2001 the assets in the trust had a fair value of $49,553,698. Because the Company’s statutory policyholders’ surplus fell below certain levels specified in the agreement, the reinsurer had the option to direct the trustee to transfer the assets of the trust to the reinsurer. On March 29, 2002, the reinsurer exercised this option and the trust assets were transferred to the reinsurer. As a result, investments and funds held under reinsurance agreements were reduced by approximately $44,000,000. The Company recorded a realized gain of approximately $486,000 as a result of the transfer. The reinsurer continues to be responsible for reimbursing the Company for claim payments covered under this agreement.

     For 1998 through 2001, the Company also has excess casualty clash reinsurance for $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of the accident. For 2002, the Company has excess casualty clash reinsurance for 35% of $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of the accident.

     For its lawyers professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims and excess casualty reinsurance for 100% of professional liability claims exceeding $1,000,000 up to $5,000,000 policy limits resulting in a maximum net claim retention per risk of $500,000.

     For its real estate agents professional liability coverages with policy effective dates prior to August 1, 2001, the Company has quota share reinsurance for 25% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $750,000. For policies with an effective date occurring on August 1, 2001 through April 15, 2002, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000.

     For its educators professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 60% of the first $1,000,000 of professional liability claims and excess casualty reinsurance for 100% of professional liability claims exceeding $1,000,000 up to $5,000,000 policy limits resulting in a maximum net claim retention per risk of $400,000.

     For its directors and officers liability coverages with policy effective dates occurring prior to 2001, the Company has quota share reinsurance for 90% of the first $5,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000. For policies with an effective date occurring during 2001, the Company has quota share reinsurance for 85% of the first $5,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $750,000.

     For its miscellaneous professional liability coverages with policy effective dates occurring during 2001 or prior, the Company has quota share reinsurance for 50% of the first $1,000,000 of professional liability claims resulting in a maximum net claim retention per risk of $500,000.

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Personal Lines

     The Company’s nonstandard personal auto business produced by National Specialty Lines, Inc. (“NSL”) and, prior to August 1, 2001, Tri-State or written on a direct basis through Midwest Casualty Insurance Company. For business produced by NSL with an effective date of April 1, 2000 through December 31, 2000, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 20% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $20,000. For business produced by NSL with an effective date of January 1, 2001 through December 31, 2001, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 50% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $12,500. For 2002 the Company wrote nonstandard personal auto policies with limits up to $25,000. In 2003 and 2004 nonstandard personal auto policy liability limits do not exceed $40,000.

     For business produced by Tri-State or written on a direct basis with MCIC with an effective date prior to August 1, 2001, the Company has excess of loss reinsurance for 100% of claims in excess of $25,000 up to the $100,000 policy limits and quota share reinsurance for 50% of the first $25,000 of claims resulting in a maximum net claim retention per risk of $12,500.

     For its umbrella coverages for 1999 through 2001, the Company has excess casualty reinsurance for 100% of umbrella claims exceeding $1,000,000 up to $10,000,000 policy limits. For policies with an effective date occurring prior to February 1, 2001, the Company also has quota share reinsurance for 75% of the first $1,000,000 of umbrella claims resulting in a maximum net claim retention per risk of $250,000. For policies with an effective date occurring on February 1, 2001 through December 31, 2001, the Company has quota share reinsurance for 77.5% of the first $1,000,000 of umbrella claims resulting in a maximum net claim retention per risk of $225,000.

     For its nonstandard personal auto coverages for 1998 through 2001, the Company has excess casualty clash reinsurance for $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of the accident. Beginning in 2002, the Company has excess casualty clash reinsurance for 35% of $5,000,000 in ultimate net losses on any one accident in excess of $1,000,000 in ultimate net losses arising out of the accident.

Commercial and Personal Lines

     Certain reinsurance carried by the Company includes “extra-contractual obligations” coverage. This coverage protects the Company against claims arising out of certain legal liability theories not directly based on the terms and conditions of the Company’s policies of insurance. Extra-contractual obligation claims are covered 90% under the quota share, excess casualty and excess casualty clash reinsurance treaties up to their respective limits.

     Prior to 2001, the Company carried catastrophe property reinsurance to protect it against catastrophe occurrences for 95% of the property claims that exceed $500,000 but do not exceed $17,500,000 for a single catastrophe. In 2001, the Company carried catastrophe property reinsurance to protect it against catastrophe occurrences for 95% of the property claims that exceed $1,500,000 but do not exceed $13,000,000 for a single catastrophe as well as second event catastrophe property reinsurance for 100% of $1,000,000 excess of $500,000 on a second catastrophic event. In 2002, the Company carried catastrophe property reinsurance to protect it against catastrophe occurrences for property claims that exceed $500,000 but do not exceed $7,000,000. The Company did not have catastrophe reinsurance for business written in 2003 because of the exit from commercial lines and because the cost for coverage for the remaining personal lines was determined to be excessive in relation to the evaluation of risks to be retained. For 2004 the Company has catastrophe reinsurance on its nonstandard personal auto physical damage business for property claims of $1,500,000 in excess of $500,000 for a single catastrophe, as well as aggregate catastrophe property reinsurance for $1,500,000 in excess of $750,000 in the aggregate. The Company has signed contracts in force for its reinsurance agreements for all years through 2004.

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Marketing and Distribution

     Certain coverages, such as auto liability, may only be written in some states by companies with the authority to write insurance on an admitted basis in such states. The Company currently is approved to write insurance on a non-admitted basis in 39 states and the District of Columbia and on an admitted basis in 44 states and the District of Columbia.

     The Company markets its nonstandard personal auto insurance through over 1,800 non-affiliated retail agencies and one general agency that are compensated on a commission basis. The agents may represent several insurance companies, some of which may compete with the Company.

     The Company utilizes the agency market because they are in direct contact with the insurance buyers. The Company requires that its agents have a specified level of errors and omissions insurance coverage.

     The Company has developed underwriting manuals to be used by its agents. The agents are authorized to bind the Company to provide insurance if the risks and terms involved in the particular coverage are within the underwriting guidelines set forth in the Company’s underwriting manuals.

     The Office of the New York Attorney General and other state attorneys general are investigating certain insurance industry practices. The New York Attorney General has filed a lawsuit against Marsh & McLennan Companies, Inc. and, in so doing, named various insurance companies who may have had involvement in the insurance industry practices in question. The Company was not named in this lawsuit, nor does the Company believe it is the target of any related investigation. The investigations appear to center around practices by which other insurance companies paid contingent compensation to insurance brokers based on the volume or profitability of the insurance placed with the insurance company for their clients, allegedly in violation of the brokers’ duty to act in the best interest of their clients rather than their own undisclosed pecuniary interest. The Company markets its nonstandard personal auto insurance principally through over 1,800 non-affiliated retail agencies that are compensated on a commission basis, which sometimes includes incentives based on the volume or profitability of the business produced, and generally does not write insurance through insurance brokers. These agencies generally owe their principal duties to the companies that they represent rather than to their retail customers. The Company believes that because it utilizes agents, rather than brokers, to market its policies, the Company will not be subject to these ongoing investigation. Management is monitoring the situation and, if necessary, intends to take appropriate action.

     To facilitate its expansion into new states, the Company intends to place an increased focus on marketing. See “Recent Developments – Nonstandard Personal Auto Line.”

Unpaid Claims and Claim Adjustment Expenses

     Accidents generally result in insurance companies paying under the insurance policies written by them amounts to individuals or companies for the risks insured. Months and sometimes years may elapse between the occurrence of an accident, reporting of the accident to the insurer and payment of the claim. Insurers record a liability for estimates of claims that will be paid for accidents reported to them, which are referred to as “case reserves”. In addition, since accidents are not always reported promptly upon the occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions, insurers estimate liabilities for such items, which are referred to as “IBNR” reserves.

     The Company maintains reserves for the payment of claims and claim adjustment expenses for both case and IBNR under policies written by its subsidiaries. These claims reserves are estimates, at a given point in time, of amounts that the Company expects to pay on incurred claims based on facts and circumstances then known. The amount of case claim reserves is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding the claim, and the policy provisions relating to the type of claim. The amount of IBNR claims reserves is determined on the basis of historical information and anticipated future conditions by lines of insurance and actuarial review. Reserves for claim adjustment expenses are intended to cover the ultimate costs of settling claims, including investigation and defense of lawsuits resulting from such claims. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.

     The process of establishing claims reserves is imprecise and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimates thereof, because (a) estimates of claims and claim adjustment expense liabilities are subject to large potential errors of estimation as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes (even after coverage is written and reserves are initially set) that broaden liability and policy definitions and increase the severity of claims obligations, subsequent damage to property, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of losses do not make provision for extraordinary future

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emergence of new classes of losses or types of losses not sufficiently represented in the Company's historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate course of future events.

     Ultimate liability may be greater or lower than current reserves. Reserves are monitored by the Company using new information on reported claims and a variety of statistical techniques. The Company does not discount to present value that portion of its claim reserves expected to be paid in future periods. Beginning in the third quarter of 2002 and for each quarter thereafter, the Company set reserves equal to the selected reserve estimate as established by an independent actuarial firm. Formerly reserves were set based upon actuarial analysis by an actuary who was an employee of the Company and these reserves were reviewed annually by an independent actuarial firm.

     The following table sets forth the changes in unpaid claims and claim adjustment expenses, net of reinsurance cessions, as shown in the Company’s consolidated financial statements for the periods indicated:

     The decrease in the unpaid claims and claim adjustment expenses during 2004 and 2003 is primarily attributable to the exiting of commercial lines and the ongoing settlement of the remaining commercial lines claims. During 2004, favorable development from nonstandard personal auto and commercial auto was recorded and this accounts for the favorable development for the year. During 2003 the commercial general liability lines recorded unfavorable development of $7.6 million primarily in the 2000 and 2001 accident years, which was offset to some extent with favorable development recorded for the commercial auto and nonstandard personal auto lines of $5.4 million primarily in the 1999 and 2002 accident years. For 2002 the development in claims and claim adjustment expenses incurred was primarily the result of unanticipated development of commercial auto claims primarily for the 2001 and 2000 accident years and commercial general liability claims primarily for the 2001, 2000, 1999, 1997 and 1993 accident years. At December 31, 2004 the Company believes that the unpaid claims and claim adjustment expenses and the reinsurance agreements currently in force are sufficient to support the future emergence of prior year claim and claim adjustment expenses.

     The following table represents the development of GAAP balance sheet reserves for the years ended December 31, 1994 through 2004. The top line of the table shows the reserves for unpaid claims and claim adjustment expenses for the current and all prior years as recorded at the balance sheet date for each of the indicated years. The reserves represent the estimated amount of claims and claim adjustment expenses for claims arising in the current and all prior years that are unpaid at the balance sheet date, including claims that have been incurred but not yet reported to the Company.

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     The second portion of the following table shows the net cumulative amount paid with respect to the previously recorded liability as of the end of each succeeding year. The third portion of the table shows the reestimated amount of the previously recorded net unpaid claims and claim adjustment expenses based on experience as of the end of each succeeding year, including net cumulative payments made since the end of the respective year. For example, the 2003 liability for net claims and claim adjustment expenses reestimated one year later (as of December 31, 2004) was $74,671,000 of which $27,501,000 has been paid, leaving a net reserve of $47,170,000 for claims and claim adjustment expenses in 2003 and prior years remaining unpaid as of December 31, 2004.

     “Net cumulative (deficiency) redundancy” represents the change in the estimate from the original balance sheet date to the date of the current estimate. For example, the 2003 net unpaid claims and claim adjustment expenses indicate a $1,900,000 net redundancy from December 31, 2003 to December 31, 2004 (one year later) whereas the 2002 net unpaid claims and claim adjustment expenses indicate a $2,005,000 net deficiency from December 31, 2002 to December 31, 2004 (two years later). Conditions and trends that have affected development of liability in the past may or may not necessarily occur in the future. Accordingly, it may or may not be appropriate to extrapolate future redundancies or deficiencies based on this table.

     For the year ended December 31, 2004 the net cumulative redundancy reported was $1.9 million and was primarily attributable to the nonstandard personal auto and commercial auto lines.

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     The Company and the independent actuary complete a full actuarial analysis of unpaid claims and claim adjustment expenses on a quarterly basis for each of its coverage lines. Based upon this actuarial analysis and the new information that became available during the quarter, unpaid claims and claim adjustment expenses are reset each quarter.

     Net unpaid claims and claim adjustment expenses at December 31, 2004 were approximately $58.5 million, which the Company believes is adequate; they are set equal to the selected estimate determined by an independent actuarial firm. Of this amount, 95% is related to the Company’s three primary reserve coverage areas: Commercial General Liability ($24.8 million); Commercial Auto Liability ($16.7 million); and Nonstandard Personal Auto ($13.8 million). The remaining $3.2 million (5%) relates to eight smaller professional and miscellaneous commercial areas.

     The Company’s provision for unpaid claims and claim adjustment expenses was selected by an independent actuarial firm based on that firm’s actuarial analysis of the Company’s claims and claims adjustment expense experience. The independent actuary has opined that the unpaid claims and claims adjustment expenses selected: a) meet the requirements of the applicable state insurance laws; b) are consistent with amounts computed in accordance with the Casualty Actuarial Society Statement of Principles Regarding Property and Casualty Loss and Loss Adjustment Expense Reserves and relevant standards of practice promulgated by the Actuarial Standards Board; and c) make a reasonable provision for all unpaid claims and claims adjustment expense obligations of the Company under the terms of its contracts and agreements.

     The independent actuary has commented that in evaluating whether the selected reserves make a reasonable provision for unpaid claims and claims adjustment expenses, it is necessary to estimate future claims and claims adjustment expense payments and that actual future losses and loss adjustment expenses will not develop exactly as estimated and may, in fact, vary significantly from the estimates. With respect to the three primary insurance areas identified above, the independent actuary’s multiple actuarial test methods produced data points that are both higher and lower than selected amounts. The selection exceeds the average of these actuarial tests for the three principal reserve coverage areas as follows: Commercial General Liability, (+$2.3million); Commercial Auto Liability (+$2.0 million); and Nonstandard Personal Automobile (+$.9 million). The Commercial Automobile Liability amount is before the application of the Company’s Reserve Reinsurance Cover Agreement. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Subsidiaries, Principally Insurance Operations.” The independent actuary opined that there are still significant risks and uncertainties that could potentially result in material adverse deviation of the unpaid claims and claim adjustment expenses, and considered approximately $6.2 million net (15% of statutory surplus) to be material for this purpose.

     The independent actuary identified that significant risk factors in its evaluation included the adverse development in the Company’s unpaid claims and claims adjustment expense in recent years (see preceding table) and the Company’s decision in 2002 to discontinue writing commercial lines. See “Recent Developments – Discontinuance of Commercial Lines.” The independent actuary further indicated that its selected projections made no provision for extraordinary future emergence of new classes of claims or types of claims not sufficiently represented in the Company’s historical base or which are not yet quantifiable. The independent actuary also noted that other risk factors not cited in its report could be identified in the future as having been a significant influence on the Company’s unpaid claims and claim adjustment expenses.

     Management has reviewed and discussed the results of the actuarial analysis with the independent actuary, and believes the unpaid claims and claim adjustment expenses estimate selected by the independent actuary to be the best estimate for the Company at this time. With reference to its discontinued lines in particular, the Company believes the results of the independent actuary’s selections for the Commercial General Liability and Commercial Auto Liability areas are consistent with a separate internal case-by-case pessimistic analysis of remaining indemnity claims which, through comparison with the independent actuary’s selection, allows for approximately

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$4.9 million (before application of reinsurance except excess casualty reinsurance) in new claims still expected to be received, potential commutation exposures and additional unforeseen adverse development, all subject to the risks identified by the independent actuary. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Subsidiaries, Principally Insurance Operations.”

Insurance Ratios

Claims, Expense and Combined Ratios:

     Claims and expense ratios are traditionally used to interpret the underwriting experience of property and casualty insurance companies. Claims and claim adjustment expenses are stated as a percentage of net premiums earned (claims ratio). Commissions, change in deferred acquisition costs, underwriting expenses and operating expenses (for the insurance subsidiaries only) are stated as a percentage of net premiums earned (expense ratio). Underwriting profit is achieved when the combined ratio is less than 100%.

     The following table presents the insurance subsidiaries’ claims, expense and combined ratios on a GAAP basis:

     The holding company provides administrative and financial services for its wholly owned subsidiaries and only a portion of these expenses are allocated to the insurance companies. The allocation of the holding company’s expenses solely to its insurance companies would have an impact on their results of operations and would also affect the ratios presented.

     The decrease in the claim ratio for 2004 is primarily related to favorable development in nonstandard personal auto and commercial auto. The decrease in the expense ratio for 2004 is primarily attributable to an increase in fee income from the agency operation, which offsets expenses. The decrease in the claim ratio for 2003 is primarily the result of significantly less unfavorable development from commercial lines than in 2002. The decrease in the expense ratio for 2003 is primarily related to the continued runoff of commercial lines.

Net Leverage Ratios:

     The following table shows, for the periods indicated, the SAP net leverage ratios for the insurance subsidiaries and their industry peer group – professional nonstandard auto writers.

     Net leverage ratio represents the sum of the SAP net premiums to SAP surplus leverage ratio and the SAP net liability to SAP surplus leverage ratio. Added together, the net leverage ratio measures the combination of a company’s exposure to underwriting/pricing error on its current book of business (net premium leverage) and errors of estimation in its unpaid obligations (net liability leverage) including unpaid claim and claim adjustment expense and unearned premium.

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Net Premiums Written Leverage Ratios:

     The following table shows, for the periods indicated, the SAP net premiums written leverage ratios for the insurance subsidiaries and their industry peer group – professional nonstandard personal auto writers.

     The net premiums written leverage ratio represents the ratio of SAP net retained writings in relation to SAP surplus. This ratio measures a company’s exposure to pricing errors on its current book of business.

Investment Portfolio Historical Results and Composition

     The following table sets forth, for the periods indicated, the Company’s investment results before income tax effects:

     The following table sets forth the composition of the investment portfolio of the Company.

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     At December 31, 2004 the Standard & Poor’s ratings on the Company’s bonds available for sale were in the following categories: 53% AAA, 1% AA, 2% A, 5% BBB, 25% B and 14% CCC. The Company does not have any securities for which a fair value cannot be obtained by reference to public markets.

     The maturity distribution of the Company’s investments in fixed maturities is as follows:

     As of December 31, 2004, the Company did not have any non-performing fixed maturity securities. In March 2002, the Company reduced the carrying value of a non-rated commercial mortgage backed security to $0 resulting in a write down of approximately $2,010,000 as a result of a significant increase in the default rate in January and February of 2002 in the underlying commercial mortgage portfolio, which had disrupted the cash flow stream sufficiently to virtually eliminate future cash flows (see Note 1(c) of Notes to Consolidated Financial Statements).

Investment Strategy

     From October 4, 1999 to January 21, 2005, the investment portfolios of GNAC and its insurance company subsidiaries were managed by GMSP pursuant to its Investment Management Agreements with the respective companies. The investment policies were subject to the oversight and direction of the Investment Committees of the Boards of Directors of the respective companies. The respective Investment Committees consist entirely of directors not affiliated with GMSP.

     On January 21, 2005, the Company consummated a recapitalization pursuant to agreements that it entered into on August 27, 2004 and that were approved by GNAC’s shareholders on January 18, 2005. As a result of the recapitalization the investment management agreements of the Company and its insurance company subsidiaries with GMSP were terminated. The Company is managing the investment portfolio internally.

     The investment policies of the insurance subsidiaries, which are also subject to the respective insurance company legal investment laws of the states in which they are organized, are to maximize after-tax yield while maintaining safety of capital together with adequate liquidity for insurance operations. See Item 7A “Quantitative and Qualitative Disclosures About Market Risk.” The insurance company portfolios may also be invested in equity securities within limits prescribed by applicable legal investment laws.

Rating

A.M. Best

     A.M. Best is the principal rating agency of the insurance industry. An insurance company’s ability to effectively compete in the market place is in part dependent upon the rating determination of A.M. Best. A.M. Best provides ratings of insurance companies based on comprehensive quantitative and qualitative evaluations and expresses its rating as an opinion of an insurer’s ability to meet its obligations to policyholders. A.M. Best has 16 possible ratings; the Company’s rating of “B-” (Fair) ranks eighth from the highest rating. A.M. Best’s assigns a “B-” rating

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to companies that have, in the opinion of A.M. Best, a fair ability to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions.

     In July 2003, A.M. Best Property and Casualty Insurance Reports was published and indicated for the Company’s insurance subsidiaries group that “the rating (“B-” Fair) reflects the group’s weak operating performance, which has depleted capital in recent years, and the continued demands on the operating subsidiaries to fund the obligations of the Company, which have had an impact on its liquidity and cash flow position.” In April 2004, A.M. Best announced a rating assignment of the Company’s insurance subsidiaries of “B-” (Fair) with a stable outlook.

Government Regulation

     The Company’s insurance companies are subject to varied governmental regulation in the states in which they conduct business. Such regulation is vested in state agencies having broad administrative power dealing with all aspects of the Company’s business and is concerned primarily with the protection of policyholders rather than shareholders. The Company’s statutory capital exceeds the benchmark capital level under the Risk Based Capital formula for its insurance companies that are subject to Risk Based Capital requirements.

     The Company is also subject to statutes governing insurance holding company systems in the states of Oklahoma and Texas. These statutes require the Company to file periodic information with the state regulatory authorities, including information concerning its capital structure, ownership, financial condition and general business operation. These statutes also limit certain transactions between the Company and its insurance companies, including the amount of dividends that may be declared and paid by the insurance companies (see Note 7 of Notes to Consolidated Financial Statements). Additionally, the Oklahoma and Texas statutes restrict the ability of any one person to acquire 10% or more of the Company’s voting securities without prior regulatory approval.

Competition

     The property and casualty insurance industry is highly competitive. Relatively few barriers exist to prevent property and casualty insurance companies from entering into the Company’s segment of the industry. To the extent this occurs, the Company can be at a competitive disadvantage because many of these companies have substantially greater financial and operational resources. See “Recent Developments – Nonstandard Personal Auto Line.”

Employees

     As of December 31, 2004, the Company employed 139 persons, of whom 12 were officers, 121 were staff and administrative personnel, and 6 were part-time employees. The Company is not a party to any collective bargaining agreement.

ITEM 2. PROPERTIES

     The Company has no material real estate properties.

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ITEM 3. LEGAL PROCEEDINGS

Securities Litigation

     The Company is named as a defendant in a proceeding initially filed in the United States District Court for the Southern District of Florida (the “Florida Federal Court”) styled, “Earl Culp, on behalf of himself, and all others similarly situated, Plaintiff, v. GAINSCO, INC., Glenn W. Anderson, and Daniel J. Coots, Defendants,” Case No. 03-20854-CIV-Lenard/Simonton. Defendant Anderson is the Company’s President and Chief Executive Officer, and Defendant Coots is the Company’s Senior Vice President and Chief Financial Officer. In the proceeding, which is a consolidation of two previously separately pending actions filed at approximately the same time and involving essentially the same facts and claims, the plaintiff alleges violations of the Federal securities laws in connection with the Company’s acquisition, operation and divestiture of its former Tri-State, Ltd. (“Tri-State”) subsidiary, a South Dakota company selling non-standard personal auto insurance.

     On March 29, 2004, plaintiff filed a Second Consolidated Amended Class Action Complaint (the “Second Amended Complaint”) that is based on the same claims as the previously consolidated proceedings. The alleged class period begins on November 17, 1999, when the Company issued a press release announcing its agreement to acquire Tri-State, and ends on February 7, 2002, when the Company issued a press release warning investors that it “expect[ed] to report a significant loss for the fourth quarter and year ended December 31, 2001.” The Second Amended Complaint seeks class certification for the litigation.

     In general, the Second Amended Complaint alleges that during the class period the Company’s press releases and filings with the SEC contained non-disclosures and deceptive disclosures in respect of Tri-State, that the Company’s press releases and filings with the SEC disclosing the Company’s losses in 2000 and 2001 failed to disclose the alleged declining financial condition and declining profitability of Tri-State, and that the Company’s financial statements were not prepared in accordance with generally accepted accounting principles, all in violation of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 thereunder. More particularly, the Second Amended Complaint includes allegations that (i) the Company issued a press release on November 17, 1999 announcing the acquisition of Tri-State and stating that the Tri-State acquisition was “expected to be minimally accretive to earnings” in 2000; (ii) the Company failed to disclose that it had imposed more lenient underwriting and claims procedures on Tri-State’s book of nonstandard personal automobile insurance policies than Tri-State’s former owners, causing a reduction in Tri-State’s net income; (iii) the Company hid problems it was having at Tri-State and failed to disclose that Tri-State had lost profitability almost immediately after the Company acquired Tri-State in January 2000; (iv) the Company “buried” Tri-State’s financial performance in its LaLande business segment or in the reporting of the Company’s overall financial performance; (v) the Company failed to disclose in a Form 8-K a lawsuit it had filed on July 7, 2001 against Herb Hill, the founder of Tri-State, contending that the Herb Hill lawsuit was a material pending legal proceeding; (vi) Defendant Anderson hid Tri-State’s performance from the Company’s board of directors; and (vii) the Company violated generally accepted accounting principles by failing to record an impairment in or write-down of approximately $5.4 million in goodwill attributable to the Tri-State acquisition until the Company announced the sale of Tri-State in August 2001 back to Herb Hill for $900,000.

     On May 24, 2004, the Company and the individual defendants filed in the Florida Federal Court a motion to dismiss the Second Amended Complaint for failure to state a cause and a motion to transfer venue of the case to the United States District Court for the Northern District of Texas, Fort Worth Division (the “Fort Worth Federal Court”). On September 22, 2004 the Florida Federal Court granted defendants’ motion to transfer venue and transferred the case to the Fort Worth Federal Court. The pending defendants’ motion to dismiss was not ruled upon and was transferred with the case to the Fort Worth Federal Court and the parties were instructed to re-file all pleadings with the motion to dismiss.

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     On January 31, 2005, the Company and the individual defendants filed a renewed motion in the Fort Worth Federal Court to dismiss the Second Amended Complaint for failure to state a cause of action on several grounds, including: (i) plaintiff failed to plead loss causation by linking any correction of alleged non-disclosures or deceptive disclosures in respect of Tri-State to a decline in the Company’s stock price; (ii) plaintiff failed to challenge the accuracy of the disclosed causes of reported losses which negatively impacted the Company’s stock price; (iii) plaintiff failed to plead that the Company’s alleged statements and omissions in respect of Tri-State were false when made or that the Company knew they were false when made; (iv) the alleged misrepresentations by defendants in respect of Tri-State were immaterial in the context of all disclosures provided to the market; (v) Tri-State was not material to the Company’s performance as a whole and overall; (vi) the Herb Hill lawsuit was not a material pending legal proceeding; (vii) the Company complied with generally accepted accounting principles in its treatment of goodwill associated with the Tri-State acquisition; and (viii) plaintiff failed to plead facts with particularity showing that the defendants acted intentionally or with severe recklessness with respect to the alleged misrepresentations and omissions. The plaintiff has made a filing in the Fort Worth Federal Court in opposition to this motion to dismiss.

     The Second Amended Complaint does not specify the amount of damages plaintiff seeks. Discovery has not commenced. The Company believes that it has meritorious defenses to the claims asserted in plaintiff’s Second Amended Complaint and, although it cannot predict the outcome, intends to vigorously defend the action.

Other Legal Proceedings

     In the normal course of its operations, the Company has been named as defendant in various legal actions seeking payments for claims denied by the Company and other monetary damages. In the opinion of the Company’s management the ultimate liability, if any, resulting from the disposition of these claims will not have a material adverse effect on the Company’s consolidated financial position or results of operations. The Company’s management believes that unpaid claims and claim adjustment expenses are adequate to cover liabilities from claims that arise in the normal course of its insurance business.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     On January 18, 2005, the Company held a Special Meeting of Shareholders at which each of the six proposals constituting the restructuring of the Company described in the Company’s proxy statement dated December 22, 2004 was approved by the Company’s shareholders. See Item 8.01 of the Company’s Current Report on Form 8-K filed on January 24, 2005.

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PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS.

     The Company’s Common Stock is listed on the OTC Bulletin Board (Symbol: GNAC). The following table sets forth for the fiscal periods indicated the high and low closing sales prices per share of the Common Stock as reported by the NYSE for the period first quarter 2002 to April 14, 2002 and reported by the OTC Bulletin Board for the period April 15, 2002 through March 18, 2005. The prices reported reflect actual sales transactions.

     As of March 18, 2005, there were 314 shareholders of record of the Company’s Common Stock, including 91 banks and brokers for whom Depositary Trust Company or its designee is custodian and 223 other holders of record.

ITEM 6. SELECTED FINANCIAL DATA

     The following selected financial data is derived from our audited financial statements for the years ended December 31, 2004, 2003, 2002, 2001, and 2000. You should read selected financial data together with the more detailed information contained in the Financial Statements and associated Notes and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Form 10-K. See also Note 12 of Notes to Consolidated Financial Statements regarding a recapitalization of the Company consummated on January 21, 2005.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Business Operations

Overview

     In 2004 the Company recorded net income of $5,508,719 compared to net income of $3,375,772 in 2003 as it continued to experience profitable operating results from its nonstandard personal auto business in Florida. The other segments, which are all in runoff, have produced less unfavorable results in 2004 than in 2003 and less unfavorable results in 2003 than in 2002. Management continued in 2004 to implement actions intended to enhance the profit potential of the Company’s only active insurance line, nonstandard personal auto. Significant improvement in the combined ratio for this business is the primary reason for its level of profitability. The net loss of $8,761,087 in 2002 was attributable primarily to unfavorable claims experience and goodwill impairment. The Company’s focus on its obligations to the holders of its Preferred Stock, however, limited the Company’s ability to pursue opportunities to further expand its personal auto business in 2004. However, in January 2005 the Company completed a recapitalization transaction that removed this obstacle to the pursuit of a long-term strategic growth plan. See “Capital Transactions – 2005 Recapitalization”.

     The source of revenues for the Company in 2004 are premiums earned on nonstandard personal auto risks, net investment income from the investment portfolio of the Company, net realized gains from the sale of investments and fee income from the insurance agency operations.

     The Company recorded GAAP combined ratios of 96.6% in 2004, 105.1% in 2003 and 125.9% in 2002. The GAAP expense ratios, included in the GAAP combined ratios, were 27.5%, 30.9% and 32.3%, respectively. The expense and combined ratios do not include the expenses of the holding company.

Nonstandard Personal Auto Line

     The Company only writes nonstandard personal auto insurance and has no plans to write any other lines of insurance. This business has been profitable in recent periods, due in large part to favorable market conditions. The Company’s current vision is to grow that business strategically to establish a broader, more geographically diversified earnings base by expanding into new states and markets to achieve growth with diversification of risk.

     During its recent transition period (see “Capital Transactions – 2005 Recapitalization”), the Company limited its growth by maintaining a ratio of net premiums written to surplus (“leverage”) of approximately 1 to 1, which is below the level at which some competitors operate. The recently completed capital restructuring (discussed in detail below) has permitted management to change its focus to seek opportunities to grow premiums written while diversifying risk.

     The Company limited its business to Florida until the fourth quarter of 2003, when it began writing policies in Texas. In 2004, the Company began writing policies in Arizona and Nevada and initiated a California program with a non-affiliated managing general agency as well. The Company experienced significant growth in premiums written during the first two months of 2005, and management currently expects continuing growth in premiums written and an increase in the Company’s leverage. Significant growth could enable the Company to increase its profitability, if it is able to achieve that growth with favorable profit margins, but it also has the potential to cause material and adverse effects on the Company’s financial condition and results if not profitably written.

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     This growth strategy necessarily entails increased operational risks and other challenges that are greater than and different from those to which the Company has previously been subject in writing nonstandard personal automobile insurance. These new risks and challenges include, but are not limited to, the following:

	•	competitive conditions for the Company’s product have intensified recently, and further pressures on pricing are anticipated;
	•	generally, new business initially produces higher loss ratios than more seasoned in-force business, and this factor could be magnified to the extent that the Company enters multiple new states and market areas within a short period of time. Furthermore, it amplifies the importance of the Company’s ability to assess any new trends accurately and respond effectively;
	•	pricing decisions in new states and markets, involving different claims environments, distribution sources and customer demographics, will be made without the same level of experience and data that is available in existing markets;
	•	the Company’s expected growth will require additional personnel resources (including management personnel), relationships with agents and vendors with whom the Company has not previously done business, and additional dependence on operating systems and technology. The Company will face substantial challenges in maintaining adequate customer service and retaining business, particularly because of the additional complexity of operating in multiple states and time zones; and
	•	if the Company grows significantly or if adverse underwriting results occur, additional capital may be required, and such capital may not be available on favorable or acceptable terms. The ability of the Company to maintain sufficient capital and perform successfully will be important factors in determinations of its A. M. Best rating, and that rating could have a significant influence on its marketing initiatives.

     The Company’s ability to manage the foregoing risks and challenges, as well as potentially declining market conditions and possible unforeseen developments affecting its business, will determine in large part whether the Company’s strategy for profitable growth can be implemented successfully. There is no assurance that the Company will be able to achieve the objectives of its growth strategy.

Discontinuance of Commercial Lines

     On February 7, 2002, the Company announced its decision to cease writing commercial insurance, due to continued adverse claims development and unprofitable results. As a result, the Company had only 3 commercial policies remaining in force at December 31, 2004. The discontinuance of writing commercial lines has resulted in the Company ceasing to be approved to write insurance in several states, however, this state action has not materially restricted the geographic expansion of the Company’s personal auto lines thus far.

     The Company continues to settle and reduce its inventory of commercial lines claims. At year-end 2004, there were 264 claims associated with the Company’s overall runoff book outstanding, compared to 525 a year earlier. Due to the long tail and litigious nature of these claims, the Company anticipates it will take a substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims it expects to receive in the future from its past business writings. Most of the remaining claims are in litigation and the Company’s future results may or may not be impacted either negatively or positively based on its ability to settle the remaining claims and new anticipated claims within its established reserve level.

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Sale of GAINSCO County Mutual

     On December 2, 2002, the Company completed the sale and transfer of the management contract controlling GAINSCO County Mutual Insurance Company (“GCM”) to an affiliate of Liberty Mutual Insurance Company (“Liberty”), for a purchase price of up to $10 million, of which $1 million was paid at closing and the balance is payable in contingent payments through September 2009, but each payment is contingent on there being no material adverse change in the regulatory treatment of GCM specifically, or county mutuals generally, from legislative or regulatory administrative actions prior to the applicable payment date.

     In the session of the Texas Legislature ended June 2, 2003, changes were made in the statutes governing the regulatory treatment of county mutual insurance companies in Texas. These changes prejudice the rights of the Company to receive contingent payments from Liberty, depending upon how the statutory changes and the Company’s agreement with Liberty are interpreted. The Company contacted Liberty to discuss its obligation to make the contingent payments in light of the recent legislation. Liberty’s position is that they have no obligation to make any of the $9 million contingent payments under the agreement. The Company has fully reserved its receivable due from Liberty of $484,967 (representing the excess of the Company’s cost basis in GCM over the $1,000,000 received from Liberty at the closing of the sale transaction) as potentially uncollectible because of the statutory changes in 2003.

A.M. Best Rating

     A.M. Best is the principal rating agency of the insurance industry. An insurance company’s ability to effectively compete in the market place is in part dependent upon the rating determination of A.M. Best. A.M. Best provides ratings of insurance companies based on comprehensive quantitative and qualitative evaluations and expresses its rating as an opinion of an insurer’s ability to meet its obligations to policyholders. A.M. Best has 16 possible ratings; the Company’s rating of “B-” (Fair) ranks eighth from the highest rating. A.M. Best’s assigns a “B-” rating to companies that have, in the opinion of A.M. Best, a fair ability to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions.

     In July 2003, A.M. Best Property and Casualty Insurance Reports was published and indicated for the Company’s insurance subsidiaries group that “the rating (“B-” Fair) reflects the group’s weak operating performance, which has depleted capital in recent years, and the continued demands on the operating subsidiaries to fund the obligations of the Company, which have had an impact on its liquidity and cash flow position.” In April 2004, A.M. Best announced a rating assignment of the Company’s insurance subsidiaries of “B-” (Fair) with a stable outlook.

Critical Accounting Policies

     The discussion and analysis of the Company’s financial condition and results of operations are based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these financial statements requires management 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 financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates under different assumptions or conditions.

     Critical accounting policies are defined as those that are reflective of significant judgements and uncertainties, and potentially result in materially different results under different assumptions and conditions. The Company’s critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies. See Note 1 of Notes to Consolidated Financial Statements.

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Investments

     Bonds available for sale are stated at fair value with changes in fair value recorded as a component of comprehensive income. Short-term investments are stated at cost. The “specific identification” method is used to determine costs of investments sold. Provisions for possible losses are recorded only when the values have experienced impairment considered “other than temporary” by a charge to realized losses resulting in a new cost basis of the investment. The Company’s policy is to review investments on a regular basis to evaluate whether or not each investment has experienced an “other than temporary” impairment. Interest rate fluctuations and credit quality of the issuer impact the variability in the fair value. See Item 7A, “Quantitative and Qualitative Disclosures about Market Risk” for a discussion of variability of estimates.

Deferred Policy Acquisition Costs and Deferred Ceding Commission Income

     Policy acquisition costs, principally commissions and premium taxes, are deferred and charged to operations over periods in which the related premiums are earned. The change in the resulting deferred asset is charged (credited) to operations. The Company utilizes investment income when assessing recoverability of deferred policy acquisition costs. Recoverability is based upon assumptions as to loss ratios, investment income and maintenance expenses and would vary with changes in these estimates.

Goodwill

     Goodwill represents the excess of purchase price over fair value of net assets acquired. The Company periodically reviews the recoverability of goodwill based on an assessment of undiscounted cash flows of future operations to ensure it is appropriately valued. The recoverability of goodwill is evaluated on a separate basis for each acquisition.

     In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets” (“Statement 142”). Statement 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead tested for impairment at least annually in accordance with the provisions of Statement 142. Statement 142 also requires that intangible assets with definite useful lives be amortized over their respective estimated useful lives to their estimated residual values, and reviewed for impairment in accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.” The Company adopted the provisions of Statement 142 effective January 1, 2002, which resulted in the Company no longer amortizing goodwill.

     Goodwill of $609,000 is associated with the 1998 acquisition of the Lalande Group and reflects a value no more than the estimated fair valuation levels of combined agency and claims handling operations of this type in the personal automobile marketplace.

Unpaid Claims and Claim Adjustment Expenses

     Accidents generally result in insurance companies paying under the insurance policies written by them amounts to individuals or companies for the risks insured. Months and sometimes years may elapse between the occurrence of an accident, reporting of the accident to the insurer and payment of the claim. Insurers record a liability for estimates of claims that will be paid for accidents reported to them, which are referred to as “case reserves”. In addition, since accidents are not always reported promptly upon the occurrence and because the assessment of existing known claims may change over time with the development of new facts, circumstances and conditions, insurers estimate liabilities for such items, which are referred to as “IBNR” reserves.

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     The Company maintains reserves for the payment of claims and claim adjustment expenses for both case and IBNR under policies written by its subsidiaries. These claims reserves are estimates, at a given point in time, of amounts that the Company expects to pay on incurred claims based on facts and circumstances then known. The amount of case claim reserves is primarily based upon a case-by-case evaluation of the type of claim involved, the circumstances surrounding the claim, and the policy provisions relating to the type of claim. The amount of IBNR claims reserves is determined on the basis of historical information and anticipated future conditions by lines of insurance and actuarial review. Reserves for claim adjustment expenses are intended to cover the ultimate costs of settling claims, including investigation and defense of lawsuits resulting from such claims. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.

     The process of establishing claims reserves is imprecise and reflects significant judgmental factors. In many liability cases, significant periods of time, ranging up to several years or more, may elapse between the occurrence of an insured claim and the settlement of the claim. The actual emergence of claims and claim adjustment expenses may vary, perhaps materially, from the Company’s estimates thereof, because (a) estimates of claims and claim adjustment expense liabilities are subject to large potential errors of estimation as the ultimate disposition of claims incurred prior to the financial statement date, whether reported or not, is subject to the outcome of events that have not yet occurred (e.g., jury decisions, court interpretations, legislative changes (even after coverage is written and reserves are initially set) that broaden liability and policy definitions and increase the severity of claims obligations, subsequent damage to property, changes in the medical condition of claimants, public attitudes and social/economic conditions such as inflation), (b) estimates of losses do not make provision for extraordinary future emergence of new classes of losses or types of losses not sufficiently represented in the Company’s historical data base or which are not yet quantifiable, and (c) estimates of future costs are subject to the inherent limitation on the ability to predict the aggregate course of future events.

     Ultimate liability may be greater or lower than current reserves. Reserves are monitored by the Company using new information on reported claims and a variety of statistical techniques. The Company does not discount to present value that portion of its claim reserves expected to be paid in future periods. Beginning in the third quarter of 2002 and for each quarter thereafter, the Company has set reserves equal to the selected reserve estimate as established by an independent actuarial firm. Formerly reserves were set based upon actuarial analysis by an actuary who was an employee of the Company and these reserves were reviewed annually by an independent actuarial firm.

Income Taxes

     The Company and its subsidiaries file a consolidated Federal income tax return. Deferred income tax items are accounted for under the “asset and liability” method which provides for temporary differences between the reporting of earnings for financial statement purposes and for tax purposes, primarily deferred policy acquisition costs, the discount on unpaid claims and claim adjustment expenses, net operating loss carry forwards and the nondeductible portion of the change in unearned premiums.

     In assessing the realization of its deferred tax assets, management considers whether it is more likely than not that a portion or all of the deferred tax assets will be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon management’s consideration of expected reversal of deferred tax liabilities, projected future taxable income and FASB Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes”, management believes it is appropriate to continue to fully reserve the deferred tax assets as of December 31, 2004.

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Accounting Pronouncements

     In June 2004, the FASB issued EITF 03-01, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” EITF 03-01 requires an investor to determine when an investment is considered impaired, evaluate whether that impairment is other than temporary, and, if the impairment is other than temporary, recognize an impairment loss equal to the difference between the investment’s cost and its fair value. The guidance also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The impairment loss recognition and measurement guidance was to be applicable to other-than-temporary impairment evaluations in reporting periods beginning after June 15, 2004. In September 2004, the FASB proposed additional guidance related to debt securities that are impaired because of interest rate and/or sector spread increases, and delayed the effective date of EITF 03-01. We do not know the effect the adoption of EITF 03-01 will have on our financial condition, results of operations or liquidity. EITF 03-01 also includes disclosure requirements for investments in an unrealized loss position for which other-than-temporary impairments have not been recognized. These disclosures are included in our Form 10-K Annual Report for the year ended December 31, 2004 as required by the EITF.

     In December 2004, the FASB issued Statement No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123®”), which requires the cost resulting from stock options be measured at fair value and recognized in earnings. This Statement replaces Statement No. 123, “Accounting for Stock-Based Compensation” and supersedes Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” which permitted the recognition of compensation expense using the intrinsic value method. SFAS No. 123® will be effective July 1, 2005. We estimate that the impact of adoption of SFAS No. 123® will approximate the impact of the adjustments made to determine pro forma net income and pro forma earnings per share under Statement No. 123. See Note 1(m) of Notes to Consolidated Financial Statements. The Company plans to adopt SFAS No. 123® on July 1, 2005 using the modified-retrospective method, revising all prior periods.

Results of Operations

     Gross premiums written in 2004 were 27% above 2003 but in 2003 they were 22% below 2002. The growth in 2004 was primarily related to growth in Florida nonstandard personal auto. The Company’s decision in the first quarter of 2002 to discontinue writing commercial lines is primarily the reason for the decrease in 2003. In the first quarter of 2002 nonstandard personal auto became the only line of insurance marketed by the Company.

     The following table compares nonstandard personal auto and all of the remaining lines that are in runoff (“Runoff lines”) between the years for gross premiums written:

     Nonstandard Personal Auto increased 34% in 2004 over 2003 primarily due to growth within Florida, with Texas and Arizona contributing 13 points of the increase.

     Net premiums earned increased 14% in 2004 primarily due to growth from nonstandard personal auto in Florida. The 43% decrease in 2003 was primarily the result of discontinuing the writing of commercial lines in 2002.

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     Net investment income decreased 26% and 28% in 2004 and 2003, respectively. The decrease for both years was primarily attributed to the decline in investment balances, due to principal payments on the note payable, commercial claim payments and the short-term investments comprising a significantly greater portion of investments each year.

     The Company recorded net realized capital gains of $1,910,359, $2,050,236 and $2,048,848 in 2004, 2003 and 2002, respectively. Variability in the timing of realized investment gains should be expected. During 2002, the Company reduced the carrying value of a non-rated commercial mortgage backed security to $0 resulting in a write down of $2,010,670 (recorded as a realized loss in the statement of operations) as a result of a significant increase in the default rate in the underlying commercial mortgage portfolio, which had disrupted the cash flow stream sufficiently to make future cash flows unpredictable. This write-down was offset by net realized gains of $3,604,462 recorded from the sale of various bond securities and other investments in 2002 and the gain of $455,056 recognized from the sale of the home office building.

     Other income increased $829,550 in 2004 from 2003 primarily as a result of an increase in agency revenues due to the increase in writings. The decrease of $2,085,012 in 2003 from 2002 was primarily the result of a decrease in the amortization of deferred reinsurance recoveries from claim payments under the reserve reinsurance cover agreement. Amortization is based upon claims recovered from the reinsurer in relation to the amount of the reinsured layer under the reserve reinsurance cover agreement. In accordance with GAAP, the reinsurance recoveries from these reserve increases are recorded as deferred revenue and not immediately recognized as reductions to Claims and claim adjustment expenses (“C & CAE”). At December 31, 2004, $1,108,973 remains as deferred reinsurance recoveries that will ultimately be amortized into Other income in future periods.

     C & CAE increased $1,492,027 in 2004 from 2003 and decreased $30,897,174 in 2003 from 2002. The C & CAE ratio was 69.1% in 2004, 74.2% in 2003 and 93.6% in 2002. The decrease in the C & CAE ratio in 2004 was primarily related to favorable development in 2004 from nonstandard personal auto and commercial auto. The decrease in the C & CAE ratio in 2003 is due to smaller increases in estimated ultimate liabilities recorded in 2003 than was recorded in 2002. In 2003 the commercial general liability lines recorded increases in the 2000 and 2001 accident years, but this was offset to some extent with decreases recorded in the commercial auto and personal auto lines for the 1999 and 2002 accident years. With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company does not provide environmental impairment coverage and excludes pollution and asbestos related coverages in its policies. A portion of the Company’s remaining claims are related to construction defects. Inflation impacts the Company by causing higher claim settlements than may have originally been estimated. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.

     The ratio of commissions and the change in deferred policy acquisition costs (“DPAC”) to net premiums earned was 12% in 2004, 13% in 2003 and 15% in 2002. The progressive decrease in this ratio is primarily due to the shift in the mix of business to nonstandard personal auto, which has lower acquisition costs than commercial lines, and changes of estimates in the calculation of DPAC in 2004.

     Commissions are paid to independent retail agents to produce the business for the Company and typically vary with gross premiums written. Commissions increased in 2004 over 2003 primarily due to the increase in premiums written.

     Change in DPAC represents the change during the period in the asset “Deferred policy acquisition cost”. This asset item is comprised of commission expenses and premium taxes, which are deferred. This asset is amortized into the results of operations through “Change in deferred policy acquisition costs” as the underlying net premiums written are earned. Change in DPAC resulted in a credit in 2004 of $1,090,256, charges of $382,861 and $1,513,880 in 2003 and 2002, respectively. The credit in 2004 is primarily attributable to changes of estimates in the calculation of DPAC in 2004 and growth in nonstandard personal auto premiums. The charges in 2003 and

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in 2002 are primarily attributable to the amortization of previous DPAC exceeding current DPAC as a result of the decision to discontinue writing commercial lines in 2002.

     Interest expense from the note payable decreased in 2003 primarily as a result of principal payments on the note which was paid in full in the fourth quarter of 2003.

     Underwriting and operating expenses were up 8% in 2004 primarily due to a decrease in the allowance for doubtful reinsurance balances receivable in 2003 which did not recur in 2004. The decrease in 2003 was primarily due to expense reductions, primarily salaries and salary related expenses, and a decrease in the allowance for doubtful reinsurance balances receivable.

     Goodwill impairment in 2002 is a result of the Company positioning itself for an exit from the personal auto business in the second quarter of 2002 and the consideration of a sale of the Lalande Group. A re-evaluation of goodwill for the Lalande Group was made during this period and an additional impairment of $2,859,507 was recorded. This re-evaluation was based upon market indications of value contained in a proposal from a potential acquirer and upon the uncertainty of achieving value levels.

     The Company recorded a valuation allowance against its deferred Federal income tax asset because of the uncertainty of future taxable operating income. The Company does not lose the right to utilization of its net operating loss carry forwards for Federal income tax purposes in the future. In 2002, 2003 and 2004 the Company recorded taxable operating losses. Current expectations are that the Company will record taxable operating income in the future, at which time the reserve for the deferred tax asset will be re-evaluated. As of December 31, 2004 the deferred tax asset remains fully reserved. A reconciliation between income taxes computed at the Federal statutory rates and the provision for income taxes is included in Note 6 of Notes to Consolidated Financial Statements. The Company recognized a current tax benefit of $2,607,796 in 2002 as a result of a carry back of alternative minimum tax losses. A change in the tax law during 2002 extended the carry back period for losses to offset income in earlier periods. As a result, the Company was entitled to a tax refund, which it received in October 2002. The Company recorded deferred tax expense during the first quarter of 2002 due to an increase in the deferred tax asset valuation allowance, as a result of excluding the effects of unrealized gains in the deferred tax asset.

Legal Proceedings

Securities Litigation

     The Company is named as a defendant in a proceeding initially filed in the United States District Court for the Southern District of Florida (the “Florida Federal Court”) styled, “Earl Culp, on behalf of himself, and all others similarly situated, Plaintiff, v. GAINSCO, INC., Glenn W. Anderson, and Daniel J. Coots, Defendants,” Case No. 03-20854-CIV-Lenard/Simonton. Defendant Anderson is the Company’s President and Chief Executive Officer, and Defendant Coots is the Company’s Senior Vice President and Chief Financial Officer. In the proceeding, which is a consolidation of two previously separately pending actions filed at approximately the same time and involving essentially the same facts and claims, the plaintiff alleges violations of the Federal securities laws in connection with the Company’s acquisition, operation and divestiture of its former Tri-State, Ltd. (“Tri-State”) subsidiary, a South Dakota company selling non-standard personal auto insurance.

     On March 29, 2004, plaintiff filed a Second Consolidated Amended Class Action Complaint (the “Second Amended Complaint”) that is based on the same claims as the previously consolidated proceedings. The alleged class period begins on November 17, 1999, when the Company issued a press release announcing its agreement to acquire Tri-State, and ends on February 7, 2002, when the Company issued a press release warning investors that it “expect[ed] to report a significant loss for the fourth quarter and year ended December 31, 2001.” The Second Amended Complaint seeks class certification for the litigation.

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     In general, the Second Amended Complaint alleges that during the class period the Company’s press releases and filings with the SEC contained non-disclosures and deceptive disclosures in respect of Tri-State, that the Company’s press releases and filings with the SEC disclosing the Company’s losses in 2000 and 2001 failed to disclose the alleged declining financial condition and declining profitability of Tri-State, and that the Company’s financial statements were not prepared in accordance with generally accepted accounting principles, all in violation of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 thereunder. More particularly, the Second Amended Complaint includes allegations that (i) the Company issued a press release on November 17, 1999 announcing the acquisition of Tri-State and stating that the Tri-State acquisition was “expected to be minimally accretive to earnings” in 2000; (ii) the Company failed to disclose that it had imposed more lenient underwriting and claims procedures on Tri-State’s book of nonstandard personal automobile insurance policies than Tri-State’s former owners, causing a reduction in Tri-State’s net income; (iii) the Company hid problems it was having at Tri-State and failed to disclose that Tri-State had lost profitability almost immediately after the Company acquired Tri-State in January 2000; (iv) the Company “buried” Tri-State’s financial performance in its LaLande business segment or in the reporting of the Company’s overall financial performance; (v) the Company failed to disclose in a Form 8-K a lawsuit it had filed on July 7, 2001 against Herb Hill, the founder of Tri-State, contending that the Herb Hill lawsuit was a material pending legal proceeding; (vi) Defendant Anderson hid Tri-State’s performance from the Company’s board of directors; and (vii) the Company violated generally accepted accounting principles by failing to record an impairment in or write-down of approximately $5.4 million in goodwill attributable to the Tri-State acquisition until the Company announced the sale of Tri-State in August 2001 back to Herb Hill for $900,000.

     On May 24, 2004, the Company and the individual defendants filed in the Florida Federal Court a motion to dismiss the Second Amended Complaint for failure to state a cause and a motion to transfer venue of the case to the United States District Court for the Northern District of Texas, Fort Worth Division (the “Fort Worth Federal Court”). On September 22, 2004 the Florida Federal Court granted defendants’ motion to transfer venue and transferred the case to the Fort Worth Federal Court. The pending defendants’ motion to dismiss was not ruled upon and was transferred with the case to the Fort Worth Federal Court and the parties were instructed to re-file all pleadings with the motion to dismiss.

     On January 31, 2005, the Company and the individual defendants filed a renewed motion in the Fort Worth Federal Court to dismiss the Second Amended Complaint for failure to state a cause of action on several grounds, including: (i) plaintiff failed to plead loss causation by linking any correction of alleged non-disclosures or deceptive disclosures in respect of Tri-State to a decline in the Company’s stock price; (ii) plaintiff failed to challenge the accuracy of the disclosed causes of reported losses which negatively impacted the Company’s stock price; (iii) plaintiff failed to plead that the Company’s alleged statements and omissions in respect of Tri-State were false when made or that the Company knew they were false when made; (iv) the alleged misrepresentations by defendants in respect of Tri-State were immaterial in the context of all disclosures provided to the market; (v) Tri-State was not material to the Company’s performance as a whole and overall; (vi) the Herb Hill lawsuit was not a material pending legal proceeding; (vii) the Company complied with generally accepted accounting principles in its treatment of goodwill associated with the Tri-State acquisition; and (viii) plaintiff failed to plead facts with particularity showing that the defendants acted intentionally or with severe recklessness with respect to the alleged misrepresentations and omissions. The plaintiff has made a filing in the Fort Worth Federal Court in opposition to this motion to dismiss.

     The Second Amended Complaint does not specify the amount of damages plaintiff seeks. Discovery has not commenced. The Company believes that it has meritorious defenses to the claims asserted in plaintiff’s Second Amended Complaint and, although it cannot predict the outcome, intends to vigorously defend the action.

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Other Legal Proceedings

     In the normal course of its operations, the Company has been named as defendant in various legal actions seeking payments for claims denied by the Company and other monetary damages. In the opinion of the Company’s management the ultimate liability, if any, resulting from the disposition of these claims will not have a material adverse effect on the Company’s consolidated financial position or results of operations. The Company’s management believes that unpaid claims and claim adjustment expenses are adequate to cover liabilities from claims that arise in the normal course of its insurance business.

Capital Transactions

2005 Recapitalization

     Introduction. On January 21, 2005, the Company consummated a recapitalization pursuant to agreements that it entered into on August 27, 2004 and that were approved by GNAC’s shareholders on January 18, 2005. The agreements were with Goff Moore Strategic Partners, L.P. (“GMSP”), then holder of the Company’s Series A and Series C Preferred Stock and approximately 5% of the outstanding Common Stock; Robert W. Stallings, the Chairman of the Board and then holder of the Company’s Series B Preferred Stock; and First Western Capital, LLC, a limited liability company (“First Western”) owned by James R. Reis. The recapitalization substantially reduced as well as extended the Company’s existing Preferred Stock redemption obligations and resulted in cash proceeds to the Company of approximately $8.7 million (before an estimated $2.2 million in transaction costs and approximately $3.4 million used to redeem the Series C Preferred Stock). The events leading up to, and the transactions constituting, the recapitalization are described below.

     1999 GMSP Transaction. On October 4, 1999 and in conclusion of a strategic alternatives review process that the Board of Directors initiated in 1998 to seek out additional ways to maximize shareholder value (including the possible sale of the Company), the Company sold to GMSP, for an aggregate purchase price of $31,620,000, (i) 31,620 shares of Series A Preferred Stock (stated value $1,000 per share), which were convertible into 6,200,000 shares of Common Stock at a conversion price of $5.10 per share (subject to adjustment for certain events), (ii) the Series A Warrant (which expired unexercised on October 4, 2004) to purchase an aggregate of 1,550,000 - shares of Common Stock at an exercise price of $6.375 per share and (iii) the Series B Warrant expiring October 4, 2006 to purchase an aggregate of 1,550,000 shares of Common Stock at an exercise of $8.50 per share. At closing, the Company and its insurance company subsidiaries entered into investment management agreements with GMSP, pursuant to which GMSP managed their respective investment portfolios. In the securities purchase agreement entered into between GMSP and the Company for the 1999 GMSP transaction, the Company agreed to nominate John C. Goff and another individual selected by GMSP, and to use its best efforts to cause them to be elected to the Board.

     Background of 2001 Transactions with GMSP and Mr. Stallings. In early 2001 it became apparent to management that the Company’s insurance company subsidiaries had suffered more unexpected severe claims development in the fourth quarter of 2000 than originally thought, largely due to runoff from the commercial trucking lines that the Company announced on November 9, 2000 that it had determined to cease writing. As a result the Company was not in compliance with two covenants in its bank credit agreement, and, if the situation were not quickly addressed through the raising of additional equity capital, the Company faced the possibility of a qualified opinion from its auditors on the year ended December 31, 2000 and a downgrade of its A.M. Best rating, which at the time was A-. Under these circumstances the Company approached GMSP for financial assistance. GMSP in turn introduced the Company to Mr. Stallings with whom GMSP has previously had a successful relationship through its investment in Pilgrim Capital Corporation.

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     To evaluate the proposals and negotiate with GMSP and Mr. Stallings, the Board appointed a Special Committee of disinterested, independent directors. The Special Committee considered with its financial advisor the alternatives that might be available to the Company, and ultimately the Special Committee concluded that the alternatives most likely to succeed within the short time available would be transactions with GMSP and Mr. Stallings. GMSP’s willingness to invest additional capital in the Company at this critical time was among other things conditioned upon the Company’s agreeing to redeem the Series A Preferred Stock on January 1, 2006.

     2001 GMSP Transaction. On March 23, 2001, the Company consummated another transaction with GMSP pursuant to which, among other things, the Company issued 3,000 shares of its newly created Series C Preferred Stock (stated value of $1,000 per share) to GMSP in exchange for an aggregate purchase price of $3 million in cash. The annual dividend rate on the Series C Preferred Stock was 10% until March 23, 2004 and 20% thereafter. The Series C Preferred Stock was redeemable at the Company’s option after March 23, 2006 and at GMSP’s option after March 23, 2007 at a price of $1,000 per share plus accrued and unpaid dividends. The Series C Preferred Stock was not convertible into Common Stock.

     The agreement with GMSP in connection with the 2001 GMSP transaction was conditioned upon the following changes in the securities acquired by GMSP in the 1999 transaction: (i) the exercise prices of the Series A Warrant and the Series B Warrant held by GMSP were reduced to $2.25 per share and $2.5875 per share, respectively (each of these warrants provided for the purchase of 1,550,000 shares of Common Stock); and (ii) the Series A Preferred Stock was called for redemption by the Company so that on January 1, 2006 the Company would have become obligated to pay $1,000 per share for 31,620 shares ($31.6 million) to the holder to the extent that it could legally do so and, to the extent it could do so, the Company was obligated to pay quarterly an amount equal to 8% interest per annum on any unpaid balance.

     The 2001 agreement with GMSP also provided an opportunity to convert the Company’s illiquid investments with a cost of $4.2 million to cash as of November 2002. In February 2002 and with GMSP’s consent, the Company exercised its option to require GMSP purchase the illiquid investments for approximately $2.1 million.

     2001 Transactions with Robert W. Stallings. On March 23, 2001, the Company sold to Robert W. Stallings for $3 million in cash 3,000 shares of its newly created Series B Preferred Stock (stated value of $1,000 per share) and a warrant expiring March 23, 2006 to purchase an aggregate of 1,050,000 shares of Common Stock at $2.25 per share. The annual dividend provisions and the redemption provisions of the Series B Preferred Stock are the same as those for the Series C Preferred Stock. The Series B Preferred Stock was convertible into 1,333,333 shares of Common Stock at $2.25 per share. Mr. Stallings also entered into a consulting agreement pursuant to which he provided consulting services to the Company’s insurance subsidiaries for $300,000 per annum. In the securities purchase agreement entered into between Mr. Stallings and the Company for this transaction, the Company agreed to nominate Mr. Stallings, and use its best efforts to cause him to be elected to the Board.

     Preferred Stock in Relation to Capital Base. At December 31, 2004, the capital base (total assets less total liabilities) of the Company was $46,546,545 and consisted of Shareholders’ Equity of $12,854,545 and three series of Redeemable Preferred Stock (the Series A Preferred Stock, the Series B Preferred Stock and the Series C Preferred Stock), which were classified under GAAP as mezzanine financing in the aggregate amount of $33,692,000. At December 31, 2004, there was $3,928,000 of unaccreted discount on Redeemable Preferred Stock that remained in Shareholders’ Equity. At December 31, 2004, the per common share Shareholders’ Equity was approximately $0.61, including unaccreted discount on Redeemable Preferred Stock of $0.19; less such unaccreted discount, the per common share Shareholders’ Equity was approximately $0.42 per common share. The aggregate redemption value at December 31, 2004 of the Preferred Stock was $37,620,000 stated value.

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     Obligation to Redeem Series A Preferred Stock on January 1, 2006. On March 23, 2001, in satisfaction of a condition to the closing of the sale of $3,000,000 of Series C Preferred Stock to GMSP, the Company called the Series A Preferred Stock for redemption so that on January 1, 2006 the Company would be obligated to pay $31,620,000 to GMSP, subject to certain conditions. To the extent that the Company was restricted from redeeming the Series A Preferred Stock because of the conditions, the Company would be obligated to pay quarterly an amount equal to 8% interest per annum on any unpaid balance.

     Obligation to Redeem Series B and Series C Preferred Stock on March 23, 2007. The Series B and Series C Preferred Stock would become redeemable at the option of the holders commencing March 23, 2007 for the aggregate liquidation amount of $6,000,000 plus accrued dividends, subject to conditions similar to those conditions on the Company’s obligation to redeem the Series A Preferred Stock.

     Background of the Recapitalization. On May 19, 2003 the Board appointed a Special Committee of disinterested, independent directors which was authorized to review any proposal submitted for any investment in a business venture by the Company in which any holder of Preferred Stock or other affiliate was a co-investor or otherwise financially interested. At the time the Company was considering entering the financial services business by acquiring a company already in that business. Since the Company did not have the necessary capital for the transaction, the Company considered obtaining the necessary capital by entering into a joint arrangement with the holders of its Preferred Stock who could have provided necessary capital. Negotiations for such a transaction never developed to the point that management brought it to the Special Committee for its consideration.

     On November 17, 2003 the Board discussed how the writing of additional private passenger automobile insurance policies to provide the possibility of expanded premium and investment income would require the commitment of additional capital in the insurance subsidiaries, but that the taking of dividends out of the insurance company subsidiaries to satisfy dividend obligations to the Preferred Stock would limit these growth opportunities. There was also discussed an opportunity to enter into a potentially long-term exclusive relationship with a general agency in another state that, if it could be properly arranged and executed, possibly could lead to significant growth in premiums written. The Board then discussed the possibility of recapitalizing some or all of the Series A, B and C Preferred Stock in order to ease pressures on the Company’s capital structure and its A.M. Best rating. See “A.M. Best Rating” below. At this Board meeting the mandate of the Special Committee was expanded to authorize and empower the Special Committee to review and evaluate any recapitalization proposal made by any holder of Preferred Stock or other affiliate, and to take all action that in its judgment may be necessary or appropriate in order to evaluate, negotiate, approve or reject any transaction arising out of any such recapitalization proposal. The Special Committee was also granted the authority to engage such investment bankers, counsel and other advisors necessary to help the Special Committee evaluate any recapitalization proposal. The membership of the Compensation Committee and the Special Committee overlapped and, when it became apparent that the recapitalization would require arrangements for the compensation of individual officers and directors, the Special Committee began to meet with the Compensation Committee.

     On August 27, 2004 after 44 meetings, often with its counsel and financial advisors, the Special Committee approved the recapitalization agreements which are described below, and the Compensation Committee approved the related employment arrangements. The Special Committee received a fairness opinion from an independent investment banking firm to the effect that the consideration to be received by the Company in the recapitalization was fair, from a financial point of view, to the holders of the Common Stock other than those affiliated with GMSP, First Western and Mr. Stallings. Later on August 27, 2004 the full Board met and approved the recapitalization agreements and related employment agreements, in each case subject to shareholder approval.

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     Recapitalization Transactions. In the recapitalization which closed on January 21, 2005, of the 31,620 shares of Series A Preferred Stock held by GMSP and called in 2001 for redemption on January 1, 2006 at a redemption price of approximately $31.6 million, 13,500 shares (redemption value of $13.5 million) were exchanged for 19,125,612 shares of Common Stock. The remaining 18,120 shares of Series A Preferred Stock (which had been called for redemption in 2006 and have a redemption value of approximately $18.1 million) became redeemable at the option of the holders on January 1, 2011, and became entitled to receive cash dividends at the rate of 6% per annum until January 1, 2006 and 10% per annum thereafter until redemption. Those remaining 18,120 shares of Series A Preferred Stock remain convertible into 3,552,941 shares of Common Stock at $5.10 per share, continue to be entitled to vote on an as-converted basis, and remain redeemable at the option of the Company commencing June 30, 2005 at a price equal to stated value plus accrued dividends. The Company received an option to purchase all of the Series C Preferred Stock from GMSP, which the Company exercised on January 21, 2005 as part of the recapitalization for approximately $3.4 million from the proceeds of the sale of Common Stock in the recapitalization. The expiration date of GMSP’s Series B Warrant to purchase 1,550,000 shares of Common Stock for $2.5875 per share was extended to January 1, 2011. The investment management agreements of the Company and its insurance company subsidiaries with GMSP were terminated, as were the agreements entered into between the Company and GMSP in connection with their 1999 and 2001 transactions.

     Also as part of the recapitalization, (i) Mr. Stallings acquired 13,459,741 shares of Common Stock in exchange for $4,629,042.44 cash, his 3,000 shares of outstanding Series B Preferred Stock and his warrant expiring March 23, 2006 to purchase 1,050,000 shares of Common Stock for $2.25 per share, and (ii) First Western acquired 6,729,871 shares of Common Stock in exchange for $4,037,922 in cash. The purchase price of these shares was $0.60 per share.

     As a result of the recapitalization, the number of shares of Common Stock outstanding increased from 21,169,736 previously to 61,084,960 after closing of the recapitalization. GMSP now owns approximately 33% of the outstanding Common Stock, Mr. Stallings owns approximately 22% and First Western owns approximately 11%.

     In conjunction with the recapitalization, Mr. Stallings became executive Chairman of the Board of the Company, and Mr. Reis became Executive Vice President of the Company with responsibility for risk management. Mr. Stallings’ agreements entered into with the Company in the 2001 transactions were terminated, as was First Western’s consulting agreement with a subsidiary of the Company. Mr. Anderson remains as the Company’s President and Chief Executive Officer.

     The recapitalization agreements with GMSP, First Western and Mr. Stallings provide that, at least until January 21, 2007, the Company will (i) continue to be registered under Section 12(g) of the Securities Exchange Act of 1934 and file reports on Forms 10-K, 10-Q and 8-K (or their equivalents) and proxy statements with the Securities and Exchange Commission and (ii) observe and comply with many of the corporate governance rules promulgated by the New York Stock Exchange (even though the Common Stock is not listed there).

     In its recapitalization agreement, GMSP further agreed that at least until January 21, 2007, it would not purchase or otherwise acquire additional shares of Common Stock if thereafter it would beneficially own more than 37.5% of the voting stock (excluding the shares of Series A Preferred Stock entitled to vote on matters submitted to the holders of Common Stock) and that GMSP would not be deemed collectively to own more than 37.5% of the voting stock solely by reason of the acquisition of Common Stock (i) by Mr. Goff, pursuant to any existing or future Company incentive stock plans, or (ii) pursuant to the conversion of shares of Series A Preferred Stock or the exercise of the Series B Warrant. Additionally, GMSP agreed that during this two year period it would vote the shares of Series A Preferred Stock in respect of each matter submitted to the holders of the Common Stock in proportion to the vote of all shares of Common Stock voted on such matter such that the vote of the shares of Series A Preferred Stock will have no effect on the outcome of any proposal submitted to the holders of the Common Stock. During this two-year period GMSP also is entitled to designate Mr. Goff to serve on the Board for so long as GMSP beneficially owns at least 20% of the voting stock.

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     The recapitalization agreements with First Western and Mr. Stallings provide that, at least until January 21,2007 neither of them will purchase or otherwise acquire additional shares of Common Stock if thereafter they would together beneficially own more than 37.5% of the voting stock (provided that they will not be deemed collectively to own more than 37.5% of the voting stock solely by reason of the acquisition of Common Stock by Messrs. Reis and Stallings pursuant to any of the existing or future incentive stock plans). Mr. Stalling’s recapitalization agreement provides that he shall be nominated to the Board for two years after closing and for so long thereafter as he beneficially owns at least 20% of the Common Stock. First Western’s recapitalization agreement provides that during this two year period and for so long thereafter as it owns at least 10% of the voting stock and in the event Mr. Stallings ceases to be a director, First Western may designate another individual (including Mr. Reis) to serve on the Board.

     The following pro forma financial statements are presented: 1) a Pro Forma Consolidated Balance Sheet as of December 31, 2004 showing pro forma adjustments to the Consolidated Balance Sheet as of December 31, 2004 with Notes explaining the pro forma adjustments and 2) Pro Forma Consolidated Statement of Operations for the Year Ended December 31, 2004 showing pro forma adjustments to the Consolidated Statement of Operations for the Year Ended December 31, 2004 with Notes explaining the pro forma adjustments. The Pro Forma Consolidated Balance Sheet presents the effects of the transaction as if it were recorded as of December 31, 2004. The Pro Forma Consolidated Statement of Operations presents the effects of the transaction as if it were effective as of January 1, 2004. The pro forma results are not necessarily indicative of the results of operations which may occur in the future or that would have occurred had the recapitalization been consummated on the date indicated.

PRO FORMA CONSOLIDATED BALANCE SHEET