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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2004.

OR

Commission File Number 1-7461

For the transition period from              to             

ACCEPTANCE INSURANCE COMPANIES INC.

(Exact name of registrant as specified in its charter)

Suite 1600, 300 West Broadway

Council Bluffs, Iowa 51503

(Address of principal executive offices)

(Zip Code)

(712) 329-3600

Registrant’s Telephone Number, Including Area Code:

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 has been required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

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

The number of shares of each class of the Registrant’s common stock outstanding on August 9, 2004 was:

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ACCEPTANCE INSURANCE COMPANIES INC. AND SUBSIDIARIES

FORM 10-Q

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

The Registrant did not obtain a review of the unaudited interim financial statements included in this Form 10-Q by an independent registered public accounting firm, although that review is required by Form 10-Q, because the Registrant has not yet engaged an independent registered public accounting firm for 2004.

ACCEPTANCE INSURANCE COMPANIES INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS (dollars in thousands except share data)

The accompanying notes are an integral part of the consolidated financial statements.

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ACCEPTANCE INSURANCE COMPANIES INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands except per share data)

THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003

The accompanying notes are an integral part of the consolidated financial statements.

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ACCEPTANCE INSURANCE COMPANIES INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands)

SIX MONTHS ENDED JUNE 30, 2004 AND 2003

The accompanying notes are an integral part of the consolidated financial statements.

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ACCEPTANCE INSURANCE COMPANIES INC. AND SUBSIDIARIES

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

SIX MONTHS ENDED JUNE 30, 2004 AND 2003

(Columnar Amounts in Thousands Except Per Share Data)

Description of Operations – Acceptance Insurance Companies Inc. and subsidiaries (collectively the “Company”) has been a provider of property and casualty insurance (“Property and Casualty Segment”).

The Company’s results may be influenced by factors which are largely beyond the Company’s control. Important among such factors are changes in state and federal regulations, changes in the reinsurance market, including the ability and willingness of reinsurers to pay claims, decisions by regulators including any increased regulatory control over Acceptance Insurance Company as discussed below, the Company’s wholly-owned subsidiary, financial market performance, changes in federal policies or court decisions affecting coverages, changes in the rate of inflation, interest rates and general economic conditions.

Principles of Consolidation – The accompanying consolidated financial statements include the accounts of the Company and its majority-owned subsidiaries, including Acceptance Insurance Company (“AIC”). All significant intercompany transactions have been eliminated. AIC has been reflected in the consolidated financial statements under the caption “Insurance Operations”.

Basis of Presentation – The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the consolidated financial statements, the Company had a stockholders’ deficit of approximately $100.8 million and $97.4 million at June 30, 2004 and December 31, 2003, respectively. These factors among others indicate that there is substantial doubt about the Company’s ability to continue as a going concern.

The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. Additionally, the National Association of Insurance Commissioners has established risk-based capital (“RBC”) standards to measure the acceptable level of capital an insurer should maintain. As of June 30, 2004 and December 31, 2003, AIC, the Company’s only remaining insurance subsidiary, had negative statutory surplus resulting in RBC at a mandatory control level and is under an administrative Order of Supervision by the Nebraska Department of Insurance (“NEDOI”). AIC is no longer authorized to write new or renewal business and may not perform other activities beyond the routine conduct of its runoff business. The Company’s continuation as a going concern is dependent upon its ability to generate sufficient cash flow to meet its obligations on a timely basis, the attainment of management’s plans as discussed below and no further regulatory action by the NEDOI.

At this time, there can be no assurance as to what actions, if any, the NEDOI will take in connection with the varying estimates of the Company’s reserves and any further changes in estimates, if any. If the NEDOI does take action there can be no assurance as to when it may do so or how long it may take to complete any such action.

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The NEDOI Director (“Director”) currently has the authority to increase regulatory control of AIC by requesting an appropriate court to enter an Order of Rehabilitation or an Order of Liquidation, with or without a change in the financial condition of AIC. The Company believes that an Order of Rehabilitation would have a significant negative impact on the Company and that an Order of Liquidation would have a material adverse effect on the Company. If the NEDOI seeks and obtains an Order of Rehabilitation or Order of Liquidation, the Company will decide to take the course of action that is in the best interests of the Company based on all relevant factors. The Company believes that its possible options will range from no action to filing bankruptcy depending on what type of order, if any, is sought and obtained by the NEDOI, what actions the NEDOI takes pursuant to any such order and all other factors relevant to taking the actions that are in the best interests of the Company. The filing of a bankruptcy proceeding would constitute an event of default under the trust agreement for the Junior Subordinated Debentures and Trust Preferred Securities (See Note 3).

Additionally, there is significant uncertainty as to whether AIC will be able to meet its future cash flow needs. A major portion of AIC’s investments are pledged (See Note 7) and AIC’s ability to meet its cash flow needs will be highly dependent upon AIC’s ability to get significant amounts of pledged funds released. Additionally, AIC’s cash flows are significantly impacted by any changes in the expected payout of insurance losses and loss adjustment expenses. AIC’s ability to meet its cash flow needs is also dependent upon the timely recovery of reinsurance balances, including the favorable resolution of balances currently in dispute (See Note 5). Based upon current estimates, management of the Company believes AIC would likely have the ability to meet its cash flow needs through June 30, 2005 assuming the NEDOI does not obtain an Order of Rehabilitation or Order of Liquidation with respect to AIC. There can be no assurances considering the significant uncertainties that exist, that AIC will have the ability to meet its cash flow needs through June 30, 2005.

There is also significant uncertainty as to whether Acceptance Insurance Companies Inc. (“AICI”) will be able to meet its cash flow needs. AICI has deferred interest payments on its Junior Subordinated Debentures (See Note 3), which in turn deferred the interest on the Trust Preferred Securities issued by AICI Capital Trust, as permitted by the trust agreement and indenture, and AICI has disputed or denied payments of certain other liabilities and commitments. Based upon current estimates, management of the Company believes AICI would likely have the ability to meet its cash flow needs through June 30, 2005 assuming the NEDOI does not obtain an Order of Rehabilitation or Order of Liquidation with respect to AIC. There can be no assurances considering the significant uncertainties that exist, that AICI will have the ability to meet its cash flow needs through June 30, 2005. If the NEDOI obtains an Order of Rehabilitation or Order of Liquidation with respect to AIC, the Company believes that it is unlikely that AICI would be able to meet its short-term cash flow needs.

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Management has not adopted or contemplated to adopt a plan of liquidation; however, management may contemplate or adopt such strategies that are believed to be in the best interests of the Company which strategy could include a bankruptcy filing in liquidation or reorganization. Management’s current short-term business plan can be summarized as follows:

Unless these current short-term strategies are successful, the Company will not have the ability to implement any longer term strategies. The total focus continues to be on successfully accomplishing the above short-term strategies. If the Company is able to meet these short-term objectives, management may consider several strategies. These strategies may include commutation of reinsurance treaties, loss portfolio transfers, unwinding of trust balances and related items, sale of active and/or shell subsidiaries or other assets and other options that may be available. The Company may be required to accomplish certain of these strategies to meet its short-term and long-term objectives. At this time, management is unable to determine if any of these strategies will be available and if so, under acceptable terms to both the Company and the NEDOI. As such, it is uncertain if the Company can achieve its short-term or long-term objectives.

Even if the Company is able to meet these short-term objectives, management believes it is unlikely the Company will be able to make its interest payments on the Junior Subordinated Debentures which have been deferred until no later than September 30, 2007 (See Note 3).

Recent Statements of Financial Accounting Standards – In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities, which the Company adopted in 2003 with no impact to the consolidated financial statements. In December 2003, the FASB revised FIN No. 46 (“FIN 46R”) and deferred its adoption for variable interest entities (“VIEs”) that meet certain criteria until the first quarter of 2004. FIN 46R clarified the definition of a variable interest such that only the holder of a variable interest can ever be the VIE’s primary beneficiary. Only primary beneficiaries are permitted to consolidate VIEs. Therefore, FIN 46R does not permit consolidation of VIEs in which a company has voting control but is not the primary beneficiary. The AICI Capital Trust that is liable for the Company’s Trust Preferred Securities meets the definition of a VIE. Under FIN 46R, the Company is not the primary beneficiary in the AICI Capital Trust. For this reason, the Company may no longer consolidate the AICI Capital Trust, even though the Company is the sole owner of the voting equity of these entities.

With the adoption of FIN No. 46R, effective January 1, 2004, prior periods were restated for comparability. The effect of adoption was to increase the Company’s long-term debt and accrued interest by approximately $3.3 million with a corresponding increase in the investment in common stock of AICI Capital Trust of an equal amount. In addition, investment income and interest expense were increased by approximately $75,000 and $69,000 for the three months ended June 30, 2004 and 2003, respectively, and $149,000 and $137,000 for the six months ended June 30, 2004 and 2003, respectively.

Reclassifications – Certain prior period amounts have been reclassified to conform with the current period presentation.

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Subsequent to the issuance of the Company’s June 30, 2003 consolidated financial statements, the Company determined that SFAS No. 144 was not properly applied to the June 30, 2003 consolidated financial statement presentation. The accounting policy the Company previously used classified the Company’s property and casualty operations as discontinued operations due to its inability to write new business under the Order of Supervision.

Under the provisions of SFAS No. 144 a component of an entity is deemed to be disposed of if both of the following conditions are met: (a) the operations and cash flows of the component have been (or will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction and (b) the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. EITF Topic No. D-104, Clarification of Transition Guidance in Paragraph 51 of FASB Statement No. 144 clarifies that when “a component of an entity will be abandoned through the liquidation or run-off of operations, that component should not be reported as a discontinued operation in accordance with FASB 144 until all operations, including run-off operations, cease.” The Company originally concluded that the Property and Casualty Segment had been discontinued when the NEDOI placed AIC in supervision. Although the Company is no longer writing property and casualty insurance policies, managing the run-off of the liabilities resulting from that business has been determined to be a continuing operation of the Company under SFAS No. 144 until all such run-off ceases. Therefore, the Company’s consolidated financial statements for June 30, 2003 have been restated from amounts previously reported to reflect the property and casualty operations as continuing operations of the Company.

Additionally, subsequent to the issuance of the June 30, 2003 financial statements, the Company determined that the consolidated statements of cash flows did not include cash flows from discontinued operations. The June 30, 2003 consolidated cash flows previously reported solely reflected cash flows from continuing operations.

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A summary of the significant effects of the restatement is as follows:

The restatement of the consolidated statement of operations had no impact to the previously reported net loss and there was no impact to the previously reported stockholders’ equity. Certain other reclassifications of the prior year’s financial statements were made to conform to the 2004 presentation.

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In August 1997, AICI Capital Trust, a Delaware business trust organized by the Company (the “Issuer Trust”) issued 3.795 million shares or $94.875 million aggregate liquidation amount of its 9% Preferred Securities (liquidation amount $25 per Preferred Security). The Company owns all of the common securities (the “Common Securities”) of the Issuer Trust. The Preferred Securities represent preferred undivided beneficial interests in the Issuer Trust’s assets. The assets of the Issuer Trust consist solely of the Company’s 9% Junior Subordinated Debentures due in 2027, which were issued in August 1997 in an amount equal to the total of the Preferred Securities and the Common Securities. Distributions on the Preferred Securities and Junior Subordinated Debentures are cumulative, accrue from the date of issuance and are payable quarterly in arrears. The Junior Subordinated Debentures are subordinate and junior in right of payment to all senior indebtedness of the Company and are subject to certain events of default. The issue costs on the Junior Subordinated Debentures are being amortized over the term of the debt.

Effective January 1, 2004, the Company adopted FIN 46R. FIN 46R required the Company to deconsolidate the AICI Capital Trust. As a result of the adoption of FIN 46R, the Company now reports $97.8 million of the Company’s Junior Subordinated Debentures, which were issued to the AICI Capital Trust, on its consolidated balance sheet. The effect of the adoption increased the Company’s long-term debt by approximately $2.9 million. In addition, investment income and interest expense were increased by approximately $75,000 and $69,000 for the three months ended June 30, 2004 and 2003, respectively, and $149,000 and $137,000 for the six months ended June 30, 2004 and 2003, respectively.

Effective November 18, 2002, the Company elected to defer payment of interest on its Junior Subordinated Debentures, as permitted by the trust agreement and indenture, beginning with the interest payment date on December 31, 2002 until not later than September 30, 2007. The interest payments on the Preferred Securities will be deferred for a corresponding period. As of June 30, 2004 approximately $16.5 million of accrued interest had been deferred. See Note 1 regarding management’s expectations regarding the Company’s ability to pay such interest payments.

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The amortized cost and related estimated fair values of investments in the accompanying consolidated balance sheets are as follows:

The following table shows the investments’ gross unrealized losses and fair value, aggregated by investment category and length of time that individual securities have been in an unrealized loss position, at June 30, 2004:

Management has reviewed these securities and the related unrealized losses and believes these are not other-than-temporarily impaired. The unrealized losses on marketable equity securities – common stock relates to three investments and the aggregate fair value of these securities has increased by approximately 19% from June 30, 2003 to June 30, 2004 resulting in a decrease in unrealized losses of approximately $108,000.

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As required by insurance regulatory laws, certain fixed maturities with an estimated fair value of approximately $7.4 million at June 30, 2004 were deposited in trust with regulatory agencies. Additionally, at June 30, 2004, approximately $34.5 million of fixed maturities available-for-sale and $5.2 million of cash equivalents were pledged to Clarendon National Insurance Company (“Clarendon”) to secure the Company’s obligations under reinsurance agreements and approximately $9.8 million of fixed maturities available-for-sale and $198,000 of cash equivalents were pledged to McM Corporation (“McM”) to secure the Company’s net obligations under the reinsurance agreements (See Note 7).

The Company’s insurance subsidiary cedes insurance to other companies under quota share, excess of loss, catastrophe and facultative treaties. The reinsurance agreements are tailored to the various programs offered by the insurance subsidiary. Reinsurance does not discharge the insurer from its obligations to its insured. If the reinsurer fails to meet its obligations, the Company remains liable to pay the insured loss.

The Company reinsures certain portions of the Company’s business issued by Clarendon, Redland Insurance Company (“Redland”), Acceptance Indemnity Insurance Company (“AIIC”) and Acceptance Casualty Insurance Company (“ACIC”). Under these reinsurance agreements, the Company assumed business after Clarendon, Redland, AIIC, and ACIC cessions to outside reinsurers (See Note 7). However, the Company is contingently liable for any uncollectible amounts due from these outside reinsurers related to business produced and managed by the Company.

At December 31, 2003, PMA Reinsurance Group (“PMA”) accounts for approximately 13% of the Company’s outstanding reinsurance recoverables and reinsurance balances for which the Company is contingently liable (collectively “Total Reinsurance Balances”). PMA had its financial strength lowered by A.M. Best from A- (Excellent) to B++ (Very Good) in the fourth quarter of 2003. As of December 31, 2003 the Company has outstanding reinsurance recoverables from PMA of approximately $26.1 million and is contingently liable for AIIC and Redland reinsurance recoverables from PMA totaling approximately $9.0 million. With the exception of outstanding questions related to specific claims, as of June 30, 2004 PMA continues to make regular payments to the Company for reinsurance billings and accordingly, no specific allowances for doubtful accounts or liability has been established for these balances.

At December 31, 2003, Gerling Global Reinsurance Corp. (“Gerling”) accounts for approximately 13% of the Total Reinsurance Balances. Gerling had its financial strength rating lowered by A.M. Best from A- (Excellent) to B- (Fair) during the fourth quarter of 2002. In January 2003, in response to a request from Gerling’s parent to withdraw from the rating process, A.M. Best withdrew its financial strength rating of B- and assigned Gerling and its parent an NR-3 rating (Rating Procedure Inapplicable). As of December 31, 2003 the Company has outstanding reinsurance recoverables from Gerling of approximately $35.1 million and is contingently liable for AIIC and Redland reinsurance recoverables from Gerling totaling approximately $1.7 million. As of June 30, 2004 Gerling continues to make regular payments to the Company for reinsurance billings and accordingly, no specific allowance for doubtful accounts or liability has been established for these balances.

The Company has reinsurance recoverables and is contingently liable for AIIC and Redland reinsurance recoverables that are currently being disputed or payments have been delayed pending resolution of outstanding inquiries. While the Company believes the reinsurers will be required to pay amounts due under the terms of the reinsurance agreements and, accordingly, a liability has not been established for these reinsurance recoveries, the ultimate outcome cannot be predicted at this time.

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As of June 30, 2004 and December 31, 2003, the only remaining consolidated insurance company of AICI is AIC. The Director entered an administrative Order of Supervision with respect to AIC on December 20, 2002 and AIC is currently operating pursuant to that Order. AIC’s total statutory policyholders’ deficit was approximately $51.8 million and $61.3 million as of June 30, 2004 and December 31, 2003. The statutory deficit at June 30, 2004 and December 31, 2003 was significantly impacted by the non-admission under statutory accounting principles of pledged investments totaling approximately $49.8 million and $57.5 million, respectively (See Note 7).

The National Association of Insurance Commissioners has established risk-based capital (“RBC”) standards. RBC standards are designed to measure the acceptable level of capital an insurer should have, based on the inherent and specific risks of each insurer. As of June 30, 2004 and December 31, 2003, AIC had negative statutory surplus, resulting in a RBC at the mandatory control level. Under the mandatory control level, the Director may take such actions as necessary to place AIC under regulatory control under the Nebraska Insurers Supervision, Rehabilitation, and Liquidation Act. Since AIC is currently in run-off, the Director is permitted to allow AIC to continue its run-off under supervision of the NEDOI. While AIC is currently in supervision, the Director has the authority to increase regulatory control of AIC by requesting an appropriate court to enter an Order of Rehabilitation or an Order of Liquidation, with or without a change in the financial condition of AIC. The Company believes that an Order of Rehabilitation would have a significant negative impact on the Company and that an Order of Liquidation would have a material adverse effect on the Company (See Note 1).

Under the Order of Supervision, AIC is required to pay all costs incurred by the Supervisor, AIC may not accept or renew any insurance business and may not perform any activities beyond those that are routine in the day-to-day conduct of its runoff business without prior approval of the Director or Supervisor. Additionally, any transactions with affiliates or former affiliates require prior approval of the Director or Supervisor.

The Company sold its wholly owned subsidiary, Redland, to Clarendon effective as of July 1, 2000. The sale was a cash transaction of approximately $10.9 million based upon the market value of Redland after the divestiture of various assets, including the Redland subsidiaries, to a wholly owned subsidiary of Acceptance Insurance Companies Inc. The transaction included the appointment of other Company subsidiaries as a producer and administrator for the business the Company wrote through Clarendon and Redland. The Company also reinsures certain portions of the Company’s business issued by Clarendon and Redland. At June 30, 2004, approximately $34.5 million of fixed maturities available-for-sale and $5.2 million of cash equivalents were placed in a trust and pledged to Clarendon to secure the Company’s obligations under reinsurance agreements. Under these reinsurance agreements, the Company assumed business from Clarendon and Redland after cessions to outside reinsurers (“Clarendon Reinsurers”). At June 30, 2004, Clarendon and Redland reinsurance recoverables from Clarendon Reinsurers, totaled approximately $69 million (See Note 5). The Company is contingently liable for any uncollectible amounts due from Clarendon Reinsurers related to this business.

The amounts pledged to Clarendon were used to secure the issuance of a $20.6 million Redland letter of credit to the California Department of Insurance related to bond requirements resulting from the Company’s workers’ compensation business written on Redland paper (“Bond Requirements”).

As of July 1, 2001, the Company sold two wholly owned insurance companies to McM. The two companies, AIIC and ACIC, underwrote primarily property and casualty insurance. The Company

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reinsures certain portions of the Company’s business issued by AIIC and ACIC. As of June 30, 2004 approximately $9.8 million of fixed maturities available-for-sale and $198,000 of cash equivalents were placed in a trust and pledged to McM to secure the Company’s net obligations under the reinsurance agreements. Under these reinsurance agreements, the Company assumed business from AIIC and ACIC after cessions to outside reinsurers (“AIIC Reinsurers”). At June 30, 2004, AIIC and ACIC reinsurance recoverables from AIIC Reinsurers, totaled approximately $21 million (See Note 5). The Company is contingently liable for any uncollectible amounts due from AIIC Reinsurers related to this business.

The Company’s off-balance sheet obligations for the Clarendon and AIIC Reinsurers total approximately $89 million. The Company has guaranteed the performance of these Clarendon and AIIC Reinsurers. If these Clarendon and AIIC Reinsurers do not meet their obligations, whether or not due to their ability or willingness to pay, the Company will be obligated. The timing for the reinsurers’ performance of these obligations is currently not known and the amounts will become due from the reinsurers as the underlying direct claim payments are made. Additionally, the $89 million is an estimate of unpaid ceded losses and loss adjustment expenses on Redland, Clarendon, AIIC and ACIC, and are subject to considerable estimation judgment due to the inherent uncertainty in projecting ultimate claim amounts that will be reported and settled over a period of many years.

The net loss per basic and diluted share for the three and six months ended June 30, 2004 and 2003 were as follows:

Stock options were not included in the above calculations for the three and six months ended June 30, 2004 and 2003 due to their antidilutive nature.

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Other comprehensive income determined in accordance with SFAS No. 130 for the three and six months ended June 30, 2004 and 2003 are as follows:

The Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (“SFAS No. 123”), Accounting for Stock-Based Compensation, establishing financial accounting and reporting standards for stock-based compensation plans. As permitted by SFAS No. 123, the Company continues to use the method prescribed by the Accounting Principles Board Opinion No. 25 (“APB 25”), Accounting for Stock Issued to Employees. Companies using APB 25 are required to make pro forma footnote disclosures of net income and earnings per share as if the fair value method of accounting, as defined in SFAS No. 123, had been applied.

The Company has adopted the pro forma footnote disclosure only provisions under SFAS No. 123, as amended by SFAS No. 148. Had compensation cost for the Company’s stock-based compensation plans been determined based on the fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, as amended by SFAS No. 148, the Company’s net loss and net loss per share would have been as indicated below:

The difference between the net loss, as reported, and the pro forma net loss relates to total stock-based employee compensation expense determined under the fair value based method.

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11. EMPLOYEE BENEFITS AND INCENTIVES

The Company expects to incur a total of approximately $1.4 million of employee termination benefits related to 30 employees, comprised primarily of retention and severance amounts. Approximately $397,000 and $308,000 of employee termination benefits have been expensed primarily in insurance operations – insurance expenses during the six months ended June 30, 2004 and 2003, respectively. During the six months ended June 30, 2004 and 2003 approximately $179,000 and $87,000, respectively, of termination benefits were paid and as of June 30, 2004 the Company has an accrued liability of approximately $780,000.

In order to induce employees of AIC to remain in the employment of AIC, AICI has agreed to pay each employee a retention bonus in the event AIC would be unable to meet this obligation. Additionally, AICI has agreed to guarantee certain amounts due under employment agreements with the Chief Executive Officer and Chief Financial Officer. During the second quarter of 2003, AICI agreed to guarantee these obligations under the retention and employment agreements by establishing an appropriate trust with a bank whereby the amount of such guarantees, totaling approximately $1.1 million, have been deposited in such trust account. The amounts held in the trust account at June 30, 2004, totaling approximately $917,000, are presented as restricted cash equivalents on the Company’s consolidated balance sheet.

During the second quarter of 2003, the Company established an incentive bonus plan. The purpose of the incentive bonus plan is to protect and enhance the interest of creditors and stockholders by providing all employees with meaningful incentives. The incentive bonus plan establishes that up to 20% of an incentive bonus pool, determined based upon value added criteria detailed in the agreement, would be allocated and paid to employees based upon established allocation percentages. As of June 30, 2004, the criteria established within the agreement have not been met and the Company is unable to estimate any amounts that may become due and, as such, no amounts have been accrued.

12. LEGAL PROCEEDINGS

Class Action Complaint

In December 1999 the Company was sued in the United States District Court for the District of Nebraska. Plaintiffs alleged the Company knowingly and intentionally understated the Company’s liabilities in order to maintain the market price of the Company’s common stock at artificially high levels and made untrue statements of material fact, and sought compensatory damages, interest, costs and attorney fees. In February 2000 other plaintiffs sued the Company in the same Court, alleging the Company intentionally understated liabilities in a registration statement filed in conjunction with the Company’s Trust Preferred Securities.

The Court consolidated these suits in April 2000 and Plaintiffs subsequently filed a consolidated class action complaint. Plaintiffs sought to represent a class consisting of all persons who purchased either Company common stock between March 10, 1998 and November 16, 1999, or AICI Capital Trust Preferred Securities between the July 29, 1997 public offering and November 25, 1999. In the consolidated complaint Plaintiffs alleged violation of Section 11 of the Securities Act of 1933 through misrepresentation or omission of a material fact in the registration statement for the Trust Preferred Securities, and violation of Section 10b of the Securities Exchange Act of 1934 and Rule 10b–5 of the U.S. Securities and Exchange Commission through failure to disclose material information between March 10, 1998 and November 16, 1999. The Company, three of its former officers, the Company’s Directors and independent accountants and other individuals, as well as the financial underwriters for the Company’s Trust Preferred Securities, were defendants in the consolidated action.

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On March 2, 2001, the Court entered an order dismissing all claims alleging violations of Section 11 of the Securities Act, and dismissing the Company’s Directors, financial underwriters, independent accountants and others as defendants in this action. The Court also ruled that certain of Plaintiffs’ allegations regarding the remaining defendants’ alleged failure to properly report contingent losses attributable to the Montrose decision, a California Supreme Court decision creating a new basis for liability coverage under years of previously issued policies, did not state a claim under Section 10b and Rule 10b-5. In two subsequent rulings, the Court and Magistrate Judge clarified the March 2, 2001 ruling to specify which of Plaintiffs’ Montrose-related allegations failed to state a Section 10b and Rule 10b-5 claim. These three rulings reduced the litigation to a claim that the Company and three of its former officers, during the period from August 14, 1997 to November 16, 1999, failed to disclose adequately information about various aspects of the Company’s operations, including information relating to the Company’s exposure after January 1, 1997 to losses resulting from the Montrose decision. Nevertheless, Plaintiffs continue to seek compensatory damages, reasonable costs and expenses incurred in this action and such other and such further relief as the Court may deem proper.

On August 6, 2001, the Magistrate Judge granted Plaintiffs’ Motion for Class Certification. Plaintiffs’ fact discovery was concluded July 31, 2002 in accordance with a schedule established by the Court. On September 16, 2002 Plaintiffs sought the Court’s permission to reinstate certain previously dismissed claims under Section 11 and 15 of the Securities Act. The Court denied Plaintiffs’ request in its entirety on February 27, 2003. The Company filed a motion to decertify the class and a motion for summary judgment. On March 31, 2004, the Court granted the defendants’ motion for summary judgment in full, dismissing all of the plaintiffs’ remaining claims against all of the remaining defendants, and denied all other pending motions as moot. The plaintiffs have appealed the Court’s decision.

The Company intends to continue vigorously contesting this action and believes Plaintiffs’ allegations are without merit. Nevertheless, the ultimate outcome of this action cannot be predicted at this time and the Company currently is unable to determine the potential effect of this litigation on its consolidated financial position, results of operations or cash flows.

Takings Claim

On December 9, 2003, the Company filed a complaint against the United States of America. The complaint was filed in the United States Court of Federal Claims as discussed in the following two paragraphs.

In November 2002, the Company and Rain and Hail L.L.C. (“Rain and Hail”) entered into a letter of intent under which Rain and Hail agreed to purchase certain insurance assets of AGIC, a wholly owned subsidiary of the Company. Such assets were reinsured by, and subject to the oversight of, the FCIC. The transaction was subject to the approval of the Office of Risk Management, or the Risk Management Agency (the “RMA”). Ross J. Davidson, the Administrator of the RMA, advised that he would not approve the proposed sale of assets from the Company to Rain and Hail. The RMA subsequently enjoined AGIC from writing any new or renewal business. The Company alleges that the RMA’s actions rendered valueless the insurance business of AGIC.

The Company also alleges that in rejecting the proposed transaction between the Company and Rain and Hail, the RMA effected a taking of the Company’s property (i.e., the AGIC insurance assets) for public use without just compensation in violation of the Fifth Amendment to the United States Constitution. The Company seeks relief for its damages for the fair market value of the AGIC insurance assets in an amount of not less than $21.5 million, reasonable attorney’s fees and expert witness costs pursuant to 42 U.S.C. § 4654(c) with interest from the date of taking and such further relief the Court deems appropriate. On February 9, 2004 the United States filed a motion to dismiss the Company’s complaint and the Company filed a response to the motion to dismiss. The Court held a hearing

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regarding the motion to dismiss and response and has the motion under advisement. The ultimate outcome of this action cannot be predicted at this time and, accordingly, the Company currently is unable to determine the potential effect of this litigation on its consolidated financial position, results of operations or cash flows.

Granite Re Action

On April 15, 2004, Granite Reinsurance Company, LTD. (“Granite Re”) filed an action against the Company in the United States District Court for the Southern District of Indiana styled Granite Reinsurance Company, Ltd. v. Acceptance Insurance Companies, Inc., (S.D. Indiana, Case. No. 1:04-cv-0670-SEB-VSS) (the “Granite Re Action”). In the Granite Re Action, Granite Re alleges the Company breached certain alleged obligations under a reinsurance treaty entered into between the parties on June 6, 2001. Specifically, Granite Re alleges the Company breached an alleged obligation to pay Granite Re $3.0 million annually for a three year period, or a total of $9.0 million, for reinsurance. The Company filed a timely motion to dismiss the complaint in the Granite Re Action arguing Granite Re filed the complaint in the wrong forum. Granite Re has yet to respond to the motion. The Company expects to vigorously defend the Granite Re Action. The ultimate outcome of this action cannot be predicted at this time and the Company currently is unable to determine the potential effect of this litigation on its financial position, results of operations or cash flows.

Buchanan Action

In July 2004, P. Thompson Buchanan, the former President and a 40% shareholder of USAG Insurance Services, Inc., a Texas corporation 60% owned by Growers, filed an Original Petition in the District Court, Lubbock County, Texas against the Company, Growers and certain officers and directors of the Company styled Buchanan v. Martin, et al., No. 2004-527 (District Court, Lubbock County, Texas). In the Original Petition, Buchanan alleges he suffered damage because he allegedly was wrongfully terminated from his employment and not paid a severance. Mr. Buchanan further alleges he suffered a business loss as a result of alleged misrepresentations and other alleged misconduct. Mr. Buchanan claims losses in an amount not less than $13,000,000. The Company has engaged counsel and intends to vigorously defend this proceeding. The ultimate outcome of this action cannot be predicted at this time and the Company currently is unable to determine the potential effect of this litigation on its financial position, results of operations or cash flows.

Pursuant to a May 1999 agreement with RMA, for a period of time AIC became the nominal holder of the Company’s Standard Reinsurance Agreement. The agreement expressly provided that it would not affect any liabilities among AGIC, AIC and other Company affiliates, and, the Company does not believe AIC has any obligations as a result of this agreement. Nevertheless, the future conduct of RMA with respect to the May 1999 agreement is uncertain and the cost of defeating even a baseless RMA allegation involving the May 1999 agreement could be material to the Company.

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

The following discussion and analysis of financial condition and results of operations of the Company and its consolidated subsidiaries should be read in conjunction with the Company’s Interim Consolidated Financial Statements and the notes thereto included elsewhere herein.

Overview

Acceptance Insurance Companies Inc.’s (“AICI”) tangible assets are comprised of approximately $2.2 million in cash and cash equivalents and $1.3 million of restricted cash equivalents. Additionally, AICI has an investment in its subsidiary, Acceptance Insurance Company (“AIC”). AICI may also benefit from proceeds, if any, related to its complaint against the United States of America (See Part II Other Information, Item 1. “Legal Proceedings”) and proceeds, if any, related to the sale of any of its shell subsidiaries or other assets. AICI’s short-term strategy is to reduce expenses and maintain adequate short-term liquidity while preserving and, if possible, enhancing assets. There is significant uncertainty as to whether or not AICI will be able to achieve the objectives under its short-term strategy. If AICI is unable to achieve these objectives or believes that other strategies or objectives are in the best interest of the Company, the Company will decide to take the course of action that is in the best interests of the Company based upon all relevant factors, which action may include filing bankruptcy either in liquidation or reorganization.

AICI currently does not have access to the assets of its wholly owned subsidiary, AIC. AIC is regulated by the Nebraska Department of Insurance (“NEDOI”). The NEDOI Director (“Director”) entered an administrative Order of Supervision with respect to AIC on December 20, 2002 and AIC currently is operating pursuant to that Order. AIC’s total statutory policyholders’ deficit was approximately $51.8 million at June 30, 2004.

The Company’s short-term strategy related to AIC is to minimize payments of losses and loss adjustment expenses, effectively manage the collection of reinsurance balances, maintain adequate short-term liquidity and reduce expenses. There is significant uncertainty as to whether or not AIC will be able to achieve the objectives under its short-term strategy. If AIC is unable to achieve these objectives, the Company believes that the Director may increase regulatory control of AIC by requesting an appropriate court to enter an Order of Rehabilitation or an Order of Liquidation. Even if AIC achieves these objectives, the Director currently has the authority to increase regulatory control of AIC. The Company believes that an Order of Rehabilitation would have a significant negative impact on the Company and that an Order of Liquidation would have a material adverse effect on the Company.

If the Company is able to meet these short-term objectives, the Company may consider several strategies. These strategies may include commutation of reinsurance treaties, loss portfolio transfers, unwinding of trust balances and related items, sale of active and/or shell subsidiaries or other assets and other options that may be available. The Company may be required to accomplish certain of these strategies to meet its short-term and long-term objectives. At this time, the Company is unable to determine if any of these strategies will be available and if so, under acceptable terms to both the Company and the NEDOI. As such, it is uncertain if the Company can achieve its short-term or long-term objectives.

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Restatement and Reclassification of Financial Statements

Subsequent to the issuance of the Company’s June 30, 2003 consolidated financial statements, the Company determined that SFAS No. 144 was not properly applied to the June 30, 2003 consolidated financial statement presentation. The accounting policy the Company previously used classified the Company’s property and casualty operations as discontinued operations due to its inability to write new business under the Order of Supervision.

Under the provisions of SFAS No. 144 a component of an entity is deemed to be disposed of if both of the following conditions are met: (a) the operations and cash flows of the component have been (or will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction and (b) the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. EITF Topic No. D-104, Clarification of Transition Guidance in Paragraph 51 of FASB Statement No. 144 clarifies that when “a component of an entity will be abandoned through the liquidation or run-off of operations, that component should not be reported as a discontinued operation in accordance with FASB 144 until all operations, including run-off operations, cease.” The Company originally concluded that the Property and Casualty Segment had been discontinued when the NEDOI placed AIC in supervision. Although the Company is no longer writing property and casualty insurance policies, managing the run-off of the liabilities resulting from that business has been determined to be a continuing operation of the Company under SFAS No. 144 until all such run-off ceases. Therefore, the Company’s consolidated financial statements for June 30, 2003 have been restated from amounts previously reported to reflect the property and casualty operations as continuing operations of the Company.

Additionally, subsequent to the issuance of the June 30, 2003 financial statements, the Company determined that the consolidated statements of cash flows did not include cash flows from discontinued operations. The June 30, 2003 consolidated cash flows previously reported solely reflected cash flows from continuing operations.

The restatement of the consolidated statement of operations had no impact to the previously reported net loss and there was no impact to the previously reported stockholders’ equity. Certain other reclassifications of the prior year’s financial statements were made to conform to the 2004 presentation.

Forward-Looking Information

Except for the historical information contained in this Quarterly Report on Form 10-Q, matters discussed herein may constitute forward-looking information within the meaning of the Private Securities Litigation Reform Act of 1995. Such forward-looking information reflects the Company’s current best estimates regarding future operations, but, as these are only estimates, actual results may differ materially from such estimates.

A variety of factors, most of which are outside the control of the Company, cannot be accurately predicted and may materially impact estimates of future operations. Important among such factors are changes in state and federal regulations, decisions by regulators including any increased regulatory control over Acceptance Insurance Company as discussed below, changes in the reinsurance market, including the ability and willingness of reinsurers to pay claims, financial market performance, changes in federal policies or court decisions affecting coverages, changes in the rate of inflation, interest rates and general economic conditions.

The Company’s consolidated financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. As shown in the consolidated financial statements, as of June 30, 2004 and December 31, 2003, the Company had a stockholders’ deficit of approximately $100.8 million and $97.4 million, respectively.

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Additionally, the National Association of Insurance Commissioners has established risk-based capital (“RBC”) standards to measure the acceptable level of capital an insurer should maintain. As of June 30, 2004 and December 31, 2003, AIC, the Company’s only remaining insurance subsidiary, had negative statutory surplus resulting in risk based capital at a mandatory control level and is under an administrative Order of Supervision by the NEDOI. AIC is no longer authorized to write new or renewal business and may not perform other activities beyond the routine conduct of its runoff business. These factors among others indicate that there is substantial doubt about the Company’s ability to continue as a going concern.

The consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. The Company’s continuation as a going concern is dependent upon its ability to generate sufficient cash flow to meet its obligations on a timely basis, the attainment of management’s plans as discussed below and no further regulatory action by the NEDOI.

The NEDOI Director (“Director”) currently has the authority to increase regulatory control of AIC by requesting an appropriate court to enter an Order of Rehabilitation or an Order of Liquidation, with or without a change in the financial condition of AIC. The Company believes that an Order of Rehabilitation would have a significant negative impact on the Company and that an Order of Liquidation would have a material adverse effect on the Company. If the NEDOI seeks and obtains an Order of Rehabilitation or Order of Liquidation, the Company will decide to take the course of action that is in the best interests of the Company based on all relevant factors. The Company believes that its possible options will range from no action to filing bankruptcy depending on what type of order, if any, is sought and obtained by the NEDOI, what actions the NEDOI takes pursuant to any such order and all other factors relevant to taking the actions that are in the best interests of the Company. The filing of a bankruptcy proceeding would constitute an event of default under the trust agreement for the Trust Preferred Securities.

Additionally, there is significant uncertainty as to whether AIC will be able to meet its future cash flow needs. A major portion of AIC’s investments are pledged and AIC’s ability to meet its cash flow needs will be highly dependent upon AIC’s ability to get significant amounts of pledged funds released. Additionally, AIC’s cash flows are significantly impacted by any changes in the expected payout of insurance losses and loss adjustment expenses. AIC’s ability to meet its cash flow needs is also dependent upon the timely recovery of reinsurance balances, including the favorable resolution of balances currently in dispute. Based upon current estimates management of the Company believes AIC would likely have the ability to meet its cash flow needs through June 30, 2005 assuming the NEDOI does not obtain an Order of Rehabilitation or Order of Liquidation with respect to AIC. There can be no assurances considering the significant uncertainties that exist that AIC will have the ability to meet its cash flow needs through June 30, 2005.

There is also significant uncertainty as to whether Acceptance Insurance Companies Inc. (“AICI”) will be able to meet its cash flow needs. AICI has deferred interest payments on its Junior Subordinated Debentures, which in turn deferred the interest on the Trust Preferred Securities issued by AICI Capital Trust, as permitted by the trust agreement and indenture, and AICI has disputed or denied payments of certain other liabilities and commitments. Based upon current estimates management of the Company believes AICI would likely have the ability to meet its cash flow needs through June 30, 2005 assuming the NEDOI does not obtain an Order of Rehabilitation or Order of Liquidation with respect to AIC. There can be no assurances considering the significant uncertainties that exist, that AICI will have the ability to meet its cash flow needs through June 30, 2005. It is unlikely that AICI will be able to meet its long-term cash flow needs if either its short-term or long-term strategies are unsuccessful. If AICI is not able to meet its cash flow needs in the future, the Company will decide to take the course of action that is in the best interests of the Company based upon all relevant factors, which action may include

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filing bankruptcy. Additionally, if the NEDOI obtains an Order of Rehabilitation or Order of Liquidation with respect to AIC, the Company believes that it is unlikely that AICI would be able to meet its cash flow needs.

Management has not adopted or contemplated to adopt a plan of liquidation; however, management may contemplate or adopt such strategies that are believed to be in the best interests of the Company which strategy could include a bankruptcy filing in liquidation or reorganization. Management’s current short-term business plan can be summarized as follows:

Unless these current short-term strategies are successful, the Company will not have the ability to implement any longer term strategies. The total focus continues to be on successfully accomplishing the above short-term strategies. If the Company is able to meet these short-term objectives, management may consider several strategies. These strategies may include commutation of reinsurance treaties, loss portfolio transfers, unwinding of trust balances and related items, sale of active and/or shell subsidiaries or other assets and other options that may be available. The Company may be required to accomplish certain of these strategies to meet its short-term or long-term objectives. At this time, management is unable to determine if any of these strategies will be available and if so, under acceptable terms to both the Company and the NEDOI. As such, it is uncertain if the Company can achieve either its short-term or long-term objectives.

Even if the Company is able to meet these objectives, management believes it is unlikely the Company will be able to make its interest payments on the Preferred Securities which have been deferred until no later than September 30, 2007.

Forward-looking information set forth herein does not take into account any impact from the various factors noted above which may affect future results.

Results of Operations

Three and Six Months Ended June 30, 2004

Compared to Three and Six Months Ended June 30, 2003

The Company’s net loss decreased to $1.1 million, or $0.08 per share, and $2.7 million, or $0.19 per share, for the three and six months ended June 30, 2004, respectively, from $11.1 million, or $0.78 per share, and $14.6 million, or $1.03 per share, for the three and six months ended June 30, 2003, respectively.

The Company’s revenue increased from $1.3 million during the three months ended June 30, 2003 to $1.9 million during the three months ended June 30, 2004. The Company’s revenue increased from $3.3 million during the six months ended June 30, 2003 to $3.5 million during the six months ended June 30, 2004. The increase in revenues for the three and six month periods was primarily due to a $664,000 and $1.1 million increase in total net realized capital gains, respectively, partially offset by a $259,000 and $727,000 decrease in total net investment income. The net investment income of the insurance operations continued to decline as the Company continues to manage the run-off of its property and casualty operations.

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During the six months ended June 30, 2003, the Company sold its office building and certain contents in Council Bluffs, Iowa. The proceeds included approximately $204,000 of cash and a note receivable with a fair value of approximately $1.3 million and the sale resulted in a gain of approximately $334,000. During the three and six months ended June 30, 2004, the Company sold Florida real estate for approximately $1.5 million and $2.7 of cash, respectively, realizing capital gains of approximately $867,000 and $1.6 million, respectively, in its insurance operations.

The Company’s total costs and expenses decreased from $10.0 million for the three months ended June 30, 2003 to $396,000 for the three months ended June 30, 2004. The Company’s total costs and expenses decreased from $13.3 million for the six months ended June 30, 2003 to $1.2 million for the six months ended June 30, 2004. The results for the second quarter of 2003 included a reserve strengthening of approximately $7.7 million, primarily as a result of higher than expected loss adjustment expenses for general liability claims and higher than expected losses for workers’ compensation claims. Additionally, the six months ended June 30, 2003 results include a reserve strengthening of approximately $692,000 recorded in the first quarter of 2003, primarily for auto liability claims. Additionally, expenses in the insurance operations declined as the Company’s continues to manage the run-off of its property and casualty operations.

Liquidity and Capital Resources

The Company has included a discussion of the liquidity and capital resources requirement of the Company and the Company’s insurance subsidiary.

The Company - Parent Only

As an insurance holding company, the AICI’s assets consist primarily of the equity interest in AIC, a surplus note issued by AIC and cash and cash equivalents held at the holding company level. The Company’s liquidity needs are primarily to service debt and pay operating expenses.

At June 30, 2004 the Company has $2.2 million in cash and cash equivalents and $1.3 million of restricted cash equivalents. The Company also holds a surplus note for $20 million issued by AIC, bearing interest at the rate of 9% per annum payable quarterly. The Company does not expect to have access to any surplus note interest payments or dividend payments from AIC, as these payments would require NEDOI approval as AIC is currently under the supervision of the NEDOI.

During the six months ended June 30, 2003, the Company sold its office building and certain contents in Council Bluffs, Iowa. The proceeds included approximately $204,000 of cash and a note receivable with a fair value of approximately $1.3 million and the sale resulted in a gain of approximately $334,000. During the fourth quarter of 2003, the Company sold the note receivable for approximately $1.2 million and the sale resulted in a loss of approximately $83,000.

In order to induce employees of AIC to remain in the employment of AIC, AICI has agreed to pay each employee a retention bonus in the event AIC would be unable to meet this obligation. Additionally, AICI has agreed to guarantee certain amounts due under employment agreements with the Chief Executive Officer and Chief Financial Officer. During the second quarter of 2003, AICI agreed to guarantee these obligations by establishing an appropriate trust with a bank whereby the amount of such guarantees, totaling approximately $1.1 million, have been deposited in such trust account. The amounts held in the trust account at June 30, 2004, totaling approximately $917,000, are presented as restricted cash equivalents on the Company’s consolidated balance sheets.

In August 1997, AICI Capital Trust, a Delaware business trust organized by the Company (the “Issuer Trust”) issued 3.795 million shares or $94.875 million aggregate liquidation amount of its 9% Preferred

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Securities (liquidation amount $25 per Preferred Security). The Company owns all of the common securities (the “Common Securities”) of the Issuer Trust. The Preferred Securities represent preferred undivided beneficial interests in the Issuer Trust’s assets. The assets of the Issuer Trust consist solely of the Company’s 9% Junior Subordinated Debentures due in 2027, which were issued in August 1997 in an amount equal to the total of the Preferred Securities and the Common Securities. Distributions on the Preferred Securities and Junior Subordinated Debentures are cumulative, accrue from the date of issuance and are payable quarterly in arrears. The Junior Subordinated Debentures are subordinate and junior in right of payment to all senior indebtedness of the Company and are subject to certain events of default. The issue costs on the Junior Subordinated Debentures are being amortized over the term of the debt.

Effective November 18, 2002, the Company elected to defer payment of interest on its Junior Subordinated Debentures, as permitted by the trust agreement and indenture, beginning with the interest payment date on December 31, 2002 until not later than September 30, 2007. The interest payments on the Preferred Securities will be deferred for a corresponding period. As of June 30, 2004 approximately $16.5 million of accrued interest had been deferred. See Note 1 regarding management’s expectations regarding the Company’s ability to pay such interest payments.

There is significant uncertainty as to whether the Company will be able to meet its cash flow needs. As noted above, the Company has deferred interest payments on its Trust Preferred Securities and additionally, the Company has disputed or denied payment of certain other liabilities and commitments. While based upon current estimates management of the Company believes AICI would likely have the ability to meet its cash flow needs through June 30, 2005, there can be no assurances considering the significant uncertainties that exist. It is unlikely that AICI will be able to meet its long-term cash flow needs if either its short-term or long-term strategies are unsuccessful. If AICI is not able to meet its cash flow needs in the future, the Company will decide to take the course of action that is in the best interest of the Company based upon all relevant factors, which action may include filing bankruptcy.

Acceptance Insurance Company

The Company’s only consolidated insurance subsidiary at June 30, 2004 is AIC. The principal liquidity needs of AIC are to fund losses and loss adjustment expense payments and operating expenses related to the run-off of its property and casualty operations. The available sources to fund these requirements are cash flows from the Company’s investment activities, of which at June 30, 2004 approximately 81% and 18% of AIC’s fixed maturity securities and cash and cash equivalents, respectively, are pledged to states and to acquirers of former Company affiliates.

AIC’s investment portfolio is primarily comprised of fixed maturities and cash equivalents. At June 30, 2004, approximately $49.7 million of fixed maturity securities and cash equivalents were placed in a trust and pledged in order to secure AIC’s obligations under reinsurance agreements. The agreements provide for the release of the pledged securities as the obligations under the reinsurance agreements decrease. However, if AIC is unsuccessful in obtaining the release of pledged securities, AIC’s liquidity would suffer a significant negative impact. See “Off-Balance Sheet Arrangements” for additional information. Additionally, as required by insurance regulatory laws, certain fixed maturity securities with an estimated fair value of approximately $7.4 million at June 30, 2004 were deposited in trust with regulatory agencies.

There is significant uncertainty as to whether AIC will be able to meet its future cash flow needs. As noted above, a major portion of AIC’s investments are pledged and AIC’s ability to meet its cash flow needs will be highly dependent upon AIC’s ability to get significant amounts of pledged funds released. Additionally, AIC’s cash flows are significantly impacted by any changes in the expected payout of insurance losses and loss adjustment expenses. AIC’s ability to meet its cash flow needs is also dependent upon the timely recovery of reinsurance balances, including the favorable resolution of

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balances currently in dispute. Based upon current estimates management of the Company believes AIC would likely have the ability to meet its cash flow needs through June 30, 2005. There can be no assurances considering the significant uncertainties that exist that AIC will have the ability to meet its cash flow needs through June 30, 2005. Based upon current agreements that are in place, primarily related to amounts pledged under the trust agreements, it is unlikely that AIC will be able to meet its long term cash flow needs without changes to existing agreements, commutation of reinsurance agreements or other strategies, if available.

Changes in Financial Condition

The Company’s stockholders’ deficit increased by approximately $3.5 million from December 31, 2003 to June 30, 2004. The principal component of this increase was a net loss of $2.7 million for the six months ended June 30, 2004.

Consolidated Cash Flows

Cash used by operating activities was approximately $10.8 and $43.0 million during the six months ended June 30, 2004 and 2003, respectively. The Company expects negative cash flows from operating activities as the Company runs off its property and casualty operations. See “The Parent – Company Only” and “Acceptance Insurance Company” regarding uncertainties of the Company to meet its ongoing cash flow needs.

Off-Balance Sheet Arrangements

The Company sold its wholly owned subsidiary, Redland Insurance Company (“Redland”), to Clarendon National Insurance Company (“Clarendon”) effective as of July 1, 2000. The sale was a cash transaction of approximately $10.9 million based upon the market value of Redland after the divestiture of various assets, including the Redland subsidiaries, to a wholly owned subsidiary of Acceptance Insurance Companies Inc. The transaction included the appointment of other Company subsidiaries as a producer and administrator for the business the Company wrote through Clarendon and Redland. The Company also reinsures certain portions of the Company’s business issued by Clarendon and Redland. At June 30, 2004, approximately $34.5 million of fixed maturities available-for-sale and $5.2 million of cash equivalents were placed in a trust and pledged to Clarendon to secure the Company’s obligations under reinsurance agreements. Under these reinsurance agreements, the Company assumed business from Clarendon and Redland after cessions to outside reinsurers (“Clarendon Reinsurers”). At June 30, 2004, Clarendon and Redland reinsurance recoverables from Clarendon Reinsurers totaled approximately $69 million. The Company is contingently liable for any uncollectible amounts due from Clarendon Reinsurers related to this business.

The amounts pledged to Clarendon were used to secure the issuance of a $20.6 million Redland letter of credit to the California Department of Insurance related to bond requirements resulting from the Company’s workers’ compensation business written on Redland paper (“Bond Requirements”).

As of July 1, 2001, the Company sold two wholly owned insurance companies to McM Corporation, a Raleigh, North Carolina based insurance holding company (“McM”). The two companies, Acceptance Indemnity Insurance Company (“AIIC”) and Acceptance Casualty Insurance Company (“ACIC”), underwrote primarily Property and Casualty Segment insurance. The Company reinsures certain portions of the Company’s business issued by AIIC and ACIC. As of June 30, 2004 approximately $9.8 million of fixed maturities available-for-sale and $198,000 of cash equivalents were placed in a trust and

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pledged to McM to secure the Company’s net obligations under the reinsurance agreements. Under these reinsurance agreements, the Company assumed business from AIIC and ACIC after cessions to outside reinsurers (“AIIC Reinsurers”). At June 30, 2004, AIIC and ACIC reinsurance recoverables from AIIC Reinsurers totaled approximately $21 million. The Company is contingently liable for any uncollectible amounts due from AIIC Reinsurers related to this business.

The Company’s off-balance sheet obligations for the Clarendon and AIIC Reinsurers total approximately $89 million (“Off-Balance Sheet Obligations”). The Company has guaranteed the performance of these Clarendon and AIIC Reinsurers. If these Clarendon and AIIC Reinsurers do not meet their obligations, whether or not due to their ability or willingness to pay, the Company will be obligated. The timing for the reinsurers’ performance of these obligations is currently not known and the amounts will become due from the reinsurers as the underlying direct claim payments are made. Additionally, the $89 million is an estimate of unpaid ceded losses and loss adjustment expenses on Redland, Clarendon, AIIC and ACIC, and are subject to considerable estimation judgment due to the inherent uncertainty in projecting ultimate claim amounts that will be reported and settled over a period of many years.

At December 31, 2003, PMA Reinsurance Group (“PMA”) accounts for approximately 7.0% of the Company’s Off-Balance Sheet Obligations. PMA had its financial strength lowered by A.M. Best from A- (Excellent) to B++ (Very Good) in the fourth quarter of 2003. With the exception of outstanding questions related to specific claims, as of June 30, 2004 PMA continues to make regular payments to the Company for reinsurance billings and accordingly, no specific liability has been established for these balances.

At December 31, 2003, Gerling Global Reinsurance Corp. (“Gerling”) accounts for approximately 1.3% of the Company’s Off-Balance Sheet Obligations. Gerling had its financial strength rating lowered by A.M. Best from A- (Excellent) to B- (Fair) during the fourth quarter of 2002. In January 2003, in response to a request from Gerling’s parent to withdraw from the rating process, A.M. Best withdrew its financial strength rating of B- and assigned Gerling and its parent an NR-3 rating (Rating Procedure Inapplicable). As of June 30, 2004 Gerling continues to make regular payments to the Company for reinsurance billings and accordingly, no specific liability has been established for these balances.

Item 3. Quantitative and Qualitative Disclosure about Market Risk

The Company’s consolidated balance sheets include a significant amount of assets and liabilities whose fair value are subject to market risk. Market risk is the risk of loss arising from adverse changes in market interest rates or prices. The Company currently has interest rate risk as it relates to its fixed maturity securities and equity price risk as it relates to its marketable equity securities. The Company’s market risk sensitive instruments are entered into for purposes other than trading.

At June 30, 2004 and December 31, 2003 the Company had $63.9 million and $74.3 million, respectively, of fixed maturity investments that were subject to market risk. At June 30, 2004 and December 31, 2003 the Company had $662,000 and $1.1 million, respectively, of marketable equity securities that were subject to market risk. The Company’s investment strategy is to manage the duration of the portfolio relative to the duration of the liabilities while managing interest rate risk.

The Company uses two models to analyze the sensitivity of its market risk assets. For its fixed maturity securities, the Company uses duration modeling to calculate changes in fair value. For its marketable equity securities, the Company uses a hypothetical 20% decrease in the fair value of these securities. Actual results may differ from the hypothetical results assumed in this disclosure due to possible actions taken by management to mitigate adverse changes in fair value and because fair values of securities may

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be affected by credit concerns of the issuer, prepayment speeds, liquidity of the security and other general market conditions. The sensitivity analysis duration model used by the Company produces a loss in fair value of $1.3 million and $587,000 on its fixed maturity securities as of June 30, 2004 and December 31, 2003, respectively, based on a 100 basis point increase in interest rates. The hypothetical 20% decrease in fair value of the Company’s marketable equity securities produces a loss in fair value of $132,000 and $211,000 as of June 30, 2004 and December 31, 2003, respectively.

Item 4. Controls and Procedures

Based on their evaluation at the end of the period covered by this Form 10-Q, the Company’s President and Chief Executive Officer (the “CEO”) and the Chief Financial Officer and Treasurer (the “CFO”) have concluded the Company’s disclosure controls and procedures are effective. In 2003 the Company eliminated its internal audit department. The Company did, however, establish a “Financial Disclosure and Internal Control Procedures” committee during 2003. There have been no significant changes in the Company’s internal controls or in other factors, including the elimination of the internal audit department, that could significantly affect these controls subsequent to the date of the evaluation.

As more fully described in Note 2 to the consolidated financial statements, subsequent to the issuance of its consolidated financial statements for the year ended December 31, 2002, the Company determined that the Company’s property and casualty insurance business should not have been presented as discontinued operations. As a result, the accompanying consolidated statements of operations and cash flows for the three and six months ended June 30, 2003 have been restated to present the results of operations and cash flows as components of continuing operations. The Company established the Financial Disclosure and Internal Control Procedures committee to further improve its internal control processes and procedures around financial reporting and public disclosures.

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Class Action Complaint

Acceptance Insurance Companies Securities Litigation (USDC, Nebraska Master File No. 8-99CV547) In December 1999 the Company was sued in the United States District Court for the District of Nebraska. Plaintiffs alleged the Company knowingly and intentionally understated the Company’s liabilities in order to maintain the market price of the Company’s common stock at artificially high levels and made untrue statements of material fact, and sought compensatory damages, interest, costs and attorney fees. In February 2000 other plaintiffs sued the Company in the same Court, alleging the Company intentionally understated liabilities in a registration statement filed in conjunction with the Company’s Trust Preferred Securities.

The Court consolidated these suits in April 2000 and Plaintiffs subsequently filed a consolidated class action complaint. Plaintiffs sought to represent a class consisting of all persons who purchased either Company common stock between March 10, 1998 and November 16, 1999, or AICI Capital Trust Preferred Securities between the July 29, 1997 public offering and November 25, 1999. In the consolidated complaint Plaintiffs alleged violation of Section 11 of the Securities Act of 1933 through misrepresentation or omission of a material fact in the registration statement for the Trust Preferred Securities, and violation of Section 10b of the Securities Exchange Act of 1934 and Rule 10b–5 of the U.S. Securities and Exchange Commission through failure to disclose material information between March 10, 1998 and November 16, 1999. The Company, three of its former officers, the Company’s Directors and independent accountants and other individuals, as well as the financial underwriters for the Company’s Trust Preferred Securities, were defendants in the consolidated action.

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On March 2, 2001, the Court entered an order dismissing all claims alleging violations of Section 11 of the Securities Act, and dismissing the Company’s Directors, financial underwriters, independent accountants and others as defendants in this action. The Court also ruled that certain of Plaintiffs’ allegations regarding the remaining defendants’ alleged failure to properly report contingent losses attributable to the Montrose decision did not state a claim under Section 10b and Rule 10b-5. In two subsequent rulings, the Court and Magistrate Judge clarified the March 2 ruling to specify which of Plaintiffs’ Montrose-related allegations failed to state a Section 10b and Rule 10b-5 claim. These three rulings reduced the litigation to a claim that the Company and three of its former officers, during the period from August 14, 1997 to November 16, 1999, failed to disclose adequately information about various aspects of the Company’s operations, including information relating to the Company’s exposure after January 1, 1997 to losses resulting from the Montrose decision. Nevertheless, Plaintiffs continue to seek compensatory damages, reasonable costs and expenses incurred in this action and such other and such further relief as the Court may deem proper.

On August 6, 2001, the Magistrate Judge granted Plaintiffs’ Motion for Class Certification. Plaintiffs’ fact discovery was concluded July 31, 2002 in accordance with a schedule established by the Court. On September 16, 2002 Plaintiffs sought the Court’s permission to reinstate certain previously dismissed claims under Section 11 and 15 of the Securities Act. The Court denied Plaintiffs’ request in its entirety on February 27, 2003. The Company filed a motion to decertify the class and a motion for summary judgment. On March 31, 2004, the Court granted the defendants’ motion for summary judgment in full, dismissing all of the plaintiffs’ remaining claims against all of the remaining defendants, and denied all other pending motions as moot. The plaintiffs have appealed the Court’s decision.

The Company intends to continue vigorously contesting this action and believes Plaintiffs’ allegations are without merit. Nevertheless, the ultimate outcome of this action cannot be predicted at this time and the Company currently is unable to determine the potential effect of this litigation on its consolidated financial position, results of operations or cash flows.

Takings Claim

Acceptance Insurance Companies Inc. Litigation (United States Court of Federal Claims) On December 9, 2003, the Company filed a complaint against the United States of America. The complaint was filed in the United States Court of Federal Claims.

In November 2002, the Company and Rain and Hail L.L.C. (“Rain and Hail”) entered into a letter of intent under which Rain and Hail agreed to purchase certain insurance assets of American Growers Insurance Company (“AGIC”), a wholly owned subsidiary of the Company. Such assets were reinsured by, and subject to the oversight of, the Federal Crop Insurance Corporation (the “FCIC”). The transaction was subject to the approval of the Office of Risk Management, or the Risk Management Agency (the “RMA”). Ross J. Davidson, the Administrator of the RMA, advised that he would not approve the proposed sale of assets from the Company to Rain and Hail. The RMA subsequently enjoined AGIC from writing any new or renewal business. The Company alleges that the RMA’s actions rendered valueless the insurance business of AGIC.

The Company also alleges that in rejecting the proposed transaction between the Company and Rain and Hail, the RMA effected a taking of the Company’s property (i.e., the AGIC insurance assets) for public use without just compensation in violation of the Fifth Amendment to the United States Constitution. The Company seeks relief for its damages for the fair market value of the AGIC insurance assets in an amount of not less than $21.5 million, reasonable attorney’s fees and expert witness costs pursuant to 42 U.S.C. § 4654(c) with interest from the date of taking and such further relief the Court deems appropriate. On February 9, 2004 the United States filed a motion to dismiss the Company’s complaint and the Company filed a response to the motion to dismiss. The Court held a hearing regarding the motion to dismiss and response and has the motion under advisement. The ultimate outcome of this

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action cannot be predicted at this time and, accordingly, the Company currently is unable to determine the potential effect of this litigation on its consolidated financial position, results of operations or cash flows.

Granite Re Action

On April 15, 2004, Granite Reinsurance Company, LTD. (“Granite Re”) filed an action against the Company in the United States District Court for the Southern District of Indiana styled Granite Reinsurance Company, Ltd. v. Acceptance Insurance Companies, Inc., (S.D. Indiana, Case. No. 1:04-cv-0670-SEB-VSS) (the “Granite Re Action”). In the Granite Re Action, Granite Re alleges the Company breached certain alleged obligations under a reinsurance treaty entered into between the parties on June 6, 2001. Specifically, Granite Re alleges the Company breached an alleged obligation to pay Granite Re $3.0 million annually for a three year period, or a total of $9.0 million, for reinsurance. The Company filed a timely motion to dismiss the complaint in the Granite Re Action arguing Granite Re filed the complaint in the wrong forum. Granite Re has yet to respond to the motion. The Company expects to vigorously defend the Granite Re Action. The ultimate outcome of this action cannot be predicted at this time and the Company currently is unable to determine the potential effect of this litigation on its financial position, results of operations or cash flows.

Buchanan Action

In July 2004, P. Thompson Buchanan, the former President and a 40% shareholder of USAG Insurance Services, Inc., a Texas corporation 60% owned by Growers, filed an Original Petition in the District Court, Lubbock County, Texas against the Company, Growers and certain officers and directors of the Company styled Buchanan v. Martin, et al., No. 2004-527 (District Court, Lubbock County, Texas). In the Original Petition, Buchanan alleges he suffered damage because he allegedly was wrongfully terminated from his employment and not paid a severance. Mr. Buchanan further alleges he suffered a business loss as a result of alleged misrepresentations and other alleged misconduct. Mr. Buchanan claims losses in an amount not less than $13,000,000. The Company has engaged counsel and intends to vigorously defend this proceeding. The ultimate outcome of this action cannot be predicted at this time and the Company currently is unable to determine the potential effect of this litigation on its financial position, results of operations or cash flows.

Item 6. Exhibits and Reports on Form 8-K

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.