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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

For the quarterly period ended June 30, 2011

OR

 

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

For the transition period from            to            

Commission file number 000-50795

 

 

 

LOGO

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   75-2770432

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

4450 Sojourn Drive, Suite 500

Addison, Texas

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

(972) 728-6300

(Registrant’s telephone number, including area code)

Not Applicable

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

 

 

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

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

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

 

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

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

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

The number of shares outstanding of the registrant’s common stock, $.01 par value, as of August 12, 2011: 15,841,858

 

 

 


Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC.

SIX MONTHS ENDED JUNE 30, 2011

INDEX TO FORM 10-Q

 

PART I – FINANCIAL INFORMATION

     3   

Item 1. Financial Statements

     3   

Consolidated Balance Sheets – June 30, 2011 and December 31, 2010

     3   

Consolidated Statements of Income (Loss) – Three and Six Months Ended June 30, 2011 and 2010

     4   

Consolidated Statements of Stockholders’ Equity – Six Months Ended June 30, 2011 and 2010

     5   

Consolidated Statements of Comprehensive Income (Loss) – Three and Six Months Ended June  30, 2011 and 2010

     5   

Consolidated Statements of Cash Flows – Six Months Ended June 30, 2011 and 2010

     6   

Notes to Consolidated Financial Statements

     8   

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

     21   

Item 3. Quantitative and Qualitative Disclosures About Market Risk

     29   

Item 4. Controls and Procedures

     31   

PART II – OTHER INFORMATION

     31   

Item 1. Legal Proceedings

     31   

Item 1A. Risk Factors

     31   

Item 6. Exhibits

     31   

SIGNATURES

     32   

 

2


Table of Contents

PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

     June 30,
2011
    December 31,
2010
 
     (Unaudited)        

Assets

    

Available-for-sale securities, at fair value

   $ 163,021      $ 210,263   

Other invested assets

     2,840        2,564   

Cash and cash equivalents

     39,830        46,364   

Fiduciary and restricted cash

     174        3,866   

Accrued investment income

     1,405        1,829   

Premiums and fees receivable, net

     30,135        43,313   

Premium finance receivable, net

     41,464        43,143   

Commissions receivable

     427        1,652   

Receivable from reinsurers

     136,923        140,211   

Deferred acquisition costs

     10,386        11,742   

Federal income taxes receivable

     784        1,803   

Investment in real property, net

     12,091        11,896   

Property and equipment (net of accumulated depreciation of $46,396 for 2011 and $41,678 for 2010)

     35,745        39,197   

Goodwill

     163,570        163,570   

Other intangible assets (net of accumulated amortization of $7,580 for 2011 and $7,495 for 2010)

     16,383        16,468   

Prepaid expenses

     5,267        5,295   

Other assets (net of allowance for doubtful accounts of $7,213 for 2011 and 2010)

     2,542        2,545   
  

 

 

   

 

 

 

Total assets

   $ 662,987      $ 745,721   
  

 

 

   

 

 

 

Liabilities and Stockholders’ Equity

    

Liabilities:

    

Reserves for losses and loss adjustment expenses

   $ 229,891      $ 252,084   

Unearned premium

     71,765        92,202   

Amounts due to reinsurers

     20,956        38,172   

Deferred revenue

     6,123        7,894   

Capital lease obligation

     22,842        25,302   

Senior secured credit facility

     93,198        95,974   

Notes payable

     76,865        76,873   

Deferred tax liability

     12,733        12,095   

Other liabilities (Includes swap of $1,453 for 2010)

     45,854        52,117   
  

 

 

   

 

 

 

Total liabilities

     580,227        652,713   
  

 

 

   

 

 

 

Stockholders’ equity:

    

Common stock, $0.01 par value; 75,000,000 shares authorized, 18,202,221 shares issued and 15,841,858 shares outstanding at June 30, 2011; 17,768,721 shares issued and 15,408,358 shares outstanding at December 31, 2010

     182        178   

Additional paid-in capital

     165,990        165,776   

Treasury stock, at cost (2,360,363 shares at June 30, 2011 and December 31, 2010)

     (32,906     (32,906

Accumulated other comprehensive income

     441        445   

Retained deficit

     (50,947     (40,485
  

 

 

   

 

 

 

Total stockholders’ equity

     82,760        93,008   
  

 

 

   

 

 

 

Total liabilities and stockholders’ equity

   $ 662,987      $ 745,721   
  

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements

 

3


Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(in thousands, except per share data)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  
     (Unaudited)  

Revenues

        

Net premiums earned

   $ 46,671      $ 96,415      $ 97,222      $ 189,137   

Commission income and fees

     17,298        22,265        37,328        45,860   

Net investment income

     1,290        1,116        2,813        2,575   

Net realized gains (losses)

     (36     3,525        116        7,180   

Other income (loss)

     221        (3,220     249        (5,033
  

 

 

   

 

 

   

 

 

   

 

 

 

Total revenues

     65,444        120,101        137,728        239,719   
  

 

 

   

 

 

   

 

 

   

 

 

 

Expenses

        

Net losses and loss adjustment expenses

     29,409        80,887        69,814        151,912   

Selling, general and administrative expenses

     28,274        42,547        61,975        85,086   

Depreciation and amortization

     2,430        2,383        4,807        4,815   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expenses

     60,113        125,817        136,596        241,813   
  

 

 

   

 

 

   

 

 

   

 

 

 

Operating income (loss)

     5,331        (5,716     1,132        (2,094

Loss on interest rate swaps

     —          (89     (2     (610

Interest expense

     5,727        5,916        10,730        12,036   
  

 

 

   

 

 

   

 

 

   

 

 

 

Loss before income tax expense

     (396     (11,721     (9,600     (14,740

Income tax expense

     418        390        862        835   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net loss

   $ (814   $ (12,111   $ (10,462   $ (15,575
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic loss per common share:

        

Net loss

   $ (0.05   $ (0.79   $ (0.68   $ (1.01
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted loss per common share:

        

Net loss

   $ (0.05   $ (0.79   $ (0.68   $ (1.01
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average common shares outstanding:

        

Basic

     15,408        15,415        15,408        15,415   
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

     15,408        15,415        15,408        15,415   
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements

 

4


Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

(in thousands, except share data)

 

     Six Months Ended June 30,  
     2011     2010  
     Shares      Amounts     Shares      Amounts  
     (Unaudited)  

Common stock

          

Balance at beginning of year

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

Issuance of restricted stock awards

     433,500         4        —           —     
  

 

 

    

 

 

   

 

 

    

 

 

 

Balance at end of period

     18,202,221       $ 182        17,768,721       $ 178   
  

 

 

    

 

 

   

 

 

    

 

 

 

Additional paid-in capital

          

Balance at beginning of year

        165,776           164,752   

Stock-based compensation

        214           386   
     

 

 

      

 

 

 

Balance at end of period

        165,990           165,138   
     

 

 

      

 

 

 

Retained earnings (deficit)

          

Balance at beginning of year

        (40,485        48,446   

Net loss

        (10,462        (15,575
     

 

 

      

 

 

 

Balance at end of period

        (50,947        32,871   
     

 

 

      

 

 

 

Treasury stock

          

Balance at beginning of year and end of period

     2,360,363         (32,906     2,353,363         (32,880
  

 

 

      

 

 

    

Accumulated other comprehensive income (loss)

          

Balance at beginning of year

        445           2,859   

Change in net unrealized gain (loss) on available-for-sale investment securities

        (4        (1,973
     

 

 

      

 

 

 

Balance at end of period

        441           886   
     

 

 

      

 

 

 

Total stockholders’ equity

      $ 82,760         $ 166,193   
     

 

 

      

 

 

 

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  
     (Unaudited)  

Net loss

   $ (814   $ (12,111   $ (10,462   $ (15,575

Other comprehensive income (loss):

        

Unrealized gains (losses) on available-for-sale investment securities arising during period

     384        (64     112        (617

Reclassification adjustment for gains (losses) included in net loss

     36        (163     (116     (1,356
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss), net

     420        (227     (4     (1,973
  

 

 

   

 

 

   

 

 

   

 

 

 

Total comprehensive loss

   $ (394   $ (12,338   $ (10,466   $ (17,548
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying Notes to Consolidated Financial Statements

 

5


Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Six Months Ended
June 30,
 
     2011     2010  
     (Unaudited)  

Cash flows from operating activities

    

Net loss

   $ (10,462   $ (15,575

Adjustments to reconcile net loss to net cash used in operating activities:

    

Depreciation and amortization

     4,807        4,815   

Stock-based compensation expense

     194        544   

Amortization of debt modification costs

     206        254   

Amortization of debt discount

     2,342        3,448   

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

     (116     (1,356

Realized gain on trading securities

     —          (5,825

Fair value loss on settlement rights for auction-rate securities

     —          5,631   

Fair value gain on investment in hedge fund

     (276     —     

Amortization of premiums on investments, net

     1,631        1,604   

Provision for doubtful premiums receivable

     (181     226   

Loss on interest rate swaps

     2        610   

Proceeds from insurance recoveries

     212        —     

Change in operating assets and liabilities:

    

Fiduciary and restricted cash

     3,692        8,116   

Premiums, fees and commissions receivable

     14,584        7,990   

Reserves for losses and loss adjustment expenses

     (22,193     (10,222

Amounts due from reinsurers

     (13,928     633   

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

     3,389        (6,480

Deferred revenue

     (1,771     (1,551

Unearned premium

     (20,437     (1,052

Deferred acquisition costs

     1,356        (46

Deferred tax liability

     637        637   

Federal income taxes receivable

     1,019        243   

Other

     (4,880     (3,683
  

 

 

   

 

 

 

Net cash used in operating activities

     (40,173     (11,039
  

 

 

   

 

 

 

Cash flows from investing activities

    

Proceeds from sales of available-for-sale securities

     39,798        77,040   

Proceeds from maturities of available-for-sale securities

     19,363        37,856   

Proceeds from sales of trading securities

     —          31,075   

Purchases of available-for-sale securities

     (13,458     (120,093

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

     (1,710     2,858   

Purchases of property and equipment

     (1,457     (3,006

Investment in real property

     (550     (4,019
  

 

 

   

 

 

 

Net cash provided by investing activities

     41,986        21,711   
  

 

 

   

 

 

 

 

6


Table of Contents

Cash flows from financing activities

    

Proceeds from financing under capital lease obligations

     —          28,189   

Principal payments under capital lease obligations

     (2,460     (578

Principal payments on senior secured credit facility

     (5,118     (17,293

Debt modification costs paid

     (769     —     
  

 

 

   

 

 

 

Net cash provided by (used in) financing activities

     (8,347     10,318   
  

 

 

   

 

 

 

Net increase (decrease) in cash and cash equivalents

     (6,534     20,990   

Cash and cash equivalents at beginning of year

     46,364        60,928   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 39,830      $ 81,918   
  

 

 

   

 

 

 

Supplemental disclosure of cash flow information:

    

Cash paid for interest

   $ 7,492      $ 8,315   

Cash paid for income taxes

   $ 310      $ 313   

See accompanying Notes to Consolidated Financial Statements

 

7


Table of Contents

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

 

 

1. General

Affirmative Insurance Holdings, Inc. (the Company), formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware in June 1998. The Company is a distributor and producer of non-standard personal automobile insurance policies and related products and services for individual consumers in targeted geographic areas. The Company currently offers insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas and Wisconsin) as well as through 5,000 independent agents or brokers in 8 states (Louisiana, Texas, Illinois, Alabama, California, Missouri, Indiana and South Carolina).

 

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements of the Company. In the opinion of management, all adjustments necessary for a fair presentation have been included and are of a normal recurring nature. Interim results are not necessarily indicative of the results that may be expected for the year. The consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2010 included in the Company’s Annual Report on Form 10-K.

The consolidated balance sheet at December 31, 2010 was derived from the audited financial statements at that date but does not include all of the information and notes required by GAAP. All material intercompany transactions and balances have been eliminated in consolidation.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ materially from those estimates. These estimates and assumptions are particularly important in determining reserves for losses and loss adjustment expenses, deferred policy acquisition costs, reinsurance receivables, valuation of available-for-sale securities, goodwill and other intangible assets, and deferred income taxes.

Recently Issued Accounting Standards

ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS, provides identical guidance with concurrently issued international financial reporting standard (IFRS) 13, Fair Value Measurements. Most of the changes in the new standard are clarifications of existing guidance, but it expands the disclosures about fair value measurements, and will require the categorization by level of the fair value hierarchy for items that are not measured at fair value in the statement of financial position, but for which the fair value is required to be disclosed, which would consist of the Company’s debt. In addition, for fair value measurements categorized as Level 3 within the fair value hierarchy, the valuation processes and sensitivity of the fair value measurements to changes in unobservable inputs shall be disclosed. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied prospectively. Early adoption is not permitted. The adoption of this standard will not impact the Company’s consolidated financial position, results of operations or cash flows.

ASU 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income, will require companies to present the components of net income and comprehensive income in either one or two consecutive financial statements. Companies will no longer be permitted to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity. Reclassifications from other comprehensive income must be presented in both the consolidated statement of income and the consolidated statement of other comprehensive income. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied retrospectively. Early adoption is permitted. The adoption of this standard will not impact the Company’s consolidated financial position, results of operations or cash flows.

ASU 2010-26, Financial Services-Insurance (Topic 944), modifies the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts. The Task Force reached a final Consensus that requires costs to be incremental or directly related to the successful acquisition of new or renewal contracts to be capitalized as a deferred acquisition cost.

 

8


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This standard is effective for interim and annual periods beginning after December 15, 2011 and may be early adopted as of the beginning of an annual reporting period using either the prospective or retrospective method. Adoption of the new standard could have a material impact on the Company’s consolidated financial position or results of operations. Management is evaluating the impact.

ASU 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (Topic 310), an amended guidance for disclosures about the credit quality of financing receivables and the allowance for credit losses. This update amends existing guidance by requiring more robust and disaggregated disclosures by an entity about the credit quality of its financing receivables and its allowance for credit losses. These disclosures will provide additional information about the nature of credit risks inherent in a company’s financing receivables, how a company analyzes and assesses credit risk in determining its allowance for credit losses, and the reasons for any changes a company may make in its allowance for credit losses. This update is generally effective for interim and annual reporting periods ending on or after December 15, 2010; however, certain aspects of the update pertaining to activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. The adoption of the new guidance had no significant effect on the Company’s consolidated financial statements.

ASU 2010-06, Fair Value Measurements and Disclosures (Topic 820), requires additional disclosures about fair value measurements, including transfers in and out of Levels 1 and 2 and activity in Level 3 on a gross basis, and clarifies certain other existing disclosure requirements including level of disaggregation and disclosures around inputs and valuation techniques. The provisions of the new standard is effective for interim or annual reporting periods beginning after December 15, 2009, except for the additional Level 3 disclosures which became effective for fiscal years beginning after December 15, 2010. This standard is disclosure-only in nature and does not change accounting requirements. Accordingly, adoption of the new standard had no impact on the Company’s consolidated financial position, results of operations or cash flows.

 

3. Available-for-Sale Investment Securities

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

The amortized cost, gross unrealized gains (losses), and estimated fair value of the Company’s available-for-sale securities at June 30, 2011, and December 31, 2010, were as follows (in thousands):

 

     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Fair Value  

June 30, 2011

          

U.S. Treasury and government agencies

   $ 19,078       $ 114       $ (67   $ 19,125   

Mortgage-backed securities

     11,525         282         (97     11,710   

States and political subdivisions

     18,492         318         (11     18,799   

Corporate debt securities

     88,127         1,313         (13     89,427   

FDIC-insured certificates of deposit

     23,819         147         (6     23,960   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 161,041       $ 2,174       $ (194   $ 163,021   
  

 

 

    

 

 

    

 

 

   

 

 

 

December 31, 2010

          

U.S. Treasury and government agencies

   $ 25,611       $ 142       $ (73   $ 25,680   

Mortgage-backed securities

     10,554         295         (19     10,830   

States and political subdivisions

     22,245         280         (137     22,388   

Corporate debt securities

     123,182         1,505         (132     124,555   

FDIC-insured certificates of deposit

     26,687         126         (3     26,810   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total

   $ 208,279       $ 2,348       $ (364   $ 210,263   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

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Table of Contents

Expected maturities may differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. The Company’s amortized cost and estimated fair values of fixed-income securities at June 30, 2011 by contractual maturity were as follows (in thousands):

 

     Amortized
Cost
     Fair Value  

Due in one year or less

   $ 44,463       $ 44,711   

Due after one year through five years

     98,361         99,855   

Due after five years through ten years

     6,692         6,745   

Mortgage-backed securities

     11,525         11,710   
  

 

 

    

 

 

 

Total

   $ 161,041       $ 163,021   
  

 

 

    

 

 

 

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

 

     2011     2010  

Gross gains

   $ 212      $ 1,397   

Gross losses

     (96     (41
  

 

 

   

 

 

 

Total

   $ 116      $ 1,356   
  

 

 

   

 

 

 

The following table summarizes the Company’s available-for-sale securities in an unrealized loss position at June 30, 2011, and December 31, 2010, the fair value and amount of gross unrealized losses, aggregated by investment category and length of time those securities have been continuously in an unrealized loss position (in thousands):

 

     June 30, 2011  
     Less Than Twelve
Months
    Twelve Months or
Greater
    Total  
     Fair
Value
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
 

U.S. Treasury and government agencies

   $ 8,938       $ (67   $ —         $ —        $ 8,938       $ (67

States and political subdivisions

     2,286         (11     —           —          2,286         (11

Corporate debt securities

     4,709         (12     182         (1     4,891         (13

Mortgage-backed securities

     6,046         (97     —           —          6,046         (97

FDIC-insured certificates of deposit

     1,556         (4     149         (2     1,705         (6
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 23,535       $ (191   $ 331       $ (3   $ 23,866       $ (194
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 
     December 31, 2010  
     Less Than Twelve
Months
    Twelve Months or
Greater
    Total  
     Fair
Value
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
    Fair
Value
     Gross
Unrealized
Losses
 

U.S. Treasury and government agencies

   $ 12,707       $ (73   $ —         $ —        $ 12,707       $ (73

States and political subdivisions

     8,619         (137     —           —          8,619         (137

Corporate debt securities

     23,801         (132     —           —          23,801         (132

Mortgage-backed securities

     3,770         (19     —           —          3,770         (19

FDIC-insured certificates of deposit

     2,183         (3     —           —          2,183         (3
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

   $ 51,080       $ (364   $ —         $ —        $ 51,080       $ (364
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

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Table of Contents

The Company’s portfolio contains approximately 42 and 64 individual investment securities that were in an unrealized loss position as of June 30, 2011 and December 31, 2010, respectively.

The unrealized losses at June 30, 2011 were attributable to changes in market interest rates since the securities were purchased. Management systematically evaluates investment securities for other-than-temporary declines in fair value on a quarterly basis. This analysis requires management to consider various factors, which include (1) duration and magnitude of the decline in value, (2) the financial condition of the issuer or issuers, (3) structure of the security and (4) the Company’s intent to sell the security or whether its more likely than not that the Company would be required to sell the security before its anticipated recovery in market value. At June 30, 2011, management performed its quarterly analysis of all securities with an unrealized loss and concluded no individual securities were other-than-temporarily impaired.

 

4. Reinsurance

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

Effective October 1, 2010, the Company entered into a quota-share reinsurance agreement with a third-party reinsurance company ceding 40% of premiums and losses on policies in-force in certain states on October 1, 2010 and policies written through December 31, 2010 on a run-off basis. The Company receives provisional ceding commission which may be adjusted based on the fully-developed loss ratio of the reinsured policies. Written premiums ceded under this agreement totalled $60.5 million as of June 30, 2011.

A separate quota-share reinsurance agreement was put in place effective January 1, 2011. Under the terms of the 2011 agreement, the Company cedes 28% of gross written premium in all states other than Michigan through December 31, 2011. Written premiums ceded under this agreement totalled $13.4 million and $33.9 million during the three and six months ended June 30, 2011, respectively. The Company’s quota-share ceding commission rate structure varies based on loss experience for both agreements. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations.

In June 2011, the Company entered into a reinsurance agreement with third-party reinsurers which provides $7.0 million in excess of the first $3.0 million of losses coverage for catastrophic events that may involve multiple insured losses.

In August 2010, the Company entered into an excess of loss reinsurance contract with third-party reinsurers which provides coverage for individual losses in excess of $100,000 up to $1 million.

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

 

     Three Months Ended June 30,  
     2011     2010  
     Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
    Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
 

Direct

   $ 42,191      $ 58,072      $ 45,810      $ 58,662      $ 78,541      $ 66,277   

Reinsurance assumed

     7,409        10,641        (891     14,299        19,010        16,639   

Reinsurance ceded

     (14,624     (22,042     (15,510     (238     (1,136     (2,029
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 34,976      $ 46,671      $ 29,409      $ 72,723      $ 96,415      $ 80,887   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
     Six Months Ended June 30,  
     2011     2010  
     Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
    Written
Premium
    Earned
Premium
    Loss and
Loss
Adjustment
Expenses
 

Direct

   $ 108,067      $ 123,311      $ 95,574      $ 156,403      $ 153,664      $ 123,217   

Reinsurance assumed

     19,312        24,058        9,270        33,640        37,936        33,111   

Reinsurance ceded

     (36,166     (50,147     (35,030     (2,449     (2,463     (4,416
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 91,213      $ 97,222      $ 69,814      $ 187,594      $ 189,137      $ 151,912   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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Under certain of the Company’s reinsurance transactions, the Company has received ceding commissions. The ceding commission rate structure varies based on loss experience. The estimates of loss experience are continually reviewed and adjusted, and the resulting adjustments to ceding commissions are reflected in current operations. Ceding commissions recognized were reflected as a reduction of selling, general and administrative expenses follows (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Selling, general and administrative expenses

   $ (3,571   $ (1   $ (9,019   $ (10
  

 

 

   

 

 

   

 

 

   

 

 

 

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

 

     June 30,
2011
     December 31,
2010
 

Losses and loss adjustment expense reserves

   $ 101,166       $ 93,084   

Unearned premium reserve

     20,168         34,149   
  

 

 

    

 

 

 

Total

   $ 121,334       $ 127,233   
  

 

 

    

 

 

 

The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. For policies effective in 2011 and 2010, the required retention is $0.5 million. As a writer of personal automobile policies in the state of Michigan, the Company ceded premiums and claims to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders.

The table below presents the ceded premiums written and ceded losses to the MCCA for the three and six months ended June 30, 2011 and 2010 (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Ceded premiums written to the MCCA

   $ 562      $ 156      $ 548      $ 2,158   
  

 

 

   

 

 

   

 

 

   

 

 

 

Ceded losses to the MCCA

   $ (1,468   $ (2,108   $ (2,124   $ (4,347
  

 

 

   

 

 

   

 

 

   

 

 

 

The table below presents the total amount of receivables due from reinsurers as of June 30, 2011 and December 31, 2010 (in thousands):

 

     June 30,
2011
     December 31,
2010
 

Michigan Catastrophic Claims Association

   $ 66,074       $ 65,727   

Quota-share reinsurer for agreements effective in fourth quarter of 2010 and in 2011

     49,401         53,743   

Vesta Insurance Group

     13,049         13,161   

Excess of loss reinsurer

     1,982         1,429   

Excess of loss reinsurer

     1,982         1,429   

Other

     4,435         4,722   
  

 

 

    

 

 

 

Total reinsurance receivable

   $ 136,923       $ 140,211   
  

 

 

    

 

 

 

The quota-share reinsurer for the agreements effective in the fourth quarter of 2010 and in 2011, and the excess of loss reinsurers all have A ratings from A.M. Best. Accordingly, the Company believes there is minimal credit risk related to these reinsurance receivables. Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), the Company’s wholly-owned subsidiaries, Affirmative Insurance Company (AIC) and Insura Property and Casualty Insurance Company (Insura), had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize gross amounts due from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement effective September 2004. In August 2005, AIC received a letter from VFIC’s President that irrevocably confirmed VFIC’s duty and obligation under the Security Fund Agreement to provide security sufficient to satisfy VFIC’s gross obligations under the reinsurance agreement (the VFIC Trust). At June 30, 2011, the VFIC Trust held $16.7 million (after cumulative withdrawals of $8.7 million through June 30, 2011), consisting of a $13.0 million U.S. Treasury money market account and $3.7 million of corporate bonds rated BBB+ or higher, to collateralize the $13.0 million net recoverable (net of $2.9 million payable) from VFIC.

 

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Table of Contents

The Company assumes reinsurance from a Texas county mutual insurance company (the county mutual) whereby the Company has assumed 100% of the policies issued by the county mutual for business produced by the Company’s owned MGAs. The county mutual does not retain any of this business and there are no loss limits other than the underlying policy limits. AIC has established a trust to secure the Company’s obligation under this reinsurance contract with a balance of $54.4 million and $52.0 million as of June 30, 2011 and December 31, 2010, respectively.

At June 30, 2011, $2.8 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $20.7 million in securities (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through June 2011, and the Special Deputy Receiver in Hawaii had cumulative withdrawals from the AIC Trust of $1.7 million through June 2011.

 

5. Premium Finance Receivables, Net

Premium finance receivables (related to policies of both the Company and third-party carriers) are secured by unearned premiums from the underlying insurance policies and consisted of the following at June 30, 2011 and December 31, 2010 (in thousands):

 

     June 30,
2011
    December 31,
2010
 

Premium finance contracts

   $ 44,061      $ 45,866   

Unearned finance charges

     (2,210     (2,286

Allowance for credit losses

     (387     (437
  

 

 

   

 

 

 

Total

   $ 41,464      $ 43,143   
  

 

 

   

 

 

 

Premium finance receivables are secured by the underlying unearned insurance premiums for which the Company obtains assignment from the policyholder in the event of non-payment. When a payment becomes past due, the Company cancels the underlying policy with the insurance carrier and receives the unearned premium to clear unpaid principal and interest. The loan is closed by writing off any uncollected amounts or refunding any overpayment to the customer. Therefore, no finance receivables are past due in excess of thirty days. Losses due to non-realization of premium finance receivables were $0.3 million and 0.7% of total premiums financed for the three months ended June 30, 2011, and $0.3 million and 0.8% of total premiums financed for the three months ended June 30, 2010. Losses due to non-realization of premium finance receivables were $0.7 million and 0.8% of total premiums financed for the six months ended June 30, 2011, and $0.5 million and 0.6% of total premiums financed for the six months ended June 30, 2010.

 

6. Deferred Policy Acquisition Costs

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

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Beginning balance

   $ 11,543      $ 28,945      $ 11,742      $ 24,230   

Additions

     8,259        17,742        18,402        42,744   

Amortization

     (9,416     (22,411     (19,758     (42,698
  

 

 

   

 

 

   

 

 

   

 

 

 

Ending balance

   $ 10,386      $ 24,276      $ 10,386      $ 24,276   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

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Table of Contents
7. Debt

The Company’s long-term debt instruments and balances outstanding at June 30, 2011 and December 31, 2010 were as follows (in thousands):

 

     June 30,
2011
     December 31,
2010
 

Notes payable due 2035

   $ 30,928       $ 30,928   

Notes payable due 2035

     25,774         25,774   

Notes payable due 2035

     20,163         20,171   
  

 

 

    

 

 

 

Total notes payable

     76,865         76,873   

Senior secured credit facility

     93,198         95,974   
  

 

 

    

 

 

 

Total long-term debt

   $ 170,063       $ 172,847   
  

 

 

    

 

 

 

The $30.9 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes bore an initial interest rate of 7.545% until March 15, 2010. Since March 15, 2010, the securities adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of June 30, 2011 was 3.85%.

The $25.8 million notes payable due 2035 are redeemable in whole or in part by the Company after June 2010. The notes bore an initial interest rate of 7.792% until June 15, 2010. Since June 15, 2010, the securities adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of June 30, 2011 was 3.80%.

The $20.2 million notes payable due 2035 are redeemable by the Company in whole or in part anytime after March 2010. The notes bore an initial interest rate of the three-month LIBOR rate plus 3.95% not exceeding 12.50% through March 2010 with no limit thereafter. The interest rate as of June 30, 2011 was 4.20%.

In March 2011, the Company entered into an amendment to the facility. The amendment included the following significant items:

 

   

A waiver of any defaults or events of default for the period prior to the effective date of the amendment related to the risk-based capital ratio and loss ratio covenants under the prior terms of the agreement.

 

   

The permitted dividend leverage ratio was changed from 1.5 to 1.0.

 

   

Indebtedness under the baskets for qualified additional subordinated debt and Affirmative Premium Finance Company was eliminated. The Company did not have any such debt.

 

   

A provision was added allowing for the acquisition of $30 million of subordinated debt if the proceeds are used as a capital contribution to the regulated insurance entities.

 

   

The assets and stock of Affirmative Premium Finance Company will be pledged and this entity will become a guarantor of the debt.

 

   

The quarterly requirements for the leverage ratio covenant calculation were changed for the first three quarters of 2011.

 

   

The quarterly requirements for the interest coverage ratio covenant calculation were changed for the first two quarters of 2011.

 

   

The quarterly requirements for the loss ratio covenant calculation were changed from December 31, 2010 through March 31, 2012.

 

   

The annual requirements for the risk-based capital covenant calculation were changed for December 31, 2010 and December 31, 2011.

 

   

At every quarter end, the Company will make a payment to the lenders equal to the excess of cash at the non-regulated entities of $12 million at December 31 and March 31 and $10 million at June 30 and September 30.

 

   

Effective April 1, 2011, the pricing under the agreement changed to if the leverage ratio is greater than 2.3, the pricing is LIBOR plus 9.00%. If the leverage ratio is greater than 2.0 and less than or equal to 2.3, the pricing is LIBOR plus 7.50%. If the leverage ratio is greater than 1.8 and less than or equal to 2.0, the pricing is LIBOR plus 6.25%. The pricing for leverage ratios less than or equal to 1.8 was unchanged.

 

   

The Company has the option to capitalize interest that is in excess of the prior payment terms to the loan balance.

In addition, the Company paid a 0.25% fee to all lenders that approved the amendment.

In accordance with ASC 470-50 Debt Modifications and Extinguishments, the Company evaluated the present value of the cash flows under the terms of the amended credit agreement to determine if they were at least 10 percent different from the present value of

 

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Table of Contents

the remaining cash flows under the terms of the existing credit agreement. It was determined that the terms were not substantially different and therefore should not be accounted for as a debt extinguishment. Accordingly, lender consent fees of approximately $0.3 million were capitalized and will be amortized, along with remaining unamortized debt issuance costs from the March 2009 debt modification, over the remaining term of the senior secured credit facility. Fees paid to other parties of approximately $0.7 million were expensed as incurred in the first six months of 2011.

During the first six months of 2011, the Company made principal payments of $5.1 million on the senior secured credit facility. As of June 30, 2011, the principal balance of the senior secured credit facility was $103.3 million with an interest rate of 12.0%.

 

8. Capital Lease Obligation

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

Property under capital lease at June 30, 2011 was as follows (in thousands):

 

     Cost      Accumulated
Depreciation
     Net  

Computer software, software licenses and hardware

   $ 28,189       $ 6,480       $ 21,709   
  

 

 

    

 

 

    

 

 

 

Estimated future lease payments for the years ending December 31 (in thousands):

 

2011

   $ 3,368   

2012

     6,736   

2013

     6,736   

2014

     6,736   

2015

     2,807   
  

 

 

 

Total estimated future lease payments

     26,383   

Less: Amount representing interest

     3,541   
  

 

 

 

Present value of future lease payments

   $ 22,842   
  

 

 

 

 

9. Income Taxes

The provision for income taxes for the three and six months ended June 30, 2011 and 2010 consisted of the following (in thousands):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011      2010      2011      2010  

Current tax expense

   $ 100       $ 77       $ 225       $ 198   

Deferred tax expense

     318         313         637         637   
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income tax expense

   $ 418       $ 390       $ 862       $ 835   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

The Company’s effective tax rate differed from the statutory rate of 35% for the three and six months ended June 30, 2011 as follows (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Loss before income taxes

   $ (396   $ (11,721   $ (9,600   $ (14,740

Tax provision computed at the federal statutory income tax rate

     (139     (4,103     (3,360     (5,159

Increases (reductions) in tax resulting from:

        

Tax-exempt interest

     (35     (93     (74     (309

State income taxes

     104        81        (30     65   

Valuation allowance

     454        4,467        4,253        6,156   

Other

     34        38        73        82   
  

 

 

   

 

 

   

 

 

   

 

 

 

Income tax expense

   $ 418      $ 390      $ 862      $ 835   
  

 

 

   

 

 

   

 

 

   

 

 

 

Effective tax rate

     (105.6 )%      (3.3 )%      (9.0 )%      (5.7 )% 
  

 

 

   

 

 

   

 

 

   

 

 

 

Net deferred tax assets prior to recognition of the valuation allowance were $57.0 million and $53.4 million at June 30, 2011 and December 31, 2010, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others.

 

10. Legal and Regulatory Proceedings

The Company and its subsidiaries are named from time to time as parties in various legal actions arising in the ordinary course of the Company’s business and arising out of or related to claims made in connection with the Company’s insurance policies and claims handling. Except as noted below, there are no material changes with respect to legal and regulatory proceedings previously disclosed in Note 16 to the consolidated financial statements included in the Company’s Form 10-K for the year ended December 31, 2010. The Company believes that the resolution of these legal actions will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, the ultimate outcome of these matters is uncertain.

On May 27, 2011, PropertyOne, Inc. filed suit against USAgencies, LLC and Affirmative Insurance Holdings, Inc. in the 19th Judicial District Court, Parish of East Baton Rouge, Louisiana. PropertyOne’s petition asserts equitable claims for payment of broker commissions arising out of the December 2009 execution of a lease with a federal agency for the Company’s building located in Baton Rouge, Louisiana. The Company removed the lawsuit to the U.S. District Court for the Middle District of Louisiana. On August 1, 2011, the Company filed a motion to dismiss and motion for summary judgment as to all of PropertyOne’s claims. The Company believes that these claims lack merit and intends to defend itself vigorously.

On October 26, 2010, the Chapter 7 Trustee for Brooke Corporation, Brooke Capital Corporation and Brooke Investments, Inc., along with Brooke Agency Services Company, LLC (“BASC”), filed an adversary proceeding in the U.S. Bankruptcy Court for the District of Kansas against Affirmative Insurance Holdings, Inc., Affirmative Insurance Services, Inc., Affirmative Insurance Services of Illinois, Inc., and Affirmative Insurance Company. The Plaintiffs assert claims for an accounting, constructive fraudulent transfer and preferential transfer under Section 547 of the Bankruptcy Code, seeking to recover premium funds transferred to the Defendants by BASC pursuant to producer agreements pursuant to which BASC’s franchisee’s sold Defendants’ insurance policies. Pursuant to the Court’s scheduling order, the Trustee provided additional disclosures on June 30, 2011, setting forth his current belief that the Company’s collective exposure for preferential transfers during the 90-day period preceding the bankruptcy and for constructively fraudulent conveyances totals approximately $0.5 million. The Trustee also asserts a claim for breach of contract for alleged unpaid profit sharing commissions. The Company’s responsive pleadings are due on August 31, 2011. Due to uncertainty at this preliminary stage of the legal proceedings, the Company has not accrued a liability as of June 30, 2011. The Company believes that these claims lack merit and intends to defend itself vigorously.

On August 17, 2009, plaintiff Toni Hollinger filed a putative class action in the U.S. District Court for the Eastern District of Texas against several county mutual insurance companies and reinsurance companies, including Affirmative Insurance Company. The complaint alleges that defendants engaged in unfair discrimination and violated the Texas Insurance Code by charging different policy fees for the same class and hazard of insurance written through county mutual insurance companies. On August 5, 2010, the Court issued an order dismissing plaintiff’s claims for lack of subject matter jurisdiction. Plaintiff appealed the dismissal of her claims. The U.S. Court of Appeals for the Fifth Circuit has scheduled oral argument for the week of August 29, 2011. The Company believes that this claim lacks merit and intends to defend itself vigorously.

 

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Affirmative Insurance Company is party to a 100% quota-share reinsurance agreement with a Texas county mutual insurance company, and the Company serves as a general agent for business written pursuant to that agreement. On January 10, 2011, the Company filed a petition for Interpleader and Declaratory Judgment in the District Court of Tarrant County, Texas on behalf of the Texas county mutual insurance company against Benjamin Rodriguez, Teresa Jaramillo, Oralia Barron and the Company’s insured, Cipriano Almanza, seeking leave to tender to the Court $20,000 in remaining proceeds of Almanza’s policy in satisfaction of a July 16, 2010 Final Judgment entered against Almanza in favor of Rodriguez, Jaramillo and Barron in the approximate amount of $770,000. The Texas county mutual insurance company included a claim for Declaratory Judgment based upon threatened action by counsel for Rodriguez, Jaramillo and Barron to assert direct claims against the Texas county mutual insurance company for amounts in excess of Almanza’s policy limits due to an alleged violation of the Stowers duty to settle within policy limits. As 100% reinsurer, the Company would be liable for any excess verdict entered against the Texas county mutual insurance company. On August 10, 2011, the Company agreed to a settlement, subject to final court approval.

The Illinois Insurance Code includes a reserve requirement that requires an insurer to maintain an amount of qualifying investments as defined at least equal to the lesser of $250.0 million or 100% of adjusted loss reserves and loss adjustment reserve expenses. As of December 31, 2010, Affirmative Insurance Company was deficient in qualifying assets by $32.1 million. The Illinois Department of Insurance approved the Company’s plan to cure the deficiency by June 30, 2011. The plan included a $3.8 million ordinary dividend and a $21.0 million extraordinary distribution from two of AIC’s insurance company subsidiaries, which were completed in March 2011 and an extraordinary dividend of $15.0 million from one of AIC’s insurance company subsidiaries, which was completed in June 2011. The Company is currently in compliance with the reserve requirement.

 

11. Net Loss Per Common Share

Net loss per common share is based on the weighted average number of shares outstanding. Diluted weighted average shares is calculated by adjusting basic weighted average shares outstanding by all potentially dilutive stock options and restricted stock. Stock options outstanding of 558,900 and 1,260,900 for the three and six months ended June 30, 2011 and 2010, respectively, were not included in the computation of diluted earnings per share because the exercise price of the options was greater than the average market price of the common stock and thus the inclusion would have been anti-dilutive.

The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for the three and six months ended June 30, 2011 and 2010 (in thousands, except per share amounts):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Numerator:

        

Loss from continuing operations

   $ (814   $ (12,111   $ (10,462   $ (15,575
  

 

 

   

 

 

   

 

 

   

 

 

 

Denominator:

        

Weighted average common shares outstanding

     15,408        15,415        15,408        15,415   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average diluted shares outstanding

     15,408        15,415        15,408        15,415   
  

 

 

   

 

 

   

 

 

   

 

 

 

Basic loss per common share from continuing operations:

   $ (0.05   $ (0.79   $ (0.68   $ (1.01
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted loss per common share from continuing operations:

   $ (0.05   $ (0.79   $ (0.68   $ (1.01
  

 

 

   

 

 

   

 

 

   

 

 

 

On March 18, 2011, 433,500 shares of Affirmative’s common stock were issued on a restricted basis, and the voting rights for all of the shares was assigned to New Affirmative, LLC via a written irrevocable proxy at the time the stock awards were made. These shares were not included in the computation of basic or diluted earnings per share due to the performance conditions not being met.

 

12. Related Party Transactions

The Company has entered into certain transactions with a partnership that is affiliated with J. Christopher Flowers. Mr. Flowers is affiliated with New Affirmative LLC, the majority shareholder of the Company. In the fourth quarter of 2010, the Company committed to invest $2.5 million in Varadero, a hedge fund, and $10.0 million in a related liquidity-focused product. The investment manager of Varadero is Varadero Capital, L.P., of which Varadero GP, LLC is the general partner. Both the investment manager and general partner are partially-owned by an entity affiliated with Mr. Flowers. As of June 30, 2011, the Company had funded $2.5 million in the hedge fund and approximately $9.0 million in the related liquidity-focused product. At June 30, 2011, the fair value of the hedge fund was approximately $2.8 million, recorded as other invested assets, and the fair value of the liquidity-focused product was approximately $8.8 million, included in available-for-sale securities in the consolidated balance sheet.

 

13. Fair Value of Financial Instruments

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

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

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

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

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

 

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

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

The following table provides information as of June 30, 2011 about the Company’s financial assets measured at fair value on a recurring basis (in thousands):

 

     June 30,
2011
     Quoted
Prices in
Active
Markets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 

Assets:

           

U.S. Treasury and government agencies

   $ 19,125       $ 19,125       $ —         $ —     

Mortgage-backed securities

     11,710         —           11,710         —     

States and political subdivisions

     18,799         —           18,799         —     

Corporate debt securities

     89,427         —           89,427         —     

FDIC-insured certificates of deposit

     23,960         —           23,960         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investment securities

     163,021         19,125         143,896         —     

Cash and cash equivalents

     39,830         39,830         —           —     

Fiduciary and restricted cash

     174         174         —           —     

Other invested assets

     2,840         —           —           2,840   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets

   $ 205,865       $ 59,129       $ 143,896       $ 2,840   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table provides information as of December 31, 2010 about the Company’s financial assets and liabilities measured at fair value on a recurring basis (in thousands):

 

     December 31,
2010
     Quoted
Prices in
Active
Markets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 

Assets:

           

U.S. Treasury and government agencies

   $ 25,680       $ 25,680       $ —         $ —     

Mortgage-backed securities

     10,830         —           10,830         —     

States and political subdivisions

     22,388         —           22,388         —     

Corporate debt securities

     124,555         —           124,555         —     

FDIC-insured certificates of deposit

     26,810         —           26,810         —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Total investment securities

     210,263         25,680         184,583         —     

Cash and cash equivalents

     46,364         46,364         —           —     

Fiduciary and restricted cash

     3,866         3,866         —           —     

Other invested assets

     2,564         —           —           2,564   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total assets

   $ 263,057       $ 75,910       $ 184,583       $ 2,564   
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities:

           

Interest rate swaps (other liabilities)

   $ 1,453       $ —         $ —         $ 1,453   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total liabilities

   $ 1,453       $ —         $ —         $ 1,453   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Table of Contents

Level 1 Financial assets

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

Level 2 Financial assets

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

Level 3 Financial assets and liabilities

At June 30, 2011, the Company’s Level 3 financial assets include other invested assets related to an investment in a hedge fund, which is presented as a separate line item in the consolidated balance sheet. The Company measured the fair value of other invested assets on the basis of the net asset value of the fund as reported by the fund manager.

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

Fair value measurements for assets in category Level 3 for the three months ended June 30, 2011 were as follows (in thousands):

 

     Fair Value Measurements
Using Significant
Unobservable Inputs
(Level 3)
Other Invested Assets
 

Balance at April 1, 2011

   $ 2,735   

Transfers into Level 3

     —     

Total gains included in earnings

     105   

Settlements

     —     
  

 

 

 

Balance at June 30, 2011

   $ 2,840   
  

 

 

 

Fair value measurements for liabilities in category Level 3 for the three months ended June 30, 2011 were as follows (in thousands):

 

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

Balance at April 1, 2011

   $ 567   

Transfers into Level 3

     —     

Total losses included in earnings

     —     

Settlements

     (567
  

 

 

 

Balance at June 30, 2011

   $ —     
  

 

 

 

The Company did not have any transfers between Levels 1 and 2 during the period ended June 30, 2011.

 

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Table of Contents

Fair value measurements for assets in category Level 3 for the six months ended June 30, 2011 were as follows (in thousands):

 

     Fair Value Measurements
Using Significant
Unobservable Inputs
(Level 3)
Other Invested Assets
 

Balance at January 1, 2011

   $ 2,564   

Transfers into Level 3

     —     

Total gains included in earnings

     276   

Settlements

     —     
  

 

 

 

Balance at June 30, 2011

   $ 2,840   
  

 

 

 

Fair value measurements for liabilities in category Level 3 for the six months ended June 30, 2011 were as follows (in thousands):

 

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

Balance at January 1, 2011

   $ 1,453   

Transfers into Level 3

     —     

Total losses included in earnings

     2   

Settlements

     (1,455
  

 

 

 

Balance at June 30, 2011

   $ —     
  

 

 

 

Gains and losses (realized and unrealized) for Level 3 assets and liabilities included in earnings for the period ended June 30, 2011, are reported in net investment income and loss on interest rate swaps as follows (in thousands):

 

     Net
Investment
Income
     Loss on
Interest
Rate
Swaps
 

Assets

     

Total gains realized in earnings

   $ 276       $ —     

Liabilities

     

Total losses realized in earnings

     —           (2
  

 

 

    

 

 

 

Total for the period ended June 30, 2011

   $ 276       $ (2
  

 

 

    

 

 

 

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

Notes payable — The fair values of the notes payable were determined using a third-party valuation source and were estimated to be $22.4 million in the aggregate with a total carrying value of $76.9 million at June 30, 2011.

Senior secured credit facility — The fair value of the senior secured credit facility was determined using a third-party valuation source and was estimated to be $87.5 million with a carrying value of $93.2 million at June 30, 2011.

 

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

OVERVIEW

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

As of June 30, 2011, our subsidiaries included insurance companies licensed to write insurance policies in 40 states, underwriting agencies, retail agencies with 203 owned stores and a relationship with one unaffiliated underwriting agency. We are currently active in offering insurance directly to individual consumers through retail stores in 9 states (Louisiana, Texas, Illinois, Alabama, Missouri, Indiana, South Carolina, Kansas and Wisconsin) and distributing our own insurance policies through our owned retail stores and 5,000 independent agents or brokers in 8 states (Louisiana, Texas, Illinois, Alabama, California, Missouri, Indiana and South Carolina). In March 2011, we discontinued writing new business in the state of Michigan, and in June 2011 we discontinued writing renewals. In May 2010, we discontinued writing new and renewal policies in the state of Florida. In July 2010, we discontinued writing new and renewal insurance policies in New Mexico.

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

 

   

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

 

   

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

 

   

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

 

   

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

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

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

CRITICAL ACCOUNTING POLICIES

There have been no changes of critical accounting policies since December 31, 2010.

RECENTLY ISSUED ACCOUNTING STANDARDS

Refer to Note 2 to the unaudited Consolidated Financial Statements for a discussion of certain accounting standards that have been adopted during 2011 and certain accounting standards that we have not yet been required to adopt and may be applicable to the Company’s future Consolidated Financial Statements.

MEASUREMENT OF PERFORMANCE

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

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

 

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Table of Contents

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

Premiums. One measurement of our performance is the level of gross premiums written and a second measurement is the relative proportion of premiums written through our three distribution channels. The following table displays our gross premiums written and assumed by distribution channel (in thousands):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011      2010      2011      2010  

Our underwriting agencies:

           

Retail agencies

   $ 34,031       $ 39,156       $ 86,219       $ 97,109   

Independent agencies

     11,808         28,723         32,939         81,730   
  

 

 

    

 

 

    

 

 

    

 

 

 

Subtotal

     45,839         67,879         119,158         178,839   

Unaffiliated underwriting agencies

     3,761         5,082         8,221         11,204   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 49,600       $ 72,961       $ 127,379       $ 190,043   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total gross premiums written for the three months ended June 30, 2011 decreased $23.4 million, or 32.0%, compared with the prior year quarter. Total gross premiums written for the six months ended June 30, 2011 decreased $62.7 million, or 33.0%, compared with the prior year period. This decrease was due to a number of actions taken during 2010 and into 2011 to increase prices and strengthen underwriting standards to improve the profitability of the gross premiums written. As a result, base rates on an overall basis increased by 17% from September 30, 2010 to the end of the second quarter of 2011. Improved processes and monitoring of pricing activity have been put in place. We suspended or constrained new business production for unprofitable independent agent relationships. We expect that these actions will continue to have a negative effect on premium production levels in 2011, but should improve the profitability of the business.

In our retail distribution channel, gross premiums written consist of premiums written for our affiliated insurance carriers’ products only and do not include premiums written for third-party insurance carriers in our retail stores. We earn commission income and fees in our retail distribution channel for sales of third-party insurance policies. The following represents gross premiums written produced by our retail agencies (in thousands):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011      2010      2011      2010  

Our policies

   $ 34,031       $ 39,156       $ 86,219       $ 97,109   

Third-party carrier policies

     12,122         10,919         27,555         24,086   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 46,153       $ 50,075       $ 113,774       $ 121,195   
  

 

 

    

 

 

    

 

 

    

 

 

 

Gross premiums written of our policies in our retail distribution channel for the three and six months ended June 30, 2011 decreased $5.1 million and $10.9 million, or 13.1% and 11.2%, respectively, compared with the prior year. This decrease is a result of the pricing and underwriting actions on our policies. However, third-party policies increased $1.2 million and $3.5 million, or 11.0% and 14.4%, respectively, for the three and six months ended June 30, 2011.

In our independent agency distribution channel, gross premiums written for the three and six months ended June 30, 2011 decreased $16.9 million and $48.8 million, or 58.9% and 59.7%, respectively, compared with the prior year.

Gross premiums written by our unaffiliated underwriting agencies for the three and six months ended June 30, 2011 decreased $1.3 million and $3.0 million, or 26.0% and 26.6%, respectively, compared with the prior year.

We introduced a multivariate pricing product in May 2011 for new business in Louisiana and in June 2011 for new business in Alabama and Texas. The multivariate pricing product is also expected to be put in place for Illinois as well during 2011. The new product is expected to result in an improvement in profitability through better segment pricing.

 

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Table of Contents

The following table displays our gross premiums written and assumed by state (in thousands):

 

     Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2011      2010      2011      2010  

Louisiana

   $ 25,235       $ 29,491       $ 64,609       $ 74,047   

Texas

     7,546         14,693         19,657         34,587   

Illinois

     5,782         9,379         13,836         21,247   

Alabama

     4,733         5,766         13,713         15,694   

California

     3,732         5,043         8,164         11,110   

Indiana

     1,340         2,222         3,486         5,284   

South Carolina

     700         1,363         1,747         2,914   

Missouri

     459         1,012         1,128         2,880   

Michigan

     55         2,864         1,015         19,798   

Other

     18         1,128         24         2,482   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 49,600       $ 72,961       $ 127,379       $ 190,043   
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table displays our net premiums written by distribution channel (in thousands):

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
     2011     2010     2011     2010  

Our underwriting agencies:

        

Retail agencies – gross premiums written

   $ 34,031      $ 39,156      $ 86,219      $ 97,109   

Ceded reinsurance

     (9,269     —          (23,218     —     
  

 

 

   

 

 

   

 

 

   

 

 

 

Subtotal retail agencies net premiums written

     24,762        39,156        63,001        97,109   
  

 

 

   

 

 

   

 

 

   

 

 

 

Independent agencies – gross premiums written

     11,808        28,723        32,939        81,730   

Ceded reinsurance

     (2,440     (156     (8,964     (2,158
  

 

 

   

 

 

   

 

 

   

 

 

 

Subtotal independent agencies net premiums written

     9,368        28,567        23,975        79,572   
  

 

 

   

 

 

   

 

 

   

 

 

 

Unaffiliated underwriting agencies – gross premiums written

     3,761        5,082        8,221        11,204   

Ceded reinsurance

     (2,267     (23     (2,284     (55
  

 

 

   

 

 

   

 

 

   

 

 

 

Subtotal unaffiliated underwriting agencies net premiums written

     1,494        5,059        5,937        11,149   
  

 

 

   

 

 

   

 

 

   

 

 

 

Excess of loss coverages with various reinsurers

     (407     —          (1,375     —     

Catastrophe coverages with various reinsurers

     (241     (59     (325     (236
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net premiums written

   $ 34,976      $ 72,723      $ 91,213      $ 187,594   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total net premiums written for the three months ended June 30, 2011 decreased $37.7 million, or 51.9%, compared with the prior year quarter. Total net premiums written for the six months ended June 30, 2011 decreased $96.4 million, or 51.4%, compared with the prior year period. The decrease was primarily due to the decline in gross written premium production and the quota-share reinsurance agreements put in place for 2010 and 2011. Ceded premiums for the three and six months ended June 30 were $14.6 million and $36.2 million, respectively, in 2011 and $0.2 million and $2.4 million, respectively, in 2010.

Effective October 1, 2010, the Company entered into a quota-share reinsurance agreement with a third-party reinsurance company ceding 40% of premiums and losses on policies in-force in all states other than Michigan on October 1, 2010 and policies written through December 31, 2010.

A separate quota-share reinsurance agreement was put in place effective January 1, 2011. Under the terms of the 2011 agreement, the Company cedes 28% of gross written premium in all states other than Michigan through December 31, 2011. The Company’s quota-share ceding commission rate structure for both quota-share agreements varies based on loss experience for both agreements.

 

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Table of Contents

RESULTS OF OPERATIONS

We had a net loss of $0.8 million and $12.1 million for the three months ended June 30, 2011 and 2010, respectively. We had a net loss of $10.5 million and $15.6 million for the six months ended June 30, 2011 and 2010, respectively.

Comparison of the Three Months Ended June 30, 2011 to the Three Months Ended June 30, 2010

Total revenues for the three months ended June 30, 2011 decreased $54.7 million, or 45.5%, compared with the three months ended June 30, 2010. The decrease was due to decreases in net premiums earned, commission income and fees, and net realized gains, partially offset by an increase in net investment income and other income.

The largest component of revenue is net premiums earned on insurance policies. Net premiums earned for the current quarter decreased $49.7 million, or 51.6%, compared with the prior year quarter primarily due to the decline in net written premium. Since insurance premiums are earned over the service period of the policies, the revenue in the current quarter includes premiums earned on insurance products written through our three distribution channels in both current and previous periods.

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

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

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

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

 

     Three Months Ended
June 30,
 
     2011      2010  

Policyholder fees

   $ 6,109       $ 11,263   

Premium finance revenue

     6,175         5,926   

Commissions and fees

     3,956         3,925   

Agency fees

     1,058         1,151   
  

 

 

    

 

 

 

Total commission income and fees

   $ 17,298       $ 22,265   
  

 

 

    

 

 

 

Total commission income and fees decreased $5.0 million, or 23.3%, compared with the prior year quarter. Policyholder fees decreased $5.2 million, or 45.8%, due to the lower overall volume of premiums written and a change in mix of states where these fees were realized. Premium finance revenue decreased $0.2 million, or 4.2%, compared with the prior year quarter. Commissions and fees were consistent with the prior year quarter.

Net Investment Income. Net investment income for the current quarter increased $0.2 million, or 15.6%, compared with the prior year quarter. The increase was primarily due to an increase in income from our investment in real estate and from our investment in a hedge fund, partially offset by a 23.2% decrease in total average invested assets to $171.2 million during the current quarter from $222.9 million during the prior year quarter. The average investment yield was 2.2% (2.4% on a taxable equivalent basis) in the current quarter, compared with 2.2% (2.5% on a taxable equivalent basis) in the prior year quarter. The $0.3 million net increase in income from our investment in real estate is due to a new long-term lease which commenced in the fourth quarter of 2010. We entered into an investment in a hedge fund in the fourth quarter of 2010 which increased $0.1 million in fair value during the three months ended June 30, 2011.

 

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

At June 30, 2011, our fixed-income investments were invested in the following: corporate debt securities 54.9%; FDIC-insured certificates of deposit 14.7%; U.S. Treasury and government agencies securities 11.7%; states and political subdivisions securities 11.5%; and mortgage-backed securities 7.2%. The average quality of our portfolio was A+ at June 30, 2011. We attempt to mitigate interest rate risk by managing the duration of our fixed-income portfolio to a target range of three years or less. As of June 30, 2011, the effective duration of our fixed-income investment portfolio was 2.0 years.

Net Realized Gains (Losses) and Other Income (Loss). Net realized gains (losses) for the current quarter decreased $3.6 million, or 101.0%, compared with the prior year quarter. Other income (loss) for the current quarter increased $3.4 million, or 106.9%, compared with the prior year quarter. The 2010 activity was primarily due to the settlement of the auction-rate municipal securities.

For the three-month period ended June 30, 2011, other income included $0.2 million for a business interruption insurance settlement related to Hurricane Gustav.

Losses and Loss Adjustment Expenses. Since the largest expenses of an insurance company are the losses and loss adjustment expenses, another measurement of our insurance carriers’ performance is the level of such expenses, specifically as a ratio to earned premiums. Our losses and loss adjustment expenses are a blend of the specific estimated and actual costs of providing the coverage contracted by the purchasers of our insurance policies. We maintain reserves to cover our estimated ultimate liability for losses and related loss adjustment expenses for both reported and unreported claims on the insurance policies issued by our insurance companies. The establishment of appropriate reserves is an inherently uncertain process, involving actuarial and statistical projections of what we expect to be the cost of the ultimate settlement and administration of claims based on historical claims information, estimates of future trends in claims severity, changes in the mix of business/limits and other variable factors such as inflation. Due to the inherent uncertainty of estimating reserves, reserve estimates can be expected to vary from period to period. The claim initiatives that we started in the second half of 2009 shortened the claims payment cycle and reduced the number of claims outstanding. The acceleration of payment patterns has necessitated increased use of judgment by management to account for the deviation in trends. To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and loss adjustment expenses and incur a charge to earnings in the period during which such reserves are increased. The historic development of our reserves for losses and loss adjustment expenses is not necessarily indicative of future trends in the development of these amounts.

Losses and loss adjustment expenses for the current quarter decreased $51.5 million, or 63.6%, compared with the prior year quarter. The percentage of losses and loss adjustment expense to net premiums earned (the loss ratio) was 63.0% in the current quarter, compared with 83.9% in the prior year quarter. The accident year decline in the loss ratio for the quarter compared with the 2010 accident year was due to the pricing and underwriting actions that were taken as well as additional process changes implemented in the handling of claims to mitigate the significant increases in severity that occurred due to the claims initiatives. Also, there was $5.0 million of favorable prior period development in the current quarter due to Vesta-related reserves, compared with the prior year quarter’s adverse loss development of $9.0 million primarily due to unfavorable development from our 2009 Texas and Michigan businesses.

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

 

     Three Months Ended
June 30,
 
     2011     2010  

Loss ratio – current quarter

     73.6     74.6

(Favorable) adverse loss ratio development – prior period business

     (10.6     9.3   
  

 

 

   

 

 

 

Reported loss ratio

     63.0     83.9
  

 

 

   

 

 

 

Selling, General and Administrative Expenses. Another measurement of our performance that addresses our overall efficiency is the level of selling, general and administrative expenses. We recognize that our customers are primarily motivated by low prices. As a result, we strive to keep our costs as low as possible to be able to keep our prices affordable and thus to maximize our sales while still maintaining profitability. Our selling, general and administrative expenses include not only the cost of acquiring the insurance policies through our insurance carriers (the amortization of the deferred acquisition costs) and managing our insurance carriers and the retail stores, but also the costs of the holding company. The largest component of selling, general and administrative expenses is personnel costs, including payroll, benefits and accrued bonus expenses. Selling, general and administrative expenses decreased $14.3 million, or 33.5%, compared with the prior year quarter, primarily due to a decrease in policy acquisition expenses due to the decrease in premium production and the ceding commission from the quota-share reinsurance agreements.

 

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

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

 

     Three Months Ended
June 30,
 
     2011     2010  

Amortization of deferred acquisition costs

   $ 9,416      $ 22,411   

Other selling, general and administrative expenses

     18,858        20,136   
  

 

 

   

 

 

 

Total selling, general and administrative expenses

   $ 28,274      $ 42,547   
  

 

 

   

 

 

 

Total as a percentage of net premiums earned

     60.6     44.1
  

 

 

   

 

 

 

Beginning deferred acquisition costs

   $ 11,543      $ 28,945   

Additions

     8,259        17,742   

Amortization

     (9,416     (22,411
  

 

 

   

 

 

 

Ending deferred acquisition costs

   $ 10,386      $ 24,276   
  

 

 

   

 

 

 

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

     20.2     23.2
  

 

 

   

 

 

 

Loss on Interest Rate Swaps. Loss on interest rate swaps for the three months ended June 30, 2011 decreased $0.1 million compared with the same period in the prior year. The loss relates to the impact on the determination of fair value associated with the decline in short-term interest rates implied in the forward yield curve. One swap instrument expired in February 2011 and the remaining swap instrument expired in April 2011.

Interest Expense. Interest expense for the current quarter decreased $0.2 million, or 3.2%, compared with the prior quarter. This decrease was due to a decrease in the amortization of debt discount, a decrease in the average debt outstanding and lower interest rates on the notes payable, which were partially offset by increases in the interest rate on the senior secured credit facility and interest expense on the lease obligation entered into in May 2010. Amortization of debt discount was $1.2 million in the current quarter as compared with $1.7 million for the prior year quarter.

Income Taxes. Income tax expense for the current and prior year quarter was $0.4 million. The income tax expense for both periods was primarily due to an increase in the deferred tax liability related to goodwill and state tax expense.

Our net deferred tax assets prior to recognition of valuation allowance were $57.0 million and $53.4 million at June 30, 2011 and December 31, 2010, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, we began recording a valuation allowance against deferred taxes in December 2009.

Comparison of the Six Months Ended June 30, 2011 to the Six Months Ended June 30, 2010

Total revenues for the six months ended June 30, 2011 decreased $102.0 million, or 42.5%, compared with the six months ended June 30, 2010. The decrease was due to decreases in net premiums earned, commission income and fees, and net realized gains, partially offset by an increase in net investment income and other income.

The largest component of revenue is net premiums earned on insurance policies. Net premiums earned for the current period decreased $91.9 million, or 48.6%, compared with the prior year period. Since insurance premiums are earned over the service period of the policies, the revenue in the current period includes premiums earned on insurance products written through our three distribution channels in both current and previous periods.

 

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Commission Income and Fees.

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

 

     Six Months Ended
June 30,
 
     2011      2010  

Policyholder fees

   $ 13,959       $ 23,416   

Premium finance revenue

     12,288         11,696   

Commissions and fees

     8,663         8,213   

Agency fees

     2,418         2,533   

Other, net

     —           2   
  

 

 

    

 

 

 

Total commission income and fees

   $ 37,328       $ 45,860   
  

 

 

    

 

 

 

Total commission income and fees decreased $8.5 million, or 18.6%, compared with the prior year period. Policyholder fees decreased $9.5 million, or 40.4%, due to the lower overall volume of premiums written and a change in mix of states where these fees are realized. Premium finance revenue increased $0.6 million, or 5.1%, due to increases in the number of policies financed and revenue per policy. We experienced a steady increase in premium finance revenue since December 2007 when we began financing third-party premiums. Commissions and fees increased $0.5 million, or 5.5%, due to more of our retail customers choosing third-party products due to pricing and underwriting actions and an expansion of our ancillary product sales.

Net Investment Income. Net investment income for the current period increased $0.2 million, or 9.2%, compared with the prior year period. The increase was primarily due to an increase in income from our investment in real estate and from our investment in a hedge fund, which was partially offset by a 22.1% decrease in total average invested assets to $183.1 million during the current period from $235.1 million during the prior year period and a reduction in yields. The average investment yield was 2.2% (2.4% on a taxable equivalent basis) in the current period, compared with 2.3% (2.8% on a taxable equivalent basis) in the prior year period. The $0.7 million net increase in income from our investment in real estate is due to a new long-term lease which commenced in the fourth quarter of 2010. We entered into an investment in a hedge fund in the fourth quarter of 2010, which increased $0.3 million in fair value during the six months ended June 30, 2011.

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

Net Realized Gains (Losses) and Other Income (Loss). Net realized gains (losses) for the current period decreased $7.1 million, or 98.4%, compared with the prior year period. Other income (loss) for the current period increased $5.3 million, or 104.9%, compared with the prior year period. The 2010 activity was primarily due to the settlement of the auction-rate municipal securities.

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

Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for the current period decreased $82.1 million, or 54.0%, compared with the prior year period. The percentage of losses and loss adjustment expense to net premiums earned (the loss ratio) was 71.8% in the current period, compared with 80.3% in the prior year period. The accident year loss ratio for the current period increased 140 basis points compared with the 2010 accident year. A better comparison is to compare the 76.9% loss ratio for the current accident period to the 85.4% ratio for the 2010 accident year. The decline in the loss ratio for the first half of 2011 compared with the 2010 accident year was due to the pricing and underwriting actions that were taken as well as additional process changes implemented in the handling of claims to mitigate the significant increases in severity that occurred due to the claims initiatives. Also, there was $5.0 million of favorable prior period development in the current period due to Vesta-related reserves, compared with the prior year period’s adverse loss development of $9.0 million primarily due to unfavorable development from our 2009 Texas and Michigan businesses.

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

 

     Six Months Ended
June 30,
 
     2011     2010  

Loss ratio – current period

     76.9     75.5

(Favorable) adverse loss ratio development – prior period business

     (5.1     4.8   
  

 

 

   

 

 

 

Reported loss ratio

     71.8     80.3
  

 

 

   

 

 

 

 

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Selling, General and Administrative Expenses. The largest component of selling, general and administrative expenses is personnel costs, including payroll, benefits and accrued bonus expenses. Selling, general and administrative expenses decreased $23.1 million, or 27.2%, compared with the prior year period, primarily due to a decrease in premium production and ceding commission from the quota-share reinsurance agreements. The primary drivers of the decrease were a drop in independent agent expense with lower premium volume and ceding commission income in the first six months of 2011 from the quota-share reinsurance agreements. There was no ceding commission income in the first six months of 2010.

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

 

     Six Months Ended
June 30,
 
     2011     2010  

Amortization of deferred acquisition costs

   $ 19,758      $ 42,698   

Other selling, general and administrative expenses

     42,217        42,388   
  

 

 

   

 

 

 

Total selling, general and administrative expenses

   $ 61,975      $ 85,086   
  

 

 

   

 

 

 

Total as a percentage of net premiums earned

     63.7     45.0
  

 

 

   

 

 

 

Beginning deferred acquisition costs

   $ 11,742      $ 24,230   

Additions

     18,402        42,744   

Amortization

     (19,758     (42,698
  

 

 

   

 

 

 

Ending deferred acquisition costs

   $ 10,386      $ 24,276   
  

 

 

   

 

 

 

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

     20.3     22.6
  

 

 

   

 

 

 

Loss on Interest Rate Swaps. Loss on interest rate swaps for the current period decreased $0.6 million from the prior year period. The loss relates to the impact on the determination of fair value associated with the decline in short-term interest rates implied in the forward yield curve. One swap instrument expired in February 2011 and the remaining swap instrument expired in April 2011.

Interest Expense. Interest expense for the current period decreased $1.3 million, or 10.9%, compared with the prior year period. This decrease was due to a decrease in the amortization of debt discount, a decrease in the average debt outstanding and lower interest rates on the notes payable, which were partially offset by increases in the interest rate on the senior secured credit facility and interest expense on the lease obligation entered into in May 2010. Amortization of debt discount was $2.3 million in the current period as compared with $3.4 million in the prior year period.

Income Taxes. Income tax expense for the current period was $0.9 million as compared with income tax expense of $0.8 million for the prior year period. The income tax expense for both periods was primarily due to an increase in the deferred tax liability related to goodwill and state tax expense.

Our net deferred tax assets prior to recognition of valuation allowance were $57.0 million and $53.4 million at June 30, 2011 and December 31, 2010, respectively. In assessing the realizability of our deferred tax assets, we considered whether it was more likely than not that our deferred tax assets will be realized based upon all available evidence, including scheduled reversal of deferred tax liabilities, historical operating results, projected future operating results, tax carry-back availability, and limitations pursuant to Section 382 of the Internal Revenue Code, among others. Based on this assessment, we began recording a valuation allowance against deferred taxes in December 2009.

LIQUIDITY AND CAPITAL RESOURCES

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

There are no restrictions on the payment of dividends by our non-insurance company subsidiaries other than state corporate laws regarding solvency. As a result, our non-insurance company subsidiaries generate revenues, profits and net cash flows that are generally unrestricted as to their availability for the payment of dividends and we have and expect to continue to use those revenues to service our corporate financial obligations, such as debt service and stockholder dividends. As of June 30, 2011, we had $0.1 million of cash and cash equivalents at the holding company level and $4.9 million of cash and cash equivalents at our non-insurance company subsidiaries.

State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the

 

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extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of June 30, 2011, our insurance companies could not pay ordinary dividends to us without prior regulatory approval due to a negative unassigned surplus position of Affirmative Insurance Company. However, as mentioned previously, our non-insurance company subsidiaries provide adequate cash flow to fund their own operations.

The National Association of Insurance Commissioners’ model law for risk-based capital provides formulas to determine the amount of capital that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. At June 30, 2011, each of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions.

The Illinois Insurance Code includes a reserve requirement that requires an insurer to maintain an amount of qualifying investments as defined at least equal to the lesser of $250.0 million or 100% of adjusted loss reserves and loss adjustment reserve expenses. As of December 31, 2010, Affirmative Insurance Company was deficient in qualifying assets by $32.1 million. The Illinois Department of Insurance approved our plan to cure the deficiency by June 30, 2011. The plan included a $3.8 million ordinary dividend and a $21.0 million extraordinary distribution from two of AIC’s insurance company subsidiaries, which were completed in March 2011 and an extraordinary dividend of $15.0 million from one of AIC’s insurance company subsidiaries, which was completed in June 2011. We are currently in compliance with the reserve requirement.

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

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

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

Interest rate risk. Our investment portfolio consists of investment-grade, fixed-income securities classified as available-for-sale investment securities. Accordingly, the primary market risk exposure to our debt securities is interest rate risk. In general, the fair market value of a portfolio of fixed-income securities increases or decreases inversely with changes in market interest rates, while net investment income realized from future investments in fixed-income securities increases or decreases along with interest rates. In addition, some of our fixed-income securities have call or prepayment options. This could subject us to reinvestment risk should interest rates fall and issuers call their securities and we reinvest at lower interest rates. We attempt to mitigate this interest rate risk by investing in securities with varied maturity dates and by managing the duration of our investment portfolio to a defined range of less than three years. The fair value of our fixed-income securities as of June 30, 2011 was $163.0 million. The effective average duration of the portfolio as of June 30, 2011 was 2.0 years. If market interest rates increase 1.0%, our fixed-income investment portfolio would be expected to decline in market value by 2.0%, or $3.3 million, representing the effective average duration multiplied by the change in market interest rates. Conversely, a 1.0% decline in interest rates would result in a 2.0%, or $3.3 million, increase in the market value of our fixed-income investment portfolio.

Our senior secured credit facility is also subject to interest rate risk. In March 2011, we entered into an amendment that changed the pricing to be tiered based on the leverage ratio and includes a LIBOR floor of 3.0%. The interest rate is floating based on LIBOR plus increments tied to the Company’s leverage ratio. Effective April 1, 2011, the pricing under the agreement is changing to if the leverage ratio is greater than 2.3, the pricing is LIBOR plus 9.00%. If the leverage ratio is greater than 2.0 and less than or equal to 2.3, the pricing is LIBOR plus 7.50%. If the leverage ratio is greater than 1.8 and less than or equal to 2.0, the pricing is LIBOR plus 6.25%. The pricing for leverage ratios less than or equal to 1.8 was unchanged. The interest rate at June 30, 2011 was 12.0%.

Our notes payable are also subject to interest rate risk. The $30.9 million notes adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of June 30, 2011 was 3.85%. The $25.8 million notes adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of June 30, 2011 was 3.80%. The $20.2 million notes payable bear an interest rate of the three-month LIBOR rate plus 3.95%. The interest rate as of June 30, 2011 was 4.20%.

 

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Credit risk. An additional exposure to our fixed-income securities portfolio is credit risk. We attempt to manage our credit risk by investing only in investment-grade securities and limiting our exposure to a single issuer. At June 30, 2011, and December 31, 2010, respectively, our fixed-income investments were invested in the following:

 

     June 30,
2011
    December 31,
2010
 

Corporate debt securities

     54.9     59.2

FDIC-insured certificates of deposit

     14.7        12.8   

U.S. Treasury and government agencies

     11.7        12.2   

States and political subdivisions

     11.5        10.7   

Mortgage-backed securities

     7.2        5.1   
  

 

 

   

 

 

 

Total

     100.0     100.0
  

 

 

   

 

 

 

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

 

     June 30,
2011
    December 31,
2010
 

Total invested assets

   $ 163,021      $ 210,263   

Tax-equivalent book yield

     2.39     2.61

Average duration in years

     2.04        2.07   

Average S&P rating

     A+        A+   

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

The table below presents the total amount of receivables due from reinsurance as of June 30, 2011 and December 31, 2010, respectively (in thousands):

 

     June 30,
2011
     December 31,
2010
 

Michigan Catastrophic Claims Association

   $ 66,074       $ 65,727   

Quota-share reinsurer for agreements effective in fourth quarter of 2010 and in 2011

     49,401         53,743   

Vesta Insurance Group

     13,049         13,161   

Excess of loss reinsurer

     1,982         1,429   

Excess of loss reinsurer

     1,982         1,429   

Other

     4,435         4,722   
  

 

 

    

 

 

 

Total reinsurance receivable

   $ 136,923       $ 140,211   
  

 

 

    

 

 

 

The quota-share reinsurer for the agreements effective in the fourth quarter of 2010 and in 2011 and excess of loss reinsurers all have A ratings from A.M. Best. Accordingly, the Company believes there is minimal risk related to these reinsurance receivables.

The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. For policies effective in 2011 the required retention is $0.5 million. As a writer of personal automobile policies in the state of Michigan, we cede premiums and claims to the MCCA. Funding for MCCA comes from assessments against automobile insurers based upon their proportionate market share of the state’s automobile liability insurance market. Insurers are allowed to pass along this cost to Michigan automobile policyholders.

Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), the Company’s wholly-owned subsidiaries Affirmative Insurance Company (AIC) and Insura Property and Casualty Insurance Company (Insura) had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize the gross amount due AIC and Insura from VFIC under the reinsurance agreement. Accordingly, AIC, Insura and VFIC entered into a Security Fund Agreement in September 2004. In August 2005, AIC received a letter from VFIC’s President that irrevocably confirmed VFIC’s duty and obligation under the Security Fund Agreement to provide security sufficient to satisfy VFIC’s gross obligations under the reinsurance agreement (the VFIC Trust). At June 30, 2011, the VFIC Trust held $16.7 million (after cumulative withdrawals of $8.7 million through June 30, 2011), consisting of a $13.0 million U.S. Treasury money market account and $3.7 million of corporate bonds rated BBB+ or higher, to collateralize the $13.0 million net recoverable from VFIC.

 

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At June 30, 2011, $2.8 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC and Insura under reinsurance agreements with the VIG affiliated companies, including Hawaiian Insurance and Guaranty Company, Ltd (Hawaiian). Affirmative established a trust account to collateralize this payable, which currently holds $20.7 million in securities (the AIC Trust). The Special Deputy Receiver (SDR) in Texas drew down the AIC Trust $0.4 million through June 2011, and the Special Deputy Receiver in Hawaii had cumulative withdrawals from the AIC Trust of $1.7 million through June 2011.

As part of the terms of the acquisition of AIC and Insura, VIG has indemnified us for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of June 30, 2011, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better.

 

Item 4. Controls and Procedures

The Company’s management performed an evaluation under the supervision and with the participation of the Company’s principal executive officer and the principal financial officer, and completed an evaluation of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as that term is defined in Rules 13a-15(e) and 15d-15(e), as adopted by the Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934, as amended (the Exchange Act) as of June 30, 2011. Disclosure controls and procedures are the controls and other procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed in the reports that the Company files or submits under the Exchange Act is accumulated and communicated to management, including the principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosures.

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

During the Company’s last fiscal quarter there were no changes in internal control over financial reporting that materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings

See Note 10 of Notes to Consolidated Financial Statements, “Legal and Regulatory Proceedings.”

 

Item 1A. Risk Factors

There are no material changes with respect to those risk factors previously disclosed in Item 1A to Part I of our Form 10-K for the year ended December 31, 2010.

 

Item 6. Exhibits

31.1 Certification of Gary Y. Kusumi, Chief Executive Officer, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

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

32.1 Certification of Gary Y. Kusumi, Chairman of the Board and Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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

101 The following materials from Affirmative Insurance Holdings, Inc.’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2011, formatted in XBRL (Extensible Business Reporting Language): (1) the Consolidated Balance Sheets, (2) the Consolidated Statements of Income (Loss), (3) the Consolidated Statements of Stockholders’ Equity, (4) the Consolidated Statements of Comprehensive Income (Loss), (5) the Consolidated Statements of Cash Flows, and (6) Notes to Consolidated Financial Statements, tagged as blocks of text.

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    Affirmative Insurance Holdings, Inc.
Date: August 15, 2011     By:   /s/ Michael J. McClure
      Michael J. McClure
     

Executive Vice President and Chief Financial Officer

(and in his capacity as Principal Financial Officer)

 

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