Form 10-K

10-K 1 d466112d10k.htm FORM 10-K Form 10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

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

For the fiscal year ended December 31, 2012

¨	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 of 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)

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common stock, $0.01 par value per share

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act: Yes ¨ No x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act: Yes ¨ No x

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

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 ¨ Smaller Reporting Company x

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

The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant as of the most recently completed second fiscal quarter (June 30, 2012), based on the price at which the common equity was last sold on such date ($0.33): $2,331,405

Indicate the number of shares outstanding of each of the registrant’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 March 25, 2013 was 15,408,358.

DOCUMENTS INCORPORATED BY REFERENCE

Certain information called for by Part III of this Form 10-K is incorporated by reference to certain sections of the Proxy Statement for the 2012 Annual Meeting of our stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days from December 31, 2012.

AFFIRMATIVE INSURANCE HOLDINGS, INC.

YEAR ENDED DECEMBER 31, 2012

INDEX TO FORM 10-K


PART I
Item 1.	Business	3
Item 1A.	Risk Factors	16
Item 1B.	Unresolved Staff Comments	28
Item 2.	Properties	28
Item 3.	Legal Proceedings	29
Item 4.	Mine Safety Disclosures	29

PART II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities	30
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	31
Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	57
Item 8.	Financial Statements and Supplementary Data	60
Item 9.	Changes in and Disagreements With Accountants on Accounting and Financial Disclosure	106
Item 9A.	Controls and Procedures	106
Item 9B.	Other Information	106

PART III
Item 10.	Directors, Executive Officers and Corporate Governance	107
Item 11.	Executive Compensation	107
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	107
Item 13.	Certain Relationships and Related Transactions, and Director Independence	107
Item 14.	Principal Accounting Fees and Services	107

PART IV
Item 15.	Exhibits, Financial Statement Schedules	108

SIGNATURES		109

PART I

Item 1.

BUSINESS

Affirmative Insurance Holdings, Inc., formerly known as Instant Insurance Holdings, Inc., was incorporated in Delaware in June 1998 and completed an initial public offering of its common stock in July 2004. In this report, the terms “Affirmative,” “the Company,” “we,” “us” or “our” mean Affirmative Insurance Holdings, Inc. and all entities included in our consolidated financial statements. 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.

Our Operating Structure

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:

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

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

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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

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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.

Insurance Products

Our insurance company products. We issue non-standard personal automobile insurance policies through our wholly-owned insurance company subsidiaries. Our insurance companies possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both our underwriting agencies and unaffiliated underwriting agencies to design, distribute and service those policies.

Our non-standard personal automobile insurance policies, which generally are issued for the minimum limits of liability coverage mandated by state laws, provide coverage to drivers who find it difficult to obtain insurance from standard insurance companies due to a number of factors, including lack of prior coverage, failure to maintain continuous coverage, age, prior accidents, driving violations, type of vehicle or limited financial resources. We believe that the majority of customers who purchase our non-standard personal automobile insurance policies do not qualify for standard policies because of financial reasons, such as the failure to maintain continuous coverage or the lack of flexible payment options in the standard market. In general, customers in the non-standard market have higher average premiums for a comparable amount of coverage than customers who qualify for the standard market resulting from increased loss costs and transaction expenses, partially offset by the lower severity of losses resulting from lower limits of coverage.

We offer a wide range of coverage options to meet our policyholders’ needs. We offer both liability-only policies, as well as full coverage policies, which include first-party coverage for the insured’s vehicle. Our liability-only policies generally include:

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Bodily injury liability coverage, which protects insureds if they are involved in accidents that cause bodily injury to others, and also provides them with a defense if others sue for covered damages; and

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Property damage liability coverage, which protects insureds if they are involved in accidents that cause damage to another’s property.

The liability-only policies may also include personal injury protection coverage and/or medical payment coverage, depending on state statutes. These policies provide coverage for injuries without regard to fault, as well as uninsured/underinsured motorist coverage.

In addition to our liability-only coverage, the full coverage policies we sell include:

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Collision coverage, which pays for damage to the insured vehicle as a result of a collision with another vehicle or object, regardless of fault; and

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Comprehensive coverage, which pays for damages to the insured vehicle as a result of causes other than collision, such as theft, hail and vandalism.

Full coverage policies may also include optional coverages such as towing, rental reimbursement and special equipment.

Our policies are designed to be priced to allow us to achieve our targeted underwriting margin while at the same time meeting our customers’ needs for low down payments and flexible payment plans. We offer a variety of policy terms ranging from one month to one year. Our policy processing systems enable us to offer a variety of payment plans while minimizing the potential credit risk of uncollectible premiums. We may offer discounts for such items as proof of having purchased automobile insurance within a prescribed prior time period, maintaining homeowners’ insurance, or owning a vehicle with safety features or anti-theft equipment. We may also surcharge the customer for traffic violations and accidents, among other things.

Third-party non-standard personal automobile insurance policies. With the exception of stores located in Louisiana and Alabama, our owned retail stores also sell non-standard personal automobile insurance policies issued by third-party insurance companies for which we receive commission income and fees. We do not bear insurance underwriting risk with respect to these policies. Our retail stores offer these insurance policies underwritten by third-party insurance companies in addition to our own insurance policies primarily to provide a range of products and pricing to meet our customers’ needs, which we believe increases our chances of making a sale. Additionally, should sales of our policies decline in favor of lower-priced non-standard personal automobile insurance products offered by the third-party insurance carriers, we believe that our ability to generate increased commission and fee revenue from sales of third-party insurance policies will help us preserve underwriting profitability and offset decreases in premium volume while maintaining our customer relationship.

Complementary insurance products. Our retail stores also sell a small amount of standard and preferred personal automobile insurance and certain other personal lines insurance products underwritten by third-party insurance companies. Our complementary insurance products are designed to appeal to purchasers of non-standard personal automobile insurance policies and currently include such products as homeowners and renters insurance, motorcycle and recreational vehicle coverage, vehicle protection and travel protection. We offer these products to complement our core offering of non-standard personal automobile insurance policies and to take advantage of our largely fixed cost retail stores, which enables us to generate additional commission income and fees with minimal incremental cost. The insurance companies that underwrite these products bear the insurance risk associated with these policies.

Ancillary non-insurance products and services. Our retail stores may offer non-insurance products and services designed to appeal to our customers, including towing, motor club memberships, hospital indemnity insurance and bond cards. We believe that these products and services will attract additional customers to our stores and will provide an additional means of generating commission income and fees with minimal incremental cost to us.

Distribution and Marketing

Our owned retail stores. Our retail stores serve as direct sales and customer service outlets for insurance companies and other vendors. As of December 31, 2012, we employed 389 licensed sales personnel who sell products and services directly to individual consumers through our 199 owned retail stores. In contrast to the traditional state-by-state marketing approach that is a common practice in our industry, we have established the designated market area (DMA) as the fundamental market focus in our retail operations. As of December 31, 2012, our retail stores were located in 30 DMAs in 9 states.

The following charts list the geographic locations of our owned retail stores by DMA and by state as of December 31, 2012:


DMA	Retail Stores		State	Retail Stores
Chicago		48	Illinois		54
Dallas/Fort Worth		20	Louisiana		48
New Orleans		16	Texas		44
Houston		12	Alabama		19
San Antonio		12	Indiana		13
Baton Rouge		9	South Carolina		11
Lafayette		9	Missouri		7
Birmingham		8	Kansas		2
Other		65	Wisconsin		1

Total		199	Total		199

We operate our retail stores under four names — A-Affordable, Driver’s Choice, InsureOne, and USAgencies — that are well established in their respective DMAs. We extend market awareness through, among other things, television and radio advertising campaigns, direct mail, billboards, digital and print advertisements that emphasize our down payments, flexible payment plans, convenient neighborhood locations and customer service, all of which are designed to generate walk-in traffic, or telephone inquiries to our retail stores. Since our retail business is highly dependent on advertising, segmenting our geographic markets into DMAs allows us to more efficiently concentrate these advertising and marketing support activities. We lease retail stores located in strip malls or other visible locations on major thoroughfares where we believe our customers drive or live. Our retail stores provide customer contact at the point of sale and most policy applications are completed in the retail stores. After completion of the initial insurance transaction, our customers often revisit these stores to make premium payments. This direct contact gives us an opportunity to establish a personal relationship with our customers, who in our experience generally prefer face-to-face interaction, and helps us provide quality and efficient service and identify opportunities to provide additional products and services.

Independent agencies. Our underwriting agencies also appoint independent retail agencies to sell our insurance company subsidiaries’ policies to individual customers. We believe that selling our insurance company subsidiaries’ policies through the independent agency distribution channel, in addition to selling through our owned retail stores, helps us to better leverage our resources to maximize sales of our insurance company subsidiaries’ policies when underwriting conditions are favorable. In 2012, we utilized approximately 3,500 independent agencies that in 2012 were responsible for 29.4% of our gross written premiums. Our top ten independent agents produced 35% of the total independent agent volume and 13% of gross written premium. Our ability to develop strong and mutually beneficial relationships with independent agencies is important to the success of our multiple distribution strategy. We believe that strong product positioning and high service standards are key to independent agency loyalty. We foster our independent agency relationships by providing them our agency software applications designed to strengthen and expand their sales and service capabilities for our products. These software applications provide independent agencies with the ability to service their customers’ accounts and access their own commission information. We maintain strict and high standards for call answering and abandonment rate service levels in our customer service call centers. We believe the level and array of services that we offer to independent agencies creates value in their businesses.

Our underwriting agencies’ centralized marketing department is responsible for managing our relationships with independent agencies. This department is split into two key areas, promotion and service. The promotion function includes prospecting and establishing independent agency relationships, initial contracting and appointment of independent agencies, establishing initial independent agency production goals and implementing market penetration strategies. The service function includes training independent agencies to sell our products and supporting their sales efforts, ongoing monitoring of independent agency performance to ensure compliance with our production and profitability standards and paying independent agency commissions.

Unaffiliated underwriting agencies. Our insurance company subsidiaries also issue insurance policies that are designed, distributed and serviced by unaffiliated underwriting agencies. We issue insurance policies sold through unaffiliated underwriting agencies with established customer bases in order to capture business in markets other than those targeted by our own underwriting agencies. In these instances, we collect fees to compensate us both for the use of our certificates of authority to transact insurance business in selected markets, as well as for assuming the risk that the unaffiliated underwriting agency will continuously and effectively administer these policies.

As of December 31, 2012, one unaffiliated underwriting agency in California actively produces business for our insurance company subsidiaries. For the years ended December 31, 2012 and 2011, unaffiliated underwriting agencies produced $17.8 million and $14.9 million of gross premiums written by our insurance company subsidiaries, respectively.

Pricing and Product Management

We believe that our insurance product management approach to risk analysis and segmentation is a driving factor in maximizing underwriting performance. We employ an insurance product management approach that requires the extensive involvement of product managers who are responsible for the profitability of a specific state or region, with the direct oversight of rate-level structure by our most senior managers. Our product managers are experienced insurance professionals with backgrounds in the major functional areas of the insurance business — accounting, actuarial, claims, information technology, operations, pricing, product development and underwriting. In addition to broad insurance industry knowledge, our product managers have experience in the non-standard personal automobile insurance market, enabling them to develop products to meet the distinctive needs of non-standard customers.

Our product managers work with our actuaries who provide them with profitability and rate assessments. These actuarial evaluations are combined with economic and business modeling information and competitive intelligence monitored by our product managers to be proactive in making appropriate revisions and

enhancements to our rate levels, product structures and underwriting guidelines. As part of our pricing and product management process, pricing and underwriting guidelines and policy attributes are developed by our product managers for each of the products that we administer and products underwritten by our insurance companies through underwriting agencies. These metrics are monitored on a weekly, monthly and quarterly basis to determine if there are deviations from expected results for each product. Based on the review of these metrics, our product managers make revisions and enhancements to products to assure that our underwriting profit targets are being attained.

We believe that the analysis of competitive intelligence is a critical element of understanding the performance of our products and our position in markets. Although we put more weight on our own product experience and performance data, we gain insights into our markets, our customers, our agents and trends in the business by monitoring changes made by our competitors. We routinely analyze changes made by competitors to understand the rate and product adjustments they are making, and we routinely compare and rank our rates against those of our competitors to understand our market position.

Premium Finance

We believe that the amount of down payment and the availability of flexible payment plans are two of the primary factors that our customers consider when purchasing non-standard personal automobile insurance. Down payments and payment plans typically are offered by insurers and agents in the form of either installment billing or premium financing arrangements. Premium finance involves making a loan to the customer that is backed by the unearned portion of the insurance premiums being financed. We offer our customers a variety of payment plans that allow for low down payments. Insurers typically use installment billing arrangements to bill for the premium of a single policy. Independent agents, who may offer policies from multiple insurers, use premium financing to finance multiple policies through one premium finance agreement.

We provide a premium finance option for many of our customers. Premium financing offers several advantages, including:

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the ability to finance multiple policies through a single premium finance agreement;

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a greater flexibility of payment plan structure and down payment;

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a defined regulatory framework for financing premiums;

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the ability to generate revenues in our non-insurance subsidiaries; and

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returns comparable to or exceeding those of installment billing.

In a typical premium finance arrangement, the premium finance company lends the amount of the premium (minus the insured’s down payment) to the insured and pays it to the insurance company on behalf of the insured. The insured makes periodic payments to the premium finance company over the term of the finance agreement. Payment plans and down payments are developed by giving consideration to expected default rates and their timing and the amount of the unearned portion of the insurance premiums being financed, since that provides security for the loan. Our billing systems also allow for the bundling of financed insurance products and non-financed ancillary products into a single pay plan.

If an insurance policy is cancelled before its term expires, the policyholder has the right to receive a return of the unearned premium. However, under a premium finance agreement, the policyholder assigns this right to the premium finance company to secure their obligation under the loan. If the policyholder defaults on a payment and after being notified of the default, fails to cure the default within the prescribed time period, the premium finance company has the right to order the insurance company to cancel the policy and pay to the premium finance company the amount of any unearned premium on the policy. If the amount of unearned premium exceeds the balance due on the loan plus any interest and applicable fees owed by the policyholder to the premium finance company, then the premium finance company returns the excess amount to the policyholder in accordance with applicable law.

The regulatory framework under which premium finance procedures are established is generally set forth in the premium finance statutes of the states in which we operate. Among other restrictions, the interest rate we may charge our customers for financing their premiums is limited by these state statutes. See “Regulatory Environment — Premium Finance Regulation” for additional information about state usury and other regulatory restrictions applicable to our premium finance operations.

We mitigate the risk of potential losses from the insured’s default under the premium finance agreement by designing payment plans that give consideration to the principal amount of the loan that is outstanding and the unearned premium securing the loan. In addition, whenever a policyholder fails to timely cure a default on his or her premium finance loan, we act promptly to order the insurance company to cancel the insurance policy and return to us any unearned premium.

Claims Management

We believe that effective claims management is critical to our success. Our claims vision is to deliver an accurate settlement at the earliest possible time in the claims cycle in an efficient and cost effective manner. We strive to pay the right amount on every claim consistent with our contractual obligations and legal responsibilities. Our measures and behaviors are focused on a holistic claims quality process which focuses on the outcome of the claim. We are customer focused and deliver on the promise of the insurance contract by providing prompt and fair claims handling, meeting expectations, and proactively keeping customers informed on the status of their claim.

Claims are handled directly by our employees for the insurance policies we administer with the exception of the California program which was handled by a third-party administrator through October 2012. Our staff began receiving directly new claims on the California business in November and will transition all open claims from the third-party administrator during 2013. Our primary claims operations are located in Addison, Texas and Baton Rouge, Louisiana.

We have staff appraisers positioned throughout our markets where we have sufficient market penetration. Through the utilization of well-trained field appraisal personnel, we are able to maintain tighter control of the vehicle repair process, thereby reducing the amount we pay for repairs, storage costs and auto rental costs. We have a national centralized claims unit which manages first notice of loss, salvage, subrogation and special investigations. We have an aligned audit and control function responsible to ensure compliance with our claims standards and ensure consistent claims handling throughout the organization. We defend litigation by retaining outside defense counsel as well as employing staff counsel for those areas in which there is a sufficient volume of claims to make staff counsel economical.

Losses and Loss Adjustment Expenses

Automobile accidents generally result in insurance companies paying settlements resulting from physical damage to an automobile or other property and injury to a person. Because our insureds and claimants typically notify us within a short time frame after an accident has occurred, our ultimate liability for losses and loss adjustment expenses on our policies generally emerges in a relatively short period of time. In some cases, however, the period of time between the occurrence of an insured event and the final settlement of a claim may be several months or years, and during this period it often becomes necessary to adjust the loss reserve estimates either upward or downward.

We record loss reserves to cover our estimated ultimate liability for reported and incurred but not reported losses under insurance policies that we write and for losses and loss adjustment expenses relating to the investigation and settlement of claims. We estimate liabilities for the cost of losses and loss adjustment expenses for both reported and unreported claims based on historical trends adjusted for changes in loss costs, underwriting standards, policy provisions and other factors. Estimating the liability for unpaid losses and loss adjustment expenses is inherently a matter of judgment and is influenced by factors that are subject to significant variation. We monitor items such as the effect of inflation on medical, hospitalization, material repair and

replacement costs, general economic trends and the legal environment. While the ultimate liability may be higher or lower than recorded loss reserves, the loss reserves for personal auto coverage can be established with a greater degree of certainty in a shorter period of time than that associated with many other property and casualty coverages which, due to the nature of the coverage being provided, take a longer period of time to establish a similar level of certainty.

Reinsurance

We may selectively utilize the reinsurance markets to increase our underwriting capacity and to reduce our exposure to losses. Reinsurance refers to an arrangement in which a reinsurer agrees in a contract to assume specified risks written by an insurance company, commonly referred to as the “ceding” company, by paying the insurance company all or a portion of the insurance company’s losses arising under specified classes of insurance policies. Generally, we cede premium and losses to reinsurers under quota-share reinsurance arrangements, pursuant to which our reinsurers agree to assume a specified percentage of our losses in exchange for a corresponding portion of the policy premiums we receive.

Although our reinsurers are liable for loss to the extent of the coverage they assume, our reinsurance contracts do not discharge our insurance company subsidiaries from primary liability for the full amount of policies issued. In order to mitigate the credit risk of reinsurance companies, we select financially strong reinsurers with an A.M. Best rating of “A-” or better and continue to evaluate their financial condition.

Competition

The non-standard personal automobile insurance business is highly competitive and, except for regulatory considerations, there are relatively few barriers to entry. We compete based on factors such as the convenience of retail store locations, price, coverages offered, availability of flexible down payment arrangements and billing plans, customer service, claims handling and agent commission. We compete with other insurance companies that sell non-standard personal automobile insurance policies through independent agencies as well as with insurance companies that sell such policies directly to their customers. Our retail agencies and the independent agencies that sell our insurance products compete both with these direct writers and with other independent agencies. Therefore, our competitors are not only large national insurance companies, but also smaller regional insurance companies and independent agencies that operate in a specific region or single state in which we operate. As of December 31, 2012, the top ten non-standard insurance groups accounted for 72.9% of direct premiums earned in the $24.5 billion market segment.

The non-standard personal automobile insurance industry historically has been cyclical in nature, characterized by periods of severe price competition and excess underwriting capacity followed by periods of high premium rates and shortages of underwriting capacity. These fluctuations in the non-standard personal automobile insurance business cycle may negatively impact our profitability.

Some of our competitors have substantially greater financial and other resources and may offer a broader range of products or competing products at lower prices. In addition, existing competitors may attempt to increase market share by lowering rates and new competitors may enter this market, particularly larger insurance companies that do not presently write non-standard personal automobile insurance in our markets. As a result, we may experience a reduction in our underwriting margins or sales of our insurance policies may decrease as individuals purchase lower-priced products from other insurance companies. A loss of business to competitors offering similar insurance products at lower prices or having other competitive advantages would negatively affect our revenues and net income.

In addition to selling policies for our own insurance companies, our retail stores offer and sell non-standard personal automobile insurance policies for third-party insurance companies. As a result, our insurance companies compete with these third-party insurance companies for sales to the customers of our retail stores. If the competing insurance products offered by a third-party insurance company are priced lower or have more

attractive features than the insurance policies offered by our insurance companies, customers of our retail stores may decide not to purchase insurance policies from our insurance companies and may instead purchase policies from the third-party insurance company. A loss of business by our insurance companies resulting from our retail stores selling relatively more policies of third-party insurance companies and fewer policies of our insurance companies would negatively affect our earned premiums. However, we would earn commission income from the third-party insurance companies and fees from the customers.

Regulatory Environment

We are subject to comprehensive regulation and supervision by government agencies in Illinois, Louisiana, Michigan and New York, the states in which our insurance company subsidiaries are domiciled, as well as in the states where we sell insurance products, issue policies and handle claims. Certain states impose restrictions or require prior regulatory approval of certain corporate actions, which may adversely affect our ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow our business profitably. These regulations provide safeguards for policy owners and are not intended to protect the interests of stockholders. Our ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner, is and will continue to be critical to our success.

Required licensing. We operate under licenses issued by various state insurance authorities. These licenses govern, among other things, the types of insurance coverage and agency and claim services that we may offer consumers in these states. Such licenses typically are issued only after we file an appropriate application and satisfy prescribed criteria. We must apply for and obtain the appropriate new licenses before we can implement any plan to expand into a new state or offer a new line of insurance or other new product that requires separate licensing.

Transactions between insurance companies and their affiliates. We are a holding company and are subject to regulation in the jurisdictions in which our insurance company subsidiaries conduct business. The insurance laws in those states provide that all transactions among members of an insurance holding company system must be fair and reasonable. Transactions between our insurance company subsidiaries and their affiliates generally must be disclosed to state regulators and prior regulatory approval generally is required before any material or extraordinary transaction may be consummated or any management agreement, services agreement, expense sharing arrangement or other contract providing for the rendering of services on a regular, systematic basis is entered into. State regulators may refuse to approve or delay approval of such a transaction, which may impact our ability to innovate or operate efficiently.

Regulation of insurance rates and approval of policy forms. The insurance laws of most states in which our insurance subsidiaries operate require insurance companies to file insurance rate schedules and insurance policy forms for review and approval. State insurance regulators have broad discretion in judging whether our rates are adequate, not excessive and not unfairly discriminatory and whether our policy forms comply with law. The speed at which we can change our rates depends, in part, on the method by which the applicable state’s rating laws are administered. Generally, state insurance regulators have the authority to disapprove our rates or requested changes in our rates.

Restrictions on cancellation, non-renewal or withdrawal. Many states have laws and regulations that limit an insurance company’s ability to exit or significantly reduce its writings in a market. For example, certain states limit an automobile insurance company’s ability to cancel or not renew policies. Some states prohibit an insurance company from withdrawing from one or more lines of business in the state, except pursuant to a plan approved by the state insurance department. In some states, this applies to reductions of anything greater than 50% in the amount of insurance written, not just to a complete withdrawal. The state insurance department may disapprove a plan that may lead to market disruption.

Investment restrictions. We are subject to state laws and regulations that require diversification of our investment portfolios and that limit the amount of investments in certain categories. Failure to comply with these laws and regulations would cause non-conforming investments to be treated as non-admitted assets for purposes of measuring statutory surplus and, in some instances, would require divestiture.

Capital requirements. Our insurance company subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act, adopted by the National Association of Insurance Commissioners (NAIC), require our insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject us to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels. At December 31, 2012 and 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. Effective January 1, 2012, the State of Illinois adopted the revised NAIC Risk-Based Capital Model Act that includes a risk-based capital (RBC) trend test as another manner under which the company action level could be triggered and will be applied as of December 31, 2012. The test is applicable when an insurance company has a risk-based capital ratio between 200% and 300% and a combined ratio of more than 120%. Each of our insurance subsidiaries was in compliance with RBC trend test requirements as of December 31, 2012.

State departments of insurance financial strength requirements. Various individual state departments of insurance in jurisdictions where our insurance company subsidiaries conduct business maintain specific requirements in connection with the financial strength of property and casualty insurance companies. Failure on the part of our insurance company subsidiaries to comply with these requirements could subject us to an examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. The Illinois Insurance Code includes a reserve requirement that an insurer maintain an amount of qualifying investments, as defined, at least equal to the lesser of $250.0 million or 100% of its adjusted loss reserves and loss adjustment expenses reserves, as defined. See discussion regarding the Company’s non-compliance with this requirement as of December 31, 2012 in the Overview section of Management’s Discussion and Analysis in this Annual Report on Form 10-K for the year ended December 31, 2012.

IRIS Ratios. The NAIC Insurance Regulatory Information System (IRIS) is part of a collection of analytical tools designed to provide state insurance regulators with an integrated approach to screening and analyzing the financial condition of insurance companies operating in their respective states. IRIS is intended to assist state insurance regulators in targeting resources to those insurers in greatest need of regulatory attention. IRIS consists of two phases: statistical and analytical. In the statistical phase, the NAIC database generates key financial ratio results based on financial information obtained from insurers’ annual statutory statements. The analytical phase is a review of the annual statements, financial ratios and other automated solvency tools. The primary goal of the analytical phase is to identify companies that appear to require immediate regulatory attention. A ratio result falling outside the usual range of IRIS ratios is not considered a failing result; rather, unusual values are viewed as part of the regulatory early monitoring system. Furthermore, in some years, it may not be unusual for financially sound companies to have several ratios with results outside the usual ranges. An insurance company may fall outside of the usual range for one or more ratios because of specific transactions that are in themselves not significant.

As of December 31, 2012, our insurance subsidiary, Affirmative Insurance Company (AIC) had eight ratios outside the usual ranges.

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One of the ratios reflects the negative operating margin reported in 2012 and over the previous two-year period. This ratio was negatively impacted by loss development on prior accident years ($5.5 million in 2012 and $5.1 million in 2011), as well as operating expenses in 2012 representing a higher percentage of declining net revenues.

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One ratio was negatively impacted by the amount of quota-share reinsurance in relation to surplus.

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Three of these ratios reflect the significant reduction in policyholder surplus resulting from the current year operating loss.

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Two ratios were triggered by the level of assumed premiums from our other insurance subsidiaries. The amount of reinsurance assumed from our other insurance subsidiaries is periodically evaluated by management and the contracts amended to affect capital utilization strategies.

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One ratio was triggered as a result of low investment yields due to a conservative investment strategy.

In addition, AIC subsidiaries had five ratios outside the usual range.

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One of the insurance subsidiaries had three of these ratios outside the usual range due to the low levels of surplus retained in their capital structure as well as the extraordinary dividends paid to AIC during the year.

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One subsidiary had a ratio outside the usual range as a result of reduced liquidity resulting from extraordinary dividends paid during the year.

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The other ratio outside the usual range related to reduced investment yields on lower levels of invested assets maintained in the subsidiaries.

Regulation of dividends. We are a holding company with no business operations of our own. Consequently, our ability to pay dividends to stockholders and meet our debt payment obligations is largely dependent on dividends or other payments from our operating subsidiaries, which include our agency subsidiaries and our insurance company subsidiaries. State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. Our insurance companies 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 the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution that, together with other distributions made within the preceding 12 months, exceeds the greater of 10% 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.

Generally, the net admitted assets of insurance companies that, subject to other applicable insurance laws and regulations, are available for transfer to the parent company cannot include the net admitted assets required to meet the minimum statutory surplus requirements of the states where the companies are licensed.

Acquisition of control. The acquisition of control of our insurance company subsidiaries requires the prior approval of their applicable insurance regulators. Generally, any person who directly or indirectly through one or more affiliates acquires 10% or more of the outstanding securities of an insurance company or its parent company is presumed to have acquired control of the insurance company. In addition, certain state insurance laws contain provisions that require pre-acquisition notification to state agencies of a change in control with respect to a non-domestic insurance company licensed to do business in that state. While such pre-acquisition notification statutes do not authorize the state agency to disapprove the change of control, such statutes do

authorize certain remedies, including the issuance of a cease and desist order with respect to the non-domestic insurer if certain conditions exist, such as undue market concentration. Such approval requirements may deter, delay or prevent certain transactions affecting the ownership of our common stock.

Shared or residual markets. Like other insurance companies, we are required to participate in mandatory shared market mechanisms or state pooling arrangements as a condition for maintaining our automobile insurance licenses to do business in various states. The purpose of these state-mandated arrangements is to provide insurance coverage to individuals who, because of poor driving records or other underwriting reasons, are unable to purchase such coverage voluntarily provided by private insurers. These risks can be assigned to all insurers licensed in the state and the maximum volume of such risks that any one insurance company may be assigned typically is proportional to that insurance company’s annual premium volume in that state. The underwriting results of this mandatory business traditionally have been unprofitable. The amount of premiums we might be required to assume in a given state in connection with an involuntary arrangement may be reduced because of credits we may receive for non-standard personal automobile insurance policies that we write voluntarily.

Guaranty funds. Under state insurance guaranty fund laws, insurance companies doing business in a state can be assessed for certain obligations of insolvent insurance companies to policyholders and claimants. Maximum contributions required by laws in any one year vary between 1% and 2% of annual written premiums in that state, but it is possible that caps on such contributions could be raised if there are numerous or large insolvencies. In most states, guaranty fund assessments are recoverable either through future policy surcharges or offsets to state premium tax liability.

Premium finance regulation. Our premium finance subsidiaries are regulated by governmental agencies in states in which they conduct business. The agency responsible for such regulation varies by state, but generally is the banking department or the insurance department of the applicable state. These regulations, which generally are designed to protect the interests of policyholders who elect to finance their insurance premiums, vary by jurisdiction, but, among other matters, usually involve:

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requiring our premium finance companies to qualify for and obtain a license and to renew the license each year;

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regulating the interest rates, fees and service charges we may charge our customers;

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establishing standards for filing annual financial reports of our premium finance companies;

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imposing minimum capital requirements for our premium finance subsidiaries or requiring surety bonds in addition to or as an alternative to such capital requirements;

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prescribing minimum notice and cure periods before we may cancel a customer’s policy for non-payment under the terms of the financing agreement;

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governing the form and content of our financing agreements;

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prescribing timing and notice procedures for collecting unearned premium from the insurance company, applying the unearned premium to our customer’s premium finance account, and, if applicable, returning any refund due to our customer;

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conducting periodic financial and market conduct examinations and investigations of our premium finance companies and its operations; and

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requiring prior notice to the regulating agency of any change of control of our premium finance companies.

Some of these states may require our premium finance subsidiaries to maintain a specified minimum net worth, post a surety bond or deposit securities with the state regulator.

In addition, our premium finance business is subject to the federal Truth-in-Lending Act (TILA) and Regulation Z promulgated pursuant to the TILA and similar state statutes.

Privacy Regulations. The Gramm-Leach-Bliley Act protects consumers from the unauthorized dissemination of certain personal information. The majority of states have implemented additional regulations to address privacy issues. These laws and regulations apply to all financial institutions, including insurance and finance companies, and require us to maintain appropriate procedures for managing and protecting certain personal information of our customers and to fully disclose our privacy practices to our customers. We may also be exposed to future privacy laws and regulations, which could impose additional costs and impact our results of operations or financial condition.

Regulation of Our Ancillary Product Vendors. The vendors of the ancillary products and services we offer to our customers are also subject to various federal and state laws and regulations. The failure of any vendor to comply with such laws and regulations could affect our ability to sell the ancillary products or services of that particular vendor. However, we believe that there are adequate alternative vendors of all the material ancillary products and services sold by us.

Trade practices. The manner in which we conduct the business of insurance is regulated in an effort to prohibit practices that constitute unfair methods of competition or unfair or deceptive acts or practices. Prohibited practices include disseminating false information or advertising; defamation; boycotting, coercion and intimidation; false statements or entries; unfair discrimination; rebating; improper tie-ins with lenders and the extension of credit; failure to maintain proper records; improper use of proprietary information; sliding, packaging or other deceptive sales conduct; failure to maintain proper complaint handling procedures; and making false statements in connection with insurance applications for the purpose of obtaining a fee, commission or other benefit. We set business conduct policies for our employees and we require them, among other things, to conduct their activities in compliance with these statutes.

Federal Insurance Office. The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) created within the United States Department of the Treasury a new Federal Insurance Office (FIO), whose purpose is (in part) to collect information about the insurance industry and monitor the industry for systemic risk. If the FIO were to recommend to the Financial Stability Oversight Council (also created by the Dodd-Frank Act) that we are systemically significant and therefore require additional regulation, or that the insurance industry as a whole should be regulated at the federal level, our businesses could be affected significantly. We are unable to predict whether any additional federal laws or regulations will be enacted and how and to what extent such laws and regulations would affect our businesses.

Unfair claims practices. Generally, insurance companies, adjusting companies and individual claims adjusters are prohibited by state statutes from engaging in unfair claims practices on a flagrant basis or with such frequency to indicate a general business practice. Unfair claims practices include:

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misrepresenting pertinent facts or insurance policy provisions relating to coverages at issue;

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failing to acknowledge and act reasonably promptly upon communications with respect to claims arising under insurance policies;

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failing to adopt and implement reasonable standards for the prompt investigation and settlement of claims arising under its policies;

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failing to affirm or deny coverage of claims within a reasonable time after proof of loss statements have been completed;

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attempting to settle a claim for less than the amount to which a reasonable person would have believed such person was entitled;

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attempting to settle claims on the basis of an application that was altered without notice to or knowledge or consent of the insured;

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compelling insureds to institute suits to recover amounts due under policies by offering substantially less than the amounts ultimately recovered in suits brought by them;

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refusing to pay claims without conducting a reasonable investigation;

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making claim payments to an insured without indicating the coverage under which each payment is being made;

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delaying the investigation or payment of claims by requiring an insured, claimant or the physician of either to submit a preliminary claim report and then requiring the subsequent submission of formal proof of loss forms, both of which submissions contains substantially the same information;

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failing, in the case of claim denials or offers of compromise or settlement, to promptly provide a reasonable and accurate explanation of the basis for such actions; and

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not attempting in good faith to effectuate prompt, fair and equitable settlements of claims in which liability has become reasonably clear.

We set business conduct policies and conduct training to make our employee-adjusters and other claims personnel aware of these prohibitions and we require them to conduct their activities in compliance with these statutes.

Licensing of retail agents and adjusters. Generally, individuals who sell, solicit or negotiate insurance, whether employed by one of our retail agencies or an independent agency, are required to be licensed by the state in which they work for the applicable line or lines of insurance they offer. Agents generally must renew their licenses annually and complete a certain number of hours of continuing education. In certain states in which we operate, insurance claims adjusters are also required to be licensed and some must fulfill annual continuing education requirements.

Financial reporting. We are required to file quarterly and annual financial reports with states using statutory accounting practices that are different from U.S. generally accepted accounting principles (GAAP), which reflect our insurance company subsidiaries on a going concern basis. The statutory accounting practices used by state regulators, in keeping with the intent to assure policyholder protection, are generally based on a liquidation concept. For a summary of significant differences for our insurance companies between statutory accounting practices and GAAP, see Note 3 of Notes to Consolidated Financial Statements contained in Item 8 of this report.

Periodic financial and market conduct examinations. The state insurance departments that have jurisdiction over our insurance company subsidiaries may conduct on-site visits and examinations of the insurance companies’ affairs, especially as to their financial condition, ability to fulfill their obligations to policyholders, market conduct, claims practices and compliance with other laws and applicable regulations. Typically, these examinations are conducted every three to five years. In addition, if circumstances dictate, regulators are authorized to conduct special or target examinations of insurance companies to address particular concerns or issues. The results of these examinations can give rise to regulatory orders requiring remedial, injunctive or other corrective action on the part of the company that is the subject of the examination or assessing fines or other penalties against that company.

Use of county mutual in Texas. In 2003, legislation was passed in Texas that was described as comprehensive insurance reform affecting the homeowners and automobile insurance business. With respect to non-standard personal automobile insurance, the most significant provisions provided for additional rate regulation and limitations on the use of credit scoring and territorial distinctions in underwriting and rating risks. For the year ended December 31, 2012, approximately 22.8% of our gross premiums written were issued to customers in Texas. These policies were primarily written by an unaffiliated county mutual insurance company

and 100% assumed by our insurance companies. We and many of our competitors contract with Texas county mutual insurance companies primarily because these entities are allowed the flexibility of multiple-rate plans. Even though the Texas Commissioner of Insurance has been given broader rulemaking authority under the 2003 law, to date we have experienced little impact in the design and pricing flexibility of our products. The county mutual system remains flexible and continues to meet our needs.

Employees

As of December 31, 2012, we employed 949 employees.

Access to Reports

Our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are made available free of charge through the “SEC Filings” link within the Investor Relations section of our website at www.affirmativeholdings.com as soon as reasonably practicable after such material is electronically filed with, or furnished to, the U.S. Securities and Exchange Commission.

Item 1A.

RISK FACTORS

There is Substantial Doubt About the Company’s Ability to Continue as a Going Concern

The Company incurred losses from operations over the last four years, including a net loss of $51.9 million for the year ended December 31, 2012. The Company’s losses over this time period were primarily due to underwriting losses, significant revenue declines and expenses declining less than the amount of revenue declines and goodwill impairments. The loss from operations was the result of prior pricing issues in some states in which the Company has taken significant pricing and underwriting actions to address profitability, losses from states that the Company has exited, such as Florida and Michigan, and goodwill impairment charges as a result of such losses. As a result of declining performance, the Company breached the leverage ratio covenant under the senior secured credit facility as of September 30, 2012; however, the lenders for the facility agreed to waive such event of default. The Company breached the leverage, interest coverage and risk-based capital ratio covenants (“Financial Covenants”) as of December 31, 2012, and the lenders for the facility have agreed to temporarily forbear from exercising their rights and remedies under the facility until the earlier of June 1, 2013, or the occurrence of a further event of default under the facility from the quarterly covenants. If the Company is unable to achieve compliance with the Financial Covenants as of June 1, 2013, or obtain an extension of the lenders’ forbearance or a waiver of any non-compliance, the lenders will be able to declare all amounts outstanding under the facility to be immediately due and payable. Even if the Company is compliant with the Financial Covenants or, if not compliant, obtains additional forbearance or waivers from its lenders, there is still substantial uncertainty that the Company will be able to refinance or extend the maturity of the senior secured facility when it expires in January 2014. If the Company’s lenders declare the amounts outstanding under our senior secured credit facility to be immediately due and payable or the Company is unable to refinance or extend the maturity of the senior secured facility when it expires in January 2014, it would have a material adverse effect on our operations and our creditors and stockholders.

June 30, 2013, which includes a number of actions. The Illinois Department of Insurance has not yet responded to the plan. If the Illinois Department of Insurance does not approve AIC’s proposed plan or if AIC is not compliant as of the plan date of June 30, 2013, the Director of the Illinois Department of Insurance could deem AIC to be in hazardous financial condition and could take one or more of the remedial actions authorized by law for such a condition. Such action by the Illinois Department of Insurance would have a material adverse affect on the Company’s operations and the interests of its creditors and stockholders. Such action by the Illinois Department of Insurance also would trigger a further event of default under the Company’s senior secured credit facility allowing the Company’s lenders to declare all amounts outstanding under the facility to be immediately due and payable, and if such amounts were declared immediately due and payable by the lenders, it would have a material adverse effect on our operations and the interests of our creditors and stockholders.

The Company is pursuing various actions to address these issues including, but not limited to, refinancing of its debt, obtaining additional financing or entering into certain transactions, such as sales of assets or operations.

The Company’s recent history of recurring losses from operations, its failure to comply with the Financial Covenants in its senior secured credit facility, its failure to comply with the Illinois Department of Insurance reserve requirement, and the substantial liquidity needs the Company will face when its senior secured credit facility expires in January 2014 raise substantial doubt about the Company’s ability to continue as a going concern. The Company’s independent registered public accounting firm included an explanatory paragraph in their auditors’ report included herein regarding the substantial doubt about the ability of the Company to continue as a going concern. This “going concern paragraph” may constitute an event of default under the Company’s senior secured credit facility; however, the lenders have waived any such event of default as of December 31, 2012.

Disruptions in the overall economy and the financial markets may adversely impact our business and results of operations.

The insurance industry can be affected by many macroeconomic factors, including changes in national, regional, and local economic conditions, employment levels and consumer spending patterns. Disruptions in the overall economy and financial markets could reduce consumer confidence in the economy and adversely affect consumers’ ability to purchase automobile insurance policies or ancillary products from us, which could be harmful to our financial position and results of operations, adversely affect our ability to comply with our covenants under our credit facility. Such declines may also, in addition to negatively impacting our operating results, adversely impact our overall financial condition, liquidity, credit rating, ability to access capital markets, and ability to retain and attract key employees. There can be no assurances that government responses to the recent disruptions in the financial markets will restore consumer confidence, stabilize the markets or increase liquidity and the availability of credit.

Our largest stockholder controls a significant percentage of our common stock and its interests may conflict with those of our other stockholders.

New Affirmative LLC (New Affirmative) beneficially owns 51.0% of our outstanding common stock. As a result, New Affirmative exercises significant influence over matters requiring stockholder approval, including the election of directors, changes to our charter documents and significant corporate transactions. This concentration of ownership makes it unlikely that any other holder or group of holders of our common stock will be able to affect the way we are managed or the direction of our business. The interests of New Affirmative with respect to matters potentially or actually involving or affecting us, such as future acquisitions, financings and other corporate opportunities and attempts to acquire us, may conflict with the interests of our other stockholders. New Affirmative’s continued concentrated ownership may have the effect of delaying or preventing a change of control of us, including transactions in which stockholders might otherwise receive a premium for their shares over then current market prices.

The market for trading our common stock may become unstable or cease to exist, which would adversely affect the market price and liquidity of our common stock.

In June 2012, our common stock was delisted from the NASDAQ Global Select Market. Our common stock is now traded exclusively in the over-the-counter market. We cannot predict the actions of market makers, investors or other market participants, and can offer no assurances that the market for our common stock will remain stable. If there is no active trading market in our common stock, the market price and liquidity of our common stock will be adversely affected.

Future issuances or sales of our common stock, including under our equity incentive plan or in connection with future acquisition activities, may adversely affect our common stock price.

As of the date of this filing, we had an aggregate of 56,797,779 shares of our common stock authorized but unissued and not reserved for specific purposes. In general, we may issue all of these shares without any action or approval by our stockholders. We have reserved 3,000,000 shares of our common stock for issuance under our equity incentive plan, of which 410,194 shares are issuable upon vesting and exercise of options granted as of the date of this filing, including exercisable options of 2,407,000 as of December 31, 2012. In addition, we may pursue acquisitions of competitors and related businesses and may issue shares of our common stock in connection with these acquisitions. Sales or issuances of a substantial number of shares of common stock, or the perception that such sales could occur, could adversely affect prevailing market prices of our common stock, and any sale or issuance of our common stock will dilute the percentage ownership held by our stockholders.

New Affirmative, our largest stockholder, beneficially owns 51.0% of our common stock. New Affirmative has certain demand and piggyback registration rights with respect to the shares of our common stock it beneficially owns. Sales of a substantial number of shares of common stock by our largest stockholder, New Affirmative, or the perception that such sales could occur, could adversely affect prevailing market prices of our common stock.

Because of our significant concentration in non-standard personal automobile insurance and in a limited number of states, our profitability may be adversely affected by negative developments and cyclical changes in the industry or negative developments in these states.

Substantially all of our gross premiums written and our commission income and fees are generated from sales of non-standard personal automobile insurance policies. As a result of our concentration in this line of business, negative developments in the business, economic, competitive or regulatory conditions affecting the non-standard personal automobile insurance industry could have a negative effect on our profitability and would have a more pronounced effect on us as compared to more diversified companies. Examples of such negative developments would be increasing trends in automobile repair costs, automobile parts costs, used car prices and medical care expenses, increased regulation, as well as increased litigation of claims and higher levels of fraudulent claims. All of these events can result in reduced profitability.

In addition, the non-standard personal automobile insurance industry historically has been cyclical in nature, characterized by periods of severe price competition and excess underwriting capacity followed by periods of high premium rates and shortages of underwriting capacity. These fluctuations in the non-standard personal automobile insurance business cycle may negatively impact our profitability.

Our financial results may be adversely affected by conditions in the states where our business is concentrated.

Our business is concentrated in a limited number of states. For the year ended December 31, 2012, 45.1% of our gross premiums written related to policies issued to customers in Louisiana, 22.8% to customers in Texas, 10.1% to customers in Illinois and 9.0% to customers in Alabama. Our revenues and profitability are therefore

subject to prevailing regulatory, legal, economic, demographic, competitive and other conditions in these states. Changes in any of these conditions could make it less attractive for us to do business in these states and could have an adverse effect on our financial results.

Intense competition could adversely affect our profitability.

The non-standard personal automobile insurance business is highly competitive and, except for regulatory considerations, there are relatively few barriers to entry. Our insurance companies compete with other insurance companies that sell non-standard personal automobile insurance policies through independent agencies as well as with insurance companies that sell such policies directly to their customers. Our retail agencies and the independent agencies that sell our insurance products compete both with these direct writers and with other independent agencies. Therefore, our competitors are not only large national insurance companies, but also smaller regional insurance companies and independent agencies. Some of our competitors have substantially greater financial and other resources than we have and may offer a broader range of products or competing products at lower prices. In addition, existing competitors may attempt to increase market share by lowering rates and new competitors may enter this market, particularly larger insurance companies that do not presently write non-standard personal automobile insurance. In this environment, we may experience a reduction in our underwriting margins or sales of our insurance policies may decrease as individuals purchase lower-priced products from other insurance companies. A loss of business to competitors offering similar insurance products at lower prices or having other competitive advantages could negatively affect our revenues and net income.

In addition to selling policies for our own insurance companies, our retail stores offer and sell non-standard personal automobile insurance policies for unaffiliated insurance companies. As a result, our insurance companies compete with these unaffiliated insurance companies for sales to the customers of our owned retail stores. If the competing insurance products offered by an unaffiliated insurance company are priced lower or have more attractive features than the insurance policies offered by our insurance companies, customers of our retail stores may decide not to purchase insurance policies from our insurance companies and may instead purchase policies from the unaffiliated insurance company. A loss of business by our insurance companies resulting from our retail stores selling relatively more policies of unaffiliated insurance companies and fewer policies of our insurance companies could negatively affect our revenues and profitability. Our retail stores would, however, earn commission income and fees from the unaffiliated insurance companies for the sales of their policies.

Our success depends on our ability to price accurately the risks we underwrite.

The results of our operations and the financial condition of our insurance companies depend on our ability to underwrite and set premium rates accurately for a wide variety of risks. Rate adequacy is necessary to generate sufficient premiums to pay losses, loss adjustment expenses and underwriting expenses and to earn a profit. In order to price our products accurately, we must collect and properly analyze a substantial amount of data; develop, test and apply appropriate rating formulas; closely monitor and timely recognize changes in trends and project both severity and frequency of losses with reasonable accuracy. Our ability to undertake these efforts successfully, and as a result price our products accurately, is subject to a number of risks and uncertainties, some of which are outside our control, including:

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the availability of sufficient reliable data and our ability to properly analyze available data;

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the uncertainties that inherently characterize estimates and assumptions;

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our selection and application of appropriate rating and pricing techniques; and

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unanticipated changes in legal standards, claim settlement practices, medical care expenses and automobile repair costs.

Consequently, we could under price risks, which would negatively affect our profit margins, or we could overprice risks, which could reduce our sales volume and competitiveness. In either event, the profitability of our insurance companies could be materially and adversely affected.

If our actual losses and loss adjustment expenses exceed our loss and loss adjustment expense reserves, we will incur additional charges to earnings.

We maintain reserves to cover our estimated ultimate liability for losses and the related loss adjustment expenses for both reported and unreported claims on 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 in multiple markets and other variable factors such as inflation. Due to the inherent uncertainty of estimating reserves, it has been necessary, and will continue to be necessary, to revise estimated future liabilities as reflected in our reserves for claims and related expenses.

We cannot be sure that our ultimate losses and loss adjustment expenses will not materially exceed our reserves. To the extent that our reserves prove to be inadequate in the future, we would be required to increase our reserves for losses and the related loss adjustment expenses and incur a charge to earnings in the subsequent period during which such reserves are increased, which could have a material and adverse impact on our financial condition and results of operations in the subsequent period. In addition, we have a limited history in establishing reserves in certain states, and our reserves for losses and loss adjustment expenses may not necessarily accurately predict future trends in our models to assess these amounts.

We may not be successful in reducing our risk and increasing our underwriting capacity through reinsurance arrangements, which could adversely affect our business, financial condition and results of operations.

We use quota-share reinsurance primarily to increase our underwriting capacity and to reduce our exposure to losses. Quota-share reinsurance is a form of pro rata reinsurance arrangement in which the reinsurer participates in a specified percentage of the premiums and losses on every risk that comes within the scope of the reinsurance agreement in return for a portion of the corresponding premiums. The availability, cost and structure of reinsurance protection is subject to changing market conditions that are outside of our control. In order for these contracts to qualify for reinsurance accounting and thereby provide the additional underwriting capacity that we might need, the reinsurer generally must assume significant risk and have a reasonable possibility of a significant loss. Reinsurance may not be continuously available to us to the same extent and on the same terms and rates that are currently available.

Although the reinsurer is liable to us to the extent we transfer, or “cede,” risk to the reinsurer, we remain ultimately liable to the policyholder on all risks reinsured. As a result, ceded reinsurance arrangements do not limit our ultimate obligations to policyholders to pay claims. We are subject to credit risks with respect to the financial strength of our reinsurers. The reinsurers for our quota share and excess of loss reinsurance agreements all have A- or better ratings from A.M. Best. Accordingly, we believe there is minimal credit risk related to these reinsurance receivables.

We are also subject to the risk that our reinsurers may dispute their obligations to pay our claims. As a result, we may not recover claims made to our reinsurers in a timely manner, if at all. In addition, if insurance departments deem that under our existing or future reinsurance contracts the reinsurer does not assume significant risk and does not have a reasonable possibility of significant loss, we may not be able to increase our

ability to write business based on this reinsurance. Any of these events could have a material adverse effect on our business, financial condition and results of operations.

We may incur significant losses if any of our reinsurers do not pay our claims in a timely manner.

Although our reinsurers are liable to us to the extent we transfer risk to the reinsurers, we remain ultimately liable to our policyholders on all risks reinsured. Consequently, if any of our reinsurers cannot pay their reinsurance obligations, or dispute these obligations, we remain liable to pay the claims of our policyholders. In addition, our reinsurance agreements are subject to specified contractual limits on the amounts and types of losses covered, and we do not have reinsurance coverage to the extent our losses exceed those limits or are not of the type reinsured. As of December 31, 2012, we had a $13.7 million net recoverable from Vesta Fire Insurance Corporation (VFIC). We have, with the approval of the VFIC Special Deputy Receiver and the District Court, Austin, Texas, withdrawn $8.7 million from the trust securing our reinsurance recoverables from VFIC, which represented 100% of the amount we paid in losses as of the date of the withdrawal covered by the VFIC reinsurance. We have made arrangements with the VFIC Special Deputy Receiver to submit quarterly statements for approval to withdraw additional funds from the trust based upon losses paid. VFIC currently has been assigned a financial strength rating of “F” (In Liquidation) from A.M. Best. According to A.M. Best, “F” ratings are assigned to companies that have been placed under an order of liquidation by a court of law or whose owners have voluntarily agreed to liquidate the company. If any of our reinsurers are unable or unwilling to pay amounts they owe us in a timely fashion, we could suffer a significant loss, which would have a material adverse effect on our business, financial condition and results of operations.

We are subject to comprehensive regulation that may restrict our ability to earn profits.

We are subject to comprehensive regulation and supervision by government agencies in the states in which our insurance company subsidiaries are domiciled, as well as in the states where our subsidiaries sell insurance products, issue policies and handle claims. Certain states impose restrictions or require prior regulatory approval of certain corporate actions, which may adversely affect our ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow our business profitably. These regulations provide safeguards for policy owners and are not intended to protect the interests of stockholders. Our ability to comply with these laws and regulations at reasonable expense and to obtain necessary regulatory actions or approvals in a timely manner is and will continue to be critical to our success.

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Required licensing. We operate under licenses issued by various state insurance authorities. If a regulatory authority denies or delays granting a new license, our ability to enter that market quickly or offer new insurance products in that market might be substantially impaired.

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Transactions between insurance companies and their affiliates. Transactions between our insurance companies and their affiliates generally must be disclosed to state regulators, and prior approval of the applicable regulator generally is required before any material or extraordinary transaction may be consummated. State regulators may refuse to approve or delay approval of such a transaction, which may impact our ability to innovate or operate efficiently.

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Restrictions on cancellation, non-renewal or withdrawal. Many states have laws and regulations that limit an insurance company’s ability to exit a market. For example, certain states limit an automobile insurance company’s ability to cancel or not renew policies. Some states prohibit an insurance company from withdrawing from one or more lines of business in the state, except pursuant to a plan approved by the state insurance department. In some states, this applies to significant reductions in the amount of insurance written, not just to a complete withdrawal. These laws and regulations could limit our ability to exit or reduce our writings in unprofitable markets or discontinue unprofitable products in the future.

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Other regulations. We must also comply with state and federal regulations involving, among other things:

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the use of non-public consumer information and related privacy issues;

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the use of credit history in underwriting and rating;

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limitations on types and amounts of investments;

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premium finance laws and regulations;

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the payment of dividends;

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the acquisition or disposition of an insurance company or of any company controlling an insurance company;

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involuntary assignments of high-risk policies, participation in reinsurance facilities and underwriting associations, assessments and other governmental charges;

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the Sarbanes-Oxley Act of 2002;

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SEC reporting;

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reporting with respect to financial condition; and

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periodic financial and market conduct examinations performed by state insurance department examiners.

Compliance with laws and regulations addressing these and other issues often will result in increased administrative costs. In addition, these laws and regulations may limit our ability to underwrite and price risks accurately, prevent us from obtaining timely rate increases necessary to cover increased costs and may restrict our ability to discontinue unprofitable relationships or exit unprofitable markets. These results, in turn, may adversely affect our profitability or our ability to grow our business in certain jurisdictions. The failure to comply with these laws and regulations may also result in actions by regulators, fines and penalties, and in extreme cases, revocation of our ability to do business in that jurisdiction. In addition, we may face individual and class action lawsuits by our insureds and other parties for alleged violations of certain of these laws or regulations.

Regulation may become more extensive in the future, which may adversely affect our business.

We cannot assure that states will not make existing insurance-related laws and regulations more restrictive in the future or enact new restrictive laws. New or more restrictive regulation in any state in which we conduct business could make it more expensive for us to conduct our business, restrict the premiums we are able to charge or otherwise change the way we do business. In such events, we may seek to reduce our writings in, or to withdraw entirely from these states. In addition, from time to time, the United States Congress and certain federal agencies investigate the current condition of the insurance industry to determine whether federal regulation is necessary. We are unable to predict whether and to what extent new laws and regulations that would affect our business will be adopted in the future, the timing of any such adoption and what effects, if any, they may have on our operations, profitability and financial condition.

New pricing, claims, coverage and financing issues and class action litigation are continually emerging in the automobile insurance industry, and these issues could adversely impact our revenues or our methods of doing business.

As automobile insurance industry practices and regulatory, judicial and consumer conditions change, unexpected and unintended issues related to claims, coverages, business practices and premium financing plans may emerge. These issues can have an adverse effect on our business by changing the way we price our products, by extending coverage beyond our underwriting intent, or by increasing the size of claims. Examples of such issues include:

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concerns over the use of an applicant’s credit score and zip code as a factor in making risk selections and pricing decisions;

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a growing trend of plaintiffs targeting automobile insurers, including us, in purported class action litigation relating to claims-handling practices, such as the permitted use of aftermarket (non-original equipment manufacturer) parts, total loss evaluation methodology and the alleged diminution in value to insureds’ vehicles involved in accidents;

•

a relatively new trend of plaintiffs targeting insurers, including automobile insurers, in purported class action litigation which seek to recharacterize installment fees and other allowed charges related to insurers’ installment billing programs as interest that violates state usury laws or other interest rate restrictions; and

•

attempts by plaintiffs to initiate purported class action litigation targeting premium finance operations relating to unearned interest rebates and the collection of service and finance charges.

The effects and costs of these and other unforeseen issues could negatively affect our revenues, income or our methods of business.

Our insurance companies are subject to minimum capital and surplus requirements, and our failure to meet these requirements could subject us to regulatory action.

Our insurance companies are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act adopted by the National Association of Insurance Commissioners, or NAIC, require our insurance companies to report their results of risk-based capital calculations to state departments of insurance and the NAIC. These risk-based capital standards provide for different levels of regulatory attention depending upon the ratio of an insurance company’s total adjusted capital, as calculated in accordance with NAIC guidelines, to its authorized control level risk-based capital and trend test. Authorized control level risk-based capital is the number determined by applying the NAIC’s risk-based capital formula, which measures the minimum amount of capital that an insurance company needs to support its overall business operations.

Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject us to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels. At December 31, 2012, each of our insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions.

Our failure to maintain financial strength requirements as set forth by various state departments of insurance could adversely affect our business and overall liquidity.

Various individual state departments of insurance in jurisdictions where our insurance company subsidiaries conduct business maintain specific requirements in connection with the financial strength of property and casualty insurance companies. Failure on the part of our insurance company subsidiaries to comply with these requirements could subject us to an examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation.

qualifying investments requirement by $16.5 million. Management has submitted a plan to cure the deficiency as of June 30, 2013, which includes a number of actions. The Illinois Department of Insurance has not yet responded to the plan. If the Illinois Department of Insurance does not approve AIC’s proposed plan or if AIC is not compliant as of the plan date of June 30, 2013, the Director of the Illinois Department of Insurance could deem AIC to be in hazardous financial condition and could take one or more of the remedial actions authorized by law for such a condition. Such action by the Illinois Department of Insurance would have a material adverse affect on the Company’s operations and the interests of its creditors and stockholders. Such action by the Illinois Department of Insurance also would trigger a further event of default under the Company’s senior secured credit facility allowing the Company’s lenders to declare all amounts outstanding under the facility to be immediately due and payable, and if such amounts were declared immediately due and payable by the lenders, it would have a material adverse effect on our operations and the interests of our creditors and stockholders.

Our failure to pay claims accurately could adversely affect our business, financial results and capital requirements.

We must accurately evaluate and pay claims that are made under our policies. Many factors affect our ability to pay claims accurately, including the training and experience of our claims representatives, the culture of our claims organization and the effectiveness of our management, our ability to develop or select and implement appropriate procedures and systems to support our claims functions and other factors. Our failure to pay claims accurately could lead to material litigation, undermine our reputation in the marketplace, impair our image, as a result, and negatively affect our financial results.

In addition, if we do not train new claims employees effectively or if we lose a significant number of experienced claims employees, our claims department’s ability to handle an increasing workload as we grow could be adversely affected. In addition to potentially requiring that growth be slowed in the affected markets, we could suffer decreased quality of claims work, which in turn could lower our operating margins.

If we are unable to retain and recruit qualified personnel, our ability to implement our business strategies could be hindered.

Our success depends in part on our ability to attract and retain qualified personnel. Our inability to recruit and retain qualified personnel could prevent us from fully implementing our business strategies and could materially and adversely affect our business, growth and profitability. We do not have key person insurance on the lives of any of our executive officers.

We may encounter difficulties in implementing our strategies of expanding into new markets and acquiring agencies.

Our growth strategy includes expanding into new geographic markets, introducing additional insurance and non-insurance products and acquiring the business and assets of underwriting and retail agencies. Our future growth will face risks, including risks associated with our ability to:

•

obtain necessary licenses;

•

properly design and price our products;

•

identify, hire and train new claims and sales employees;

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identify agency acquisition candidates; and

•

assimilate and integrate the operations, personnel, technologies, products and information systems of the acquired companies.

We may also encounter difficulties in connection with implementing our growth strategy, including unanticipated expenditures, damaged or lost relationships with customers and independent agencies and

contractual, intellectual property or employment issues relating to companies we acquire. In addition, our growth strategy may require us to enter into a geographic or business market in which we have little or no prior experience.

Further, any potential agency acquisitions may require significant capital outlays, and if we issue equity or convertible debt securities to pay for an acquisition, these securities may have rights, preferences or privileges senior to those of our common stockholders or the issuance may be dilutive to our existing stockholders. Once agencies are acquired, we could suffer increased costs, disruption of our business and distraction of our management if we are unable to smoothly integrate the agencies into our operations. Our expansion will also continue to place significant demands on our management, operations, systems, accounting, internal controls and financial resources. Any failure by us to manage our growth and to respond to changes in our business could have a material adverse effect on our business and profitability and could cause the price of our common stock to decline.

Our underwriting operations are vulnerable to a reduction in the amount of business written by independent agencies.

For the year ended December 31, 2012, independent agencies were responsible for 29.4% of the gross premiums produced by our underwriting agencies. As a result, our business depends in part on the marketing efforts of independent agencies and on our ability to offer insurance products and services that meet the requirements of these independent agencies and their customers. Independent agencies are not obligated to sell or promote our products, and since many of our competitors rely significantly on the independent agency market, we must compete with other insurance companies and underwriting agencies for independent agencies’ business. Some of our competitors offer a larger variety of products, lower prices for insurance coverage or higher commissions, and we therefore may not be able to continue to attract and retain independent agencies to sell our insurance products. A material reduction in the amount of business our independent agencies sell would negatively impact our revenues.

If we are unable to establish and maintain relationships with unaffiliated insurance companies to sell their non-standard personal automobile policies through our owned retail stores, our sales volume and profitability may suffer.

Our owned retail stores sell non-standard personal automobile insurance policies for our insurance companies and also for unaffiliated insurance companies. Particularly in soft markets, our commitment to underwriting discipline may result in declining sales of our insurance companies’ policies in favor of lower-priced products from other insurance companies willing to accept less attractive underwriting margins. Consequently, part of our strategy in a soft market is to generate increased commission income and fees from sales of third-party policies through our retail stores’ relationships with unaffiliated underwriting agencies and insurance companies. If our retail stores are unable to establish and maintain these relationships, they would have a more limited selection of non-standard personal automobile insurance policies to sell. In such an event, our retail stores might experience a net decline in overall sales volume of non-standard personal automobile insurance policies, which would decrease our profitability.

We face litigation, which if decided adversely to us, could adversely impact our financial results.

We are a party in a number of lawsuits. These lawsuits are described more fully elsewhere in this report. Litigation, by its very nature, is unpredictable and the outcome of these cases is uncertain. The precise nature of the relief that may be sought or granted in any lawsuits is uncertain and may, if these lawsuits are determined adversely to us, negatively impact our earnings.

In addition, potential litigation involving new claim, coverage and business practice issues could adversely affect our business by changing the way we price our products, extending coverage beyond our underwriting

intent or increasing the size of claims. The effects of these and other unforeseen emerging claims, coverage and business practice issues could negatively impact our profitability or our methods of doing business.

Adverse securities market conditions can have a significant and negative impact on our investment portfolio.

Our results of operations depend in part on the performance of our invested assets. As of December 31, 2012, our investment portfolio was primarily invested in fixed-income securities. Certain risks are inherent in connection with fixed maturity securities including loss upon default and price volatility in reaction to changes in interest rates and general market factors. In general, the fair value of a portfolio of fixed-income securities increases or decreases inversely with changes in the 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. We attempt to mitigate this risk by investing in securities with varied maturity dates, so that only a portion of the portfolio will mature at any point in time. Furthermore, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations. An investment has prepayment risk when there is a risk that the timing of cash flows that result from the repayment of principal might occur earlier than anticipated because of declining interest rates or later than anticipated because of rising interest rates. If market interest rates were to change 1.0% (for example, the difference between 5.0% and 6.0%), the fair value of our fixed-income securities would change approximately $0.5 million. The change in fair value was determined using duration modeling assuming no prepayments.

If we are unable to refinance our debt as it matures, it could have an adverse impact on our business and overall liquidity.

In 2007, we entered into a $220.0 million senior secured credit facility (the facility) provided by a syndicate of lenders, that provided for a $200.0 million senior term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing capacity. The principal amount of the term loan is payable in quarterly installments, with the remaining balance due January 31, 2014. Beginning in 2008, we were also required to make additional annual principal payments that are calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. During 2012, we made $3.5 million in principal payments. The revolving portion of the facility expired in January 2010. In November 2012, we entered into an incremental term loan with a face amount of $8.0 million, and funded amount of $5.5 million net of a $2.5 million non-cash original issue discount. Repayment of the full $8.0 million is due on or prior to January 17, 2014.

Our obligations under the facility are guaranteed by our material operating subsidiaries (other than our insurance companies) and are secured by a first lien security interest on all of our assets and the assets of our material operating subsidiaries (other than our insurance companies), including a pledge of 100% of the stock of AIC.

Due to declining performance and continued losses from operations, the Company was in violation of certain debt covenants as of December 31, 2012. See discussion under the first Risk Factor “There is Substantial Doubt About the Company’s Ability to Continue as a Going Concern” in this Annual Report on Form 10-K for the year ended December 31, 2012. If the Company is unable to refinance or extend the maturity of the senior secured credit facility when it expires in January 2014, it would have a material adverse effect on our operations and our creditors and stockholders.

We are subject to a number of restrictive debt covenants under our credit facility that may restrict our business and financing activities.

Our credit facility contains restrictive debt covenants that, among other things, restrict our ability to:

•

Borrow money;

•

Pay dividends and make distributions;

•

Issue stock;

•

Make certain investments;

•

Use assets as security in other transactions;

•

Create liens;

•

Enter into affiliate transactions;

•

Merge or consolidate; or

•

Transfer and sell assets.

Our credit facility also requires us to meet certain financial tests, and our need to meet the requirements of these financial tests may limit our ability to expand or pursue our business strategies.

We rely on our information technology and telecommunications systems, and the failure of these systems could disrupt our operations.

Our business is highly dependent upon the successful and uninterrupted functioning of our current information technology and telecommunications systems as well as our recently implemented integrated policy and claims system. We rely on these systems to process new and renewal business, provide customer service, make claims payments and facilitate collections and cancellations, as well as to perform actuarial and other analytical functions necessary for pricing and product development. As a result, the failure of these systems could interrupt our operations and adversely affect our financial results. Because our information technology and telecommunications systems interface with and depend on third-party systems, we could experience service denials if demand for such service exceeds capacity or such third-party systems fail or experience interruptions. If sustained or repeated, a system failure or service denial could result in a deterioration of our ability to write and process new and renewal business and provide customer service or compromise our ability to pay claims in a timely manner. This could result in a material adverse effect on our business.

As part of our efforts to continue improving our internal control over financial reporting, we upgraded and transformed our information technology system. We may experience difficulties in transitioning to new or upgraded systems, including loss of data and decreases in productivity until personnel become familiar with new systems. In addition, our management information systems will require modification and refinement as we grow and as our business needs change, which could prolong difficulties we experience with systems transitions, and we may not always employ the most effective systems for our purposes. If we experience difficulties in implementing new or upgraded information systems or experience significant system failures, or if we are unable to successfully modify our management information systems and respond to changes in our business needs, our operating results could be harmed or we may fail to meet our reporting obligations.

We could be harmed by data loss or other security breaches

Because we rely on information technology and telecommunications systems to operate our business, and we store large amounts of data, including personal information regarding our customers, a loss of data or security breach involving those systems could expose us or our customers to a risk of loss or misuse of such information, adversely affect our operating results, result in litigation or potential liability, or otherwise harm our business. Additionally, we rely on third parties and their information technology systems to provide services associated with certain aspects of our business. Although we have implemented systems and processes designed to protect personal information regarding our customers and prevent data loss and other security breaches, such measures cannot provide absolute security.

Severe weather conditions and other catastrophes may result in an increase in the number and amount of claims filed against us.

Our business is exposed to the risk of severe weather conditions and other catastrophic events, such as rainstorms, snowstorms, hail and ice storms, hurricanes, tornadoes, earthquakes, fires and other events such as explosions, terrorist attacks and riots. The incidence and severity of catastrophes and severe weather conditions are inherently unpredictable. Such conditions generally result in higher incidence of automobile accidents and an increase in the number of claims filed, as well as the amount of compensation sought by claimants.

As a holding company, we are dependent on the results of operations of our operating subsidiaries to meet our obligations.

We are organized as a holding company, a legal entity separate and distinct from our operating subsidiaries. As a holding company without significant operations of our own, we are dependent upon dividends and other payments from our operating subsidiaries, which include our agency subsidiaries and our insurance company subsidiaries.

State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2012, Affirmative Insurance Company (AIC) could not pay ordinary dividends to the holding company without prior regulatory approval due to AIC’s negative unassigned surplus position.

Item 1B.

UNRESOLVED STAFF COMMENTS

Not applicable.

Item 2.

PROPERTIES

As of December 31, 2012, we leased an aggregate of 434,249 square feet of office space in various locations throughout the United States. The office space includes a lease for 56,875 aggregate square feet of office space in a common building in Burr Ridge, Illinois, and our Burr Ridge lease term expires in November 2016. Effective November 2012, we subleased 38,341 square feet of the common building in Burr Ridge through November 2016. We lease 56,888 square feet of office space in Addison, Texas, and our Addison lease term expires in March 2015. We also have two leases of 55,186 aggregate square feet of office space in Baton Rouge, Louisiana.

One Baton Rouge lease is for 51,792 square feet of office space with a term that expires in January 2020. The second Baton Rouge lease is for 3,394 square feet of office space with a term that expires in July 2014. We also have offices in Chicago, Dallas and Plymouth, Michigan, which have 4,003, 2,619 and 1,705 square feet, respectively. In addition, we have 199 owned retail stores that presently lease space on an individual basis at various locations in the states in which we do business. None of these individual retail store leases are material to our operations.

In Baton Rouge, Louisiana, we own a building of approximately 177,469 square feet for investment purposes. The building is under a lease agreement with a federal agency. The lease expires on November 16, 2020. However, the federal agency may terminate the lease, in whole or in part, on or after December 17, 2015 by giving at least one hundred twenty days’ written notice.

We believe that our properties have been adequately maintained, are in generally good condition and are suitable for our business as presently conducted. We believe our existing facilities sufficiently provide for both our present and presently anticipated needs. We also believe that, with respect to leased properties, upon the expiration of our current leases, we will be able to either secure renewal terms or enter into leases for alternative locations on acceptable market terms.

Item 3.

LEGAL PROCEEDINGS

We and our subsidiaries are named from time to time as parties in various legal actions arising in the ordinary course of our business and arising out of or related to claims made in connection with our insurance policies and claims handling. We believe that the resolution of these legal actions will not have a material adverse effect on our 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 19^th 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 our building located in Baton Rouge, Louisiana. We removed the lawsuit to the U.S. District Court for the Middle District of Louisiana. The parties are now engaged in discovery. We believe that these claims lack merit and intend to defend ourselves vigorously. No estimate of the range of potential loss can be made at this time.

Item 4.

MINE SAFETY DISCLOSURES

Not applicable.

PART II

Item 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

Market Information

Our common stock is traded on the over-the-counter market under the symbol AFFM. Prior to being delisted on June 25, 2012, our common stock traded on the NASDAQ Global Select Market under the symbol AFFM. The following table sets forth, for the periods indicated, the high, low and closing sales prices for our common stock as reported on the OTC Market and the NASDAQ Global Select Market:


	First Quarter Ended March 31		Second Quarter Ended June 30		Third Quarter Ended September 30		Fourth Quarter Ended December 31
2012
High	$	1.21	$	0.56	$	0.45	$	0.45
Low		0.43		0.24		0.14		0.10
Close		0.53		0.33		0.45		0.14
Cash dividends declared per share		—		—		—		—
2011
High	$	2.95	$	2.65	$	2.45	$	1.71
Low		2.01		2.11		1.30		0.51
Close		2.53		2.35		1.58		0.53
Cash dividends declared per share		—		—		—		—

Shareholders of Record

On March 25, 2013, the closing sales price of our common stock as reported by the OTC Market was $0.33 per share, there were 15,408,358 shares of our common stock issued and outstanding and there were 9 known holders of record of our common stock and approximately 600 beneficial owners.

Dividends

The declaration and payment of dividends is subject to the discretion of our board of directors and will depend on our financial condition, results of operations, cash requirements, future prospects, regulatory and contractual restrictions on the payment of dividends by our subsidiaries, and other factors deemed relevant by our board of directors. In March 2011, we amended our senior secured credit facility. Under the terms of the amendment, dividends are permitted only if the leverage ratio is less than or equal to 1.0. As a result, no dividends were eligible to be paid in 2012, 2011 or 2010, and management believes dividends will not be eligible to be paid during 2013. Further, we may enter into new agreements or incur additional indebtedness in the future which may further prohibit or restrict the payment of dividends. There is no requirement that we must, and we cannot assure that we will, declare and pay any dividends in the future. Our board of directors may determine to retain such capital for repayment of indebtedness, general corporate or other purposes. For a discussion of our cash resources and needs, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Financial Condition — Liquidity and Capital Resources”.

We are a holding company and a legal entity separate and distinct from our operating subsidiaries. As a holding company without significant operations of our own, our principal sources of funds are dividends and other payments from our operating subsidiaries. The ability of our insurance subsidiaries to pay dividends is subject to limits under insurance laws of the states in which they are domiciled. Furthermore, there are no restrictions on payment of dividends from our agency, administrative, and consumer products subsidiaries, other than typical state corporation law requirements.

Item 7.

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 December 31, 2012, our subsidiaries included insurance companies licensed to write insurance policies in 39 states, underwriting agencies, retail agencies with 199 owned stores and a relationship with one unaffiliated underwriting agency. Affirmative Insurance Company of Michigan, USAgencies Casualty Insurance Company, Inc. (Casualty) and USAgencies Direct Insurance Company (Direct) are wholly-owned subsidiaries of Affirmative Insurance Company (AIC), a wholly-owned subsidiary of Affirmative Insurance Group, Inc., a wholly-owned subsidiary of Affirmative Insurance Holdings, Inc. (Holdings). In November 2012, Insura Property and Casualty Insurance Company (formerly a wholly-owned subsidiary of AIC) was merged into AIC and Direct was sold from AIC to Casualty. 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 approximately 5,400 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 polices 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:

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

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

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

The accompanying consolidated financial statements have been prepared assuming we will continue as a going concern. This assumes continuing operations and the realization of assets and liabilities in the normal course of business.

We incurred losses from operations over the last four years, including a net loss of $51.9 million for the year ended December 31, 2012. Losses over this time period were primarily due to underwriting losses, significant revenue declines and expenses declining less than the amount of revenue declines and goodwill impairments. The loss from operations was the result of prior pricing issues in some states in which we have taken significant pricing and underwriting actions to address profitability, losses from states that we have exited, such as Florida and Michigan, and goodwill impairment charges as a result of such losses. As a result of declining performance, we have breached the leverage ratio covenant under the senior secured credit facility as of September 30, 2012; however, the lenders for the facility agreed to waive such event of default. We breached the leverage, interest coverage and risk-based capital ratio covenants (“Financial Covenants”) as of December 31, 2012, and the lenders for the facility have agreed to temporarily forbear from exercising their rights and remedies under the facility until the earlier of June 1, 2013, or the occurrence of a further event of default under the facility from the quarterly covenants. If we are unable to achieve compliance with the Financial Covenants as of June 1, 2013, or obtain an extension of the lenders’ forbearance or a waiver of any non-compliance, the lenders will be able to declare all amounts outstanding under the facility to be immediately due and payable. Even if we are compliant with the Financial Covenants or, if not compliant, obtain additional forbearance or waivers from our lenders, there is still substantial uncertainty that we will be able to refinance or extend the maturity of the senior secured facility when it expires in January 2014. If our lenders declare the amounts outstanding under our senior secured credit facility to be immediately due and payable or we are unable to refinance or extend the maturity of the senior secured facility when it expires in January 2014, it would have a material adverse effect on our operations and our creditors and stockholders.

The Illinois Insurance Code includes a reserve requirement that an insurer maintain an amount of qualifying investments, as defined, at least equal to the lesser of $250.0 million or 100% of its adjusted loss reserves and loss adjustment expenses reserves, as defined. As of December 31, 2011, Affirmative Insurance Company (AIC) was deficient in meeting the qualifying investments requirement by $18.9 million, but submitted a plan to cure such deficiency to the Illinois Department of Insurance by September 30, 2012, which was approved and through various actions AIC was deemed by the Illinois Department of Insurance to be in compliance with the reserve requirement as of September 30, 2012. As of December 31, 2012, AIC was deficient in meeting the qualifying investments requirement by $16.5 million. We submitted a plan to cure the deficiency as of June 30, 2013 which includes a number of actions. The Illinois Department of Insurance has not yet responded to the plan. If the Illinois Department of Insurance does not approve AIC’s proposed plan or if AIC is not compliant as of the plan date of June 30, 2013, the Director of the Illinois Department of Insurance could deem AIC to be in hazardous financial condition and could take one or more of the remedial actions authorized by law for such a condition. Such action by the Illinois Department of Insurance would have a material adverse affect on our operations and the interests of our creditors and stockholders. Such action by the Illinois Department of Insurance also would trigger a further event of default under our senior secured credit facility allowing our lenders to declare all amounts outstanding under the facility to be immediately due and payable, and if such amounts were declared immediately due and payable by the lenders, it would have a material adverse effect on our operations and the interests of our creditors and stockholders.

We are pursuing various actions to address these issues including, but not limited to, refinancing of our debt, obtaining additional financing or entering into certain transactions, such as sales of assets or operations.

Our recent history of recurring losses from operations, our failure to comply with the Financial Covenants in our senior secured credit facility, our failure to comply with the Illinois Department of Insurance reserve requirement, and the substantial liquidity needs we will face when its senior secured credit facility expires in January 2014 raise substantial doubt about the Company’s ability to continue as a going concern.

The accompanying consolidated financial statements do not include any adjustments to reflect the possible future effects of this uncertainty on the recoverability or classification of recorded asset amounts or the amounts or classification of liabilities.

CRITICAL ACCOUNTING POLICIES

The preparation of our consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions when applying our accounting policies. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and potentially result in materially different results under different assumptions and conditions. Our critical accounting policies are described below. For a detailed discussion on the application of these and other accounting policies, see Note 3 of Notes to Consolidated Financial Statements which appears in Item 8 of this Annual Report.

•

reserving for unpaid losses and loss adjustment expenses;

•

reinsurance recoverable on paid and incurred losses;

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valuation of available-for-sale investments;

•

valuation of goodwill and other intangible assets;

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deferred acquisition costs; and

•

income taxes.

Reserving for unpaid losses and loss adjustment expenses. On a quarterly basis at the end of each financial reporting period, we record our best estimate of our overall reserve for both current and prior accident years. The amount recorded represents the remaining amount we expect to pay for all covered losses that occurred, including unreported, through the current financial statement date, as well as the amount we expect to expend for all claim settlement expenses. The overall reserve for losses and loss adjustment expenses estimate that we record is the difference between (1) our point estimate of the ultimate loss and ultimate loss adjustment expenses, and (2) the amount of losses and loss adjustment expenses paid through the current financial statement date. Our point estimate of ultimate loss consists of a point estimate for incurred but not reported (IBNR) losses and case reserves. The point estimate of ultimate loss adjustment expenses consists of a separate point estimate for adjusting and other expenses and for defense and cost containment expenses.

We utilize different processes to determine our best estimate for unpaid losses and unpaid loss adjustment expenses. We establish a standard system-generated case loss reserve that varies by state, program, coverage and, in some instances for certain coverages, elapsed time since date of loss or if the claim is in litigation. The only variation to this methodology for setting case loss reserves exists in the instance where we believe our financial exposure for a particular loss event is significant and in fact may approach or be equal to our policy limits. In these instances, we will establish a case loss reserve to reflect our view regarding the potential cost of this exposure to us. The system automatically adjusts the case loss reserves downward in the event a partial payment is made and a claim remains open. We will re-adjust the case loss reserves in an instance where a partial payment is made if we believe the facts of the claim justify a different reserve. This activity is generally limited to our personal injury protection coverage, where we have a significant amount of this type of activity, the settlement time is longer than for our normal business and the types of losses do not lend themselves to an average reserve methodology.

We estimate IBNR losses and ultimate loss adjustment expenses quarterly using detailed statistical analyses and judgment, including adjustment for deviations in trends caused by internal and external variables that may affect the resulting reserves. The underlying processes require the use of estimates and informed judgment, and as a result the establishment of loss and loss adjustment expenses reserves is an inherently uncertain process. The following generally accepted actuarial loss and loss adjustment expenses (LAE) reserving methodologies are used in our analysis:

•

Paid Loss Development — We use historical loss or loss adjustment expense payments over discrete periods of time to estimate future losses or loss adjustment expense. Paid development methods assume that the pattern of paid losses or loss adjustment expense occurring in past periods will recur for losses or loss adjustment expense occurring in subsequent periods.

•

Incurred Loss Development — We use historical case incurred loss and loss adjustment expense (i.e., the sum of cumulative loss or loss adjustment expense payments plus outstanding case loss reserves) over discrete periods of time to estimate future losses. Incurred development methods assume that the case loss and loss adjustment expense reserving practices are consistently applied over time.

•

Paid Bornhuetter/Ferguson — We use a combination of paid development methods and expected loss and loss adjustment expense methods. Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information used in pricing and are multiplied by the total amount of premiums earned to calculate ultimate loss and loss adjustment expense which is then proportionately added to the actual paid to date.

•

Incurred Bornhuetter/Ferguson — We use a combination of incurred development methods and expected loss and loss adjustment expense methods. Expected loss ratio methods are based on the assumption that ultimate losses vary proportionately with premiums. Expected loss and loss adjustment expense ratios are typically developed based upon the information used in pricing and are multiplied by the total amount of premiums earned to calculate ultimate loss and loss adjustment expense which is then proportionately added to the actual incurred to date.

•

Frequency and Severity Trends — We use historical claim count development over discrete periods of time to estimate future claim count development. These projected ultimate claim counts are then divided by earned car years and expected claim frequency is selected. We utilize internal and external information to determine trends in loss severity and select ultimate severity by accident period. The resulting frequency and severity measures are then reviewed to ascertain their reasonableness in ultimate selections.

There are numerous factors, both internal and external, that we consider when evaluating the reasonableness of the various methods used to determine the actuarial best estimate of loss and loss adjustment expense reserves. Many of the factors vary for different states, programs, coverage groups, and accident periods. Some examples of internal factors considered are changes in product mix, changes in claims-handling practices, loss cost trends and underwriting standards and rules. With the most recent change in claims practices, a key variable that we are monitoring is the decrease in claim duration and the effect on the claims tail and severity. External factors considered include frequency, severity, changes in the limits required by the states, the effect of inflation on medical hospitalization, material repair and replacement costs, as well as general economic and legal trends.

We track monthly the actual emergence of loss and loss adjustment expense data by accident period and compare it to the expected emergence. We review any deviations and determine if it is appropriate to revise any assumptions that will be used to develop loss and loss adjustment expense reserve estimates.

We review loss reserve adequacy quarterly by accident year at a state, program and coverage level. Carried reserves are adjusted as additional information becomes known. Such adjustments are reflected in our current year operations.

The range of potential ultimate values for any accident year diminishes with the age of the accident year. A recent accident year will tend to have a wider range of potential values as the claims may have only recently been reported or details as to the injuries are still unknown. As the accident year ages, the number of open claims diminishes and the specifics of the injury become clearer.

There can be no assurance that actual future loss and LAE development variability will be consistent with any potential variation indicated by our historical loss and LAE development experience. It is expected that the final outcome for the accident years will lie within the range of estimates and should be centered around the selected value if normal development comes to pass.

Reinsurance recoverable on paid and incurred losses. We record the amounts we expect to receive from reinsurers as an asset on our balance sheet. Our insurance companies report as assets the estimated reinsurance recoverable on paid losses and unpaid losses, including an estimate for losses incurred but not reported. These amounts are estimated based on our interpretation of each reinsurer’s obligations pursuant to the individual reinsurance contracts between us and each reinsurer, as well as judgments we make regarding the financial viability of each reinsurer and its ability to pay us what is owed under the reinsurance contract.

We routinely monitor the collectability of the reinsurance recoverables of our insurance companies to determine if an amount is potentially uncollectible. Our evaluation is based on periodic reviews of our aged recoverables, as well as our assessment of recoverables due from reinsurers known to be in financial difficulty. Excluding VFIC, all significant reinsurers are currently rated A- or better by A. M. Best. Our estimates and judgment about collectability of the recoverables and the financial condition of reinsurers can change, and these changes can affect the level of reserve required.

At December 31, 2012, our receivables from reinsurers included $13.7 million net recoverable from VFIC. At December 31, 2012, the VFIC Trust held $16.8 million to collateralize the $13.7 million net recoverable from VFIC. We have, with the approval of the VFIC Special Deputy Receiver and the District Court, Austin, Texas, withdrawn $8.7 million through December 31, 2012 from the trust securing our reinsurance recoverables from VFIC, which represented 100% of the amount we paid in losses as of the date of the withdrawal covered by the VFIC reinsurance. We have made arrangements with the VFIC Special Deputy Receiver to submit quarterly statements for approval to withdraw additional funds from the trust based upon losses paid.

As of December 31, 2012 and 2011, we had no reserve for uncollectible reinsurance recoverables. We assessed the collectability of our year-end receivables and believe all amounts are collectible based on currently available information.

Valuation of available-for-sale investments. Our available-for-sale investment securities are recorded at fair value, which is typically based on publicly-available quoted prices. From time to time, the carrying value of our investments may be temporarily impaired because of the inherent volatility of publicly-traded investments. We do not adjust the carrying value of any investment unless management determines that the impairment of an investment’s value is other than temporary.

We conduct regular reviews to assess whether our investments are impaired and if any impairment is other than temporary. Factors considered by us in assessing whether an impairment is other than temporary include the credit quality of the investment, the duration of the impairment, our ability and intent to hold the investment until recovery or maturity and overall economic conditions. An other-than-temporary impairment is triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss), a component of stockholders’ equity (deficit). All impairments on our available-for-sale investment securities were considered temporary in nature as of December 31, 2012 and 2011, respectively. Accordingly, unrealized losses are recorded in other comprehensive income (loss) on our consolidated balance sheet.

Gains and losses realized on the disposition of investment securities are determined on the specific-identification basis and credited or charged to income. Premium and discount on investment securities are amortized and accreted using the interest method and charged or credited to investment income.

Valuation of goodwill and other intangible assets. We evaluate goodwill for impairment annually as of September 30, or more frequently if events or circumstances indicate that the carrying value may not be recoverable. We report under a single reporting segment and, as such, the goodwill analysis is measured at the

consolidated company level. Consistent with prior assessments, the fair value of the Company was determined using an internally developed discounted cash flow methodology and other relevant indicators of value available in the market place such as market transactions and trading values of similar companies. Management considered its market capitalization in relation to its book value and believes that our market capitalization is not representative of the long-term value of the Company. In arriving at this conclusion, management considered the limited daily trading volume of the Company’s stock, lack of liquidity in our Company’s stock and the impact on our Company’s stock from being a controlled company.

We completed our annual goodwill and indefinite lived intangible asset impairment analyses as of September 30, 2012. Current trends and recent developments resulted in management concluding that it was more likely than not that a goodwill impairment existed at September 30, 2012. Specifically, operating income and cash flow was less than plan, and premium production was below forecast. Due to our negative equity position as of September 30, 2012, GAAP required that we perform step two of the goodwill impairment test.

Consistent with prior assessments, our fair value was determined using an internally developed discounted cash flow method. Management made significant assumptions and estimates about the extent and timing of future cash flows, growth rates, and discount rates that represent unobservable inputs into the valuation methodologies used to calculate fair value. A discount rate of 19% was used at September 30, 2012, which we believed adequately reflected an appropriate risk-adjusted discount rate based on our overall cost of capital and company-specific risk factors related to cash flow, debt covenants compliance, and regulatory risk, as discussed in Note 2. The cash flows were estimated over a significant future period of time, which made those estimates and assumptions subject to a high degree of uncertainty. Based upon the results of the assessment, we concluded that the carrying value of goodwill was fully impaired as of September 30, 2012. In step two of the goodwill impairment analysis, we determined the fair values of our assets and liabilities (including any unrecognized intangible assets) as if we had been acquired in a business combination. Determining the implied fair value of goodwill was judgmental in nature and involved the use of significant estimates and assumptions. The resulting implied fair value of goodwill was compared to the carrying value of goodwill, resulting in the write-off of the remaining goodwill balance of $23.4 million.

Due to prior period adverse loss development on our Michigan business recorded in 2011 and negative premium production trends, we revised our five-year forecast and updated our discounted cash flow model to assess the recoverability of recorded goodwill at December 31, 2011. A discount rate of 14.5% was used at December 31, 2011, which we believe remained an appropriate risk-adjusted discount rate based on our overall cost of capital. Based on this updated discounted cash flow analysis, we concluded that the carrying amount of goodwill was not recoverable. In step two of the goodwill impairment analysis, we determined the fair values of the Company’s assets and liabilities (including any unrecognized intangible assets) as if the Company had been acquired in a business combination. The resulting implied fair value was compared to the carrying value of goodwill with the excess carrying value resulting in an impairment. The step two analysis resulted in the recognition of a non-cash, pretax goodwill impairment charge of $140.1 million.

Indefinite-lived intangible assets primarily consist of trade names. In measuring the fair value of these intangible assets, the Company utilizes the relief-from-royalty method. This method assumes that trade names have value to the extent that their owner is relieved of the obligation to pay royalties for the benefits received from them. This method requires an estimate of future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. This analysis indicated an impairment of indefinite-lived intangible assets of $0.2 million as of September 30, 2012. There was no impairment of indefinite-lived intangible assets in 2011.

Intangible assets with definite lives consist of agency relationships acquired through various business combinations or asset acquisitions. Significant declines in 2011 in premiums written in the markets corresponding to the recorded agency relationship compared with prior periods and forecast, as well as customer attrition rates indicated that the carrying amounts of definite-lived intangible assets were not recoverable, resulting in a non-cash impairment charge of $1.7 million in 2011.

Deferred acquisition costs. Deferred acquisition costs represent the deferral of expenses that we incur in the successful acquisition of new business or renewing existing business. Policy acquisition costs (primarily commissions, premium taxes, net of ceding commission income, related to the successful issuance of a policy) are deferred and charged against income ratably over the terms of the related policies. Management regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency and a corresponding charge to income is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs and maintenance costs exceeds related unearned premiums and anticipated investment income. At December 31, 2012 and 2011, there were no premium deficiencies. Judgments as to the ultimate recoverability of such deferred costs are highly dependent upon estimated future loss costs associated with unearned premiums.

Income taxes. Significant management judgment is required in determining the provision for income taxes, deferred tax assets and liabilities, and the valuation allowance recorded against net deferred tax assets. The process involves summarizing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the consolidated balance sheet. In addition, we assess whether valuation allowances should be established against deferred tax assets based on consideration of all available evidence using a “more likely than not” standard. To the extent a valuation allowance is established in a period, an expense must be recorded within the income tax provision in the consolidated statement of operations. We carry a full valuation allowance as of December 31, 2012 and 2011 that was initially established in 2009.

If sufficient positive evidence arises in the future indicating that all or a portion of the deferred tax assets meet the more likely than not standard, the valuation allowance would be reversed accordingly in the period that such a conclusion is reached, which would materially impact our financial position and results of operations in a favorable manner.

RECENTLY ADOPTED ACCOUNTING STANDARDS

In October 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-26, Financial Services-Insurance (Topic 944). ASU 2010-26 modified the definitions of the type of costs that can be capitalized in the successful acquisition of new and renewal insurance contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. We retrospectively adopted ASU 2010-26 on January 1, 2012. The cumulative effect of the adoption was a decrease of shareholders’ equity by $11.3 million, net of tax, as of January 1, 2011.

The following table illustrates the effect of adopting ASU 2010-26 in the consolidated balance sheets (in thousands):


	December 31, 2011
	Previously Reported			As Adjusted
Deferred acquisition costs, net	$	3,206		$	(6,464	)
Stockholders’ deficit		(71,307	)		(80,977	)

The following table illustrates the effect of adopting ASU 2010-26 in the consolidated statements of operations (in thousands, except per share amounts):


	Year Ended December 31, 2011						Year Ended December 31, 2010
	Previously Reported			As Adjusted			Previously Reported			As Adjusted
Selling, general and administrative expenses	$	112,327		$	110,716		$	166,916		$	164,908
Net loss		(164,209	)		(162,598	)		(88,931	)		(86,923	)
Net loss per share:
Basic		(10.66	)		(10.55	)		(5.77	)		(5.64	)
Diluted		(10.66	)		(10.55	)		(5.77	)		(5.64	)

ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. Additionally, if the carrying amount of a reporting unit is zero or negative, the second step of the impairment test shall be performed to measure the amount of the impairment loss, if any, when it is more likely than not that a goodwill impairment exists. In considering whether it is more likely than not that a goodwill impairment exists, a qualitative assessment will be performed. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. This standard is effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this standard did not have an impact on our consolidated financial position, results of operations or cash flows.

ASU 2011-05, Comprehensive Income (Topic 220):Presentation of Comprehensive Income, requires 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. This standard is effective for interim and annual periods beginning after December 15, 2011, and should be applied retrospectively. The adoption of this standard did not impact our consolidated financial position, results of operations or cash flows.

ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, 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 requires 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 our debt, cash and cash equivalents, and fiduciary and restricted cash. 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. The adoption of this standard did not impact our consolidated financial position, results of operations or cash flows.

RECENTLY ISSUED ACCOUNTING STANDARDS

In July 2012, the FASB issued ASU 2012-02, Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. This ASU gives entities testing indefinite-lived intangible assets for impairment the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, the entity is not required to take further action. However, if an entity concludes otherwise, a quantitative impairment test is required. This guidance is effective for annual and

interim impairment tests beginning January 1, 2013, with early adoption permitted. We will adopt this standard on January 1, 2013 and do not believe the adoption will have a material effect on our consolidated financial position, results of operations or cash flows.

RESULTS OF OPERATIONS

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 (except those in Louisiana and Alabama), 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.

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.

For 2012, we had a net loss of $51.9 million, which included a goodwill impairment charge of $23.4 million. For 2011, we had a net loss of $162.6 million, which included a goodwill impairment charge of $140.1 million and losses from our Michigan business of $14.7 million. For 2010, we had a net loss of $86.9 million.

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):


	Year Ended December 31,
	2012		2011		2010
Our underwriting agencies:
Retail agencies	$	149,478	$	158,368	$	184,464
Independent agencies		69,768		55,968		148,851

Subtotal		219,246		214,336		333,315
Unaffiliated underwriting agencies		17,776		14,893		20,565

Total	$	237,022	$	229,229	$	353,880

Total gross premiums written for 2012 increased $7.8 million, or 3.4%, compared with 2011. This increase was primarily due to an increase in new business policies generated in Texas from independent agencies during 2012. New business policies in Texas increased 41.4% for 2012 compared with 2011, which was comprised of a 12.6% increase from our retail stores and a 131.3% increase from independent agents. We anticipate further gross written premium growth in 2013.

Total gross premiums written for 2011 decreased $124.7 million, or 35.2%, compared with 2010 as pricing increases and changes in underwriting guidelines as well as the suspension or limitation of new business production for unprofitable independent agent relationships, which included our withdrawal from the Michigan market, were the primary causes of the decline.

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):


	Year Ended December 31,
	2012		2011		2010
Our policies	$	149,478	$	158,368	$	184,464
Third-party carrier policies		49,651		54,467		48,375

Total	$	199,129	$	212,835	$	232,839

Gross premiums written of our policies in our retail distribution channel for 2012 decreased $8.9 million, or 5.6%, compared with 2011. This decrease is a result of a decline in renewal policies as a result of the pricing and underwriting actions undertaken in 2011. Third-party policies for 2012 decreased $4.8 million, or 8.8%, compared with 2011. In 2011, our policies produced by our retail agencies decreased $26.1 million, or 14.1%, compared with 2010 primarily due to the pricing and underwriting actions. Third-party policies for 2011 increased $6.1 million, or 12.6%, compared with 2010.

In our independent agency distribution channel, gross premiums written for 2012 increased $13.8 million, or 24.7%, compared with 2011 primarily due to increases in our Texas business. In our independent agency distribution channel, gross premiums written for 2011 decreased $92.9 million, or 62.4%, compared with 2010. The 2011 decrease was primarily due to the suspension of new business production from unprofitable independent agent relationships, which included our withdrawal from the Michigan market, as well as our pricing and underwriting actions.

Gross premiums written by our unaffiliated underwriting agencies for 2012 increased $2.9 million, or 19.4%, compared with 2011. Gross premiums written by our unaffiliated underwriting agencies for 2011 decreased $5.7 million, or 27.6%, compared with 2010.

We introduced a multivariate pricing product in May 2011 for new business in Louisiana, in June 2011 for new business in Alabama and Texas, and in September 2011 for new business in Illinois.

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


	Year Ended December 31,
	2012		2011			2010
Louisiana	$	106,841	$	116,462		$	140,642
Texas		54,009		36,257			67,078
Illinois		23,887		25,577			41,417
Alabama		21,270		23,377			28,475
California		17,706		14,789			20,404
Indiana		8,092		6,463			10,277
Missouri		3,084		1,885			4,541
South Carolina		2,127		3,442			5,571
Michigan		—		895			32,314
Florida		—		(8	)		1,337
New Mexico		—		(14	)		1,665
Other		6		104			159

Total	$	237,022	$	229,229		$	353,880

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


	Year Ended December 31,
	2012			2011			2010
Our underwriting agencies:
Retail agencies — gross premiums written	$	149,478		$	158,368		$	184,464
Ceded reinsurance		(46,745	)		(60,618	)		(37,433	)

Subtotal retail agencies net premiums written		102,733			97,750			147,031

Independent agencies — gross premiums written		69,768			55,968			148,851
Ceded reinsurance		(19,823	)		(21,135	)		(27,461	)

Subtotal independent agencies net premiums written		49,945			34,833			121,390

Unaffiliated underwriting agencies — gross premiums written		17,776			14,893			20,565
Ceded reinsurance		601			(4,169	)		(3,542	)

Subtotal unaffiliated underwriting agencies net premiums written		18,377			10,724			17,023

Excess of loss coverages with various reinsurers		(535	)		(1,496	)		(2,858	)
Catastrophe coverages with various reinsurers		20			(647	)		(538	)

Total net premiums written	$	170,540		$	141,164		$	282,048

Total net premiums written for 2012 increased $29.4 million, or 20.8%, compared with 2011. The increase was primarily due to the increase in gross written premium and the termination of a quota-share reinsurance agreement on January 1, 2012. This contract, put in place effective January 1, 2011, terminated on a cut-off basis and resulted in the return of $11.8 million of ceded unearned premium, net of $4.3 million of deferred ceding commissions during the year ended December 31, 2012. Total net premiums written for 2011 decreased $140.9 million, or 50.0%, compared with 2010.

Total net premiums earned for 2012 decreased $32.8 million, or 18.6%, compared with 2011. The decrease was primarily due to the decline in gross written premium for the first half of 2012. Total net premiums earned for 2011 decreased $156.7 million, or 47.0%, compared with 2010. The decrease was primarily due to the decline in gross written premium and the effects of reinsurance purchased for the fourth quarter of 2010 and year ended December 31, 2011.

Reinsurance. The following table reflects the premiums ceded and assumed under reinsurance agreements in our consolidated financial statements (in thousands):


	Year Ended December 31,
	2012			2011			2010
Direct premiums written	$	198,359		$	193,528		$	288,296
Assumed premiums		38,663			35,701			65,584

Gross premiums written		237,022			229,229			353,880
Ceded premiums written		(66,482	)		(88,065	)		(71,832	)

Net premiums written	$	170,540		$	141,164		$	282,048

We assume reinsurance from a Texas county mutual insurance company (the county mutual) whereby we have assumed 100% of the policies issued by the county mutual for business produced by our owned general agents.

Effective October 1, 2010, we 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 on a run-off basis. Written premiums ceded under this agreement totaled $60.8 million through December 31, 2012. This contract was commuted effective November 30, 2012.

A quota-share reinsurance agreement was put in place effective January 1, 2011 ceding 28% of gross written premium in all states other than Michigan through December 31, 2011. This contract terminated on January 1, 2012 on a cut-off basis and resulted in the return of $11.8 million of ceded unearned premium, net of $4.3 million of deferred ceding commissions. Written premiums ceded under this agreement totaled $50.6 million.

In 2011, we entered into an additional quota-share agreement with a third-party reinsurance company under which we ceded 10% of business produced in Louisiana, Alabama, Texas and Illinois from September 1, 2011 through December 31, 2011. At December 31, 2011, this contract converted to a 40% quota-share reinsurance contract on the in-force business for the applicable states throughout 2012 and was extended to March 31, 2013. Written premiums ceded under this agreement totaled $82.0 million during 2012. Written premiums ceded under this agreement totaled $104.9 million since inception through December 31, 2012. In March 2013, we entered into a new quota-share agreement with this third-party reinsurance company effective March 31, 2013, which we cede 40% for the same four states as the expiring agreement and 100% of business originated through the Texas county mutual. This agreement is through December 31, 2013 but has automatic one-year renewals unless either party provides notice of intent not to renew within 75 days.

The amount of recoveries pertaining to reinsurance contracts that were deducted from losses and loss adjustment expenses incurred during 2012, 2011 and 2010 was approximately $49.8 million, $40.6 million and $75.2 million, respectively. The amount of loss reserves and unearned premium we would remain liable for in the event our reinsurers are unable to meet their obligations was as follows (in thousands):


	Year Ended December 31,
	2012		2011		2010
Losses and loss adjustment expense reserves	$	67,166	$	78,510	$	93,084
Unearned premium reserve		24,628		36,674		34,149

Total	$	91,794	$	115,184	$	127,233

The following table summarizes the ceded incurred losses and loss adjustment expenses (consisting of ceded paid losses and loss adjustment expenses and change in reserves for loss and loss adjustment expenses ceded) to various reinsurers (in thousands):


	Year Ended December 31,
	2012			2011			2010
Paid losses and loss adjustment expenses ceded	$	61,186		$	55,197		$	14,604
Change in loss and loss adjustment expense reserves ceded		(11,344	)		(14,574	)		60,636

Incurred losses and loss adjustment expenses ceded	$	49,842		$	40,623		$	75,240

The Michigan Catastrophic Claims Association (MCCA) is the mandatory reinsurance facility that covers no-fault medical losses above a specific retention amount in Michigan. We stopped writing policies in Michigan in 2011. For policies effective in 2011 and 2010, the retention amount was $0.5 million. When we wrote personal automobile policies in the state of Michigan, we ceded premiums and claims to the MCCA. Funding for MCCA comes from assessments against active 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 loss and loss adjustment expenses to the MCCA (in thousands):


	Year Ended December 31,
	2012			2011			2010
Ceded premiums written	$	—		$	528		$	3,305

Ceded loss and loss adjustment expenses	$	(158	)	$	(16,071	)	$	50,707

We entered into an excess of loss reinsurance contract effective August 1, 2010 that provides coverage for individual losses in excess of $100,000 up to $1 million primarily to reduce our exposure to no-fault medical losses in Michigan. This contract terminated July 31, 2011 on a run-off basis. In addition, we entered into a reinsurance agreement effective June 1, 2012 (as we have previously done on an annual basis) to provide coverage for catastrophic events that may involve multiple insured losses.

In February 2012, we entered into a one-year excess of loss reinsurance contract with third-party reinsurers which provides coverage for individual losses in excess of $100,000 up to $1.0 million.

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 years ended December 31, 2012, 2011 and 2010 (in thousands):


	Year Ended December 31,
	2012		2011		2010
Premium finance revenue	$	21,078	$	22,897	$	23,442
Policyholder fees		20,694		24,334		39,614
Commissions and fees		16,153		16,315		15,598
Agency fees		3,570		4,339		4,854

Total commission income and fees	$	61,495	$	67,885	$	83,508

Commission income and fees for 2012 decreased $6.4 million, or 9.4%, compared with 2011. Premium finance revenue decreased $1.8 million, or 7.9%, due to decreases in the number of policies financed and revenue per policy. Policyholder fees decreased $3.6 million, or 15.0%, due to the lower overall volume of premiums written and a change in mix of states. Commissions and fees decreased $0.2 million, or 1.0%, due to a decrease in ancillary product sales.

Commission income and fees for 2011 decreased $15.6 million, or 18.7%, compared with 2010. Policyholder fees decreased $15.3 million, or 38.6%, due to the lower overall volume of premiums written and a change in mix of states. Premium finance revenue decreased $0.5 million, or 2.3%, due to decreases in the number of policies financed. Commissions and fees increased $0.7 million, or 4.6%, due to more of our retail customers choosing third-party products due to pricing and underwriting actions on our products and an expansion of our ancillary product sales.

Net Investment Income and Other Income. Net investment income includes income on our portfolio of debt securities and net rental income from our investment in real property. Net investment income for 2012 decreased $1.9 million, or 37.8%, compared with 2011. The decrease was primarily due to a 52.1% decrease in total average invested assets to $76.3 million during 2012 from $159.4 million during 2011, which was partially offset by a $0.3 million increase in income from our investment in real estate. The average investment yield was 1.9% (2.0% on a taxable equivalent basis) in 2012, compared with 2.3% (2.4% on a taxable equivalent basis) in 2011.

Net investment income for 2011 increased $0.1 million, or 1.3%, compared with 2010. The increase was primarily due to a $1.3 million increase in income from our investment in real estate and from our investment in a hedge fund, which was partially offset by a 31.4% decrease in total average invested assets to $159.4 million during 2011 from $232.3 million during 2010 and a reduction in yields. The average investment yield was 2.3% (2.4% on a taxable equivalent basis) in 2011, compared with 2.3% (2.6% on a taxable equivalent basis) in 2010. The $1.3 million net increase in income from our investment in real estate is due to a new long-term lease with a federal agency for our Baton Rouge building that commenced in the fourth quarter of 2010.

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 $123.6 million of available-for-sale securities during 2010 for a net realized gain of $1.6 million.

At December 31, 2012, our fixed-income investments were invested in the following: corporate debt securities 40.6%; FDIC-insured certificates of deposit 27.8%; U.S. Treasury and government agencies securities 24.0%; and states and political subdivisions securities 7.6%. The average quality of our portfolio was AA- at December 31, 2012. We attempt to mitigate interest rate risk by managing the duration of our fixed-income portfolio to the duration of our reserves. As of December 31, 2012, the effective duration of our fixed-income investment portfolio was 1.1 years.

Our investment strategy is to conservatively manage our investment portfolio by primarily investing in readily marketable, investment-grade, fixed-income securities. We currently do not invest in common equity securities and we have no direct exposure to foreign currency risk. The Investment Committee of our Board of Directors has established investment guidelines and periodically reviews portfolio performance for compliance with our guidelines.

In 2010, we redeemed all remaining auction-rate securities, at par, of $46.4 million and realized gains of $9.0 million during 2010 offset by a corresponding reduction in fair value of the settlement recorded in other income (loss).

Losses and Loss Adjustment Expenses. Losses and loss adjustment expenses for 2012 decreased $25.8 million, or 18.7%, compared with 2011. Losses and loss adjustment expenses for 2011 decreased $175.0 million, or 56.0%, compared with 2010.

The following table displays loss ratios:


	Year Ended December 31,
	2012			2011			2010
Loss ratio — current year		74.0	%		75.1	%		85.4	%
Adverse loss ratio development — prior year business		3.8			2.9			8.4

Reported loss ratio		77.8	%		78.0	%		93.8	%

In 2012, the percentage of calendar year losses and loss adjustment expense to net premiums earned (the net loss ratio) was 77.8% compared with 78.0% in 2011. On an accident year basis, the net loss ratio was 74.0% in 2012 compared with 75.1% in 2011. Loss adjustment expenses include all of the business subject to the quota-share treaties with ceding commission income booked as an offset to selling, general and administrative expenses. As such, the quota-share treaties’ impact on the loss ratio was to increase it by 4.6 points for 2012 and 3.1 points for 2011. Excluding the impact of the quota-share, the net loss ratio for the 2012 accident year was 69.4% and 71.1% for the 2011 accident year. This decrease reflects the pricing, claims and underwriting actions that commenced in the second half of 2010 through 2011. Also reflected in the above numbers is the effect of catastrophes. In the current accident year we have incurred catastrophes, net of reinsurance, equal to 2.0 points for 2012 compared to 1.5 points in 2011. Both of these numbers are higher than our long term average expectation of 0.5 points. The adverse prior period development taken in 2012 was primarily due to an increase in the estimated severity for Louisiana bodily injury claims in 2011.

The decrease in the 2012 accident year resulted from the confluence of a number of initiatives. During 2012, we realized the full benefit of our new multi-variate pricing model in our four largest states, implemented pricing and underwriting changes and our continuing improvements in our claims process. The combination of these improvements has allowed us to start growing in the fourth quarter while keeping our losses at levels lower than 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 $10.1 million of adverse prior period development related to our Michigan business and $5.0 million of favorable prior period development in 2011 due to Vesta-related reserves, compared with 2010’s adverse loss development of $28.0 million primarily related to our 2009 Texas and Michigan business. The accident year decline was even more significant when the impact of the quota-share treaties that were entered into for the fourth quarter of 2010 and for all of 2011 are taken into account. As such, the quota-share treaties’ impact on the calendar year loss ratio was to increase it by 3.1 points for 2011 and 1.7 points for 2010. We ceased writing new business in Michigan in March 2011 and renewal business in June 2011.

In 2010, the increase in the accident year loss ratio was due to increased losses on the Texas and Michigan businesses as well as significantly increased severity, which was primarily due to the claims transformation project that began in the third quarter of 2009. Significant pricing and underwriting actions were taken to address Texas and Michigan profitability in 2010 and 2011. Also, additional controls were instituted in the handling of claims to mitigate the significant increases in severity that occurred.

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 and other variable factors such as inflation. Significant change in claims practices that began in the third quarter of 2009 and continued throughout 2010 and 2011 added additional uncertainty to the reserving process. Due to the inherent uncertainty of estimating reserves, reserve estimates can be expected to vary from period to period. 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.

If existing estimates of the ultimate liability for losses and related loss adjustment expenses are lowered, then that favorable development is recognized in the subsequent period in which the reserves are reduced. This has the effect of benefiting that subsequent period, when the aggregate losses and loss adjustment expenses (reflecting the favorable development related to previously reported earned premiums) are reduced relative to that period’s earned premium. Although the favorable development must be included in that subsequent period’s financial statements, it is appropriate for measurement purposes to compare only the losses and loss adjustment expenses related to any specific period’s earned premiums in evaluating performance during that particular period. During 2010, we experienced frequency indications that were flat compared to prior year selections and severity trends for liability business that were significantly higher than in the past. In a period of stable premium rates, these trends would have resulted in deteriorating loss ratios.

The following table provides a reconciliation of the beginning and ending reserves for unpaid losses and loss adjustment expenses (in thousands):


	Year Ended December 31,
	2012		2011		2010
Gross balance at beginning of year	$	183,836	$	252,084	$	193,647
Less: Reinsurance recoverable		78,510		93,084		32,447
Less: Deposits		—		213		245

Net balance at beginning of year		105,326		158,787		160,955
Incurred related to:
Current year		106,379		132,557		284,623
Prior year		5,479		5,100		28,046
Paid related to:
Current year		66,916		87,117		183,364
Prior year		78,580		104,001		131,473

Net balance at the end of year		71,688		105,326		158,787
Reinsurance recoverable		67,166		78,510		93,084
Deposits		—		—		213

Gross balance at the end of year	$	138,854	$	183,836	$	252,084

Our losses, loss adjustment expense reserves and deposit liabilities of $138.9 million on a gross basis and $71.7 million on a net basis are our best estimates as of December 31, 2012. The analysis provided by our internal valuation methods indicated that the expected range for the ultimate liability for our losses and loss adjustment expense reserves, as of December 31, 2012, was between $107.9 million and $149.3 million on a gross basis and between $59.5 million and $77.9 million on a net basis.

The following table presents the development of reserves for unpaid losses and loss adjustment expenses from 2002 through 2012 for our insurance company subsidiaries, net of reinsurance recoveries or recoverables. The first line of the table presents the reserves at December 31 for each indicated year. This represents the estimated amounts of losses and loss adjustment expenses for claims arising in that year and all prior years that are unpaid at the balance sheet date, including losses incurred but not reported to us. The upper portion of the table presents the cumulative amounts subsequently paid as of successive years with respect to those claims. The lower portion of the table presents an update of the estimated amount of the previously recorded reserves based upon the experience as of the end of each succeeding year. The estimates are revised as more information becomes known about the payments, frequency and severity of claims for individual years. A redundancy (deficiency) exists when the reestimated reserves at each December 31 is less (greater) than the prior reserve estimate. The cumulative redundancy (deficiency) depicted in the table, for any particular calendar year, represents the aggregate change in the initial estimates over all subsequent calendar years.

Our historical net liabilities for losses and loss adjustment expenses are impacted by our 100% quota-share reinsurance contract with VFIC. For the years 2002 and 2003 we reinsured 100% of business written or assumed by our insurance companies to VFIC. The following table summarizes the development of reserves for unpaid losses and loss adjustment expenses (in thousands):


	2002		2003		2004		2005		2006		2007			2008			2009			2010			2011			2012
Net liability for unpaid losses and LAE:
Originally estimated	$	—	$	—		55,500	$	116,109	$	138,421	$	180,745		$	163,454		$	160,955		$	158,787		$	105,326		$	71,688
Reserve adjustment from acquisition of USAgencies		—		—		—		—		27,810		—			—			—			—			—			—

Adjusted reserves, net of reinsurance		—		—		55,500		116,109		166,231		180,745			163,454			160,955			158,787			105,326			71,688
Cumulative paid as of December 31,
One year later		—		—		17,396		62,715		99,235		126,991			118,314			131,474			104,002			78,580
Two years later		—		—		31,194		83,974		131,873		160,754			155,317			157,213			139,023
Three years later		—		—		39,686		94,879		145,652		176,911			164,463			166,837
Four years later		—		—		43,106		100,444		153,103		181,381			167,830
Five years later		—		—		45,409		104,699		155,618		182,830
Six years later		—		—		46,458		105,674		156,224
Seven years later		—		—		46,952		105,963
Eight years later		—		—		47,167
Nine years later		—		—
Ten years later		—

Liability re-estimated as of December 31,
One year later		—		—		46,948		110,875		161,208		184,470			178,262			189,001			163,887			110,805
Two years later		—		—		47,417		109,193		161,734		195,550			187,370			182,790			169,978
Three years later		—		—		48,404		110,015		168,066		198,643			179,900			179,767
Four years later		—		—		48,452		116,171		169,075		190,450			176,847
Five years later		—		—		51,279		117,353		162,578		188,458
Six years later		—		—		51,634		113,860		160,890
Seven years later		—		—		49,930		112,445
Eight years later		—		—		49,273
Nine years later		—		—
Ten years later		—

Net cumulative redundancy/ (deficiency)	$	—	$	—	$	6,227	$	3,664	$	5,341	$	(7,713	)	$	(13,393	)	$	(18,812	)	$	(11,191	)	$	(5,479	)		N/A

The following table is a reconciliation of our net liability to our gross liability for losses and loss adjustment expenses (in thousands):


	2002			2003		2004		2005		2006		2007			2008			2009			2010		2011			2012
As originally estimated:
Net liability shown above	$	—		$	—	$	55,500	$	116,109	$	138,421	$	180,745		$	163,454		$	160,955		$	158,787	$	105,326		$	71,688
Add reinsurance recoverable		64,677			58,507		43,363		19,169		21,590		46,854			40,667			32,447			93,084		78,510			67,166

Gross liability		64,677			58,507		98,863		135,278		160,011		227,599			204,121			193,402			251,871		183,836			138,854
Adjusted for acquisition of USAgencies		—			—		—		—		71,522		—			—			—			—		—			—

Adjusted gross liability		64,677			58,507		98,863		135,278		231,533		227,599			204,121			193,402			251,871		183,836			138,854

As re-estimated as of December 31, 2012:
Net liability shown above		—			—		49,273		112,445		160,890		188,458			176,847			179,767			169,978		110,805
Add reinsurance recoverable		67,202			50,340		39,743		14,093		65,568		45,968			48,297			49,391			75,435		80,778
Gross liability		67,202			50,340		89,016		126,538		226,458		234,426			225,144			229,158			245,413		191,583

Net cumulative redundancy/ (deficiency)	$	(2,525	)	$	8,167	$	9,847	$	8,740	$	5,075	$	(6,827	)	$	(21,023	)	$	(35,756	)	$	6,458	$	(7,747	)

The adverse prior period development taken in 2012 was primarily due to an increase in the estimated severity for Louisiana bodily injury claims in 2011. The gross cumulative redundancy in 2010 was primarily due to a reduction of Michigan case reserves for 2010 due to revised estimates of losses. The gross cumulative deficiency in 2009 increased as a result of revised case reserves on our Michigan business due to increased estimates of ultimate losses.

As a result of the 100% quota-share reinsurance contract with VFIC, all losses and loss adjustment expense reserves of our insurance companies as of December 31, 2003 were reinsured by VFIC.

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 compensation and benefits. Selling, general and administrative expenses for 2012 decreased $14.7 million, or 13.2%, compared with 2011, primarily due to a $10.0 million decline in policy acquisition expenses, a $2.2 million impairment in the fourth quarter of 2011 related to our office space, and a $3.7 million decline in employee compensation and benefits due to management actions to reduce expenses.

Selling, general and administrative expenses for 2011 decreased $54.2 million, or 32.9%, compared with 2010, primarily due to a decrease in premium production and recognition of ceding commission income 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 2011 from the quota-share reinsurance agreements. There was no ceding commission income in the first nine months of 2010. Also, the decrease for 2011 reflected a $9.0 million decrease in employee compensation and benefits primarily due to management actions to reduce expenses, a $5.2 million decrease due to lease termination and related charges incurred in 2010, a $3.1 million decrease due to lower IT consulting, a $1.9 million decrease in temporary labor costs and a $1.5 million decrease in severance costs.

Deferred policy acquisition costs represent the deferral of expenses that we incur related to successful contract acquisition of new business or renewal of existing business. Policy acquisition costs, consisting of primarily commission expenses and premium taxes, 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 selling, general and administrative expenses. The following table sets forth the impact that amortization of deferred acquisition costs had on selling, general and administrative expenses and the change in deferred acquisition costs (in thousands):


	Year Ended December 31,
	2012			2011			2010
Amortization of deferred acquisition costs, net	$	(5,221	)	$	(241	)	$	37,573
Other selling, general and administrative expenses		101,276			110,957			127,335

Total selling, general and administrative expenses	$	96,055		$	110,716		$	164,908

Total as a percentage of net premiums earned		66.8	%		62.7	%		49.5	%

Beginning deferred acquisition costs, net	$	(6,464	)	$	460		$	1,529
Additions, net of ceding commission		1,341			(7,165	)		36,504
Amortization, net of ceding commissions		5,221			241			(37,573	)

Ending deferred acquisition costs	$	98		$	(6,464	)	$	460

Amortization of deferred acquisition costs, net, as a percentage of net premiums earned		3.6	%		0.1	%		11.3	%

Additions to deferred acquisition costs in 2012 increased by $8.5 million, and additions to the related amortization increased by $5.0 million compared with 2011. The increase in additions is primarily due to an increase in business written by independent agents and a decrease in ceded deferred policy acquisition expenses. The increase in amortization is due to an increase in net written premium and higher policy acquisition expenses.

Additions to deferred acquisition costs in 2011 decreased by $43.7 million and additions to the related amortization decreased by $37.8 million compared with 2010. The decrease in additions is primarily due to a decline in gross written premium and an increase in ceded commissions in 2011. The decrease in amortization is due to a decline in net written premium and lower policy acquisition expenses.

ASU 2010-26, Financial Services-Insurance (Topic 944), modifies the definitions of the type of costs that can be capitalized in the successful acquisition of new and renewal insurance contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. We adopted this guidance on January 1, 2012 using retrospective application.

The following table illustrates the effect of adopting ASU 2010-26 in the consolidated balance sheets (in thousands):


	December 31, 2011
	Previously Reported			As Adjusted
Deferred acquisition costs, net	$	3,206		$	(6,464	)
Stockholders’ deficit		(71,307	)		(80,977	)

The following table illustrates the effect of adopting ASU 2010-26 in the consolidated statements of operations (in thousands, except per share amounts):


	Year Ended December 31, 2011						Year Ended December 31, 2010
	Previously Reported			As Adjusted			Previously Reported			As Adjusted
Selling, general and administrative expenses	$	112,327		$	110,716		$	166,916		$	164,908
Net loss		(164,209	)		(162,598	)		(88,931	)		(86,923	)
Net loss per share:
Basic		(10.66	)		(10.55	)		(5.77	)		(5.64	)
Diluted		(10.66	)		(10.55	)		(5.77	)		(5.64	)

Net expenses, defined as the sum of selling, general and administrative expenses and depreciation and amortization less commission income and fees, as a percentage of net premiums earned (the net expense ratio) increased to 31.0% in 2012 compared with 29.7% in 2011. The increase was primarily due to an 18.6% decrease in net premiums earned and a 13.2% decrease in selling, general and administrative expenses, which were partially offset by a 9.4% decrease in commission income and fees. Net expenses as a percentage of net premiums earned (the net expense ratio) increased to 29.7% in 2011 compared with 27.3% in 2010. The increase was primarily due to a 47.0% decrease in net premiums earned and a 32.9% decrease in selling, general and administrative expenses, which were partially offset by an 18.7% decrease in commission income and fees. The following table sets forth the components of the net expenses and the computation of the net expense ratios (in thousands):


	Year Ended December 31,
	2012			2011			2010
Selling, general and administrative expenses	$	96,055		$	110,716		$	164,908
Depreciation and amortization		10,062			9,674			9,622
Less: Commission income and fees		(61,495	)		(67,885	)		(83,508	)

Net expenses	$	44,622		$	52,505		$	91,022

Net premiums earned	$	143,736		$	176,549		$	333,267

Net expense ratio		31.0	%		29.7	%		27.3	%

Depreciation and Amortization. Depreciation and amortization expenses for 2012 increased $0.4 million, or 4.0%, compared with 2011. Depreciation and amortization expenses for 2011 were comparable to 2010.

Loss on Interest Rate Swaps. Loss on interest rate swaps for 2011 decreased $0.9 million compared with 2010. 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 2012 decreased $1.8 million, or 8.5%, compared with 2011. This decrease was due to decreases in the average debt outstanding, in the amortization of debt discount and in interest expense on the lease obligation entered into in May 2010. In 2012, we repaid $3.5 million of the senior secured facility. Amortization of debt discount was $4.1 million in 2012, compared with $4.5 million in 2011.

Interest expense for 2011 decreased $1.2 million, or 5.3%, compared with 2010. 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. The average principal balance of our senior secured credit facility was $105.2 million during 2011, a decrease of $13.8 million, or 11.6%, from the

average principal balance during 2010. In 2011, we repaid $9.8 million of the senior secured facility. Amortization of debt discount was $4.5 million in 2011 as compared with $6.1 million in 2010.

Income Taxes. Income tax expense for 2012 was $0.3 million as compared to an income tax benefit of $9.0 million in 2011. Income tax expense for 2012 represents increasing deferred tax liabilities arising from timing differences on goodwill and other intangible assets.

Income tax benefit for 2011 was $9.0 million as compared to expense of $1.7 million for 2010. The income tax benefit was related to the reduction of deferred tax liabilities from the goodwill and other intangible asset impairment charges.

Our gross deferred tax assets prior to recognition of valuation allowance were $103.4 million and $91.2 million at December 31, 2012 and 2011, 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. The valuation allowance was $101.9 million and $88.9 million at December 31, 2012 and 2011, respectively.

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 December 31, 2012, we had $2.3 million of cash and cash equivalents at our holding company and non-insurance company subsidiaries.

State insurance laws restrict the ability of our insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2012, 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.

In 2010, we entered into a capital lease obligation related to certain computer software, software licenses, and hardware currently used by and on the books of Affirmative Insurance Company. The lease term was 60 months and the lease obligation was fully secured with FDIC-insured certificates of deposit. On October 17, 2012, we received notice from one of the lessors (Lessor) under a capital lease obligation that, based upon Lessor’s claim of an alleged default under the terms of the applicable lease and security agreements, it elected to

immediately seek recovery of an amount equal to the casualty loss value of the leased property, together with all other sums allegedly due to Lessor, which Lessor calculated as $9.6 million. Lessor informed the Company that it had directed the escrow agent to redeem the CDs securing the Company’s lease payment obligation and disburse to it the approximately $8.3 million in proceeds, which Lessor received on October 15, 2012. Lessor threatened legal action against the Company to recover the remaining $1.3 million, alleged liquidated damages. The Company contests that any event of default has occurred and also disputes Lessor’s demand for payment of the casualty loss value of the leased property. The Company has demanded that Lessor pay the Company approximately $0.5 million, the amount by which the CD redemption proceeds exceeded Lessor’s remaining interest in the lease at the time it declared default. On December 26, 2012, Lessor conveyed all right and interest in the leased property back to the Company, although both parties reserved all claims with respect to the disputed demands for payment. Neither party has filed suit at this time.

Our insurance company subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act, adopted by the National Association of Insurance Commissioners (NAIC), require our insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject us to further examination or corrective action imposed by state regulators, including limitations on our writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require us to increase our statutory capital levels. At December 31, 2012 and 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. Effective January 1, 2012, the State of Illinois adopted the revised NAIC Risk-Based Capital Model Act that includes a risk-based capital trend test as another manner under which the company action level could be triggered and will be applied as of December 31, 2012. The test is applicable when an insurance company has a risk-based capital ratio between 200% and 300% and a combined ratio of more than 120%. All of our insurance subsidiaries were in compliance with the RBC trend test as of December 31, 2012.

On February 28, 2012, we exercised our right to defer interest payments on selected Notes Payable beginning with the scheduled interest payment due in March 2012 and continuing for a period of up to five years. The affected notes are associated with obligations to our unconsolidated trusts. The outstanding balance of the affected notes was $56.7 million as of December 31, 2012. We will continue to accrue interest on the principal during the extension period and the unpaid deferred interest will also accrue interest. Deferred interest will be due and payable at the expiration of the extension period.

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, and other actions taken by the Company 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. For the year ended December 31, 2012, our net cash used in operations was $48.8 million. We believe that this amount will be significantly reduced in 2013 due to our exit from the Michigan business and premium production increasing. The runoff of the Michigan business and previous decline in insurance premiums had a substantial impact on the net cash used in operations during the year ended December 31, 2012. Cash provided by investing activities of $65.9 million was utilized to fund operating cash needs for the year ended December 31, 2012. We do not currently know of any events that could cause a material increase or decrease in our long-term liquidity needs other than the 2014 expiration of our senior secured credit facility.

Senior secured credit facility. In 2007, we entered into a $220.0 million senior secured credit facility (the facility) provided by a syndicate of lenders, that provide for a $200.0 million senior term loan facility and a revolving facility of up to $20.0 million, depending on our borrowing capacity. The principal amount of the term loan is payable in quarterly installments, with the remaining balance due January 31, 2014. Beginning in 2008, we were also required to make additional annual principal payments that are calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments. During 2012, we made $3.5 million in principal payments. The revolving portion of the facility expired in January 2010.

In November 2012, a new class of loans under the senior secured credit facility was created allowing for an incremental term loan. The incremental term loan has the following characteristics:

•

Face amount of $8.0 million with a funded amount of $5.5 million, of which we contributed $4.6 million to Affirmative Insurance Company.

•

Repayment of the full $8.0 million will be on a first out basis, payable in full, on or prior to January 17, 2014, with priority over all other amounts outstanding under the senior secured credit facility. The incremental term loan lenders retained $2.5 million, representing original issue discount.

•

All additional proceeds not used to satisfy Affirmative Insurance Company’s reserve requirement as of September 30, 2012 as described in Note 12 are to be used solely for paying the incremental term loan lenders’ and administrative agent’s professional fees.

•

A $60,000 principal payment is due as of March 31, 2013 and $40,000 is due each quarter end for the remainder of 2013. The remaining balance is due at maturity.

•

As of December 31, 2012, a non-cash closing fee of $550,000 was recorded in other liabilities, and subsequently added to the principal amount of the incremental term loan as of January 1, 2013.

•

The incremental term loan lenders will receive an 8% prepayment premium of the principal amount if the incremental term loan is prepaid.

•

The incremental term loan lenders have the right to retain a financial advisor to assess the financial, operational and regulatory condition of the Company.

In March 2011, we 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. We 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 were pledged and this entity became 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, we 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.

•

We have the option to capitalize interest that is in excess of the prior payment terms to the loan balance.

In addition, we paid a 0.25% fee to all lenders that approved the March 2011 amendment.

Contractual Obligations

The following table summarizes our contractual obligations at December 31, 2012 (in thousands):


	2013		2014		2015		2016		2017		Thereafter		Total
Operating leases(1)	$	10,720	$	9,333	$	6,072	$	3,145	$	1,002	$	1,894	$	32,166
Capital lease obligation(2)		2,943		3,175		1,395		—		—		—		7,513
Notes payable(3)		—		—		—		—		—		76,842		76,842
Senior secured credit facility(4)		1,191		107,798		—		—		—		—		108,989
Interest on capital lease obligation		448		216		17		—		—		—		681
Interest on notes payable(3)		3,142		3,235		3,331		3,428		3,533		51,704		68,373
Interest on senior secured credit facility(4)		12,490		1,146		—		—		—		—		13,636
Data processing services(5)		7,364		7,364		7,364		6,137		—		—		28,229
Reserves for loss and loss adjustment expense(6)		92,426		20,707		8,580		4,743		3,030		9,368		138,854

Total	$	130,724	$	152,974	$	26,759	$	17,453	$	7,565	$	139,808	$	475,283

(1)	As of December 31, 2012, we leased an aggregate of approximately 434,249 square feet of office space for our agencies, insurance companies and retail stores in various locations throughout the United States. These amounts represent our minimum future operating lease commitments.

(2)	In 2010, we entered into a capital lease obligation related to certain computer software, software licenses, and hardware currently used by and on the books of Affirmative Insurance Company.

(3)

All of the outstanding notes payable at December 31, 2012 are redeemable in whole or in part after five years from issuance. For this disclosure, it is assumed that none of these notes will be redeemed before their contractual maturities and interest rates on these notes will remain at their current levels.

(4)

The principal amount of the senior secured credit facility is payable in quarterly installments with the remaining balance due on the seventh anniversary of the closing of the facility. We are also required to make additional annual principal payments that are to be calculated based upon our financial performance during the preceding fiscal year. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments.

(5)

On October 16, 2012, Affirmative and Accenture materially amended the Master Agreement effective September 1, 2012 (“Amended Agreement”), whereby we reassumed responsibility for managing substantially all of our IT operations, including our data center and applications management at an annual cost of $6.1 million. The Amended Agreement terminates on October 30, 2016, subject to termination for convenience provisions that may be invoked by us at any time, subject to the payment of certain stranded costs and other termination fees. Termination costs may be incurred for early termination under other specific circumstances as well. In addition, we contracted with a third party to provide network infrastructure services for $1.2 million annually.

(6)	The payout pattern for reserves for losses and loss adjustment expenses is based upon historical payment patterns and does not represent actual contractual obligations. The timing and amount ultimately paid can and will vary from these estimates.

Item 7A.

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 the duration of our reserves. The fair value of our fixed-income securities as of December 31, 2012 was $47.7 million. The effective average duration of the portfolio as of December 31, 2012 was 1.1 years. If market interest rates increase 1.0%, our fixed-income investment portfolio would be expected to decline in market value by 1.1%, or $0.5 million, representing the effective average duration multiplied by the change in market interest rates. Conversely, a 1.0% decline in interest rates would result in a 1.1%, or $0.5 million, increase in the market value of our fixed-income investment portfolio.

Our senior secured credit facility is also subject to interest rate risk. 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 our leverage ratio. 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 interest rate at December 31, 2012 was 11.25%.

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 December 31, 2012 was 3.91%. The $25.8 million notes adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of December 31, 2012 was 3.86%. The $20.2 million notes payable bear an interest rate of the three-month LIBOR rate plus 3.95%. The interest rate as of December 31, 2012 was 4.26%.

Credit risk. An additional exposure to our investment 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 December 31, 2012 and 2011, respectively, our investments were in the following:


	December 31, 2012			December 31, 2011
Corporate debt securities		40.6	%		50.1	%
FDIC-insured certificates of deposit		27.8			17.2
U.S. Treasury and government agencies		24.0			9.8
States and political subdivisions		7.6			14.0
Mortgage-backed securities		—			8.9

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):


	December 31, 2012			December 31, 2011
Total invested assets	$	47,748		$	122,922
Tax-equivalent book yield		2.04	%		2.44	%
Average duration in years		1.05			1.82
Average S&P rating		AA-			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.

Our hedge fund investment of $3.4 million at December 31, 2012 is also subject to credit and counterparty risk, in the event that issuers of any of the underlying commercial and residential mortgage-backed securities should default. However, this investment is not material to our overall investment portfolio or consolidated assets and we have established investment policy guidelines to limit the amount of investments other than high quality fixed-income securities.

The table below presents the total amount of receivables due from reinsurance as of December 30, 2012 and 2011, respectively (in thousands):


	December 31, 2012		December 31, 2011
Quota-share reinsurer for agreement effective September 1, 2011	$	53,195	$	22,102
Michigan Catastrophic Claims Association		39,652		44,049
Vesta Insurance Group		13,674		10,068
Quota-share reinsurer for agreements effective in fourth quarter of 2010 and January 2011		5,800		46,103
Excess of loss reinsurers		5,521		5,458
Other		2,759		3,667

Total reinsurance receivable	$	120,601	$	131,447

The quota-share reinsurers and excess of loss reinsurers all have A- ratings from A.M. Best. Accordingly, we believe 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. We stopped writing business in Michigan in 2011. For policies effective in 2011 and 2010 the retention amount was $0.5 million. When we wrote personal automobile policies in the state of Michigan, we ceded premiums and claims to the MCCA. Funding for MCCA comes from assessments against active 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.

In 2010, we 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. We receive provisional ceding commission which may be adjusted based on the fully-developed loss ratio of the reinsured policies. Written premiums ceded under this agreement totaled $60.8 million through December 31, 2012.

In June 2012, we entered into a reinsurance agreement with third-party reinsurers which provides $5.0 million in excess of the first $3.0 million of losses coverage for catastrophic events that may involve multiple insured losses.

In February 2012, we entered into a one-year excess of loss reinsurance contract with third-party reinsurers which provides coverage for individual losses in excess of $100,000 up to $1.0 million.

Under the reinsurance agreement with Vesta Insurance Group (VIG), including primarily Vesta Fire Insurance Corporation (VFIC), our wholly-owned subsidiaries Affirmative Insurance Company (AIC) had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize the gross amount due AIC from VFIC under the reinsurance agreement. Accordingly, AIC 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 December 31, 2012, the VFIC Trust held $16.8 million (after cumulative withdrawals of $8.7 million through December 31, 2012), consisting of a $14.7 million U.S. Treasury money market account and $2.1 million of corporate bonds rated BBB+ or higher, to collateralize the $13.7 million net recoverable from VFIC.

At December 31, 2012, $2.5 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC under a reinsurance agreement with VIG affiliated companies. Affirmative established a trust account to secure the Company’s obligations under this reinsurance contract, which currently holds $15.7 million in a money market cash equivalent account (the AIC Trust). Cumulative withdrawals by the Special Deputy Receiver of $2.1 million were made through December 31, 2012.

As part of the terms of the acquisition of AIC, VIG 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 December 31, 2012, all such unaffiliated reinsurers had A.M. Best ratings of “A-” or better.

Item 8.

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Consolidated Financial Statements


	Page
Report of Independent Registered Public Accounting Firm		61
Consolidated Balance Sheets		62
Consolidated Statements of Operations		63
Consolidated Statements of Comprehensive Income (Loss)		64
Consolidated Statements of Stockholders’ Equity (Deficit)		64
Consolidated Statements of Cash Flows		65
Notes to Consolidated Financial Statements		66

Report of Independent Registered Public Accounting Firm

The Board of Directors and Stockholders

Affirmative Insurance Holdings, Inc.:

We have audited the accompanying consolidated balance sheets of Affirmative Insurance Holdings, Inc. and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Affirmative Insurance Holdings, Inc. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.

The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, the Company’s recent history of recurring losses from operations, failure to comply with the financial covenants in the senior secured credit facility, failure to comply with the Illinois Department of Insurance reserve requirement, and substantial liquidity needs the Company will face when the senior secured credit facility expires in January 2014 raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

As discussed in Note 3 to the consolidated financial statements, effective January 1, 2012 the Company adopted ASU 2010-26, Financial Services-Insurance (ASC Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts.

/s/ KPMG LLP

Dallas, Texas

April 1, 2013

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)


	December 31,
	2012			2011
				(As Adjusted See Note 3)
Assets
Available-for-sale securities, at fair value	$	47,748		$	122,922
Other invested assets		3,390			2,898
Cash and cash equivalents		38,176			28,559
Fiduciary and restricted cash		569			2,478
Accrued investment income		284			1,058
Premiums and fees receivable, net		29,431			22,579
Premium finance receivable, net		38,942			38,082
Commissions receivable		1,869			1,786
Receivable from reinsurers		120,601			131,447
Deferred acquisition costs, net asset		98			—
Income taxes receivable		150			739
Investment in real property, net		10,996			11,776
Property and equipment (net of accumulated depreciation of $60,242 for 2012 and $51,204 for 2011)		22,571			32,130
Goodwill		—			23,448
Other intangible assets (net of accumulated amortization of $7,665 for 2012 and 2011)		14,265			14,609
Prepaid expenses		6,318			5,147
Other assets (net of allowance for doubtful accounts of $7,213 for 2012 and 2011)		2,987			1,944

Total assets	$	338,395		$	441,602

Liabilities and Stockholders’ Deficit
Liabilities:
Reserves for losses and loss adjustment expenses	$	138,854		$	183,836
Unearned premium		72,861			58,242
Amounts due to reinsurers		27,363			34,709
Deferred revenue		6,117			4,816
Capital lease obligation		7,513			20,301
Senior secured credit facility		99,323			91,683
Notes payable		76,842			76,857
Deferred tax liability		3,178			2,928
Deferred acquisition costs, net liability		—			6,464
Other liabilities		39,598			42,743

Total liabilities		471,649			522,579

Stockholders’ deficit:
Common stock, $0.01 par value; 75,000,000 shares authorized, 18,202,221 shares issued and 15,408,358 shares outstanding at December 31, 2012 and 2011		182			182
Additional paid-in capital		166,749			166,342
Treasury stock, at cost (2,793,863 shares at December 31, 2012 and 2011)		(32,910	)		(32,910	)
Accumulated other comprehensive loss		(998	)		(227	)
Retained deficit		(266,277	)		(214,364	)

Total stockholders’ deficit		(133,254	)		(80,977	)

Total liabilities and stockholders’ deficit	$	338,395		$	441,602

See accompanying Notes to Consolidated Financial Statements.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)


	Year Ended December 31,
	2012			2011			2010
				(As Adjusted See Note 3)			(As Adjusted See Note 3)
Revenues
Net premiums earned	$	143,736		$	176,549		$	333,267
Commission income and fees		61,495			67,885			83,508
Net investment income		3,105			4,992			4,926
Net realized gains		922			107			10,632
Other income (loss)		503			265			(6,566	)

Total revenues		209,761			249,798			425,767

Expenses
Net losses and loss adjustment expenses		111,858			137,657			312,669
Selling, general and administrative expenses		96,055			110,716			164,908
Depreciation and amortization		10,062			9,674			9,622

Total expenses		217,975			258,047			487,199

Operating loss		(8,214	)		(8,249	)		(61,432	)
Loss on interest rate swaps		—			(2	)		(961	)
Interest expense		19,743			21,575			22,782
Goodwill and other intangible assets impairment		23,692			141,812			—

Loss before income tax expense (benefit)		(51,649	)		(171,638	)		(85,175	)
Income tax expense (benefit)		264			(9,040	)		1,748

Net loss	$	(51,913	)	$	(162,598	)	$	(86,923	)

Basic loss per common share:
Net loss	$	(3.37	)	$	(10.55	)	$	(5.64	)

Diluted loss per common share:
Net loss	$	(3.37	)	$	(10.55	)	$	(5.64	)

Weighted average common shares outstanding:
Basic		15,408			15,408			15,414

Diluted		15,408			15,408			15,414

See accompanying Notes to Consolidated Financial Statements.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)


	Year Ended December 31,
	2012			2011			2010
				(As Adjusted See Note 3)			(As Adjusted See Note 3)
Net loss	$	(51,913	)	$	(162,598	)	$	(86,923	)
Other comprehensive loss:
Unrealized gains (losses) on available-for-sale investment securities arising during period		117			(593	)		(794	)
Reclassification adjustment for realized gains included in net loss		(888	)		(79	)		(1,620	)

Other comprehensive loss, net		(771	)		(672	)		(2,414	)

Total comprehensive loss	$	(52,684	)	$	(163,270	)	$	(89,337	)

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)

(in thousands, except share data)


	2012					2011					2010
	Shares		Amounts			Shares		Amounts			Shares		Amounts
								(As Adjusted See Note 3)					(As Adjusted See Note 3)
Common stock
Balance at January 1		18,202,221	$	182			17,768,721	$	178			17,768,721	$	178
Issuance of restricted stock awards		—		—			433,500		4			—		—

Balance at December 31		18,202,221		182			18,202,221		182			17,768,721		178

Additional paid-in capital
Balance at January 1				166,342					165,776					164,752
Stock-based compensation				407					566					1,024

Balance at December 31				166,749					166,342					165,776

Treasury stock
Balance at January 1		2,793,863		(32,910	)		2,360,363		(32,906	)		2,353,363		(32,880	)
Acquisition of treasury stock		—		—			433,500		(4	)		7,000		(26	)

Balance at December 31		2,793,863		(32,910	)		2,793,863		(32,910	)		2,360,363		(32,906	)

Accumulated other comprehensive income (loss)
Balance at January 1				(227	)				445					2,859
Unrealized loss on available-for-sale investment securities				(771	)				(672	)				(2,414	)

Balance at December 31				(998	)				(227	)				445

Retained deficit
Balance at January 1				(214,364	)				(51,766	)				35,157
Net loss				(51,913	)				(162,598	)				(86,923	)

Balance at December 31				(266,277	)				(214,364	)				(51,766	)

Total stockholders’ equity (deficit)			$	(133,254	)			$	(80,977	)			$	81,727

See accompanying Notes to Consolidated Financial Statements.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)


	Year Ended December 31,
	2012			2011			2010
				(As Adjusted See Note 3)			(As Adjusted See Note 3)
Cash flows from operating activities
Net loss	$	(51,913	)	$	(162,598	)	$	(86,923	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		10,842			9,674			9,622
Stock-based compensation expense		390			446			1,150
Amortization of debt modification costs		435			409			448
Amortization of debt discount		4,126			4,468			6,118
Net realized gains from sales of available-for-sale securities		(888	)		(79	)		(1,620	)
Realized gain on trading securities		—			—			(9,024	)
Fair value loss on settlement rights for auction-rate securities		—			—			8,830
Fair value gain on investment in hedge fund		(492	)		(334	)		(64	)
(Gain)/loss on disposal of assets		(34	)		(28	)		12
Amortization of premiums on investments, net		1,515			2,818			3,507
Provision for doubtful accounts		451			734			484
Loss on interest rate swaps		—			2			961
Proceeds from insurance recoveries		—			(212	)		—
Paid-in-kind interest		1,543			1,003			—
Goodwill and other intangible assets impairment		23,692			141,812			—
Deferred tax asset valuation allowance		12,708			19,703			33,064

Change in operating assets and liabilities:
Fiduciary and restricted cash		1,909			1,388			11,138
Premiums, fees and commissions receivable, net		(7,833	)		19,866			19,257
Reserves for losses and loss adjustment expenses		(44,982	)		(68,248	)		58,437
Amounts due from reinsurers		3,500			6,963			(62,963	)
Premium finance receivable, net (related to our insurance premiums)		(2,251	)		9,217			(6,211	)
Deferred revenue		1,301			(3,078	)		(2,296	)
Unearned premium		14,619			(33,960	)		(17,159	)
Deferred acquisition costs, net		(6,562	)		6,925			10,480
Deferred taxes		(12,458	)		(28,870	)		(31,789	)
Income taxes receivable		589			1,064			1,523
Other		961			(7,834	)		757

Net cash used in operating activities		(48,832	)		(78,749	)		(52,261	)

Cash flows from investing activities
Proceeds from sales of available-for-sale securities		37,447			70,247			123,609
Proceeds from maturities of available-for-sale securities		37,871			34,759			58,661
Proceeds from sales of trading securities		—			—			46,440
Purchases of available-for-sale securities		(9,392	)		(21,076	)		(183,178	)
Purchases of other invested assets		—			—			(2,500	)
Premium finance receivable, net (related to third-party insurance premiums)		1,391			(4,156	)		3,893
Purchases of property and equipment		(1,443	)		(2,703	)		(6,576	)
Proceeds from insurance recoveries		30			—			—
Investment in real property, net		—			(591	)		(6,278	)

Net cash provided by investing activities		65,904			76,480			34,071

Cash flows from financing activities
Proceeds from financing under capital lease obligations		—			—			28,189
Borrowings under senior secured credit facility		5,500			—			—
Principal payments under capital lease obligations		(4,937	)		(5,001	)		(2,887	)
Principal payments on senior secured credit facility		(3,530	)		(9,762	)		(21,650	)
Debt modification costs paid		—			(769	)		—
Bank overdrafts		(4,488	)		—			—
Acquisition of treasury stock		—			(4	)		(26	)

Net cash provided by (used in) financing activities		(7,455	)		(15,536	)		3,626

Net increase (decrease) in cash and cash equivalents		9,617			(17,805	)		(14,564	)
Cash and cash equivalents at beginning of year		28,559			46,364			60,928

Cash and cash equivalents at end of year	$	38,176		$	28,559		$	46,364

Supplemental disclosure of cash flow information:
Cash paid for interest	$	10,941		$	14,116		$	15,110
Cash paid for income taxes		336			371			365
Disclosure of non-cash information:
Capital lease obligation settled by transfer of securities (see Note 13)	$	7,851		$	—		$	—

See accompanying Notes to Consolidated Financial Statements

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 5,400 independent agents or brokers in 8 states (Louisiana, Texas, Illinois, Alabama, California, Missouri, Indiana and South Carolina).

2. Going Concern

The accompanying consolidated financial statements have been prepared assuming the Company will continue as a going concern. This assumes continuing operations and the realization of assets and liabilities in the normal course of business.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

hazardous financial condition and could take one or more of the remedial actions authorized by law for such a condition. Such action by the Illinois Department of Insurance would have a material adverse affect on the Company’s operations and the interests of its creditors and stockholders. Such action by the Illinois Department of Insurance also would trigger a further event of default under the Company’s senior secured credit facility allowing the Company’s lenders to declare all amounts outstanding under the facility to be immediately due and payable, and if such amounts were declared immediately due and payable by the lenders it would have a material adverse effect on the Company’s operations and the interests of its creditors and stockholders.

3. Summary of Significant Accounting Policies

Basis of Presentation • The consolidated financial statements include the accounts of Affirmative Insurance Holdings, Inc. and its subsidiaries (together the Company), and have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). All material intercompany transactions and balances have been eliminated in consolidation.

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

Use of Estimates • The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ 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 investments, goodwill and other intangible assets, and deferred income taxes.

Cash and Cash Equivalents • Cash and cash equivalents are highly liquid investments with an original maturity of ninety days or less and include principally money market funds, repurchase agreements, and other bank deposits. Unless the right-of-setoff requirements have been met, bank overdrafts or negative book cash balances, if material, are recorded in other liabilities in the consolidated balance sheet. As of December 31, 2012, $4.5 million negative book cash balance was reflected in other liabilities in the consolidated balance sheet.

Fiduciary and Restricted Cash • Fiduciary and restricted cash consists of non-operating FDIC-insured certificates of deposit required by state regulations and/or under various agreements with third parties.

Investments • Investment securities consist of debt securities, and are recorded at fair value on the consolidated balance sheet. These investments are classified as available-for-sale, based on management’s intent and ability to hold to maturity. Unrealized gains and losses are recorded in accumulated other comprehensive

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

income (loss), a separate component of stockholders’ equity (deficit). No income tax effect of unrealized gains and losses is reflected in other comprehensive income (loss) due to the Company carrying a full deferred tax valuation allowance. The Investment Committee periodically reviews investment portfolio results and evaluates strategies to maximize yields, to match maturity durations with anticipated needs, and to maintain compliance with investment guidelines.

Fair value is based on quoted prices in active markets or third-party valuation sources when observable market prices are not available. Gains and losses realized on the disposition of investment securities are determined on the specific-identification basis and credited or charged to income. Premium and discount on investment securities are amortized and accreted using the interest method and charged or credited to investment income.

Other invested assets is comprised of an investment in a hedge fund, which primarily invests in mortgage-backed securities with the strategy of seeking attractive yields on commercial and residential mortgage-backed securities. The Company elected the fair value option for its investment in the hedge fund and measures the fair value of this investment using the net asset value of the fund as reported by the fund manager. The financial statements of the hedge fund are subject to annual audits evaluating the net asset positions of the underlying investments. The fair value is included in the Level 3 fair value hierarchy. The Company records changes in the value of its other invested assets as a component of net investment income.

Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. On a quarterly basis, the Company considers available quantitative and qualitative evidence in evaluating potential impairment of its investments. If the cost of an investment exceeds its fair value, the Company evaluates, among other factors, general market conditions, the duration and extent to which the fair value is less than cost. If the fair value of a debt security is less than its amortized cost basis, an other-than-temporary impairment may be triggered in circumstances where (1) an entity has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss). The Company also considers potential adverse conditions related to the financial health of the issuer based on rating agency actions.

Premium Finance Receivable • The Company recognizes interest and origination fees from finance receivables over the term of the finance contract. Late fee revenue is recognized when received. Premium finance receivables are secured by the underlying unearned policy 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. An insignificant amount of finance receivables are past due in excess of thirty days.

Amounts Due from/to Reinsurers • The Company collects premiums from insureds and after deducting its authorized commissions, the Company remits these premiums to the appropriate reinsurance companies. The Company’s obligation to remit these premiums is recorded as amounts due reinsurers in its consolidated balance sheet. The Company records the amounts it expects to receive from reinsurers for paid and unpaid losses as an asset on its consolidated balance sheet.

Deferred Policy Acquisition Costs, net of ceding commission • Deferred policy acquisition costs represent the deferral of expenses that the Company incurs in the successful acquisition of new business or renew existing

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

insurance policies. Policy acquisition costs, consisting of primarily commissions and premium taxes, net of ceding commission income, are deferred and charged against income ratably over the terms of the related policies. The Company regularly reviews the categories of acquisition costs that are deferred and assesses the recoverability of this asset. A premium deficiency, and a corresponding charge to income, is recognized if the sum of the expected losses and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and anticipated investment income. Amounts received as ceding commissions on reinsurance contracts are recorded as reductions of deferred acquisition costs and are recognized into income ratably as the related ceded premium is earned. Amortization of deferred policy acquisition costs is recorded in selling, general and administrative expenses in the consolidated statement of operations.

Property and Equipment, Net • Property and equipment is stated at cost, less accumulated depreciation. Depreciation is recognized using the straight-line method over the estimated useful lives of the Company’s assets, typically ranging from three to eight years. Leasehold improvements are depreciated over the shorter of the estimated useful lives of the assets or the remainder of the lease term.

Goodwill and Other Intangible Assets, Net • Goodwill and other intangible assets with indefinite useful lives are tested for impairment annually as of September 30 or more frequently if events or changes in circumstances indicate that the assets might be impaired.

Management evaluates goodwill for impairment by comparing the fair value of the Company as a whole to its carrying value as of the measurement date. To determine the fair values, management used the market approach based on comparable publicly traded companies in similar lines of business and the income approach based on estimated discounted future cash flows. Cash flow assumptions consider historical financial performance; recent financial performance; the Company’s financial forecast, and other relevant factors.

Identifiable intangible assets consist of brand names and state insurance company licenses. The Company reviews such intangibles for impairment whenever an impairment indicator exists. Management continually monitors events and changes in circumstances that could indicate carrying amounts of long-lived assets, including intangible assets, may not be recoverable. When such events or changes in circumstances occur, management assesses recoverability by determining whether the carrying value of such assets will be recovered through the undiscounted expected future cash flows. If the future undiscounted cash flows are less than the carrying amount of these assets, an impairment loss is recognized based on the excess of the carrying amount over the fair value of the assets.

Variable Interest Entities • Affirmative Insurance Holdings Statutory Trust I (“Trust I”), is an unconsolidated trust subsidiary, for the sole purpose of issuing $30.0 million trust preferred securities in 2004. Trust I used the proceeds from the sale of these securities and the Company’s initial capital contribution to purchase $30.9 million of subordinated debt securities from the Company. The debt securities are the sole assets of Trust I, and the payments under the debt securities are the sole revenues of Trust I. The Company’s initial capital contribution consisted of the purchase of 928,000 common securities issued by Trust I for $928 thousand, which represented 3% of the total dollar amount of subordinated debentures issued.

Affirmative Insurance Holdings Statutory Trust II (“Trust II”), is an unconsolidated trust subsidiary, for the sole purpose of issuing $25.0 million trust preferred securities in 2005. Trust II used the proceeds from the sale of these securities and the Company’s initial capital contribution to purchase $25.8 million of subordinated debt securities from the Company. The debt securities are the sole assets of Trust II, and the payments under the debt securities are the sole revenues of Trust II. The Company’s initial capital contribution consisted of the purchase of 774,000 common securities issued by Trust II for $774 thousand, which represented 3% of the total dollar amount of subordinated debentures issued.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The investment in the common securities totaling $1.7 million is reflected in other assets in the Company’s consolidated balance sheets. The subordinated debentures totaling $56.7 million are included in notes payable in the Company’s consolidated balance sheets.

Management evaluates on an ongoing basis the Company’s investments in Trust I and II (collectively the “Trusts”) and continue to conclude that, while the Trusts continue to be variable interest entities (“VIE’s”), the Company is not the primary beneficiary. Therefore, the Trusts are not included in the Company’s consolidated financial statements.

Reserves for Losses and Loss Adjustment Expenses • The Company maintains reserves for the estimated ultimate liability for unpaid losses and loss adjustment expenses related to incurred claims and estimates of unreported claims. The estimation of the ultimate liability for unpaid losses and loss adjustment expenses is based on projections developed by the Company’s actuaries using analytical methodologies commonly used in the property-casualty insurance industry. Liabilities for unpaid claims and for expenses of investigation and adjustment of unpaid claims are based on: (1) the accumulation of estimates of individual claims for losses reported prior to the close of the accounting period; (2) estimates received from ceding companies, reinsurers and insurance pools and associations; (3) estimates of unreported losses based on past experience; (4) estimates based on past experience of expenses for investigating and adjusting claims; and (5) estimates of subrogation and salvage collections. Management periodically adjusts the losses and loss adjustment expense reserves for changes in product mix, underwriting standards, loss cost trends and other factors. Losses and loss adjustment expense reserves may also be impacted by factors such as the rate of inflation, claims settlement patterns, litigation and legislative and regulatory activities. Unpaid losses and loss adjustment expenses have not been reduced for amounts recoverable from reinsurers. Changes in estimates of liabilities for unpaid losses and loss adjustment expenses are reflected in the consolidated statement of operations in the period in which determined. Ultimately, the actual losses and loss adjustment expenses may differ materially from recorded estimates.

Treasury Stock • Treasury stock purchases are accounted for using the cost method, whereby the entire cost of the acquired stock is recorded as treasury stock. When reissued, shares of treasury stock will be removed from the treasury stock account at the average purchase price per share of the aggregate treasury shares held.

Revenue Recognition • Premium income — Premiums, net of premiums ceded, is earned over the life of the underlying policies. Unearned premiums represent that portion of premiums written that are applicable to the unexpired terms of policies in force. Premiums receivable are recorded net of an estimated allowance for uncollectible amounts.

Commission income — Commission income and related policy fees, written for third-party insurance companies, are recognized, net of an allowance for estimated policy cancellations, at the date the customer is initially billed or as of the effective date of the insurance policy, whichever is later. Commissions on premium endorsements are recognized when premiums are processed. The allowance for estimated third-party cancellations is periodically evaluated and adjusted as necessary.

Profit-sharing commissions, which enable the Company to collect commission income and fees in excess of provisional commissions, are recorded when it is probable that estimates of loss ratios will be below the levels stated in the Company’s agency contracts. Provisional commissions may be reduced when it is probable that estimates of loss ratios will be above the levels stated in the related agency contract.

Fee Income — Policy origination fees, agency fees and installment fees compensate the Company for the costs of providing installment payment plans, as well as late payment, policy cancellation, policy rewrite and

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

reinstatement fees. Policy origination fees are recognized over the underlying policy terms. Other fees are recognized when services are provided. Premium finance and origination fees are recognized over the term of the finance contracts.

Accounting and Reporting for Reinsurance • Income and expense on reinsurance contracts are recognized principally over the term of the reinsurance contracts or until the reinsurers maximum liability is exhausted, whichever comes first. Reinsurance contracts do not relieve the Company from its obligations to policyholders. The Company continually monitors reinsurers to minimize the exposure to significant losses from reinsurer insolvencies. The Company only cedes risks to reinsurers whom it believes to be financially sound.

Stock-Based Compensation • Compensation cost is measured based on the grant-date fair value of an award utilizing the assumptions discussed in Note 18. Compensation cost is recognized for financial reporting purposes on a straight-line basis over the period in which the employee is required to provide service in exchange for the award.

Income Taxes • The Company accounts for income taxes under the asset and liability method. Under this method, deferred income taxes are recognized for temporary differences between the financial statement and tax return bases of assets and liabilities. Recorded amounts are adjusted to reflect changes in income tax rates for the period in which the change is enacted. Any resulting future tax benefits are recognized to the extent that realization of such benefits is more likely than not, and a valuation allowance is established for any portion of a deferred tax asset that management believes will not be realized. While the Company typically does not incur significant interest or penalties on income tax liabilities, the Company’s policy is to classify such amounts as income tax expense on the consolidated statement of operations.

Net Income (Loss) Per Common Share • Basic net income (loss) per common share is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the year. Diluted net income (loss) per share is computed by giving effect to the potential dilution that could occur if securities or other contracts to issue common shares were exercised and converted into common shares during the year.

Fair Value of Financial Instruments • The Company determines fair value for all financial assets and liabilities and non-financial assets and liabilities that are recognized or disclosed at fair value in the financial statements on a recurring basis. The Company defines fair value as the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. When determining fair value, the Company considers the principal or most advantageous market in which the Company would transact and the market-based risk measurements or assumptions that market participants would use in pricing the asset or liability, such as inherent risk, transfer restrictions and credit risk.

Segment Reporting • The Company’s operations consist of designing, selling, underwriting and servicing non-standard personal automobile insurance policies. The Company is a holding company, with no operating revenues and only interest expense on corporate debt. The Company’s subsidiaries consist of several types of legal entities: insurance companies, underwriting agencies, retail agencies, premium finance companies and a service company from which all employees are paid. Insurance subsidiaries possess the certificates of authority and capital necessary to transact insurance business and issue policies, but they rely on both affiliated and unaffiliated underwriting agencies to design, distribute and service those policies. Underwriting agencies primarily design, distribute and service policies issued or reinsured by the Company’s insurance subsidiaries and that are distributed by the Company’s retail entities and by independent agents. Given the homogeneity of the Company’s products, the regulatory environments in which the Company operates, the nature of the Company’s customers and distribution channels, Company management monitors, controls and manages the business as an integrated entity offering non-standard personal automobile insurance products through multiple distribution channels.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Statutory Accounting Practices • The Company’s insurance subsidiaries are required to report results of operations and financial position to insurance regulatory authorities based upon statutory accounting principles (SAP). The more significant differences between SAP and GAAP are as follows:

•

Under SAP, all sales and other policy acquisition costs are expensed as they are incurred rather than capitalized and amortized over the expected life of the policy as required by GAAP. The immediate charge off of sales and acquisition expenses and other conservative valuations under SAP generally cause a lag between the sale of a policy and the emergence of reported earnings. Since this lag can reduce income from operations on a SAP basis, it can have the effect of reducing the amount of funds available for dividends from insurance companies.

•

Under SAP, certain assets, including deferred taxes, are designated as “non-admitted” and are charged directly to unassigned surplus, whereas under GAAP, such assets are included in the consolidated balance sheet net of an appropriate valuation allowance.

•

SAP requires available-for-sale investments generally be carried at amortized book value while GAAP requires available-for-sale investments be carried at fair value.

Recently Adopted Accounting Standards • In October 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-26, Financial Services-Insurance (Topic 944): Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts. ASU 2010-26 modified the definitions of the type of costs that can be capitalized in the successful acquisition of new and renewal insurance contracts. ASU 2010-26 requires incremental direct costs of successful contract acquisition as well as certain costs related to underwriting, policy issuance and processing, medical and inspection and sales force contract selling for successful contract acquisition to be capitalized. These incremental direct costs and other costs are those that are essential to the contract transaction and would not have been incurred had the contract transaction not occurred. The Company retrospectively adopted ASU 2010-26 on January 1, 2012. The cumulative effect of the adoption was a decrease of shareholders’ equity by $11.3 million, net of tax, as of January 1, 2011.

The following table illustrates the effect of adopting ASU 2010-26 in the consolidated balance sheets (in thousands):


	December 31, 2011
	Previously Reported			As Adjusted
Deferred acquisition costs, net	$	3,206		$	(6,464	)
Stockholders’ deficit		(71,307	)		(80,977	)

The following table illustrates the effect of adopting ASU 2010-26 in the consolidated statements of operations (in thousands, except per share amounts):


	Year Ended December 31, 2011						Year Ended December 31, 2010
	Previously Reported			As Adjusted			Previously Reported			As Adjusted
Selling, general and administrative expenses	$	112,327		$	110,716		$	166,916		$	164,908
Net loss		(164,209	)		(162,598	)		(88,931	)		(86,923	)
Net loss per share:
Basic		(10.66	)		(10.55	)		(5.77	)		(5.64	)
Diluted		(10.66	)		(10.55	)		(5.77	)		(5.64	)

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

ASU 2011-08, Intangibles-Goodwill and Other (Topic 350): Testing Goodwill for Impairment, permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the two-step goodwill impairment test. Additionally, if the carrying amount of a reporting unit is zero or negative, the second step of the impairment test shall be performed to measure the amount of the impairment loss, if any, when it is more likely than not that a goodwill impairment exists. In considering whether it is more likely than not that a goodwill impairment exists, a qualitative assessment will be performed. If an entity concludes it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it need not perform the two-step impairment test. This standard is effective for interim and annual goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The adoption of this standard did not have an impact on the Company’s consolidated financial position, results of operations or cash flows.

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

ASU 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, 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 requires 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, cash and cash equivalents, and fiduciary and restricted cash. 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. The adoption of this standard did not impact the Company’s consolidated financial position, results of operations or cash flows.

Recently Issued Accounting Standards

In July 2012, the FASB issued ASU 2012-02, Intangibles—Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment. This ASU gives entities testing indefinite-lived intangible assets for impairment the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, the entity is not required to take further action. However, if an entity concludes otherwise, a quantitative impairment test is required. This guidance is effective for annual and interim impairment tests beginning January 1, 2013, with early adoption permitted. Management does not believe the adoption of this standard will have a material effect on the Company’s consolidated financial position, results of operations or cash flows.

4. Available-for-sale Investment Securities

The Company’s available-for-sale investment securities are carried at fair value with unrealized gains and losses reported in accumulated other comprehensive income (loss), a separate component of stockholders’ equity

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(deficit). No income tax effect of unrealized gains and losses is reflected in other comprehensive income (loss) due to the Company carrying a full deferred tax valuation allowance. Gains and losses realized on the disposition of investment securities are determined on the specific-identification basis and credited or charged to income at the time of disposal.

The amortized cost, gross unrealized gains (losses), and estimated fair value of the Company’s available-for-sale securities at December 31, 2012 and 2011, were as follows (in thousands):


	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Estimated Fair Value
December 31, 2012
U.S. Treasury and government agencies	$	11,354	$	112	$	—		$	11,466
States and political subdivisions		3,535		107		(3	)		3,639
Corporate debt securities		19,108		262		(1	)		19,369
FDIC-insured certificates of deposit		13,210		65		(1	)		13,274

Total	$	47,207	$	546	$	(5	)	$	47,748

December 31, 2011
U.S. Treasury and government agencies	$	11,804	$	172	$	(1	)	$	11,975
Mortgage-backed securities		10,803		283		(135	)		10,951
States and political subdivisions		16,841		338		(1	)		17,178
Corporate debt securities		61,031		764		(158	)		61,637
FDIC-insured certificates of deposit		21,131		53		(3	)		21,181

Total	$	121,610	$	1,610	$	(298	)	$	122,922

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 December 31, 2012 by contractual maturity were as follows (in thousands):


	Amortized Cost		Estimated Fair Value
Due in one year or less	$	28,686	$	28,784
Due after one year through five years		18,142		18,553
Due after five years through ten years		379		411

Total	$	47,207	$	47,748

Major categories of net investment income for the years ended December 31 were as follows (in thousands):


	2012			2011			2010
Available-for-sale investment securities	$	1,520		$	3,818		$	5,133
Trading securities		—			—			177
Rental income from investment in real property		2,410			2,388			462
Income from investment in hedge fund		492			334			64
Cash and cash equivalents		3			—			23

		4,425			6,540			5,859
Less investment expense		(1,320	)		(1,548	)		(933	)

Net investment income	$	3,105		$	4,992		$	4,926

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Gross realized gains and losses on available-for-sale investments for the years ended December 31 were as follows (in thousands):


	2012			2011			2010
Gross gains	$	1,025		$	267		$	1,692
Gross losses		(137	)		(188	)		(72	)

Total	$	888		$	79		$	1,620

The following table summarizes the Company’s available-for-sale securities in an unrealized loss position at December 31, 2012 and 2011, the estimated 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):


	December 31, 2012
	Less Than Twelve Months					Twelve Months or Greater					Total
	Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses
States and political subdivisions	$	—	$	—		$	71	$	(3	)	$	71	$	(3	)
Corporate debt securities		979		(1	)		—		—			979		(1	)
FDIC-insured certificates of deposit		499		(1	)		—		—			499		(1	)

Total	$	1,478	$	(2	)	$	71	$	(3	)	$	1,549	$	(5	)


	December 31, 2011
	Less Than Twelve Months					Twelve Months or Greater					Total
	Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses			Estimated Fair Value		Gross Unrealized Losses
U.S. Treasury and government agencies	$	505	$	(1	)	$	—	$	—		$	505	$	(1	)
Mortgage-backed securities		2,688		(36	)		3,312		(99	)		6,000		(135	)
States and political subdivisions		—		—			74		(1	)		74		(1	)
Corporate debt securities		13,982		(137	)		1,344		(21	)		15,326		(158	)
FDIC-insured certificates of deposit		958		(1	)		348		(2	)		1,306		(3	)

Total	$	18,133	$	(175	)	$	5,078	$	(123	)	$	23,211	$	(298	)

The Company’s portfolio contained approximately 16 and 34 individual investment securities that were in an unrealized loss position as of December 31, 2012 and 2011, respectively.

The unrealized losses at December 31, 2012 were primarily 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. Investments are considered to be impaired when a decline in fair value is judged to be other-than-temporary. On a quarterly basis, the Company considers available quantitative and qualitative evidence in evaluating potential impairment of its investments. If the cost of an investment exceeds its fair value, the Company evaluates, among other factors, general market conditions, duration and extent to which the fair value is less than cost. If the fair value of a debt security is less than its amortized cost basis, an other-than-temporary impairment may be triggered in circumstances where (1) an entity

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

has an intent to sell the security, (2) it is more likely than not that the entity will be required to sell the security before recovery of its amortized cost basis, or (3) the entity does not expect to recover the entire amortized cost basis of the security (that is, a credit loss exists). Other-than-temporary impairments are separated into amounts representing credit losses which are recognized in earnings and amounts related to all other factors which are recognized in other comprehensive income (loss). The Company also considers potential adverse conditions related to the financial health of the issuer based on rating agency actions. As a result of management’s quarterly analyses for the years ended December 31, 2012 and 2011, no individual securities were other-than-temporarily impaired in either year.

At December 31, 2012 and 2011, investments in fixed-maturity securities with an approximate carrying value of $7.1 million and $10.2 million, respectively, were on deposit with regulatory authorities as required by insurance regulations.

5. Reinsurance

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

In 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 totaled $60.8 million through December 31, 2012. This agreement was commuted effective November 30, 2012.

In 2011, the Company entered into an additional quota-share agreement with a third-party reinsurance company under which the Company ceded 10% of business produced in Louisiana, Alabama, Texas and Illinois from September 1, 2011 through December 31, 2011. At December 31, 2011, this contract converted to a 40% quota-share reinsurance contract on the in-force business for the applicable states throughout 2012. Written premiums ceded under this agreement totaled $82.0 million during the year ended December 31, 2012. Written premiums ceded under this agreement totaled $104.9 million since inception through December 31, 2012. This agreement was extended under the same terms through March 31, 2013. In March 2013, the Company entered into a new quota-share agreement with this third-party reinsurance company effective March 31, 2013, which the Company cedes 40% for the same four states as the expiring agreement and 100% of business originated through the Texas county mutual. This agreement is through December 31, 2013 but has automatic one-year renewals unless either party provides notice of intent not to renew within 75 days.

In June 2012, the Company entered into a reinsurance agreement with third-party reinsurers which provides $5.0 million in excess of the first $3.0 million of losses coverage for catastrophic events that may involve multiple insured losses.

The Company’s quota-share ceding commission rate structure varies based on loss experience for quota-share 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 one-year 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.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

In February 2012, the Company entered into a one-year excess of loss reinsurance contract with third-party reinsurers which provides coverage for individual losses in excess of $100,000 up to $1.0 million.

In August 2010, the Company entered into a one-year excess of loss reinsurance contract with third-party reinsurers which provides coverage for individual losses in excess of $100,000 up to $1 million. This contract terminated July 31, 2011 on a run-off basis.

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


	Year Ended December 31,
	2012						2011						2010
	Written			Earned			Written			Earned			Written			Earned
Direct	$	198,359		$	185,546		$	193,528		$	220,156		$	288,296		$	299,224
Reinsurance assumed		38,663			36,718			35,701			41,933			65,584			72,823
Reinsurance ceded		(66,482	)		(78,528	)		(88,065	)		(85,540	)		(71,832	)		(38,780	)

Total	$	170,540		$	143,736		$	141,164		$	176,549		$	282,048		$	333,267

Under certain of the Company’s reinsurance transactions, the Company has received ceding commissions. The ceding commission rate 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, reflected as a reduction of selling, general and administrative expenses, were as follows (in thousands):


	Year Ended December 31,
	2012			2011			2010
Selling, general and administrative expenses	$	(26,676	)	$	(24,026	)	$	(7,817	)

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):


	Year Ended December 31,
	2012		2011
Losses and loss adjustment expense reserves	$	67,166	$	78,510
Unearned premium reserve		24,628		36,674

Total	$	91,794	$	115,184


	Year Ended December 31,
	2012			2011			2010
Paid losses and loss adjustment expenses ceded	$	61,186		$	55,197		$	14,604
Change in reserves for loss and loss adjustment expenses ceded		(11,344	)		(14,574	)		60,636

Incurred losses and loss adjustment expenses ceded	$	49,842		$	40,623		$	75,240

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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 retention amount was $0.5 million. For policies effective July 1, 2009 to June 30, 2010, the retention amount was $0.5 million. For policies effective July 1, 2008 to June 30, 2009, the retention amount was $0.4 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 active 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 loss and loss adjustment expenses to the MCCA (in thousands):


	Year Ended December 31,
	2012			2011			2010
Ceded premiums written	$	—		$	528		$	3,305

Ceded loss and loss adjustment expenses	$	(158	)	$	(16,071	)	$	50,707

The Company discontinued writing new policies in Michigan in March 2011 and renewing policies in June 2011.

The table below presents the total amount of receivables due from reinsurers as of December 31, 2012 and 2011 (in thousands):


	December 31, 2012		December 31, 2011
Quota-share reinsurer for agreement effective September 1, 2011	$	53,195	$	22,102
Michigan Catastrophic Claims Association		39,652		44,049
Vesta Insurance Group		13,674		10,068
Quota-share reinsurer for agreements effective in fourth quarter of 2010 and January 2011		5,800		46,103
Excess of loss reinsurers		5,521		5,458
Other		2,759		3,667

Total reinsurance receivable	$	120,601	$	131,447

The quota-share reinsurers 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 subsidiary, Affirmative Insurance Company (AIC) had the right, under certain circumstances, to require VFIC to provide a letter of credit or establish a trust account to collateralize gross amounts due from VFIC under the reinsurance agreement. Accordingly, AIC 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 December 31, 2012, the VFIC Trust held $16.8 million (after cumulative withdrawals of $8.7 million through December 31, 2012), consisting of $14.7 million of a U.S. Treasury money market account held in cash and cash equivalents, and $2.1 million of corporate bonds rated BBB+ or higher, to collateralize the $13.7 million net recoverable from VFIC.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

In June 2006, the Texas Department of Insurance (TDI) placed VFIC, along with several of its affiliates, into rehabilitation and subsequently into liquidation (except for VIG which remains in rehabilitation). In accordance with the TDI liquidation orders, all VIG subsidiary reinsurance agreements were terminated. Prior to the termination, the Company assumed various quota-share percentages according to which managing general agents (MGAs) produced the business. With respect to business produced by certain MGAs, the Company assumed 100% of the contracts. For business produced by other MGAs, the Company’s assumption was net after VIG cession to other reinsurers. For this latter assumed business, the other reinsurers and their participation varied by MGA. Prior to the termination of the VIG subsidiary reinsurance agreements, the agreements contained no maximum loss limit other than the underlying policy limits. The ceding company’s retention was zero and these agreements could be terminated at the end of any calendar quarter by either party with prior written notice of not less than 90 days.

VIG indemnified the Company for any losses due to uncollectible reinsurance related to reinsurance agreements entered into with unaffiliated reinsurers prior to December 31, 2003. As of December 31, 2012, all such unaffiliated reinsurers had A.M. best ratings of A- or better. The Company had reinsurance recoverable from VIG of $2.5 million and $2.8 million as of December 31, 2012 and 2011, respectively.

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 general agents. 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 $27.7 million and $34.4 million as of December 31, 2012 and 2011, of which $9.9 million and $0.4 million was held in cash equivalents as of December 31, 2012 and 2011, respectively.

Assumed written premiums by ceding insurer were as follows (in thousands):


	Year Ended December 31,
	2012		2011		2010
County mutual insurance company	$	38,663	$	35,701	$	65,584

At December 31, 2012, $2.5 million was included in reserves for losses and loss adjustment expenses that represented the amounts owed by AIC under a reinsurance agreement with a VIG affiliated company. Affirmative established a trust account to secure the Company’s obligations under this reinsurance contract, which currently holds $15.7 million in a money market cash equivalent account (the AIC Trust). The Special Deputy Receiver in Texas had cumulative withdrawals from the AIC Trust of $0.4 million through December 2012, and the Special Deputy Receiver in Hawaii had cumulative withdrawals from the AIC Trust of $1.7 million through December 2012.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

6. Premium Finance Receivables, Net

Premium finance receivables (related to policies of both the Company and third-party carriers) were as follows at December 31, 2012 and 2011 (in thousands):


	2012			2011
Premium finance contracts	$	41,363		$	40,472
Unearned finance charges		(1,961	)		(1,911	)
Allowance for credit losses		(460	)		(479	)

Total	$	38,942		$	38,082

Premium finance receivables are secured by the underlying unearned policy 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. An insignificant amount of finance receivables are past due in excess of thirty days. Losses due to non-realization of premium finance receivables were $0.4 million and 0.2% of total premiums financed for 2012, $0.6 million and 0.4% of total premiums financed for 2011 and $0.7 million and 0.4% of total premiums financed for 2010.

7. Deferred Policy Acquisition Costs

Policy acquisition costs, consisting of primarily commissions and premium taxes, net of ceding commission income, 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):


	Gross			Ceded			Net
Balance at January 1, 2011, as adjusted	$	9,432		$	(8,972	)	$	460
Additions		15,903			(23,068	)		(7,165	)
Amortization		(21,667	)		21,908			241

Ending balance at December 31, 2011, as adjusted		3,668			(10,132	)		(6,464	)
Additions		20,431			(19,090	)		1,341
Amortization		(16,988	)		22,209			5,221

Ending balance at December 31, 2012	$	7,111		$	(7,013	)	$	98

Amortization of deferred policy acquisition costs was $(32.1) million for 2010. At December 31, 2010, the Company determined a premium deficiency existed and recorded a $0.5 million reduction of deferred acquisition costs.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

8. Property and Equipment, Net

Property and equipment, net, consisted of the following as of December 31, 2012 and 2011 (in thousands):


	2012			2011
Computer software	$	57,401		$	56,806
Leasehold improvements		10,366			10,757
Data processing equipment		9,513			9,300
Furniture and office equipment		5,069			5,919
Automobiles		464			552

		82,813			83,334
Accumulated depreciation		(60,242	)		(51,204	)

Property and equipment, net	$	22,571		$	32,130

The Company’s depreciation expense was $10.0 million, $9.5 million and $9.3 million for the years ended December 31, 2012, 2011 and 2010, respectively.

9. Goodwill and Other Intangible Assets

The Company completed its annual goodwill and indefinite lived intangible asset impairment analyses as of September 30, 2012. The Company reports under a single reporting segment and, as such, the goodwill analysis is measured under one reporting unit. Current trends and recent developments resulted in management concluding that it is more likely than not that a goodwill impairment existed at September 30, 2012. Specifically, operating income and cash flow was less than plan, and premium production was below forecast. Due to the Company’s negative equity position of $101.3 million as of September 30, 2012, prior to goodwill impairment, ASC 350-20-35-30 required that the Company perform step two of the goodwill impairment test.

Consistent with prior assessments, the fair value of the Company was determined using an internally developed discounted cash flow method. Management made significant assumptions and estimates about the extent and timing of future cash flows, growth rates, and discount rates that represent unobservable inputs into the valuation methodologies used to calculate fair value. A discount rate of 19% was used at September 30, 2012, which the Company believes adequately reflected an appropriate risk-adjusted discount rate based on its overall cost of capital and company-specific risk factors related to cash flow, debt covenants compliance, and regulatory risk, as discussed in Note 2. The cash flows were estimated over a significant future period of time, which made those estimates and assumptions subject to a high degree of uncertainty. Based upon the results of the assessment, the Company concluded that the carrying value of goodwill was fully impaired as of September 30, 2012. In step two of the goodwill impairment analysis, the Company determined the fair values of the Company’s assets and liabilities (including any unrecognized intangible assets) as if the Company had been acquired in a business combination. Determining the implied fair value of goodwill was judgmental in nature and involved the use of significant estimates and assumptions. The resulting implied fair value of goodwill was compared to the carrying value of goodwill, resulting in the write-off of the remaining goodwill balance of $23.4 million.

The Company completed its annual goodwill and indefinite lived intangible asset impairment analysis as of September 30, 2011. Based upon the results of the assessment, the Company concluded that the carrying values of goodwill and other intangible assets were not impaired as of September 30, 2011. Due to prior period adverse loss development on the Company’s Michigan business recorded in the fourth quarter of 2011 and recent negative premium production trends, the Company revised its five-year forecast and updated its discounted cash

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

flow model to assess the recoverability of recorded goodwill at December 31, 2011. A discount rate of 14.5% was used at December 31, 2011, which the Company believed was an appropriate risk-adjusted discount rate based on the Company’s overall cost of capital. Based on this updated analysis, the Company concluded that the carrying amount of goodwill was not recoverable. In step two of the goodwill impairment analysis, the Company determined the fair values of the Company’s assets and liabilities (including any unrecognized intangible assets) as if the Company had been acquired in a business combination. The resulting implied fair value was compared to the carrying value of goodwill with the excess carrying value resulting in an impairment. The step two analysis resulted in the recognition of a non-cash, pretax goodwill impairment charge of $140.1 million.

The fair value of goodwill presented below is not necessarily indicative of the amounts the Company might realize in actual market transactions. The carrying amount and fair value for goodwill is summarized as follows (in thousands):


	Carrying Value		Fair Value						Total Recognized Impairment Loss
Goodwill as of and for the Year Ended December 31,	Carrying Value		Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Total Recognized Impairment Loss
2012	$	—	$	—	$	—	$	—	$	23,448
2011		23,448		—		—		23,448		140,122

Intangible assets with definite lives consisted of agency relationships acquired through various business combinations or asset acquisitions. Significant declines in the fourth quarter of 2011 in premiums written in the markets corresponding to the recorded agency relationship compared with prior periods and forecast, as well as customer attrition rates indicated that the carrying amounts of definite-lived intangible assets were not recoverable, resulting in a non-cash impairment charge of $1.7 million.

Changes in the carrying value of goodwill for the year ended December 31, 2012 and 2011 were as follows (in thousands):


	Year Ended December 31,
	2012			2011
Beginning balance	$	23,448		$	163,570
Goodwill impairment		(23,448	)		(140,122	)

Ending balance	$	—		$	23,448

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Other intangible assets at December 31, 2012 and 2011 were as follows (in thousands):


	2012										2011
	Cost		Impairment			Accumulated Amortization			Net		Cost		Impairment			Accumulated Amortization			Net
Amortizable intangible assets:
Agency and customer relationships	$	8,054	$	(1,689	)	$	(6,365	)	$	—	$	8,054	$	(1,689	)	$	(6,365	)	$	—
Non-amortizable intangible assets:
Trade names and licenses		15,909		(244	)		(1,400	)		14,265		15,909		—			(1,300	)		14,609

Total	$	23,963	$	(1,933	)	$	(7,765	)	$	14,265	$	23,963	$	(1,689	)	$	(7,665	)	$	14,609


Amortization expense for the years ended December 31 (in thousands):
2012	$	100
2011		170
2010		284

10. Reserve for Losses and Loss Adjustment Expenses

The following table provides a reconciliation of the beginning and ending reserves for unpaid losses and loss adjustment expenses for the periods indicated (in thousands):


	Year Ended December 31,
	2012		2011		2010
Gross balance at beginning of year	$	183,836	$	252,084	$	193,647
Less: Reinsurance recoverable		78,510		93,084		32,447
Less: Deposits		—		213		245

Net balance at beginning of year		105,326		158,787		160,955
Incurred related to:
Current year		106,379		132,557		284,623
Prior years		5,479		5,100		28,046
Paid related to:
Current year		66,916		87,117		183,364
Prior years		78,580		104,001		131,473

Net balance at the end of year		71,688		105,326		158,787
Reinsurance recoverable		67,166		78,510		93,084
Deposits		—		—		213

Gross balance at the end of year	$	138,854	$	183,836	$	252,084

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

for the 2011 accident year. Management believes this decrease reflects the pricing, claims and underwriting actions that commenced in the second half of 2010 through 2011. Also reflected in the above numbers is the effect of catastrophes. In the current accident year we have incurred catastrophes, net of reinsurance, equal to 2.0 points for 2012 compared to 1.5 points in 2011. The adverse prior period development recognized in 2012 was primarily due to an increase in the estimated severity for Louisiana bodily injury claims in 2011.

Management believes the decrease in the 2012 accident year resulted from the confluence of a number of initiatives. During 2012, we realized the full benefit of our new multi-variate pricing model in our four largest states, implemented pricing and underwriting changes and our continuing improvements in our claims process. Management believes the combination of these improvements has allowed us to start growing in the fourth quarter while keeping our losses at levels lower than 2011.

In 2011, the percentage of calendar year losses and loss adjustment expense to net premiums earned (the loss ratio) was 78.0% compared with 93.8% in 2010. The accident year loss ratio for 2011 decreased 13.7 points compared with the current 2010 accident year loss ratio of 88.8% based on estimates as of December 31, 2011. The decline in the loss ratio for 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 $10.1 million of adverse prior period development related to our Michigan business and $5.0 million of favorable prior period development in 2011 due to Vesta-related reserves, compared with 2010’s adverse loss development of $28.0 million primarily related to our 2009 Texas and Michigan business. The accident year decline was even more significant when the impact of the quota-share treaties that were entered into for the fourth quarter of 2010 and for all of 2011 are taken into account. As such, the quota-share treaties’ impact on the calendar year loss ratio was to increase it by 3.1 points for 2011 and 1.7 points for 2010. We ceased writing new business in Michigan in March 2011 and renewal business in June 2011.

In 2010, the increase in the accident year loss ratio was due to increased losses on the Texas and Michigan businesses as well as significantly increased severity, which was primarily due to the claims transformation project that began in the third quarter of 2009. Significant pricing and underwriting actions were taken to address Texas and Michigan profitability in 2010 and in 2011. Also, additional controls were instituted in the handling of claims intended to mitigate the significant increases in severity that occurred.

11. Notes Payable

The Company’s long-term debt instruments and balances outstanding at December 31, 2012 and 2011 were as follows (in thousands):


	2012		2011
Notes payable due 2035	$	30,928	$	30,928
Notes payable due 2035		25,774		25,774
Notes payable due 2035		20,140		20,155

Total notes payable	$	76,842	$	76,857

The $30.9 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes adjust quarterly to the three-month LIBOR rate plus 3.60%. The interest rate as of December 31, 2012 was 3.91%.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The $25.8 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes adjust quarterly to the three-month LIBOR rate plus 3.55%. The interest rate as of December 31, 2012 was 3.86%.

On February 28, 2012, the Company exercised its right to defer interest payments on the two Notes Payable mentioned above beginning with the scheduled interest payment due in March 2012 and continuing for a period of up to five years. The affected notes are associated with obligations to the Company’s unconsolidated trusts. The outstanding balance of the affected notes was $56.7 million as of December 31, 2012. The Company will continue to accrue interest on the principal during the interest deferral period and the unpaid deferred interest will also accrue interest. Deferred interest will be due and payable at the expiration of the interest deferral period and totaled $2.3 million as of December 31, 2012.

The $20.1 million notes payable due 2035 are redeemable in whole or in part by the Company. The notes adjust quarterly to the three-month LIBOR rate plus 3.95%. The interest rate as of December 31, 2012 was 4.26%.

12. Senior Secured Credit Facility

In conjunction with the 2007 acquisition of USAgencies, the Company entered into a $220.0 million senior secured credit facility (the facility) with a syndicate of lenders that consisted of a $200.0 million senior term loan facility, and a revolving facility of up to $20.0 million, depending on the Company’s borrowing capacity.

The pricing under the senior secured credit facility is currently subject to a LIBOR floor of 3.00% plus 6.25%, and is tiered based on the Company’s leverage ratio. The interest rate as of December 31, 2012 was 11.25%. As of December 31, 2012 and 2011, the principal balance of the senior secured credit facility was $105.6 million and $99.6 million, respectively. The facility expires in January 2014.

The facility provides that on any interest payment date, the Company has the option to capitalize some of the interest payable and therefore increase the outstanding principal balance of the credit facility. The amount of interest eligible to be capitalized with each payment represents the excess interest above a minimum cash amount. During 2012 and 2011, the Company elected this option at certain interest payment dates and capitalized interest totaling $1.5 million and $1.0 million, respectively, which has been accrued as an increase to the principal balance of the credit facility.

The facility contains certain financial covenants, which include capital expenditure limitations, minimum interest coverage requirements, maximum leverage ratio requirements, minimum risk-based capital requirements, maximum loss ratio limitations, minimum fixed charge coverage ratios and a minimum consolidated net worth requirement, as well as other restrictive covenants. As time passes, certain of the financial covenants become increasingly more restrictive. The Company breached its leverage ratio, interest coverage and risk-based capital covenants under the senior secured credit facility as of December 31, 2012. However, the lenders for the facility have agreed to temporarily forbear from exercising their rights and remedies under the facility until the earlier of June 1, 2013, or the occurrence of a further event of default under the facility. See Note 2 regarding going concern and breach of covenants.

In November 2012, a new class of loans under the senior secured credit facility was created allowing for an incremental term loan. The incremental term loan has the following characteristics:

•

Face amount of $8.0 million with a funded amount of $5.5 million, of which the Company contributed $4.6 million to Affirmative Insurance Company.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

•

Of the total proceeds, $900 thousand was held in escrow to be used solely for paying the incremental term loan lenders’ and administrative agent’s professional fees.

•

A $60,000 principal payment is due as of March 31, 2013 and $40,000 is due each quarter end for the remainder of 2013. The remaining balance is due at maturity.

•

As of December 31, 2012, a non-cash closing fee of $550,000 was recorded in other liabilities, and subsequently added to the principal amount of the incremental term loan as of January 1, 2013.

•

The incremental term loan lenders receive an 8% prepayment premium of the principal amount if the incremental term loan is prepaid.

•

The incremental term loan lenders retained a financial advisor to assess the financial, operational and regulatory condition of the Company.

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

•

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 were pledged and this entity became 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.

•

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

•

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 March 2011 amendment.

In accordance with ASC 470-50 Debt Modifications and Extinguishments, for both the 2012 and 2011 amendments, 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 the remaining cash flows under the terms of the existing credit agreement. It was determined that the terms of both the 2012 and 2011 amendments were not substantially different and therefore should not be accounted for as a debt extinguishment. For the 2012 amendment, fees paid to other parties of approximately $0.5 million were expensed as incurred. The non-cash closing fee of $0.55 million was capitalized and recorded in other liabilities as of December 31, 2012 and added to the principal amount of the incremental term loan as of January 1, 2013. The closing fee is amortized over the term of the incremental term loan. For the 2011 amendment, lender consent fees of approximately $0.3 million were capitalized and are 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 2011.

The Company’s obligations under the facility are guaranteed by its material operating subsidiaries (other than the Company’s insurance companies) and are secured by a first lien security interest on all of the Company’s assets and the assets of its material operating subsidiaries (other than the Company’s insurance companies), including a pledge of 100% of the stock of AIC.

The following table summarizes the Company’s senior secured credit facility and incremental term loan scheduled payments (in thousands):


2013	$	1,191
2014		107,798

Total	$	108,989

The principal amount of the term loan is payable in quarterly installments, with the remaining balance due on the seventh anniversary of the closing of the facility. The Company is also required to make additional annual principal payments that are to be calculated based upon the Company’s financial performance during the preceding fiscal year after deducting voluntary prepayments made during the year. The Company does not expect to have an additional required principal payment due March 2013. In addition, certain events, such as the sale of material assets or the issuance of significant new equity, necessitate additional required principal repayments.

In 2007 and 2008, the Company entered into two interest rate swap arrangements to hedge its exposure to variable cash flows related to interest payments on its senior secured credit facility. One swap instrument expired in February 2011 and the remaining swap instrument expired in April 2011.

13. Capital Lease Obligation

In May 2010, the Company entered into two capital lease obligations 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

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

securities as collateral against all of the Company’s obligations under the lease. Securities pledged as collateral and held as available-for-sale securities were $8.3 million and $21.2 million as of December 31, 2012 and 2011, respectively. 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.

On October 17, 2012, the Company received notice from one of the lessors (Lessor) under a capital lease obligation that, based upon Lessor’s claim of an alleged default under the terms of the applicable lease and security agreements, it elected to immediately seek recovery of an amount equal to the casualty loss value of the leased property, together with all other sums allegedly due to Lessor, which Lessor calculated as $9.6 million. Lessor informed the Company that it had directed the escrow agent to redeem the CDs securing the Company’s lease payment obligation and disburse to it the approximately $8.3 million in proceeds, which Lessor received on October 15, 2012. Lessor threatened legal action against the Company to recover the remaining $1.3 million, alleged liquidated damages. The Company contests that any event of default has occurred and also disputes Lessor’s demand for payment of the casualty loss value of the leased property. The Company has demanded that Lessor pay the Company approximately $0.5 million, the amount by which the CD redemption proceeds exceeded Lessor’s remaining interest in the lease at the time it declared default. On December 26, 2012, Lessor conveyed all right and interest in the leased property back to the Company, although both parties reserved all claims with respect to the disputed demands for payment. Neither party has filed suit at this time.

Property under capital lease consisted of the following as of December 31, 2012 and 2011 (in thousands):


	December 31, 2012			December 31, 2011
Computer software, software licenses and hardware	$	14,189		$	28,189
Accumulated depreciation		(7,211	)		(8,821	)

Computer software, software licenses and hardware, net	$	6,978		$	19,368

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


2013	$	3,391
2014		3,390
2015		1,413

Total estimated future lease payments		8,194
Less: Amount representing interest		681

Present value of future lease payments	$	7,513

14. Income Taxes

The provision for income taxes for the years ended December 31 consisted of the following (in thousands):


	2012		2011			2010
Current tax expense	$	14	$	127		$	473
Deferred tax expense (benefit)		250		(9,167	)		1,275

Net income tax expense (benefit)	$	264	$	(9,040	)	$	1,748

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The Company’s effective tax rate differed from the statutory rate of 35% for the years ended December 31 as follows (in thousands):


	2012			2011			2010
Loss before income tax expense (benefit)	$	(51,649	)	$	(171,638	)	$	(85,175	)
Tax provision computed at the federal statutory income tax rate		(18,077	)		(60,073	)		(29,811	)
Increases (reductions) in tax resulting from:
Tax-exempt interest		(67	)		(139	)		(395	)
State income taxes		140			(1,517	)		(368	)
IRS audit settlement		(118	)		—			—
Goodwill impairment (non-deductible)		5,623			33,606			—
Valuation allowance		12,766			19,139			32,361
Other		(3	)		(56	)		(39	)

Income tax expense (benefit)	$	264		$	(9,040	)	$	1,748

Effective tax rate		0.5	%		5.3	%		2.1	%

Tax effects of temporary differences that give rise to significant portions of the Company’s deferred tax assets and deferred tax liabilities at December 31, 2012 and 2011 were as follows (in thousands):


	2012			2011
Deferred tax assets:
Unearned and advance premiums	$	3,347		$	1,465
Net operating loss carryforward		76,051			64,550
Discounted unpaid losses		1,407			2,150
Deferred revenue		2,141			1,686
Allowance for doubtful accounts		3,775			3,890
Goodwill		6,216			4,630
Rent deferral		1,205			2,522
Deferred acquisition costs, net asset		—			2,263
Capital loss carryforward		—			147
Depreciation on fixed assets		1,785			866
Alternative minimum tax and work opportunity credits		671			671
Other		6,835			6,362

Total deferred tax assets		103,433			91,202

Deferred tax liabilities:
Unrealized gains		190			459
Intangibles		2,268			2,018
Deferred acquisition costs, net liability		34			—
Debt extinguishment		2,206			2,775

Total deferred tax liabilities		4,698			5,252

Deferred tax assets, net, before valuation allowance		98,735			85,950
Valuation allowance		101,913			88,878

Deferred tax assets (liabilities), net	$	(3,178	)	$	(2,928	)

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The change in valuation allowance attributable to continuing operations and other comprehensive income is presented for the years ended December 31 as follows (in thousands):


	2012		2011
Continuing operations	$	12,766	$	19,139
Changes in other comprehensive income		270		235

	$	13,036	$	19,374

If actual results differ from these estimates or these estimates are adjusted in future periods, the valuation allowance may need to be adjusted, which could materially impact the Company’s financial position and results of operations. If sufficient positive evidence arises in the future indicating that all or a portion of the deferred tax assets meet the more likely than not standard, the valuation allowance would be reversed accordingly in the period that such a conclusion is reached.

As of December 31, 2012, the Company has available for income tax purposes federal net operating loss carryforwards (NOL’s), which may be used to offset future taxable income. The Company’s NOL’s expire as follows (in thousands):


2020	$	7,443
2021		5,951
2022		90
2023		4
2024		2,140
2027		15,557
2028		4,886
2029		26,569
2030		82,417
2031		39,122
2032		33,110

	$	217,289

At December 31, 2012, the Company’s 2007 and prior tax years were closed by the IRS.

15. Commitments

In 2006, the Company entered into an IT outsourcing contract with a data processing services provider under which the Company outsourced substantially all of its IT operations, including the Company’s data center, field support and application management. The initial term of the agreement was ten years, although it may be terminated for convenience by the Company at any time upon six month’s notice after the first two years, subject to the payment of certain stranded costs and other termination fees. In October 2012, the Company amended its Master Service Agreement with a third party whereby the Company assumed responsibility for managing substantially all of its IT operations, including data center and applications management at an annual cost of $6.1 million. In addition, the Company contracted with a third party to provide network infrastructure services for $1.2 million annually. The Company’s IT outsourcing expenses were $11.2 million, $13.0 million and $14.2 million for the years ended December 31, 2012, 2011 and 2010, respectively.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

As of December 31, 2012, the Company leased office space for its agencies, insurance companies and retail stores in various locations throughout the United States. The Company’s operating lease rental expenses were $8.8 million, $7.8 million and $9.1 million for the years ended December 31, 2012, 2011 and 2010, respectively.

The following table summarizes the Company’s minimum future IT outsourcing and operating lease commitments at December 31, 2012 (in thousands):


2013	$	18,084
2014		16,697
2015		13,436
2016		9,282
2017		1,002
Thereafter		1,894

Total	$	60,395

16. Legal Proceedings

The Company and its subsidiaries are named from time to time as parties in various legal actions arising in the ordinary course of the Company’s business and arising out of or related to claims made in connection with the Company’s insurance policies and claims handling. The Company believes that the resolution of these legal actions will not have a material adverse effect on the Company’s consolidated financial position or results of operations. However, the ultimate outcome of these matters is uncertain.

On May 27, 2011, PropertyOne, Inc. filed suit against USAgencies, LLC and Affirmative Insurance Holdings, Inc. in the 19^th 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. The parties are now engaged in discovery. The Company believes that these claims lack merit and intends to defend itself vigorously. No estimate of the range of potential loss can be made at this time.

17. 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 2,407,000, 1,748,000 and 1,235,900 for the years ended December 31, 2012, 2011 and 2010, respectively, were not included in the computation of diluted earnings per share because there was a loss from continuing operations in the respective periods.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table sets forth the reconciliation of numerators and denominators for the basic and diluted earnings per share computation for each of the years ended December 31, 2012, 2011 and 2010 (in thousands, except per share amounts):


	2012			2011			2010
Numerator:
Net loss	$	(51,913	)	$	(162,598	)	$	(86,923	)

Denominator:
Weighted average basic shares
Weighted average common shares outstanding		15,408			15,408			15,414

Weighted average diluted shares
Weighted average diluted shares outstanding		15,408			15,408			15,414

Basic loss per common share	$	(3.37	)	$	(10.55	)	$	(5.64	)

Diluted loss per common share	$	(3.37	)	$	(10.55	)	$	(5.64	)

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 were assigned to New Affirmative, LLC via a written irrevocable proxy at the time the stock awards were made. On August 10, 2011, the restricted shares were repurchased at par and 1,272,500 stock options were awarded to various executives. On February 24, 2012, 750,000 stock options were awarded to various executives.

18. Stock-Based Compensation

In May 2004, the Company’s board of directors adopted and its stockholders approved the 2004 Stock Incentive Plan (2004 Plan) to enable the Company to attract, retain and motivate eligible employees, directors and consultants through equity-based compensatory awards, including stock options, stock bonus awards, restricted and unrestricted stock awards, performance stock awards, stock appreciation rights and dividend equivalent rights. The maximum number of shares of common stock reserved for issuance under the 2004 Plan, as amended, is 3,000,000, subject to adjustment to reflect certain corporate transactions or changes in the Company’s capital structure. At December 31, 2012, 410,194 shares were reserved for future grants under the 2004 Plan.

Under the 2004 Plan, the board or Compensation Committee may fix the term and vesting schedule of each stock option, but no incentive stock option will be exercisable more than ten years after the date of grant. Vested stock options generally remain exercisable for up to three months after a participant’s termination of service or up to 12 months after a participant’s death or disability. Typically, the exercise price of each incentive stock option must not be less than 100% of the fair market value of the Company’s common stock on the grant date, and the exercise price of a nonqualified stock option must not be less than 20% of the fair market value of the Company’s common stock on the grant date. In the event that an incentive stock option is granted to a 10% stockholder, the term of such stock option may not be more than five years and the exercise price may not be less than 110% of the fair market value on the grant date. The exercise price of each stock option granted under the 2004 Plan may be paid in cash or in other forms of consideration in certain circumstances, including shares of common stock, deferred payment arrangements or pursuant to cashless exercise programs. A stock option award may provide that if shares of the Company’s common stock are used to pay the exercise price, additional stock options will be granted to the participant to purchase that number of shares used to pay the exercise price. Generally, stock options are not transferable except by will or the laws of descent and distribution, unless the board or Compensation Committee provides that a nonqualified stock option may be transferred.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The Company has a 1998 Omnibus Incentive Plan (1998 Plan) under which the Company may grant options to employees, directors and consultants for up to 803,169 shares of common stock. The exercise prices are determined by the board of directors, but shall not be less than 100% of the fair market value on the grant date or, in the case of any employee who is deemed to own more than 10% of the voting power of all classes of the Company’s stock, not less than 110% of the fair market value. The terms of the options are also determined by the board of directors, but shall never exceed ten years or, in the case of any employee who is deemed to own more than 10% of the voting power of all classes of the Company’s common stock, shall not exceed five years. The Company does not expect to grant any further equity awards under the 1998 Plan, but intends to make all future awards under the 2004 Plan. While all awards previously granted under the 1998 Plan will remain outstanding, 1998 Plan shares will not be available for re-grant if these outstanding awards are forfeited or cancelled.

Stock Options • The Company used the modified Black-Scholes model to estimate the fair value of employee stock options on the date of grant utilizing the assumptions noted below. The risk-free rate is based on the U.S. Treasury bill yield curve in effect at the time of grant for the expected term of the option. The expected term of options granted represents the period of time that the options are expected to be outstanding. The expected volatility assumption is derived from the historical volatility of the Company’s common stock over the most recent period commensurate with the estimated expected life of the Company’s stock options, adjusted for periods of significant volatility not expected to recur. The dividend yield was based on expected dividends at the time of grant.


	2012
Weighted-average grant date fair value	$	0.69
Weighted-average risk-free interest rate		1.15	%
Expected term of option in years		6.00
Weighted-average expected volatility		43	%
Dividend yield		—


	2011
Weighted-average grant date fair value	$	1.76
Weighted-average risk-free interest rate		1.23	%
Expected term of option in years		6.00
Weighted-average expected volatility		43	%
Dividend yield		—

There were no stock options issued in 2010.

A summary of stock option activity for each of the three years ended December 31 follows (shares in thousands):


	2012					2011					2010
	Shares			Weighted Average Exercise Price		Shares			Weighted Average Exercise Price		Shares			Weighted Average Exercise Price
Outstanding at beginning of year		1,748		$	6.82		1,236		$	19.23		1,275		$	19.10
Granted		750			0.69		1,272			1.76		—			—
Forfeited		(91	)		1.65		(760	)		18.52		(39	)		15.09

Outstanding at end of year		2,407			5.07		1,748			6.82		1,236			19.23

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The Company recognized total compensation expense related to the stock options of $403,000, $378,000 and $472,000 during 2012, 2011 and 2010, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statements of operations. Total unrecognized compensation expense related to unvested stock options was $578,000 at December 31, 2012, which will be recognized over a weighted-average period of approximately 1.6 years.

Stock options outstanding and exercisable at December 31, 2012 were as follows (shares in thousands):


Options Outstanding							Options Exercisable
Range of Exercise Prices	Number Outstanding		Weighted Average Exercise Price		Weighted Average Years of Remaining Contractual Life		Number Exercisable		Weighted Average Exercise Price
$0.69 to $1.76		688	$	0.69		9.15		—	$	—
$1.76 to $10.37		1,200	$	1.76		8.56		405	$	1.76
$10.38 to $15.00		55		11.79		4.10		55		11.79
$15.01 to $22.00		354		17.51		3.97		354		17.51
$22.01 to $30.00		110		25.15		3.99		110		25.15

$0.69 to $30.00		2,407		5.07		7.74		924		11.18

The stock options outstanding and exercisable at December 31, 2012 had aggregate intrinsic values of zero as the aggregate exercise price was greater than the aggregate market value. No stock options were exercised during 2012, 2011 or 2010.

Restricted Stock Awards • A summary of activity for the Company’s restricted stock grants for each of the years ended December 31 was as follows (shares in thousands):


	2012					2011						2010
	Restricted Shares			Weighted Average Grant Date Fair Value		Restricted Shares			Weighted Average Grant Date Fair Value			Restricted Shares			Weighted Average Grant Date Fair Value
Outstanding at beginning of year		1		$	16.50		12		$	16.37			50		$	15.53
Granted		—			—		434			0.91			—			—
Vested		(1	)		2.75		(11	)		6.49			(38	)		14.37
Cancelled		—			—		(434	)		(0.91	)		—			—
Forfeited		—			—		—			—			—			—

Outstanding at end of year		—			—		1			16.50			12			16.37

The Company recognized total compensation expense related to the restricted stock awards of $4,000, $159,000 and $553,000 during 2012, 2011 and 2010, respectively. Compensation expense is included in selling, general and administrative expenses in the consolidated statements of operations. As of December 31, 2012, there was no unrecognized compensation cost related to unvested restricted stock awards.

The aggregate fair value of restricted stock awards vested during 2012, 2011 and 2010 was $1,000, $15,000 and $141,000 at the date of vesting, respectively.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

19. Employee Benefit Plan

The Company sponsors a defined contribution retirement plan under Section 401(k) of the Internal Revenue Code. The plan covers substantially all employees who meet specified service requirements. Under the plan, the Company may, at its discretion, match 100% of each employee’s contribution, up to 3% of the employee’s earnings, plus 50% of each employee’s contribution for the next 2% of the employee’s salary. There were no employer matching contributions to the 401(k) plan in 2012, 2011 or 2010.

20. Regulatory Restrictions

The Company is subject to comprehensive regulation and supervision by government agencies in Illinois, Louisiana, Michigan, and New York, the states in which the Company’s insurance company subsidiaries are domiciled, as well as in the states where its subsidiaries sell insurance products, issue policies, handle claims and finance premiums. Certain states impose restrictions or require prior regulatory approval of certain corporate actions, which may adversely affect the Company’s ability to operate, innovate, obtain necessary rate adjustments in a timely manner or grow its business profitably. These regulations provide safeguards for policy owners and are not intended to protect the interests of stockholders. The Company’s ability to comply with these laws and regulations, and to obtain necessary regulatory action in a timely manner, is and will continue to be critical to its success.

The Company’s insurance company subsidiaries are subject to risk-based capital standards and other minimum capital and surplus requirements imposed under applicable state laws, including the laws of their state of domicile. The risk-based capital standards, based upon the Risk-Based Capital Model Act, adopted by the National Association of Insurance Commissioners (NAIC), require the Company’s insurance company subsidiaries to report their results of risk-based capital calculations to state departments of insurance and the NAIC. Failure to meet applicable risk-based capital requirements or minimum statutory capital requirements could subject the Company to further examination or corrective action imposed by state regulators, including limitations on the Company’s writing of additional business, state supervision or liquidation. Any changes in existing risk-based capital requirements or minimum statutory capital requirements may require the Company to increase its statutory capital levels. At December 31, 2012, and 2011, each of the Company’s insurance subsidiaries maintained a risk-based capital level that was in excess of an amount that would require any corrective actions. Effective January 1, 2012, the NAIC revised the Risk-Based Capital Model Act to include a risk-based capital trend test as another manner under which the company action level could be triggered and will be applied as of December 31, 2012. The test is applicable when an insurance company has a risk-based capital ratio between 200% and 300% and a combined ratio of more than 120%. Each of the Company’s insurance subsidiaries was in compliance with risk-based capital trend test requirements as of December 31, 2012.

State insurance laws restrict the ability of the Company’s insurance company subsidiaries to declare stockholder dividends. These subsidiaries may not make an “extraordinary dividend” until 30 days after the applicable commissioner of insurance has received notice of the intended dividend and has not objected in such time or until the commissioner has approved the payment of the extraordinary dividend within the 30-day period. In most states, an extraordinary dividend is defined as any dividend or distribution of cash or other property whose fair market value, together with that of other dividends and distributions made within the preceding 12 months, exceeds the greater of 10.0% of the insurance company’s surplus as of the preceding year-end or the insurance company’s net income for the preceding year, in each case determined in accordance with statutory accounting practices. In addition, dividends may only be paid from unassigned earnings and an insurance company’s remaining surplus must be both reasonable in relation to its outstanding liabilities and adequate to its financial needs. As of December 31, 2012, the Company’s insurance companies could not pay ordinary dividends to the Company without prior regulatory approval due to a negative unassigned surplus position of Affirmative

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Insurance Company. However, as mentioned previously, management believes the Company’s non-insurance company subsidiaries provide adequate cash flow to fund their own operations.

Refer to Note 2 regarding going concern and noncompliance with the Illinois Insurance Code.

21. Business Concentrations

The majority of the Company’s commission income and fees are directly related to the premiums written through its insurance subsidiaries from policies sold to individuals located in certain states. Accordingly, the Company could be adversely affected by economic downturns, natural disasters, and other conditions that may occur from time-to-time in these states.

The following table identifies the states in which the Company operates and the gross premiums written by state (in thousands):


	Year Ended December 31,
	2012		2011			2010
Louisiana	$	106,841	$	116,462		$	140,642
Texas		54,009		36,257			67,078
Illinois		23,887		25,577			41,417
Alabama		21,270		23,377			28,475
California		17,706		14,789			20,404
Indiana		8,092		6,463			10,277
Missouri		3,084		1,885			4,541
South Carolina		2,127		3,442			5,571
Michigan		—		895			32,314
Florida		—		(8	)		1,337
New Mexico		—		(14	)		1,665
Other		6		104			159

Total	$	237,022	$	229,229		$	353,880

22. 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 and other invested assets. Following is a brief description of the type of valuation information that qualifies as 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.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

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

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

Where possible, the Company utilizes quoted market prices to measure fair value. For assets and liabilities that have quoted market prices in active markets, the Company uses the quoted market prices as fair value and includes these prices in the amounts disclosed in Level 1 of the hierarchy. When quoted market prices in active markets are unavailable, the Company determines fair values based on independent external valuation information obtained from independent pricing services, which utilize 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 flows. 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. Additional pricing services are used as a comparison to ensure that realistic fair values are used in pricing the investment portfolio.

Financial assets measured at fair value on a recurring basis

The following table provides information as of December 31, 2012 about the Company’s financial assets measured at fair value on a recurring basis (in thousands):


	Total		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	$	11,466	$	11,466	$	—	$	—
States and political subdivisions		3,639		—		3,639		—
Corporate debt securities		19,369		—		19,369		—
FDIC-insured certificates of deposit		13,274		—		13,274		—

Total investment securities		47,748		11,466		36,282		—
Other invested assets		3,390		—		—		3,390

Total assets	$	51,138	$	11,466	$	36,282	$	3,390

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table provides information as of December 31, 2011 about the Company’s financial assets measured at fair value on a recurring basis (in thousands):


	Total		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	$	11,975	$	11,975	$	—	$	—
Mortgage-backed securities		10,951		—		10,951		—
States and political subdivisions		17,178		—		17,178		—
Corporate debt securities		61,637		—		61,637		—
FDIC-insured certificates of deposit		21,181		—		21,181		—

Total investment securities		122,922		11,975		110,947		—
Other invested assets		2,898		—		—		2,898

Total assets	$	125,820	$	11,975	$	110,947	$	2,898

Level 1 Financial assets

Financial assets classified as Level 1 in the fair value hierarchy include U.S. Treasury and government agencies securities. These securities are actively traded and the Company estimates the fair value of these securities using unadjusted quoted market prices.

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. 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

At December 31, 2012, the Company’s Level 3 financial assets include an investment in a hedge fund, which is presented as other invested assets in the consolidated balance sheets. The Company elected the fair value option for its investment in the hedge fund and measures the fair value of the hedge fund on the basis of the net asset value of the fund as reported by the fund manager. The hedge fund is primarily invested in residential mortgage-backed securities and other asset-backed securities which are recorded at fair value as determined by the fund manager. Such fair value determination is based on quoted marked prices, bid prices, or the fund manager’s proprietary valuation models where quoted prices are unavailable or deemed to be inadequately representative of fair value. Significant decreases in the fair value of the underlying securities in the hedge fund would result in a significantly lower fair value measurement of other invested assets as reported in the consolidated balance sheets.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Fair value measurements for assets in Level 3 for the year ended December 31, 2012 were as follows (in thousands):


	Fair Value Measurements Using Significant Unobservable Inputs (Level 3) Other Invested Assets
Balance at January 1, 2012	$	2,898
Transfers into Level 3		—
Total gains included in earnings as net investment income		492
Settlements		—

Balance at December 31, 2012	$	3,390

Fair value measurements for assets in Level 3 for the year ended December 31, 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 as net investment income		334
Settlements		—

Balance at December 31, 2011	$	2,898

Fair value measurements for liabilities in Level 3 for the year ended December 31, 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 as loss on interest rate swaps		2
Settlements		(1,455	)

Balance at December 31, 2011	$	—

The Company did not have any transfers between Levels 1 and 2 during the years ended December 31, 2012 or 2011.

Financial Instruments Disclosed, But Not Carried, At Fair Value

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.

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

The following table presents the carrying value and estimated fair value of the Company’s financial assets and liabilities disclosed, but not carried, at fair value at December 31, 2012 and the level within the fair value hierarchy (in thousands):


	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
Assets:
Cash and cash equivalents	$	38,176	$	38,176	$	38,176	$	—	$	—
Fiduciary and restricted cash		569		569		569		—		—

Total	$	38,745	$	38,745	$	38,745	$	—	$	—

Liabilities:
Notes payable	$	76,842	$	7,655	$	—	$	—	$	7,655
Senior secured credit facility		99,323		55,002		—		—		55,002

Total	$	176,165	$	62,657	$	—	$	—	$	62,657

The following table presents the carrying value and estimated fair value of the Company’s financial assets and liabilities disclosed, but not carried, at fair value at December 31, 2011 and the level within the fair value hierarchy (in thousands):


	Carrying Value		Estimated Fair Value		Level 1		Level 2		Level 3
Assets:
Cash and cash equivalents	$	28,559	$	28,559	$	28,559	$	—	$	—
Fiduciary and restricted cash		2,478		2,478		2,478		—		—

Total	$	31,037	$	31,037	$	31,037	$	—	$	—

Liabilities:
Notes payable	$	76,857	$	17,433	$	—	$	—	$	17,433
Senior secured credit facility		91,683		79,554		—		—		79,554

Total	$	168,540	$	96,987	$	—	$	—	$	96,987

Notes payable and Senior secured credit facility – The fair value of the notes payable and senior secured credit facility was determined using a third-party valuation source.

23. Statutory Financial Information and Accounting Policies

The Company’s insurance subsidiaries are required to file statutory-basis financial statements with state insurance departments in all states where they are licensed. These statements are prepared in accordance with accounting practices prescribed or permitted by the applicable state of domicile. Each state of domicile requires that insurance companies domiciled in those states prepare their statutory-basis financial statements in accordance with the National Association of Insurance Commissioners Accounting Principles and Procedures Manual subject to any deviations prescribed or permitted by the insurance commissioner in each state of domicile.

100

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Affirmative Insurance Company of Michigan (AIC of Michigan), USAgencies Casualty Insurance Company, Inc. (Casualty), and USAgencies Direct Insurance Company (Direct) are wholly-owned subsidiaries of AIC and are included as common stock investments on AIC’s balance sheet in its statutory surplus. In November 2012, Insura was merged into AIC and Direct was sold from AIC to Casualty. The following table summarizes selected statutory information of the Company’s insurance subsidiaries ended December 31 (in thousands):


	December 31,
	2012		2011		2010
*Statutory capital and surplus:*
Affirmative Insurance Company (AIC)	$	48,115	$	69,158	$	85,119
Insura Property and Casualty Insurance Company (Insura)		—		6,297		27,046
Affirmative Insurance Company of Michigan (AIC of Michigan)		9,206		9,213		9,127
USAgencies Casualty Insurance Company, Inc (Casualty)		24,258		32,780		50,340
USAgencies Direct Insurance Company (Direct)		5,273		5,259		5,253


	Year Ended December 31,
	2012			2011			2010
*Statutory net income (loss):*
Affirmative Insurance Company	$	(20,786	)	$	(11,957	)	$	(61,977	)
Insura Property and Casualty Insurance Company		—			240			527
Affirmative Insurance Company of Michigan		(7	)		85			127
USAgencies Casualty Insurance Company, Inc.		1,128			1,226			1,693
USAgencies Direct Insurance Company		15			12			27

The amount of statutory capital and surplus necessary for AIC to satisfy regulatory requirements as of December 31, 2012 was $42.8 million. The statutory capital and surplus of each of the Company’s insurance subsidiaries exceeded the highest level of minimum regulatory required capital as of December 31, 2012, 2011 and 2010.

101

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

24. Unaudited Quarterly Financial Data

The following is a summary of the Company’s unaudited quarterly consolidated results from continuing operations for the years ended December 31, 2012 and 2011 (in thousands, except per share data):


	Quarter Ended
	March 31			June 30			September 30			December 31
*2012:*
Net premiums earned	$	34,181		$	34,935		$	35,261		$	39,359
Total revenues		51,451			51,759			51,155			55,396
Net losses and loss adjustment expenses		25,670			26,719			25,397			34,072
Net loss		(8,480	)		(5,695	)		(29,458	)		(8,280	)
Diluted loss per common share		(0.55	)		(0.37	)		(1.91	)		(0.54	)
Diluted weighted-average common shares		15,408			15,408			15,408			15,408
*2011:*
Net premiums earned	$	50,551		$	46,671		$	42,042		$	37,285
Total revenues		72,284			65,444			59,348			52,722
Net losses and loss adjustment expenses		40,405			29,409			31,562			36,281
Net income (loss)		(9,810	)		19			(7,638	)		(145,169	)
Diluted loss per common share		(0.63	)		—			(0.50	)		(9.42	)
Diluted weighted-average common shares		15,483			15,408			15,408			15,408

102

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

25. Parent Company Financials

The condensed financial information of the parent company, Affirmative Insurance Holdings, Inc. as of December 31, 2012 and 2011, and for each of the three years ended December 31, 2012, 2011 and 2010 is presented as follows (in thousands, except share data):

Condensed Balance Sheets


	2012			2011
				(As Adjusted See Note 3)
Assets
Cash and cash equivalents	$	17		$	16
Fiduciary and restricted cash		165			166
Investment in subsidiaries		140,684			180,238
Income taxes receivable		150			739
Goodwill		—			1,398
Other intangible assets, net		273			273
Other assets		4,204			3,774

Total assets	$	145,493		$	186,604

Liabilities and Stockholders’ Deficit
Liabilities:
Payable to subsidiaries	$	119,629		$	117,712
Senior secured credit facility		99,323			91,683
Notes payable		56,702			56,702
Other liabilities		3,093			1,484

Total liabilities		278,747			267,581

Stockholders’ deficit:
Common stock, $0.01 par value; 75,000,000 shares authorized; 18,202,221 shares issued and 15,408,358 shares outstanding at December 31, 2012 and 2011		182			182
Additional paid-in capital		166,749			166,342
Treasury stock, at cost (2,793,863 shares at December 31, 2012 and 2011)		(32,910	)		(32,910	)
Accumulated other comprehensive loss		(998	)		(227	)
Retained deficit		(266,277	)		(214,364	)

Total stockholders’ deficit		(133,254	)		(80,977	)

Total liabilities and stockholders’ deficit	$	145,493		$	186,604

103

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

Condensed Statements of Operations


	Year Ended December 31,
	2012			2011			2010
				(As Adjusted See Note 3)			(As Adjusted See Note 3)
Revenues
Dividends from subsidiaries	$	14,714		$	26,613		$	31,300
Net investment income		—			—			13
Other income		—			—			237

Total revenues		14,714			26,613			31,550

Expenses
Operating expenses		352			581			1,327
Loss on interest rate swaps		—			2			961
Interest expense		17,616			18,992			20,620
Goodwill and other intangible assets impairment		1,398			8,357			—

Total expenses		19,366			27,932			22,908

Income (loss) before income taxes and equity interest in subsidiaries		(4,652	)		(1,319	)		8,642
Income tax expense		2,447			1,545			2,209
Equity interest in undistributed loss of subsidiaries		(44,814	)		(159,734	)		(93,356	)

Net loss	$	(51,913	)	$	(162,598	)	$	(86,923	)

Condensed Statements of Cash Flows


	Year Ended December 31,
	2012			2011			2010
Net cash used in operating activities	$	(16,683	)	$	(17,679	)	$	(3,290	)

Cash flows from investing activities
Dividends received from subsidiaries		14,714			26,613			31,300
Investment in affiliates		—			—			(6,000	)

Net cash provided by investing activities		14,714			26,613			25,300

Cash flows from financing activities
Borrowings under senior secured credit facility		5,500			—			—
Principal payments on senior secured credit facility		(3,530	)		(9,762	)		(21,650	)
Debt modification costs paid		—			(769	)		—
Acquisition of treasury stock		—			(4	)		(26	)

Net cash provided by (used in) financing activities		1,970			(10,535	)		(21,676	)

Net increase (decrease) in cash and cash equivalents		1			(1,601	)		334
Cash and cash equivalents at beginning of year		16			1,617			1,283

Cash and cash equivalents at end of year	$	17		$	16		$	1,617

104

AFFIRMATIVE INSURANCE HOLDINGS, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

26. Subsequent Event

On March 15, 2013, the Company, through one of its indirect, wholly-owned subsidiaries, entered into a $4.8 million loan secured by commercial real estate to provide liquidity to AIC. The loan is evidenced by a promissory note secured by a mortgage security agreement and assignment of leases and rents on real estate located in Baton Rouge, Louisiana, which is held as investment in real property in the consolidated balance sheets.

The promissory note bears interest at a per annum fixed rate of 4.95%. The promissory note requires monthly payments of principal and interest with the final payment due on the maturity date of December 15, 2015. As security for payments, the Company has assigned rents due under the federal agency lease to a trustee. Pursuant to an escrow and servicing agreement, the trustee will receive rent due under the lease, make required payments due under the promissory note and maintain certain escrow accounts to pay for the necessary expenses of the property until the promissory note is paid in full.

105

Item 9.

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

None.

Item 9A.

Controls and Procedures

Evaluation of Disclosure 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 U.S. Securities and Exchange Commission (SEC) under the Securities Exchange Act of 1934, as amended (the Exchange Act) as of December 31, 2012. 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.

Management’s Report on Internal Control over Financial Reporting

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting (as that term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f)). To evaluate the effectiveness of the Company’s internal control over financial reporting, the Company uses the framework in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO Framework). Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements on a timely basis and projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies and procedures may deteriorate.

Using the COSO Framework, the Company’s management, including the Company’s principal executive officer and principal financial officer, evaluated the Company’s internal control over financial reporting. As a result, management has concluded that our internal control over financial reporting was effective as of December 31, 2012 based upon the COSO Framework.

Changes in Internal Control over Financial Reporting

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.

Item 9B.

Other Information

None.

106

PART III

Item 10.

Directors, Executive Officers and Corporate Governance

The information relating to this Item 10 is incorporated by reference to the disclosure in the sections headed “Item 1 — Election of Directors,” “Executive Officers,” “Section 16(a) Beneficial Ownership Reporting Compliance” and “Corporate Governance” in the Proxy Statement for our 2012 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012.

Item 11.

Executive Compensation

The information relating to this Item 11 is incorporated by reference to the disclosure in the sections headed “Compensation Discussion and Analysis,” “Compensation Committee Report” and “ Executive Compensation” in the Proxy Statement for our 2012 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012.

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information relating to this Item 12 is incorporated by reference to the disclosure in the sections headed “Equity Compensation Plan Information” and “Security Ownership of Certain Beneficial Owners and Management” in the Proxy Statement for our 2012 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012.

Securities Authorized for Issuance Under Equity Compensation Plans

The following table sets forth information as of December 31, 2012 about all of our equity compensation plans. All plans have been approved by our stockholders.


	Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (a)		Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights		Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plan (Excluding Securities Reflected in Column (a))
2004 Stock Incentive Plan		2,407,000	$	5.07		410,194

We repurchased 433,500 shares of our restricted stock and awarded 1,272,500 stock options to various executives during the third quarter of 2011.

Item 13.

Certain Relationships and Related Transactions, and Director Independence

The information relating to this Item 13 is incorporated by reference to the disclosure in the section headed “Certain Relationships and Related Transactions” in the Proxy Statement for our 2012 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012.

Item 14.

Principal Accounting Fees and Services

The information relating to this Item 14 is incorporated by reference to the disclosure in the section headed “Corporate Governance — Audit Committee — Fees Paid to Independent Auditor” and “Corporate Governance — Audit Committee — Approval of Audit and Non-Audit Services” in the Proxy Statement for our 2012 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission no later than 120 days after December 31, 2012.

107

PART IV

Item 15.

Exhibits, Financial Statement Schedules

(a)

Financial Statements: See “Index to Consolidated Financial Statements” in Part II, Item 8 of this Form 10-K.

(b)

Exhibits: Exhibits: The exhibits listed in the accompanying index to exhibits are filed or incorporated by reference as part of this Form 10-K.

108

SIGNATURES

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


AFFIRMATIVE INSURANCE HOLDINGS, INC.

By:		/s/ GARY Y. KUSUMI
		Gary Y. Kusumi
		Chief Executive Officer

Date: April 1, 2013

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated below.


Signature	Title	Date
/s/ GARY Y. KUSUMI Gary Y. Kusumi	Chairman and Chief Executive Officer	April 1, 2013

/s/ MICHAEL J. MCCLURE Michael J. McClure	Executive Vice President and Chief Financial Officer	April 1, 2013

/s/ EARL R. FONVILLE Earl R. Fonville	Senior Vice President and Chief Accounting Officer	April 1, 2013

/s/ THOMAS C. DAVIS Thomas C. Davis	Director	April 1, 2013

/s/ NIMROD T. FRAZER Nimrod T. Frazer	Director	April 1, 2013

/s/ MORY KATZ Mory Katz	Director	April 1, 2013

/s/ DAVID I. SCHAMIS David I. Schamis	Director	April 1, 2013

/s/ ROBERT T. WILLIAMS Robert T. Williams	Director	April 1, 2013

/s/ PAUL J. ZUCCONI Paul J. Zucconi	Director	April 1, 2013

109

EXHIBIT INDEX

The following documents are filed as a part of this report. Those exhibits previously filed and incorporated herein by reference are identified by reference to prior filings. Exhibits not required for this report have been omitted.


Exhibit		Description
2.1		Purchase and Sale Agreement, dated October 3, 2006 and effective as of October 12, 2006, by and among the equityholders of USAgencies, L.L.C. and Affirmative Insurance Holdings, Inc. (incorporated by reference to Exhibit 2.1 to our Current Report on Form 8-K filed with the SEC on October 18, 2006, File No. 000-50795).

3.1		Amended and Restated Certificate of Incorporation of Affirmative Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.1 to our Registration Statement on Form S-1 filed with SEC on March 22, 2004, File No. 333-113793).

3.2		Amended and Restated Bylaws of Affirmative Insurance Holdings, Inc. (incorporated by reference to Exhibit 3.2 to our Current Report on Form 8-K filed with the SEC on November 24, 2008, File No. 000-50795).

4.1		Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to our Annual Report on Form 10-K filed with the SEC on March 17, 2008, File No. 000-50795).

4.2		Form of Registration Rights Agreement between Affirmative Insurance Holdings, Inc. and Vesta Insurance Group, Inc. (incorporated by reference to Exhibit 4.2 to Amendment No. 2 to our Registration Statement on Form S-1 filed with the SEC on May 27, 2004, File No. 333-113793).

10.1+		Affirmative Insurance Holdings, Inc. Amended and Restated 2004 Stock Incentive Plan (incorporated by reference to our Information Statement on Form DEF 14-C filed with the SEC on December 30, 2005, File No. 000-50795).

10.2+		First Amendment to the Amended and Restated Affirmative Insurance Holdings, Inc. 2004 Stock Incentive Plan (incorporated by reference to Annex A to our Definitive Proxy Statement on Form DEF 14A filed with the SEC on April 28, 2006, File No. 000-50795).

10.3+		Form of Stock Option Agreement (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on March 1, 2005, File No. 000-50795). Form of 2011 Stock Option Award Agreement (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on February 28, 2012, File No. 000-50795).

10.4+		Form of Restricted Stock Award Agreement (incorporated by reference to Exhibit 10.2 to our Current Report on Form 8-K filed with the SEC on March 1, 2005, File No. 000-50795).

10.5+		Form of Restricted Stock Award Agreement (reflecting restricted stock awards issued to named executive officers in February 2011) (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on March 21, 2011, File No. 000-50795). Form of Retention Bonus Agreement (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on July 13, 2012, File No. 000-50795).

10.6+		Affirmative Insurance Holdings, Inc. Performance-Based Annual Incentive Plan, effective January 1, 2007 (incorporated by reference to Appendix A to our Definitive Proxy Statement on Form DEF 14A filed with the SEC on April 5, 2007, File No. 000-50795).

10.7+		Description of Non-Employee Director Compensation (incorporated by reference to Exhibit 10.3 to our Quarterly Report on Form 10-Q filed with the SEC on May 16, 2005, File No. 000-50795).

10.8+		Executive Employment Agreement, dated January 4, 2011 (effective October 1, 2010), between Affirmative Insurance Holdings, Inc. and Gary Y. Kusumi (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on January 10, 2011, File No. 000-50795).

110


Exhibit		Description
10.9+		First Amended and Restated Executive Employment Agreement, dated January 7, 2011 (effective December 1, 2010), between Affirmative Insurance Holdings, Inc. and Michael J. McClure (incorporated by reference to Exhibit 10.2 to our Current Report on Form 8-K filed with the SEC on January 10, 2011, File No. 000-50795).

10.10+		Second Amended and Restated Executive Employment Agreement, dated January 7, 2011 (effective January 1, 2011), between Affirmative Insurance Holdings, Inc. and Robert A. Bondi (incorporated by reference to Exhibit 10.3 to our Current Report on Form 8-K filed with the SEC on January 10, 2011, File No. 000-50795).

10.11*+		Second Amended and Restated Executive Employment Agreement, dated January 4, 2011 (effective January 1, 2011), between Affirmative Insurance Holdings, Inc. and Joseph G. Fisher.

10.12		Automobile Quota Share Reinsurance Contract between Swiss Reinsurance America Corporation and Affirmative Insurance Company, dated as of December 28, 2010, for the period October 1, 2010 to December 31, 2010 (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K/A filed with the SEC on January 10, 2011, File No. 000-50795).

10.13		Automobile Quota Share Reinsurance Contract between Swiss Reinsurance America Corporation and Affirmative Insurance Company, dated as of December 29, 2010, for the period January 1, 2011 to December 31, 2011(incorporated by reference to Exhibit 10.2 to our Current Report on Form 8-K/A filed with the SEC on January 10, 2011, File No. 000-50795).

10.14		Automobile Quota Share Reinsurance Contract between Greenlight Reinsurance, Ltd. and Affirmative Insurance Company, dated as of September 1, 2011, for the period September 1, 2011 through December 31, 2012 (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on November 15, 2011, File No. 000-50795).

10.15*		Addendum No. 1 (effective September 1, 2011) to the Interests and Liabilities Agreement of Greenlight Reinsurance, Ltd. with respect to the Automobile Quota Share Reinsurance Contract between Greenlight Reinsurance, Ltd. and Affirmative Insurance Company, dated as of September 1, 2011, for the period September 1, 2011 through December 31, 2012

10.16*		Addendum No. 2 (effective September 1, 2011) to the Interests and Liabilities Agreement of Greenlight Reinsurance, Ltd. with respect to the Automobile Quota Share Reinsurance Contract between Greenlight Reinsurance, Ltd. and Affirmative Insurance Company, dated as of September 1, 2011, for the period September 1, 2011 through December 31, 2012

10.17*		Addendum No. 3 (effective February 28, 2012) to the Interests and Liabilities Agreement of Greenlight Reinsurance, Ltd. with respect to the Automobile Quota Share Reinsurance Contract between Greenlight Reinsurance, Ltd. and Affirmative Insurance Company, dated as of September 1, 2011, for the period September 1, 2011 through December 31, 2012

10.18		Addendum No. 4 (effective December 31, 2012) to the Interests and Liabilities Agreement of Greenlight Reinsurance, Ltd. with respect to the Automobile Quota Share Reinsurance Contract between Greenlight Reinsurance, Ltd. and Affirmative Insurance Company, dated as of September 1, 2011, for the period September 1, 2011 through March 31, 2013 (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on January 4, 2013, File No. 000-50795).

10.19		Master Services Agreement, dated as of October 16, 2006, between Affirmative Insurance Holdings, Inc. and Accenture LLP (incorporated by reference to Exhibit 10.27 to our Current Report on Form 8-K filed with the SEC on October 20, 2006, File No. 000-50795).

10.20		Amendment No. 19 to Services Agreement No. 1, effective September 1, 2012, between Affirmative Insurance Holdings, Inc. and Accenture LLP (incorporated by reference to Exhibit 10.1 to our Current Report on Form 8-K filed with the SEC on October 22, 2012, File No. 000-50795).

111


Exhibit		Description
10.21		$220,000,000 Credit Agreement dated as of January 31, 2007, among Affirmative Insurance Holdings, Inc. as Borrower, the Lenders party thereto, Credit Suisse, Cayman Islands Branch as Administrative Agent and Collateral Agent and Credit Suisse Securities (USA) LLC, as Sole Bookrunner and Sole Lead Arranger (incorporated by reference to Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 16, 2007, File No. 000-50795).

10.22		First Amendment to Credit Agreement and Guarantee and Collateral Agreement, dated as of March 8, 2007, among Affirmative Insurance Holdings, Inc. as Borrower, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as Administrative Agent, Collateral Agent, Outgoing Issuing Bank and Outgoing Swingline Lender and The Frost National Bank as Incoming Issuing Bank and Incoming Swingline Lender (incorporated by reference to Exhibit 10.32 to our Annual Report on Form 10-K filed with the SEC on March 16, 2007, File No. 000-50795).

10.23		Second Amendment to Credit Agreement and Guarantee and Collateral Agreement, dated as of February 4, 2008, among Affirmative Insurance Holdings, Inc. as Borrower, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as Administrative Agent, Collateral Agent, Outgoing Issuing Bank and Outgoing Swingline Lender and The Frost National Bank as Incoming Issuing Bank and Incoming Swingline Lender (incorporated by reference to Exhibit 10.30 to our Annual Report on Form 10-K filed with the SEC on March 17, 2008, File No. 000-50795).

10.24		Third Amendment to Credit Agreement and Guarantee and Collateral Agreement, dated as of March 27, 2009, among Affirmative Insurance Holdings, Inc., as Borrower, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as Administrative Agent, Collateral Agent, outgoing Issuing Bank and Outgoing Swingline Lender and The Frost National Bank as Incoming Issuing Bank and Incoming Swingline Lender (incorporated by reference to Exhibit 10.36 to our Annual Report on Form 10-K filed with the SEC on March 31, 2009, File No. 000-50795).

10.25*		Fourth Amendment to Credit Agreement dated as of June 2, 2009, among Affirmative Insurance Holdings, Inc., as Borrower, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as administrative agent and collateral agent.

10.26		Fifth Amendment to Credit Agreement and Guarantee and Collateral Agreement, dated as of March 30, 2011, among Affirmative Insurance Holdings, Inc., as Borrower, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as Administrative Agent, Collateral Agent, outgoing Issuing Bank and Outgoing Swingline Lender and The Frost National Bank as Incoming Issuing Bank and Incoming Swingline Lender. (incorporated by reference to Exhibit 10.29 to our Annual Report on Form 10-K filed with the SEC on March 31, 2011, File No. 000-50795).

10.27		Sixth Amendment to Credit Agreement dated as of September 20, 2012, among Affirmative Insurance Holdings, Inc., as Borrower, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as administrative agent and collateral agent (incorporated by reference to Exhibit 10.32 to our Quarterly Report on Form 10-Q filed with the SEC on November 19, 2012, File No. 000-50795).

10.28		Seventh Amendment to Credit Agreement, dated as of November 19, 2012, among Affirmative Insurance Holdings, Inc., as Borrower, the lenders party thereto, Credit Suisse, Cayman Islands Branch, as administrative agent and collateral agent (incorporated by reference to Exhibit 10.33 to our Quarterly Report on Form 10-Q filed with the SEC on November 19, 2012, File No. 000-50795).

21.1*		Subsidiaries of Affirmative Insurance Holdings, Inc. as of March 31, 2013.

23.1*		Consent of KPMG LLP.

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.

112


Exhibit		Description
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 Annual Report on Form 10-K for the year ended December 31, 2012, formatted in XBRL (Extensible Business Reporting Language): (1) the Consolidated Balance Sheets, (2) the Consolidated Statements of Operations, (3) the Consolidated Statements of Comprehensive Income (Loss), (4) the Consolidated Statements of Stockholders’ Equity (Deficit), (5) the Consolidated Statements of Cash Flows, and (6) Notes to Consolidated Financial Statements, including detailed tagging of footnotes and schedules.

*	Filed herewith

+	Management contract, compensatory plan or arrangement

113