UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

Commission File Number: 001-12117

FIRST ACCEPTANCE CORPORATION

(Exact name of registrant as specified in its charter)

Delaware		75-1328153
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)
3813 Green Hills Village Drive Nashville, Tennessee		37215
(Address of principal executive offices)		(Zip Code)

(615) 844-2800
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ                 No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

Yes o                 No o

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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer o		Accelerated filer o		Non-accelerated filer o		Smaller Reporting Company þ
				(Do not check if a smaller reporting company)

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o                 No þ

At November 4, 2010, there were 48,509,258 shares outstanding of the registrant’s common stock, par value $0.01 per share.

 

 

FIRST ACCEPTANCE CORPORATION
FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2010

INDEX

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements		1
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		16
Item 3. Quantitative and Qualitative Disclosures About Market Risk		24
Item 4. Controls and Procedures		27
PART II — OTHER INFORMATION
Item 6. Exhibits		28
SIGNATURES		29

PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)

		September 30,				June 30,
		2010				2010
		(Unaudited)
ASSETS
Investments, available-for-sale at fair value (amortized cost of $185,048 and $187,907, respectively)		$	197,511			$	196,550
Cash and cash equivalents			28,871				26,184
Premiums and fees receivable, net of allowance of $436 and $418			44,665				41,276
Other assets			9,519				8,733
Property and equipment, net			3,155				3,524
Deferred acquisition costs			4,053				3,623
Goodwill			70,092				70,092
Identifiable intangible assets			6,360				6,360
TOTAL ASSETS		$	364,226			$	356,342
LIABILITIES AND STOCKHOLDERS’ EQUITY
Loss and loss adjustment expense reserves		$	71,191			$	73,198
Unearned premiums and fees			55,011				52,563
Debentures payable			41,240				41,240
Other liabilities			15,190				12,151
Total liabilities			182,632				179,152
Stockholders’ equity:
Preferred stock, $.01 par value, 10,000 shares authorized			—				—
Common stock, $.01 par value, 75,000 shares authorized; 48,509 shares issued and outstanding			485				485
Additional paid-in capital			466,023				465,831
Accumulated other comprehensive income			12,463				8,643
Accumulated deficit			(297,377	)			(297,769	)
Total stockholders’ equity			181,594				177,190
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	364,226			$	356,342

See notes to consolidated financial statements.

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(in thousands, except per share data)

		Three Months Ended
		September 30,
		2010				2009
Revenues:
Premiums earned		$	43,934			$	48,467
Commission and fee income			7,276				6,954
Investment income			2,137				1,913
Net realized losses on investments, available-for-sale			(224	)			(22	)
			53,123				57,312
Costs and expenses:
Losses and loss adjustment expenses			32,057				33,153
Insurance operating expenses			18,508				19,570
Other operating expenses			387				273
Litigation settlement			—				(381	)
Stock-based compensation			192				383
Depreciation and amortization			476				464
Interest expense			991				989
			52,611				54,451
Income before income taxes			512				2,861
Provision for income taxes			120				101
Net income		$	392			$	2,760
Net income per share:
Basic and diluted		$	0.01			$	0.06
Number of shares used to calculate net income per share:
Basic			48,037				47,877
Diluted			48,509				48,308
Reconciliation of net income to comprehensive income:
Net income		$	392			$	2,760
Net unrealized change in investments			3,820				4,175
Comprehensive income		$	4,212			$	6,935

Detail of net realized losses on investments, available-for-sale:
Net realized gains on sales		$	80			$	299
Unrealized losses on investments with other-than-temporary impairment charges			(306	)			(321	)
Non-credit portion included in comprehensive income			2				—
Other-than-temporary impairment charges recognized in income			(304	)			(321	)
Net realized losses on investments, available-for-sale		$	(224	)		$	(22	)

See notes to consolidated financial statements.

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(in thousands)

		Three Months Ended
		September 30,
		2010				2009
Cash flows from operating activities:
Net income		$	392			$	2,760
Adjustments to reconcile net income to cash provided by (used in) operating activities:
Depreciation and amortization			476				464
Stock-based compensation			192				383
Other-than-temporary impairment on investment securities			304				321
Net realized gains on sales of investments			(80	)			(299	)
Other			96				127
Change in:
Premiums and fees receivable			(3,371	)			(324	)
Loss and loss adjustment expense reserves			(2,007	)			(2,237	)
Unearned premiums and fees			2,448				(742	)
Litigation settlement			(33	)			1,480
Other			1,875				(4,383	)
Net cash provided by (used in) operating activities			292				(2,450	)
Cash flows from investing activities:
Purchases of investments, available-for-sale			(1,875	)			(51,298	)
Maturities and paydowns of investments, available-for-sale			3,650				2,452
Sales of investments, available-for-sale			749				11,545
Capital expenditures			(110	)			(149	)
Other			—				(21	)
Net cash provided by (used in) investing activities			2,414				(37,471	)
Cash flows from financing activities:
Payments on borrowings			(19	)			(9	)
Net cash used in financing activities			(19	)			(9	)
Net increase (decrease) in cash and cash equivalents			2,687				(39,930	)
Cash and cash equivalents, beginning of period			26,184				77,201
Cash and cash equivalents, end of period		$	28,871			$	37,271

See notes to consolidated financial statements.

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

1. General

     The consolidated financial statements of First Acceptance Corporation (the “Company”) included herein have been prepared without audit pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles have been omitted. In the opinion of management, the consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair statement of the interim periods. Certain reclassifications have been made to the prior year’s consolidated financial statements to conform with the current year presentation.

     The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. These consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in its Annual Report on Form 10-K for the fiscal year ended June 30, 2010.

2. Investments

     Fair Value

     Fair value is the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The Company holds available-for-sale investments, which are carried at fair value.

     Fair value measurements are generally based upon observable and unobservable inputs. Observable inputs are based on market data from independent sources, while unobservable inputs reflect the Company’s view of market assumptions in the absence of observable market information. All assets and liabilities that are carried at fair value are classified and disclosed in one of the following categories:

	Level 1 —		Quoted prices in active markets for identical assets or liabilities.
	Level 2 —		Quoted market prices for similar assets or liabilities in active markets; quoted prices by independent pricing services for identical or similar assets or liabilities in markets that are not active; and valuations, using models or other valuation techniques, that use observable market data. All significant inputs are observable, or derived from observable information in the marketplace, or are supported by observable levels at which transactions are executed in the market place.
	Level 3 —		Instruments that use non-binding broker quotes or model driven valuations that do not have observable market data.

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     The following table presents the fair-value measurements for each major category of assets that are measured on a recurring basis (in thousands).

						Fair Value Measurements Using
						Quoted Prices in
						Active Markets for				Significant Other				Significant
						Identical Assets				Observable Inputs				Unobservable Inputs
September 30, 2010		Total				(Level 1)				(Level 2)				(Level 3)
Fixed maturities, available-for-sale:
U.S. government and agencies		$	29,844			$	29,844			$	—			$	—
State			7,873				—				7,873				—
Political subdivisions			1,845				—				1,845				—
Revenue and assessment			29,718				—				29,718				—
Corporate bonds			80,064				—				80,064				—
Collateralized mortgage obligations:
Agency backed			26,448				—				26,448				—
Non-agency backed — residential			6,553				—				6,553				—
Non-agency backed — commercial			7,069				—				7,069				—
Redeemable preferred stock			176				176				—				—
Total fixed maturities, available-for-sale			189,590				30,020				159,570				—
Investment in mutual fund, available-for-sale			7,921				7,921				—				—
Total investments, available-for-sale			197,511				37,941				159,570				—
Cash and cash equivalents			28,871				28,871				—				—
Total		$	226,382			$	66,812			$	159,570			$	—

						Fair Value Measurements Using
						Quoted Prices in
						Active Markets for				Significant Other				Significant
						Identical Assets				Observable Inputs				Unobservable Inputs
June 30, 2010		Total				(Level 1)				(Level 2)				(Level 3)
Fixed maturities, available-for-sale:
U.S. government and agencies		$	29,499			$	29,499			$	—			$	—
State			7,848				—				7,848				—
Political subdivisions			1,830				—				1,830				—
Revenue and assessment			29,286				—				29,286				—
Corporate bonds			78,803				—				78,803				—
Collateralized mortgage obligations:
Agency backed			28,036				—				28,036				—
Non-agency backed — residential			6,612				—				6,612				—
Non-agency backed — commercial			7,180				—				7,180				—
Total fixed maturities, available-for-sale			189,094				29,499				159,595				—
Investment in mutual fund, available-for-sale			7,456				7,456				—				—
Total investments, available-for-sale			196,550				36,955				159,595				—
Cash and cash equivalents			26,184				26,184				—				—
Total		$	222,734			$	63,139			$	159,595			$	—

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     The fair values of the Company’s investments are determined by management after taking into consideration available sources of data. All of the portfolio valuations classified as Level 1 or Level 2 in the above tables are priced exclusively by utilizing the services of independent pricing sources using observable market data. The Level 2 classified security valuations are obtained from a single independent pricing service. There were no transfers between Level 1 and Level 2 for the three months ended September 30, 2010 and 2009. The Company’s policy is to recognize transfers between levels at the end of the reporting period. The Company has not made any adjustments to the prices obtained from the independent pricing sources.

     The Company has reviewed the pricing techniques and methodologies of the independent pricing sources and believes that their policies adequately consider market activity, either based on specific transactions for the security valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. The Company monitored security-specific valuation trends and discussed material changes or the absence of expected changes with the pricing source to understand the underlying factors and inputs and to validate the reasonableness of the pricing.

     Based on the above categorization, there were no Level 3 classified security valuations at June 30, 2010 and September 30, 2010. The following table represents the quantitative disclosure for those assets classified as Level 3 during the three months ended September 30, 2009 (in thousands).

		Fair Value Measurements Using
		Significant Unobservable Inputs (Level 3)
		Collateralized mortgage obligations
		Non-agency				Non-agency
		backed —				backed —
Three Months Ended September 30, 2009:		residential				commercial				Total
Balance at July 1, 2009		$	1,930			$	707			$	2,637
Total gains or losses (realized or unrealized):
Included in net income			22				—				22
Included in other comprehensive income			182				81				263
Sales			(2	)			—				(2	)
Transfers into Level 3			2,390				—				2,390
Transfers out of Level 3			(1,228	)			(788	)			(2,016	)
Balance at September 30, 2009		$	3,294			$	—			$	3,294

     Investment Income and Net Realized Gains and Losses

     The major categories of investment income follow (in thousands).

		Three Months Ended
		September 30,
		2010				2009
Fixed maturities, available-for-sale		$	2,124			$	2,029
Investment in mutual fund, available-for-sale			145				—
Cash and cash equivalents			4				19
Other			29				29
Investment expenses			(165	)			(164	)
		$	2,137			$	1,913

     FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     The components of net realized losses on investments, available-for-sale are as follows (in thousands).

		Three Months Ended
		September 30,
		2010				2009
Gains		$	81			$	303
Losses			(1	)			(4	)
Other-than-temporary impairment			(304	)			(321	)
		$	(224	)		$	(22	)

     Realized gains and losses on sales of securities are computed based on specific identification. The non-credit related portion of other-than-temporary impairment (“OTTI”) charges is included in other comprehensive income. At September 30, 2010, the amounts of such charges taken for securities still owned was $0.4 million for non-agency backed residential collateralized mortgage obligations (“CMOs”). At June 30, 2010, the amount of such charges taken for securities still owned was $0.6 million for non-agency backed residential CMOs and $0.3 million for non-agency backed commercial CMOs.

     Investments, Available-for-Sale

     The following tables summarize the Company’s investment securities (in thousands).

		Amortized				Gross Unrealized				Gross Unrealized				Fair
September 30, 2010		Cost				Gains				Losses				Value
U.S. government and agencies		$	28,246			$	1,598			$	—			$	29,844
State			7,437				436				—				7,873
Political subdivisions			1,793				52				—				1,845
Revenue and assessment			27,980				1,754				(16	)			29,718
Corporate bonds			73,667				6,553				(156	)			80,064
Collateralized mortgage obligations:
Agency backed			24,655				1,793				—				26,448
Non-agency backed — residential			6,720				187				(354	)			6,553
Non-agency backed — commercial			6,874				243				(48	)			7,069
Redeemable preferred stock			176				—				—				176
Total fixed maturities, available-for-sale			177,548				12,616				(574	)			189,590
Investment in mutual fund, available-for-sale			7,500				421				—				7,921
		$	185,048			$	13,037			$	(574	)		$	197,511

		Amortized				Gross Unrealized				Gross Unrealized				Fair
June 30, 2010		Cost				Gains				Losses				Value
U.S. government and agencies		$	28,263			$	1,236			$	—			$	29,499
State			7,461				387				—				7,848
Political subdivisions			1,792				52				(14	)			1,830
Revenue and assessment			28,209				1,217				(140	)			29,286
Corporate bonds			73,868				5,181				(246	)			78,803
Collateralized mortgage obligations:
Agency backed			26,262				1,774				—				28,036
Non-agency backed — residential			7,189				56				(633	)			6,612
Non-agency backed — commercial			7,363				158				(341	)			7,180
Total fixed maturities, available-for-sale			180,407				10,061				(1,374	)			189,094
Investment in mutual fund, available-for-sale			7,500				—				(44	)			7,456
		$	187,907			$	10,061			$	(1,418	)		$	196,550

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     The following tables set forth the scheduled maturities of the Company’s fixed maturity securities based on their fair values (in thousands). Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.

										Securities with No				All
		Securities with				Securities with				Unrealized Gains or				Fixed Maturity
September 30, 2010		Unrealized Gains				Unrealized Losses				Losses				Securities
One year or less		$	12,403			$	—			$	—			$	12,403
After one through five years			79,085				150				—				79,235
After five through ten years			40,895				—				—				40,895
After ten years			14,211				2,776				—				16,987
No single maturity date			36,533				3,194				343				40,070
		$	183,127			$	6,120			$	343			$	189,590

										Securities with No				All
		Securities with				Securities with				Unrealized Gains or				Fixed Maturity
June 30, 2010		Unrealized Gains				Unrealized Losses				Losses				Securities
One year or less		$	9,137			$	—			$	—			$	9,137
After one through five years			82,250				642				—				82,892
After five through ten years			39,567				—				—				39,567
After ten years			8,607				7,063				—				15,670
No single maturity date			33,676				8,085				67				41,828
		$	173,237			$	15,790			$	67			$	189,094

     The following table reflects the number of securities with gross unrealized gains and losses. Gross unrealized losses are further segregated by the length of time that individual securities have been in a continuous unrealized loss position.

Gross Unrealized Losses

Less than or equal

Greater than 12

Gross Unrealized

At:

to 12 months

months

Gains

September 30, 2010

3

7

164

June 30, 2010

6

18

153

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     The following tables reflect the fair value and gross unrealized losses of those securities in a continuous unrealized loss position for greater than 12 months. Gross unrealized losses are further segregated by the percentage of amortized cost (in thousands, except number of securities).

		Number								Gross
Gross Unrealized Losses		of				Fair				Unrealized
at September 30, 2010:		Securities				Value				Losses
Less than 10%			4			$	4,146			$	(222	)
Greater than 10%			3				887				(330	)
			7			$	5,033			$	(552	)

		Number								Gross
Gross Unrealized Losses		of				Fair				Unrealized
at June 30, 2010:		Securities				Value				Losses
Less than 10%			11			$	7,931			$	(276	)
Greater than 10%			7				3,366				(965	)
			18			$	11,297			$	(1,241	)

     The following tables set forth the amount of gross unrealized losses by current severity (as compared to amortized cost) and length of time that individual securities have been in a continuous unrealized loss position (in thousands).

		Fair Value of
		Securities with								Severity of Gross Unrealized Losses
Length of		Gross				Gross												Greater
Gross Unrealized Losses		Unrealized				Unrealized				Less				5% to				than
at September 30, 2010:		Losses				Losses				than 5%				10%				10%
Less than or equal to:
Three months		$	937			$	(17	)		$	(17	)		$	—			$	—
Six months			1				(2	)			—				—				(2	)
Nine months			—				—				—				—				—
Twelve months			149				(3	)			(3	)			—				—
Greater than twelve months			5,033				(552	)			(19	)			(203	)			(330	)
Total		$	6,120			$	(574	)		$	(39	)		$	(203	)		$	(332	)

		Fair Value of
		Securities with								Severity of Gross Unrealized Losses
Length of		Gross				Gross												Greater
Gross Unrealized Losses		Unrealized				Unrealized				Less				5% to				than
at June 30, 2010:		Losses				Losses				than 5%				10%				10%
Less than or equal to:
Three months		$	11,291			$	(170	)		$	(145	)		$	(25	)		$	—
Six months			—				—				—				—				—
Nine months			152				(2	)			(2	)			—				—
Twelve months			505				(5	)			(5	)			—				—
Greater than twelve months			11,297				(1,241	)			(153	)			(123	)			(965	)
Total		$	23,245			$	(1,418	)		$	(305	)		$	(148	)		$	(965	)

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     Other-Than-Temporary Impairment

     In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 320-10-65, Recognition and Presentation of Other-Than-Temporary Impairments (“FASB ASC 320-10-65”), the Company separates OTTI into the following two components: (i) the amount related to credit losses, which is recognized in the consolidated statement of operations and (ii) the amount related to all other factors, which is recorded in other comprehensive income. The credit-related portion of an OTTI is measured by comparing a security’s amortized cost to the present value of its current expected cash flows discounted at its effective yield prior to the impairment charge.

     The determination of whether unrealized losses are “other-than-temporary” requires judgment based on subjective as well as objective factors. The Company routinely monitors its investment portfolio for changes in fair value that might indicate potential impairments and performs detailed reviews on such securities. Changes in fair value are evaluated to determine the extent to which such changes are attributable to (i) fundamental factors specific to the issuer or (ii) market-related factors such as interest rates or sector declines.

     Securities with declines attributable to issuer-specific fundamentals are reviewed to identify all available evidence to estimate the potential for impairment. Resources used include historical financial data included in filings with the SEC for corporate bonds and performance data regarding the underlying loans for CMOs. Securities with declines attributable solely to market or sector declines where the Company does not intend to sell the security and it is more likely than not that the Company will not be required to sell the security before the full recovery of its amortized cost basis are not deemed to be other-than-temporary.

     The issuer-specific factors considered in reaching the conclusion that securities with declines are not other-than-temporary include (i) the extent and duration of the decline in fair value, including the duration of any significant decline in value, (ii) whether the security is current as to payments of principal and interest, (iii) a valuation of any underlying collateral, (iv) current and future conditions and trends for both the business and its industry, (v) changes in cash flow assumptions for CMOs and (vi) rating agency actions. Based on these factors, the Company makes a determination as to the probability of recovering principal and interest on the security.

     The number and amount of securities for which the Company has recognized OTTI charges in net income are presented in the following tables (in thousands, except for the number of securities).

		Three Months Ended September 30,
		2010								2009
		Number								Number
		of								of
		Securities				OTTI				Securities				OTTI
Collateralized mortgage obligations:
Non-agency backed — residential			4			$	(36	)			3			$	(321	)
Non-agency backed — commercial			3				(270	)			—				—
			7				(306	)			3				(321	)
Portion of loss recognized in accumulated other comprehensive income							2								—
Net OTTI recognized in net income						$	(304	)						$	(321	)

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     Since the adoption of FASB ASC 320-10-65, the following is a progression of the credit-related portion of OTTI on investments owned at September 30, 2010 and 2009 (in thousands).

		Three Months Ended
		September 30,
		2010				2009
Beginning balance		$	(3,301	)		$	(2,870	)
Additional credit impairments on:
Previously impaired securities			(304	)			(49	)
Securities without previous impairments			—				(272	)
			(304	)			(321	)
Reductions for securities sold			—				552
		$	(3,605	)		$	(2,639	)

     On a quarterly basis, the Company reviews cash flow estimates for certain non-agency backed CMOs of lesser credit quality following the guidance of FASB ASC 325-40-65, Amendments to the Impairment Guidance of EITF Issue No. 99-20 (“FASB ASC 325-40-65”). Accordingly, when changes in estimated cash flows from the cash flows previously estimated occur due to actual or estimated prepayment or credit loss experience, and the present value of the revised cash flows is less than the present value previously estimated, OTTI is deemed to have occurred. For non-agency backed CMOs not subject to FASB ASC 325-40-65, the Company reviews quarterly projected cash flow analyses and recognizes OTTI when it determines that a loss is probable. The Company has recognized OTTI related to certain non-agency backed CMOs as the underlying cash flows have been adversely impacted due to a reduction in prepayments from mortgage refinancing and an increase in actual and projected delinquencies in the underlying mortgages.

     The Company’s review of non-agency backed CMOs included an analysis of available information such as collateral quality, anticipated cash flows, credit enhancements, default rates, loss severities, the securities’ relative position in their respective capital structures, and credit ratings from statistical rating agencies. The Company reviews quarterly projected cash flow analyses for each security utilizing current assumptions regarding (i) actual and anticipated delinquencies, (ii) delinquency transition-to-default rates and (iii) loss severities. Based on its quarterly reviews, the Company determined that there had not been an adverse change in projected cash flows, except in the case of those securities for which OTTI charges have been recorded. The Company believes that the unrealized losses on the remaining securities for which OTTI charges have not been recorded are not necessarily predictive of the ultimate performance of the underlying collateral. The Company does not intend to sell these securities and it is more likely than not that the Company will not be required to sell these securities before the recovery of their amortized cost basis.

     The Company believes that the remaining securities having unrealized losses at September 30, 2010 were not other-than-temporarily impaired. The Company also does not intend to sell any of these securities and it is more likely than not that the Company will not be required to sell any of these securities before the recovery of their amortized cost basis.

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

3. Net Income Per Share

     The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share data).

		Three Months Ended
		September 30,
		2010				2009
Net income		$	392			$	2,760
Weighted average common basic shares			48,037				47,877
Effect of dilutive securities			472				431
Weighted average common dilutive shares			48,509				48,308
Basic and diluted net income per share		$	0.01			$	0.06

     For the three months ended September 30, 2010 and 2009, the computations of diluted net income per share include shares of unvested restricted common stock of 0.5 million and 0.4 million, respectively. Options to purchase approximately 4.6 million shares and 5.3 million shares for the three months ended September 30, 2010 and 2009, respectively, were not included in the computation of diluted net income per share as their exercise prices were in excess of the average stock prices for the periods presented.

4. Income Taxes

     The provision for income taxes consisted of the following (in thousands).

		Three Months Ended
		September 30,
		2010				2009
Federal:
Current		$	—			$	—
Deferred			—				—
			—				—
State:
Current			120				101
Deferred			—				—
			120				101
		$	120			$	101

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     The provision for income taxes differs from the amounts computed by applying the statutory federal corporate tax rate of 35% to income before income taxes as a result of the following (in thousands).

		Three Months Ended
		September 30,
		2010				2009
Provision for income taxes at statutory rate		$	179			$	1,001
Tax effect of:
Tax-exempt investment income			(4	)			(4	)
Change in the beginning of the year balance of the valuation allowance for deferred tax assets allocated to income taxes			(180	)			(1,000	)
Restricted stock			1				—
State income taxes, net of federal income tax benefit and valuation allowance			120				101
Other			4				3
		$	120			$	101

     The Company had a valuation allowance of $15.5 million and $16.9 million at September 30, 2010 and June 30, 2010, respectively, to reduce deferred tax assets to the amount that is more likely than not to be realized, which included all net deferred tax assets at September 30, 2010 and June 30, 2010. The change in the total valuation allowance for the three months ended September 30, 2010 was a decrease of $1.4 million. For the three months ended September 30, 2010, the change in the valuation allowance primarily included the unrealized change on investments of $1.3 million included in other comprehensive income.

     In assessing the realization of deferred tax assets, management considered whether it was more likely than not that some portion or all of the deferred tax assets will not be realized. The Company is required to assess whether a valuation allowance should be established against the Company’s deferred tax assets based on the consideration of all available evidence using a more likely than not standard. In making such judgments, significant weight is given to evidence that can be objectively verified. In assessing the Company’s ability to support the realizability of its deferred tax assets, management considered both positive and negative evidence. The Company placed greater weight on historical results than on the Company’s outlook for future profitability and established a deferred tax valuation allowance against all net deferred tax assets at September 30, 2010 and June 30, 2010. The deferred tax valuation allowance may be adjusted in future periods if management determines that it is more likely than not that some portion or all of the deferred tax assets will be realized. In the event the deferred tax valuation allowance is adjusted, the Company would record an income tax benefit for the adjustment.

5. Goodwill and Identifiable Intangible Assets

     Goodwill and other identifiable intangible assets are attributable to the Company’s insurance operations and were initially recorded at their estimated fair values at the date of acquisition. Goodwill and other intangible assets, primarily comprised of trade names, having an indefinite useful life are not amortized for financial statement purposes. The Company performs required annual impairment tests of its goodwill and intangible assets as of the last day of the fourth quarter of each fiscal year. In the event that facts and circumstances indicate that the goodwill and other identifiable intangible assets may be impaired, an interim impairment test would be required.

     The goodwill impairment test is a two-step process that requires management to make judgments in determining what assumptions to use in the calculation. The first step of the process consists of estimating the fair value of each reporting unit based on valuation techniques, including a discounted cash flow model using revenue and profit forecasts, and comparing those estimated fair values with the carrying values of those assets and liabilities, which includes the allocated goodwill. If the estimated fair value is less than the carrying value, a second step is performed to compute the amount of the impairment, if any, by determining an “implied fair value” of goodwill. The determination of the “implied fair value” of goodwill of a reporting unit requires the Company to allocate the estimated fair value of the reporting unit to the assets and liabilities of the reporting unit. Any unallocated fair value represents the “implied fair value” of goodwill, which is compared to its corresponding carrying value.

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

     The Company’s evaluation includes multiple assumptions, including estimated discounted cash flows and other estimates that may change over time. If future discounted cash flows become less than those projected by the Company, impairment charges may become necessary that could have a materially adverse impact on the Company’s results of operations and financial condition. As quoted market prices in active stock markets are relevant evidence of fair value, a significant decline in the Company’s common stock trading price may indicate an impairment of goodwill.

6. Fair Value of Financial Instruments

     The carrying values and fair values of certain of the Company’s financial instruments at September 30, 2010 and June 30, 2010 were as follows (in thousands).

		September 30, 2010								June 30, 2010
		Carrying				Fair				Carrying				Fair
		Value				Value				Value				Value
Assets:
Investments, available-for-sale		$	197,511			$	197,511			$	196,550			$	196,550
Cash and cash equivalents			28,871				28,871				26,184				26,184
Premiums and fees receivable, net			44,665				44,665				41,276				41,276
Liabilities:
Debentures payable			41,240				19,104				41,240				19,701

     The fair values as presented represent the Company’s best estimates and may not be substantiated by comparisons to independent markets. The fair value of the debentures payable was based on current market rates offered for debt with similar risks and maturities. Certain financial instruments and all non-financial instruments are not required to be disclosed. Therefore, the aggregate fair values presented in the table do not purport to represent the Company’s underlying value.

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)
(Unaudited)

7. Segment Information

     The Company operates in two business segments with its primary focus being the selling, servicing and underwriting of non-standard personal automobile insurance. The real estate and corporate segment consists of the activities related to the disposition of foreclosed real estate held for sale, interest expense associated with all debt and other general corporate overhead expenses.

     The following table presents selected financial data by business segment (in thousands).

		Three Months Ended
		September 30,
		2010				2009
Revenues:
Insurance		$	53,093			$	57,283
Real estate and corporate			30				29
Consolidated total		$	53,123			$	57,312
Income (loss) before income taxes:
Insurance		$	2,051			$	4,476
Real estate and corporate			(1,539	)			(1,615	)
Consolidated total		$	512			$	2,861

		September 30,				June 30,
		2010				2010
Total assets:
Insurance		$	351,036			$	343,499
Real estate and corporate			13,190				12,843
Consolidated total		$	364,226			$	356,342

8. Recent Accounting Pronouncements

     In December 2009, the FASB issued Accounting Standards Update (“ASU”) No. 2009-17, Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities (Topic 810) (“FASB ASU No. 2009-17”), which amends FASB ASC 810-10, Variable Interest Entities. FASB ASU No. 2009-17 amends the evaluation criteria to identify the primary beneficiary of a variable interest entity and requires ongoing reassessment of whether an enterprise is the primary beneficiary of the variable interest entity. The Company adopted the provisions of FASB ASU No. 2009-17 in the quarter ended September 30, 2010. The adoption did not have an impact on the Company’s results of operations or financial condition.

     In October 2010, the FASB issued ASU No. 2010-26, Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts (a consensus of the FASB Emerging Issues Task Force) (Topic 944) (“FASB ASU No. 2010-26”), which amends FASB ASC 944-340, Other Assets and Deferred Costs. FASB ASU No. 2010-26 clarifies what costs should be deferred by insurance companies when issuing or renewing insurance contracts. FASB ASU 2010-26 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2011. The Company is currently evaluating the impact that the adoption of FASB ASU 2010-26 will have on future consolidated financial statements.

FIRST ACCEPTANCE CORPORATION 10-Q

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

     Management’s Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements which involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such a difference include those discussed in Item 1A. “Risk Factors” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2010. The following discussion should be read in conjunction with our consolidated financial statements included with this report and our consolidated financial statements and related Management’s Discussion and Analysis of Financial Condition and Results of Operations for the fiscal year ended June 30, 2010 included in our Annual Report on Form 10-K.

General

     At September 30, 2010, we leased and operated 393 retail locations (or “stores”) staffed by employee-agents who primarily sell non-standard personal automobile insurance products underwritten by us as well as certain commissionable ancillary products. In certain states, our employee-agents also sell other complementary insurance products underwritten by us. At September 30, 2010, we wrote non-standard personal automobile insurance in 12 states and were licensed in 13 additional states. See the discussion in Item 1. “Business — General” in our Annual Report on Form 10-K for the fiscal year ended June 30, 2010 for additional information with respect to our business.

     The following table shows the number of our retail locations. Retail location counts are based upon the date that a location commenced or ceased writing business.

		Three Months Ended
		September 30,
		2010				2009
Retail locations — beginning of period			394				418
Opened			—				—
Closed			(1	)			(3	)
Retail locations — end of period			393				415

     The following tables show the number of our retail locations by state.

		September 30,								June 30,
		2010				2009				2010				2009
Alabama			25				25				25				25
Florida			31				36				31				39
Georgia			60				61				60				61
Illinois			74				78				74				78
Indiana			17				18				17				18
Mississippi			8				8				8				8
Missouri			12				12				12				12
Ohio			27				27				27				27
Pennsylvania			16				17				16				17
South Carolina			26				27				26				27
Tennessee			19				20				19				20
Texas			78				86				79				86
Total			393				415				394				418

FIRST ACCEPTANCE CORPORATION 10-Q

Consolidated Results of Operations

Overview

     Our primary focus is the selling, servicing and underwriting of non-standard personal automobile insurance. Our real estate and corporate segment consists of activities related to the disposition of real estate held for sale, interest expense associated with debt, and other general corporate overhead expenses. Our insurance operations generate revenues from selling, servicing and underwriting non-standard personal automobile insurance policies in 12 states. We conduct our underwriting operations through three insurance company subsidiaries: First Acceptance Insurance Company, Inc., First Acceptance Insurance Company of Georgia, Inc. and First Acceptance Insurance Company of Tennessee, Inc. Our insurance revenues are primarily generated from:

	•		premiums earned, including policy and renewal fees, from sales of policies written and assumed by our insurance company subsidiaries;
	•		commission and fee income, including installment billing fees on policies written, agency fees and commissions and fees for other ancillary products and services; and
	•		investment income earned on the invested assets of the insurance company subsidiaries.

     The following table presents premiums earned by state (in thousands).

		Three Months Ended
		September 30,
		2010				2009
Premiums earned:
Georgia		$	9,591			$	10,902
Texas			5,910				5,912
Illinois			5,806				6,331
Florida			4,818				5,261
Alabama			4,386				5,210
Ohio			3,224				2,952
Tennessee			2,714				3,104
South Carolina			2,500				3,138
Pennsylvania			2,416				2,819
Indiana			1,145				1,221
Missouri			738				827
Mississippi			686				790
Total premiums earned		$	43,934			$	48,467

     The following table presents the change in the total number of policies in force for the insurance operations. Policies in force increase as a result of new policies issued and decrease as a result of policies that are canceled or expire and are not renewed.

		Three Months Ended
		September 30,
		2010				2009
Policies in force — beginning of period			154,655				158,222
Net decrease during period			(4,480	)			(5,356	)
Policies in force — end of period			150,175				152,866

     Insurance companies present a combined ratio as a measure of their overall underwriting profitability. The components of the combined ratio are as follows.

     Loss Ratio — Loss ratio is the ratio (expressed as a percentage) of losses and loss adjustment expenses incurred to premiums earned and is a basic element of underwriting profitability. We calculate this ratio based on all direct and assumed premiums earned.

FIRST ACCEPTANCE CORPORATION 10-Q

     Expense Ratio — Expense ratio is the ratio (expressed as a percentage) of insurance operating expenses to premiums earned. Insurance operating expenses are reduced by commission and fee income from insureds. This is a measurement that illustrates relative management efficiency in administering our operations.

     Combined Ratio — Combined ratio is the sum of the loss ratio and the expense ratio. If the combined ratio is at or above 100%, an insurance company cannot be profitable without sufficient investment income.

     The following table presents the loss, expense and combined ratios for our insurance operations.

		Three Months Ended
		September 30,
		2010				2009
Loss and loss adjustment expense			73.0	%			68.4	%
Expense			25.5	%			26.0	%
Combined			98.5	%			94.4	%

     The non-standard personal automobile insurance industry is cyclical in nature. Likewise, adverse economic conditions impact our customers and many will choose to reduce their coverage or go uninsured during a weak economy.

Investments

     We use the services of an independent investment manager to manage our investment portfolio. The investment manager conducts, in accordance with our investment policy, all of the investment purchases and sales for our insurance company subsidiaries. Our investment policy has been established by the Investment Committee of our Board of Directors and specifically addresses overall investment goals and objectives, authorized investments, prohibited securities, restrictions on sales by the investment manager and guidelines as to asset allocation, duration and credit quality. Management and the Investment Committee meet regularly with our investment manager to review the performance of the portfolio and compliance with our investment guidelines.

     The invested assets of the insurance company subsidiaries consist substantially of marketable, investment grade, U.S. government securities, municipal bonds, corporate bonds and collateralized mortgage obligations (“CMOs”). We also invest a portion of the portfolio in certain securities issued by political subdivisions, which enable our insurance company subsidiaries to obtain premium tax credits. Investment income is comprised primarily of interest earned on these securities, net of related investment expenses. Realized gains and losses may occur from time to time as changes are made to our holdings based upon changes in interest rates or the credit quality of specific securities.

     Our consolidated investment portfolio was $197.5 million at September 30, 2010 and consisted of fixed maturity securities and an investment in a mutual fund, all carried at fair value with unrealized gains and losses reported as a separate component of stockholders’ equity. At September 30, 2010, we had gross unrealized gains of $13.0 million and gross unrealized losses of $0.6 million.

     At September 30, 2010, 95.2% of the fair value of our fixed maturity portfolio was rated “investment grade” (a credit rating of AAA to BBB-) by nationally recognized rating organizations. The average credit rating of our fixed maturity portfolio was AA- at September 30, 2010. Investment grade securities generally bear lower yields and have lower degrees of risk than those that are unrated or non-investment grade. We believe that a high quality investment portfolio is more likely to generate a stable and predictable investment return.

     Investments in CMOs had a fair value of $40.1 million at September 30, 2010 and represented 20% of our fixed maturity portfolio. At September 30, 2010, 88% of our CMOs were considered investment grade by nationally recognized rating agencies. In addition, 81% of our CMOs were rated AAA and 66% of our CMOs were backed by agencies of the United States government. Of the non-agency backed CMOs, 43% were rated AAA.

FIRST ACCEPTANCE CORPORATION 10-Q

     The following table summarizes our investment securities at September 30, 2010 (in thousands).

						Gross				Gross
		Amortized				Unrealized				Unrealized				Fair
September 30, 2010		Cost				Gains				Losses				Value
U.S. government and agencies		$	28,246			$	1,598			$	—			$	29,844
State			7,437				436				—				7,873
Political subdivisions			1,793				52				—				1,845
Revenue and assessment			27,980				1,754				(16	)			29,718
Corporate bonds			73,667				6,553				(156	)			80,064
Collateralized mortgage obligations:
Agency backed			24,655				1,793				—				26,448
Non-agency backed — residential			6,720				187				(354	)			6,553
Non-agency backed — commercial			6,874				243				(48	)			7,069
Redeemable preferred stock			176				—				—				176
Total fixed maturities, available-for-sale			177,548				12,616				(574	)			189,590
Investment in mutual fund, available-for-sale			7,500				421				—				7,921
		$	185,048			$	13,037			$	(574	)		$	197,511

     The following table sets forth the scheduled maturities of our fixed maturity securities at September 30, 2010 based on their fair values (in thousands). Actual maturities may differ from contractual maturities because certain securities may be called or prepaid by the issuers.

										Securities
		Securities				Securities				with No				All
		with				with				Unrealized				Fixed
		Unrealized				Unrealized				Gains or				Maturity
		Gains				Losses				Losses				Securities
One year or less		$	12,403			$	—			$	—			$	12,403
After one through five years			79,085				150				—				79,235
After five through ten years			40,895				—				—				40,895
After ten years			14,211				2,776				—				16,987
No single maturity date			36,533				3,194				343				40,070
		$	183,127			$	6,120			$	343			$	189,590