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, 2008. 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, 2008 included in our Annual Report on Form 10-K.
General
As of September 30, 2008, we leased and operated 429 retail locations (or "stores"), staffed by employee-agents. Our employee-agents exclusively sell insurance products either underwritten or serviced by us. As of September 30, 2008, 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, 2008 for additional information with respect to our business.
The following table shows the change in the number of our retail locations for the periods presented. Retail location counts are based upon the date that a location commenced or ceased writing business.

Three Months Ended September 30, 2008 2007 Retail locations - beginning of period 431 462 Opened 1 1 Closed (3 ) (5 ) Retail locations - end of period 429 458

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

September 30, June 30, 2008 2007 2008 2007 Alabama 25 25 25 25 Florida 39 41 40 41 Georgia 61 62 61 62 Illinois 81 81 80 81 Indiana 19 23 19 24 Mississippi 8 8 8 8 Missouri 13 16 14 15 Ohio 29 30 29 30 Pennsylvania 18 24 19 25 South Carolina 28 28 28 28 Tennessee 20 20 20 20 Texas 88 100 88 103 Total 429 458 431 462

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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 foreclosed 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, 2008 2007 Premiums earned: Georgia $ 13,427 $ 16,103 Florida 7,616 12,361 Illinois 7,361 8,169 Texas 7,002 8,526 Alabama 6,572 7,504 South Carolina 5,450 5,640 Tennessee 4,415 5,522 Ohio 3,451 4,000 Pennsylvania 2,787 2,301 Indiana 1,563 1,968 Missouri 1,128 1,470 Mississippi 1,066 1,239 Total premiums earned $ 61,838 $ 74,803

The following table presents the change in the total number of policies in force for the insurance operations for the periods presented. 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, 2008 2007 Policies in force - beginning of period 194,079 226,974 Net decrease during period (23,524 ) (14,463 ) Policies in force - end of period 170,555 212,511

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.

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FIRST ACCEPTANCE CORPORATION 10-Q Expense Ratio - Expense ratio is the ratio (expressed as a percentage) of operating expenses to premiums earned. 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 for the periods presented. Three Months Ended September 30, 2008 2007 Loss and loss adjustment expense 70.7 % 77.1 % Expense 21.4 % 19.6 % Combined 92.1 % 96.7 %

Investments
We use the services of an independent investment manager to manage our fixed maturities 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. The portfolio is compared with a customized index. We do not invest in equity securities. Management and the Investment Committee meet regularly 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, which are included in other revenues in our consolidated statements of operations, may occur from time to time as changes are made to our holdings to obtain premium tax credits or based upon changes in interest rates.
Our consolidated investment portfolio was $189.0 million at September 30, 2008 and consisted of fixed maturity securities, all carried at fair value with unrealized gains and losses reported as a separate component of stockholders' equity on an after-tax basis. At September 30, 2008, we had gross unrealized gains of $2.1 million and gross unrealized losses of $6.1 million, which resulted in a net unrealized loss of $3.9 million on our fixed maturity securities.
At September 30, 2008, 99.8% of our investment portfolio was rated "investment grade" (a credit rating of AAA to BBB) by nationally recognized rating agencies. The average credit rating of our fixed maturity portfolio was AA+ at September 30, 2008. Investment grade securities generally bear lower yields and lower degrees of risk than those that are unrated or non-investment grade. Management believes that a high quality investment portfolio is more likely to generate a stable and predictable investment return.
Investments in CMOs were $64.7 million at September 30, 2008 and represented 34% of our fixed maturity portfolio. CMOs are subject to significant extension risk in periods of rising interest rates and economic decline as mortgages may be repaid slower than expected. As of September 30, 2008, all of our CMOs were considered investment grade. In addition, 96% of the CMOs were rated AAA and 79% of our CMOs were backed by agencies of the United States government. Of the non-agency CMOs, 81% were rated AAA.

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FIRST ACCEPTANCE CORPORATION 10-Q The following table summarizes our fixed maturity securities at September 30, 2008 (in thousands). Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value U.S. government and agencies $ 30,310 $ 1,154 $ (86 ) $ 31,378 State 7,418 163 (20 ) 7,561 Political subdivisions 3,365 19 (22 ) 3,362 Revenue and assessment 29,928 276 (323 ) 29,881 Corporate bonds 55,427 105 (3,421 ) 52,111 Collateralized mortgage obligations 66,524 419 (2,196 ) 64,747 $ 192,972 $ 2,136 $ (6,068 ) $ 189,040

The following table sets forth the scheduled maturities of our fixed maturity securities at September 30, 2008 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 $ 6,257 $ 1,383 $ 580 $ 8,220 After one through five years 43,479 19,318 544 63,341 After five through ten years 13,194 27,812 - 41,006 After ten years 2,186 9,083 457 11,726 No single maturity date 34,646 29,060 1,041 64,747 $ 99,762 $ 86,656 $ 2,622 $ 189,040

Three Months Ended September 30, 2008 Compared with the Three Months Ended September 30, 2007
Consolidated Results
Revenues for the three months ended September 30, 2008 decreased 18% to $71.6 million from $87.2 million in the same period last year. Net income for the three months ended September 30, 2008 was $1.8 million, compared with net income of $1.9 million for the three months ended September 30, 2007. Basic and diluted net income per share was $0.04 for both the three months ended September 30, 2008 and 2007.
Insurance Operations
Revenues from insurance operations were $71.6 million for the three months ended September 30, 2008, compared with $87.1 million for the three months ended September 30, 2007. Income before income taxes from insurance operations for the three months ended September 30, 2008 was $5.8 million, compared with $5.1 million for the three months ended September 30, 2007.
Premiums Earned
Premiums earned decreased by $13.0 million, or 17%, to $61.8 million for the three months ended September 30, 2008 from $74.8 million for the three months ended September 30, 2007. The decrease in premiums earned was due to declines in policies written resulting from the current recessionary conditions, rate increases taken in a number of states to improve underwriting profitability and the closure of 48 poor performing stores since January 2007.
Approximately 78% of the $13.0 million decline in premiums earned for the three months ended September 30, 2008 was in our Florida, Georgia, Texas and Tennessee markets. These states collectively accounted for 52% of premiums earned during the three months ended September 30, 2008, down from 57% for the same period in the prior year.

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FIRST ACCEPTANCE CORPORATION 10-Q Our premiums earned in these states were adversely affected by the current recessionary conditions, as well as a decline in used car sales, which have historically been a significant contributor to new policy growth in these markets. Additionally, the decline in our Florida market was due to a January 1, 2008 rate increase to improve our underwriting profitability.
The total number of insured policies in force at September 30, 2008 decreased 20% over the same date in 2007 from 212,511 to 170,555, primarily due to the factors noted above. At September 30, 2008, we operated 429 stores, compared with 458 stores at September 30, 2007.
Commission and Fee Income
Commission and fee income decreased 11% to $8.2 million for the three months ended September 30, 2008 from $9.3 million for the three months ended September 30, 2007. The decrease in fee income was a result of the decrease in policies in force, partially offset by higher fee income in Florida.
Investment Income
Investment income decreased during the three months ended September 30, 2008 primarily as a result of the decrease in the total amount of invested assets and the decline in yields on cash equivalents. At September 30, 2008 and 2007, the tax-equivalent book yields for our fixed maturities portfolio were 5.2%, with effective durations of 3.50 and 3.26 years, respectively. The yields for the comparable customized indices were 5.5% and 5.1% at September 30, 2008 and 2007, respectively.
Other
Included in other revenues during the three months ended September 30, 2008 is $1.3 million of charges related to other-than-temporary impairment ("OTTI") on investments comprised of $0.6 million for certain non-agency CMOs and $0.7 million for two corporate bonds. Management's assessment of whether an impairment is other-than-temporary includes an evaluation of factors such as the credit quality of the investment, the duration of the impairment, issuer-specific fundamentals, our ability and intent to hold the investment until recovery or maturity and overall economic conditions. If it is determined that the value of any investment is other-than-temporarily impaired, the impairment would be charged against earnings and a new cost basis for the security would be established. Due to the deterioration in liquidity in the credit markets during calendar 2008, yields on certain non-agency mortgage-backed securities declined below projected book yield requiring a $0.6 million impairment of these securities under the guidance set forth in Emerging Issues Task Force Issue No. 99-20 "Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests That Continue to Be Held by a Transferor in Securitized Financial Assets". We also recognized OTTI charges of $0.7 million related to two corporate bonds due to the extent and duration of the declines in their fair values and issuer-specific fundamentals. We believe that the remaining securities having unrealized losses at September 30, 2008 were not other-than-temporarily impaired and that we have the ability and intent to hold these securities for a period of time sufficient to allow for recovery of their impairment.
Losses and Loss Adjustment Expenses
The loss and loss adjustment expense ratio was 70.7% for the three months ended September 30, 2008, compared with 77.1% for the three months ended September 30, 2007. For the three months ended September 30, 2008, we experienced favorable development of approximately $1.4 million for losses occurring prior to calendar year 2008. For the three months ended September 30, 2007, we did not experience any significant development for prior accident periods. In addition, we did not experience any significant weather-related losses during the three months ended September 30, 2008.
Excluding the favorable development noted above, the loss and loss adjustment expense ratio for the three months ended September 30, 2008 was 73.0%. The improvement over the same period last year was the result of rate increases taken in early 2008 in our Florida, Illinois, Indiana, Texas and South Carolina markets and the continued improvement in our underwriting and claim handling practices.

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FIRST ACCEPTANCE CORPORATION 10-Q Operating Expenses
Insurance operating expenses decreased 11% to $21.4 million for the three months ended September 30, 2008 from $24.0 million for the three months ended September 30, 2007. This decrease was primarily a result of a reduction in costs (such as variable employee-agent compensation and premium taxes) that vary along with the decrease in premiums earned as well as savings realized from the closure of underperforming stores.
The expense ratio increased from 19.6% for the three months ended September 30, 2007 to 21.4% for the same period in the current fiscal year. This increase was primarily due to the decline in premiums earned discussed above.
Overall, the combined ratio decreased to 92.1% for the three months ended September 30, 2008 from 96.7% for the three months ended September 30, 2007.
Litigation Settlement
Litigation settlement costs for the three months ended September 30, 2008 of $0.1 million relate to the costs incurred in connection with our defense of the litigation in Alabama and Georgia. We have entered into a settlement agreement relating to the Georgia litigation effective September 10, 2008, which is subject to approval by the court, and have agreed upon preliminary settlement terms with the plaintiffs in the Alabama actions. The settlement of the Alabama litigation is subject to negotiation of a definitive settlement agreement and approval by the applicable courts. Pursuant to the litigation settlements, we would (i) provide the plaintiffs with either a premium credit towards a future insurance policy or a reimbursement certificate for certain future towing and rental expenses, (ii) strengthen our disclosures to customers of all relevant fees, charges and coverages, (iii) pay an aggregate of $6.3 million in fees and expenses for the attorneys for the plaintiffs and (iv) pay the costs associated with the administration of the settlements.
At this time, we are unable to estimate the total costs associated with the Georgia and Alabama litigation settlements. The costs of the settlements will depend, among other factors, upon whether class members receive premium credits or reimbursement certificates pursuant to the terms of the settlements and the rate of redemption and forfeiture of the premium credits and reimbursement certificates. The litigation settlement costs are set forth separately in the consolidated statements of operations. We anticipate that our payment of the $6.3 million in plaintiffs' attorneys' fees and expenses and the $0.4 million in estimated costs associated with the administration of the settlement, both of which were accrued at June 30, 2008, will occur in calendar year 2009, after the final approvals from the courts.
We are currently in discussions with our insurance carriers regarding coverage for the costs and expenses incurred relating to the litigation settlements and are not able currently to estimate the amount, if any, that we may receive from our insurance carriers. As a result, we have not accrued any amount at September 30, 2008 for insurance recoveries that may offset the costs and expenses relating to the litigation settlements. Any such insurance recoveries will be recorded in our operating results during the periods in which the recoveries are probable. For additional information with respect to the litigation settlements, see "Part II - Item 1. Legal Proceedings." Real Estate and Corporate
Loss before income taxes for the three months ended September 30, 2008 was $2.0 million, compared with a loss of $2.1 million for the three months ended September 30, 2007. During the three months ended September 30, 2008, we incurred $0.2 million of interest expense in connection with credit facility borrowings compared with $0.3 million for the three months ended September 30, 2007. In addition, we incurred $1.0 million of interest expense during both the three months ended September 30, 2008 and September 30, 2007 related to the debentures issued in June 2007.

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FIRST ACCEPTANCE CORPORATION 10-Q Liquidity and Capital Resources
Our primary sources of funds are premiums, fees and investment income from our insurance company subsidiaries and commissions and fee income from our non-insurance company subsidiaries that sell ancillary products to our insureds. Our primary uses of funds are the payment of claims and operating expenses. Operating activities for the three months ended September 30, 2008 used $2.5 million of cash, compared with $3.0 million provided in the same period in fiscal 2008. The decrease in cash provided by operating activities was the result of a decrease in cash collected on premiums written. Net cash used in investing activities for the three months ended September 30, 2008 was $5.5 million, compared with net cash provided by investing activities of $15.1 million for the same period in fiscal 2008. Both periods reflect net additions to our investment portfolio, while the three months ended September 30, 2007 includes the settlement of a $20.0 million receivable for securities in July 2007. Financing activities for the three months ended September 30, 2008 included a principal prepayment of $1.0 million on our term loan facility in August 2008, while the three months ended September 30, 2007 included the repayment of $5.0 million related to our revolving credit facility. The three months ended September 30, 2008 and 2007 included scheduled quarterly principal payments on our term loan facility of $0.4 million and $1.4 million, respectively. We paid the final $2.5 million principal payment and terminated our term loan facility in October 2008.
Our holding company requires cash for general corporate overhead expenses and debt service. However, we are part of an insurance holding company system with substantially all of our operations conducted by our insurance company subsidiaries. Accordingly, the holding company's primary sources of unrestricted cash to meet its obligations are dividends from our insurance company subsidiaries and from our non-insurance company subsidiaries that sell ancillary products to our insureds. The holding company will also receive cash from operating activities as a result of investment income and the ultimate liquidation of our foreclosed real estate held for sale. In addition, as a result of our net operating loss ("NOL") carryforwards, taxable income generated by the insurance company subsidiaries through June 30, 2009 will provide cash to the holding company through an intercompany tax allocation agreement through which the insurance company subsidiaries reimburse the holding company for current tax benefits utilized through recognition of the NOL carryforwards. Future taxable losses by the holding company will also provide cash through this agreement should the insurance company subsidiaries generate taxable income.
We anticipate that our insurance company subsidiaries will pay the amounts due under our Georgia litigation settlement, which includes $3.8 million in plaintiffs' attorneys' fees and expenses, $0.4 million in estimated costs associated with the administration of the settlement and amounts to be paid with regards to premium credits and reimbursement certificates. The Alabama . . .