The discussion in this Item includes forward-looking statements and should be read in the context of the risks, uncertainties and other variables referred to below under the caption "Forward-Looking Statements."

Business Operations

Introduction

The Company is engaged in the property and casualty insurance business through its insurance company and managing general agency subsidiaries. Insurance operations include ongoing nonstandard personal auto insurance and the runoff of the commercial lines business, which was discontinued in 2002. The principal sources of revenues for the Company are premiums on nonstandard personal auto insurance, net investment income from the Company's investment portfolio and fee income from insurance agency operations.

In the third quarter of 2008, the Company recorded net realized losses of approximately $5.7 million; approximately $5.0 million related to write downs for other-than-temporary declines in fair value of various investments including $3.7 million from auction preferred securities backed by preferred stock of the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"). Net premiums earned were $44.1 million and $46.9 million in the third quarter of 2008 and 2007, respectively, and were $132.0 million and $149.3 million for the nine months ended September 30, 2008 and 2007, respectively. Gross premiums written were $47.7 million and $46.6 million in the third quarter of 2008 and 2007, respectively, and were $139.4 million and $147.9 million for the nine months ended September 30, 2008 and 2007, respectively. The Company reported net losses of $4.4 million and $4.3 million for the third quarter of 2008 and 2007, respectively. The Company reported net losses of $3.3 million and $7.6 million for the nine months ended September 30, 2008 and 2007, respectively.

As of September 30, 2008, the statutory surplus of its insurance subsidiary was $90.1 million, as compared with $96.0 million as of December 31, 2007. The unpaid claims and claim adjustment expenses was estimated at $72.6 million and $74.7 million at September 30, 2008 and December 31, 2007, respectively, of which unpaid claims and claim adjustment expenses attributable to ongoing nonstandard personal automobile lines was $62.0 million and $55.7 million, respectively.

The following table presents selected financial information in thousands of dollars:

                                       Three months ended September 30,            Nine months ended September 30,
                                          2008                    2007                2008                 2007
Gross premiums written              $          47,664                46,625             139,391              147,923

Net premiums earned                 $          44,070                46,904             131,987              149,337

Loss before Federal income taxes    $          (4,356 )              (3,035 )            (3,256 )             (6,144 )

Federal income tax expense          $              68                 1,247                  34                1,424

Net loss                            $          (4,424 )              (4,282 )            (3,290 )             (7,568 )

GAAP C & CAE ratio (1)                           73.4 %                80.4 %              73.4 %               79.9 %

GAAP Expense ratio (2) (3)                       24.5 %                27.1 %              25.5 %               25.2 %

GAAP Combined ratio (2)                          97.9 %               107.5 %              98.9 %              105.1 %

(1) C & CAE is an abbreviation for Claims and Claims Adjustment expenses, stated as a percentage of net premiums earned.

(2) The Expense and Combined ratios do not reflect expenses of the holding company, which include interest expense on the note payable and subordinated debentures.

(3) Commissions, change in deferred acquisition costs, underwriting expenses and operating expenses (insurance subsidiaries only) are offset by agency revenues and are stated as a percentage of net premiums earned.

We believe rate increases, selective reduction in the agency force and the effects of the slowing economy are the main reasons for the decrease in gross premiums written and net premiums earned for the comparative nine month periods. The decrease in the C & CAE ratio in 2008 from the 2007 periods was primarily due to a smaller amount of unfavorable development for claims occurring in prior accident years on the nonstandard personal auto lines and improvement in the 2008 accident periods as compared to the 2007 accident periods. The expense ratio decreased for the third quarter of 2008 from the third quarter of 2007 primarily due to decreases in advertising and compensation.

The Company believes it is pursuing a strategy that has the potential to build a larger, competitively distinctive and successful franchise in the nonstandard personal auto business over time and is endeavoring to manage its investments and risks to achieve this result. These risks and other challenges, occurring in rapidly changing economic, financial, competitive, regulatory and claims environments, are greater than and in some cases different from those to which the Company previously was subject in writing nonstandard personal auto insurance. The Company's operating and financial results vary from period to period as a result of numerous factors inherent in the insurance business, many of which are affected by such changes.

The Company continues to settle and reduce its inventory of commercial lines claims, although new claims continue to be asserted. At September 30, 2008, there were 38 claims associated with the Company's runoff book outstanding, compared to 47 as of December 31, 2007. As of September 30, 2008, in respect of its runoff lines, the Company had $7,612,000 in net unpaid C & CAE compared to $10,275,000 as of December 31, 2007. For the periods presented, the Company has recorded favorable development in unpaid C & CAE from the runoff lines with the settlement and reduction in the inventory of commercial lines claims. See "Results of Operations - Claims and claims adjustment expenses." Due to the long tail and litigious nature of these claims, the Company anticipates it will take a substantial number of years to complete the adjustment and settlement process with regard to existing claims and the additional claims it expects to receive in the future from its past business writings. Most of the remaining claims are in suit, and the Company's future results may or may not be impacted either negatively or positively based on its ability to settle the remaining claims and new anticipated claims within its established reserve level.

Results of Operations

The discussion below primarily relates to the Company's insurance operations, although the selected consolidated financial data appearing elsewhere is on a consolidated basis. The expense item "Underwriting and operating expenses" includes the operating expenses of the holding company, GAINSCO, INC. ("GAN").

Gross premiums written in the third quarter of 2008 increased 2% as compared to the third quarter of 2007 but decreased 6% from the first nine months of 2008 as compared to the first nine months of 2007. We believe the primary reasons for the decrease to be the result of rate increases, selective reduction in the agency force and the effects of the slowing economy. The increase between quarters was primarily due to product enhancements, rate adjustments and expanded marketing efforts in the Southeast region. The following table presents gross premiums written by region:

                                      Three months ended September 30,            Nine months ended September 30,
                                          2008                    2007                2008                  2007
                                                                (Amounts in thousands)
Region:
Southeast (Florida, South
Carolina)                         $     28,956       61 %     26,270    56 %       81,378      58 %      81,076    55 %
South Central (Texas)                   11,133       23       11,039    24         34,240      25        37,358    25
Southwest (Arizona, Nevada, New
Mexico)                                  7,138       15        8,524    18         22,009      16        26,533    18
West (California)                          437        1          792     2          1,764       1         2,956     2

Total                             $     47,664      100 %     46,625   100 %      139,391     100 %     147,923   100 %

The percent of premium increase (decrease) by region for 2008 from 2007 is as follows: Quarterly, Southeast 10%, South Central 1%, Southwest (16)% and West
(45)%; nine months, Southeast 1%, South Central (8)%, Southwest (17)% and West
(40)%. Net premiums earned decreased 6% in the third quarter of 2008 from the third quarter of 2007 and decreased 12% in the first nine months of 2008 from the first nine months of 2007 primarily as a result of a decline in gross premiums written in the previous two quarters from the respective prior years' comparable previous two quarters.

Net investment income decreased $287,000 (13%) in the third quarter of 2008 from the third quarter of 2007 and decreased $1,074,000 (15%) in the first nine months of 2008 from the first nine months of 2007, primarily due to the decline in the level of interest rates between these periods. The annualized return on average investments, at amortized cost, was 4.6% for the first nine months of 2008 versus 5.1% for the first nine months of 2007.

In the third quarter of 2008, the Company recorded net realized losses of approximately $5,716,000, approximately $5,027,000 related to write downs for other-than-temporary declines in fair value of various investments, including approximately $3,748,000 from auction preferred securities backed by preferred stock of Fannie Mae and Freddie Mac that are included in short-term investments.

Agency revenues decreased $497,000 (5%) in the first nine months of 2008 from the first nine months of 2007 primarily as a result of the decrease in writings in the previous two quarters from the respective prior years' comparable previous two quarters. Agency revenues are primarily fees charged on insureds' premiums due.

Claims and claims adjustment expenses decreased $5,325,000 (14%) in the third quarter of 2008 as compared to the third quarter of 2007. The C & CAE ratio was 73.4% in the third quarter of 2008 versus 80.4% in the third quarter of 2007. The runoff lines recorded unfavorable development for prior accident years of approximately $76,000 in the third quarter of 2008 and favorable development for prior accident years of approximately $83,000 in the third quarter of 2007. The C & CAE ratio for nonstandard personal auto was 73.3% for the third quarter of 2008 versus 80.5% for the third quarter of 2007. The decrease in the C & CAE ratio in the third quarter of 2008 from the third quarter of 2007 was primarily due to less unfavorable development for claims occurring in prior accident years of approximately $838,000 in the third quarter of 2008 versus $2,388,000 in the third quarter of 2007 and improvement in the third quarter of 2008 accident period as compared to the third quarter of 2007 accident period.

Claims and claims adjustment expenses decreased $22,539,000 (19%) in the first nine months of 2008 from the first nine months of 2007. The C & CAE ratio was 73.4% in the first nine months of 2008 versus 79.9% in the first nine months of 2007. The runoff lines recorded favorable development for prior accident years of approximately $1,247,000 in the first nine months of 2008 and $2,297,000 during the first nine months of 2007. The C & CAE ratio for nonstandard personal auto was 74.3% for the first nine months of 2008 versus 81.5% for the first nine months of 2007. The decrease in the C & CAE ratio was primarily due to less unfavorable development for claims occurring in prior accident years of approximately $4,747,000 in the first nine months of 2008 versus $10,548,000 in the first nine months of 2007 and improvement in the first nine months of 2008 accident period as compared to the first nine months of 2007 accident period.

The following presents the unfavorable development for claims occurring in prior accident years for each of the three major regions in the third quarter and first nine months of 2008:

                                            Three months ended    Nine months ended
                                            September 30, 2008    September 30, 2008
 Region:
 Southeast (Florida, South Carolina)       $            514,000            1,200,000

 South Central (Texas)                     $             64,000            2,005,000

 Southwest (Arizona, Nevada, New Mexico)   $            272,000              940,000

New business and the entry into new territories and product lines, associated with the Company's growth beginning in 2005, has generally produced higher claims and greater uncertainty in determining reserves than more seasoned in-force business; see ITEM 1A. Risk Factors in the Company's Annual Report on Form 10-K for the year ended December 31, 2007. The Company's growth and the associated risks and uncertainties (see ITEM 1A. Risk Factors in the Company's Annual Report on Form 10-K for the year ended December 31, 2007) made it difficult to estimate ultimate claims liabilities, and the unfavorable development occurred as the Company revised previous estimates to reflect current claims data. The unfavorable development for prior accident years includes approximately $385,000 recognized in 2008 relating to "extra-contractual" claims (see ITEM 1A. Risk Factors - "Litigation may adversely affect our financial condition, results of operations and cash flows" in the Company's Annual Report on Form 10-K for the year ended December 31, 2007).

Claims for "extra-contractual" liability arise when a claim is originally denied or the claimant asserts that a claim has been handled inappropriately, and the claimant further asserts that such denial or allegedly inappropriate response was improper or in "bad faith." In such cases, which tend to arise in cases involving serious injury or death, it is not unusual for the amount of the claim to exceed by a substantial amount the policy limits that would otherwise be applicable. Where the Company becomes aware of such a potential claim, it typically consults with outside counsel and, if appropriate, seeks to settle the claim on terms as favorable as possible in light of all the relevant circumstances. The amounts required for settlement of such claims, and the potential award if a case cannot be settled on acceptable terms, vary widely depending on the specific facts of the claim, the applicable law and other factors.

During 2006, the Company began implementing improved claim practices in each of the major regions' claims departments in order to seek to ultimately decrease the average time from when a claim occurs to when it is settled. The Company believes that, over the long term, timeliness in the settlement of claims is likely to produce the most favorable claim results for the Company. However, when this practice is initially implemented, it can cause an increase in the C & CAE and introduce greater uncertainty into the process of setting reserves. These operational changes may result in an increase in the amount of aggregate claim settlements and cause our ultimate claim and claim adjustment expense to increase in comparison to prior accident years.

We believe it is reasonably likely that our loss costs could increase or decrease by 2% from current estimates, as remaining claims are recorded and resolved. Loss costs reflect the incurred loss per unit of exposure and are the product of frequency and severity. A 2% increase or decrease in our loss costs would result in unfavorable or favorable development of $7.5 million (based on C & CAE incurred as of September 30, 2008). This estimate of sensitivity is informational only, is not a projection of future results and does not take into account possible effects of extraordinary litigation events (such as class action claims).

Policy acquisition costs include commission expense, change in deferred policy acquisition costs, premium taxes, marketing expense and some underwriting expenses. The decrease of $1,415,000 in the third quarter of 2008 from the third quarter of 2007 and of $5,121,000 in the first nine months of 2008 from the first nine months of 2007 was primarily due to decreases in marketing and underwriting expenses and the reversal of the premium deficiency for expected underwriting losses on the South Central business that was recorded in 2007. The ratio of Policy acquisition costs to Net premiums earned was 16% for the third quarter of 2008 and 18% for the third quarter of 2007. It was 17% for the first nine months of 2008 and 18% for the first nine months of 2007.

Underwriting and operating expenses decreased $433,000 (5%) in the third quarter of 2008 from the third quarter of 2007 primarily due to a decrease in advertising and compensation expense. Underwriting and operating expenses increased $862,000 (4%) in the first nine months of 2008 primarily due to an increase in software depreciation and software maintenance. Underwriting and operating expenses, net of Agency revenues, as a percent of Net premiums earned were 11% and 9% for the first nine months of 2008 and 2007, respectively.

Interest expense decreased between the quarterly periods as well as the nine month periods primarily due to the decline in the 3-month London Interbank Offered Rate and its related impact on the interest expense of subordinated debentures.

Liquidity and Capital Resources

Parent Company

GAN provides administrative and financial services for its wholly owned subsidiaries. GAN needs cash during 2008 primarily for administrative expenses and interest on the Subordinated debentures and the Note payable. GAN has approximately $6.0 million in cash and marketable securities, of which $2.0 million was required to be held in connection with the Note payable as of September 30, 2008. Another source of cash to meet obligations is statutorily permitted dividend payments from its insurance subsidiary, which requires approval from the Texas Department of Insurance. For 2008, cash dividends of $5.0 million were paid to GAN. GAN believes the cash available from its short-term investments and available dividends from subsidiaries should be sufficient to meet its expected obligations for 2008.

Net Operating Loss Carryforwards

Deferred tax assets are evaluated and a valuation allowance is established if it is more likely than not that all or a portion of the deferred tax asset will not be realized. See Note 1(d) "Federal Income Taxes" in Notes to Consolidated Financial Statement appearing under Part 1. Financial Information - Item 1. "Financial Statements" of this report for further discussion.

As a result of losses in prior years, as of September 30, 2008, the Company had net operating loss carryforwards for tax purposes aggregating $72,705,000. These net operating loss carryforwards of $11,405,000, $33,950,000, $13,687,000, $633,000 and $13,030,000, if not utilized, will expire in 2020, 2021, 2022, 2023 and 2027, respectively. As of September 30, 2008, the tax benefit of the net operating loss carryforwards was $24,720,000, which was calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $72,705,000.

As of September 30, 2008 and December 31, 2007, the net deferred tax asset before valuation allowance was $32,163,000 and $28,951,000 and the valuation allowance was $29,851,000 and $28,699,000, respectively. The Company does not record a tax valuation allowance relating to the net unrealized losses on investments, excluding common stocks because it is more likely than not that these losses would reverse or be used in future periods. The Company has the ability and it is the Company's intent to fully recover the principal, which could require the Company to hold these securities until their maturity; therefore, the Company considers the impairment to be temporary.

Subsidiaries, Principally Insurance Operations

The primary sources of the insurance subsidiary's liquidity are funds generated from insurance premiums, net investment income and maturing investments. The short-term investments and cash are intended to provide adequate funds to pay claims without selling fixed maturity investments. At September 30, 2008, the insurance subsidiary held short-term investments and cash that the insurance subsidiary believes is adequate liquidity for the payment of claims and other short-term commitments.

With regard to liquidity, the average duration of the investment portfolio is approximately 1.7 years. Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At September 30, 2008 and December 31, 2007, the balance on deposit for the benefit of such policyholders totaled $5,412,000 and $5,218,000, respectively.

Net cash provided by operating activities was $9,346,000 for the first nine months of 2008 and cash used for operating activities was $11,331,000 for the first nine months of 2007. The change in cash as a result of operating activities between the periods was primarily attributable to lower C & CAE paid ratios for nonstandard personal auto between the periods.

Investments and Cash decreased primarily as a result of the decline in market value for the period. At September 30, 2008, 74% of the Company's investments were rated investment grade with an average duration of approximately 1.7 years, including approximately 34% that were held in short-term investments. The Company classifies its bond securities as available for sale. The net unrealized loss associated with the investment portfolio was $4,753,000 (net of tax effect) at September 30, 2008 (see Note 2 to Condensed Consolidated Financial Statements which appears in Item 1 of this Report).

The Company has performed a detailed review of our asset-backed securities to identify the extent to which our asset values may have been impacted by direct exposure to the subprime mortgage loan disruption, as well as broader credit market events. One of our mortgage-backed securities is collateralized by residential mortgage loans that are considered subprime. This security was considered other-than-temporarily impaired in the third quarter of 2008 and the book value was reduced by $932,000 to the current market value and this decline was recorded as a realized loss. At September 30, 2008 and December 31, 2007, we had $8,527,000 and $8,457,000, respectively, in nonprime collateralized mortgage obligations (Alt-A securities) with issuers rated "AAA" by Standard and Poor's. The cost and fair value of these investments were $8,469,000 and $6,582,000, respectively, at September 30, 2008 compared to $8,382,000 and $8,331,000, respectively, at December 31, 2007. The Company, at this time based upon information currently available, expects to receive all payments on these securities in accordance with their original contractual terms as the securities approach their maturity dates, or sooner if market yields for such securities decline. Based on management's evaluation and intent to hold these securities to maturity if necessary to recover the cost, none of the unrealized losses are considered other than temporary.

Premiums receivable increased primarily due to the increase in premium writings for the six months ended September 30, 2008 over the six months ended December 31, 2007. This balance is comprised primarily of premiums due from insureds. Most of the policies are written with a down payment and monthly payment terms of up to four months on six month policies. The Company recorded an allowance for doubtful accounts of $888,000 and $569,000 as of September 30, 3008 and December 31, 2007, respectively, which it considers adequate. The increase in the allowance for doubtful accounts was due primarily to an increase in over thirty day receivables.

Ceded unpaid C & CAE decreased as a result of the settlement of runoff claims subject to excess casualty and quota share reinsurance agreements. This balance represents unpaid C & CAE which have been ceded to reinsurers under the Company's various reinsurance agreements, other than the reserve reinsurance cover agreement. These amounts are not currently due from the reinsurers but could become due in the future when the Company pays the claim and requests reimbursement from the reinsurers.

Deferred policy acquisition costs increased primarily as a result of the 2008 reversal of the premium deficiency for expected underwriting losses on the South Central business that had been recorded in 2007.

Deferred Federal income taxes include temporary differences and the tax asset from net operating loss carryforwards less a valuation allowance that fully reserves these two items, see "Liquidity and Capital Resources - Net Operating Loss Carryforwards." The increase is primarily due to the increase in unrealized losses on investments.

Unpaid C & CAE decreased primarily as a result of favorable development recorded for the runoff lines during the nine months ended September 30, 2008. As of September 30, 2008, the Company had $69,602,000 in net unpaid C & CAE (Unpaid C & CAE of $72,579,000 less Ceded unpaid C & CAE of $2,977,000). This amount represents management's best estimate of the ultimate liabilities. The significant operational changes we have recently made in the nonstandard personal auto claims adjustment process and changing claims trends increase the uncertainties which exist in the estimation process and could lead to inaccurate estimates of claim and claim adjustment expense.

The reserve estimates were made as of September 30, 2008 by our in-house actuarial staff. Prior to the third quarter of 2007, an independent actuarial consulting firm had the responsibility for making the reserve estimates used in our financial statements. Beginning with the third quarter of 2007, the estimates are made by our in-house actuarial staff, and we do not rely on a review by the independent actuarial firm to estimate reserves.

As of September 30, 2008 and December 31, 2007, in respect of its runoff lines, the Company had $7,612,000 and $10,275,000, respectively, in net unpaid C & CAE. Historically, the Company has experienced significant volatility in its reserve projections for its runoff lines. This volatility has been primarily attributable to its commercial automobile and general liability product lines. On February 7, 2002, the Company announced it had decided to discontinue writing commercial lines insurance due to continued adverse claims development and . . .