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 December 31, 2008, we leased and operated 424 retail locations (or "stores"), staffed by employee-agents. Our employee-agents primarily sell insurance products either underwritten or serviced by us. As of December 31, 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 Six Months Ended December 31, December 31, 2008 2007 2008 2007 Retail locations - beginning of period 429 458 431 462 Opened - 1 1 2 Closed (5 ) (19 ) (8 ) (24 ) Retail locations - end of period 424 440 424 440

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

December 31, September 30, June 30, 2008 2007 2008 2007 2008 2007 Alabama 25 25 25 25 25 25 Florida 39 40 39 41 40 41 Georgia 61 61 61 62 61 62 Illinois 81 80 81 81 80 81 Indiana 18 22 19 23 19 24 Mississippi 8 8 8 8 8 8 Missouri 12 16 13 16 14 15 Ohio 28 29 29 30 29 30 Pennsylvania 18 19 18 24 19 25 South Carolina 27 28 28 28 28 28 Tennessee 20 20 20 20 20 20 Texas 87 92 88 100 88 103 Total 424 440 429 458 431 462

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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 Six Months Ended December 31, December 31, 2008 2007 2008 2007 Premiums earned: Georgia $ 12,344 $ 15,135 $ 25,772 $ 31,238 Illinois 6,826 7,931 14,188 16,100 Florida 6,196 10,820 13,812 23,181 Texas 6,133 8,217 13,134 16,743 Alabama 5,888 7,034 12,460 14,538 South Carolina 4,491 5,650 9,941 11,290 Tennessee 3,800 5,168 8,215 10,690 Ohio 3,182 3,814 6,633 7,814 Pennsylvania 2,786 2,360 5,572 4,661 Indiana 1,298 1,806 2,861 3,774 Missouri 956 1,382 2,085 2,852 Mississippi 923 1,167 1,988 2,406 Total premiums earned $ 54,823 $ 70,484 $ 116,661 $ 145,287

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 Six Months Ended December 31, December 31, 2008 2007 2008 2007 Policies in force - beginning of period 170,555 212,511 194,079 226,974 Net decrease during period (10,998 ) (9,503 ) (34,522 ) (23,966 ) Policies in force - end of period 159,557 203,008 159,557 203,008

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 Six Months Ended December 31, December 31, 2008 2007 2008 2007 Loss and loss adjustment expense 68.5 % 77.1 % 69.7 % 77.1 % Expense 25.2 % 23.0 % 23.2 % 21.3 % Combined 93.7 % 100.1 % 92.9 % 98.4 %

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 $190.0 million at December 31, 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 December 31, 2008, we had gross unrealized gains of $5.7 million and gross unrealized losses of $7.9 million.
At December 31, 2008, 99.9% of our investment portfolio was rated "investment grade" (a credit rating of AAA to BBB) by Standard & Poor's Corporation, a nationally recognized rating agency. The average credit rating of our fixed maturity portfolio was AA+ at December 31, 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 $64.3 million at December 31, 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 December 31, 2008, 99.7% of our CMOs were considered investment grade by all of the nationally recognized rating agencies. In addition, 96% of the CMOs were rated AAA and 83% of our CMOs were backed by agencies of the United States government. Of the non-agency backed CMOs, 76% were rated AAA.

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FIRST ACCEPTANCE CORPORATION 10-Q The following table summarizes our fixed maturity securities at December 31, 2008 (in thousands). Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value U.S. government and agencies $ 30,110 $ 2,189 $ - $ 32,299 State 8,262 260 (7 ) 8,515 Political subdivisions 3,357 37 (37 ) 3,357 Revenue and assessment 29,006 618 (251 ) 29,373 Corporate bonds 53,712 745 (2,343 ) 52,114 Collateralized mortgage obligations 67,656 1,892 (5,246 ) 64,302 $ 192,103 $ 5,741 $ (7,884 ) $ 189,960

The following table sets forth the scheduled maturities of our fixed maturity securities at December 31, 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 $ 5,367 $ 1,432 $ 2,360 $ 9,159 After one through five years 44,533 17,708 - 62,241 After five through ten years 27,191 15,059 1,525 43,775 After ten years 2,902 7,581 - 10,483 No single maturity date 53,383 10,919 - 64,302 $ 133,376 $ 52,699 $ 3,885 $ 189,960

Three and Six Months Ended December 31, 2008 Compared with the Three and Six Months Ended December 31, 2007
Consolidated Results
Revenues for the three months ended December 31, 2008 decreased 21% to $65.1 million from $82.3 million in the same period last year. Net loss for the three months ended December 31, 2008 was $1.0 million, compared with a net loss of $11.7 million for the three months ended December 31, 2007. Basic and diluted net loss per share was $0.02 for the three months ended December 31, 2008 compared with $0.25 for the three months ended December 31, 2007.
Revenues for the six months ended December 31, 2008 decreased 19% to $136.7 million from $169.5 million in the same period last year. Net income for the six months ended December 31, 2008 was $0.8 million, compared with a net loss of $9.8 million for the six months ended December 31, 2007. Basic and diluted net income per share was $0.02 for the six months ended December 31, 2008 compared with net loss per share of $0.21 for the six months ended December 31, 2007.
Insurance Operations
Revenues from insurance operations were $65.0 million for the three months ended December 31, 2008, compared with $82.3 million for the three months ended December 31, 2007. For the six months ended December 31, 2008, revenues from insurance operations were $136.6 million, compared with $169.4 million for the six months ended December 31, 2007.
Income before income taxes from insurance operations for the three months ended December 31, 2008 was $0.4 million, compared with $2.4 million for the three months ended December 31, 2007. Income before income taxes from insurance operations for the six months ended December 31, 2008 was $6.2 million, compared with $7.5 million for the six months ended December 31, 2007.

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FIRST ACCEPTANCE CORPORATION 10-Q Premiums Earned
Premiums earned decreased by $15.7 million, or 22%, to $54.8 million for the three months ended December 31, 2008 from $70.5 million for the three months ended December 31, 2007. For the six months ended December 31, 2008, premiums earned decreased by $28.6 million, or 20%, to $116.7 million from $145.3 million for the six months ended December 31, 2007. The decreases in premiums earned were primarily due to declines in policies written resulting from the weak economic conditions, rate increases taken in a number of states to improve underwriting profitability, and the closure of 53 poor performing stores since January 2007.
Approximately 69% of the $15.7 million decline in premiums earned for the three months ended December 31, 2008 and approximately 73% of the $28.6 million decline in premiums earned for the six months ended December 31, 2008 was in our Florida, Georgia, Texas and Tennessee markets. These states collectively accounted for 52% of premiums earned during both the three and six months ended December 31, 2008, down from 56% for the same periods in the prior year. Our premiums earned in these states were adversely affected by the weak economic 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 December 31, 2008 decreased 21% over the same date in 2007 from 203,008 to 159,557, primarily due to the factors noted above. At December 31, 2008, we operated 424 stores, compared with 440 stores at December 31, 2007.
Commission and Fee Income
Commission and fee income decreased 15% to $7.7 million for the three months ended December 31, 2008 from $9.0 million for the three months ended December 31, 2007. The decrease in fee income was a result of the decrease in policies in force, partially offset by higher fee income in Florida.
For the six months ended December 31, 2008, commission and fee income decreased by $2.4 million, or 13%, to $15.9 million from $18.3 million for the six months ended December 31, 2007. The decrease in fee income was the result of factors discussed above for the three months ended December 31, 2008.
Investment Income
Investment income decreased during the three and six months ended December 31, 2008 primarily as a result of the decrease in the total amount of invested assets and the significant decline in yields on cash equivalents. At December 31, 2008 and 2007, the tax-equivalent book yields for our fixed maturities portfolio were 5.0% and 5.2%, respectively, with effective durations of 3.56 and 3.46 years, respectively.
Other
Included in other revenues during the six months ended December 31, 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 backed 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. For the three months ended September 30, 2008, as a result of the deterioration in liquidity in the credit markets, yields on certain non-agency mortgage-backed securities declined below projected book yield requiring an impairment to those CMOs totaling $0.6 million. Effective for interim and annual reporting periods ending after December 15, 2008, the Financial Accounting Standards Board ("FASB") issued Staff Position EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20 (the "FSP"), which eliminated the previous requirement that a holder's best estimate of cash flows be based upon those that a market participant would use. Instead, the FSP requires that an other-than-temporary impairment be recognized as a realized loss through earnings when it is probable there has been an adverse change in the holder's estimated cash flows from the cash flows previously projected, which is consistent with the impairment model in FASB Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities. Retroactive application to a prior interim or annual reporting period is not permitted. Based upon our best estimate of cash flows on eligible securities, there has been no adverse change in such cash flows, and therefore, no further impairment was recorded at December 31, 2008.

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FIRST ACCEPTANCE CORPORATION 10-Q At December 31, 2008, our portfolio included non-agency backed CMOs with an original cost of $18.3 million and a current fair value of $11.0 million. Such fair value was obtained from either an independent third-party valuation service provider or non-binding broker quotes. For the year ended June 30, 2008 and the three months ended September 30, 2008, we recognized $1.4 million and $0.5 million, respectively, of OTTI in accordance with the guidance of EITF Issue No. 99-20, "Recognition of Interest Income and Impairment of Purchased Beneficial Interests and Beneficial Interests that Continue to Be Held by a Transferor in Securitized Financial Assets". Our review of these securities included the analysis of available information such as collateral quality, anticipated cash flows, credit enhancements, default rates, loss severities, the securities' relative position within their respective capital structures, and credit ratings from statistical rating agencies. Based on our review, we believe that the unrealized losses on these securities are not necessarily predictive of the ultimate performance of the underlying collateral. In the absence of further deterioration in the collateral relative to its positions in these securities' respective capital structures, which could be other-than-temporary, we believe the unrealized losses should reverse over the remaining lives of the securities. We have both the ability and intention to hold these securities to maturity.
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 December 31, 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 68.5% for the three months ended December 31, 2008, compared with 77.1% for the three months ended December 31, 2007. The loss and loss adjustment expense ratio was 69.7% for the six months ended December 31, 2008, compared with 77.1% for the six months ended December 31, 2007. For the three and six months ended December 31, 2008, we experienced unfavorable development of approximately $0.3 million and favorable development of approximately $1.1 million for losses occurring prior to calendar year 2008. For the three and six months ended December 31, 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 and six months ended December 31, 2008.
Excluding the development noted above, the loss and loss adjustment expense ratio for the three and six months ended December 31, 2008 was 68.0% and 70.6%, respectively. These improvements over the same periods last year were primarily the result of a revision in our estimate of the loss and loss adjustment expense ratio for calendar 2008 which improved from 76.5% at June 30, 2008 to 73.8% at December 31, 2008. We attribute this improvement to the impact of the rate increases taken in early calendar 2008 in our Florida, Illinois, Indiana, Texas and South Carolina markets and the continued improvement in our underwriting and claim handling practices.
Operating Expenses
Insurance operating expenses decreased 15% to $21.5 million for the three months ended December 31, 2008 from $25.2 million for the three months ended December 31, 2007. For the six months ended December 31, 2008, insurance operating expenses decreased 13% to $43.0 million from $49.2 million for the six months ended December 31, 2007. These decreases were primarily a result of a reduction in costs (such as agent commissions and premium taxes) that varied along with the decrease in premiums earned as well as savings realized from the closure of underperforming stores.
The expense ratio increased from 23.0% for the three months ended December 31, 2007 to 25.2% for the same period in the current fiscal year. The expense ratio increased from 21.3% for the six months ended December 31, 2007 to 23.2% for the same period in the current fiscal year. These increases were primarily due to the declines in premiums earned discussed above.
Overall, the combined ratio decreased to 93.7% for the three months ended December 31, 2008 from 100.1% for the three months ended December 31, 2007. For the six months ended December 31, 2008, the combined ratio decreased to 92.9% from 98.4% for the six months ended December 31, 2007.

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FIRST ACCEPTANCE CORPORATION 10-Q Litigation Settlement
Litigation settlement costs for the three and six months ended December 31, 2008 of $5.1 million and $5.2 million, respectively, relate to the costs incurred in connection with our settlement and defense of the litigation in Alabama and Georgia. We have entered into settlement agreements relating to the Georgia litigation and the Alabama litigation. Pursuant to the litigation settlements, we will (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 $6.1 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 costs associated with the Georgia . . .