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

Overview

Following development of a larger and more diverse franchise in 2005 and 2006, which resulted in significant premium growth, the Company encountered challenges in 2007. Despite efforts to operate profitably, the emergence of a claims ratio higher than previously estimated, resulting primarily from our rapid growth, caused a loss for the year ended December 31, 2007. Throughout 2007, the Company implemented actions to address these challenges and improve the claims and expense ratios, including the following:

• Implementation of multiple rate increases in most markets to attempt to strengthen pricing adequacy while maintaining desirable business segments;

• Adoption of market initiatives to eliminate sources of unprofitable business, whether derived from specific markets or coverages or originated by agents with identifiable unprofitable business;

• Upgrade of claims systems, procedures and personnel, including practices intended to accelerate the recognition and resolution of exposure throughout the claims process, from initial recording of claims to their ultimate resolution;

• Continuing consolidation of functions and personnel in the Dallas headquarters office, to reduce expenses where practicable while maintaining or improving customer service;

• Deferral of entry into new markets; and

• Continued settlement of runoff claims in an orderly manner. We also sold a former subsidiary (General Agents), which is not utilized in the nonstandard personal automobile business, in a transaction in which the Company realized a net gain of $4.6 million.

The Company reported a net loss of $3.5 million for the year ended December 31, 2008, compared with net loss of $18.6 million for the year ended December 31, 2007. In 2008, the Company recorded net realized losses of approximately $6.3 million, approximately $5.7 million related to write downs for other-than-temporary declines in fair value of various investments including $4.0 million from auction preferred securities backed by preferred stock of the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corp. ("Freddie Mac"). Net premiums earned were $176.6 million and $192.8 million in 2008 and 2007, respectively, and gross premiums written were $181.8 million and $184.9 million in 2008 and 2007, respectively.

As of December 31, 2008, the statutory surplus was $89.8 million, after a $5.0 million dividend paid to GAN, compared to $96.0 million as of December 31, 2007. The unpaid claims and claim adjustment expenses stood at $75.5 million and $74.7 million at December 31, 2008 and 2007, respectively, of which unpaid claims and claim adjustment expenses attributable to ongoing nonstandard personal automobile lines was $66.0 million and $55.7 million, respectively.

The Company believes that the improved C & CAE ratio for nonstandard personal auto insurance discussed below is the result of numerous factors, including the improvements in pricing and underwriting, upgrades of claims systems, procedures and personnel, and actions to closely monitor and address emerging claims trends. The Company believes that it should be able to achieve additional improvement in this C & CAE ratio, subject to the significant risks and uncertainties identified in this report (see ITEM 1A. Risk Factors).

The Company limited its nonstandard personal auto insurance business to Florida until the fourth quarter of 2003, when it began writing policies in Texas. The Company began writing policies in Arizona and Nevada in 2004, in California, with an independent managing general agency, in 2005, and in South Carolina in 2006, and we entered New Mexico in the first quarter of 2007. The Company markets its policies through approximately 4,000 independent agency locations in Arizona, Florida, Nevada, New Mexico, South Carolina and Texas and one general agency in California that markets through approximately 1,000 insurance broker locations. Beginning in 2005, significant growth has been realized as a result of these expansion activities, which has increased the operating leverage, the claims ratio and the overall financial and operational risk profile of the Company.

The following table presents selected financial information:

                                               Years ended December 31,
                                                 2008                2007
                                             (Dollar amounts in thousands)
        Gross premiums written             $        181,849          184,870

        Net premiums earned                $        176,606          192,767

        Loss before Federal income taxes   $         (3,404 )         (8,361 )

        Federal income tax expense         $             46           10,192

        Net loss                           $         (3,450 )        (18,553 )


        GAAP C & CAE ratio (1)                         73.3 %           81.7 %
        GAAP Expense ratio (2) (3)                     25.7 %           25.9 %

        GAAP Combined ratio (2)                        99.0 %          107.6 %

(1) C & CAE is an abbreviation for Claims and claim 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 years. 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 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.

Discontinuance of Commercial Lines

On February 7, 2002, the Company announced its decision to cease writing commercial insurance due to continued adverse claims development and unprofitable results. The discontinuance of writing commercial lines resulted in the Company ceasing to be approved to write insurance in several states; however, this state action has not materially restricted the geographic expansion of the Company's nonstandard personal auto lines thus far.

The Company continues to settle and reduce its inventory of commercial lines claims. At December 31, 2008, there were 30 claims associated with the Company's runoff book outstanding, compared to 47 as of December 31, 2007. As of December 31, 2008, in respect of its runoff lines, the Company had $7.1 million in net unpaid claims and claim adjustment expenses ("C & CAE") compared to $10.3 million 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 claim 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 levels.

Results of Operations

The discussion below primarily relates to the Company's insurance operations, although the selected consolidated financial information 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").

Revenue

Gross premiums written in 2008 decreased 2% as compared to 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
following table presents gross premiums written by region:



                                                 For the years ending December 31,
                                                     2008                    2007
                                                   (Dollar amounts in thousands)
   Region:
   Southeast (Florida, South Carolina)       $     110,123      60 %     102,208    55 %
   South Central (Texas)                            41,221      23        45,373    25
   Southwest (Arizona, New Mexico, Nevada)          28,381      16        33,692    18
   West (California)                                 2,124       1         3,597     2

   Total                                     $     181,849     100 %     184,870   100 %

Each of the regions, except for Southeast, recorded premium declines in 2008 from 2007. The percent of premium (decrease) increase by region for 2008 from 2007 is as follows: Southeast 8%, South Central (9)%, Southwest (16)% and West
(41)%. In the Southeast region, we believe product enhancements, rate adjustments and expanded marketing efforts accounts for the increase in gross premiums written. Net premiums earned decreased 8% in 2008 from 2007 primarily as a result of gross premiums written in the first six months of 2008 being 9% below the comparable period in 2007.

Net investment income decreased $1,473,000 (16)% in 2008 primarily due to the decrease in Bonds available for sale, which provide higher returns than Short-term investments and the decline in interest rates. At December 31, 2008, Bonds available for sale comprised 57% of Investments versus 73% at December 31, 2007. The return on average investments was 4.4% in 2008 versus 5.0% in 2007.

The Company recorded net realized losses of $6,313,000 in 2008 and net realized gains of $4,629,000 in 2007. Approximately $5,671,000 of the net realized losses in 2008 related to write downs for other-than-temporary declines in fair value of various investments, including approximately $3,950,000 from auction preferred securities backed by preferred stock of Fannie Mae and Freddie Mac that are included in preferred stock (see note 3 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report). The net realized gains in 2007 were primarily due to the sale of General Agents. See "Significant Corporate Transactions - Sale of General Agents." Variability in the timing of net realized capital gains and losses should be expected.

Agency revenues decreased $334,000 (3)% in 2008 primarily as a result of the decrease in writings in 2008. Agency revenues are primarily fees charged on insureds' premiums due, as discussed previously.

Expenses

Claims and claim adjustment expenses decreased $27,962,000 (18%) in 2008 and the C & CAE ratio was 73.3% in 2008 versus 81.7% in 2007. The runoff lines recorded favorable development for prior accident years of approximately $1,421,000 and $2,315,000 during 2008 and 2007, respectively. The C & CAE ratio for nonstandard personal auto was 74.2% and 82.9% for 2008 and 2007, respectively. The decrease in the C & CAE ratio was primarily due to less unfavorable development for claims occurring in prior accident years of approximately $4,385,000 in 2008 versus $16,043,000 in 2007. Also contributing to the lower C & CAE ratio was improvement in 2008 accident year as compared the 2007 accident year. The following presents the unfavorable development for claims occurring in prior accident years for each of the three major regions during 2008:

• Southeast Region (primarily Florida)-$1,080,000

• South Central Region (Texas)-$2,010,000

• Southwest Region (primarily Arizona and Nevada)-$733,000

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. The unfavorable development for prior accident years for nonstandard personal auto in 2008 is primarily the result of actual and projected increases in severity associated with bodily injury liability. The Company's growth and the associated risks and uncertainties (see ITEM 1A. Risk Factors) 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 $993,000 recognized in 2008 relating to "extra-contractual" claims, in which claimants seek to recover amounts significantly in excess of applicable policy limits. In 2007, the Company incurred several "extra-contractual" claims of approximately $2,051,000 primarily related to prior accident years (see ITEM 1A. Risk Factors
- "Litigation may adversely affect our financial condition, results of operations and cash flows").

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. When 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.

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 December 31, 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).

With regard to environmental and product liability claims, the Company has an immaterial amount of exposure. The Company did not provide environmental impairment coverage and excluded pollution and asbestos related coverages in its policies. A portion of the Company's remaining claims is related to construction defects.

Inflation impacts the Company by causing higher claim settlements than may have originally been estimated. Inflation is implicitly reflected in the reserving process through analysis of cost trends and review of historical reserve results.

Policy acquisition costs include commissions, premium taxes, marketing and underwriting expenses and the amortization of the premium deficiency. The expenses are charged to operations over the period in which the related premiums are earned. The decrease of $5,962,000 (17)% in 2008 was primarily due to decreases in commission, marketing expenses and the amortization of the premium deficiency for expected underwriting losses on the South Central business that was recorded in deferred policy acquisitions costs in 2007. Commissions decreased primarily as a result of the decline in premiums. The decrease in marketing expenses occurred primarily as a result of reducing the number of territory managers by expanding individual territory manager's geographical area in order to become more efficient. Commissions are paid to the independent agents based upon premium writings. The marketing expenses are primarily salaries, telephone and travel expenses of our territory managers who oversee the efforts of the agents within a geographical area. Their time is focused on the supervision, relationship management and support of existing agents and recruiting new agents, as well as actively soliciting new business from these agents. Accordingly, these costs vary with and are primarily related to the acquisition of new and renewal insurance policies. The ratio of Policy acquisition costs to Net premiums earned was 17% and 18% for 2008 and 2007, respectively.

Underwriting and operating expenses increased $1,024,000 (3%) in 2008 from 2007 primarily due to an increase in software amortization and software maintenance. Underwriting and operating expenses as a percent of Net premiums earned and Agency revenues were 17% for 2008 and 15% for 2007. The increase in the ratio was due to the expense increases and the decline in premium earned.

The decrease in interest expense of $922,000 (22)% is primarily due to the decline in the 3-month London Interbank Offered Rate for U.S. dollar deposits ("LIBOR") during 2008.

Federal income taxes

The Company recorded deferred tax expense in 2007 as a result of increasing the valuation allowance for Deferred Federal income tax asset. The Company considered it appropriate to increase the valuation allowance, see "Liquidity and Capital Resources - Net Operating Loss Carryforwards."

Liquidity and Capital Resources

Parent Company

GAN provides administrative and financial services for its wholly owned subsidiaries. GAN needs cash during 2009 primarily for administrative expenses and interest on the Subordinated debentures and the Note payable. GAN has approximately $3.4 million in cash and marketable securities that can be used for general corporate purposes. 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 (see note 11 to Consolidated Financial Statements which appears in Item 8 of this Annual Report. For 2008, cash dividends of $5.0 million were paid to GAN. GAN believes the cash available from its short-term investments and dividends from its insurance subsidiary, if permitted, should be sufficient to meet its expected obligations for 2009.

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(j) "Federal Income Taxes" in Notes to Consolidated Financial Statement appearing under Part 1. Financial Information - Item 1. "Financial Statements" of this Annual Report for further discussion.

As a result of losses in prior years, as of December 31, 2008 the Company had net operating loss carryforwards for tax purposes aggregating $71,953,000. These net operating loss carryforwards of $10,782,000, $33,950,000, $13,687,000, $633,000 and $12,901,000, if not utilized, will expire in 2020, 2021, 2022, 2023 and 2027, respectively. As of December 31, 2008, the tax benefit of the net operating loss carryforwards was $24,464,000, which is calculated by applying the Federal statutory income tax rate of 34% against the net operating loss carryforwards of $71,953,000.

The Company considers available evidence, both objective and subjective, including historical levels of income, expectations and risks associated with estimates of future taxable income in assessing the need for the valuation allowance. In 2007, the Company increased the amount of the valuation allowance by $13,183,000, resulting in an allowance on the gross deferred tax asset of $28,699,000. In making this determination, the Company considered all available evidence, including the fact that the Company incurred a taxable loss in 2007 and had incurred, as of December 31, 2007, a cumulative taxable loss for the three years then ended.

As of December 31, 2008 and 2007, the net deferred tax asset before valuation allowance was $32,397,000 and $28,951,000 and the valuation allowance was $29,905,000 and $28,699,000, respectively. The Company does not record a tax valuation allowance relating to the net unrealized losses on investments, excluding equity securities 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 December 31, 2008, the insurance subsidiary held short-term investments and cash that the insurance subsidiary believes is at 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 2.0 years. The fair value of the fixed maturity portfolio at December 31, 2008 was $7,331,000 below amortized cost, before taxes see note 2 and note 18 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report). Various insurance departments of states in which the Company operates require the deposit of funds to protect policyholders within those states. At December 31, 2008 and 2007, the balance on deposit for the benefit of such policyholders totaled $5,447,000 and $5,218,000, respectively.

Net cash provided by operating activities was $15,625,000 for 2008 versus cash used for operating activities of $18,277,000 for 2007. The change in cash as a result of operating activities between the periods was primarily attributable to a lower C & CAE paid ratio in 2008 than in 2007.

Investments and Cash increased in 2008 primarily as a result of cash from operations offset by the decline in fair value of the investment securities. At December 31, 2008, 66% of the Company's investments were rated investment grade. The average duration was approximately 2.0 years, including approximately 38% of the Investments 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 $4,839,000 (net of tax effects) at December 31, 2008 (see note 2 of Notes to Consolidated Financial Statements which appear in Item 8 of this Annual Report).

The Company has performed a detailed review of the securities in the investment portfolio and has recorded approximately $5,671,000 in Net realized losses on certain securities that were considered other than temporarily impaired. The Company, at this time based upon information currently available and management's evaluation and intent to hold securities to maturity if necessary to recover the cost, expects to recover the net unrealized loss of $4,839,000 (net of tax effects) and considers this impairment to be temporary.

Premiums receivable increased primarily due to the increase in premium writings for the six months ended December 31, 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 $1,029,000 and $569,000 as of December 31, 2008 and 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 claims subject to the 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 are principally commissions, premium taxes, marketing expenses and some underwriting expenses which are deferred. The increase of $674,000 in 2008 from 2007 was primarily due to the amortization in 2008 of a $623,000 premium deficiency that was previously recorded in 2007 for expected underwriting losses on the South Central business. The premium deficiency amortized to zero as a result of significant improvement in the expected C & CAE ratio in the South Central region.

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, excluding common stocks.

Funds held under reinsurance agreements decreased primarily due to the release of amounts held in trust by the New York Insurance Department for the benefit of policyholders of General Agents. Under the terms of the sale, General Agents returned these amounts to the Company when they were released by the insurance department.

. . .