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 March 31, 2009, we leased and operated 419 retail locations (or "stores"), staffed by employee-agents. Our employee-agents primarily sell insurance products either underwritten or serviced by us. As of March 31, 2009, 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 Nine Months Ended March 31, March 31, 2009 2008 2009 2008 Retail locations - beginning of period 424 440 431 462 Opened - - 1 2 Closed (5 ) (8 ) (13 ) (32 ) Retail locations - end of period 419 432 419 432

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

March 31, December 31, June 30, 2009 2008 2008 2007 2008 2007 Alabama 25 25 25 25 25 25 Florida 39 40 39 40 40 41 Georgia 61 61 61 61 61 62 Illinois 80 80 81 80 80 81 Indiana 18 19 18 22 19 24 Mississippi 8 8 8 8 8 8 Missouri 12 15 12 16 14 15 Ohio 27 29 28 29 29 30 Pennsylvania 17 19 18 19 19 25 South Carolina 27 28 27 28 28 28 Tennessee 20 20 20 20 20 20 Texas 85 88 87 92 88 103 Total 419 432 424 440 431 462

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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 Nine Months Ended March 31, March 31, 2009 2008 2009 2008 Premiums earned: Georgia $ 12,273 $ 15,237 $ 38,045 $ 46,475 Illinois 6,736 8,016 20,923 24,116 Florida 6,382 10,762 20,194 33,943 Texas 6,459 8,781 19,593 25,524 Alabama 5,845 7,209 18,305 21,747 South Carolina 4,219 6,195 14,160 17,485 Tennessee 3,650 5,179 11,865 15,869 Ohio 3,182 3,846 9,815 11,660 Pennsylvania 2,883 2,606 8,455 7,267 Indiana 1,359 1,736 4,221 5,510 Missouri 939 1,435 3,023 4,287 Mississippi 918 1,207 2,907 3,613 Total premiums earned $ 54,845 $ 72,209 $ 171,506 $ 217,496

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 Nine Months Ended March 31, March 31, 2009 2008 2009 2008 Policies in force - beginning of period 159,557 203,008 194,079 226,974 Net increase (decrease) during period 14,117 12,849 (20,405 ) (11,117 ) Policies in force - end of period 173,674 215,857 173,674 215,857

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 Nine Months Ended March 31, March 31, 2009 2008 2009 2008 Loss and loss adjustment expense 71.0 % 76.6 % 70.1 % 76.9 % Expense 25.3 % 21.0 % 23.9 % 21.2 % Combined 96.3 % 97.6 % 94.0 % 98.1 %

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 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. Securities were also sold during the current quarter to generate taxable income in order to utilize expiring tax net operating loss carryforwards.
Our consolidated investment portfolio was $140.6 million at March 31, 2009 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 March 31, 2009, we had gross unrealized gains of $3.9 million and gross unrealized losses of $7.9 million.
At March 31, 2009, 99.8% 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 March 31, 2009. 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 $42.9 million at March 31, 2009 and represented 31% 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 March 31, 2009, 99.9% of our CMOs were considered investment grade by each of the nationally recognized rating agencies. In addition, 95% of the CMOs were rated AAA and 76% of our CMOs were backed by agencies of the United States government. Of the non-agency backed CMOs, 78% were rated AAA.

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FIRST ACCEPTANCE CORPORATION 10-Q The following table summarizes our fixed maturity securities at March 31, 2009 (in thousands). Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value U.S. government and agencies $ 11,746 $ 653 $ (24 ) $ 12,375 State 7,187 305 (16 ) 7,476 Political subdivisions 1,833 51 (42 ) 1,842 Revenue and assessment 29,575 814 (254 ) 30,135 Corporate bonds 47,475 788 (2,439 ) 45,824 Collateralized mortgage obligations: Agency backed 31,212 1,248 - 32,460 Non-agency backed - residential 7,975 18 (2,736 ) 5,257 Non-agency backed - commercial 7,656 - (2,435 ) 5,221 $ 144,659 $ 3,877 $ (7,946 ) $ 140,590

The following table sets forth the scheduled maturities of our fixed maturity securities at March 31, 2009 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 $ 7,077 $ 1,431 $ 585 $ 9,093 After one through five years 39,625 11,413 858 51,896 After five through ten years 15,328 10,118 - 25,446 After ten years 3,829 7,388 - 11,217 No single maturity date 32,526 10,099 313 42,938 $ 98,385 $ 40,449 $ 1,756 $ 140,590

Three and Nine Months Ended March 31, 2009 Compared with the Three and Nine Months Ended March 31, 2008
Consolidated Results
Revenues for the three months ended March 31, 2009 decreased 20% to $67.1 million from $84.0 million in the same period last year. Net income for the three months ended March 31, 2009 was $2.4 million, compared with $0.8 million for the three months ended March 31, 2008. Basic and diluted net income per share was $0.05 for the three months ended March 31, 2009 compared with basic and diluted net income per share of $0.02 for the three months ended March 31, 2008.
Revenues for the nine months ended March 31, 2009 decreased 20% to $203.8 million from $253.5 million in the same period last year. Net income for the nine months ended March 31, 2009 was $3.2 million, compared with a net loss of $9.1 million for the nine months ended March 31, 2008. Basic and diluted net income per share was $0.07 for the nine months ended March 31, 2009 compared with basic and diluted net loss per share of $0.19 for the nine months ended March 31, 2008.
Insurance Operations
Revenues from insurance operations were $67.1 million for the three months ended March 31, 2009, compared with $84.0 million for the three months ended March 31, 2008. For the nine months ended March 31, 2009, revenues from insurance operations were $203.7 million, compared with $253.3 million for the nine months ended March 31, 2008.
Income before income taxes from insurance operations for the three months ended March 31, 2009 was $5.7 million, compared with $3.2 million for the three months ended March 31, 2008. Income before income taxes

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FIRST ACCEPTANCE CORPORATION 10-Q from insurance operations for the nine months ended March 31, 2009 was $11.9 million, compared with $10.7 million for the nine months ended March 31, 2008.
Premiums Earned
Premiums earned decreased by $17.4 million, or 24%, to $54.8 million for the three months ended March 31, 2009 from $72.2 million for the three months ended March 31, 2008. For the nine months ended March 31, 2009, premiums earned decreased by $46.0 million, or 21%, to $171.5 million from $217.5 million for the nine months ended March 31, 2008. The decreases in premiums earned were primarily due to the weak economic conditions which have caused both a decline in the number of policies written as well as an increase in the percentage of our customers purchasing liability only coverage. Rate increases taken in a number of states to improve underwriting profitability and the closure of stores also contributed toward the decreases in premiums earned.
Approximately 67% of the $17.4 million decline in premiums earned for the three months ended March 31, 2009 and approximately 68% of the $46.0 million decline in premiums earned for the nine months ended March 31, 2009 was in our Florida, Georgia, South Carolina and Texas markets. 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.
The total number of insured policies in force at March 31, 2009 decreased 20% over the same date in 2008 from 215,857 to 173,674, primarily due to the factors noted above. At March 31, 2009, we operated 419 stores, compared with 432 stores at March 31, 2008.
Commission and Fee Income
Commission and fee income decreased 13% to $8.1 million for the three months ended March 31, 2009 from $9.3 million for the three months ended March 31, 2008. 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 nine months ended March 31, 2009, commission and fee income decreased by $3.6 million, or 13%, to $24.0 million from $27.6 million for the nine months ended March 31, 2008. The decrease in fee income was the result of factors discussed above for the three months ended March 31, 2009.
Investment Income
Investment income decreased during the three and nine months ended March 31, 2009 primarily as a result of the decrease in the total amount of invested assets and the significant decline in yields on cash equivalents. At March 31, 2009 and 2008, the tax-equivalent book yields for our fixed maturities portfolio were 3.8% and 5.1%, respectively, with effective durations of 2.45 and 3.44 years, respectively.
Net realized gains (losses) on fixed maturities, available-for-sale Net realized gains (losses) on fixed maturities, available-for-sale during the nine months ended March 31, 2009 included $2.5 million in net realized gains from the sales of $35.3 million of U.S. government and agency backed CMOs which were sold in March 2009 in order to utilize expiring tax net operating loss carryforwards. In addition, net realized gains (losses) on fixed maturities, available-for-sale included $2.0 million of charges related to other-than-temporary impairment ("OTTI") on investments which was comprised of $1.1 million related to certain non-agency backed CMOs and $0.9 million related to three 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 backed CMOs declined below projected book yields requiring an impairment to those CMOs totaling $0.5 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

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FIRST ACCEPTANCE CORPORATION 10-Q 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. In accordance with this new requirement, for the three months ended March 31, 2009, based on an adverse change in our best estimate of cash flows on eligible securities, we recognized further impairment of $0.2 million during the three months ended March 31, 2009. In addition, during the three months ended March 31, 2009, we recognized an impairment of $0.4 million on a non-agency backed CMO not subject to the FSP based on our quarterly projected cash flow analysis which indicated that a principal loss was probable for this security.
At March 31, 2009, our portfolio included non-agency backed CMOs with an adjusted cost of $15.6 million and a current fair value of $10.5 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 nine months ended March 31, 2009, we recognized $1.4 million and $0.7 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 Assetsand, effective with the quarter ended December 31, 2008, the FSP. The OTTI charges recognized to date on these securities resulted from an adverse change in expected cash flows. The timing of projected cash flows on these securities has changed as economic conditions have prevented the underlying borrowers from refinancing the mortgages underlying these securities, thereby reducing the amount of projected prepayments. Likewise, economic conditions have caused an increase in the actual and projected delinquencies in the underlying mortgages. In addition, as previously discussed, during the three months ended March 31, 2009, we also recognized $0.4 million of OTTI on a non-EITF 99-20 CMO.
Our review of these non-agency backed CMOs 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. We perform a quarterly projected cash flow analysis for each security utilizing current assumptions regarding (i) unemployment,
(ii) delinquency transition-to-default rates, (iii) and loss severities. Based on our current quarter review, we determined that there had not been an adverse change from the previous quarter in projected cash flows, except in the case of the securities previously discussed, which incurred OTTI charges. 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. An OTTI charge of $0.2 million was recognized on a bond that was sold in April 2009 at a loss as we considered the bond's issuer to be underperforming. We believe that the remaining securities having unrealized losses at March 31, 2009 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 71.0% for the three months ended March 31, 2009, compared with 76.6% for the three months ended March 31, 2008. The loss and loss adjustment expense ratio was 70.1% for the nine months ended March 31, 2009, compared with 76.9% for the nine months ended March 31, 2008. For the three and nine months ended March 31, 2009, we experienced favorable development of approximately $2.7 million and $6.9 million, respectively, for losses occurring prior to June 30, 2008. For the three and nine months ended March 31, 2008, we did not experience any significant development for losses occurring prior to June 30, 2008. In addition, we did not experience any significant weather-related losses during these periods.
Excluding the development noted above, the loss and loss adjustment expense ratio for the three and nine months ended March 31, 2009 was 75.9% and 74.1%, 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 73.5% at March 31, 2009. We attribute

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FIRST ACCEPTANCE CORPORATION 10-Q this improvement to the impact of the rate increases taken in early calendar 2008 in Florida, Illinois, Indiana, Texas and South Carolina and the continued improvement in our underwriting and claim handling practices, as well as favorable severity trends most notably in our property damage and physical damage coverages.
Operating Expenses
Insurance operating expenses decreased 10% to $22.0 million for the three . . .