Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in this report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this report, particularly under the caption "Item 1A. Risk Factors."
General
We are principally a retailer, servicer and underwriter of non-standard personal automobile insurance. We also own two tracts of land in San Antonio, Texas that are held for sale. Non-standard personal automobile insurance is made available to individuals who are categorized as "non-standard" because of their inability or unwillingness to obtain standard insurance coverage due to various factors, including payment history, payment preference, failure in the past to maintain continuous insurance coverage, driving record and/or vehicle type. Generally, our customers are required by law to buy a minimum amount of automobile insurance.
As of September 1, 2009, we leased and operated 418 retail locations (or "stores"), staffed by employee-agents. Our employee-agents exclusively sell non-standard automobile insurance products underwritten by us. As of September 1, 2009, we wrote non-standard personal automobile insurance in 12 states and were licensed in 13 additional states.
The following table shows the number of our retail locations. Retail location counts are based upon the date that a location commenced or ceased writing business.

Year Ended June 30, 2009 2008 Retail locations - beginning of period 431 462 Opened 1 4 Closed (14 ) (35 ) Retail locations - end of period 418 431

The following table shows the number of our retail locations by state.

June 30, 2009 2008 2007 Alabama 25 25 25 Florida 39 40 41 Georgia 61 61 62 Illinois 78 80 81 Indiana 18 19 24 Mississippi 8 8 8 Missouri 12 14 15 Ohio 27 29 30 Pennsylvania 17 19 25 South Carolina 27 28 28 Tennessee 20 20 20 Texas 86 88 103 Total 418 431 462

---

Table of Contents

FIRST ACCEPTANCE CORPORATION 10-K 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 real estate held for sale, interest expense associated with debt, and other general corporate overhead expenses. The following table presents selected financial data for our insurance operations and real estate and corporate segments (in thousands). Year Ended June 30, 2009 2008 2007 Revenues: Insurance $ 265,341 $ 332,219 $ 347,431 Real estate and corporate 124 180 206 Consolidated total $ 265,465 $ 332,399 $ 347,637 Income (loss) before income taxes: Insurance $ (42,536 ) $ 4,685 $ 6,252 Real estate and corporate (7,368 ) (8,708 ) (5,336 ) Consolidated total $ (49,904 ) $ (4,023 ) $ 916

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).

Year Ended June 30, 2009 2008 2007 Premiums earned: Georgia $ 49,762 $ 60,928 $ 70,312 Illinois 27,583 32,009 31,201 Florida 26,113 43,017 55,117 Texas 25,971 33,769 32,480 Alabama 23,948 28,780 30,316 South Carolina 17,887 23,634 14,797 Tennessee 15,269 20,772 23,800 Ohio 12,914 15,416 16,455 Pennsylvania 11,437 10,041 6,937 Indiana 5,537 7,131 8,186 Missouri 3,907 5,630 6,087 Mississippi 3,785 4,787 4,973 Total premiums earned $ 224,113 $ 285,914 $ 300,661

---

Table of Contents

FIRST ACCEPTANCE CORPORATION 10-K The following table presents the change in the total number of policies in force for the insurance operations. 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. Year Ended June 30, 2009 2008 2007 Policies in force - beginning of period 194,079 226,974 200,401 Net increase (decrease) during period (35,857 ) (32,895 ) 26,573 Policies in force - end of period 158,222 194,079 226,974

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.
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.

Year Ended June 30, 2009 2008 2007 Loss and loss adjustment expense 66.6 % 76.9 % 80.4 % Expense 24.7 % 21.7 % 19.8 % Combined 91.3 % 98.6 % 100.2 %

The non-standard personal automobile insurance industry is cyclical in nature. Likewise, adverse economic conditions impact our customers and many will choose to reduce their coverage or go uninsured during a weak economy. In the past, the industry has been characterized by periods of price competition and excess capacity followed by periods of high premium rates and shortages of underwriting capacity. If new competitors enter this market, existing competitors may attempt to increase market share by lowering rates. Such conditions could lead to reduced prices, which would negatively impact our revenues and profitability.

---

Table of Contents

FIRST ACCEPTANCE CORPORATION 10-K 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. This policy currently does not allow investments in equity securities. Management and the Investment Committee meet regularly with our investment manager 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 or the credit quality of specific securities. During the 2009 fiscal year, we sold securities with unrealized gains to generate taxable income in order to utilize expiring tax NOL carryforwards.
The value of our consolidated investment portfolio was $140.3 million at June 30, 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 June 30, 2009, we had gross unrealized gains of $4.6 million and gross unrealized losses of $5.2 million.
At June 30, 2009, 98.0% of the fair value 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 June 30, 2009. Investment grade securities generally bear lower yields and have 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 $43.5 million at June 30, 2009 and represented 31% of our fixed maturity portfolio. As of June 30, 2009, 98.5% of our CMOs were considered investment grade by each of the nationally recognized rating agencies. In addition, 89% of our CMOs were rated AAA and 74% of our CMOs were backed by agencies of the United States government. Of the non-agency backed CMOs, 58% were rated AAA.
The following table summarizes our fixed maturity securities at June 30, 2009 (in thousands).

Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value U.S. government and agencies $ 10,744 $ 473 $ (37 ) $ 11,180 State 8,238 344 (19 ) 8,563 Political subdivisions 1,834 52 (32 ) 1,854 Revenue and assessment 27,816 831 (166 ) 28,481 Corporate bonds 45,737 1,654 (665 ) 46,726 Collateralized mortgage obligations: Agency backed 30,656 1,270 - 31,926 Non-agency backed - residential 8,178 1 (2,561 ) 5,618 Non-agency backed - commercial 7,646 - (1,683 ) 5,963 $ 140,849 $ 4,625 $ (5,163 ) $ 140,311

---

Table of Contents

FIRST ACCEPTANCE CORPORATION 10-K The following table sets forth the scheduled maturities of our fixed maturity securities at June 30, 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 $ 4,376 $ 905 $ 250 $ 5,531 After one through five years 50,827 1,951 - 52,778 After five through ten years 21,554 5,490 - 27,044 After ten years 4,777 6,674 - 11,451 No single maturity date 32,531 10,862 114 43,507 $ 114,065 $ 25,882 $ 364 $ 140,311

Year Ended June 30, 2009 Compared with the Year Ended June 30, 2008 Consolidated Results
Revenues for the year ended June 30, 2009 decreased 20% to $265.5 million from $332.4 million in the prior year. Loss before income taxes for the year ended June 30, 2009 was $49.9 million, compared with a loss before income taxes of $4.0 million for the year ended June 30, 2008. The loss before income taxes for the year ended June 30, 2009 included a goodwill impairment charge of $68.0 million. Net loss for the year ended June 30, 2009 was $68.3 million, compared with a net loss of $17.8 million for the year ended June 30, 2008. The net loss for the year ended June 30, 2009 included a net charge of $10.2 million resulting from the $15.3 million tax effect of the goodwill impairment charge and the establishment of a full valuation allowance on the remaining deferred tax assets offset by a tax benefit of $5.1 million related to the utilization of federal NOL carryforwards that were to expire on June 30, 2009 that had been previously reserved for through a valuation allowance. Basic and diluted net loss per share was $1.43 for the year ended June 30, 2009, compared with basic and diluted net loss per share of $0.37 for the year ended June 30, 2008.
Insurance Operations
Revenues from insurance operations were $265.3 million for the year ended June 30, 2009, compared with $332.2 million for the year ended June 30, 2008. Loss before income taxes from insurance operations for the year ended June 30, 2009 was $42.5 million, compared with income before income taxes from insurance operations of $4.7 million for the year ended June 30, 2008.
Premiums Earned
Premiums earned decreased by $61.8 million, or 22%, to $224.1 million for the year ended June 30, 2009, from $285.9 million for the year ended June 30, 2008. The decrease in premiums earned was 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 actions taken in a number of states to improve underwriting profitability and the closure of underperforming stores also contributed toward the decrease in policies written and premiums earned. Approximately 67% of the $61.8 million decline in premiums earned for the year ended June 30, 2009 was in our Florida, Georgia, South Carolina and Texas markets.
The total number of insured policies in force at June 30, 2009 decreased 18% over the same date in 2008 from 194,079 to 158,222, primarily due to the factors noted above. At June 30, 2009, we operated 418 stores, compared with 431 stores at June 30, 2008.
Commission and Fee Income
Commission and fee income decreased 13% to $31.8 million for the year ended June 30, 2009, from $36.5 million for the year ended June 30, 2008. The decrease was a result of the decrease in the number of policies in force, partially offset by higher fee income related to commissionable products sold through our network of retail locations.

---

Table of Contents

FIRST ACCEPTANCE CORPORATION 10-K Investment Income
Investment income decreased to $9.5 million during the year ended June 30, 2009 from $11.3 million during the year ended June 30, 2008 primarily as a result of an increase in cash and cash equivalents, a decrease in the amount of assets invested in fixed maturities and the significant decline in yields on cash equivalents. Cash and cash equivalents increased from $38.6 million at June 30, 2008 to $77.2 million at June 30, 2009 primarily as a result of the sale of $35.3 million of U.S. government and agency securities and agency backed CMOs in March 2009 to generate taxable income in order to utilize expiring net operating losses. The proceeds from these sales had not been reinvested as of June 30, 2009. At June 30, 2009 and 2008, the tax-equivalent book yields for our fixed maturities and cash equivalents portfolio were 3.5% and 5.1%, respectively, with effective durations of 2.26 and 3.69 years, respectively, which both declined as a result of the increase in cash equivalents previously discussed.
Net realized gains (losses) on fixed maturities, available-for-sale Net realized gains (losses) on fixed maturities, available-for-sale during the year ended June 30, 2009 included $2.5 million in net realized gains from the sale of $35.3 million of U.S. government and agency securities and agency backed CMOs in March 2009 as previously noted. Net realized gains (losses) on fixed maturities, available-for-sale included $2.4 million of charges related to other-than-temporary impairment ("OTTI") on investments, which was comprised of $1.5 million related to certain non-agency backed CMOs and $0.9 million related to three corporate bonds.
Effective April 1, 2009, we adopted the provisions of Staff Position 115-2, Recognition and Presentation of Other-Than-Temporary Impairments. Under this guidance, we separate OTTI into the following two components: (i) the amount related to credit losses which is recognized in the consolidated statement of operations and (ii) the amount related to all other factors which is recorded in other comprehensive income (loss). The credit-related portion of an OTTI is measured by comparing a security's amortized cost to the present value of its current expected cash flows discounted at its effective yield at the date of acquisition. As a result of the adoption of this pronouncement, the cumulative effect resulted in an adjustment of $0.6 million to reclassify the non-credit component of previously recognized impairments from accumulated deficit to accumulated other comprehensive loss.
The determination of whether unrealized losses are "other-than-temporary" requires judgment based on subjective as well as objective factors. We routinely monitor our fixed maturities portfolio for changes in fair value that might indicate potential impairments and perform detailed reviews on such securities. Changes in fair value are evaluated to determine the extent to which such changes are attributable to (i) fundamental factors specific to the issuer or
(ii) market-related factors such as interest rates or sector declines. Securities with declines attributable to issuer-specific fundamentals are reviewed to identify all available evidence to estimate the potential for impairment. Resources used include historical financial data included in SEC filings for corporate bonds and performance data regarding the underlying loans for CMOs. Securities with declines attributable solely to market or sector declines where we do not intend to sell the security and it is more likely than not that we will not be required to sell the security before the full recovery of its amortized cost basis are not deemed to be other-than-temporary. The issuer-specific factors considered in reaching the conclusion that securities with declines are not other-than-temporary include (i) the extent and duration of the decline in fair value, including the duration of any significant decline in value, (ii) whether the security is current as to payments of principal and interest, (iii) a valuation of any underlying collateral,
(iv) current and future conditions and trends for both the business and its industry, (v) changes in cash flow assumptions for CMOs and (vi) rating agency actions. Based on these factors, we will make a determination as to the probability of recovering principal and interest on the security. On a quarterly basis, we review cash flow estimates for certain non-agency backed CMOs of lesser credit quality following the guidance of FSP EITF 99-20-1, Amendments to the Impairment Guidance of EITF Issue No. 99-20 ("FSP EITF 99-20-1"). Accordingly, when changes in estimated cash flows from the cash flows previously estimated occur due to actual prepayment and credit loss experience, and the present value of the revised cash flows is less than the present value previously estimated, OTTI is deemed to have occurred. For non-agency backed CMOs not subject to FSP EITF 99-20-1, we prepare quarterly projected cash flow analyses and when it is indicated that a principal loss is probable, OTTI is deemed to have occurred. The timing of projected cash flows on CMOs has changed as economic conditions have prevented the underlying borrowers from refinancing the mortgages

---

Table of Contents

FIRST ACCEPTANCE CORPORATION 10-K 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. These factors have resulted in the OTTI that we have recognized related to non-agency backed CMOs.
Our review of non-agency backed CMOs included an analysis of available information such as collateral quality, anticipated cash flows, credit enhancements, default rates, loss severities, the securities' relative position in their respective capital structures, and credit ratings from statistical rating agencies. We review quarterly projected cash flow analyses for each security utilizing current assumptions regarding (i) actual and anticipated delinquencies, (ii) delinquency transition-to-default rates, and (iii) loss severities. Based on our quarterly reviews, we determined that there had not been adverse changes in projected cash flows, except in the case of those 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. We do not intend to sell these securities and it is more likely than not that we will not be required to sell these securities before the recovery of their amortized cost basis.
The OTTI charges on corporate bonds was recognized as these bonds were considered to be impaired based on the extent and duration of the declines in their fair values and issuer-specific fundamentals relating to (i) poor operating results and weakened financial conditions, (ii) negative industry trends further impacted by the recent economic decline, and (iii) a series of downgrades to their credit ratings. Based on the factors that existed at the time of impairment, we did not believe that these bonds would recover their unrealized losses in the near future.
We believe that the remaining securities having unrealized losses at June 30, 2009 were not other-than-temporarily impaired. We also do not intend to sell any of these securities and it is more likely than not that we will not be required to sell any of these securities before the recovery of their amortized cost basis.
Loss and Loss Adjustment Expenses
The loss and loss adjustment expense ratio was 66.6% for the year ended June 30, 2009, compared with 76.9% for the year ended June 30, 2008. For the year ended June 30, 2009, we experienced favorable development of approximately $11.4 million for losses occurring prior to June 30, 2008.
The favorable development for the year ended June 30, 2009 was due to lower than anticipated severity and frequency of accidents in the states in which we operate. Excluding the development noted above, the loss and loss adjustment expense ratio for the year ended June 30, 2009 was 71.7%. The year-over-year improvement reflects among other things, favorable severity trends in property and physical damage coverages, rate actions taken in a number of states to improve underwriting profitability, improvement in our underwriting and claim handling practices, and the shift in business mix toward renewal policies, which have lower loss ratios than new policies. . . .