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, 2009. 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, 2009 included in our Annual Report on Form 10-K.
General
At September 30, 2009, we leased and operated 415 retail locations (or "stores") staffed by employee-agents. Our employee-agents exclusively sell non-standard automobile insurance products underwritten by us. At September 30, 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, 2009 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 September 30, 2009 2008 Retail locations - beginning of period 418 431 Opened - 1 Closed (3 ) (3 ) Retail locations - end of period 415 429

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

September 30, June 30, 2009 2008 2009 2008 Alabama 25 25 25 25 Florida 36 39 39 40 Georgia 61 61 61 61 Illinois 78 81 78 80 Indiana 18 19 18 19 Mississippi 8 8 8 8 Missouri 12 13 12 14 Ohio 27 29 27 29 Pennsylvania 17 18 17 19 South Carolina 27 28 27 28 Tennessee 20 20 20 20 Texas 86 88 86 88 Total 415 429 418 431

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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 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 September 30, 2009 2008 Premiums earned: Georgia $ 10,902 $ 13,427 Illinois 6,331 7,361 Texas 5,912 7,002 Florida 5,261 7,616 Alabama 5,210 6,572 South Carolina 3,138 5,450 Tennessee 3,104 4,415 Ohio 2,952 3,451 Pennsylvania 2,819 2,787 Indiana 1,221 1,563 Missouri 827 1,128 Mississippi 790 1,066 Total premiums earned $ 48,467 $ 61,838

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.

Three Months Ended September 30, 2009 2008 Policies in force - beginning of period 158,222 194,079 Net decrease during period (5,356 ) (23,524 ) Policies in force - end of period 152,866 170,555

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 insurance operating expenses to premiums earned. Insurance operating expenses are reduced by commission and fee income from insureds. 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.

Three Months Ended September 30, 2009 2008 Loss and loss adjustment expense 68.4 % 70.7 % Expense 26.0 % 21.4 % Combined 94.4 % 92.1 %

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.
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 or based upon changes in interest rates or the credit quality of specific securities.
The value of our consolidated investment portfolio was $181.6 million at September 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 September 30, 2009, we had gross unrealized gains of $6.7 million and gross unrealized losses of $3.1 million.
At September 30, 2009, 98.6% 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 September 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 had a fair value of $44.3 million at September 30, 2009 and represented 24% of our fixed maturity portfolio. At September 30, 2009, 95% of our CMOs were considered investment grade by each of the nationally recognized rating agencies. In addition, 84% of our CMOs were rated AAA and 71% of our CMOs were backed by agencies of the United States government. Of the non-agency backed CMOs, 47% were rated AAA.

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FIRST ACCEPTANCE CORPORATION 10-Q The following table summarizes our fixed maturity securities at September 30, 2009 (in thousands). Gross Gross Amortized Unrealized Unrealized Fair Cost Gains Losses Value U.S. government and agencies $ 23,542 $ 565 $ - $ 24,107 State 7,975 370 (4 ) 8,341 Political subdivisions 1,825 59 (21 ) 1,863 Revenue and assessment 27,169 1,014 (60 ) 28,123 Corporate bonds 72,076 3,046 (237 ) 74,885 Collateralized mortgage obligations: Agency backed 29,991 1,637 - 31,628 Non-agency backed - residential 7,806 17 (1,757 ) 6,066 Non-agency backed - commercial 7,619 1 (993 ) 6,627 $ 178,003 $ 6,709 $ (3,072 ) $ 181,640

The following table sets forth the scheduled maturities of our fixed maturity securities at September 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 $ 3,896 $ 978 $ - $ 4,874 After one through five years 81,628 492 - 82,120 After five through ten years 38,429 734 - 39,163 After ten years 5,203 5,959 - 11,162 No single maturity date 32,236 11,917 168 44,321 $ 161,392 $ 20,080 $ 168 $ 181,640

Other-Than-Temporary Impairment
Effective April 1, 2009, we adopted the provisions of Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 320-10-65, Recognition and Presentation of Other-Than-Temporary Impairments (Prior authoritative literature: FASB Staff Position No. FAS 115-2). Under this guidance, we separate other-than-temporary impairment ("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. 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 maturity 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 filings with the Securities and Exchange Commission 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.

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FIRST ACCEPTANCE CORPORATION 10-Q 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 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 FASB ASC 325-40-65, Amendments to the Impairment Guidance of EITF Issue No. 99-20 (Prior authoritative literature: FSP EITF 99-20-1) ("FASB ASC 325-40-65"). Accordingly, when changes in estimated cash flows from the cash flows previously estimated occur due to actual or estimated prepayment or 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 FASB ASC 325-40-65, we prepare quarterly projected cash flow analyses and recognize OTTI when it is determined that a loss is probable. We have recognized OTTI related to certain non-agency backed CMOs as the underlying cash flows have been adversely impacted due to a reduction in prepayments from mortgage refinancing and an increase in actual and projected delinquencies in the underlying mortgages. 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 in Note 2 to our consolidated financial statements which incurred OTTI charges of $0.3 million. 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 in fiscal year 2009 on corporate bonds were recorded 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 September 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.
Three Months Ended September 30, 2009 Compared with the Three Months Ended September 30, 2008
Consolidated Results
Revenues for the three months ended September 30, 2009 decreased 20% to $57.3 million from $71.6 million in the same period in the prior year. Income before income taxes for the three months ended September 30, 2009 was $2.9 million, compared with $3.8 million for the three months ended September 30, 2008. Net income for the three months ended September 30, 2009 was $2.8 million, compared with $1.8 million for the three months ended September 30, 2008. Basic and diluted net income per share was $0.06 for the three months ended September 30, 2009, compared with $0.04 for the three months ended September 30, 2008.

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FIRST ACCEPTANCE CORPORATION 10-Q Insurance Operations
Revenues from insurance operations were $57.3 million for the three months ended September 30, 2009, compared with $71.6 million for the three months ended September 30, 2008. Income before income taxes from insurance operations for the three months ended September 30, 2009 was $4.5 million, compared with income before income taxes from insurance operations of $5.8 million for the three months ended September 30, 2008.
Premiums Earned
Premiums earned decreased by $13.4 million, or 22%, to $48.5 million for the three months ended September 30, 2009, from $61.8 million for the three months ended September 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 54% of the $13.4 million decline in premiums earned for the three months ended September 30, 2009 was in our Florida, Georgia and South Carolina markets.
The number of insured policies in force at September 30, 2009 decreased 10% over the same date in 2008 from 170,555 to 152,866, primarily due to the factors noted above. At September 30, 2009, we operated 415 stores, compared with 429 stores at September 30, 2008.
Commission and Fee Income
Commission and fee income decreased 16% to $7.0 million for the three months ended September 30, 2009, from $8.2 million for the three months ended September 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 ancillary products sold through our network of retail locations.
Investment Income
Investment income decreased to $1.9 million during the three months ended September 30, 2009 from $2.7 million during the three months ended September 30, 2008. This decrease was primarily as a result of the increase in cash and cash equivalents from the sale of fixed maturity investments in fiscal year 2009 and the significant decline in yields on cash equivalents. At September 30, 2009 and 2008, the tax-equivalent book yields for our portfolio were 4.1% and 5.2%, respectively, with effective durations of 3.22 and 3.50 years, respectively, which both declined as a result of the increase in cash equivalents and the decline in yields previously discussed.
Net realized gains (losses) on fixed maturities, available-for-sale Net realized gains (losses) on fixed maturities, available-for-sale during the three months ended September 30, 2009 included $0.3 million in net realized gains on sales and $0.3 million of charges related to OTTI on certain non-agency backed CMOs. The three months ended September 30, 2008 included $1.3 million of charges related to OTTI and $0.1 million in net realized gains on sales.
Loss and Loss Adjustment Expenses
The loss and loss adjustment expense ratio was 68.4% for the three months ended September 30, 2009, compared with 70.7% for the three months ended September 30, 2008. For the three months ended September 30, 2009 and 2008, we experienced favorable development on losses related to prior periods of approximately $3.7 million and $4.3 million, respectively.
The favorable development for the three months ended September 30, 2009 was due to lower than anticipated severity and frequency of accidents. Excluding favorable development, the loss and loss adjustment expense ratios for the three months ended September 30, 2009 and 2008 were 75.9% and 77.7%, respectively. 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

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FIRST ACCEPTANCE CORPORATION 10-Q underwriting and claim handling practices, and the shift in business mix toward renewal policies, which have lower loss ratios than new policies.
Operating Expenses
Insurance operating expenses decreased 9% to $19.6 million for the three months ended September 30, 2009 from $21.4 million for the three months ended September 30, 2008. The decrease was primarily a result of a reduction in costs (such as employee-agent commissions and premium taxes) that varied along with the decrease in premiums earned partially offset by $0.4 million in costs associated with employee severance and the closure of underperforming stores.
The expense ratio increased from 21.4% for the three months ended September 30, 2008 to 26.0% for the same period in the current fiscal year. The year-over-year increase in the expense ratio was due to the drop in premiums earned, which resulted in a higher percentage of fixed expenses (such as rent and base salary).
Overall, the combined ratio increased to 94.4% for the three months ended September 30, 2009 from 92.1% for the three months ended September 30, 2008.
Litigation Settlement
Litigation settlement costs for the three months ended September 30, 2009 were $(0.4) million, compared with $0.1 million for the same period in fiscal year 2008. The reduction in expense during the three months ended September 30, 2009 related to the forfeiture of available premium credits by Georgia and Alabama class members, while the costs during the three months ended September 30, 2008 were incurred in connection with our settlement and defense of the litigation.
Pursuant to the terms of the settlements, eligible class members are entitled to certain premium credits towards a future automobile insurance policy with the Company or a reimbursement certificate for future rental or towing expenses. . . .