First Acceptance (FACO) 10-Q 2013 Q2 Quarterly report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2013

Commission File Number: 001-12117

FIRST ACCEPTANCE CORPORATION

(Exact name of registrant as specified in its charter)

Delaware	75-1328153
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification No.)

3813 Green Hills Village Drive Nashville, Tennessee	37215
(Address of principal executive offices)	(Zip Code)

(615) 844-2800

(Registrant’s telephone number, including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨  (Do not check if a smaller reporting company)	Smaller Reporting Company	x

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

At August 5, 2013, there were 40,966,899 shares outstanding of the registrant’s common stock, par value $0.01 per share.

FIRST ACCEPTANCE CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED JUNE 30, 2013

INDEX

PART I – FINANCIAL INFORMATION
Item 1.	Financial Statements	1
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	15
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	25
Item 4.	Controls and Procedures	28
PART II – OTHER INFORMATION
Item 1.	Legal Proceedings	29
Item 4.	Mine Safety Disclosures	29
Item 6.	Exhibits	29
SIGNATURES

i

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

	June 30, 2013			December 31, 2012
	(Unaudited)
ASSETS
Investments, available-for-sale at fair value (amortized cost of $128,065 and $130,342, respectively)	$	132,762		$	139,046
Cash and cash equivalents		74,382			59,104
Premiums and fees receivable, net of allowance of $434 and $306		47,437			45,286
Other assets		7,556			6,190
Property and equipment, net		4,177			4,656
Deferred acquisition costs		3,136			3,221
Identifiable intangible assets		4,800			4,800
TOTAL ASSETS	$	274,250		$	262,303
LIABILITIES AND STOCKHOLDERS’ EQUITY
Loss and loss adjustment expense reserves	$	85,998		$	79,260
Unearned premiums and fees		59,480			55,092
Debentures payable		40,281			40,261
Other liabilities		15,474			14,897
Total liabilities		201,233			189,510
Stockholders’ equity:
Preferred stock, $.01 par value, 10,000 shares authorized		—			—
Common stock, $.01 par value, 75,000 shares authorized; 40,967 and 40,962 shares issued and outstanding, respectively		410			410
Additional paid-in capital		456,866			456,705
Accumulated other comprehensive income		4,677			8,704
Accumulated deficit		(388,936	)		(393,026	)
Total stockholders’ equity		73,017			72,793
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	274,250		$	262,303

See notes to consolidated financial statements.

1

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(in thousands, except per share data)

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Revenues:
Premiums earned	$	52,118		$	47,701		$	101,521		$	93,120
Commission and fee income		9,162			8,501			17,759			16,753
Investment income		1,268			1,762			2,544			3,532
Net realized gains (losses) on investments, available-for-sale (includes $(55), $(19), $(42) and $7, respectively, of accumulated other comprehensive income reclassification for unrealized gains (losses))		(55	)		(19	)		(42	)		7
		62,493			57,945			121,782			113,412
Costs and expenses:
Losses and loss adjustment expenses		39,087			39,726			72,592			78,590
Insurance operating expenses		19,909			20,798			42,249			43,560
Other operating expenses		223			224			452			490
Stock-based compensation		56			115			140			410
Depreciation and amortization		537			573			1,108			1,002
Interest expense		427			979			870			1,958
		60,239			62,415			117,411			126,010
Income (loss) before income taxes		2,254			(4,470	)		4,371			(12,598	)
Provision (benefit) for income taxes (includes $(19), $(7), $(15) and $2, respectively, of income tax expense from reclassification items)		188			(262	)		281			(183	)
Net income (loss)	$	2,066		$	(4,208	)	$	4,090		$	(12,415	)
Net income (loss) per share:
Basic	$	0.05		$	(0.10	)	$	0.10		$	(0.30	)
Diluted	$	0.05		$	(0.10	)	$	0.10		$	(0.30	)
Number of shares used to calculate net income (loss) per share:
Basic		40,921			40,852			40,915			40,847
Diluted		40,948			40,852			40,942			40,847
Reconciliation of net income (loss) to comprehensive loss:
Net income (loss)	$	2,066		$	(4,208	)	$	4,090		$	(12,415	)
Net unrealized change in investments		(3,623	)		144			(4,027	)		1,016
Comprehensive income (loss)	$	(1,557	)	$	(4,064	)	$	63		$	(11,399	)
Detail of net realized gains (losses) on investments, available-for-sale:
Net realized gains (losses) on sales and redemptions	$	(55	)	$	(4	)	$	(14	)	$	23
OTTI charges reclassified from other comprehensive income (loss)		—			(15	)		(28	)		(16	)
OTTI charges recognized in net income (loss)		—			(15	)		(28	)		(16	)
Net realized gains (losses) on investments, available-for-sale	$	(55	)	$	(19	)	$	(42	)	$	7

See notes to consolidated financial statements.

2

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(in thousands)

	Six Months Ended June 30,
	2013			2012
Cash flows from operating activities:
Net income (loss)	$	4,090		$	(12,415	)
Adjustments to reconcile net income (loss) to cash provided by (used in) operating activities:
Depreciation and amortization		1,108			1,002
Stock-based compensation		140			410
Other-than-temporary impairment on investment securities		28			16
Net realized (gains) losses on sales and redemptions of investments		14			(23	)
Other		47			231
Change in:
Premiums and fees receivable		(2,023	)		(5,667	)
Loss and loss adjustment expense reserves		6,738			5,637
Unearned premiums and fees		4,388			7,911
Other		1,043			1,929
Net cash provided by (used in) operating activities		15,573			(969	)
Cash flows from investing activities:
Purchases of investments, available-for-sale		(8,287	)		(3,260	)
Purchases limited partnership interests		(1,747	)		—
Maturities and redemptions of investments, available-for-sale		10,348			15,116
Capital expenditures		(631	)		(2,849	)
Other		(2	)		—
Net cash provided by (used in) investing activities		(319	)		9,007
Cash flows from financing activities:
Payments on borrowings		—			(13	)
Net proceeds from issuance of common stock		24			26
Net cash provided by financing activities		24			13
Net change in cash and cash equivalents		15,278			8,051
Cash and cash equivalents, beginning of period		59,104			23,751
Cash and cash equivalents, end of period	$	74,382		$	31,802

See notes to consolidated financial statements.

3

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. General

The consolidated financial statements of First Acceptance Corporation (the “Company”) included herein have been prepared without audit pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Accordingly, certain information and disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been omitted. In the opinion of management, the consolidated financial statements reflect all adjustments (consisting of normal recurring adjustments) necessary for a fair statement of the interim periods. Certain reclassifications have been made to the prior year’s consolidated financial statements to conform with the current year presentation.

The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for the full year. These consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements included in its Annual Report on Form 10-K for the year ended December 31, 2012.

2. Fair Value

Fair value is the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are generally based upon observable and unobservable inputs. Observable inputs are based on market data from independent sources, while unobservable inputs reflect the Company’s view of market assumptions in the absence of observable market information. All assets and liabilities that are carried at fair value are classified and disclosed in one of the following categories:

Level 1 -	Quoted prices in active markets for identical assets or liabilities.
Level 2 -	Quoted market prices for similar assets or liabilities in active markets; quoted prices by independent pricing services for identical or similar assets or liabilities in markets that are not active; and valuations, using models or other valuation techniques, that use observable market data. All significant inputs are observable, or derived from observable information in the marketplace, or are supported by observable levels at which transactions are executed in the market place.
Level 3 -	Instruments that use non-binding broker quotes, model driven valuations that do not have observable market data or those that are estimated based on an ownership interest to which a proportionate share of net assets is attributed.

The Company categorizes valuation methods used in its identifiable intangible assets impairment tests as Level 3. To determine the fair value of acquired trademarks and trade names, the Company uses the relief-from-royalty method, which requires the Company to estimate the future revenue for the related brands, the appropriate royalty rate and the weighted average cost of capital. The Company also categorizes valuation methods used to fair value its investments in limited partnerships as Level 3, since the Company uses an estimate based on its ownership interest to which a proportionate share of the partners’ net assets is attributed.

Fair Value of Financial Instruments

The carrying values and fair values of certain of the Company’s financial instruments were as follows (in thousands).

	June 30, 2013				December 31, 2012
	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets:
Investments, available-for-sale	$	132,762	$	132,762	$	139,046	$	139,046
Other investments		1,727		1,727		—		—
Liabilities:
Debentures payable		40,281		12,588		40,261		12,723

4

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The fair values as presented represent the Company’s best estimates and may not be substantiated by comparisons to independent markets. The fair value of the debentures payable was based on current market rates offered for debt with similar risks and maturities. Carrying values of certain financial instruments, such as cash and cash equivalents and premiums and fees receivable, approximate fair value due to the short-term nature of the instruments and are not required to be disclosed. Therefore, the aggregate of the fair values presented in the preceding table do not purport to represent the Company’s underlying value.

The Company holds available-for-sale investments and limited partnership interests, which are carried at fair value. The following tables present the fair-value measurements for each major category of assets that are measured on a recurring basis (in thousands).

			Fair Value Measurements Using
June 30, 2013	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Fixed maturities, available-for-sale:
U.S. government and agencies	$	11,872	$	11,872	$	—	$	—
State		3,044		—		3,044		—
Political subdivisions		773		—		773		—
Revenue and assessment		16,134		—		16,134		—
Corporate bonds		69,320		—		69,320		—
Collateralized mortgage obligations:
Agency backed		9,334		—		9,334		—
Non-agency backed – residential		5,102		—		5,102		—
Non-agency backed – commercial		4,853		—		4,853		—
Redeemable preferred stocks		1,693		1,693		—		—
Total fixed maturities, available-for-sale		122,125		13,565		108,560		—
Mutual funds, available-for-sale		10,637		10,637		—		—
Total investments, available-for-sale		132,762		24,202		108,560		—
Limited partnership interests		1,727		—		—		1,727
Cash and cash equivalents		74,382		74,382		—		—
Total	$	208,871	$	98,584	$	108,560	$	1,727

5

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

			Fair Value Measurements Using
December 31, 2012	Total		Quoted Prices in Active Markets for Identical Assets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)
Fixed maturities, available-for-sale:
U.S. government and agencies	$	12,110	$	12,110	$	—	$	—
State		4,111		—		4,111		—
Political subdivisions		790		—		790		—
Revenue and assessment		17,996		—		17,996		—
Corporate bonds		71,537		—		71,537		—
Collateralized mortgage obligations:
Agency backed		11,870		—		11,870		—
Non-agency backed – residential		5,472		—		5,472		—
Non-agency backed – commercial		5,109		—		5,109		—
Redeemable preferred stock		1,718		1,718		—		—
Total fixed maturities, available-for-sale		130,713		13,828		116,885		—
Mutual fund, available-for-sale		8,333		8,333		—		—
Total investments, available-for-sale		139,046		22,161		116,885		—
Cash and cash equivalents		59,104		59,104		—		—
Total	$	198,150	$	81,265	$	116,885	$	—

The fair values of the Company’s investments are determined by management after taking into consideration available sources of data. All of the portfolio valuations classified as Level 1 or Level 2 in the above tables are priced exclusively by utilizing the services of independent pricing sources using observable market data. The Level 2 classified security valuations are obtained from a single independent pricing service. The Level 3 classified securities in the table above consist of limited partnership interests for which fair value is estimated based on the Company’s ownership interest in partners’ capital. There were no transfers between Level 1 and Level 2 for the three and six months ended June 30, 2013 and 2012. The Company’s policy is to recognize transfers between levels at the end of the reporting period. The Company has not made any adjustments to the prices obtained from the independent pricing sources.

The Company has reviewed the pricing techniques and methodologies of the independent pricing service for Level 2 investments and believes that its policies adequately consider market activity, either based on specific transactions for the security valued or based on modeling of securities with similar credit quality, duration, yield and structure that were recently traded. The Company monitored security-specific valuation trends and has made inquiries with the pricing service about material changes or the absence of expected changes to understand the underlying factors and inputs and to validate the reasonableness of the pricing.

Based on the above categorization, there were no Level 3 classified security valuations at June 30, 2012 and December 31, 2012 and 2011, nor any transfers into or out of Level 3 during these periods. At June 30, 2013, the Level 3 classification was the result of purchases during the three months ended June 30, 2013.

6

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

3. Investments

Investments, Available-for-Sale

The following tables summarize the Company’s investment securities (in thousands).

June 30, 2013	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
U.S. government and agencies	$	11,202	$	670	$	—		$	11,872
State		2,986		61		(3	)		3,044
Political subdivisions		752		21		—			773
Revenue and assessment		15,219		920		(5	)		16,134
Corporate bonds		68,725		2,449		(1,854	)		69,320
Collateralized mortgage obligations:
Agency backed		8,781		553		—			9,334
Non-agency backed – residential		4,642		479		(19	)		5,102
Non-agency backed – commercial		4,357		496		—			4,853
Redeemable preferred stocks		1,500		193		—			1,693
Total fixed maturities, available-for-sale		118,164		5,842		(1,881	)		122,125
Mutual funds, available-for-sale		9,901		737		(1	)		10,637
	$	128,065	$	6,579	$	(1,882	)	$	132,762

December 31, 2012	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
U.S. government and agencies	$	11,202	$	908	$	—		$	12,110
State		3,994		117		—			4,111
Political subdivisions		753		37		—			790
Revenue and assessment		16,449		1,553		(6	)		17,996
Corporate bonds		68,114		3,669		(246	)		71,537
Collateralized mortgage obligations:
Agency backed		11,079		791		—			11,870
Non-agency backed – residential		5,098		472		(98	)		5,472
Non-agency backed – commercial		4,652		457		—			5,109
Redeemable preferred stock		1,500		218		—			1,718
Total fixed maturities, available-for-sale		122,841		8,222		(350	)		130,713
Mutual fund, available-for-sale		7,501		832		—			8,333
	$	130,342	$	9,054	$	(350	)	$	139,046

7

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The following tables set forth the scheduled maturities of the Company’s fixed maturity securities 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.

June 30, 2013	Securities with Unrealized Gains		Securities with Unrealized Losses		Securities with No Unrealized Gains or Losses		All Fixed Maturity Securities
One year or less	$	10,260	$	—	$	1,585	$	11,845
After one through five years		28,724		13,579		—		42,303
After five through ten years		17,080		20,409		—		37,489
After ten years		6,756		2,749		—		9,505
No single maturity date		20,605		378		—		20,983
	$	83,425	$	37,115	$	1,585	$	122,125

December 31, 2012	Securities with Unrealized Gains		Securities with Unrealized Losses		Securities with No Unrealized Gains or Losses		All Fixed Maturity Securities
One year or less	$	9,380	$	—	$	5	$	9,385
After one through five years		34,460		11,518		—		45,978
After five through ten years		25,230		15,181		—		40,411
After ten years		10,770		—		—		10,770
No single maturity date		23,833		336		—		24,169
	$	103,673	$	27,035	$	5	$	130,713

The following table reflects the number of fixed maturity securities with gross unrealized gains and losses. Gross unrealized losses are further segregated by the length of time that individual securities have been in a continuous unrealized loss position.

	Gross Unrealized Losses
At:	Less than or equal to 12 months		Greater than  12 months		Gross Unrealized Gains
June 30, 2013		18		2		113
December 31, 2012		13		1		108

The following tables reflect the fair value and gross unrealized losses of those fixed maturity securities in a continuous unrealized loss position for greater than 12 months. Gross unrealized losses are further segregated by the percentage of amortized cost (in thousands, except number of securities).

Gross Unrealized Losses at June 30, 2013:	Number of Securities		Fair Value		Gross Unrealized Losses
Less than or equal to 10%		2	$	947	$	(17	)
Greater than 10%		—		—		—
		2	$	947	$	(17	)

Gross Unrealized Losses at December 31, 2012:	Number of Securities		Fair Value		Gross Unrealized Losses
Less than or equal to 10%		—	$	—	$	—
Greater than 10%		1		212		(78	)
		1	$	212	$	(78	)

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

The following tables set forth the amount of gross unrealized losses by current severity (as compared to amortized cost) and length of time that individual securities have been in a continuous unrealized loss position (in thousands).

	Fair Value of Securities with					Severity of Gross Unrealized Losses
Length of Gross Unrealized Losses at June 30, 2013:	Gross Unrealized Losses		Gross Unrealized Losses			Less than 5%			5% to 10%			Greater than 10%
Less than or equal to:
Three months	$	21,915	$	(804	)	$	(386	)	$	(419	)	$	—
Six months		3,368		(278	)		—			(278	)		—
Nine months		10,885		(782	)		(108	)		(674	)		—
Twelve months		—		—			—			—			—
Greater than twelve months		947		(17	)		(17	)		—			—
Total	$	37,115	$	(1,881	)	$	(511	)	$	(1,371	)	$	—

	Fair Value of Securities with					Severity of Gross Unrealized Losses
Length of Gross Unrealized Losses at December 31, 2012:	Gross Unrealized Losses		Gross Unrealized Losses			Less than 5%			5% to 10%		Greater than 10%
Less than or equal to:
Three months	$	26,121	$	(266	)	$	(246	)	$	—	$	(20	)
Six months		—		—			—			—		—
Nine months		—		—			—			—		—
Twelve months		702		(6	)		(6	)		—		—
Greater than twelve months		212		(78	)		—			—		(78	)
Total	$	27,035	$	(350	)	$	(252	)	$	—	$	(98	)

Other Investments

The following table summarizes the Company’s other investments, which are included within other assets (in thousands).

June 30, 2013	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
Limited partnership interests	$	1,747	$	—	$	(20	)	$	1,727

Limited partnership interests consist of investments in two private equity ventures that invest in small balance distressed secured loans and securities and international equity, respectively. These investments have redemption restrictions. However, the Company does not intend to sell these limited partnership interests, and it is more likely than not that the Company will not be required to sell them before the expiration of such restrictions. At June 30, 2013, the Company had unfunded commitments of $3.8 million to its limited partnership interests.

Restrictions

At June 30, 2013, fixed maturities and cash equivalents with a fair value and amortized cost of $5.3 million were on deposit with various insurance departments as a requirement of doing business in those states. Cash equivalents with a fair value and amortized cost of $9.4 million were on deposit with another insurance company as collateral for an assumed reinsurance contract.

9

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

Investment Income and Net Realized Gains and Losses

The major categories of investment income follow (in thousands).

	Three Months Ended June  30,						Six Months Ended June 30,
	2013			2012			2013			2012
Fixed maturities, available-for-sale	$	1,270		$	1,746		$	2,553		$	3,506
Mutual fund, available-for-sale		145			140			285			277
Other		22			38			42			67
Investment expenses		(169	)		(162	)		(336	)		(318	)
	$	1,268		$	1,762		$	2,544		$	3,532

The components of net realized gains (losses) on investments, available-for-sale at fair value follow (in thousands).

	Three Months Ended June  30,						Six Months Ended June  30,
	2013			2012			2013			2012
Gains	$	7		$	5		$	48		$	32
Losses		(62	)		(9	)		(62	)		(9	)
Other-than-temporary impairment		—			(15	)		(28	)		(16	)
	$	(55	)	$	(19	)	$	(42	)	$	7

Realized gains and losses on sales and redemptions are computed based on specific identification. The non-credit related portion of other-than-temporary impairment (“OTTI”) charges is included in other comprehensive income (loss). The amounts of non-credit OTTI for securities still owned was $1.0 million for non-agency backed residential collateralized mortgage obligations (“CMOs”) and $0.2 million related to non-agency backed commercial CMOs at both June 30, 2013 and December 31, 2012.

Other-Than-Temporary Impairment

In accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 320-10, the Company separates OTTI into the following two components: (i) the amount related to credit losses, which is recognized in the consolidated statement of operations and comprehensive income (loss) 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 prior to the impairment charge.

The determination of whether unrealized losses are “other-than-temporary” requires judgment based on subjective as well as objective factors. The Company routinely monitors its investment portfolio for changes in fair value that might indicate potential impairments and performs 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 SEC for corporate bonds and performance data regarding the underlying loans for CMOs. Securities with declines attributable solely to market or sector declines where the Company does not intend to sell the security and it is more likely than not that the Company will not be required to sell the security before the full recovery of its amortized cost basis are not deemed to be other-than-temporarily impaired.

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

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, the Company makes a determination as to the probability of recovering principal and interest on the security.

The number and amount of securities for which the Company has recognized OTTI charges in net income (loss) are presented in the following tables (in thousands, except for the number of securities).

	Three Months Ended June 30,
	2013				2012
	Number of Securities		OTTI		Number of Securities		OTTI
Collateralized mortgage obligations:
Non-agency backed – commercial		—	$	—		1	$	(15	)
Portion of loss recognized in accumulated other comprehensive income (loss)				—				—
Net OTTI recognized in net loss			$	—			$	(15	)

	Six Months Ended June 30,
	2013					2012
	Number of Securities		OTTI			Number of Securities		OTTI
Collateralized mortgage obligations:
Non-agency backed – residential		1	$	(28	)		1	$	(1	)
Non-agency backed – commercial		—		—			1		(15	)
		1		(28	)		2		(16	)
Portion of loss recognized in accumulated other comprehensive income (loss)				—					—
Net OTTI recognized in net loss			$	(28	)			$	(16	)

The following is a progression of the credit-related portion of OTTI on investments owned at June 30, 2013 and 2012 (in thousands).

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Beginning balance	$	(2,607	)	$	(3,426	)	$	(2,666	)	$	(3,425	)
Additional credit impairments on:
Previously impaired securities		—			(15	)		(28	)		(16	)
Securities without previous impairments		—			—			—			—
		—			(15	)		(28	)		(16	)
Reductions for securities sold (realized)		(8	)		—			(95	)		—
	$	(2,599	)	$	(3,441	)	$	(2,599	)	$	(3,441	)

On a quarterly basis, the Company reviews cash flow estimates for certain non-agency backed CMOs of lesser credit quality following the guidance of FASB ASC 325-40, Investments - Other - Beneficial Interests in Securitized Financial Assets (“FASB ASC 325-40”). Accordingly, when changes in estimated cash flows 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

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

not subject to FASB ASC 325-40, the Company reviews quarterly projected cash flow analyses and recognizes OTTI when it determines that a loss is probable. The Company has 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.

The Company’s 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. The Company reviews 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 its quarterly reviews, the Company determined that there had not been an adverse change in projected cash flows, except in the case of those securities for which OTTI charges have been recorded. The Company believes that the unrealized losses on the remaining non-agency backed securities for which OTTI charges have not been recorded are not necessarily predictive of the ultimate performance of the underlying collateral. The Company does not intend to sell these securities and it is more likely than not that the Company will not be required to sell these securities before the recovery of their amortized cost basis.

The Company believes that the remaining securities having unrealized losses at June 30, 2013 were not other-than-temporarily impaired. The Company also does not intend to sell any of these securities and it is more likely than not that the Company will not be required to sell any of these securities before the recovery of their amortized cost basis.

4. Net Income (Loss) Per Share

The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share data).

	Three Months Ended June 30,					Six Months Ended June 30,
	2013		2012			2013		2012
Net income (loss)	$	2,066	$	(4,208	)	$	4,090	$	(12,415	)
Weighted average common basic shares		40,921		40,852			40,915		40,847
Effect of dilutive securities		27		—			27		—
Weighted average common dilutive shares		40,948		40,852			40,942		40,847
Basic and diluted net income (loss) per share	$	0.05	$	(0.10	)	$	0.10	$	(0.30	)

For both the three and six months ended June 30, 2013, 27 thousand shares of unvested restricted common stock were included in the computation of diluted income per share. For both the three and six months ended June 30, 2012, the computation of diluted net loss per share did not include 0.1 million shares of unvested restricted common stock as their inclusion would have been anti-dilutive. Options to purchase approximately 1.3 million and 5.3 million shares for the three and six months ended June 30, 2013 and 2012, respectively, were also not included in the computation of diluted net loss per share as their exercise prices were in excess of the average stock prices for the periods presented.

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

5. Income Taxes

The provision (benefit) for income taxes consisted of the following (in thousands).

	Three Months Ended June  30,						Six Months Ended June  30,
	2013			2012			2013		2012
Federal:
Current	$	41		$	—		$	67	$	—
Deferred		—	��		—			—		—
		41			—			67		—
State:
Current		146			(262	)		212		(184	)
Deferred		1			—			2		1
		147			(262	)		214		(183	)
	$	188		$	(262	)	$	281	$	(183	)

The provision (benefit) for income taxes differs from the amounts computed by applying the statutory federal corporate tax rate of 35% to loss before income taxes as a result of the following (in thousands).

	Three Months Ended June  30,						Six Months Ended June 30,
	2013			2012			2013			2012
Provision (benefit) for income taxes at statutory rate	$	789		$	(1,565	)	$	1,530		$	(4,409	)
Tax effect of:
Tax-exempt investment income		(5	)		(1	)		(10	)		(2	)
Change in the beginning of the period balance of the valuation allowance for deferred tax assets allocated to federal income taxes		(749	)		1,545			(1,635	)		4,372
Restricted stock		—			1			171			13
State income taxes, net of federal income tax benefit and valuation allowance		147			(262	)		214			(183	)
Other		6			20			11			26
	$	188		$	(262	)	$	281		$	(183	)

The Company had a valuation allowance of $28.2 million and $28.4 million at June 30, 2013 and December 31, 2012, respectively, to reduce deferred tax assets to the amount that is more likely than not to be realized. The change in the total valuation allowance for the six months ended June 30, 2013 was a decrease of $0.2 million. For the six months ended June 30, 2013, the change in the valuation allowance included an increase of $1.4 million related to unrealized change in investments included in other comprehensive income (loss).

In assessing the realization of deferred tax assets, management considered whether it was more likely than not that some portion or all of the deferred tax assets will not be realized. The Company is required to assess whether a valuation allowance should be established against the Company’s net deferred tax assets based on the consideration of all available evidence using a more likely than not standard. In making such judgments, significant weight is given to evidence that can be objectively verified. In assessing the Company’s ability to support the realizability of its deferred tax assets, management considered both positive and negative evidence. The Company placed greater weight on historical results than on the Company’s outlook for future profitability and established a deferred tax valuation allowance at June 30, 2013 and December 31, 2012. The deferred tax valuation allowance may be adjusted in future periods if management determines that it is more likely than not that some portion or all of the deferred tax assets will be realized. In the event the deferred tax valuation allowance is adjusted, the Company would record an income tax benefit for the adjustment.

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (continued)

(Unaudited)

6. Segment Information

The Company operates in two business segments with its primary focus being the selling, servicing and underwriting of non-standard personal automobile insurance. The real estate and corporate segment consists of the activities related to the disposition of foreclosed real estate held for sale, interest expense associated with all debt and other general corporate overhead expenses.

The following table presents selected financial data by business segment (in thousands).

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Revenues:
Insurance	$	62,481		$	57,916		$	121,759		$	113,350
Real estate and corporate		12			29			23			62
Consolidated total	$	62,493		$	57,945		$	121,782		$	113,412
Income (loss) before income taxes:
Insurance	$	2,949		$	(3,181	)	$	5,811		$	(9,803	)
Real estate and corporate		(695	)		(1,289	)		(1,440	)		(2,795	)
Consolidated total	$	2,254		$	(4,470	)	$	4,371		$	(12,598	)

	June 30, 2013		December 31, 2012
Total assets:
Insurance	$	266,861	$	256,670
Real estate and corporate		7,389		5,633
Consolidated total	$	274,250	$	262,303

7. Recent Accounting Pronouncement

In February 2013, the FASB issued ASU No. 2013-02,Presentation of Comprehensive Income, which requires a company to provide information about the amounts reclassified out of accumulated other comprehensive income by component. There are no changes to the components that are recognized in net income or other comprehensive income under current GAAP. The Company adopted the provisions of this guidance in the quarter ended March 31, 2013. The adoption of this guidance did not have an impact on the Company’s financial position or results of operations, other than the presentation thereof.

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FIRST ACCEPTANCE CORPORATION 10-Q

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 year ended December 31, 2012. 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 year ended December 31, 2012 included in our Annual Report on Form 10-K for the year ended December 31, 2012.

Forward-Looking Statements

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements made in this report, other than statements of historical fact, are forward-looking statements. You can identify these statements from our use of the words “may,” “should,” “could,” “potential,” “continue,” “plan,” “forecast,” “estimate,” “project,” “believe,” “intent,” “anticipate,” “expect,” “target,” “is likely,” “will,” or the negative of these terms and similar expressions. These statements are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements may include, among other things, statements and assumptions relating to:

• our future growth, income (loss), income (loss) per share and other financial performance measures;

• the anticipated effects on our results of operations or financial condition from recent and expected developments or events;

• the financial condition of, and other issues relating to the strength of and liquidity available to, issuers of securities held in our investment portfolio;

• the accuracy and adequacy of our loss reserving methodologies; and

• our business and growth strategies.

We believe that our expectations are based on reasonable assumptions. However, these forward-looking statements involve known and unknown risks, uncertainties and other important factors that could cause our actual results, performance or achievements, or industry results to differ materially from our expectations of future results, performance or achievements expressed or implied by these forward-looking statements. In addition, our past results of operations do not necessarily indicate our future results. We discuss these and other uncertainties in “Item 1A. Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2012.

You should not place undue reliance on any forward-looking statements. These statements speak only as of the date of this report. Except as otherwise required by applicable laws, we undertake no obligation to publicly update or revise any forward-looking statements or the risk factors described in this report, whether as a result of new information, future events, changed circumstances or any other reason after the date of this report.

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.

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FIRST ACCEPTANCE CORPORATION 10-Q

At June 30, 2013, we leased and operated 366 retail locations (or “stores”) staffed by employee-agents who primarily sell non-standard personal automobile insurance products underwritten by us as well as certain commissionable ancillary products. In most states, our employee-agents also sell a complementary tenant homeowner insurance product underwritten by us. In addition, during the six months ended June 30, 2013, select retail locations in highly competitive markets in Illinois and Texas began offering non-standard personal automobile insurance serviced and underwritten by other third-party insurance carriers. At June 30, 2013, 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 year ended December 31, 2012 for additional information with respect to our business.

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.

	Three Months Ended June  30,						Six Months Ended June  30,
	2013			2012			2013			2012
Retail locations – beginning of period		367			378			369			382
Opened		—			—			—			—
Closed		(1	)		(9	)		(3	)		(13	)
Retail locations – end of period		366			369			366			369

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

	June 30,				March 31,				December 31,
	2013		2012		2013		2012		2012		2011
Alabama		24		24		24		24		24		24
Florida		30		30		30		30		30		30
Georgia		60		60		60		60		60		60
Illinois		62		63		62		66		63		67
Indiana		17		17		17		17		17		17
Mississippi		7		7		7		8		7		8
Missouri		11		11		11		12		11		12
Ohio		27		27		27		27		27		27
Pennsylvania		16		16		16		16		16		16
South Carolina		26		26		26		26		26		26
Tennessee		19		19		19		19		19		20
Texas		67		69		68		73		69		75
Total		366		369		367		378		369		382

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FIRST ACCEPTANCE CORPORATION 10-Q

Consolidated Results of Operations

Overview

Our primary focus is selling, servicing and underwriting 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 and related products 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 policies sold on behalf of third-party insurance carriers; and

• investment income earned on the invested assets of the insurance company subsidiaries.

The following table presents gross premiums earned by state (in thousands). Driven by improvements in sales execution, a higher percentage of full coverage policies sold and rate increases taken in most states, net premiums earned for the three and six months ended June 30, 2013 increased 9.3% and 9.0%, respectively, compared with the same periods in the prior year. The changes in premiums earned in Illinois and Texas for the three and six months ended June 30, 2013 were adversely impacted by the increase in policies sold on behalf of third party carriers which generate commission and fee income instead of premiums earned.

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Gross premiums earned:
Georgia	$	9,887		$	9,904		$	19,538		$	19,433
Florida		8,092			6,847			15,713			12,919
Texas		6,168			5,851			11,990			11,528
Alabama		5,523			4,442			10,571			8,670
Illinois		5,327			5,586			10,644			11,124
Ohio		4,684			3,999			9,044			7,802
South Carolina		4,036			3,222			7,694			6,234
Tennessee		3,182			3,058			6,222			6,010
Pennsylvania		2,228			2,100			4,372			4,147
Indiana		1,355			1,203			2,599			2,379
Missouri		982			834			1,870			1,622
Mississippi		703			702			1,361			1,348
Total gross premiums earned		52,167			47,748			101,618			93,216
Premiums ceded to reinsurer		(49	)		(47	)		(97	)		(96	)
Total net premiums earned	$	52,118		$	47,701		$	101,521		$	93,120

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FIRST ACCEPTANCE CORPORATION 10-Q

The following table presents the change in the total number of policies in force (“PIF”) for the insurance operations, including policies underwritten on behalf of third party carriers. PIF increases as a result of new policies issued and decreases as a result of policies that are canceled or expire and are not renewed. At June 30, 2013, PIF was 2.1% higher than at the same date in the prior year.

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013		2012
Policies in force – beginning of period		174,456			170,254			147,176		141,862
Net change during period		(13,411	)		(12,459	)		13,869		15,933
Policies in force – end of period		161,045			157,795			161,045		157,795

The following tables present total PIF for the insurance operations segregated by policies that were sold through retail locations, independent agents, call center and website, and include those sold on behalf of third party carriers. For our retail locations, PIF are further segregated by (i) new and renewal and (ii) liability-only or full coverage. New policies are defined as those policies issued to both first-time customers and customers who have reinstated a lapsed or cancelled policy. Renewal policies are those policies which renewed after completing their full uninterrupted policy term. Liability-only policies are defined as those policies including only bodily injury (or no-fault) and property damage coverages, which are the required coverages in most states. The PIF for policies sold through our call center and website grew to 3,535; representing 2.2% of total PIF at June 30, 2013, compared with 0.6% at the same date in the prior year.

	June 30,
	2013		2012
Retail locations:
New		77,615		75,819
Renewal		78,117		78,908
		155,732		154,727
Independent agents		1,778		2,117
Call center and website		3,535		951
Total policies in force		161,045		157,795

	June 30,
	2013		2012
Retail locations:
Liability-only		89,871		90,766
Full coverage		65,861		63,961
		155,732		154,727
Independent agents		1,778		2,117
Call center and website		3,535		951
Total policies in force		161,045		157,795

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, net of ceded reinsurance.

Expense Ratio -Expense ratio is the ratio (expressed as a percentage) of insurance operating expenses to net 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.

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FIRST ACCEPTANCE CORPORATION 10-Q

The following table presents the loss, expense and combined ratios for our insurance operations.

	Three Months Ended June 30,						Six Months Ended June 30,
	2013			2012			2013			2012
Loss and loss adjustment expense		75.0	%		83.3	%		71.5	%		84.4	%
Expense		20.6	%		25.8	%		24.1	%		28.8	%
Combined		95.6	%		109.1	%		95.6	%		113.2	%

Operational Initiatives

Since the beginning of 2012, we renewed our focus on improving the customer experience and value through several initiatives. Through July 2013, our progress has included:

• investment in our sales organization to improve the quality and consistency of the customer experience in our retail stores,

• continued development of our brand,

• investment in rebranding our store fronts and refurbishing our store interiors,

• development of electronic signature capabilities, thereby enabling most customers to receive quotes and bind policies over the phone and through our website,

• development of a consumer-based website that reflects our branding strategy, improves the customer experience, and allows for full-service capabilities including quoting, binding and receiving payments,

• launch of our trial implementation of sales of third party carrier automobile insurance to select Illinois and Texas locations where pricing is highly competitive,

• development of an internet-specific sales strategy to drive quote traffic to our website,

• expanded our call center processes and people in order to better support our phone sales efforts, and

• launched the sale of a complementary term life insurance product through our retail stores.

Moving forward, we continue to believe that our retail stores are the foundation of our business, providing an opportunity for us to directly interact with our customers on a regular basis. We also recognize that customer preferences have changed and that we need to adapt to meet those needs. For that reason, we will continue to invest in our people, retail stores, website and call center initiatives, and our customer interaction efforts in order to improve the customer experience. Our current initiatives include:

• expansion of our potential customer base through enhancements to our insurance products,

• continued investment and refinement of our internet-specific sales strategy,

• continued investment and development of our website’s full-service capabilities, and

• continued assessment and possible expansion of sales of third party carrier auto insurance in select locations where pricing is highly competitive.

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FIRST ACCEPTANCE CORPORATION 10-Q

Investments

We use the services of an independent investment manager to manage our 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. 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 debt securities, and include U.S. government securities, municipal bonds, corporate bonds and collateralized mortgage obligations (“CMOs”). 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 based upon changes in interest rates or the credit quality of specific securities.

The value of our consolidated available-for-sale investment portfolio was $132.8 million at June 30, 2013 and consisted of fixed maturity securities and investments in mutual funds, all carried at fair value with unrealized gains and losses reported as a separate component of stockholders’ equity. At June 30, 2013, we had gross unrealized gains of $6.6 million and gross unrealized losses of $1.9 million in our consolidated investment portfolio.

At June 30, 2013, 84% of the fair value of our fixed maturity portfolio was rated “investment grade” (a credit rating of AAA to BBB-) by nationally recognized statistical rating organizations. Investment grade securities generally bear lower yields and have lower degrees of risk than those that are unrated or non-investment grade. We believe 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 $19.3 million at June 30, 2013 and represented 15% of our fixed maturity portfolio. At June 30, 2013, 71% of our CMOs were considered investment grade by nationally recognized statistical rating agencies and 49% were backed by agencies of the United States government.

The following table summarizes our investment securities at June 30, 2013 (in thousands).

June 30, 2013	Amortized Cost		Gross Unrealized Gains		Gross Unrealized Losses			Fair Value
U.S. government and agencies	$	11,202	$	670	$	—		$	11,872
State		2,986		61		(3	)		3,044
Political subdivisions		752		21		—			773
Revenue and assessment		15,219		920		(5	)		16,134
Corporate bonds		68,725		2,449		(1,854	)		69,320
Collateralized mortgage obligations:
Agency backed		8,781		553		—			9,334
Non-agency backed – residential		4,642		479		(19	)		5,102
Non-agency backed – commercial		4,357		496		—			4,853
Redeemable preferred stocks		1,500		193		—			1,693
Total fixed maturities, available-for-sale		118,164		5,842		(1,881	)		122,125
Mutual fund, available-for-sale		9,901		737		(1	)		10,637
	$	128,065	$	6,579	$	(1,882	)	$	132,762

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FIRST ACCEPTANCE CORPORATION 10-Q

Three and Six Months Ended June 30, 2013 Compared with the Three and Six Months Ended June 30, 2012

Consolidated Results

Revenues for the three months ended June 30, 2013 increased 8% to $62.5 million from $57.9 million in the same period in the prior year. Income before income taxes for the three months ended June 30, 2013 was $2.3 million, compared with loss before income taxes of $4.5 million for the three months ended June 30, 2012. Net income for the three months ended June 30, 2013 was $2.1 million, compared with net loss of $4.2 million for the three months ended June 30, 2012. Basic and diluted net income per share were $0.05 for the three months ended June 30, 2013, compared with basic and diluted net loss per share of $0.10 for the same period in the prior year.

Revenues for the six months ended June 30, 2013 increased 7% to $121.8 million from $113.4 million in the same period in the prior year. Income before income taxes for the six months ended June 30, 2013 was $4.4 million, compared with loss before income taxes of $12.6 million for the six months ended June 30, 2012. Net income for the six months ended June 30, 2013 was $4.1 million, compared with net loss of $12.4 million for the six months ended June 30, 2012. Basic and diluted net income per share were $0.10 for the six months ended June 30, 2013, compared with basic and diluted net loss per share of $0.30 for the same period in the prior year.

Insurance Operations

Revenues from insurance operations were $62.5 million for the three months ended June 30, 2013, compared with $57.9 million for the three months ended June 30, 2012. Revenues from insurance operations were $121.8 million for the six months ended June 30, 2013, compared with $113.4 million for the six months ended June 30, 2012.

Income before income taxes from insurance operations for the three months ended June 30, 2013 was $2.9 million, compared with loss before income taxes from insurance operations of $3.2 million for the three months ended June 30, 2012. Income before income taxes from insurance operations for the six months ended June 30, 2013 was $5.8 million, compared with loss before income taxes from insurance operations of $9.8 million for the six months ended June 30, 2012.

Premiums Earned

Premiums earned increased by $4.4 million, or 9%, to $52.1 million for the three months ended June 30, 2013, from $47.7 million for the three months ended June 30, 2012. For the six months ended June 30, 2013, premiums earned increased by $8.4 million, or 9%, to $101.5 million from $93.1 million for the six months ended June 30, 2012. This improvement was primarily due to the continued sales, marketing, customer interaction and product initiatives, in addition to our recent pricing actions.

Commission and Fee Income

Commission and fee income increased 8% to $9.2 million for the three months ended June 30, 2013, from $8.5 million for the three months ended June 30, 2012. For the six months ended June 30, 2013, commission and fee income increased 6% to $17.8 million from $16.8 million for the six months ended June 30, 2012. This increase in commission and fee income was a result of higher fee income related to commissionable products sold on behalf of third-party insurance carriers sold through our retail locations.

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FIRST ACCEPTANCE CORPORATION 10-Q

Investment Income

Investment income decreased to $1.3 million during the three months ended June 30, 2013 from $1.8 million during the three months ended June 30, 2012. For the six months ended June 30, 2013, investment income decreased to $2.5 million from $3.5 million during the six months ended June 30, 2012. This decrease in investment income was primarily a result of the low-yielding reinvestment opportunities for both portfolio maturities and the proceeds from the sale in September 2012 of $29.6 million of corporate bonds in order to increase the statutory surplus of the insurance company subsidiaries. At June 30, 2013 and 2012, the tax-equivalent book yields for our fixed maturities portfolio were 3.1% and 4.4%, respectively, with effective durations of 2.98 and 3.05 years, respectively.

Net realized gains (losses) on investments, available-for-sale

Net realized losses on investments, available-for-sale during the three months ended June 30, 2013 included $55 thousand of net realized losses on redemptions. Net realized losses on investments, available-for-sale during the three months ended June 30, 2012 primarily included $15 thousand of charges related to other-than-temporary impairment (“OTTI”) on certain non-agency backed CMOs .

For the six months ended June 30, 2013 net realized losses on investments, available-for-sale included $14 thousand in net realized losses on redemptions and $28 thousand of charges related to OTTI on certain non-agency backed CMOs. Net realized gains on investments, available-for-sale during the six months ended June 30, 2012 included $23 thousand in net realized gains on redemptions and $16 thousand of charges related to OTTI on certain non-agency backed CMOs. For additional information with respect to the determination of OTTI losses on investment securities, see Note 3 to our consolidated financial statements.

Loss and Loss Adjustment Expenses

The loss and loss adjustment expense ratio was 75.0% for the three months ended June 30, 2013, compared with 83.3% for the three months ended June 30, 2012. The loss and loss adjustment expense ratio was 71.5% for the six months ended June 30, 2013, compared with 84.4% for the six months ended June 30, 2012. We experienced favorable development related to prior periods of $1.4 million for the three months ended June 30, 2013, compared with unfavorable development of $0.8 million for the three months ended June 30, 2012. For the six months ended June 30, 2013, we experienced favorable development related to prior periods of $2.5 million, compared with unfavorable development of $4.0 million for the six months ended June 30, 2012. The favorable development for the three and six month periods ended June 30, 2013 was primarily due to lower than expected development related to property damage liability and no-fault claims that occurred in calendar year 2012, as well as lower than expected development related to bodily injury claims that occurred in calendar years 2011 and 2012.

Excluding the development related to prior periods, the loss and loss adjustment expense ratios for the three months ended June 30, 2013 and 2012 were 77.8% and 81.5%, respectively. Excluding the development related to prior periods, the loss and loss adjustment expense ratios for the six months ended June 30, 2013 and 2012 were 74.0% and 80.1%, respectively. The year-over-year decrease in the loss and loss adjustment expense ratio was primarily due to the impact of pricing actions taken throughout 2012.

Operating Expenses

Insurance operating expenses decreased 4% to $19.9 million for the three months ended June 30, 2013 from $20.8 million for the three months ended June 30, 2012. For the six months ended June 30, 2013, insurance operating expenses decreased 3% to $42.2 million from $43.6 million for the six months ended June 30, 2012. These decreases were a result of savings realized from the closure of underperforming stores in addition to efficiencies resulting from our operational initiatives.

The expense ratio was 20.6% for the three months ended June 30, 2013, compared with 25.8% for the three months ended June 30, 2012. The expense ratio was 24.1% for the six months ended June 30, 2013, compared with 28.8% for the six months ended June 30, 2012. The year-over-year decrease in the expense ratio was primarily due to the increase in premiums earned which resulted in a lower percentage of fixed expenses in our retail operations (such as rent and base salary).

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FIRST ACCEPTANCE CORPORATION 10-Q

Overall, the combined ratio decreased to 95.6% for the three months ended June 30, 2013 from 109.1% for the three months ended June 30, 2012. For the six months ended June 30, 2013, the combined ratio decreased to 95.6% from 113.2% for the six months ended June 30, 2012.

Provision (Benefit) for Income Taxes

The provision for income taxes was $0.2 million for the three months ended June 30, 2013, compared with the benefit for income taxes of $0.3 million for the three months ended June 30, 2012. For the six months ended June 30, 2013, the provision for income taxes was $0.3 million compared with the benefit for income taxes of $0.2 million for the six months ended June 30, 2012. The provision (benefit) for income taxes related to current state income taxes for certain subsidiaries with taxable income. The provision (benefit) for income taxes for the three and six months ended June 30, 2012 included adjustments that reduced certain state income taxes. At June 30, 2013 and 2012, we established a valuation allowance to reduce deferred tax assets to the amount that is more likely than not to be realized. In assessing our ability to support the realizability of our deferred tax assets, we considered both positive and negative evidence. We placed greater weight on historical results than on our outlook for future profitability. The deferred tax valuation allowance may be adjusted in future periods if we determine that it is more likely than not that some portion or all of the deferred tax assets will be realized. In the event the deferred tax valuation allowance is adjusted, we would record an income tax benefit for the adjustment.

Real Estate and Corporate

Loss before income taxes from real estate and corporate operations for the three months ended June 30, 2013 was $0.7 million, compared with a loss before income taxes from real estate and corporate operations of $1.3 million for the three months ended June 30, 2012. Loss before income taxes from real estate and corporate operations for the six months ended June 30, 2013 was $1.4 million, compared with a loss before income taxes from real estate and corporate operations of $2.8 million for the six months ended June 30, 2012. Segment losses consist of other operating expenses not directly related to our insurance operations, interest expense and stock-based compensation offset by investment income on corporate invested assets. We incurred $0.4 million and $1.0 million of interest expense for the three months ended June 30, 2013 and 2012, respectively, related to debentures issued in July 2007. We incurred $0.8 million and $2.0 million of interest expense for the six months ended June 30, 2013 and 2012, respectively, related to debentures issued in July 2007. The decrease in interest expense was due to the contractual interest rate related to the debentures decreasing effective August 2012. For additional information, see “Liquidity and Capital Resources” in this report.

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FIRST ACCEPTANCE CORPORATION 10-Q

Liquidity and Capital Resources

Our primary sources of funds are premiums, fees and investment income from our insurance company subsidiaries and commissions and fee income from our non-insurance company subsidiaries. Our primary uses of funds are the payment of claims and operating expenses. Net cash provided by operating activities for the six months ended June 30, 2013 was $15.6 million, compared with net cash used in operating activities of $1.0 million for the same period in the prior fiscal year. Net cash used in operating activities for the six months ended June 30, 2012 was primarily the result of loss for the period partially offset by the increase in policy liabilities for losses and unearned premiums as a result of the increase in premiums written. Net cash used in investing activities for the six months ended June 30, 2013 was $0.3 million, compared with net cash provided by investing activities of $9.0 million for the same period in the prior fiscal year. The six months ended June 30, 2013 and 2012 included net reductions in our investment portfolio of $0.3 million and $11.9 million, respectively. The net reductions in our investment portfolio in both periods were primarily a result of maturities and redemptions in excess of purchases. Investing activities during the six months ended June 30, 2013 also included capital expenditures primarily related to system enhancements of $0.6 million as compared to $2.8 million in the same period in the prior year.

Our holding company requires cash for general corporate overhead expenses and for debt service related to our debentures payable. The holding company’s primary source of unrestricted cash to meet its obligations is the sale of ancillary products to our insureds and, if necessary and available subject to state law limitations, the holding company may receive dividends from our insurance company subsidiaries. The holding company also receives cash from operating activities as a result of investment income. Through an intercompany tax allocation arrangement, taxable losses of the holding company provide cash to the holding company to the extent that taxable income is generated by the insurance company subsidiaries. At June 30, 2013, we had $5.4 million available in unrestricted cash and investments outside of the insurance company subsidiaries. These funds and the additional unrestricted cash from the sources noted above will be used to pay our future cash requirements outside of the insurance company subsidiaries.

The holding company has debt service requirements related to the debentures payable. The debentures are interest-only and mature in full in July 2037. The debentures paid a fixed rate of 9.277% until July 30, 2012, after which time the rate became variable (Three-Month LIBOR plus 375 basis points). The interest rate related to the debentures was 4.026% for the period from April 2013 to July 2013 at which time the interest rate will reset to 4.015% through October 2013.

State insurance laws limit the amount of dividends that may be paid from our insurance company subsidiaries. At June 30, 2013, our insurance company subsidiaries could not pay ordinary dividends without prior regulatory approval due to a negative earned surplus position.

The National Association of Insurance Commissioners Model Act for risk-based capital provides formulas to determine each December 31 on an annual basis the amount of statutory capital and surplus that an insurance company needs to ensure that it has an acceptable expectation of not becoming financially impaired. There are also statutory guidelines that suggest that on an annual calendar year basis an insurance company should not exceed a ratio of net premiums written to statutory capital and surplus of 3-to-1. On a combined basis, the ratios for our insurance company subsidiaries of net premiums written for the last twelve months to statutory capital and surplus were 2.11-to-1 at June 30, 2013. Based on our current forecast on a combined basis, we anticipate that our risk-based capital levels will be adequate and that our ratio of net premiums written to statutory capital and surplus will not exceed the 3-to-1 statutory guideline for the reasonably foreseeable future. We therefore believe that our insurance company subsidiaries have sufficient statutory capital and surplus available to support their net premium writings in this time frame.

We believe that existing cash and investment balances, when combined with anticipated cash flows as noted above, will be adequate to meet our expected liquidity needs, for both the holding company and our insurance company subsidiaries, in both the short-term and the reasonably foreseeable future. Any future growth strategy may require external financing, and we may from time to time seek to obtain external financing. We cannot assure that additional sources of financing will be available to us on favorable terms, or at all, or that any such financing would not negatively impact our results of operations.

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FIRST ACCEPTANCE CORPORATION 10-Q

Off-Balance Sheet Arrangements

We have not entered into any new off-balance sheet arrangements since December 31, 2012. For information with respect to our off-balance sheet arrangements at December 31, 2012, see Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Off-Balance Sheet Arrangements” included in our Annual Report on Form 10-K for the year ended December 31, 2012.

Critical Accounting Estimates

There have been no significant changes to our critical accounting estimates during the six months ended June 30, 2013 compared with those disclosed in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Estimates” included in our Annual Report on Form 10-K for the year ended December 31, 2012.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Market risk represents the potential economic loss arising from adverse changes in the fair value of financial instruments. Our exposures to market risk relate primarily to our investment portfolio, which is exposed primarily to interest rate risk and credit risk. The fair value of our investment portfolio is directly impacted by changes in market interest rates; generally, the fair value of fixed-income investments moves inversely with movements in market interest rates. Our fixed maturity portfolio is comprised of substantially all fixed rate investments with primarily short-term and intermediate-term maturities. Likewise, the underlying investments of our mutual fund investments are also primarily fixed-income investments. This portfolio composition allows flexibility in reacting to fluctuations of interest rates. The portfolios of our insurance company subsidiaries are managed to achieve an adequate risk-adjusted return while maintaining sufficient liquidity to meet policyholder obligations.

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FIRST ACCEPTANCE CORPORATION 10-Q

Interest Rate Risk

The fair values of our fixed maturity investments fluctuate in response to changes in market interest rates. Increases and decreases in prevailing interest rates generally translate into decreases and increases, respectively, in the fair values of those instruments. Additionally, the fair values of interest rate sensitive instruments may be affected by the creditworthiness of the issuer, prepayment options, relative values of alternative investments, the liquidity of the instrument and other general market conditions.

The following table summarizes the estimated effects of hypothetical increases and decreases in interest rates resulting from parallel shifts in market yield curves on our fixed maturity portfolio (in thousands). It is assumed that the effects are realized immediately upon the change in interest rates. The hypothetical changes in market interest rates do not reflect what could be deemed best or worst case scenarios. Variations in market interest rates could produce significant changes in the timing of repayments due to prepayment options available. For these and other reasons, actual results might differ from those reflected in the table.

	Sensitivity to Instantaneous Interest Rate Changes (basis points)
	(100)		(50)		0		50		100		200
Fair value of fixed maturity portfolio	$	127,339	$	124,705	$	122,125	$	119,631	$	117,228	$	112,665

The following table provides information about our fixed maturity investments at June 30, 2013 which are sensitive to interest rate risk. The table shows expected principal cash flows (at par value, which differs from amortized cost as a result of premiums or discounts at the time of purchase and OTTI) by expected maturity date for each of the next five fiscal years and collectively for all fiscal years thereafter (in thousands). Callable bonds and notes are included based on call date or maturity date depending upon which date produces the most conservative yield. CMOs and sinking fund issues are included based on maturity year adjusted for expected payment patterns. Actual cash flows may differ from those expected.

Year Ending December 31,	Securities with Unrealized Gains		Securities with Unrealized Losses		Securities with No Unrealized Gains or Losses		All Fixed Maturity Securities
2013	$	2,960	$	—	$	1,585	$	4,545
2014		17,114		—		—		17,114
2015		8,264		3,700		—		11,964
2016		7,333		1,025		—		8,358
2017		4,360		6,575		—		10,935
Thereafter		34,932		26,551		—		61,483
Total	$	74,963	$	37,851	$	1,585	$	114,399
Fair value	$	83,425	$	37,115	$	1,585	$	122,125

On June 15, 2007, our wholly-owned unconsolidated trust entity, First Acceptance Statutory Trust I (FAST I), used the proceeds from its sale of trust preferred securities to purchase $41.2 million of junior subordinated debentures. The debentures paid a fixed rate of 9.277% until July 30, 2012, after which the rate became variable (Three-Month LIBOR plus 375 basis points). The interest rate related to the debentures was 4.026% for the period from April 2013 to July 2013 at which time the interest rate will reset to 4.015% through October 2013.

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FIRST ACCEPTANCE CORPORATION 10-Q

Credit Risk

Credit risk is managed by diversifying our investment portfolio to avoid concentrations in any single industry group or issuer and by limiting investments in securities with lower credit ratings. Our largest investment in any one investment, excluding U.S. government and agency securities, is our investment in a single mutual fund with a fair value of $8.2 million, or 6% of our investment portfolio. Our five largest investments make up 18% of our available-for-sale investment portfolio.

The following table presents the underlying ratings of our fixed maturity portfolio by nationally recognized statistical rating organizations at June 30, 2013 (in thousands).

Comparable Rating	Amortized Cost		% of Amortized Cost			Fair Value		% of Fair Value
AAA	$	8,164		6	%	$	8,423		6	%
AA+, AA, AA-		49,094		38	%		50,540		38	%
A+, A, A-		41,423		32	%		41,706		31	%
BBB+, BBB, BBB-		10,251		8	%		11,294		9	%
Total investment grade		108,932		84	%		111,963		84	%
Not rated		14,228		11	%		15,196		11	%
BB+, BB, BB-		718		1	%		768		1	%
B+, B, B-		732		1	%		786		1	%
CCC+, CCC, CCC-		2,681		2	%		3,074		2	%
CC+, CC, CC-		54		0	%		165		0	%
C+, C, C-		714		1	%		796		1	%
D		6		0	%		14		0	%
Total non-investment grade		4,905		5	%		5,603		5	%
Total	$	128,065		100	%	$	132,762		100	%

The mortgage industry has experienced a significant number of delinquencies and foreclosures, particularly among lower quality exposures (“sub-prime” and “Alt-A”). As a result of these delinquencies and foreclosures, many CMOs with underlying sub-prime and Alt-A mortgages as collateral experienced significant declines in fair value. At June 30, 2013, our fixed maturity portfolio included three CMOs having sub-prime exposure with fair value of $0.9 million and no exposure to Alt-A investments.

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FIRST ACCEPTANCE CORPORATION 10-Q

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

Under the supervision and with the participation of our management team, including our Chief Executive Officer and Principal Financial Officer, we conducted an evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, or the “Exchange Act”) as of June 30, 2013. Based on that evaluation, our Chief Executive Officer (principal executive officer) and Acting Chief Financial Officer (principal financial officer) concluded that our disclosure controls and procedures were effective as of June 30, 2013 to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Changes in Internal Control Over Financial Reporting

During the period covered by this report, there has been no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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FIRST ACCEPTANCE CORPORATION 10-Q

PART II – OTHER INFORMATION

Item 1. Legal Proceedings

We and our subsidiaries are named from time to time as defendants in various legal actions that are incidental to our business, including those which arise out of or are related to the handling of claims made in connection with our insurance policies and claims handling. The plaintiffs in some of these lawsuits have alleged bad faith or extra-contractual damages, and some have sought punitive damages or class action status. We believe that the resolution of these legal actions will not have a material adverse effect on our financial condition or results of operations. However, the ultimate outcome of these matters is uncertain.

Item 4. Mine Safety Disclosures

None.

Item 6. Exhibits

The following exhibits are attached to this report:

31.1	Certification of Principal Executive Officer pursuant to Rule 13a-14(a).
31.2	Certification of Principal Financial Officer pursuant to Rule 13a-14(a).
32.1	Principal Executive Officer’s Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Principal Financial Officer’s Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101 –	XBRL

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FIRST ACCEPTANCE CORPORATION 10-Q

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

	FIRST ACCEPTANCE CORPORATION
Date: August 6, 2013	By:	/s/ Michael J. Bodayle
		Michael J. Bodayle
		Acting Chief Financial Officer

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