First Acceptance (FACO) 10-Q 2017 Q1 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 March 31, 2017

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 ☒    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 ☒    No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth 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	☒
Emerging growth company	☐

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    ☐

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

At May 8, 2017, there were 41,160,011 shares outstanding of the registrant’s common stock, par value $0.01 per share.

FIRST ACCEPTANCE CORPORATION

FORM 10-Q

FOR THE QUARTER ENDED MARCH 31, 2017

INDEX

PART I – FINANCIAL INFORMATION
Item 1. Financial Statements	1
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3. Quantitative and Qualitative Disclosures About Market Risk	24
Item 4. Controls and Procedures	25
PART II – OTHER INFORMATION
Item 1. Legal Proceedings	26
Item 4. Mine Safety Disclosures	26
Item 6. Exhibits	26
SIGNATURES

i

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

	March 31,			December 31,
	2017			2016
	(Unaudited)
ASSETS
Investments, available-for-sale at fair value (amortized cost of $117,619 and    $117,902, respectively)	$	117,431		$	117,212
Cash, cash equivalents, and restricted cash		120,496			118,681
Premiums, fees, and commissions receivable, net of allowance of $309 and    $279, respectively		90,251			66,393
Deferred tax assets, net		34,761			35,641
Other investments		10,140			9,994
Other assets		5,944			6,078
Property and equipment, net		3,789			4,213
Deferred acquisition costs		5,869			4,852
Goodwill		29,384			29,384
Identifiable intangible assets, net		7,433			7,626
TOTAL ASSETS	$	425,498		$	400,074
LIABILITIES AND STOCKHOLDERS’ EQUITY
Loss and loss adjustment expense reserves	$	156,410		$	161,079
Unearned premiums and fees		106,877			78,861
Debentures payable		40,313			40,302
Term loan from principal stockholder		29,786			29,779
Accrued expenses		5,566			7,089
Other liabilities		12,851			10,476
Total liabilities		351,803			327,586
Stockholders’ equity:
Preferred stock, $.01 par value, 10,000 shares authorized		—			—
Common stock, $.01 par value, 75,000 shares authorized; 41,160 issued and outstanding		412			412
Additional paid-in capital		457,789			457,750
Accumulated other comprehensive income, net of tax of $(873) and $(1,110), respectively		1,754			1,316
Accumulated deficit		(386,260	)		(386,990	)
Total stockholders’ equity		73,695			72,488
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	425,498		$	400,074

See notes to consolidated financial statements.

1

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(Unaudited)

(in thousands, except per share data)

	Three Months Ended
	March 31,
	2017			2016
Revenues:
Premiums earned	$	69,813		$	76,407
Commission and fee income		17,228			19,581
Investment income		1,033			962
Net realized losses on investments, available-for-sale		(5	)		(2	)
		88,069			96,948
Costs and expenses:
Losses and loss adjustment expenses		56,280			73,419
Insurance operating expenses		28,056			29,647
Other operating expenses		271			280
Stock-based compensation		39			37
Depreciation		546			651
Amortization of identifiable intangibles assets		203			238
Interest expense		1,098			1,050
		86,493			105,322
Income (loss) before income taxes		1,576			(8,374	)
Provision (benefit) for income taxes		846			(2,869	)
Net income (loss)	$	730		$	(5,505	)
Net income (loss) per share:
Basic	$	0.02		$	(0.13	)
Diluted	$	0.02		$	(0.13	)
Number of shares used to calculate net income (loss) per share:
Basic		41,160			41,060
Diluted		41,181			41,060
Reconciliation of net income (loss) to other comprehensive income (loss):
Net income (loss)	$	730		$	(5,505	)
Net unrealized change in investments, net of tax of $236 and $911, respectively		438			1,691
Comprehensive income (loss)	$	1,168		$	(3,814	)

See notes to consolidated financial statements.

2

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

(in thousands)

	Three Months Ended
	March 31,
	2017			2016
Cash flows from operating activities:
Net income (loss)	$	730		$	(5,505	)
Adjustments to reconcile net income (loss) to cash provided by operating activities:
Depreciation		546			651
Amortization of identifiable intangibles assets		203			238
Stock-based compensation		39			37
Deferred income taxes		644			(2,968	)
Net realized losses on redemptions of investments		5			2
Investment (income) loss from other investments		(149	)		170
Other		139			33
Change in:
Premiums, fees, and commission receivable		(23,888	)		(23,197	)
Deferred acquisition costs		(1,017	)		(993	)
Loss and loss adjustment expense reserves		(4,669	)		10,579
Unearned premiums and fees		28,016			26,331
Other liabilities		2,375			4,249
Other		(1,370	)		892
Net cash provided by operating activities		1,604			10,519
Cash flows from investing activities:
Purchases of investments, available-for-sale		(505	)		—
Maturities and redemptions of investments, available-for-sale		670			3,206
Purchases of other investments		(78	)		(207	)
Distributions from other investments		256			1,007
Capital expenditures		(122	)		(1,206	)
Acquisition of identifiable intangible assets		(10	)		—
Net cash provided by investing activities		211			2,800
Net change in cash, cash equivalents, and restricted cash		1,815			13,319
Cash, cash equivalents, and restricted cash, beginning of period		118,681			115,587
Cash, cash equivalents, and restricted cash, end of period	$	120,496		$	128,906

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.

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, 2016.

Cash, Cash Equivalents, and Restricted Cash

Cash, cash equivalents, and restricted cash consist of bank demand deposits and highly-liquid investments. All investments with maturities of three months or less at the date of purchase are considered cash equivalents. At March 31, 2017 and December 31, 2016 the Company had restricted cash equivalents of $17.3 million and $18.6 million, respectively.

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 marketplace.

Level 3 - Instruments that use non-binding broker quotes or model driven valuations that do not have observable market data.

NAV    -   Calculated net asset value (“NAV”) based on an ownership interest to which a proportionate share of net assets is attributed.

The Company considers the valuation methods used in both its identifiable intangible assets initial measurement and 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. To determine the fair value of the acquired policy renewal rights and customer relationships, the Company uses an “excess earnings” method that relies on projected future net cash flows and includes key assumptions for the customer retention and renewal rates. The data used in these methods is not observable in the market.

4

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

Fair Value of Financial Instruments

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

	March 31, 2017				December 31, 2016
	Carrying		Fair		Carrying		Fair
	Value		Value		Value		Value
Assets:
Investments, available-for-sale	$	117,431	$	117,431	$	117,212	$	117,212
Other investments		10,140		10,140		9,994		9,994
Liabilities:
Debentures payable		40,313		13,443		40,302		11,488
Term loan from principal stockholder		29,786		17,210		29,779		15,000

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 and the term loan from principal shareholder are categorized as Level 3, since they were based on current market rates offered for debt with similar risks and maturities, an unobservable input categorized as Level 3. Carrying values of certain financial instruments, such as cash and cash equivalents and premiums, fees, and commissions 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 does not purport to represent the Company’s underlying value.

The following tables present the fair-value measurements for each major category of assets that are measured on a recurring basis (in thousands). Other investments are carried at net asset value which approximates fair value.

			Fair Value Measurements Using
			Quoted Prices		Significant
			in Active		Other		Significant		Proportionate
			Markets for		Observable		Unobservable		Share of
			Identical Assets		Inputs		Inputs		Net Assets
March 31, 2017	Total		(Level 1)		(Level 2)		(Level 3)		(NAV)
Fixed maturities, available-for-sale:
U.S. government and agencies	$	19,469	$	19,469	$	—	$	—	$	—
Political subdivisions		4,189		—		4,189		—		—
Revenue and assessment		5,590		—		5,590		—		—
Corporate bonds		45,650		—		45,650		—		—
Collateralized mortgage obligations:
Agency backed		21,998		—		21,998		—		—
Non-agency backed – residential		2,845		—		2,845		—		—
Non-agency backed – commercial		1,843		—		1,843		—		—
Total fixed maturities, available-for-sale		101,584		19,469		82,115		—		—
Preferred stocks, available-for-sale		3,153		3,153		—		—		—
Mutual funds, available-for-sale		12,694		12,694	—			—		—
Total investments, available-for-sale		117,431		35,316		82,115		—		—
Other investments		10,140		—		—		5,110		5,030
Cash, cash equivalents, and restricted cash		120,496		120,496		—		—		—
Total	$	248,067	$	155,812	$	82,115	$	5,110	$	5,030

5

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

			Fair Value Measurements Using
			Quoted Prices		Significant
			in Active		Other		Significant		Proportionate
			Markets for		Observable		Unobservable		Share of
			Identical Assets		Inputs		Inputs		Net Assets
December 31, 2016	Total		(Level 1)		(Level 2)		(Level 3)		(NAV)
Fixed maturities, available-for-sale:
U.S. government and agencies	$	18,951	$	18,951	$	—	$	—	$	—
Political subdivisions		4,165		—		4,165		—		—
Revenue and assessment		5,683		—		5,683		—		—
Corporate bonds		45,540		—		45,540		—		—
Collateralized mortgage obligations:
Agency backed		22,422		—		22,422		—		—
Non-agency backed – residential		2,933		—		2,933		—		—
Non-agency backed – commercial		1,895		—		1,895		—		—
Total fixed maturities, available-for-sale		101,589		18,951		82,638		—		—
Preferred stocks, available-for-sale		3,112		3,112		—		—		—
Mutual funds, available-for-sale		12,511		12,511	—			—		—
Total investments, available-for-sale		117,212		34,574		82,638		—		—
Other investment		9,994		—		—		4,858		5,136
Cash, cash equivalents, and restricted cash		118,681		118,681		—		—		—
Total	$	245,887	$	153,255	$	82,638	$	4,858	$	5,136

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 security in the table above consists of an investment in the common stock of a real estate investment trust for which fair value has been determined using a model driven valuation that does not have observable market data. There were no transfers between Level 1 and Level 2 for the three months ended March 31, 2017 and 2016. The Company’s policy is to recognize transfers between levels at the end of the reporting period based on specific identification. 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.  Likewise, the Company reviews the Level 3 valuation model to understand the underlying factors and inputs and to validate the reasonableness of the pricing.

6

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The following table represents the quantitative disclosure for the asset classified as Level 3 during the three months ended March 31, 2017 (in thousands).

	Fair Value
	Measurements Using
	Significant Unobservable
	Inputs (Level 3)
	Common Stock
	at Fair Value
Balance at December 31, 2016	$	4,858
Gains included in net loss		—
Gains included in comprehensive income (loss)		174
Investments and capital calls		78
Distributions received		—
Transfers into and out of Level 3		—
Balance at March 31, 2017	$	5,110

3. Investments

Investments, Available-for-Sale

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

		Gross	Gross
	Amortized	Unrealized	Unrealized	Fair
March 31, 2017	Cost	Gains	Losses	Value
U.S. government and agencies	$       19,639	$               106	$              (276)	$          19,469
Political subdivisions	4,203	—	(14)	4,189
Revenue and assessment	5,436	186	(32)	5,590
Corporate bonds	47,189	81	(1,620)	45,650
Collateralized mortgage obligations:
Agency backed	22,666	72	(740)	21,998
Non-agency backed – residential	2,309	543	(7)	2,845
Non-agency backed – commercial	1,339	504	—	1,843
Total fixed maturities, available-for-sale	102,781	1,492	(2,689)	101,584
Preferred stocks, available-for-sale	3,025	220	(92)	3,153
Mutual funds, available-for-sale	11,813	881	—	12,694
	$        117,619	$            2,593	$           (2,781)	$        117,431

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
December 31, 2016	Cost		Gains		Losses			Value
U.S. government and agencies	$	19,142	$	112	$	(303	)	$	18,951
Political subdivisions		4,233		—		(68	)		4,165
Revenue and assessment		5,539		185		(41	)		5,683
Corporate bonds		47,238		107		(1,805	)		45,540
Collateralized mortgage obligations:
Agency backed		23,093		73		(744	)		22,422
Non-agency backed – residential		2,411		529		(7	)		2,933
Non-agency backed – commercial		1,408		487		—			1,895
Total fixed maturities, available-for-sale		103,064		1,493		(2,968	)		101,589
Preferred stocks, available-for-sale		3,025		198		(111	)		3,112
Mutual funds, available-for-sale		11,813		698		—			12,511
	$	117,902	$	2,389	$	(3,079	)	$	117,212

7

FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The following table sets 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.

					Securities
	Securities		Securities		with No		All
	with		with		Unrealized		Fixed
	Unrealized		Unrealized		Gains or		Maturity
March 31, 2017	Gains		Losses		Losses		Securities
One year or less	$	2,701	$	6,574	$	—	$	9,275
After one through five years		7,059		23,556				30,615
After five through ten years		—		33,254		—		33,254
After ten years		1,754		—		—		1,754
No single maturity date		5,046		21,640		—		26,686
	$	16,560	$	85,024	$	—	$	101,584

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
	Less than		Greater		Gross
	or equal to		than 12		Unrealized
At:	12 months		months		Gains
March 31, 2017		37		1		38
December 31, 2016		37		—		40

The following table reflects the fair value and gross unrealized losses of those fixed maturity securities in a continuous unrealized loss position for greater than 12 months at March 31, 2017. There were no securities meeting these criteria at December 31, 2016. Gross unrealized losses are further segregated by the percentage of amortized cost (in thousands, except number of securities).

	Number				Gross
Gross Unrealized Losses	of		Fair		Unrealized
at March 31, 2017:	Securities		Value		Losses
Less than or equal to 10%		1	$	106	$	(6	)
Greater than 10%		—		—		—
		1	$	106	$	(6	)

8

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
Length of	Gross		Gross			Severity of Gross Unrealized Losses
Gross Unrealized Losses	Unrealized		Unrealized			Less			5% to			Greater
at March 31, 2017:	Losses		Losses			than 5%				10%		than 10%
Less than or equal to:
Three months	$	5,394	$	(7	)	$	(7	)	$	—		$	—
Six months		55,253		(1,708	)		(1,427	)		(281	)		—
Nine months		25,206		(1,060	)		(204	)		(856	)		—
Twelve months		—		—			—			—			—
Greater than twelve months		106		(6	)		(6	)		—			—
Total	$	85,959	$	(2,781	)	$	(1,644	)	$	(1,137	)	$	—

	Fair Value of
	Securities with
Length of	Gross		Gross			Severity of Gross Unrealized Losses
Gross Unrealized Losses	Unrealized		Unrealized			Less			5% to			Greater
at December 31, 2016:	Losses		Losses			than 5%				10%		than 10%
Less than or equal to:
Three months	$	58,550	$	(1,886	)	$	(1,461	)	$	(425	)	$	—
Six months		27,193		(1,186	)		(232	)		(954	)		—
Nine months		152		—			—			—
Twelve months		105		(7	)		—			(7	)		—
Greater than twelve months		—		—			—			—			—
Total	$	86,000	$	(3,079	)	$	(1,693	)	$	(1,386	)	$	-

Other-Than-Temporary Impairment

For the three months ended March 31, 2017, the Company did not recognize any OTTI charges in net income (loss).

The Company believes that the securities having unrealized losses at March 31, 2017 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.

Other Investments

Other investments consist of the common stock of a real estate investment trust and limited partnership interests in two funds that invest in (i) commercial real estate and secured commercial real estate loans acquired from financial intuitions and (ii) undervalued international publicly-traded equities. These investments have redemption and transfer restrictions. The Company does not intend to sell these investments, and it is more likely than not that the Company will not be required to sell them before the expiration of such restrictions.At March 31, 2017, the Company had an unfunded commitment to invest $2.5 million into limited partnership that invests in a pre-identified pool of select buyout private equity funds.

Restrictions

At March 31, 2017, fixed maturities and cash equivalents with a fair value and amortized cost of $6.3 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 $17.1 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
	March 31,
	2017			2016
Fixed maturities, available-for-sale	$	623		$	970
Mutual funds, available-for-sale		162			206
Preferred stocks		45			24
Other investments		149			(170	)
Cash and cash equivalents		159			40
Other		14			14
Investment expenses		(119	)		(122	)
	$	1,033		$	962

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

	Three Months Ended
	March 31,
	2017			2016
Gains	$	—		$	—
Losses		(5	)		(2	)
	$	(5	)	$	(2	)

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”) is included in other comprehensive loss. The amounts of non-credit OTTI for securities still owned was $1.1 million at both March 31, 2017 and December 31, 2016.

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
	March 31,
	2017		2016
Net income (loss)	$	730	$	(5,505	)
Weighted average common basic shares		41,160		41,060
Effect of dilutive securities		21		—
Weighted average common dilutive shares		41,181		41,060
Basic and diluted net income (loss) per share	$	0.02	$	(0.13	)

For the three months ended March 31, 2017, the computation of diluted net income per share included 76 thousand restricted stock units having a dilutive effect of 21 thousand shares. Options to purchase 120 thousand shares and 93 thousand restricted stock units were not included in the computation of diluted net income per share for the three months ended March 31, 2017, since the exercise price of the stock options was in excess of the average stock price for this period and the inclusion of the restricted stock units would have been anti-dilutive.

For the three months ended March 31, 2016, the computation of diluted net loss per share did not include options to purchase 825 thousand shares and 257 thousand restricted stock units, a dilutive effect of 276 thousand shares, since their inclusion would have been anti-dilutive. Options to purchase 260 thousand shares were not included in the computation of diluted net loss per share for the three months ended March 31, 2016, since their exercise price was in excess of the average stock price for this period.     

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

5. Losses and Loss Adjustment Expenses Incurred and Paid

Information regarding the reserve for unpaid losses and loss adjustment expenses (“LAE”) is as follows (in thousands).

	March 31,
	2017			2016
Liability for unpaid losses and LAE at beginning of period, gross	$	161,079		$	122,071
Reinsurance balances receivable		(769	)		(464	)
Liability for unpaid losses and LAE at beginning of period, net		160,310			121,607
Add: Provision for losses and LAE:
Current period		56,812			63,105
Prior periods		(532	)		10,314
Net losses and LAE incurred		56,280			73,419
Less: Losses and LAE paid:
Current period		16,137			18,404
Prior periods		44,806			44,463
Net losses and LAE paid		60,943			62,867
Liability for unpaid losses and LAE at end of period, net		155,647			132,159
Reinsurance balances receivable		763			491
Liability for unpaid losses and LAE at end of period, gross	$	156,410		$	132,650

The favorable development for the three months ended March 31, 2017 was primarily the result of favorable LAE development related to bodily injury claims over multiple prior accident periods, partially offset by some unfavorable development on losses related to bodily injury severity.  

The unfavorable development for the three months ended March 31, 2016 was the result of an increase in losses across all major coverages and over multiple prior accident periods. The primary causes of the unfavorable development were a sharp increase in bodily injury severity and a greater than usual amount of subsequent payments on previously closed claims.

6. Income Taxes

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

	Three Months Ended
	March 31,
	2017		2016
Federal:
Current	$	122	$	(1	)
Deferred		627		(2,962	)
		749		(2,963	)
State:
Current		80		100
Deferred		17		(6	)
		97		94
	$	846	$	(2,869	)

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

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

	Three Months Ended
	March 31,
	2017			2016
Provision (benefit) for income taxes at statutory rate	$	552		$	(2,931	)
Tax effect of:
Tax-exempt investment income		(14	)		(10	)
Stock option expirations		229			4
State income taxes, net of federal income tax benefit    and state valuation allowance		69			59
Other		10			9
	$	846		$	(2,869	)

The Company had a deferred tax asset (“DTA”) valuation allowance of $1.8 million at March 31, 2017 and $1.9 million at December 31, 2016, attributable to certain amounts related to state taxes and OTTI that are not more likely than not to be realized. In assessing the Company’s ability to realize the DTA, both positive and negative evidence are used to evaluate the allowance. Although the Company incurred a 2016 pre-tax loss of $45.1 million which is a source of negative evidence, it placed greater weight on its outlook for future taxable income over the allowable time period for realization of the DTA and concluded that it is more likely than not that the remaining DTA will be realized. Regarding the length of time available to realize the DTA, at March 31, 2017, $22.1 million of the DTA related to net operating loss carryforwards do not expire until 2031 through 2036 and $2.1 million in AMT (“Alternative Minimum Tax”) carryforwards have no expiration date. The DTA 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 DTA will not be realized. In the event the DTA valuation allowance is increased, the Company would record an income tax expense for the adjustment.

7. 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
	March 31,
	2017			2016
Revenues:
Insurance	$	88,053		$	96,933
Real estate and corporate		16			15
Consolidated total	$	88,069		$	96,948
Income (loss) before income taxes:
Insurance	$	2,968		$	(7,021	)
Real estate and corporate		(1,392	)		(1,353	)
Consolidated total	$	1,576		$	(8,374	)

	March 31,		December 31,
	2017		2016
Total assets:
Insurance	$	381,852	$	354,008
Real estate and corporate		43,646		46,066
Consolidated total	$	425,498	$	400,074

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

8. Litigation

The Company is named as a defendant in various lawsuits, arising in the ordinary course of business, generally relating to its insurance operations. All legal actions relating to claims made under insurance policies are considered by the Company in establishing its loss and loss adjustment expense reserves. The Company also faces lawsuits from time to time that seek damages beyond policy limits, commonly known as bad faith claims, as well as class action and individual lawsuits that involve issues arising in the course of the Company’s business. The Company continually evaluates potential liabilities and reserves for litigation of these types using the criteria established by FASB ASC 450, Contingencies (“FASB ASC 450”). Pursuant to FASB ASC 450, reserves for a loss may only be recognized if the likelihood of occurrence is probable and the amount can be reasonably estimated. If a loss, while not probable, is judged to be reasonably possible, management will disclose, if it can be estimated, a possible range of loss or state that an estimate cannot be made. Management evaluates each legal action and records reserves for losses, as warranted, by establishing a reserve in its consolidated balance sheets in loss and loss adjustment expense reserves for bad faith claims and in other liabilities for other lawsuits. Amounts incurred are recorded in the Company’s consolidated statements of comprehensive income (loss) in losses and loss adjustment expenses for bad faith claims and in insurance operating expenses for other lawsuits unless otherwise disclosed.

9. Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) and the International Accounting Standards Board (“IASB”) jointly issued a new revenue recognition standard, Accounting Standard Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers,” that will supersede virtually all revenue recognition guidance in GAAP and International Financial Reporting Standards (“IFRS”). This guidance had an effective date for public companies for annual and interim periods beginning after December 15, 2016, with early adoption not permitted. In July 2015, the FASB issued a one-year deferral of this effective date with the option for entities to early adopt at the original effective date. The standard is intended to increase comparability across industries and jurisdictions. The underlying principle of the new standard is that a business or other organization will recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects what it expects in exchange for the goods or services. The new standard will not change accounting guidance for insurance contracts. The Company has revenue from non-insurance arrangements, such as commissionable ancillary products, which will fall under this guidance. The Company has not finalized the impact, if any, on our consolidated financial statements at this time. However, based on the initial evaluation of this guidance as it relates to these non-insurance arrangements, the Company does not expect the future impacts to be material.

In January 2016, the FASB issued ASU No. 2016-01, “Financial Instruments – Overall (Subtopic 825-20): Recognition and Measure of Financial Assets and Financial Liabilities” which requires entities to measure many equity investments at fair value and recognize changes in fair value in net income (loss), as opposed to the current practice of other comprehensive income (loss). The requirement does not apply to equity investments that result in consolidation, those accounted for under the equity method and certain others. The guidance provides a new measurement alternative for equity investments that do not have readily determinable fair values and do not qualify for the net asset value practical expedient. Under this alternative, these investments can be measured at cost, less any impairment, plus or minus changes resulting from observable price changes in orderly transactions for the identical or a similar investment of the same issuer. The guidance is effective for public business entities for annual periods beginning after December 15, 2017, and interim periods within those years. The Company believes that its other investment in a REIT will fall under the guidance of the new measurement alternative and that future changes in fair value will be recognized in net income (loss), as opposed to the current practice of other comprehensive income (loss). The Company has not determined the impact on future consolidated financial statements once this is adopted.

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)” which requires lessees to record most leases on their balance sheets as lease liabilities with corresponding right-of-use assets, but recognize expense in a manner similar to the current accounting treatment. The guidance also eliminates the current real estate-specific provisions and changes the guidance on sale-leaseback transactions, initial direct costs and lease executory costs for all entities. The guidance could have broad implications for an entity’s finances and operations and will require additional disclosures. The guidance is effective for public business entities for annual periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted. Entities are required to use a modified retrospective approach for leases that exist or are entered into after the beginning of the earliest comparative period in their financial statements. The Company’s lease arrangements fall under this guidance and will be required to be shown on its consolidated balance sheet. The Company is currently evaluating controls and processes to ensure this guidance is reflected properly on future consolidated financial statements.  

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

In March 2016, the FASB issued ASU No. 2016-09, “Improvements to Employee Share-Based Payment Accounting” which addressed the recognition, presentation and classification of awards, forfeitures and shares withheld for tax purposes. The standard was effective for fiscal periods beginning after December 15, 2016, with each provision having a different application method. The adoption of this standard did not have a material impact on our consolidated financial statements.

In June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments – Credit Losses (Topic 326)” which requires financial assets measured at amortized cost basis to be presented at the net amount expected to be collected. The allowance for credit losses will be based on relevant information, including historical experience, current conditions, and reasonable and supportable forecasts that affect the collectability of the reported amount. The expected increases and decreases in the credit loss will be reflected on the consolidated statement of comprehensive income (loss). The guidance is effective for public business entities for annual periods beginning after December 15, 2019, and interim periods within those years. Early adoption is permitted. The Company has not determined the impact on future consolidated financial statements once this is adopted.

In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments” which clarifies how entities should classify certain cash receipts and cash payments, including how the predominance principle should be applied when cash receipts and cash payments have aspects of more than one class of cash flows. The guidance is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those years. Early adoption is permitted. Entities will have to apply the guidance retrospectively, but if it is impracticable to do so for an issue, the amendments related to that issue would be applied prospectively. The Company has not determined the impact on future consolidated financial statements once this is adopted.

In January 2017, the FASB issued ASU No. 2017-04, “Intangibles – Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment” which eliminates the requirement to calculate the implied fair value of goodwill to measure an impairment charge. Instead, entities will record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value. The standard will be applied prospectively. The guidance is effective for annual and interim impairment tests performed by public business entities for periods beginning after December 15, 2019. Early adoption is permitted for impairment testing dates after January 1, 2017. The Company believes that it will be reasonably able to comply with these requirements.

10. Related Parties

In April 2016, the Company entered into standard agreements for treasury and investment custodial services with a bank in which our principal shareholder has a 15% indirect ownership interest. The fees under these agreements for the three months ended March 31, 2017 were $42 thousand.

11. Current Liquidity and Statutory Capital and Surplus

The Company has $70.0 million in long-term borrowings of which $40.0 million matures in 2037 and $30.0 million matures in 2025. At March 31, 2017, the Company was in compliance with the covenants related to these borrowings. Such borrowings are not obligations of the Company’s regulated insurance company subsidiaries who at March 31, 2017 had combined statutory capital and surplus of $60.7 million. The Company believes that it has sufficient liquidity to meet its current obligations in the foreseeable future, including the payment of interest on its long-term borrowings which it currently funds through the cash flows of its agency operations which are generated outside the Company’s regulated insurance company subsidiaries and are not subject to any limitation on the payment of dividends to the holding company.

The Company has three insurance company subsidiaries that are organized and domiciled under the insurance statutes of Texas, Georgia, and Tennessee. The insurance company subsidiaries operate under licenses issued by various state insurance authorities. Such licenses may be of perpetual duration or periodically renewable, provided the insurance company subsidiaries continue to meet applicable regulatory requirements.

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FIRST ACCEPTANCE CORPORATION AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(Unaudited)

The National Association of Insurance Commissioners (“NAIC”) 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. Failure to meet applicable risk-based capital requirements could subject our insurance company subsidiaries to further examination or corrective action imposed by state regulators, including limitations on their writing of additional business, state supervision, or even liquidation. Although statutory risk-based capital calculations are only made as of each December 31, the Company estimated that the three insurance company subsidiaries are above the regulatory company action levels as of March 31, 2017. 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 ratio for our insurance company subsidiaries of net premiums written for the last twelve months to statutory capital and surplus was 4.85-to-1 at March 31, 2017 which is in excess of the suggested guidelines. Management is currently operating under a business plan to reduce premium writings and increase statutory capital and surplus to address the net premiums written to statutory capital and surplus guidelines.

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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, 2016. 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, 2016 included in our Annual Report on Form 10-K for the year ended December 31, 2016.

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:

• the accuracy and adequacy of our loss reserving methodologies;

• 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;

• 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, 2016.

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. Non-standard personal automobile insurance is made available to individuals because of their inability or unwillingness to obtain standard insurance coverage due to various factors, including payment history, payment preference, and failure in the past to maintain continuous insurance coverage, driving record and/or vehicle type. At March 31, 2017, we also owned a tract of land in San Antonio, Texas that is held for sale.

At March 31, 2017, we leased and operated 355 retail locations (or “stores”) and a call center 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 insurance product providing personal property and liability coverage for renters underwritten by us. In addition, retail locations in some markets offer non-standard personal automobile insurance serviced and underwritten by other third-party insurance carriers for which we receive a commission.

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FIRST ACCEPTANCE CORPORATION 10-Q

Our insurance operations actively generate revenue from selling non-standard personal automobile insurance products and related products in 16 states. In December 2016, we closed all of our retail locations and ceased writing new business in the state of Missouri. As a result, we currently conduct our servicing and underwriting operations in 13 states and are licensed as an insurer in 13 additional states. After obtaining a license in California, we began selling our non-standard personal automobile insurance product in late June 2016 on a limited basis.

At March 31, 2017, 278 of our 355 stores primarily sell non-standard personal automobile insurance products underwritten by us. The other retail locations primarily offer non-standard personal automobile insurance serviced and underwritten by other third-party insurance carriers for which we receive a commission.

See the discussion in Item 1. “Business—General” in our Annual Report on Form 10-K for the year ended December 31, 2016 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. Since December 31, 2015, 89 locations were closed which included 53 that were part of our recent actions to improve profitability, 24 in the Chicago-area whose leases expired in January 2016, and 12 others closed in the normal course of business. During this period, 4 new locations were strategically-placed to replace and consolidate the closed Chicago-area locations.

	Three Months Ended
	March 31,
	2017		2016
Retail locations – beginning of period		355		440
Opened		—		2
Closed		—		(28	)
Retail locations – end of period		355		414

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

	March 31,		December 31,
	2017	2016	2016	2015
Alabama	23	24	23	24
Arizona	10	10	10	10
California	47	48	47	48
Florida	34	39	34	39
Georgia	50	60	50	60
Illinois	39	39	39	61
Indiana	16	17	16	17
Mississippi	6	7	6	7
Missouri	—	9	—	9
Nevada	4	4	4	4
New Mexico	5	5	5	5
Ohio	27	27	27	27
Pennsylvania	11	14	11	14
South Carolina	15	23	15	24
Tennessee	23	23	23	23
Texas	45	65	45	68
Total	355	414	355	440

In response to consumer demand to purchase personal automobile insurance over the phone and through the internet, we offer customers the choice to purchase a policy through an employee-agent in our call center or via our www.acceptance.com website and mobile platform. As of March 31, 2017, approximately 10% of our policies in force were sold through a non-retail sales channel. 

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FIRST ACCEPTANCE CORPORATION 10-Q

Recent Actions

Since August 2016, we have taken the following actions to reduce premiums written and increase statutory capital and surplus with the goal of returning our ratio of net premiums written to statutory capital and surplus to within regulatory guidelines and improving profitability:

• Continued to strengthen our Product team and filed and received approval for substantial rate increases and structural changes in our rating programs in response to our increase in claim frequency.  The magnitude and frequency of these rate increases are unprecedented in our recent history;

• Reduced premium writings, through the closing of 53 poorly performing stores, by temporarily suspending or eliminating new business in selected areas of our business, and tightening our underwriting standards;

• Took further aggressive actions in our claims-handling operations where we have hired a new Senior Vice-President, restructured management, improved processes and increased staffing and training to reduce pending claims to targeted levels;

• Increased our statutory capital and surplus by selling available-for-sale securities with unrealized gains ($4.9 million) and through capital contributions from net income derived from our insurance agency operations ($6.7 million).

At March 31, 2017, these actions have resulted in a year-over year 21% decrease in our policies in force, which has been partially offset by a 16% year-over-year increase in our average in-force premium. We believe that these actions collectively have contributed to the improved loss ratio for the current 2017 accident period.  

Consolidated Results of Operations

Overview

Our insurance operations actively generate revenues from selling non-standard personal automobile insurance products and related products in 16 states. We currently conduct our servicing and underwriting operations in 13 states 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. (In December 2016, we closed all of our retail locations and ceased writing new business in the state of Missouri.) Our insurance revenues were 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 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.

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FIRST ACCEPTANCE CORPORATION 10-Q

The following table presents gross premiums earned by state (in thousands). The effect of a 21% decrease in our year-over-year policies in force offset by a 16% year-over-year increase in our average in-force premium, resulted in net premiums earned for the three months ended March 31, 2017 decreasing by 9% compared with the same period in the prior year.

	Three Months Ended
	March 31,
	2017	2016
Gross premiums earned:
Georgia	$          16,261	$          15,057
Florida	10,251	11,609
Texas	8,544	10,617
Alabama	7,454	6,764
Ohio	7,305	7,596
South Carolina	4,950	6,594
Tennessee	4,748	4,881
Illinois	4,207	5,740
Indiana	2,318	2,277
Pennsylvania	2,251	2,418
Mississippi	963	995
California	314	—
Missouri	242	1,753
Virginia	110	214
Total gross premiums earned	69,918	76,515
Premiums ceded to reinsurer	(105)	(108)
Total net premiums earned	$          69,813	$          76,407

Our insurance segment presents a combined ratio as a measure of its 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 (including depreciation and amortization) 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.

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

	Three Months Ended
	March 31,
	2017			2016
Loss		80.6	%		96.1	%
Expense		16.6	%		14.3	%
Combined		97.2	%		110.4	%

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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, mutual funds, and collateralized mortgage obligations (“CMOs”), in addition to other alternative investments made into limited partnership interests and a real estate investment trust. Investment income is comprised primarily of interest earned on these securities, net of related investment expenses. Although investments are generally purchased with the intention to hold them until maturity, realized gains and losses could 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, or as we did in 2016, to increase the statutory capital and surplus of the insurance company subsidiaries that carry fixed maturity securities at amortized cost.

The value of our consolidated available-for-sale investment portfolio was $117.4 million at March 31, 2017 and consisted of fixed maturity securities, preferred stocks, and investments in mutual funds, all carried at fair value with unrealized gains and losses reported in a separate component of stockholders’ equity. At March 31, 2017, we had gross unrealized gains of $2.6 million and gross unrealized losses of $2.8 million in our consolidated investments available-for-sale portfolio.

The value of our other investments was $10.1 million at March 31, 2017 and consisted of limited partnership interests carried at net asset value, which approximates fair value, with unrealized gains and losses reported as investment income, and a privately-held real estate investment trust (“REIT”) carried at fair value, with unrealized gains and losses reported in a separate component of stockholders’ equity. At March 31, 2017, we had gross unrealized gains attributable to the REIT of $1.0 million in our consolidated other investments.

At March 31, 2017, 96% 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.

The following table summarizes our investment securities at March 31, 2017 (in thousands).

			Gross		Gross
	Amortized		Unrealized		Unrealized			Fair
March 31, 2017	Cost		Gains		Losses			Value
U.S. government and agencies	$	19,639	$	106	$	(276	)	$	19,469
Political subdivisions		4,203		—		(14	)		4,189
Revenue and assessment		5,436		186		(32	)		5,590
Corporate bonds		47,189		81		(1,620	)		45,650
Collateralized mortgage obligations:
Agency backed		22,666		72		(740	)		21,998
Non-agency backed – residential		2,309		543		(7	)		2,845
Non-agency backed – commercial		1,339		504	—				1,843
Total fixed maturities, available-for-sale		102,781		1,492		(2,689	)		101,584
Preferred stocks, available-for-sale		3,025		220		(92	)		3,153
Mutual funds, available-for-sale		11,813		881		—			12,694
	$	117,619	$	2,593	$	(2,781	)	$	117,431

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FIRST ACCEPTANCE CORPORATION 10-Q

Three Months Ended March 31, 2017 Compared with the Three Months Ended March 31, 2016

Consolidated Results

Revenues for the three months ended March 31, 2017 decreased 9% to $88.1 million from $96.9 million in the same period in the prior year. Income before income taxes, for the three months ended March 31, 2017 was $1.6 million, compared with a loss before income taxes of  $8.4 million for the three months ended March 31, 2016. Net income for the three months ended March 31, 2017 was $0.7 million, compared with a net loss of  $5.5 million for the three months ended March 31, 2016. Basic and diluted net income per share were $0.02 for the three months ended March 31, 2017, compared with a basic and diluted net loss per share of  $0.13 for the same period in the prior year.  

For the three months ended March 31, 2017, we recognized $0.5 million of favorable prior period loss and LAE development, and for the three months ended March 31, 2016, we recognized $10.3 million of unfavorable prior period loss and LAE development.

Insurance Operations

Revenues from insurance operations were $88.1 million for the three months ended March 31, 2017, compared with $96.9 million for the three months ended March 31, 2016. Income before income taxes from insurance operations for the three months ended March 31, 2017 was $3.0 million, compared with loss before income taxes from insurance operations of $7.0 million for the three months ended March 31, 2016.

Premiums Earned

Premiums earned decreased by $6.6 million, or 9%, to $69.8 million for the three months ended March 31, 2017, from $76.4 million for the three months ended March 31, 2016. This decrease was the result of a targeted decline in new policies written to eliminate unprofitable business through store closures, rate increases and the tightening of underwriting standards. These actions resulted in a 21% decrease in our year-over-year policies in force which was partially offset by a 16% year-over-year increase in our average in-force premium that was driven by our recent rate actions.

Commission and Fee Income

Commission and fee income decreased by $2.4 million, or 12%, to $17.2 million for the three months ended March 31, 2017, from $19.6 million for the three months ended March 31, 2016. This decrease was primarily the result of a decrease in monthly billing fees as a result of the previously-mentioned decline in the number of policies in force.

Investment Income

Investment income was $1.0 million for both the three months ended March 31, 2017 and 2016. At March 31, 2017 and 2016, the tax-equivalent book yields for our managed fixed maturities and cash equivalents portfolio were 1.9% and 2.1%, respectively, with effective durations of 2.46 and 2.81 years, respectively.

During the three months ended September 30, 2016, in order to increase the statutory capital and surplus of our insurance company subsidiaries by realizing gains on fixed maturities carried at amortized cost for statutory purposes, we sold $66.9 million of available-for-sale securities yielding 3.6% and reinvested the proceeds at 2.2%. As a result, our investment income in subsequent periods will decline from the reduced yield in our fixed maturities portfolio.

Net Realized Losses on Investments, Available-for-sale

Net realized losses on investments, available-for-sale, during the three months ended March 31, 2017 and 2016 included $5 thousand and $2 thousand, respectively, of net realized losses from redemptions.

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FIRST ACCEPTANCE CORPORATION 10-Q

Loss and Loss Adjustment Expenses

The loss ratio was 80.6% for the three months ended March 31, 2017, compared with 96.1% for the three months ended March 31, 2016. We experienced favorable development related to prior periods of $0.5 million for the three months ended March 31, 2017, compared with unfavorable development of $10.3 million for the three months ended March 31, 2016. The favorable development for the three months ended March 31, 2017 was primarily the result of favorable LAE development related to bodily injury claims over multiple prior accident periods, partially offset by some unfavorable development related to bodily injury severity. The unfavorable development for the three months ended March 31, 2016 was the result of an increase in losses across all major coverages and over multiple prior accident periods. The primary causes of the unfavorable development were a sharp increase in bodily injury severity and a greater than usual amount of subsequent payments on previously closed claims.

Excluding the development related to prior periods, the loss ratio for the three months ended March 31, 2017 was 81.4% as compared with 88.2% for the preceding three months ended December 31, 2016. We believe that this improvement in the loss ratio was the result of our aggressive rate and underwriting actions in addition to a moderate reduction in claims frequency.

Insurance Operating Expenses

Insurance operating expenses decreased 5% to $28.1 million for the three months ended March 31, 2017, from $29.6 million for the three months ended March 31, 2016. This decrease in operating expenses is primarily due to the costs savings from the recent store closures, a reduction in advertising costs, and reduced variable expenses (e.g. underwriting reports and postage) as a result of the decline in new business written.

The expense ratio was 16.6% for the three months ended March 31, 2017, compared with 14.3% for the three months ended March 31, 2016. The year-over-year increase in the expense ratio was primarily due to the decrease in premiums earned which resulted in a higher percentage of fixed expenses and the previously-mentioned decline in commission and fee income.

Overall, the combined ratio decreased to 97.2% for the three months ended March 31, 2017 from 110.4% for the three months ended March 31, 2016.

Provision (Benefit) for Income Taxes

The provision for income taxes was $0.8 million for the three months ended March 31, 2017, compared with a benefit of $2.9 million for the three months ended March 31, 2016.

In assessing our ability to realize our deferred tax assets (“DTA”), both positive and negative evidence are used to evaluate the allowance. Although we incurred a 2016 pre-tax loss of $45.1 million which is a source of negative evidence, we placed greater weight on our outlook for future taxable income over the allowable time period for realization of the DTA and concluded that it is more likely than not that the remaining DTA will be realized. Regarding the length of time available to realize the DTA, at March 31, 2017, $22.1 million of the DTA related to net operating loss carryforwards do not expire until 2031 through 2036 and $2.1 million in AMT (“Alternative Minimum Tax”) carryforwards have no expiration date. The DTA 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 DTA will not be realized. In the event the DTA valuation allowance is increased, we would record an income tax expense for the adjustment. Likewise, we would record an income tax expense in the period in which any reduction in the corporate tax rate was enacted.

Real Estate and Corporate

Loss before income taxes from real estate and corporate operations was $1.4 million for both the three months ended March 31, 2017 and 2016. 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 $1.1 million of interest expense for both the three months ended March 31, 2017 and 2016. Interest expense is from our debentures payable and the term loan from our principal stockholder to finance the July 1, 2015 Titan Agencies acquisition. 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 three months ended March 31, 2017 was $1.6 million, compared with net cash provided by operating activities of $10.5 million for the same period in the prior year. This decrease was primarily the result of the recent reduction in new business written and a decrease in loss and LAE reserves resulting from increased payments on prior period losses included in these reserves. Net cash provided by investing activities for the three months ended March 31, 2017 was $0.2 million, compared to $2.8 million for the same period in the prior year. This decrease was primarily the result of a greater amount of maturities and redemptions of investments in the prior year.

Our holding company requires cash for general corporate overhead expenses and for debt service related to our debentures and term loan payable. The holding company’s primary source of unrestricted cash to meet its obligations is the sale of ancillary products and insurance policies on behalf of third-party carriers by our agency operations, including the 2015 Titan Agencies acquisition. During the three months ended March 31, 2017, the holding company contributed $2.0 million to the statutory capital and surplus of the insurance company subsidiaries from our insurance agency net income. At March 31, 2017, our holding company had $2.7 million available remaining in unrestricted cash and investments. These funds and the additional unrestricted cash from our agency operations will be used to pay our future cash requirements outside of the insurance company subsidiaries in the short-term and foreseeable future.

The holding company has debt service requirements related to the debentures payable and the term loan to a principal stockholder. The debentures are interest-only and mature in full in July 2037. The debentures accrue interest at a variable rate equal to Three-Month LIBOR plus 375 basis points, which resets quarterly. The interest rate related to the debentures for the three months ended March 31, 2017 ranged from 4.637% to 4.789%. In April 2017, the interest rate reset to 4.920% through July 2017. The term loan is interest-only and matures in full in June 2025. The interest rate on the term loan is 8%.

State insurance laws limit the amount of dividends that may be paid from our insurance company subsidiaries. At March 31, 2017, our insurance company subsidiaries could not pay any dividends due to a negative unassigned surplus position.

We have three insurance company subsidiaries that are organized and domiciled under the insurance statutes of Texas, Georgia, and Tennessee. Our insurance company subsidiaries also operate under licenses issued by various state insurance authorities. Such licenses may be of perpetual duration or periodically renewable, provided we continue to meet applicable regulatory requirements.

The National Association of Insurance Commissioners (“NAIC”) 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. Failure to meet applicable risk-based capital requirements could subject our insurance company subsidiaries to further examination or corrective action imposed by state regulators, including limitations on their writing of additional business, state supervision or even liquidation. Although statutory risk-based capital calculations are only made as of each December 31, we have estimated that the insurance company subsidiaries remain above the company action levels as of March 31, 2017. 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 ratio for our insurance company subsidiaries of net premiums written for the last twelve months to statutory capital and surplus was 4.85-to-1 at March 31, 2017 which is in excess of the suggested guidelines.

Management is currently operating under a business plan to reduce premium writings and increase statutory capital and surplus to address the net premiums written to statutory capital and surplus guidelines. 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 foreseeable future.

Off-Balance Sheet Arrangements

We use off-balance sheet arrangements (e.g., operating leases) where the economics and sound business principles warrant their use. For information with respect to our off-balance sheet arrangements at December 31, 2016, 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, 2016. We have not entered into any new material off-balance sheet arrangements since December 31, 2016.

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Critical Accounting Estimates

There have been no significant changes to our critical accounting estimates during the three months ended March 31, 2017 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, 2016.

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. Other investments offer additional risk through the diversity of their underlying investments and their lack of marketability. The portfolios of our insurance company subsidiaries are managed to achieve an adequate risk-adjusted return while maintaining sufficient liquidity to meet policyholder obligations.

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	$	106,528	$	104,058	$	101,584	$	99,113	$	96,642	$	91,701

The following table provides information about our fixed maturity investments at March 31, 2017 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 any previously recognized impairment) 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
2017	$	4,441	$	9,962	$	—	$	14,403
2018		3,935		4,496		—		8,431
2019		4,013		7,496		—		11,509
2020		1,797		9,994		—		11,791
2021		464		17,112		—		17,576
Thereafter		2,120		36,329		—		38,449
Total	$	16,770	$	85,389	$	—	$	102,159
Fair value	$	16,560	$	85,024	$	—	$	101,584

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FIRST ACCEPTANCE CORPORATION 10-Q

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. FAST I is a variable interest entity that does not meet the requirements for consolidation of FASB ASC 810, Consolidation. The debentures are interest-only and mature in full in July 2037. The debentures accrue interest at a variable rate equal to Three-Month LIBOR plus 375 basis points, which resets quarterly. The interest rate related to the debentures for the three months ended March 31, 2017 ranged from 4.637% to 4.789%. In April 2017, the interest rate reset to 4.920% through July 2017.

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, excluding U.S. government and agency securities, is in a single mutual fund with a fair value of $7.8 million, or 7% of our available-for-sale portfolio. Our five largest investments make up 24% of our available-for-sale portfolio.

The following table presents the underlying ratings of our fixed maturity portfolio by nationally recognized statistical rating organizations at March 31, 2017 (in thousands).

Comparable Rating	Amortized Cost		% of Amortized Cost			Fair Value		% of Fair Value
AAA	$	1,375		1	%	$	1,389		1	%
AA+, AA, AA-		57,372		56	%		56,364		55	%
A+, A, A-		31,254		30	%		30,336		30	%
BBB+, BBB, BBB-		9,708		9	%		9,400		9	%
Total investment grade		99,709		97	%		97,489		96	%
Not rated		—		0	%		—		0	%
BB+, BB, BB-		500		0	%		509		1	%
B+, B, B-		587		1	%		624		1	%
CCC+, CCC, CCC-		656		1	%		1,237		1	%
CC+, CC, CC-		54		0	%		241		0	%
C+, C, C-		425		0	%		418		0	%
D		850		1	%		1,066		1	%
Total non-investment grade		3,072		3	%		4,095		4	%
Total	$	102,781		100	%	$	101,584		100	%

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 Chief 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 March 31, 2017. Based on that evaluation, our Chief Executive Officer (principal executive officer) and Chief Financial Officer (principal financial officer) concluded that our disclosure controls and procedures were effective as of March 31, 2017 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. 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. See Note 8 to our consolidated financial statements for further information about legal proceedings.

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: May 9, 2017	By:	/s/ Brent J. Gay
		Brent J. Gay
		Chief Financial Officer

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