ASSURANCEAMERICA CORP – 10-Q – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Results of Operations

On March 22, 2012, the Company entered into an agreement with an investment banker to assist in indentifying strategic alternatives for the Company, including the potential sale of its wholly owned subsidiaries AAIC and MGA. The assets have been evaluated for impairment and none has been recorded as of March 31, 2012. AAIC and MGA represent substantially all of the operating assets of the Company and as such, are currently reflected as continuing operations in the consolidated financial statements ending March 31, 2012 and 2011. TrustWay was sold in 2011 and is reported as discontinued operations in the consolidated financial statements for those same periods.

For the three months ended March 31, 2012, the Company reported a net loss of $1.0 million compared to a net loss of $75 thousand for the same period in 2011. The Company reported basic and fully diluted losses per common share of $0.016 and $0.001, respectively, for the same periods.

The loss for the three months ended March 31, 2012 resulted primarily from a decline in revenue of $4.1 million. This reduction reflects actions taken by the Company to improve underwriting results and the impact of the challenging economic environment on the non-standard segment. Total expenses declined by $2.8 million year-over-year with a reduction in loss and loss adjustment expense of $1.8 million and a reduction in selling, general and administrative expenses of $1.0 million. The $75 thousand loss in 2011 includes a net loss of $229 thousand on the discontinued operations of TrustWay.

Revenues

Premiums

Gross premiums written ("GPW") for the three months ended March 31, 2012 were $20.1 million, a decline of 3% compared to the same period in 2011. The decline in premium was driven by a reduction in new business policies as well as a product mix shift from 12 month policies to 6 month policies. The reduction in new business is primarily due to actions taken by the Company to improve profitability in underperforming market segments. These actions included rate increases, implementation of tighter underwriting guidelines and restrictions on new business in high fraud areas in the state of Florida. Additionally, the Company stopped writing new business in the states of Texas, Mississippi and Louisiana in November, 2011.

Policies in-force of 63,598 as of March 31, 2012 decreased 7.4% from policies in-force at December 31, 2011.

The Company ceded approximately 59% or $11.8 million of its direct premiums written to its reinsurers during the first quarter of 2012 compared to 56% or $17.1 million in 2011. The decrease in dollars is the result of lower direct premium volume produced.

Premiums written refers to the total amount of premiums billed to the policyholder less the amount of premiums returned, generally as a result of cancellations, during a given period. Premiums written become premiums earned as the policy ages. Barring premium rate changes, if an insurance company writes the same gross premiums written ("GPW") each year, premiums written and premiums earned will be equal and the unearned premium reserve will remain constant. During periods of growth in GPW, the unearned premium reserve will increase, causing premiums earned to be less than premiums written. Conversely, during periods of decline in GPW, the unearned premium reserve will decrease, causing premiums earned to be greater than premiums written. The Company's net premiums earned, after deducting reinsurance, was $6.9 million for the first three months of 2012 compared to $9.0 million for the same period in 2011.

Commission and Fee Income

Our MGA operations receive managing general agent commissions for agency, underwriting, policy administration, and claims adjusting services performed on behalf of insurers. Commission income for the three months ended March 31, 2012 was $2.0 million compared to $3.2 million in 2011. The decrease in commission income is due to the reduction in premium volume and a lower ceding commission rate. AAIC pays the MGA commission on premium, which AAIC retains and this amount is subsequently eliminated upon consolidation.

The MGA operations also receive finance and other fees associated with premium installment plans. Managing general agent fees of $2.1 million for the three months ended March 31, 2012 were $0.9 million lower than the prior year, resulting from the reduction of in-force policies.

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Net Investment Income and Investment Gains

Our investment portfolio is highly liquid and consists substantially of readily marketable, investment-grade debt securities. Net investment income is primarily comprised of interest and dividends earned on these securities and related investment expenses. Net investment income including gains (losses) on securities was $117 thousand for the three month periods ended March 31, 2012.

Expenses

Insurance Loss and Loss Adjustment Expenses

Insurance losses and loss adjustment expenses include payments made to settle claims, estimates for future claim payments and changes in those estimates for current and prior periods, as well as loss adjustment expenses incurred in connection with settling claims. Insurance losses and loss adjustment expenses are influenced by many factors, such as claims frequency and severity trends, the impact of changes in estimates for prior accident years, and increases in the cost of medical treatment and automobile repairs. The anticipated impact of inflation is considered when we establish our premium rates and set loss reserves. Our outside actuarial firm performs quarterly analyses of accident year results to update reserve requirements. The estimate of ultimate loss and loss adjustment expenses is evaluated by accident quarter and by major coverage group (e.g., bodily injury, physical damage). The quarterly analyses are gross of reinsurance and then reinsurance terms are applied to calculate indicated net reserves.

We have historically used reinsurance to manage our exposure to losses and loss adjustment expenses by ceding a portion of our gross losses and loss adjustment expenses to reinsurers. We remain obligated for amounts covered by reinsurance in the event that the reinsurers do not meet their obligations under the reinsurance agreements due to, for example, disputes with the reinsurer or the reinsurer's insolvency.

Effective April 1, 2011, the Company entered into a new quota share agreement with Greenlight Reinsurance Ltd. ("Greenlight") for premium written in the state of Florida for the period of April 1, 2011 to March 31, 2012. The Company cedes 50% of premiums and losses for bodily injury liability, physical damage and other automobile liability coverages to Greenlight.

Effective May 15, 2011, the Company entered into a twelve month catastrophe agreement with Shelter Mutual Insurance Company ("SMIC"). SMIC shall be liable for private passenger automobile physical damage coverage with respect to each loss occurrence, for the ultimate net loss over and above an initial ultimate net loss of $400,000 each event such as a storm or flood, subject to a limit of liability to the reinsurer of $1,600,000 each event, and further subject to a limit of liability to SMIC of $3,200,000 with respects to all events commencing during the term of this contract.

Effective January 1, 2012, the Company entered into a new quota share agreement with Greenlight Reinsurance Ltd. ("Greenlight") for premium written for the period of January 1, 2012 to December 31, 2012 in all states excluding Florida, Texas, Louisiana and Mississippi. Premium written in the state of Florida will be covered by the agreement for the period of April 1, 2012 to December 31, 2012. The Company cedes 50% of premiums and losses for bodily injury liability and 85% of premiums and losses for coverages other than bodily injury liability. The terms of the agreement include a loss ratio cap with respect to the bodily injury liability coverage of 77.5% for the individual states of Georgia and Florida and collectively for all other states combined. The reinsurer's liability for loss and loss adjustment expense plus ceding commission shall not exceed 140% of written premium during the term of this contract.

As a result of the reinsurance agreements, the Company ceded to its reinsurers approximately 68% of its direct loss and loss adjustment expenses incurred during the first three months of 2012 and 2011.

After making deductions for the effect of reinsurance, losses and loss adjustment expenses were $5.2 million for the three months ended March 31, 2012, compared to $7.0 million for the same period in 2011. The amount represents actual payments made and changes in estimated future payments to be made to or on behalf of AAIC's policyholders, including the expenses associated with settling claims. As a percentage of earned premiums, the loss and loss adjustment expense ratio for the three months ended March 31, 2012 was 74.5% and 77.0% for the same period in 2011. The 2011 loss ratio results included $1.0 million of reserve strengthening for liability coverages. The Company also implemented rate and underwriting actions during 2011 to improve loss results.

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Operating Expenses

Selling, general and administrative expenses were $6.6 million for the three months ended March 31, 2012 and $7.7 million for the same period in 2011. The decrease of $1.1 million relates to a $0.7 million decrease in selling expenses due to lower premium volume, and a reduction of $0.4 million in general and administrative expense. The Company incurred interest expense of $218 thousand for the three month period in 2012, directly related to the promissory notes and warrants issued in December 2011.

Income Tax Expense

A valuation allowance of $4,851,743 was established based on the "more likely than not" threshold for the Company's net deferred income tax asset as of December 31, 2011. The valuation allowance was increased to $5,228,717 as of March 31, 2012. The company's ability to realize deferred tax assets depends on the ability to generate sufficient taxable income within the carryforward period provided for in the tax law. The Company considered the following possible sources of taxable income when assessing the possible realization of deferred tax assets: future reversals of existing taxable temporary differences; future taxable income exclusive of reversing temporary differences and carryforwards; taxable income in prior carryback years; and tax planning strategies.

Financial Condition

As of March 31, 2012, the Company had investments and cash of $16.3 million, compared to $16.6 million at December 31, 2011. The Company's investment strategy is to invest in bonds with short durations in order to meet its insurance obligations. As of March 31, 2012, the Company had $8.3 million in cash and short-term investments, which included $0.3 million of cash restricted to provide security for certain reinsurance reserve obligations. The Company's long term investments of $7.4 million are spread among direct obligations of the U.S. Treasury as well as those securities unconditionally guaranteed as to the payment of principal and interest by the United States government or any agency thereof and in corporate bonds. The other long term investments of $0.6 million represent low income housing tax credits, which will be used to offset the Company's future tax liabilities.

The Company's investment activities are made in accordance with the Company's investment policy. The objectives of the investment policy are to obtain favorable after-tax returns on investments through a diversified portfolio of fixed income securities. The Company's investment criteria and practices reflect the short-term duration of its contractual obligations with policyholders. Tax considerations include federal and state income tax as well as premium tax abatement and credit opportunities offered to insurance companies in the states where AAIC writes policies.

As of March 31, 2012, the Company's assets included two promissory notes secured by real estate mortgages, in the amount of $2.5 million and $1.5 million, respectively. The two notes were subsequently assigned by the Company as a capital contribution to its subsidiary AAIC. The assigned promissory notes are secured by mortgages and real estate deeds owned by the Chairman of the Company. See Note 5 of the Consolidated Financial Statements for further details regarding the notes.

Receivable from insureds as of March 31, 2012, decreased $300 thousand to $24.8 million. The Company's policy is to write off uncollected receivable balances within 60 days of cancellation or expiration, and the Company does not consider an allowance for doubtful accounts to be necessary.

Reinsurance recoverable as of March 31, 2012, decreased $2.5 million to $34.2 million compared to $36.7 million as of December 31, 2011. The decrease is directly related to a reduction in ceded loss reserves. AAIC maintains quota-share reinsurance treaties whereby it cedes approximately 68% of losses. The $34.2 million represents the reinsurers' portion of losses and loss adjustment expenses, both paid and unpaid.

Prepaid reinsurance premiums as of March 31, 2012, decreased $1.0 million to $18.4 million compared to $19.4 million as of December 31, 2011. The decrease results from AAIC's decline in premium volume. Prepaid reinsurance premiums represent premiums ceded to its reinsurers which have not been fully earned.

Other receivables as of March 31, 2012 decreased $0.3 million to $1.3 million. The balance primarily relates to amounts due on managing general agency agreements and a $0.2 million note receivable due from the purchaser of the TrustWay Alabama agencies.

The Company has a full valuation allowance on its deferred income tax asset. The valuation allowance was $5,228,717 as of March 31, 2012, an increase of $377 thousand from December 31, 2011. See Note 9 of the Consolidated Financial Statements.

Accounts payable and accrued expenses as of March 31, 2012, increased $0.3 million to $7.6 million. The increase is due to a $0.5 million increase in premium tax accruals and an increase of $0.3 million in amounts due to agents, partially offset by a reduction of $0.2 million in unclaimed property, a reduction in salary accruals of $0.2 million and $0.1 million reduction in general expense accruals.

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Unearned premium increased $0.3 million to $28.4 million as of March 31, 2012 and represents premiums written but not earned. This increase is directly attributable to the increase in AAIC's premium writings in the three months ended March 31, 2012 as compared to the three months ended December 31, 2011.

Unpaid losses and loss adjustment expenses decreased $2.6 million to $39.5 million as of March 31, 2012. This amount represents actuarial estimates of future amounts needed to pay claims and related expenses. The decrease is primarily related to a reduction in claims inventory.

Reinsurance payable as of March 31, 2012 decreased $1.3 million to $19.9 million. The amount represents premiums owed to the Company's reinsurers. AAIC maintains nine reinsurance treaties with its reinsurers and is currently ceding approximately 59% of premiums written. The decrease in reinsurance payable is mainly due to the decrease in premiums volume.

Provisional commission reserve represents the difference between the minimum ceding commission and the provisional amount paid by the reinsurers. This balance as of March 31, 2012 decreased $0.7 million to $1.8 million, compared to the balance at December 31, 2011 of $2.5 million. The decrease is related to the partial repayment of provisional commissions received for the 2010 treaty year.

Notes payable due to a related party increased by $89 thousand. The increase represents the amortization of the discount on warrants issued. In December 2011, two notes payable were issued in the amount of $2.5 million and $1.5 million to the Chairman of the Company, in consideration of providing the secured notes to AAC, (for assignment by the Company as a capital contribution to its subsidiary AAIC). As additional consideration, the Company also issued a Warrant Agreement giving the Chairman the right to purchase 11,629,000 shares of the common stock of the Company for $0.01 per share. At March 31, 2012, the recorded balance of the notes was $1,646,516, net of $2,353,484 discount related to the issuance of the warrants. The discount will be amortized over the life of the notes as a cost adjustment. See Note 10 of the Consolidated Financial Statements for further information.

Liquidity and Capital Resources

Net cash used by operating activities for the three months ended March 31, 2012, was $390 thousand compared to net cash provided by operating activities of $2.1 million for the same period of 2011. The decrease is driven primarily by the reduction in net earnings, lower premium volume and the partial repayment of treaty year 2010 provisional commissions.

Investing activities provided cash for the three months ended March 31, 2012 of $408 thousand as compared to $272 thousand for the same period of 2011. The increase in the amount provided was attributable to a reduction in spending for capital assets.

Financing activities for the three-months ended March 31, 2012 and 2011, provided cash of $135 thousand and $65 thousand, respectively.

To support Company growth, the Company maintains a highly liquid investment portfolio and closely manages capital requirements. AAIC is required by the state of South Carolina to maintain minimum Statutory Capital and Surplus of $3.0 million. As of March 31, 2012, AAIC's statutory Capital and Surplus was $10.9 million.

Off-Balance Sheet Arrangements

The Company does have off balance sheet leasing arrangements. For further information, please refer to Note 14 in the financial statements.

Loss and LAE Reserves

The Company is required to make certain estimates and assumptions when preparing its financial statements and accompanying notes in accordance with GAAP. One area which requires estimations and assumptions is the establishment of loss and LAE reserves. Loss and LAE reserves are established to reflect the estimated costs of paying claims and claims expenses under insurance policies we have issued. These reserves are an approximation of amounts necessary to settle all outstanding claims, including claims of which we are aware and claims that have been incurred but not reported ("IBNR") as of the financial statement date.

At March 31, 2012 and December 31, 2011, the Company had $14.0 million and $14.5 million of net loss and LAE reserves, respectively, which included $4.5 million and $5.1 million of case reserves and $9.5 million and $9.4 million of IBNR reserves. For the three months ended March 31, 2012, the Company's case reserves decreased $0.6 million and IBNR reserves increased $100 thousand. This decrease in reserves is related to a reduction in claims inventory.

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GROSS RESERVES BY LINE OF BUSINESS

The following table presents the gross reserves by line of business as of March 31, 2012 and December 31, 2011:

                                                          2012             2011       Personal Auto Liability                      $ 38,433,638     $ 39,969,262       Personal Auto Physical Damage                   1,021,433        2,129,001        Total Gross Reserves-Unpaid Losses and LAE   $ 39,455,071     $ 42,098,263   

The decrease in gross reserves of $2.6 million was represented by a decrease in the auto physical damage coverage of $1.1 million and $1.5 million</money> in bodily injury and personal injury protection coverages.

Variability of Reserves for Loss and LAE

Management believes that there are no reasonably likely changes in the key factors and assumptions that materially affect the Company's estimate of the reserve for loss and LAE that would materially impact the Company's financial position, liquidity and results of operations. The Company's low average policy limit and concentration on the nonstandard auto driver classification help stabilize fluctuations in frequency and severity, thereby limiting the potential variability the reserve level may have on reported results. For example, approximately 96% of policies included within the nonstandard book of business include only the state-mandated minimum policy limits for bodily injury and property damage, which mitigates the complexity of estimating average severity. These low limits tend to reduce the exposure of the loss reserves on this coverage to medical cost inflation on severe injuries since the minimum policy limits will limit the total payout.

The following table provides the estimated changes in the liability and related payments made for the three months ended March 31, 2012 and 2011:

                                                     2012             2011          Change in net loss and LAE reserves   $  (521,040 )    $   700,515          Paid losses and LAE                     5,679,430        6,254,277           Total incurred losses and LAE         $ 5,158,390      $ 6,954,792           Loss and LAE ratio(1)                        74.5 %           77.0 %     

(1) The ratio was calculated by taking losses and LAE divided by the Net Premiums

Earned.

Losses and Loss Adjustment Expenses (LAE)

The Company's claims costs represent payments made and estimated future payments to be made to or on behalf of our policyholders, including expenses needed to adjust or settle claims. These costs relate to current costs under our non-standard state-mandated automobile insurance programs. Claims costs are impacted by loss severity and frequency and are influenced by inflation and driving patterns, among other factors. Accordingly, anticipated changes in these factors are taken into account when we establish premium rates and loss reserves.

During the quarter ended March 31, 2012, our loss and LAE ratio decreased 2.6 %, as compared to an increase of 6.3% in the same period a year ago. The year-over-year change reflects reserve strengthening in 2011 for prior year loss development. We continuously monitor internal and industry-wide severity trends and adjust rates as appropriate to compensate for the higher loss costs.

The table below presents the development experienced during the three months ended March 31, 2012 and 2011:

                                                           2012              2011   Prior year incurred losses                         $  (530,748 )     $ 1,217,001   Current year incurred losses and LAE                 5,689,138         5,737,791    Total incurred losses and LAE                      $ 5,158,390       $ 6,954,792    Increase to the calendar year loss and LAE ratio          (2.6 %)            6.3 %   

Ceded Reinsurance

The Company cedes a significant portion of its personal automobile premium to other reinsurers. The Company's reinsurance strategy is to use quota share reinsurance to mitigate the financial impact of losses on its operations, while enabling premium growth within its capital base. Historically, the Company's reinsurance contracts have been one or two years in duration, subject to renewal.

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Effective January 1, 2012, the Company entered into a new quota share agreement with Greenlight Reinsurance Ltd. ("Greenlight") for premium written for the period of January 1, 2012 to December 31, 2012 in all states excluding Florida, Texas, Louisiana and Mississippi. Premium written in the state of Florida will be covered by the agreement for the period of April 1, 2012 to December 31, 2012. The Company cedes 50% of premiums and losses for bodily injury liability and 85% of premiums and losses for coverages other than bodily injury liability. The terms of the agreement include a loss ratio cap with respect to the bodily injury liability coverage of 77.5% for the individual states of Georgia and Florida and collectively for all other states combined. The reinsurer's liability for loss and loss adjustment expense plus ceding commission shall not exceed 140% of ceded written premium during the term of this contract.

Reinsurance contracts do not relieve the Company from its obligations to policyholders. The Company periodically reviews the financial condition of its reinsurers to minimize its exposure to losses from reinsurer insolvencies. The Company has eight reinsurers, of which seven are A- rated or better based on the most recent A.M. Best ratings available. While the eighth reinsurer does not have a rating and the contract is in run-off. Further, the reinsurers cover up to $2,000,000 in aggregate claims for extra contractual obligations each policy year.

  The impact of reinsurance on the Statements of Operations for the three months ended March 31 is as follows:                                                               2012             2011   Ceded premiums written                               $ 11,783,110     $ 17,066,393   Ceded commissions incurred                           $  1,912,461     $  3,528,655   Ceded losses and loss adjustment expenses incurred   $ 10,727,962     $ 15,010,521  

The impact of reinsurance on the balance sheets as of March 31, 2012 and December 31, 2011 is as follows:

                                                            2012             2011    Reinsurance recoverable                           $ 34,179,425     $ 36,664,396    Ceded unpaid losses and loss adjustment expense   $ 25,428,057     $ 27,550,209    Ceded unearned premiums                           $ 18,432,025     $ 19,455,257    Reinsurance payable                               $ 19,940,086     $ 20,538,203  

Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies. The Company reports as assets (a) the estimated reinsurance recoverable on unpaid losses, including an estimate for losses incurred but not reported, and (b) amounts paid to reinsurers applicable to the policies-in-force.

The Company ceded approximately 59% of its premium and 68% of losses during the first quarter of March 31, 2012 as compared to approximately 56% of its premium and 68% of losses ceded to reinsurers for the prior year. The ceded premium and losses reflect the new contract terms entered into during 2011 and 2012 as previously mentioned. The ceded premium under these reinsurance agreements for the three months ended March 31, 2012 and 2011 were $11.8 million and $17.1 million, respectively. The related ceding commission was approximately $1.9 million and $3.5 million for the same periods, respectively. The lower ceded premium and commission were mainly due to the reduction in the Company's premium volume.

Ceded reinsurance for all programs reduced the Company's incurred losses and LAE for the three months ended March 31, 2012 and 2011 by $10.7 million and $15.0 million, respectively.

Reinsurance assets include balances due from other contracted reinsurers under the terms of reinsurance agreements. Amounts applicable to ceded unearned premiums, ceded loss payments, and ceded claims liabilities are reported as assets in the accompanying balance sheets. Under the reinsurance agreements, the Company has four reinsurers that are required to collateralize their reinsurance recoverables. As of March 31, 2012, all reinsurers have provided a letter of credit or a secured trust account to provide security sufficient to satisfy the Company's obligations under the reinsurance agreement. The Company believes the fair value of its reinsurance recoverables approximates their carrying amounts.

The Company's reinsurance recoverable balances amounted to $34.2 million and $36.7 million as of March 31, 2012 and December 31, 2011, respectively. The recoverable includes ceded unpaid losses and loss adjustment expenses of $25.4 million and $27.6 million of the same periods, respectively. The ceded reserves from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policies ceded. Reinsurance recoverable assets include paid loss balances due from other reinsurers under the terms of reinsurance agreements in the amount of $8.8 million and $9.1 million as of March 31, 2012 and December 31, 2011, respectively. The paid loss recoverables are in good standing as of March 31, 2012.

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The Company's ceded unearned premium relates to policies in force which is recognized ratably over the policy period. As of March 31, 2012 and December 31, 2011, the ceded unearned premiums amounted to $18.4 million and $19.5 million, respectively. Reinsurance payable of $19.9 million and $20.5 million as of March 31, 2012 and December 31, 2011, respectively, represents the amounts due to reinsurers for ceded premiums net of commissions. The Company pays its reinsurers on a collected premium basis. The Company does not have any balances that are in dispute as of March 31, 2012.

The Company's quota share reinsurance facility has a significant impact on its cash flows. Since the Company cedes a significant amount of its premium and losses, the Company relies heavily on its reinsurers to settle outstanding reinsurance balances due for loss payments net of premiums collected. The Company paid ceded premiums net of commissions of $10.1 million and $6.5 million and received reinsurance recoverables on paid loss and loss adjustment expenses of $13.2 million and $7.4 million during the three months ended March 31, 2012 and 2011, respectively.

The Company's reinsurance strategies have not changed from previous years and the Company's limited loss exposure is based on the existing quota share agreement. While the Company monitors conditions within the reinsurance market, adverse conditions could have an impact on the Company's ability to secure reinsurance capacity, thereby limiting its ability to cede future losses.