NSEC-6.30.2011-10Q
Table of Contents

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
 (Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For Quarterly Period Ended June 30, 2011
or      
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from           to          .

Commission File Number 0-18649

The National Security Group, Inc.
(Exact name of registrant as specified in its charter)

Delaware
 
63-1020300
(State or Other Jurisdiction of
Incorporation or Organization)
 
(IRS Employer
Identification No.)
 
 
 
661 East Davis Street
Elba, Alabama
 
36323
(Address of principal executive offices)
 
(Zip-Code)
 
Registrant’s Telephone Number including Area Code (334) 897-2273

           
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  þ    No  o 

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 (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    o Yes    o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in rule 12b-2 of the Act).  (Check One) :    Large accelerated filer o Accelerated filer  o Non-accelerated filer  o Smaller reporting company  þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o No  þ
As of August 15, 2011, there were 2,466,600 shares, $1.00 par value, of the registrant’s common stock outstanding.



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Table of Contents

THE NATIONAL SECURITY GROUP, INC

INDEX

PART I. FINANCIAL INFORMATION
 
 
 
 
Page No.
 
Item 1.  Financial Statements (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
CERTIFICATIONS
 

2
Table of Contents

Cautionary Statement Regarding Forward-Looking Statements

Any statement contained in this report which is not a historical fact, or which might otherwise be considered an opinion or projection concerning the Company or its business, whether expressed or implied, is meant as and should be considered a forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1995.  The following report contains forward-looking statements that are not strictly historical and that involve risks and uncertainties.  Such statements include any statements containing the words “expect,” “plan,” “estimate,” “anticipate” or other words of a similar nature. Management cautions investors about forward-looking statements.  Forward-looking statements involve certain evaluation criteria, such as risks, uncertainties, estimates, and/or assumptions made by individuals informed of the Company and industries in which we operate.  Any variation in the preceding evaluation criteria could cause actual results to differ materially from those expressed or implied by such forward-looking statements.  These risks and uncertainties include, without limitation, the following:

▪
The insurance industry is highly competitive and the Company encounters significant competition in all lines of business from other insurance companies.  Many of the competing companies have more abundant financial resources than the Company.
▪
Insurance is a highly regulated industry.  It is possible that legislation may be enacted which would have an adverse effect on the Company’s business.
▪
The Company is subject to regulation by state governments for each of the states in which it conducts business.  The Company cannot predict the subject of any future regulatory initiative(s) or its (their) impact on the Company’s business.
▪
The Company is rated by various insurance rating agencies.  If a rating is downgraded from its current level by one of these agencies, sales of the Company’s products and stock could be adversely impacted.
▪
The Company’s financial results are adversely affected by increases in policy claims received by the Company.  While a manageable risk, this fluctuation is often unpredictable.
▪
The Company’s investments are subject to a variety of risks.  Investments are subject to defaults and changes in market value.  Market value can be affected by changes in interest rates, market performance and the economy.
▪
The Company mitigates risk associated with life policies through implementing effective underwriting and reinsurance strategies.  These factors mitigate, not eliminate, risk related to mortality and morbidity exposure.  The Company has established reserves for claims and future policy benefits based on amounts determined by independent actuaries.  There is no assurance that these estimated reserves will prove to be sufficient or that the Company will not incur claims exceeding reserves, which could result in operating losses.
▪
The Company mitigates risk associated with property and casualty policies through implementing effective underwriting and reinsurance strategies.  The Company obtains reinsurance which increases underwriting capacity and limits the risk associated with policy claims.  The Company is subject to credit risk with regard to reinsurers as reinsurance does not alleviate the Company’s liability to its insured’s for the ceded risks.  The Company utilizes a third-party to develop a reinsurance treaty with reinsurers who are reliable and financially stable.  However, there is no guarantee that booked reinsurance recoverable will actually be recovered.  A reinsurer’s insolvency or inability to make payments due could have a material adverse impact on the financial condition of the Company.
▪
The Company’s ability to continue to pay dividends to shareholders is contingent upon profitability and capital adequacy of the insurance subsidiaries.  The insurance subsidiaries operate under regulatory restrictions that could limit the ability to fund future dividend payments of the Company.  An adverse event or series of events could materially impact the ability of the insurance subsidiaries to fund future dividends and consequently the Board of Directors would have to suspend the declaration of dividends to shareholders.
▪
The Company is subject to the risk of adverse settlements or judgments resulting from litigation of contested claims.  It is difficult to predict or quantify the expected results of litigation because the outcome depends on decisions of the court and jury that are based on facts and legal arguments presented at the trial.


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Table of Contents

Part I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
 
 
June 30,
 
December 31,
 
 
2011
 
2010
ASSETS
 
(unaudited)
 
 
Investments
 
 
 
 
Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2011 - $3,840;
2010 - $5,144)
 
$
3,673

 
$
4,959

Fixed maturities available-for-sale, at estimated fair value (cost: 2011 - $71,726;
2010 -$77,119)
 
73,221

 
78,468

Equity securities available-for-sale, at estimated fair value (cost: 2011 - $4,969;
2010 - $5,478)
 
8,767

 
9,047

Trading securities
 
860

 
705

Mortgage loans on real estate, at cost
 
393

 
935

Investment real estate, at book value
 
5,643

 
5,010

Policy loans
 
1,185

 
1,123

Company owned life insurance
 
5,652

 
5,520

Other invested assets
 
3,871

 
3,915

Total Investments
 
103,265

 
109,682

Cash
 
965

 
1,572

Accrued investment income
 
714

 
823

Policy receivables and agents' balances
 
10,837

 
9,531

Reinsurance recoverable
 
3,531

 
1,699

Deferred policy acquisition costs
 
10,216

 
10,189

Property and equipment, net
 
2,295

 
2,437

Accrued income tax recoverable
 
2,477

 
—

Other assets
 
1,246

 
934

Total Assets
 
$
135,546

 
$
136,867

 
 
 
 
 
LIABILITIES AND SHAREHOLDERS' EQUITY
 
 

 
 

Property and casualty benefit and loss reserves
 
$
14,596

 
$
13,184

Accident and health benefit and loss reserves
 
1,948

 
1,881

Life and annuity benefit and loss reserves
 
29,406

 
28,897

Unearned premiums
 
27,937

 
26,433

Policy and contract claims
 
620

 
611

Other policyholder funds
 
1,379

 
1,351

Short-term notes payable
 
175

 
500

Long-term debt
 
12,372

 
12,372

Accrued income taxes
 
—

 
127

Deferred income tax liability
 
1,132

 
1,043

Other liabilities
 
6,731

 
6,758

Total Liabilities
 
96,296

 
93,157

Contingencies
 


 


Shareholders' Equity
 
 

 
 

Common stock
 
2,467

 
2,467

Additional paid-in capital
 
4,951

 
4,951

Accumulated other comprehensive income
 
3,252

 
3,022

Retained earnings
 
28,580

 
33,270

Total Shareholders' Equity
 
39,250

 
43,710

Total Liabilities and Shareholders' Equity
 
$
135,546

 
$
136,867


The Notes to Condensed Consolidated Financial Statements are an integral part of these statements.

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Table of Contents

THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS) (UNAUDITED)
(In thousands, except per share amounts)

 
 
Three Months Ended
 
Six Months Ended
 
 
June 30
 
June 30
 
 
2011
 
2010
 
2011
 
2010
REVENUES
 
 
 
 
 
 
 
 
Net premiums earned
 
$
13,321

 
$
15,903

 
$
28,191

 
$
30,941

Net investment income
 
1,257

 
1,195

 
2,399

 
2,521

Net realized investment gains
 
261

 
689

 
1,031

 
1,358

Other income
 
256

 
256

 
511

 
555

Total Revenues
 
15,095

 
18,043

 
32,132

 
35,375

EXPENSES
 
 

 
 

 
 

 
 

Policyholder benefits paid or provided
 
15,682

 
11,061

 
25,004

 
19,534

Policy acquisition costs
 
3,071

 
2,970

 
5,995

 
5,718

General expenses
 
2,986

 
2,155

 
5,549

 
4,740

Taxes, licenses and fees
 
622

 
480

 
1,102

 
967

Interest expense
 
285

 
307

 
570

 
565

Total Expenses
 
22,646

 
16,973

 
38,220

 
31,524

 
 
 
 
 
 
 
 
 
(Loss) Income Before Income Taxes
 
(7,551
)
 
1,070

 
(6,088
)
 
3,851

 
 
 
 
 
 
 
 
 
INCOME TAX (BENEFIT) EXPENSE
 
 

 
 

 
 

 
 

Current
 
(2,515
)
 
(14
)
 
(2,165
)
 
588

Deferred
 
(91
)
 
270

 
27

 
555

 
 
(2,606
)
 
256

 
(2,138
)
 
1,143

 
 
 
 
 
 
 
 
 
Net (Loss) Income
 
$
(4,945
)
 
$
814

 
$
(3,950
)
 
$
2,708

 
 
 
 
 
 
 
 
 
(LOSS) EARNINGS PER COMMON SHARE
 
$
(2.00
)
 
$
0.33

 
$
(1.60
)
 
$
1.10

 
 
 
 
 
 
 
 
 
DIVIDENDS DECLARED PER SHARE
 
$
0.15

 
$
0.15

 
$
0.30

 
$
0.30


The Notes to Condensed Consolidated Financial Statements are an integral part of these statements.


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THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY (UNAUDITED)
(In thousands, except per share amounts)

 
 
Total
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Common
Stock
 
Additional
Paid-in
Capital
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2010
 
$
43,710

 
$
33,270

 
$
3,022

 
$
2,467

 
$
4,951

 
 
 
 
 
 
 
 
 
 
 
Comprehensive Loss
 
 

 
 

 
 

 
 

 
 

Net loss six months ended 6/30/2011
 
(3,950
)
 
(3,950
)
 
 

 
 

 
 

Other comprehensive income (loss) (net of tax)
 
 

 
 

 
 

 
 

 
 

Unrealized gain on securities, net of reclassification adjustment of $680
 
285

 
 

 
285

 
 

 
 

Unrealized loss on interest rate swap
 
(55
)
 
 

 
(55
)
 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
Total Comprehensive Loss
 
(3,720
)
 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
Cash dividends
 
(740
)
 
(740
)
 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2011 (Unaudited)
 
$
39,250

 
$
28,580

 
$
3,252

 
$
2,467

 
$
4,951


The Notes to the Condensed Consolidated Financial Statements are an integral part of these statements.


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THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)

 
 
Six Months Ended
 
 
June 30,
 
 
2011
 
2010
Cash Flows from Operating Activities
 
 
 
 
Net (loss) income
 
$
(3,950
)
 
$
2,708

Adjustments to reconcile (loss) income from continuing operations to net cash
provided by operating activities:
 
 

 
 

Change in accrued investment income
 
109

 
(52
)
Change in reinsurance recoverable
 
(1,832
)
 
31

Change in deferred policy acquisition costs
 
(27
)
 
(514
)
Change in accrued income taxes
 
(2,604
)
 
(62
)
Change in deferred income taxes
 
(27
)
 
(555
)
Depreciation expense
 
187

 
194

Change in policy liabilities and claims
 
2,195

 
(88
)
Other, net
 
(1,660
)
 
(466
)
Net cash (used in) provided by operating activities
 
(7,609
)
 
1,196

 
 
 
 
 
Cash Flows from Investing Activities
 
 

 
 

Cost of investments acquired
 
(11,777
)
 
(22,379
)
Sale and maturity of investments
 
19,847

 
19,652

Purchase of property and equipment
 
(31
)
 
(101
)
Net cash provided by (used in) investing activities
 
8,039

 
(2,828
)
 
 
 
 
 
Cash Flows from Financing Activities
 
 

 
 

Change in other policyholder funds
 
28

 
(16
)
Change in short-term notes payable
 
(325
)
 
400

Dividends paid
 
(740
)
 
(740
)
Net cash used in financing activities
 
(1,037
)
 
(356
)
 
 
 
 
 
Net change in cash and cash equivalents
 
(607
)
 
(1,988
)
 
 
 
 
 
Cash and cash equivalents, beginning of period
 
1,572

 
4,686

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
965

 
$
2,698


The Notes to the Condensed Consolidated Financial Statements are an integral part of these statements.


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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

NOTE 1 – SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation
The accompanying condensed consolidated financial statements include the accounts of The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries:  National Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and  NATSCO, Inc. (NATSCO).  NSFC includes a wholly-owned subsidiary - Omega One Insurance Company (Omega) .  The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).  All significant intercompany transactions and accounts have been eliminated.  The financial information presented herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2010, which includes information and disclosures not presented herein.

Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these financial statements are reserves for future policy benefits, liabilities for losses and loss adjustment expenses, reinsurance recoverable asset on associated loss and loss adjustment expense liabilities, deferred policy acquisition costs, deferred income tax assets and liabilities, assessments of other than temporary impairments on investments and accruals for contingencies.   Actual results could differ from those estimates.

Recently Issued Accounting Standards

Intangibles-Goodwill and Other
Effective for interim and annual reporting periods beginning after December 15, 2010, the FASB revised guidance related to goodwill impairment testing. The revised guidance clarifies that when evaluating goodwill associated with a reporting unit that has a zero or negative carrying value, an initial determination should be made as to whether it is more likely than not that the goodwill is impaired. When impairment is more likely than not, the goodwill is required to be tested for impairment. We adopted the guidance on January 1, 2011. Adoption did not have a material effect on our results of operations or financial position.

Fair Value Measurements
Effective for interim and annual reporting periods beginning after December 15, 2010, the FASB revised guidance to require additional disclosure about purchases, sales, issuances, and settlements in the roll forward activity in Level 3 fair value measurements. We adopted the guidance on January 1, 2011; adoption did not have a material effect on our results of operations or financial position.

Accounting Changes Not Yet Adopted

Presentation of Comprehensive Income
Effective for interim and annual reporting periods beginning after December 15, 2011, the FASB revised guidance related to the way other comprehensive income (“OCI”) appears within the financial statements. Companies will be required to show net income, OCI and total comprehensive income in one continuous statement or in two separate but consecutive statements. Components of OCI may no longer be presented solely in the statement of changes in shareholders’ equity. Any reclassification between OCI and net income will be presented on the face of the financial statements. We do not expect the impact of this revised guidance to change reported net income or comprehensive income upon adoption in 2012.  

Fair Value Measurements
Effective for interim and annual reporting periods beginning after December 15, 2011, the FASB revised guidance related to fair value measurements and disclosures, all of which are to be applied prospectively. The new guidance increases disclosure requirements regarding valuation methods used to determine fair value measurements categorized as Level 3, as well as the sensitivity to change of those measurements, and requires additional disclosures regarding the consideration given to highest and best use in fair value measurements of nonfinancial assets. The guidance requires that when fair value measurements of items not carried at fair value are disclosed, the fair value measurements are to be categorized by level of fair value hierarchy. Additionally, the guidance also clarifies or revises certain fair value measurement principles related to the valuation of financial instruments managed within a portfolio, the valuation of instruments classified as a part of shareholders' equity, the appropriate application of the highest and best use valuation premise, and the consideration of premium and discounts in a fair value measurement.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

We are currently evaluating the impact of this revised guidance.  However, we do not expect a material effect on our results of operations or financial position upon adoption in 2012.

 
Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
Effective for fiscal years beginning after December 15, 2011, the FASB revised guidance regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. The guidance permits deferral of qualifying costs associated only with successful contract acquisitions. The portion of internal selling agent and underwriter salary and benefit costs allocated to unsuccessful contracts, as well as advertising costs, are excluded. The guidance should be applied prospectively, but may be applied retrospectively for all prior periods. We are currently evaluating the impact of this revised guidance on our financial statements.  However, we do not expect a material effect on our results of operations or financial position upon adoption in 2012.

NOTE 2 – REINSURANCE

In the normal course of business, NSFC seeks to reduce the loss that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers.  NSFC maintains a catastrophe reinsurance agreement to cover losses from catastrophic events, primarily hurricanes.
 
Under the catastrophe reinsurance program, the Company retains the first $3.5 million in losses from each event.  Reinsurance is maintained in four layers as follows:

Layer
Reinsurers' Limits of Liability
First Layer
95% of  $6,500,000 in excess of $3,500,000
Second Layer
95% of  $7,500,000 in excess of $10,000,000
Third Layer
100% of  $25,000,000 in excess of $17,500,000
Fourth Layer
100% of  $30,000,000 in excess of $42,500,000

Layers 1-4 cover events occurring from January 1-December 31 of the contract year.  All significant reinsurers under the program carry A.M. Best ratings of A- (Excellent) or higher, or equivalent ratings.

Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy.  Amounts paid for prospective reinsurance contracts are reported as prepaid reinsurance premiums and amortized over the remaining contract period.

In the normal course of business, NSIC seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage contracts.  NSIC retains a maximum of $50,000 of coverage per individual life.  The cost of reinsurance is amortized over the contract period of the reinsurance.

NOTE 3 – CALCULATION OF EARNINGS PER SHARE

Earnings per share were based on net income (loss) divided by the weighted average common shares outstanding.  The weighted average number of shares outstanding for the three month and six month periods ending June 30, 2011 and 2010 were 2,466,600.

NOTE 4 – CHANGES IN SHAREHOLDERS' EQUITY

During the six months ended June 30, 2011 and 2010, there were no changes in shareholders' equity except for a net loss of $3,950,000 and net income of $2,708,000, respectively; dividends paid of $740,000 in 2011 and 2010; changes in accumulated other comprehensive income, net of applicable taxes of $230,000 and $191,000, respectively.  Other comprehensive income consists of accumulated unrealized gains and losses on securities and unrealized gains and losses on interest rate swaps.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

NOTE 5 – INVESTMENTS

The amortized cost and aggregate fair values of investments in securities are as follows:

 
 
(Dollars in thousands)
 
 
June 30, 2011
 
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Available-for-sale securities:
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
18,576

 
$
1,283

 
$
83

 
$
19,776

Mortgage backed securities
 
7,377

 
241

 
103

 
7,515

Private label mortgage backed securities
 
11,602

 
131

 
290

 
11,443

Obligations of states and political subdivisions
 
18,974

 
372

 
329

 
19,017

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
15,197

 
406

 
133

 
15,470

Total fixed maturities
 
71,726

 
2,433

 
938

 
73,221

Equity securities
 
4,969

 
4,300

 
502

 
8,767

 
 
 
 
 
 
 
 
 
Total
 
$
76,695

 
$
6,733

 
$
1,440

 
$
81,988

Held-to-maturity securities:
 
 

 
 

 
 

 
 

Mortgage backed securities
 
$
2,320

 
$
118

 
$
10

 
$
2,428

Private label mortgage backed securities
 
81

 
2

 
—

 
83

Obligations of states and political subdivisions
 
991

 
39

 
3

 
1,027

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
281

 
21

 
—

 
302

 
 
 
 
 
 
 
 
 
Total
 
$
3,673

 
$
180

 
$
13

 
$
3,840


 
 
(Dollars in thousands)
 
 
December 31, 2010
 
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Available-for-sale securities:
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
22,405

 
$
1,666

 
$
119

 
$
23,952

Mortgage backed securities
 
7,053

 
326

 
104

 
7,275

Private label mortgage backed securities
 
13,313

 
200

 
407

 
13,106

Obligations of states and political subdivisions
 
18,902

 
252

 
739

 
18,415

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
15,446

 
446

 
172

 
15,720

Total fixed maturities
 
77,119

 
2,890

 
1,541

 
78,468

Equity securities
 
5,478

 
4,014

 
445

 
9,047

 
 
 
 
 
 
 
 
 
Total
 
$
82,597

 
$
6,904

 
$
1,986

 
$
87,515

Held-to-maturity securities:
 
 

 
 

 
 

 
 

Mortgage backed securities
 
$
2,669

 
$
126

 
$
1

 
$
2,794

Private label mortgage backed securities
 
118

 
4

 
—

 
122

Obligations of states and political subdivisions
 
1,837

 
48

 
12

 
1,873

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
335

 
20

 
—

 
355

 
 
 
 
 
 
 
 
 
Total
 
$
4,959

 
$
198

 
$
13

 
$
5,144


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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

The amortized cost and aggregate fair value of debt securities at June 30, 2011, by contractual maturity, are as follows.  Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
 
(Dollars in Thousands)
 
 
Amortized
Cost
 
Fair
Value
Available-for-sale securities:
 
 
 
 
Due in one year or less
 
$
164

 
$
166

Due after one year through five years
 
9,643

 
10,355

Due after five years through ten years
 
23,572

 
24,766

Due after ten years
 
38,347

 
37,934

 
 
 
 
 
Total
 
$
71,726

 
$
73,221

Held-to-maturity securities:
 
 

 
 

Due in one year or less
 
$
300

 
$
306

Due after one year through five years
 
—

 
—

Due after five years through ten years
 
1,290

 
1,374

Due after ten years
 
2,083

 
2,160

 
 
 
 
 
Total
 
$
3,673

 
$
3,840


A summary of securities available-for-sale with unrealized losses as of June 30, 2011 and December 31, 2010 along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows:

 
 
(Dollars in thousands)
 
June 30, 2011
 
 
 
Less than 12 months
 
12 months or longer
 
Total
 
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a
Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
5,513

 
$
83

 
$
—

 
$
—

 
$
5,513

 
$
83

 
12

Mortgage backed securities
 
2,743

 
103

 
—

 
—

 
2,743

 
103

 
8

Private label mortgage backed securities
 
2,704

 
61

 
1,344

 
229

 
4,048

 
290

 
11

Obligations of state and political subdivisions
 
5,038

 
227

 
1,646

 
102

 
6,684

 
329

 
21

U.S. Treasury securities and obligations of U.S. government corporations and agencies
 
6,278

 
133

 
—

 
—

 
6,278

 
133

 
13

Equity securities
 
534

 
37

 
878

 
465

 
1,412

 
502

 
6

 
 
$
22,810

 
$
644

 
$
3,868

 
$
796

 
$
26,678

 
$
1,440

 
71





11
Table of Contents

THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

 
 
(Dollars in thousands)
 
December 31, 2010
 
 
 
Less than 12 months
 
12 months or longer
 
Total
 
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a
Loss Position
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
4,504

 
$
112

 
$
250

 
$
7

 
$
4,754

 
$
119

 
11

Mortgage backed securities
 
1,909

 
104

 
—

 
—

 
1,909

 
104

 
8

Private label mortgage backed securities
 
2,463

 
46

 
3,591

 
361

 
6,054

 
407

 
12

Obligations of state and political subdivisions
 
8,216

 
612

 
1,304

 
127

 
9,520

 
739

 
34

U.S. Treasury securities and obligations of U.S. government corporations and agencies
 
4,020

 
172

 
—

 
—

 
4,020

 
172

 
9

Equity securities
 
264

 
10

 
903

 
435

 
1,167

 
445

 
3

 
 
$
21,376

 
$
1,056

 
$
6,048

 
$
930

 
$
27,424

 
$
1,986

 
77


A summary of securities held-to-maturity with unrealized losses as of June 30, 2011 and December 31, 2010 along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows:

 
 
(Dollars in thousands)
 
June 30, 2011
 
 
 
Less than 12 months
 
12 months or longer
 
Total
 
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a
Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage backed securities
 
$
323

 
$
10

 
$
—

 
$
—

 
$
323

 
$
10

 
$
1

Obligations of state and political subdivisions
 
174

 
3

 
—

 
—

 
174

 
3

 
1

 
 
$
497

 
$
13

 
$
—

 
$
—

 
$
497

 
$
13

 
2










12
Table of Contents

THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

 
 
(Dollars in thousands)
 
December 31, 2010
 
 
 
Less than 12 months
 
12 months or longer
 
Total
 
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a
Loss Position
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage backed securities
 
$
331

 
$
1

 
$
—

 
$
—

 
$
331

 
$
1

 
$
1

Obligations of state and political subdivisions
 
161

 
12

 
—

 
—

 
161

 
12

 
1

 
 
$
492

 
$
13

 
$
—

 
$
—

 
$
492

 
$
13

 
2


According to the most recent accounting guidance, for securities in an unrealized loss position, the Company is required to assess whether the Company has the intent to sell the security or more likely than not will be required to sell the security before the anticipated recovery.  If either of these conditions is met, the Company is required to recognize an other-than-temporary impairment with the entire unrealized loss reported in earnings.  For securities in an unrealized loss position that do not meet these conditions, the Company assesses whether the impairment of a security is other-than-temporary.  If the impairment is determined to be other-than-temporary, the Company is required to separate the other-than-temporary impairments into two components:  the amount representing the credit loss and the amount related to all other factors.  The credit loss is the portion of the amortized book value in excess of the net present value of the projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment.  The credit loss component of other-than-temporary impairments is reported in earnings, whereas the amount relating to factors other than credit losses are recorded in other comprehensive income, net of taxes.

Management has evaluated each security in a significant unrealized loss position.  For the three month and six months ended June 30, 2011, the Company realized no additional other-than-temporary impairments.  The single largest accumulated loss at June 30, 2011, was in the equity portfolio and totaled $392,000.  The second largest loss position was in the bond portfolio and totaled $182,000.  The third largest loss position was in the bond portfolio and totaled $63,000.  Most unrealized losses in the fixed income portfolio are interest rate driven as opposed to credit quality driven and management believes no ultimate loss will be realized.  The Company has no material exposure to sub-prime mortgage loans and less than 3% of the fixed income investment portfolio is rated below investment grade.  In evaluating whether or not the equity loss positions were other-than-temporary impairments, Management evaluated financial information on each company and where available reviewed analyst reports from at least two independent sources.  Based on a review of the available financial information, the prospect for future earnings of each company and consideration of the Company’s intent and ability to hold the securities until market values recovered, it was determined that the remaining securities in an accumulated loss position in the portfolio were temporary impairments.

For the year ended December 31, 2010, the Company realized no other than temporary impairments.  The single largest accumulated loss was in the equity portfolio and totaled $360,000.  The second largest loss position was in the bond portfolio and totaled $185,000.  The third largest loss position was in the equity portfolio and totaled $83,000.  Most unrealized losses in the fixed income portfolio are interest rate driven as opposed to credit quality driven, and management believes no ultimate loss will be realized.  The Company has no material exposure to sub-prime mortgage loans and less than 4% of the fixed income investment portfolio is rated below investment grade.











13
Table of Contents

THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)



An analysis of the net change in unrealized appreciation on available-for-sale securities follows:

 
 
(Dollars in thousands)
 
 
June 30, 2011
 
December 31, 2010
 
 
(unaudited)
 
 
Net change in unrealized appreciation on available-for-sale securities before deferred tax
 
$
375

 
$
1,261

Deferred income tax
 
(90
)
 
(414
)
Net change in unrealized appreciation on available-for-sale securities
 
$
285

 
$
847



NOTE 6 – INCOME TAXES

The Company recognizes tax-related interest and penalties as a component of tax expense.  The Company incurred no interest or penalties as of both June 30, 2011 and December 31, 2010. The Company files income tax returns in the U.S. federal jurisdiction and various states.  The Company is not subject to examinations by authorities related to its U.S. federal or state income tax filings for years prior to 2007. Tax returns have been filed through the year 2009 with extensions filed for 2010.

Net deferred tax liabilities are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax laws.  Management believes that, based on its historical pattern of taxable income, the Company will produce sufficient income in the future to realize its deferred tax assets.   The Company recognized net deferred tax liability positions of $1,132,000 at June 30, 2011 and $1,043,000 at December 31, 2010.

The tax effect of significant differences representing deferred tax assets and liabilities are as follows (dollars in thousands):

 
 
June 30, 2011
 
December 31, 2010
General insurance expenses
 
$
1,540

 
$
1,442

Unearned premiums
 
1,897

 
1,795

Claims liabilities
 
304

 
301

Trading securities
 
7

 
17

Other than temporary impairments on securities owned
 
184

 
115

Unrealized loss on interest rate swaps
 
106

 
77

Deferred tax assets
 
$
4,038

 
$
3,747

 
 
 
 
 
Depreciation
 
$
(155
)
 
$
(171
)
Deferred policy acquisition costs
 
(3,178
)
 
(2,874
)
Unrealized gains on securities available-for-sale
 
(1,837
)
 
(1,745
)
Deferred tax liabilities
 
$
(5,170
)
 
$
(4,790
)
 
 
 
 
 
Net deferred tax liability
 
$
(1,132
)
 
$
(1,043
)







14
Table of Contents

THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)



The appropriate income tax effects of changes in temporary differences are as follows (dollars in thousands):

 
 
Six months ended June 30,
 
 
2011
 
2010
Deferred policy acquisition costs
 
$
304

 
$
157

Other-than-temporary-impairments
 
(69
)
 
(144
)
Trading securities
 
10

 
—

Unearned premiums
 
(102
)
 
(3
)
General insurance expenses
 
(98
)
 
84

Depreciation
 
(16
)
 
(8
)
Claim liabilities
 
(2
)
 
469

 
 
 
 
 
Deferred income tax expense
 
$
27

 
$
555


Total income tax expense varies from amounts computed by applying current federal income tax rates to income before income taxes.  The reason for these differences and the approximate tax effects are as follows (dollars in thousands):

 
 
Six months ended June 30,
 
 
2011
 
2010
Federal income tax rate applied to pre-tax income
 
$
(2,070
)
 
$
1,309

Dividends received deduction and tax-exempt interest
 
(101
)
 
(89
)
Company owned life insurance
 
(45
)
 
(36
)
Small life deduction
 
(187
)
 
3

Other, net
 
265

 
(44
)
 
 
 
 
 
Federal income tax (benefit) expense
 
$
(2,138
)
 
$
1,143


NOTE 7 –NOTES PAYABLE AND LONG-TERM DEBT

Short-term notes payable consisted of the following as of June 30, 2011 and December 31, 2010:

 
 
(Dollars in thousands)
 
 
2011
 
2010
Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 5.0% floor.  Interest payments due quarterly.  Unsecured.
 
$
175

 
$
500











15
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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

Long-term debt consisted of the following as of June 30, 2011 and December 31, 2010:

 
 
(Dollars in thousands)
 
 
2011
 
2010
 
 
 
 
 
Subordinated debentures issued on December 15, 2005 with fixed interest rate of 8.83% each distribution period thereafter until December 15, 2015 when the coupon rate shall equal the 3-month LIBOR plus 3.75% applied to the outstanding principal; maturity December 2035.  Interest payments due quarterly.  All may be redeemed at any time following the tenth anniversary of issuance.  Unsecured.
 
$
9,279

 
$
9,279

 
 
 
 
 
Subordinated debentures issued on June 21, 2007 with a floating interest rate equal to the 3 Month LIBOR plus 3.40% applied to the outstanding principal; maturity June 15, 2037. Interest payments due quarterly.  All may be redeemed at any time following the fifth anniversary of issuance.  Unsecured.
 
3,093

 
3,093

 
 
$
12,372

 
$
12,372


The subordinated debentures (debentures) have the same maturities and other applicable terms and features as the associated trust preferred securities (TPS).  Payment of interest may be deferred for up to 20 consecutive quarters; however, stockholder dividends cannot be paid during any extended interest payment period or any time the debentures are in default.  All have stated maturities of thirty years.  None of the securities require the Company to maintain minimum financial covenants. The Company has guaranteed that amounts paid to the Trusts will be remitted to the holders of the associated TPS.  This guarantee, when taken together with the obligations of the Company under the debentures, the Indentures pursuant to which the debentures were issued, and the related trust agreement (including obligations to pay related trust fees, expenses, debt and other obligations with respect to the TPS), provides a full and unconditional guarantee of amounts due the Trusts.  The amount guaranteed is not expected to at any time exceed the obligations of the TPS, and no additional liability has been recorded related to the guarantee.

On September 13, 2007, the Company entered into a 5 year swap effective September 17, 2007 with a notional amount of $3,000,000 and designated the swap as a hedge against changes in cash flows attributable to changes in the benchmark interest rate (LIBOR) associated with the subordinated debentures issued on June 21, 2007.  Commencing December 17, 2007, under the terms of the swap, the Company will receive interest at the three-month LIBOR rate plus 3.4% and pay interest at the fixed rate of 8.34%.

On March 19, 2009, the Company entered into a forward swap effective September 17, 2012, which will also hedge against changes in cash flows following the termination of the 5 year swap agreement discussed previously.  Commencing September 17, 2012, under the terms of the forward swap, the Company will receive interest at the three-month LIBOR rate plus 3.4% and pay interest at the fixed rate of 7.02%.  This forward swap will effectively fix the interest rate on $3,000,000 in debt until September of 2019.

On May 26, 2010, the Company entered into a forward swap with a notional amount of $9,000,000 effective December 15, 2015, which will hedge against changes in cash flows following the termination of the fixed rate period. Quarterly, commencing March 16, 2016 under the terms of the forward swap, the Company will pay interest at a fixed rate of 8.49% until March 15, 2020.

The swaps entered into in 2007, 2009 and 2010 have fair values of $139,000 (liability), $87,000 (liability) and $84,000 (liability), respectively, for a total liability of $310,000 at June 30, 2011 ($227,000 at December 31, 2010).  The swap liability is reported as a component of other liabilities on the condensed consolidated balance sheets.  A net valuation loss of $55,000 is included in accumulated other comprehensive income related to the swap agreements for the current period.  A net valuation loss of $90,000 was included in accumulated other comprehensive income related to the swap at December 31, 2010.

We use dollar offset at the hedge's inception and for each reporting period thereafter to assess whether the derivative used in a hedging transaction is expected to be, and has been, effective in offsetting changes in the fair value of the hedged item. Since inception no portion of the hedged item has been deemed ineffective. For all hedges, we discontinue hedge accounting if it is determined that a derivative is not expected to be, or has ceased to be, effective as a hedge.

16
Table of Contents


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

The Company’s interest rate swaps include provisions requiring the Company to post collateral when the derivative is in a net liability position.  The Company has securities on deposit with fair market values of $821,000 ($765,000 of which is posted as collateral) ($660,000 at December 31, 2010).  See Note 9 for additional information about the interest rate swaps.

In December of 2010, the Company renewed an unsecured line of credit for $700,000, with an interest rate of 5%, to be made available for general corporate purposes.  As of June 30, 2011, $175,000 was drawn on this line ($500,000 at December 31, 2010).

NOTE 8 – CONTINGENCIES

Litigation

The Company and its subsidiaries continue to be named individually as parties to litigation related to the conduct of their insurance operations.  These suits involve alleged breaches of contracts, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of the Company’s subsidiaries, and miscellaneous other causes of action.  Most of these lawsuits include claims for punitive damages in addition to other specified relief.

The Company’s property & casualty subsidiaries are defending a number of matters filed in the aftermath of Hurricanes Katrina and Rita in Mississippi, Louisiana and Alabama.  These actions include individual lawsuits and purported statewide class action lawsuits, although to date no class has been certified in any action.  These actions make a number of allegations of underpayment of hurricane-related claims,  including allegations that the flood exclusion found in the Company’s subsidiaries’ policies, and in certain actions other insurance companies’ policies, is either ambiguous, unenforceable as unconscionable or contrary to public policy, or inapplicable to the damage sustained. 
The various suits seek a variety of remedies, including actual and/or punitive damages in unspecified amounts and/or declaratory relief.  All of these matters are in various stages of development and the Company’s subsidiaries intend to vigorously defend them.  The outcome of these disputes is currently uncertain. 

The Company has been sued in a putative class action in the State of Alabama. The Plaintiff alleges entitlement to, but did not receive, payment for general contractor overhead and profit (“GCOP”) in the proceeds received from the Company concerning the repair of the Plaintiff’s home. Plaintiff alleges that said failure to include GCOP is a material breach by the Company of the terms of its contract of insurance with Plaintiff and seeks monetary damages in the form of contractual damages. A class certification hearing was held on March 1, 2010 with the trial court taking the Plaintiff’s motion for class certification under advisement. On May 10, 2010, the trial court issued its ruling granting Plaintiff’s motion to certify the class. The Company filed its Appellant Brief on October 5, 2010. The Company denies Plaintiff’s allegations and intends to vigorously defend this lawsuit.  

In April 2007, the Company sold substantially all of its 50% interest in its subsidiary, Mobile Attic, Inc.    The Company, Peter L. Cash and Russell L. Cash (collectively the "Sellers") sold to Purchaser 61% of the outstanding stock of Mobile Attic under the terms of a Stock Purchase Agreement dated April 5, 2007, executed by Sellers, Mobile Attic and Purchaser's assignor, James W. Bagley (the "Stock Purchase Agreement"). 
 
Under the terms of the Stock Purchase Agreement, the Purchaser paid the Company $2,700,000 for 45% of the total outstanding stock of Mobile Attic and paid the other Sellers $960,000 for an additional 16% of the total outstanding stock in Mobile Attic, thus obtaining a controlling interest of 61% of the outstanding stock.  The Stock Purchase Agreement also required the Purchaser as a condition to the transaction to cause the Company to be released from its guaranty of a bank loan to Mobile Attic having an outstanding principal balance of approximately $9,400,000.  The bank loan was secured by portable storage containers of Mobile Attic.   The Sellers made certain warranties to the Purchaser in the Stock Purchase Agreement regarding the financial condition of Mobile Attic and agreed to jointly and severally indemnify the Purchaser for any damages resulting from a breach of any of the warranties.
 
On January 9, 2009, Mobile Attic, MA Manufacturing Company, Inc., and Purchaser initiated an action against Peter Cash, Cash Brothers Leasing, Inc., Bridgeville Trailers, Inc., and Barfield, Murphy, Shank & Smith, P.C. in the United States District Court for the Middle District of Alabama. In the complaint, Plaintiffs asserted, among other claims, a claim for damages resulting from a breach of certain of the warranties regarding the financial statements of Mobile Attic and other financial information provided by Mobile Attic. 

17
Table of Contents


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

Purchaser then notified the Company of its claim for breach of warranty under the Stock Purchase Agreement and requested indemnity from the Company.   
  
The Purchaser has asserted that the Company is jointly and severally liable with the other Sellers (whom the Company believes have limited resources) for all losses suffered by Purchaser as a result of Sellers' misrepresentations.  Purchaser claims that the misrepresentations caused Purchaser to purchase the stock of Mobile Attic, Inc. with the result that Sellers should be liable for all
of Purchaser's losses resulting from the transaction, which include the value paid for the stock of Mobile Attic, Inc., the losses suffered on the assumption of the bank loan, the operating losses funded by Purchaser after the transaction, and attorneys' fees incurred by Purchaser to enforce its claim for indemnity.

On July 9, 2009, the Company filed a complaint in intervention requesting the Court to find that the Company is not liable for indemnity under the Stock Purchase Agreement, or in the alternative, to award damages to the Company for any loss suffered as a result of the fraudulent actions of Peter Cash and as a result of the negligence of Mobile Attic and its auditors in the preparation of Mobile Attic's financial statements.  [Mobile Attic, Inc., MA Manufacturing Company, Inc. and Bagley Family Revocable Trust, plaintiffs, v. Peter L. Cash, Cash Brothers Leasing, Inc., Bridgeville Trailers, Inc., and Barfield, Murphy, Shank & Smith, P.C, defendants, v. The National Security Group, Inc., intervenor plaintiff, v. Peter L. Cash, Barfield, Murphy, Shank & Smith, P.C. and Bagley Family Revocable Trust, intervenor defendants, U.S. District Court, Middle District of Alabama, Eastern Division, Civil Action No. 09-cv-00024.] 

On August 13, 2009, the Court granted the Company's motion to intervene.  The parties have conducted initial discovery in this action, and at the request of the Court, each party filed an amended complaint on or before August 23, 2010.  The Purchaser has asserted counterclaims against the Company for losses incurred as a result of failure to disclose material facts or alleged innocent, negligent or reckless false representations made to induce Purchaser to enter into the Stock Purchase Agreement, breach of the Stock Purchase Agreement and indemnification of Purchaser's losses and damages as a result of the breach of representations and warranties in the Stock Purchase Agreement.
 
The Company has denied the allegations supporting Purchaser's claims.  The financial records of Mobile Attic have been in the possession of Purchaser since Purchaser acquired the stock of Mobile Attic in early 2007 and are only available to the Company through discovery in the litigation.  The Company is actively conducting discovery in defense of Purchaser's claims and has requested Purchaser to provide the financial information supporting the allegations made in its complaint.  Discovery has not been completed at this time.  The Company believes that the Purchaser's claim for damages is unreasonable and excessive even if the Purchaser is able to prove the alleged misrepresentations in Mobile Attic's financial statements.  Given the difficulty in obtaining access to the Mobile Attic financial records and the fact that discovery is ongoing, the Company is unable to predict the amount of the ultimate liability that the Company may have if the Purchaser is successful in this litigation.  Management has recorded an estimate of aggregate litigation related expenses related to these actions as of June 30, 2011 and December 31, 2010, and the amounts are included in other liabilities in the accompanying condensed consolidated financial statements.
 
The Company establishes and maintains reserves on contingent liabilities.  In many instances, however, it is not feasible to predict the ultimate outcome with any degree of accuracy. 

NOTE 9 – FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES

Our securities available-for-sale consists of fixed maturity and equity securities which are recorded at fair value in the accompanying condensed consolidated balance sheets.  The change in the fair value of these investments, unless deemed to be other than temporarily impaired, is recorded as a component of other comprehensive income.

We are permitted to elect to measure financial instruments and certain other items at fair value, with the change in fair value recorded in earnings.  We elected not to measure any eligible items using the fair value option.

Accounting standards define fair value as the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework to make the measurement of fair value more consistent and comparable.  In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets.

18
Table of Contents


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)


The Company categorizes assets and liabilities carried at their fair value based upon a fair value hierarchy:

Level 1 – Quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.

Level 1 assets and liabilities consist of money market fund deposits and certain of our marketable debt and equity instruments, including equity instruments offsetting deferred compensation, that are traded in an active market with sufficient volume and frequency of transactions.

Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 2 assets include certain of our marketable debt and equity instruments with quoted market prices that are traded in less active markets or priced using a quoted market price for similar instruments. Level 2 assets also include marketable equity instruments with security-specific restrictions that would transfer to the buyer, marketable debt instruments priced using indicator prices which represent non-binding market consensus prices that can be corroborated by observable market quotes, as well as derivative contracts and debt instruments priced using inputs that are observable in the market or can be derived principally from or corroborated by observable market data.  Marketable debt instruments in this category generally include commercial paper, bank time deposits, repurchase agreements for fixed-income instruments, and a majority of floating-rate notes, corporate bonds, and municipal bonds.

Level 3 - Unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.

Level 3 assets and liabilities include marketable debt instruments, non-marketable equity investments, derivative contracts, and company issued debt whose values are determined using inputs that are both unobservable and significant to the values of the instruments being measured. Level 3 assets also include marketable debt instruments that are priced using indicator prices that we were unable to corroborate with observable market quotes.

Marketable debt instruments in this category generally include asset-backed securities and certain of our floating-rate notes, corporate bonds, and municipal bonds.


 

 
















19
Table of Contents


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

Assets/Liabilities Measured at Fair Value on a Recurring Basis
 
Financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2011 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):
 
 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
19,776

 
$
—

 
$
19,776

 
$
—

Mortgage backed securities
 
7,515

 
 
 
7,515

 
 
Private label mortgage backed securities
 
11,443

 
—

 
11,443

 
—

Obligations of states and political subdivisions
 
19,017

 
—

 
19,017

 
—

U.S. Treasury securities and obligations of
 
 

 
 

 
 
 
 

U.S. Government corporations and agencies
 
15,470

 
15,470

 
—

 
—

Trading securities
 
860

 
860

 
—

 
—

Equity securities available-for-sale
 
8,767

 
8,035

 
—

 
732

Total Financial Assets
 
$
82,848

 
$
24,365

 
$
57,751

 
$
732

Financial Liabilities
 
 

 
 

 
 

 
 

Interest rate swap
 
$
310

 
$
—

 
$
—

 
$
310

Total Financial Liabilities
 
$
310

 
$
—

 
$
—

 
$
310

 
The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2011:
 
 
 
For the six-months ended June 30, 2011
(In Thousands)
 
Fixed Maturities Available-for-Sale
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
—

 
$
787

 
$
(227
)
Total gains or losses (realized and
 
 

 
 

 
 

unrealized):
 
 

 
 

 
 

Included in earnings
 
—

 
(55
)
 
—

Included in other comprehensive income
 
—

 
—

 
(83
)
Purchases:
 
—

 
—

 
—

Sales:
 
—

 
—

 
—

Issuances:
 
—

 
—

 
—

Settlements
 
—

 
—

 
—

Transfers in/(out) of Level 3
 
—

 
—

 
—

Ending balance
 
$
—

 
$
732

 
$
(310
)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of
 
 

 
 

 
 

June 30, 2011
 
$
—

 
$
—

 
$
—



For the quarter ended June 30, 2011, there were no assets or liabilities measured at fair values on a nonrecurring basis.






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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):

 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
23,952

 
$
—

 
$
23,952

 
$
—

Mortgage backed securities
 
7,275

 
—

 
7,275

 
—

Private label mortgage backed securities
 
13,106

 
—

 
13,106

 
—

Obligations of states and political subdivisions
 
18,415

 
—

 
18,415

 
—

U.S. Treasury securities and obligations of
 
 

 
 

 
 

 
 

U.S. Government corporations and agencies
 
15,720

 
15,720

 
—

 
—

Trading securities
 
705

 
705

 
—

 
—

Equity securities available-for-sale
 
9,047

 
8,260

 
—

 
787

 
 
 
 
 
 
 
 
 
Total Financial Assets
 
$
88,220

 
$
24,685

 
$
62,748

 
$
787

Financial Liabilities
 
 

 
 

 
 

 
 

Interest rate swap
 
$
227

 
$
—

 
$
—

 
$
227

 
 
 
 
 
 
 
 
 
Total Financial Liabilities
 
$
227

 
$
—

 
$
—

 
$
227


The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2010:
 
 
For the year ended December 31, 2010
(In Thousands)
 
Corporate Debt Securities
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
577

 
$
662

 
$
(60
)
Total gains or losses (realized and
 
 

 
 

 
 

unrealized):
 
 

 
 

 
 

Included in earnings
 
63

 
—

 
—

Included in other comprehensive income
 
—

 
(19
)
 
(167
)
Purchases:
 
—

 
144

 
—

Sales:
 
(640
)
 
—

 
—

Issuances:
 
—

 
—

 
—

Settlements
 
—

 
—

 
—

Transfers in/(out) of Level 3
 
—

 
—

 
—

Ending balance
 
$
—

 
$
787

 
$
(227
)
 
 
 

 
 

 
 

The amount of total gains or losses for the period included in earnings change in unrealized gains or losses relating attributable to the to assets and liabilities still held as of
 
 

 
 

 
 

  December 31, 2010
 
$
—

 
$
—

 
$
—


For the year ended December 31, 2010, there were no assets or liabilities measured at fair values on a nonrecurring basis.






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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

The Company is exposed to certain risks in the normal course of its business operations.  The primary risk that is managed through the use of derivatives is interest rate risk on floating rate borrowings.  This risk is managed through the use of interest rate swaps which are designated as cash flow hedges.  For cash flow hedges, the effective portion of the gain or loss on the interest rate swap is included as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction is recognized in earnings.  The Company does not hold or issue derivatives that are not designated as hedging instruments.  See Note 7 for additional information about the interest rate swaps.

The following methods and assumptions were used to estimate fair value of each class of financial instrument for which it is practical to estimate that value:

Cash and cash equivalents—the carrying amount is a reasonable estimate of fair value.

Mortgage receivables—the carrying amount is a reasonable estimate of fair value due to the restrictive nature and limited marketability of the mortgage notes.

Other invested assets—the carrying amount is a reasonable estimate of fair value.

Other policyholder funds—the carrying amount is a reasonable estimate of fair value.

Debt—the carrying amount is a reasonable estimate of fair value.

The carrying amount and estimate fair value of the Company’s financial instruments as of June 30, 2011 and December 31, 2010 are as follows:

 
 
In Thousands of Dollars
 
 
June 30, 2011
 
December 31, 2010
 
 
Carrying
Value
 
Estimated
Fair Value
 
Carrying
Value
 
Estimated
Fair Value
Assets and related instruments
 
 
 
 
 
 
 
 
Mortgage loans
 
$
393

 
$
393

 
$
935

 
$
935

Policy loans
 
1,185

 
1,185

 
1,123

 
1,123

Company owned life insurance
 
5,652

 
5,652

 
5,520

 
5,520

Other invested assets
 
3,871

 
3,871

 
3,915

 
3,915

 
 
 
 
 
 
 
 
 
Liabilities and related instruments
 
 

 
 

 
 

 
 

Other policyholder funds
 
1,379

 
1,379

 
1,351

 
1,351

Short-term debt
 
175

 
175

 
500

 
500

Long-term debt
 
12,372

 
12,372

 
12,372

 
12,372


NOTE 10 – SEGMENTS

The Company’s property and casualty insurance operations comprise one business segment.  The property and casualty insurance segment consists of seven lines of business:  dwelling fire and extended coverage, homeowners (including mobile homeowners), ocean marine, other liability, private passenger auto liability, commercial auto liability and auto physical damage.  Management organizes the business utilizing a niche strategy focusing on lower valued dwellings as well as non-standard automobile products.  Our chief decision makers (President, Chief Financial Officer and Chief Executive Officer) review results and operating plans making decisions on resource allocations on a company-wide basis.  The Company’s products are primarily produced through agents within the states in which we operate.  The Company’s life and accident and health operations comprise the second business segment.  The life and accident and health insurance segment consists of two lines of business: traditional life insurance and accident and health insurance.



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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

The following table presents the Company’s gross and net premiums written for the property and casualty segment and the life and accident and health segment for the three month and six month periods ended June 30, 2011 and 2010, respectively:
 

 
 
Three Months Ended
 
Six Months Ended
 
 
June 30,
 
June 30,
 
 
2011
 
2010
 
2011
 
2010
Premiums written:
 
 
 
 
 
 
 
 
Life, accident and health operations:
 
 
 
 
 
 
 
 
Traditional life insurance
 
1,226

 
1,295

 
2,531

 
2,610

Accident and health insurance
 
474

 
486

 
958

 
977

Total life, accident and health
 
1,700

 
1,781

 
3,489

 
3,587

 
 
 
 
 
 
 
 
 
Property and Casualty operations:
 
 
 
 
 
 
 
 
Dwelling fire & extended coverage
 
7,271

 
7,453

 
13,968

 
14,044

Homeowners (Including mobile homeowners)
 
7,439

 
7,735

 
13,446

 
14,136

Ocean marine
 
397

 
456

 
516

 
556

Other liability
 
377

 
355

 
711

 
681

Private passenger auto liability
 
393

 
826

 
1,247

 
2,013

Commercial auto liability
 
92

 
120

 
211

 
253

Auto physical damage
 
175

 
331

 
511

 
801

Total property and casualty
 
16,144

 
17,276

 
30,610

 
32,484

 
 
 
 
 
 
 
 
 
Gross premiums written
 
17,844

 
19,057

 
34,099

 
36,071

Reinsurance premium ceded
 
(3,039
)
 
(1,554
)
 
(4,568
)
 
(3,082
)
 
 
 
 
 
 
 
 
 
Net premiums written
 
14,805

 
17,503

 
29,531

 
32,989






















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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(Continued)

The following table presents the Company’s gross and net premiums earned for the property and casualty segment and the life and accident and health segment for the three month and six month periods ended June 30, 2011 and 2010, respectively:
 
 
 
Three Months Ended
 
Six Months Ended
 
 
June 30,
 
June 30,
 
 
2011
 
2010
 
2011
 
2010
Premiums earned:
 
 

 
 

 
 

 
 

Life, accident and health operations:
 
 

 
 

 
 

 
 

Traditional life insurance
 
$
1,302

 
$
1,315

 
$
2,688

 
$
2,679

Accident and health insurance
 
475

 
474

 
958

 
972

Total life, accident and health
 
1,777

 
1,789

 
3,646

 
3,651

 
 
 
 
 
 
 
 
 
Property and Casualty operations:
 
 

 
 

 
 

 
 

Dwelling fire & extended coverage
 
6,666

 
6,239

 
13,165

 
12,621

Homeowners (Including mobile homeowners)
 
6,227

 
7,270

 
12,471

 
13,864

Ocean marine
 
300

 
312

 
619

 
632

Other liability
 
321

 
333

 
631

 
643

Private passenger auto liability
 
685

 
960

 
1,441

 
1,635

Commercial auto liability
 
92

 
121

 
211

 
253

Auto physical damage
 
274

 
405

 
571

 
707

Total property and casualty
 
14,565

 
15,640

 
29,109

 
30,355

 
 
 
 
 
 
 
 
 
Gross premiums earned
 
$
16,342

 
$
17,429

 
$
32,755

 
$
34,006

 
 
 
 
 
 
 
 
 
Reinsurance premium ceded
 
(3,021
)
 
(1,526
)
 
(4,564
)
 
(3,065
)
 
 
 
 
 
 
 
 
 
Net premiums earned
 
$
13,321

 
$
15,903

 
$
28,191

 
$
30,941


NOTE 11 – PREFERRED AND COMMON STOCK

The table below provides information regarding the Company's preferred and common stock as of June 30, 2011 and December 31, 2010:
 
June 30, 2011
 
December 31, 2010
 
Authorized
Issued
Outstanding
 
Authorized
Issued
Outstanding
Preferred Stock, $1 par value
500,000

—

—

 
500,000

—

—

Class A Common Stock, $1 par value
2,000,000

—

—

 
2,000,000

—

—

Common Stock, $1 par value
3,000,000

2,466,600

2,466,600

 
3,000,000

2,466,600

2,466,600


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Table of Contents



REVIEW OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Directors and Shareholders
The National Security Group, Inc.

We have reviewed the condensed consolidated balance sheet of The National Security Group, Inc. as of June 30, 2011, and related condensed consolidated statements of income (loss) for the three-month and six-month periods ended June 30, 2011 and 2010, shareholders' equity for the six-month period ended June 30, 2011, and cash flows for the six-month periods ended June 30, 2011 and 2010.  These condensed consolidated financial statements are the responsibility of the company's management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the consolidated financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the accompanying condensed consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with auditing standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of The National Security Group, Inc. as of December 31, 2010, and the related consolidated statements of income, shareholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 31, 2011, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2010, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ Warren Averett Kimbrough & Marino, LLC

Birmingham, Alabama
August 15, 2011

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Table of Contents

Item 2.
MANAGEMENTS’ DISCUSSION AND ANALYSIS OF
 FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 
The following discussion addresses the financial condition of The National Security Group, Inc. (referred to in this document as we, our, us, the Company or NSEC) as of June 30, 2011, compared with December 31, 2010 and its results of operations and cash flows for the quarter ending June 30, 2011, compared with the same period last year. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes thereto included in Part I, Item 1 of this report and with our audited consolidated financial statements and related notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2010.
 
This discussion will primarily consist of an analysis of the two segments of our operations.  The life segment consists of the operations of our life insurance subsidiary, National Security Insurance Company (NSIC).  The property and casualty (P&C) segment consists of the operations of our two property and casualty insurance subsidiaries, National Security Fire & Casualty Company (NSFC) and Omega One Insurance Company (Omega).

This discussion contains forward-looking statements that are not historical facts, including statements about our beliefs and expectations. These statements are based upon current plans, estimates and projections. Our actual results may differ materially from those projected in these forward-looking statements as a result of various factors. See “Cautionary Statement Regarding Forward-Looking Statements” contained on Page 3 of this report.

The reader is assumed to have access to the Company’s 2010 Annual Report.  This discussion should be read in conjunction with the Annual Report and with condensed consolidated financial information on pages 5 through 29 of this form 10-Q.

Information in this discussion is presented in whole dollars rounded to the nearest thousand.

The National Security Group operates in the property and casualty and life, accident and supplemental health insurance businesses and markets products primarily through independent agents.  The company operates in eleven states with just under 54% of total premium revenue generated in the states of Alabama and Mississippi.  Property and casualty insurance is the most significant segment accounting for 87.1% of total insurance premium revenue during the first six months of 2011.  Revenue generated from the life segment accounted for 12.9% of total insurance premium revenue.

National Security Insurance Company (NSIC) is a life, accident and health insurance company founded in 1947 and is the oldest subsidiary of the Company.  The premium revenue produced in NSIC from the traditional life products and accident and health products accounted for 9.5% and 3.4%, respectively, of total premium revenue.  All references to NSIC in the remainder of this management discussion and analysis will refer to the combined life, accident and health insurance operations and will compose the life segment of the Company.  NSIC is licensed to underwrite life and accident and health insurance in Alabama, Florida, Georgia, Mississippi, South Carolina and Texas.

Omega One Insurance Company (Omega) is a property and casualty insurance company incorporated in 1992.  Omega is a wholly owned subsidiary of National Security Fire and Casualty Company (NSFC) and is the smallest of the insurance subsidiaries accounting for approximately 8% of consolidated premium revenue.  Omega is licensed and underwrites property and casualty insurance in the states of Alabama and Louisiana.  There is no material product differentiation between those products underwritten by NSFC and Omega as both primarily underwrite personal lines of insurance.

National Security Fire and Casualty Company (NSFC) is a property and casualty insurance company and is the largest of the insurance subsidiaries accounting for over 79.1% of total premium revenue of the Company.  NSFC operates primarily in the personal lines segment of the property and casualty insurance market.  NSFC has been in operation since 1959.  NSFC is licensed and underwrites property and casualty insurance in the states of Alabama, Arkansas, Florida, Georgia, Mississippi, Oklahoma, South Carolina and Tennessee.  NSFC is licensed, but does not currently underwrite any business, in the states of Kentucky and West Virginia.  NSFC also underwrites insurance on a non-admitted or surplus lines basis in the states of Louisiana, Missouri and Texas.

All of the insurance subsidiaries are Alabama domiciled insurance companies and therefore the Alabama Department of Insurance is the primary insurance regulator.  However, each subsidiary is subject to regulation by the respective insurance regulators of each state in which it is licensed to transact business.  Insurance rates charged by each of the insurance subsidiaries are typically reviewed and approved by each insurance department for the respective state to which the rates will apply.


26
Table of Contents

All of our insurance companies have been assigned ratings by A.M. Best.  The property and casualty group has been assigned a group rating of “B++” (Good) with a negative outlook.  In addition, A.M. Best has assigned an issuer credit rating of “bbb” with a negative outlook.  NSFC, the largest of the insurance subsidiaries, carries the same A.M. Best ratings as the group.  Omega carries an A.M. Best rating of “B+” (Good) with a stable outlook and an issuer credit rating of “bbb-” with a stable outlook.  The life insurance subsidiary, NSIC, has been assigned a rating of “B” (Fair) with a stable outlook and an issuer credit ration of “bb” with a stable outlook.  All ratings are reviewed at least annually by A.M. Best with the latest ratings effective date of January 28, 2011.

The two primary segments in which we report insurance operations are the personal lines property and casualty segment (NSFC) and the life, accident and health insurance segment (NSIC).  Please note that due to the small amount of premium revenue produced by Omega and the fact that Omega is a wholly owned subsidiary of NSFC underwriting similar lines of business, all references to NSFC in the remainder of this management discussion and analysis will include the insurance operations of both NSFC and Omega.  Our income is principally derived from net underwriting profits and investment income.  Net underwriting profit is principally derived from earned premiums received less claims paid, sales commissions to agents, costs of underwriting and insurance taxes and fees.  Investment income includes interest and dividend income and gains and losses on investment holdings.
 
CONSOLIDATED RESULTS OF OPERATIONS

Summary:

The Company ended the first six months of 2011 with a net loss of $3,950,000 compared to net income of $2,708,000 for the same period last year.  The primary reason for the decline in net income was the $5,470,000 increase in policyholder benefits paid or provided.  The 28% increase in policyholder benefits paid or provided was largely related to the $5,262,000 increase in incurred losses and incurred adjustment expenses in the P&C segment from several severe weather related events during the second quarter of 2011. The P&C segment incurred losses and loss adjustment expenses from one weather event (officially assigned catastrophe number 46 by Property Claim Services) which caused us to pierce our catastrophe reinsurance. Throughout the reminder of this document, claims from the storm with the aforementioned loss dates will be referred to as "catastrophe 46" or "cat 46" and references to reinsured losses in 2011will be all-encompassing of catastrophe 46.

The life insurance segment ended June 2011 with a $255,000 increase in incurred losses compared to June 2010 with the primary source being death and maturity benefits which increased 6.2% compared to the same period last year.





























27
Table of Contents

Three-months ended June 30, 2011 compared to three-months ended June 30, 2010:

Premium revenue:

The table below provides earned premium revenue by segment for the three-months ended June 30, 2011 and 2010:

 
 
Three months ended June 30,
 
Percent
 
 
2011
 
2010
 
increase (decrease)
Life, accident and health operations:
 
 
 
 
 
 
Traditional life insurance
 
$
1,302,000

 
$
1,315,000

 
(0.99
)%
Accident and health insurance
 
475,000

 
474,000

 
0.21
 %
Total life, accident and health
 
1,777,000

 
1,789,000

 
(0.67
)%
 
 
 
 
 
 
 
Property and Casualty operations:
 
 

 
 

 
 

Dwelling fire & extended coverage
 
6,666,000

 
6,239,000

 
6.84
 %
Homeowners (Including mobile homeowners)
 
6,227,000

 
7,270,000

 
(14.35
)%
Ocean marine
 
300,000

 
312,000

 
(3.85
)%
Other liability
 
321,000

 
333,000

 
(3.60
)%
Private passenger auto liability
 
685,000

 
960,000

 
(28.65
)%
Commercial auto liability
 
92,000

 
121,000

 
(23.97
)%
Auto physical damage
 
274,000

 
405,000

 
(32.35
)%
Reinsurance premium ceded
 
(3,021,000
)
 
(1,526,000
)
 
97.97
 %
Total property and casualty
 
11,544,000

 
14,114,000

 
(18.21
)%
 
 
 
 
 
 
 
 Total earned premium revenue                              
 
$
13,321,000

 
$
15,903,000

 
(16.24
)%

Premium revenue decreased $2,582,000 or 16.2% to $13,321,000 in the second quarter of 2011 compared to $15,903,000 for the same period last year. The P&C segment had an 18.2% decrease in net premiums earned for the three-months ended June 30, 2011 compared to the same period last year. The primary reason for the decrease in net earned premium was an increase in ceded premium from catastrophe reinstatement totaling $1,490,000. The reinstatement premium was triggered by tornado, wind and hail related catastrophe losses which occurred from cat 46.

Decreases in the homeowners and personal lines auto business were the primary factors contributing the remaining decrease in premium revenue. The implementation of stricter underwriting standards along with ongoing limitations on growth along the Alabama, Mississippi and Louisiana coasts were primary reasons for the decrease in net premiums earned for the homeowners program compared to June 2010. The primary reason for the decline in net premiums earned in the automobile line of business was the implementation of rate increases which slowed growth in this program; principally in the state of Louisiana.

Premium revenue from the life segment was virtually unchanged with an overall decline of 0.7% for the second quarter of 2011 compared to the second quarter of 2010.

Investment income:

Investment income in the second quarter of 2011 was $1,257,000, an increase of $62,000 compared to $1,195,000 for the same period last year. The primary reason for the increase was investment income generated from our company owned life insurance (COLI). For the three-months ended June 30, 2011, COLI investment income totaled $69,000 compared to $16,000 for the same period last year. The primary reason for the increase was an improvement in the performance of the fixed income investments in the portfolio.

Realized investment gains and losses:

Net realized investment gains totaled $261,000 for the second quarter of 2011 compared to net realized investment gains of $689,000 for the second quarter of 2010. The reduction in realized capital gains was due to fewer shifts in the investment portfolio in the second quarter of 2011 compared to last year.




28
Table of Contents

Other income:

For the three-months ended June 30, 2011 and 2010, other income was $256,000. Other income is primarily composed of billing, payment and policy fees associated with residential property and automobile policies issued in the P&C segment.

Policyholder benefits and settlement expenses:

For the three-months ended June 30, 2011, the Company incurred policyholder benefits and settlement expenses totaling $15,682,000 compared to $11,061,000 for the same period last year; an increase of 41.8%. The principal reason for the increase for the three-month period was an increase in incurred losses in the P&C segment, primarily in the property programs, compared to the same period last year. A series of severe spring storm systems occurred in the month of April causing widespread tornado, wind and hail damage.  The storm damage impacted policyholders in the states of Alabama, Arkansas, Georgia, Mississippi, Oklahoma, South Carolina and Tennessee.  The heaviest concentration of insured losses were incurred in a tornado outbreak in the states of Alabama, Georgia and Mississippi from catastrophe 46. This storm system generated over 1,300 policyholder claims. Total gross incurred losses from this event were $9,936,000 and exceeded the retention limit of $3,500,000 in our catastrophe reinsurance coverage. After reinsurance recoveries, our net incurred losses from this event totaled $4,234,000, which included our retention and coinsurance amounts under our catastrophe reinsurance coverage. The claims related to catastrophe 46 increased the second quarter 2011 loss ratio 40.4 percentage points. The loss ratio for the second quarter of 2011 was 117.7% (77.3% without cat 46 claims) compared to 69.6% for the second quarter of 2010.

In addition to losses generated by cat 46, we incurred $2,560,000 in insured losses from other tornado, wind and hail storm events during the second quarter of 2011 compared to $1,463,000 for the same period last year. The $1,097,000 increase in non-reinsured storm losses increased the loss ratio in the second quarter of 2011 an additional 17.3 percentage points compared to 2010 storm related losses which increased the loss ratio 9.2 percentage points for the three-month period ended June 30, 2010.

Policy acquisition cost:

For the three-month period ended June 30, 2011, policy acquisition cost was $3,071,000 compared to $2,970,000 for the same period last year. The primary factor contributing to the increase in policy acquisition cost was an increase in the amortization of deferred acquisition cost in the life subsidiary.

General expenses:

General expenses for the three-months ended June 30, 2011, totaled $2,986,000 compared to $2,155,000 for the same period last year. The most significant factor affecting the increase in general expenses was litigation related defense costs compared to the same period last year. See Note 8 to the condensed consolidated financial statements for further discussion regarding litigation.

Taxes, licenses and fees:

Taxes, licenses and fees totaled $622,000 for the quarter-ended June 30, 2011, compared to $480,000 for the quarter-ended June 30, 2010; a $142,000 increase. As a percent of premiums earned, taxes, licenses and fees were 4.7% for the second quarter of 2011 compared to 3.2% for the same period last year. Examination fees associated with a periodic regulatory examination conducted by the Alabama Department of Insurance was the primary reason for the increase. The examination concluded in May of 2011.

Interest expense:

Interest expense was down moderately due to a lower average balance outstanding on a bank line of credit.

Income taxes:

For the three-month period ended June 30, 2011, income tax benefit totaled $2,606,000 compared to an income tax expense of $256,000 for the same period last year.  The effective tax rate for the three-month period ended June 30, 2011 was 34.5% compared to 23.9% for the same period last year. Significant losses sustained in the property and casualty subsidiaries have generated considerable tax benefits for the current quarter. Because the effective tax rate in the property and casualty subsidiaries is higher than in the life subsidiary coupled with the higher percentage of total net losses generated from the P&C segment, the effective tax rate increased in the second quarter of 2011 compared to the second quarter of 2010. Because the property and casualty companies posted profitable results in each of the prior two years, it is expected that, should full year 2011 results generate a net operating loss, the tax benefit of any net operating losses for 2011 will be recovered immediately through carry back provisions of the Federal Tax Code.

29
Table of Contents


Six-months ended June 30, 2011 compared to six-months ended June 30, 2010:

Premium Revenue:
 
The table below provides earned premium revenue by segment for the six months ended June 30, 2011 and 2010:

 
 
Six months ended June 30,
 
Percent
 
 
2011
 
2010
 
increase (decrease)
Life, accident and health operations:
 
 
 
 
 
 
Traditional life insurance
 
$
2,688,000

 
$
2,679,000

 
0.34
 %
Accident and health insurance
 
958,000

 
972,000

 
(1.44
)%
Total life, accident and health
 
3,646,000

 
3,651,000

 
(0.14
)%
 
 
 
 
 
 
 
Property and Casualty operations:
 
 

 
 

 
 

Dwelling fire & extended coverage
 
13,165,000

 
12,621,000

 
4.31
 %
Homeowners (Including mobile homeowners)
 
12,471,000

 
13,864,000

 
(10.05
)%
Ocean marine
 
619,000

 
632,000

 
(2.06
)%
Other liability
 
631,000

 
643,000

 
(1.87
)%
Private passenger auto liability
 
1,441,000

 
1,635,000

 
(11.87
)%
Commercial auto liability
 
211,000

 
253,000

 
(16.60
)%
Auto physical damage
 
571,000

 
707,000

 
(19.24
)%
Reinsurance premium ceded
 
(4,564,000
)
 
(3,065,000
)
 
48.91
 %
Total property and casualty
 
24,545,000

 
27,290,000

 
(10.06
)%
 
 
 
 
 
 
 
 Total earned premium revenue                              
 
$
28,191,000

 
$
30,941,000

 
(8.89
)%

Consolidated premium revenue was $28,191,000 as of June 2011 compared to $30,941,000 as of June 2010; a decrease of $2,750,000 or 8.9%. The decline was primarily driven by declines in net earned premium in the P&C segment due to catastrophe reinstatement premium, a decrease in auto policies in-force and a moderate decline in homeowners business.

The P&C segment ended June 2011 with year-to-date net earned premiums of $24,545,000 compared to $27,290,000 for the same period last year; a decrease of 10.1%. The primary reason for the decrease in net earned premium was an increase in ceded catastrophe reinstatement premium of $1,490,000 triggered by tornado related catastrophe losses in the last week of April, 2011.

Decreases in the homeowners and personal lines auto business were the primary factors contributing the the remaining decrease in premium revenue. The implementation of stricter underwriting standards along with ongoing limitations on growth along the Alabama, Mississippi and Louisiana coasts were primary reasons for the decrease in net premiums earned for the homeowners program compared to June 2010. The primary reason for the decline in net premiums earned in the automobile line of business was the implementation of rate increases which slowed growth in this program; principally in the state of Louisiana.

Life segment premium revenue was virtually unchanged in the six month period ending June 30, 2011 at $3,646,000 compared to $3,651,000 for the same period last year; a decrease of 0.1%.  

Investment income:

Investment income decreased $122,000 to $2,399,000 as of June 2011 from $2,521,000 in June 2010.  The decrease in investment income was primarily due to lower yields on reinvested cash flows from sells and maturities in the fixed income portfolio.

Realized investment gains and losses:

For the first six months of 2011, realized investment gains totaled $1,031,000 compared to $1,358,000 for the same period last year; a decrease of $327,000.  The investment gains realized in the current year totaled $643,000 and $358,000 in the P&C and life segments, respectively compared to $341,000 and $328,000 for the same period last year. The primary reason for the decrease in realized capital gains was that fewer changes were made in the investment portfolio during the period.
 


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Other income:

Other income was $511,000 as of June 2011 compared to $555,000 as of June 2010; a decrease of 7.9%.  Other income is primarily composed of billing, payment and policy fees associated with residential property and automobile policies issued in the P&C segment.  Due to the decline in production our auto program, billing, payment and policy fees declined and was the primary reason for the overall reduction in other income for the current year.

Policyholder benefits:

Policyholder benefits paid or provided as of June 2011 were $25,004,000 compared to $19,534,000 for the same period last year; an increase of 28%.  The primary reason for the 18.7 percentage point increase in the loss ratio for the current year was related to increased claim activity in the P&C segment primarily resulting from severe wind, hail and tornado damage incurred from catastrophe 46. The losses incurred from this storm exceeded our catastrophe reinsurance retention of $3,500,000 and triggered coverage under our catastrophe reinsurance program. The P&C segment incurred gross losses and loss adjustment expenses totaling $9,936,000 ($4,234,000 net of reinsurance) from cat 46. The reinsurance related claims increased the overall loss ratio 18.7 percentage points in 2011 compared to 2010.

The remainder of the increase in policyholder claims is attributable to a higher frequency of tornado and windstorm losses in early April 2011. In addition to the $4,234,000 in pretax net losses incurred from catastrophe 46, we experienced an additional $2,775,000 from various other tornado and hail storm events during 2011; most of these losses were incurred in early April. Cumulatively, tornado and windstorm losses incurred during the month of April 2011 were tenfold greater than any other single month of spring storms experienced previously. The 2011 tornado and windstorm claims contributed just under $2,775,000 to incurred losses and added 9.3 percentage points to the 2011 loss ratio (excluding cat 46). In comparison, tornado and windstorm losses during the first half of 2010 totaled $1,597,000 and added 5.2 percentage points to the loss ratio.

 Policy acquisition cost:

For the six months ended June 30, 2011, policy acquisition costs were $5,995,000 compared to $5,718,000 for the same period last year. The increase was primarily attributable to an increase in amortization of policy acquisition cost in the life subsidiary.

General Expenses:

General expenses were up $809,000 as of June 2011 at $5,549,000 compared to $4,740,000 as of June 2010.  The primary reason for the increase was related to litigation expenses in our holding company. Litigation expenses were $789,000 as of June 2011 compared to $166,000 for the same period last year; an increase of $623,000. This increase accounted for 77% of the overall increase in general expenses through the second quarter of 2011. See Note 8 to the condensed consolidated financial statements for further discussion regarding litigation.

Taxes, licenses and fees:

Taxes, licenses and fees were up $135,000 for the six months ending June 2011 at $1,102,000 compared to $967,000 for the same period last year.  Taxes, licenses and fees as a percentage of earned premiums were 3.9% as of June 30, 2011 and 3.1% for the same period last year. The primary reason for the increase was fees incurred from the recently completed regulatory examination conducted by the Alabama Department of Insurance.

Interest expense:

Interest expense was virtually unchanged at $570,000 as of June 30, 2011, compared to $565,000 for the same period last year.

Income taxes:

For the period ended June 30, 2011, income tax benefit totaled $2,138,000 compared to an income tax expense of $1,143,000 for the same period last year.  The effective tax rate as of June 30, 2011 was 35.1% compared to 29.7% for the same period last year. Income tax (benefit)/expense was composed of current taxes totaling $(2,165,000) and $588,000 for first six months of 2011 and 2010, respectively, while deferred tax expense totaled $27,000 and $555,000, for the same time periods respectively.  As mentioned previously, the significant losses sustained in the property and casualty subsidiaries generated considerable tax benefits during 2011 and therefore increased the effective tax rate in the current year compared to the same period last year.



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Liquidity and capital resources:

At June 30, 2011, the Company had aggregate equity capital, unrealized investment gains (net of income taxes) and retained earnings of $39,250,000 down $4,460,000 compared to $43,710,000 at December 31, 2010.  Components of the change in equity were a net loss of $3,950,000, net unrealized gains of $285,000 and a net unrealized loss of $55,000 related to interest rate swaps and cash dividends paid totaling $740,000.

The Company has $12,372,000 in debt outstanding consisting of long-term debt from the proceeds of two separate trust preferred securities issuances, the latest of which totaled $3,000,000 and was completed in June 2007.  The Company has an operating line of credit to allow flexibility with respect to cash management at the holding company level.  The outstanding balance on the line, at June 30, 2011, was $175,000. We had $525,000 available at June 30, 2011 under the operating credit line.

The Company had $965,000 in cash and cash equivalents at June 30, 2011 compared to $2,698,000 at June 30, 2010.  Cash flow from operations declined $8,805,000 for the six months compared to the same period last year.  The primary reason for the decline in operating cash flow was a reduction in net income related to catastrophe losses during the month of April 2011.  Gross losses from a single storm system that swept across the Southeast in late April totaled $9,936,000. The Company maintains a catastrophe reinsurance program to limit the effect of such catastrophic events on the Company’s financial condition. Net income, net of reinsurance, for the period ended June 30, 2011, was reduced by $3,777,000 ($1.53 per share) due to storm related losses from this event. Also largely associated with the storms and the decline in cash flow from operations were increases in reinsurance recoverables of $1,832,000 and a decline in accrued income taxes totaling $2,604,000.

The payment of catastrophe claims during the second quarter led the Company to liquidate certain investments in order to provide more cash to pay claims. Cash provided by investing activities increased $10,867,000 during the first six months of 2011 compared to the same period last year. The cash provided from investments was primarily used to pay storm related claims.

The liquidity requirements of the Company are primarily met by funds provided from operations of the life insurance and property/casualty subsidiaries.  The Company receives funds from its subsidiaries consisting of dividends, payments for federal income taxes, and reimbursement of expenses incurred at the corporate level for the subsidiaries.  These funds are used to pay stockholder dividends, interest on debt, corporate administrative expenses, federal income taxes, and for funding investments in subsidiaries. Dividends paid from the insurance subsidiaries are subject to regulatory restrictions and prior approval of the Alabama Department of Insurance.

As disclosed in Note 8 to the condensed consolidated financial statements regarding contingencies, the Company is involved in litigation related to the sale of Mobile Attic, Inc.  As is customarily discussed in the Management Discussion and Analysis, the Company’s liquidity requirements are primarily met by funds provided from operations of the insurance subsidiaries.  The Company maintains minimal liquidity in order to maximize liquidity within the insurance subsidiaries in order to support ongoing insurance operations.  The Company has no separate source of revenue other than dividends and fees from the insurance subsidiaries.    Also, dividends from the insurance subsidiaries are subject to regulatory restrictions and, therefore, are limited depending on capital levels and earnings of the subsidiaries.  In the event of a substantial adverse judgment related to the litigation against the Company, we could face limitations in our ability to fund shareholder dividends and service interest payments on outstanding debt.

The uncertainty related to the pending litigation could also impair our ability to raise new debt or equity capital.  The Company is vigorously defending the allegations raised in this litigation and is unable to determine a potential ultimate liability at this time which limits our ability to predict the ultimate impact on our liquidity and capital resources.

The Company’s subsidiaries require cash in order to fund policy acquisition costs, claims, other policy benefits, interest expense, general expenses, and dividends to the Company.  Premium and investment income, as well as maturities, calls, and sales of invested assets, provide the primary sources of cash for both subsidiaries.  A significant portion of the Company’s investment portfolio consists of readily marketable securities, which can be sold for cash.

Except as discussed above and in Note 8 to the condensed consolidated financial statements, the Company is aware of no known trends, events, or uncertainties reasonably likely to have a material effect on its liquidity, capital resources, or operations.  Additionally, the Company has not been made aware of any recommendations of regulatory authorities, which if implemented, would have such an effect.

Item 3.  Quantitative and Qualitative Disclosures about Market Risk

Under smaller reporting company rules, we are not required to disclose information required under Item 3.  However, in order to provide information to our investors, we have elected to provide information related to market risk.

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Table of Contents


The Company’s primary objectives in managing its investment portfolio are to maximize investment income and total investment returns while minimizing overall credit risk.  Investment strategies are developed based on many factors including changes in interest rates, overall market conditions, underwriting results, regulatory requirements, and tax position.  Investment decisions are made by management and reviewed by the Board of Directors.  Market risk represents the potential for loss due to adverse changes in fair value of securities.  The three potential risks related to the Company’s fixed maturity portfolio are interest rate risk, prepayment risk, and default risk.  The primary risk related to the Company’s equity portfolio is equity price risk.  The Company has not incurred material losses in its investment portfolio in the first six months of 2011 related to interest rate changes, defaults on certain securities and changes in value of equity investments.  Changes are discussed in detail under Item 2 of this Form 10-Q.   For further information regarding market risk, reference is made to the Company’s Form 10-K for the year ended December 31, 2010.

Item 4.  Controls and Procedures

Our management carried out an evaluation, with the participation of our chief executive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures as of June 30, 2011. Based upon that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.

There has not been any change in our internal control over financial reporting in connection with the evaluation required by Rule 13A-15(d) under the Exchange Act that occurred during the three month period ended June 30, 2011, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



Part II. OTHER INFORMATION

Item 1.   Legal Proceedings
Please refer to Note 8 to the financial statements.

Item 1A. Risk Factors
There has been no material change in risk factors previously disclosed under Item 1A. of the Company’s annual report for 2010 on Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None

Item 3.  Defaults Upon Senior Securities
None

Item 5.  Other Information
None


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Table of Contents

Item 6.  Exhibits

a.  Exhibits

31.1  
Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
31.2  
Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
 
 
32.1  
Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
 
 
101.INS
XBRL Instance Document
 
 
101.SCH
XBRL Taxonomy Extension Schema Document
 
 
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
 
 
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document


b.  Reports on Form 8-K during the quarter ended June 30, 2011

Date of Report
 
Date Filed
 
Description
 
 
 
 
 
April 15, 2011
 
April 15, 2011
 
Press release, dated April 15, 2011, issued by The National Security Group, Inc.
 
 
 
 
 
May 11, 2011
 
May 11, 2011
 
Press release, dated May 11, 2011 issued by The National Security Group, Inc.
 
 
 
 
 
May 16, 2011
 
May 17, 2011
 
Press release, dated May 17, 2011 issued by The National Security Group, Inc.
 
 
 
 
 
May 20, 2011
 
May 23, 2011
 
Submission of matters to a vote of security holders.

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Table of Contents

SIGNATURE

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

The National Security Group, Inc.

/s/ William L. Brunson, Jr.
 
/s/ Brian R. McLeod
William L. Brunson, Jr.
 
Brian R. McLeod
President and Chief Executive Officer
 
Vice President  and Chief Financial Officer


Dated: August 15, 2011

35