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National Security Group 10-Q 2011

Documents found in this filing:

  1. 10-Q
  2. Graphic
  3. Ex-31.1
  4. Ex-31.2
  5. Ex-32.1
  6. Ex-32.1
nsg10q.htm
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 March 31, 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 May 16, 2011, there were 2,466,600 shares, $1.00 par value, of the registrant’s common stock outstanding.
 

 
1

 

THE NATIONAL SECURITY GROUP, INC

INDEX



PART I. FINANCIAL INFORMATION
   
       
Page No.
 
Item 1.  Financial Statements (unaudited)
   
         
     
4
     
5
   
6
     
7
   
8
   
26
       
 
27
         
       
 
32
       
   
32
         
         
PART II. OTHER INFORMATION
   
         
   
32
   
32
 
32
   
32
   
32
   
32
         
         
   
34
         
CERTIFICATIONS
     

 
 



 
2

 

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.
 



 
3

 


 
Part I.  FINANCIAL INFORMATION

Item 1.  Financial Statements
THE NATIONAL SECURITY GROUP, INC.

(In thousands, except per share amounts)

             
             
     
March 31,
   
December 31,
ASSETS
   
2011
   
2010
     
(unaudited)
     
Investments
           
Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2011 - $4,501;
           
  2010 - $5,144)     $ 4,352     $ 4,959
Fixed maturities available-for-sale, at estimated fair value (cost: 2011 - $76,683;
               
  2010 -$ 77,119)       77,420       78,468
Equity securities available-for-sale, at estimated fair value (cost: 2011 - $5,211;
               
  2010 - $5,478)       9,091       9,047
Trading securities
      838       705
Receivable for securities sold
      125       -
Mortgage loans on real estate, at cost
      395       935
Investment real estate, at book value
      5,579       5,010
Policy loans
      1,149       1,123
Company owned life insurance
      5,583       5,520
Other invested assets
      3,898       3,915
                   
Total Investments
      108,430       109,682
                   
Cash
      3,266       1,572
Accrued investment income
      826       823
Policy receivables and agents' balances
      9,421       9,531
Reinsurance recoverable
      1,637       1,699
Deferred policy acquisition costs
      10,220       10,189
Property and equipment, net
      2,356       2,437
Other assets
      1,116       934
                   
Total Assets
    $ 137,272     $ 136,867
                   
LIABILITIES AND SHAREHOLDERS' EQUITY
               
                   
Property and casualty benefit and loss reserves
    $ 13,372     $ 13,184
Accident and health benefit and loss reserves
      1,893       1,881
Life and annuity benefit and loss reserves
      29,249       28,897
Unearned premiums
      26,365       26,433
Policy and contract claims
      600       611
Other policyholder funds
      1,368       1,351
Short-term notes payable
      -       500
Long-term debt
      12,372       12,372
Accrued income taxes
      238       127
Deferred income tax liability
      1,065       1,043
Other liabilities
      6,547       6,758
                   
Total Liabilities
      93,069       93,157
                   
Contingencies
      -       -
                   
Shareholders' Equity
               
Preferred stock, $1 par value, 500,000 shares authorized, none issued or outstanding
      -       -
Class A common stock, $1 par value, 2,000,000 shares authorized, none issued or outstanding
      -       -
Common stock, $1 par value, 3,000,000 authorized, 2,466,600 shares issued and outstanding
      2,467       2,467
Additional paid-in capital
      4,951       4,951
Accumulated other comprehensive income
      2,890       3,022
Retained earnings
      33,895       33,270
                   
Total Shareholders' Equity
      44,203       43,710
                   
Total Liabilities and Shareholders' Equity
    $ 137,272     $ 136,867


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

 
4

 


THE NATIONAL SECURITY GROUP, INC.

(In thousands, except per share amounts)


   
Three Months
   
Ended March 31
   
2011
   
2010
           
REVENUES
         
Net premiums earned
  $ 14,870     $ 15,038
Net investment income
    1,142       1,326
Net realized investment gains
    770       669
Other income
    255       299
               
  Total Revenues
    17,037       17,332
               
EXPENSES
             
Policyholder benefits paid or provided
    9,322       8,473
Policy acquisition costs
    2,924       2,748
General expenses
    2,563       2,585
Taxes, licenses and fees
    480       487
Interest expense
    285       258
   Total Expenses
             
    15,574       14,551
               
  Income Before Income Taxes
    1,463       2,781
               
INCOME TAX EXPENSE
             
      Current
    350       602
      Deferred
    118       285
      468       887
               
   Net Income
  $ 995     $ 1,894
               
               
EARNINGS PER COMMON SHARE
  $ 0.40     $ 0.77
               
DIVIDENDS DECLARED PER SHARE
  $ 0.150     $ 0.150
               



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

 
5

 

THE NATIONAL SECURITY GROUP, INC.

(In thousands, except per share amounts)

               
Accumulated
             
               
Other
         
Additional
 
         
Retained
   
Comprehensive
   
Common
   
Paid-in
 
   
Total
   
Earnings
   
Income
   
Stock
   
Capital
 
                               
Balance at December 31, 2010
  $ 43,710     $ 33,270     $ 3,022     $ 2,467     $ 4,951  
                                         
Comprehensive Income
                                       
Net income three months ended 3/31/2011
    995       995                          
Other comprehensive income (net of tax)
                                       
      Unrealized loss on securities, net of
                                       
      reclassification adjustment of $508
    (180 )             (180 )                
    Unrealized gain on interest rate swap
    48               48                  
                                         
Total Comprehensive Income
    863                                  
                                         
Cash dividends
    (370 )     (370 )                        
                                         
Balance at March 31, 2011 (Unaudited)
  $ 44,203     $ 33,895     $ 2,890     $ 2,467     $ 4,951  


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

 
6

 

THE NATIONAL SECURITY GROUP, INC.

(In thousands)



   
Three Months
 
   
Ended March 31,
 
   
2011
   
2010
 
             
Cash Flows from Operating Activities
           
  Net income
  $ 995     $ 1,894  
  Adjustments to reconcile income from continuing operations to net cash
               
    provided by operating activities:
               
    Change in receivable for securities sold
    (125 )     (73 )
    Change in accrued investment income
    (3 )     (60 )
    Change in reinsurance recoverable
    62       113  
    Change in deferred policy acquisition costs
    (31 )     (273 )
    Change in accrued income taxes
    111       452  
    Change in deferred income taxes
    118       285  
    Depreciation expense
    93       74  
    Change in policy liabilities and claims
    583       (458 )
    Other, net
    (1,122 )     (1,236 )
      Net cash provided by operating activities
    681       718  
                 
Cash Flows from Investing Activities
               
    Cost of investments acquired
    (8,172 )     (13,372 )
    Sale and maturity of investments
    10,050       10,411  
    Purchase of property and equipment
    (12 )     (17 )
                 
    Net cash provided by (used in) investing activities
    1,866       (2,978 )
                 
Cash Flows from Financing Activities
               
    Change in other policyholder funds
    17       6  
    Change in short-term notes payable
    (500 )     -  
    Dividends paid
    (370 )     (370 )
      Net cash used in financing activities
    (853 )     (364 )
                 
Net change in cash and cash equivalents
    1,694       (2,624 )
                 
Cash and cash equivalents, beginning of period
    1,572       4,686  
                 
Cash and cash equivalents, end of period
  $ 3,266     $ 2,062  








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





 
7

 




THE NATIONAL SECURITY GROUP, INC.


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

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.  However, we do not expect a material effect on our results of operations or financial position.


 
 
 
 
8

 

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
 (Continued)

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 divided by the weighted average common shares outstanding.  The weighted average number of shares outstanding for the period ending March 31, 2011 and 2010 were 2,466,600.

NOTE 4 – CHANGES IN SHAREHOLDER'S EQUITY

During the three months ended March 31, 2011 and 2010, there were no changes in shareholders' equity except for net income of $995,000 and $1,894,000, respectively; dividends paid of $370,000 in 2011 and 2010; changes in accumulated other comprehensive (loss) income, net of applicable taxes of $(132,000) and 743,000, respectively.  Other comprehensive income consists of accumulated unrealized gains and losses on securities and unrealized gains and losses on interest rate swaps.





 
9

 



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)
 
   
March 31, 2011
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
Value
 
Available-for-sale securities:
                       
Corporate debt securities
  $ 19,747     $ 1,197     $ 67     $ 20,877  
Mortgage backed securities
    6,799       220       125       6,894  
Private label mortgage backed securities
    12,261       155       283       12,133  
Obligations of states and political subdivisions
    19,434       194       718       18,910  
U.S. Treasury securities and obligations of
                               
U.S. Government corporations and agencies
    18,442       388       224       18,606  
Total fixed maturities
    76,683       2,154       1,417       77,420  
Equity securities
    5,211       4,340       460       9,091  
                                 
Total
  $ 81,894     $ 6,494     $ 1,877     $ 86,511  
                                 
Held-to-maturity securities:
                               
Corporate debt securities
  $ -     $ -     $ -     $ -  
Mortgage backed securities
    2,443       120       13       2,550  
Private label mortgage backed securities
    96       3       -       99  
Obligations of states and political subdivisions
    1,489       32       14       1,507  
U.S. Treasury securities and obligations of
                               
U.S. Government corporations and agencies
    324       21       -       345  
                                 
Total
  $ 4,352     $ 176     $ 27     $ 4,501  


 
10

 


THE NATIONAL SECURITY GROUP, INC.

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


                         
   
(Dollars in thousands)
 
   
December 31, 2010
 
         
Gross
   
Gross
       
   
Amortized
   
Unrealized
   
Unrealized
   
Fair
 
   
Cost
   
Gains
   
Losses
   
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  



The amortized cost and aggregate fair value of debt securities at March 31, 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
   
Fair
 
Available-for-sale securities:
 
Cost
   
Value
 
Due in one year or less
  $ 952     $ 989  
Due after one year through five years
    12,610       13,278  
Due after five years through ten years
    23,892       24,857  
Due after ten years
    39,229       38,296  
                 
Total
  $ 76,683     $ 77,420  
                 
Held-to-maturity securities:
               
Due in one year or less
  $ 500     $ 500  
Due after one year through five years
    300       307  
Due after five years through ten years
    1,342       1,417  
Due after ten years
    2,210       2,277  
                 
Total
  $ 4,352     $ 4,501  
 
 
 
 
 
 
 
 
 
 
 
 
 

 
11

 


THE NATIONAL SECURITY GROUP, INC.

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

A summary of securities available-for-sale with unrealized losses as of March 31, 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)
   
March 31, 2011
 
   
Less than 12 months
   
12 months or longer
   
Total
 
         
Gross
         
Gross
         
Gross
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Securities in a
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
   
Loss Position
 
Fixed maturities
                                         
Corporate debt securities
  $ 980     $ 17     $ 1,707     $ 50     $ 2,687     $ 67       6  
Mortgage backed securities
    993       34       1,409       91       2,402       125       7  
Private label mortgage backed
                                                       
 securities
    578       1       2,319       282       2,897       283       9  
Obligations of state and
                                                       
 political subdivisions
    1,638       20       9,126       698       10,764       718       37  
U.S. Treasury securities and
                                                       
 obligations of U.S. government
                                                       
 corporations and agencies
    5,002       29       3,997       195       8,999       224       19  
Equity securities
    405       27       767       433       1,172       460       5  
    $ 9,596     $ 128     $ 19,325     $ 1,749     $ 28,921     $ 1,877       83  


   
(Dollars in thousands)
   
December 31, 2010
 
   
Less than 12 months
   
12 months or longer
   
Total
 
         
Gross
         
Gross
         
Gross
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Securities in a
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
   
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  



 
12

 


THE NATIONAL SECURITY GROUP, INC.

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

A summary of securities held-to-maturity with unrealized losses as of March 31, 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)
   
March 31, 2011
 
   
Less than 12 months
   
12 months or longer
   
Total
 
         
Gross
         
Gross
         
Gross
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Securities in a
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
   
Loss Position
 
Fixed maturities
                                         
Corporate
  $ -     $ -     $ -     $ -     $ -     $ -       -  
Mortgage backed securities
    -       -       319       13       319       13       1  
Private label mortgage backed
                                                       
 securities
    -       -       -       -       -       -       -  
Obligations of state and
                                                       
 political subdivisions
    -       -       161       14       161       14       1  
U.S. Treasury securities and
                                                       
 obligations of U.S. government
                                                       
 corporations and agencies
    -       -       -       -       -       -       -  
Equity securities
    -       -       -       -       -       -       -  
    $ -     $ -     $ 480     $ 27     $ 480     $ 27       2  



   
(Dollars in thousands)
   
December 31, 2010
 
   
Less than 12 months
   
12 months or longer
   
Total
 
         
Gross
         
Gross
         
Gross
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Securities in a
 
   
Value
   
Losses
   
Value
   
Losses
   
Value
   
Losses
   
Loss Position
 
Fixed maturities:
                                         
Corporate debt securities
  $ -     $ -     $ -     $ -     $ -     $ -       -  
Mortgage backed securities
    331       1       -       -       331       1       1  
Private label mortgage backed
                                                       
 securities
    -       -       -       -       -       -       -  
Obligations of state and
                                                       
 political subdivisions
    161       12       -       -       161       12       1  
U.S. Treasury securities and
                                                       
 obligations of U.S. government
                                                       
 corporations and agencies
    -       -       -       -       -       -       -  
                                                         
    $ 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.

 
13

 

THE NATIONAL SECURITY GROUP, INC.

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

Management has evaluated each security in a significant unrealized loss position.  For the quarter ended March 31, 2011, the Company realized no additional other-than-temporary impairments.  The single largest accumulated loss at March 31, 2011 was in the equity portfolio and totaled $355,000.  The second largest loss position was in the bond portfolio and totaled $178,000.  The third largest loss position was in the bond portfolio and totaled $102,000.  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.

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


             
   
(Dollars in thousands)
 
       
   
March 31 ,2011
   
December 31, 2010
 
             
   
(unaudited)
       
Net change in unrealized appreciation on available-
           
for-sale securities before deferred tax
  $ (301 )   $ 1,261  
Deferred income tax
    121       (414 )
                 
Net change in unrealized appreciation on available-
               
for-sale securities
  $ (180 )   $ 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 March 31, 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 $1,065,000 at March 31, 2011 and $1,043,000 at December 31, 2010.
 
 
 
 
 
14

 
THE NATIONAL SECURITY GROUP, INC.

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


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

   
March 31,
   
December 31,
 
   
2011
   
2010
 
General insurance expenses
  $ 1,450     $ 1,442  
Unearned premiums
    1,791       1,795  
Claims liabilities
    305       301  
Trading securities
    7       17  
Other than temporary impairments on securities owned
    149       115  
Unrealized loss on interest rate swaps
    52       77  
  Deferred tax assets
  $ 3,754     $ 3,747  
                 
Depreciation
  $ (162 )   $ (171 )
Deferred policy acquisition costs
    (3,032 )     (2,874 )
Unrealized gains on securities available-for-sale
    (1,625 )     (1,745 )
  Deferred tax liabilities
  $ (4,819 )   $ (4,790 )
                 
Net deferred tax liability
  $ (1,065 )   $ (1,043 )

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

   
Quarter ended March 31,
 
   
2011
   
2010
 
             
Deferred policy acquisition costs
  $ 158     $ 240  
Other-than-temporary-impairments
    (34 )     19  
Trading securities
    10       -  
Unearned premiums
    4       (35 )
General insurance expenses
    (8 )     55  
Depreciation
    (9 )     (4 )
Claim liabilities
    (4 )     10  
                 
    $ 118     $ 285  




 
15

 


THE NATIONAL SECURITY GROUP, INC.

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

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)
 
   
Quarter ended March 31,
 
   
2011
   
2010
 
             
Federal income tax rate applied to pre-tax income
  $ 497     $ 946  
Dividends received deduction and tax-exempt interest
    (50 )     (55 )
Company owned life insurance
    (22 )     (30 )
Small life deduction
    (110 )     (97 )
Other, net
    153       123  
                 
Federal income tax expense
  $ 468     $ 887  

NOTE 7 –LONG-TERM DEBT

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


   
(Dollars in thousands)
 
   
2011
   
2010
 
             
Line of credit with variable interest rate equal to the WSJ prime rate, currently 5.0%.  Interest payments due quarterly.  Unsecured.
  $ -     $ 500  

Long-term debt consisted of the following as of March 31, 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  


 
16

 


THE NATIONAL SECURITY GROUP, INC.

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

The $9,279,000 of subordinated debentures is due in 2035 and $3,093,000 of subordinated debentures is due in 2037.

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 $167,000 (liability), $19,000 (asset) and $6,000 (liability), respectively, for a net liability of $154,000 at March 31, 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 gain of $48,000 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.

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 $822,000 ($660,000 of which is posted as collateral) ($660,000 at December 31, 2010).  See Note 9 for additional information about the interest rate swaps.

 
 
 
 
17

 
 
 
THE NATIONAL SECURITY GROUP, INC.

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

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.  No funds were drawn on this line at March 31, 2011 and $500,000 was drawn on this line 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
 
 
 
 
 
18

 
 
 
 
NATIONAL SECURITY GROUP, INC.

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

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.  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 March 31, 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. 


 
19

 

THE NATIONAL SECURITY GROUP, INC.

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

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.

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.
 
 
 
 
20

 
 
 
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 March 31, 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