UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549  FORM 10-K  ANNUAL REPORT PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  (Mark One) xANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  For the fiscal year ended December 31, 2006  OR oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from
        to
  Commission file number:001-32377  KMG AMERICA CORPORATION  (Exact Name of Registrant as Specified in its Charter)  Virginia
(State or Other Jurisdiction of Incorporation or Organization)
        20-1377270
(I.R.S. Employer Identification No.)12600 Whitewater Drive, Suite 150, Minnetonka, Minnesota
(Address of Principal Executive Offices)
        55343
(Zip Code)
  Registrants telephone number, including area code:(952) 930-4800  Securities registered pursuant to Section 12(b) of the Act:  Title of each class
        Name of each exchange on which registeredCommon Stock, par value $0.01 per share
        New York Stock Exchange
  Securities pursuant to Section 12(g) of the Act: None (Title of Class)  Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o Nox  Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act from their obligations under those Sections. Yes o Nox  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. YesxNo o  Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o  Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of "accelerated filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. Check one: Large Accelerated Filer o Accelerated FilerxNon-Accelerated Filer o  Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o Nox  The aggregate market value of the voting and non-voting common equity held by nonaffiliates of the registrant, as of June 30, 2006, was approximately $192,803,704 computed by reference to the price at which common equity was last sold on June 30, 2006.  As of February 23, 2007, the number of shares of Common Stock outstanding was 22,211,478.  Portions of the registrants definitive Proxy Statement for the annual meeting of shareholders to be held on May 3, 2007, are incorporated in Part III by reference. The exhibit index to this Form 10-K begins on page 118 of this Form 10-K.  KMG AMERICA CORPORATION TABLE OF CONTENTS  Item No.
        Page No.PART IITEM 1. BUSINESS
        2ITEM 1A. RISK FACTORS
        17ITEM 1B. UNRESOLVED STAFF COMMENTS
        35ITEM 2. PROPERTIES
        36ITEM 3   LEGAL PROCEEDINGS
        36ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
        36PART IIITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
        36ITEM 6. SELECTED FINANCIAL DATA
        40ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
        42ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
        70ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
        73ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
        114ITEM 9A. CONTROLS AND PROCEDURES
        114ITEM 9B. OTHER INFORMATION
        115PART IIIITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE OF OUR COMPANY
        115ITEM 11. EXECUTIVE COMPENSATION
        115ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
        115ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
        115ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
        116PART IVITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
        116SIGNATURES
        117EXHIBIT INDEX
        118
   i  In this report, unless the context requires otherwise, references to we, us, our, KMG America or the Company are intended to mean KMG America Corporation and its consolidated subsidiaries, including, without limitation, Kanawha Insurance Company (Kanawha). References to our predecessor mean Kanawha prior to it being acquired by KMG America.  CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS  Forward-Looking Statements  In addition to historical information, this annual report on Form 10-K contains forward-looking statements that involve risks and uncertainties that could cause actual results to differ materially from those expressed in our forward-looking statements. Forward-looking statements include statements regarding our goals, beliefs, plans or current expectations, taking into account the information currently available to our management. Forward-looking statements are not statements of historical fact. For example, when we use words such as believe, anticipate, expect, estimate, intend, should, would, could, may, will likely result, will continue, project, or other words that convey uncertainty of future events or outcome, we are making forward-looking
statements. Forward-looking statements include, without limitation, statements concerning:  
        future results of operations;
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        liquidity, cash flow and capital expenditures;
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        acquisition activities and the effect of completed acquisitions, including expected synergies and cost savings;
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        pending or anticipated litigation;
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        debt levels and the ability to obtain additional financing or make payments on our debt;
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        regulatory developments, industry conditions and market conditions; and
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        general economic conditions.
  Factors that might cause or contribute to differences between actual results and those expressed in our forward-looking statements include, but are not limited to, those discussed in Items 1A and 7 of this report, which are incorporated herein by reference. Caution should be used when extrapolating historical results to future periods. Our actual results and financial condition may differ, perhaps materially, from the anticipated results and financial condition in any forward-looking statements.  Accordingly, readers are cautioned not to place undue reliance on such statements. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.  Industry and Market Data  We obtained the market and competitive position data used throughout this report from our own research, surveys or studies conducted by third parties, and industry or general publications. Industry publications and surveys generally state that they have obtained information from sources believed to be reliable, but do not guarantee the accuracy and completeness of such information. While we believe that each of these studies and publications is reliable, we have not independently verified such data, and we do not make any representation as to the accuracy of such information. Similarly, we believe our internal research is reliable, but it has not been verified by any independent sources.   1  PART I ITEM 1.
        BUSINESS.
  Overview of Initial Public Offering, Kanawha Acquisition and Nature of Operations  KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. KMG America commenced operations shortly before it completed its initial public offering of common stock on December 21, 2004, and its shares trade on the New York Stock Exchange under the symbol KMA.  Concurrently with the completion of its initial public offering, KMG America completed its acquisition of Kanawha and its subsidiaries, which are KMG Americas primary operating subsidiaries and which underwrite and sell life and health insurance products.  Kanawha, the primary operating subsidiary of KMG America, is licensed to issue life and accident and health insurance. Kanawha is domiciled in South Carolina. Kanawha has one wholly owned subsidiary, Kanawha HealthCare Solutions, Inc., a third-party administrator with operations in Lancaster and Greenville, South Carolina.  The primary insurance products that we underwrite include: group and individual life insurance; group long term disability insurance; group and individual short term disability insurance; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. We ceased actively underwriting new long-term care insurance policies after December 31, 2005.  We intend to retain and actively manage our existing block of in force long-term care policies. Our third-party administration and medical management businesses include a wide array of services with the primary emphasis on the offering of administrative service-only products.  Historically, our sales have been primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina, but are now expanding nationwide. Sales are made through an internal sales force, full-time agents, general agents and brokers.  Under our current business strategy, we expect group lines of business to account for an increasing percentage of the Company's premium revenues.  For accounting purposes, Kanawha is treated as our predecessor entity and is referred to in this report as our predecessor.  For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material to our predecessors consolidated statements of operations, cash flows, and changes in shareholders equity for the year ended December 31, 2004. Accordingly, financial information in the following discussion that relates to our predecessors consolidated results of operations, cash flows and changes in shareholders equity for the year ended 2004 is reported on a historical basis without GAAP (generally accepted accounting principles in the United States)
purchase accounting adjustments reflecting the acquisition. Financial information relating to our financial position, consolidated results of operations, cash flows and changes in shareholders equity as of December 31, 2004 and for all dates and periods thereafter reflect GAAP purchase accounting adjustments made as of December 31, 2004, to reflect the acquisition.  Business Segments  Our operations consist of three primary business segments: worksite insurance business, senior market insurance business and third-party administration business. For the year ended December 31, 2006, the worksite insurance business produced premiums, commissions and fees, excluding intercompany payments, of $83.8 million, which accounted for 58.0% of our premiums, commissions and fees, excluding intercompany payments. For the year ended December 31, 2006, the senior market insurance business produced premiums, commissions and fees, excluding intercompany payments, of $41.5 million, which accounted for 28.7% of our premiums, commissions and fees, excluding intercompany payments. For the year ended December 31, 2006, the third-party administration business produced premiums, commissions and fees, excluding intercompany payments, of $ 16.1 million, which accounted for 11.2% of our premiums,
commissions and fees, excluding intercompany payments. See the consolidated financial statements, the notes thereto and Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, in this report for information regarding our revenues, profits and losses and total assets by business segment.   2  Worksite Insurance Business  Our worksite insurance business is a provider of life and health insurance products to employers and their employees. Our predecessors marketing and sales efforts were primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina. Since acquiring our predecessor, we have begun to implement our business strategy to market our products nationwide.  Our worksite insurance business underwrites primary insurance products including life insurance, disability insurance, dental insurance, indemnity health insurance (which provides benefits to cover many costs incurred upon the occurrence of an accidental injury or sickness), employer excess risk insurance and critical illness insurance.  Our insurance products are marketed through an internal sales force and independent insurance agents to brokers, consultants, employers and other worksite producers.  Our worksite insurance products are both employer paid and voluntary products.  Many of our worksite insurance products are group products where the employer or association pays the premiums for insurance benefiting its employees or members as part of the employees or members compensation package.  Our employer excess risk insurance is sold exclusively to employers who self-fund
health benefits.  The voluntary products are made available by the employer or association offering the products to its employees or members as part of an array of insurance and health benefits from which the employee or member may choose.  The individual employee or member elects which products to purchase and the premiums are paid by the employee or group member.  The employer will often deduct the premium from the employees periodic paycheck and remit the premium to us.  Most of the insurance products offered by our worksite insurance business are underwritten by us and the primary underwriting risk under the policies is retained by us. Some of the insurance products marketed by us are underwritten by other insurance companies who retain the underwriting risk. We refer to insurance products underwritten by other carriers, but sold by us, as in-sourced products. Our worksite insurance business is licensed to offer group and individual life and health insurance products in 46 states, plus the District of Columbia. The earnings reported in any period for our worksite insurance business generally depends on growth in underwritten business, business mix, persistency of business in force, benefit payouts and administrative expenses incurred.  Worksite Insurance Products.The primary insurance products that we underwrite include the following:  
        Individual life insurance. Individual life insurance insures the life of a single individual. It is typically sold on a renewable term basis or with a cash value component such as whole life insurance.
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        Group life insurance. Group life insurance insures the lives of a group of individuals and pays benefits upon the death of each member within the group. The group typically is comprised of an entire employer workforce or other class of covered individuals.
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        Disability insurance.  Disability insurance protects against the loss of wages due to illness or accidental injury.  Disability insurance generally provides income replacement on a weekly or monthly basis while the insured is disabled.
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        Dental insurance. Dental insurance generally covers all or a portion of the costs of diagnostic and preventative dental and orthodontic services. It generally is offered on a voluntary basis and provides benefits on a reimbursement basis.
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        Critical illness insurance. Critical illness insurance is designed to fill financial gaps not covered by health, disability, life and accident insurance policies when insureds are diagnosed with a critical illness.
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        Indemnity health insurance. Indemnity health insurance provides benefits to cover many costs incurred upon the occurrence of an accidental injury or sickness.
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        Employer excess risk insurance. Employer excess risk insurance provides insurance protection to employers who self-fund a portion or all of employee health benefits.
  In addition to marketing the products discussed above, our worksite insurance business works with each employer or association to assess its unique insurance requirements and to create a customized, bundled package of insurance products and services designed to meet those requirements. The package may consist of insurance products and services offered by our worksite insurance business and/or in-sourced products underwritten by other insurance carriers.   3  Marketing and Distribution.Most of the products sold by our worksite insurance business are sold to individuals through their employer or other group of which they are a member. This is a marketing and distribution effort that we refer to as worksite marketing. Worksite marketing sales generally have two components:  
        group products, where the employer or association pays the premiums for insurance that covers the employee or member as part of the employees or members compensation package; and
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        voluntary individual products, where the employee or member elects to purchase supplemental coverage and/or additional insurance products not sponsored by the employer or association, and the employee or member pays the premiums, which are often deducted from the employees or members pay and submitted to the insurance company by the employer or association.
  Most of our worksite insurance products are sold as voluntary individual products; however some are sold as employer-paid group products.  Prior to our acquisition of Kanawha, the majority of Kanawhas worksite benefits business was marketed through independent insurance agents. Since the acquisition, we have been developing an internal sales force that markets our worksite products nationwide to larger employers and groups. Both the independent agents and our internal sales force call on employers, consultants, brokers and other intermediaries that arrange to present product offerings to sponsoring employers or groups located throughout the United States. In general, intermediaries involved in placing our worksite products with employers or groups receive a brokerage commission and/or other fee arrangement which is a percentage of gross premiums generated from the placement. Our original worksite business uses independent agents to target small employers and groups generally having fewer than 200 individual employees or
members and our internal sales force to target larger employers and groups with 50 to 10,000 employees.  Worksite Insurance Competition.We face competition from many firms in the life and health insurance industry, but we believe a limited number of companies participate in the market in the same manner as we do. We view the worksite benefits segment of the life and health insurance business as being composed of three different types of companies:  (1) companies selling primarily group insurance products, (2) companies selling primarily voluntary insurance products and (3) companies offering both group and voluntary insurance products, but through separate distribution channels. We believe that most insurers competing in the worksite market tend to focus on either the group market or the voluntary market, with very few competitors focused on offering both group and voluntary products through the same sales organization, which is how we operate. We believe the
fastest growth in the worksite insurance market in the future will be achieved by those insurers offering both group and voluntary products where cross-selling and product packaging opportunities are significant.  Our competitors in the worksite insurance market include AFLAC, Inc., StanCorp Financial Group, Inc., AIG, Transamerica Corporation, Metropolitan Life Insurance Company, American Fidelity Life Insurance Company, Prudential Financial, Inc., Assurity Life Insurance Company, United Health Group Incorporated ING Groep N.V., Lincoln Financial Group and Allstate Life Insurance Company. Other commercial competitors that offer various products in the worksite insurance market that do not easily fit into any one of these categories include various small and medium sized life insurance companies. In the worksite insurance market, competition tends to focus more on the distribution channel. Competition in the worksite insurance market is based primarily on product mix, service and pricing.  We believe that there are a limited number of competitors that offer both group and voluntary insurance products to the worksite insurance market through the same sales force.  Examples of such carriers include ING Groep N.V., United Health Group and UnumProvident Corp.  Senior Market Insurance Business  Our senior market insurance business has been a provider in the southeastern United States of individual insurance products tailored to the needs of older individuals. The primary insurance product included in this business is long-term care insurance that we underwrote.  Long-term care insurance protects the insured from the costs of long-term care services. These services include nursing homes, assisted living facilities, adult day care and home health care. Our long-term care insurance products were underwritten by us and we continue to bear the underwriting risk. A portion of this risk is reinsured.   4


Effective January 1, 2006, we ceased actively underwriting long-term care insurance policies. Significant factors that contributed to our decision to cease actively underwriting long-term care insurance policies include, among others:  (1) sales for this business were significantly lower than originally projected; and (2) the lack of strategic fit between the underwriting and distribution of long-term care products and our current strategy of focusing on worksite marketing of life and health insurance products.  We intend to retain and actively manage the existing block of in-force long-term care insurance policies (including the right to receive future premiums and the liability for future claims).  Third-Party Administration Business  Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services. This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business including our existing in force policies. Our third-party administration business also provides administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, and managed care plans. Our third-party benefits administration business focuses on three primary services:  insured products administration; self funded health care plan administration; and managed care services. As of December 31, 2006, our third-party administration business employed 336 individuals. Based on 2006 revenues, we ranked in the top 12%
of the nearly 400 third-party plan administrators that are members of the Society of Professional Benefit Administrators, or SPBA. This ranking was based on SPBAs most recently released directory for 2006.  Insured Products Administration.As of December 31, 2006, our third-party administration business administered over 240,000 in force insurance policies, including a wide variety of voluntary, group and individual insurance and reinsurance products. The primary responsibility of our third-party administration business is to administer the products underwritten by our worksite insurance business and our senior market insurance business, and most of the products administered by the third-party administration business are products underwritten by our insurance businesses. In addition, the third-party administration business administers various insurance products underwritten by other insurance companies, including Metropolitan Life Insurance Company, AXA Financial, Inc., Blue Cross & Blue Shield affiliates and several reinsurance companies. The insurance products
that our third-party administration business administers include long-term care insurance, group and individual life and health insurance, accident and health and critical illness insurance and group and individual dental insurance. The insurance administration services we provide include:  underwriting and policy issuance; claims management; reinsurance administration; and customer service and support.  Self-Funded Health Care Plan Administration.As of December 31, 2006, our third-party administration business provides plan administration services for approximately 125,000 participants of employers or associations that self insure their health care benefits. We administer preferred provider organization plans, point-of-service plans, exclusive provider organization plans, indemnity plans and other healthcare plans provided by independent organizations as well as plans provided by our worksite insurance business and senior market insurance business. The self-funded health plan administration services provided include: claims administration; eligibility administration; call center administration; design and coordination for customized plans; administration of Health Reimbursement Accounts, or HRAs; Health Savings Accounts, or HSAs, which are employer-funded
accounts provided to employees for reimbursement of qualifying medical expenses and the reimbursements are excludable from employee gross income; and administration of dental and short-term disability insurance plans.  Managed Care Services.Our third-party administration business also provides managed care services through our own proprietary provider network of approximately15,000 providers, with over 30 leased networks nationwide and our Utilization Review Accreditation Commission, or URAC, accredited medical management unit. The managed care programs and services we provide include:  utilization and case management (a process through which an insurer assesses, plans, implements, coordinates, monitors and evaluates options and services to meet an individuals health needs using communication and available resources to promote quality care and cost effective outcomes) and outpatient review; maternity management; disease management (a system of coordinated healthcare intervention and communication for patients with conditions in which the patients typically take a
significant role in their own care); data aggregation and predictive modeling; and on-site and 24-hour nurse triage. These programs are administered by a fully staffed URAC accredited medical management department.   A few of the programs require some coordination with outside vendors.   5  Third-Party Administration Competition.The third-party administration marketplace tends to be highly competitive. Historically, third-party administration firms competed primarily on the basis of service, efficiency and cost. These competitors ranged from small local firms to large national firms and include a number of third-party divisions of insurance companies and general agencies.  More recently, preferential access to and/or control over healthcare provider networks has given certain competitors, such as Blue Cross  Blue Shield, United Health Group Incorporated, CIGNA Corporation and Aetna, Inc.a competitive advantage.  Our third-party administration business also competes indirectly in certain services provided by general outsourcing firms. In some cases, third-party administration platforms of larger, well-established companies may have
substantially greater financial, management and marketing resources than our third-party administration business. However, we view our third-party administration business as an integral complementary component of our worksite marketing product strategy going forward.  Acquired Business  Our predecessor obtained over time, through assumption and indemnity reinsurance transactions, a number of blocks of life and health insurance business in which it has since elected to discontinue accepting new business. Revenue from this business reflects renewal premiums and other considerations on business in force that will continue to decline over time as policies lapse. The earnings generated by acquired blocks of business in any period will be affected by, among other things, historical pricing levels together with approved premium rate increases (if any), diversification of the underlying insurance policies, persistency and loss frequency and severity.  Corporate and Other  The corporate and other segment includes investment income earned on the investment portfolio related to capital and surplus not allocated to the insurance segments. This segment also includes marketing allowances, commissions and related expenses pertaining to product sales for other insurance carriers, which are currently not material. In addition, this segment includes certain unallocated expenses, primarily deferred compensation and incentive compensation costs, and other unallocated immaterial items. The results of this business segment are reflected in discussions of net investment income, realized investment gains and losses, and general insurance expenses. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations.  Customers  We have many customers that purchase our insurance products, and we are not dependent on any single customer, or group of customers in any of our business segments. No single customer represents more than ten percent of our total consolidated revenue. Longstanding relationships exist with many customers who purchase products on a recurring basis, and we continually attempt to maintain and improve these relationships. The loss of business from these customers or an increase in business from these customers could have a significant impact on the results of our operations.  Competitive Factors  We believe that the factors that enable us to compete effectively include:  An experienced management team and an entrepreneurial culture. We have a talented and experienced management team both at the holding company level and at each of our operating businesses. Our management team is led by our chairman, president and chief executive officer, Kenneth U. Kuk, who has 19 years of experience in the life insurance industry. Stanley D. Johnson has been the chief executive officer of Kanawha since 1986 and is a member of our board of directors. Members of our executive management team have an average of over 20 years of experience in the life and health insurance industry, including experience in the areas of executive management, underwriting, marketing, distribution, claims processing, actuarial, legal, finance and investments. We believe this experience is useful in executing our business strategy to grow our own nationwide worksite
marketing operation and marketing our insurance products nationwide. We promote a set of corporate values and a common corporate culture that we believe enables us to take advantage of business ideas, risk management expertise and focus on regulatory compliance across our businesses. We reward and encourage entrepreneurship at each business segment, in part with a performance-based compensation system.   6  Strong relationships with key clients, distributors and industry personnel. Our executive managers, senior executives and sales managers have strong relationships with existing and potential worksite market customers throughout the United States, which include employers, voluntary benefit organizations (commonly referred to as VBOs), enrollment firms, internal wholesalers, employee benefit consultants and national and regional insurance brokers. We believe that the strength of these distribution relationships enables us to market our products and services in an effective and efficient manner and will be instrumental in our nationwide worksite marketing.  A broad product mix of both voluntary and group insurance products offered through an integrated distribution platform. We offer a variety of products that meet the needs of group and voluntary customers throughout various stages of their development and lifecycles. We have the capability to package our insurance products, insurance products from other carriers and administrative services options as a total solutions package to our clients and customers.  We do not believe this can be duplicated easily by our competitors. We believe our insurance products combined with products in-sourced from other carriers and administrative services options provided by our third-party administration business provide the foundation for significant product cross-selling and product extension opportunities. We believe that persistency and profitability are enhanced by
offering a wide variety of insurance products to group and voluntary customers.  Strong administrative capabilities in third-party administration. Our third-party administration business provides plan administration services for over 125,000 employees or members of employers or associations that self-fund their healthcare benefits. We offer a flexible and broad suite of administrative services and products that can be highly customized to provide tailored solutions to customers. We intend to significantly expand our strong regional third-party administration business as it administers the increasing volume of policies and products that we anticipate will be sold by our worksite insurance business.  A disciplined approach to underwriting and risk management. We have implemented a disciplined underwriting and risk management policy. We focus on generating profitability through careful analysis of risks and draw on our experience in core specialized markets.  We closely monitor regulatory and market developments and adapt our approach as we deem necessary to achieve our underwriting and risk management goals. For example, we have exited products in which we were not achieving acceptable profitability or that do not fit with our worksite marketing strategy and we intend to introduce new products in insurance environments that are more favorable. Our worksite and third party administration businesses offer a diverse mix of products and services throughout the United States. These products and businesses generally are not affected in the same way by economic and
operating trends, which we believe allows us to maintain a greater level of financial stability than many of our competitors across business and economic cycles. We expect our product and geographic diversity to further increase as we continue to implement our business strategy by expanding our product mix and implementing our nationwide marketing effort. We are focused on loss containment, and we purchase reinsurance as a risk management tool to diversify our risk and protect against unexpected catastrophic events.  Excellent financial strength. As of December 31, 2006, we had approximately $832 million of total assets and approximately $ 192 million of shareholders equity. Kanawha, our insurance subsidiary, has financial strength ratings of A- (excellent) from A.M. Best and A- (strong) from S&P, both with a stable outlook. These ratings reflect each rating agencys current opinion of Kanawhas financial strength, operating performance and ability to meet obligations to policyholders and contract holders. We employ a conservative investment policy and our portfolio primarily consists of high grade, fixed income securities. As of December 31, 2006, we had approximately $ 580 million of cash and investments, consisting primarily of investment grade bonds with an average rating of AA-. We believe our solid capital base and overall financial
strength allow us to distinguish ourselves from our competitors and enable us to attract clients that are seeking an insurance company with long-term financial stability.  Business Strategy  Our objective is to transform our historical position as a regional voluntary life and health insurance company into a national life and health insurance company with an expanded product mix and nationwide marketing focus. We intend to achieve this objective by executing the following strategies in pursuit of profitable growth:  Expand our experienced management team. We continue to hire personnel with a significant amount of experience in the life and health insurance industry, particularly with experience in key areas within the organization. We believe this diverse experience is useful in executing our business strategy to quickly grow our own national worksite operation.  7   Develop a nationwide marketing organization primarily focused on the worksite market. We believe that one of our critical success factors is to build a national sales and marketing organization that is focused on the worksite market. We believe the creation of such an organization, combined with our product development strategies, is the foundation for our future growth. To implement our strategy to grow our worksite marketing operation we are taking the following actions:  
        Continue to hire employees with worksite benefits experience. We intend to continue to recruit additional insurance professionals with experience in working with worksite benefits products for sponsoring employers and third parties including VBOs, enrollment firms, internal wholesalers, employee benefit consultants, brokers and other parties. As part of our strategy to expand our product mix and to expand our geographic coverage of our sales and marketing efforts, we have hired and intend to continue hiring individuals who have experience with the new products that we intend to introduce and with customer relationships in the new geographic areas that we are targeting.
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        Target larger employers nationwide. Our new and expanding internal sales force is targeting employers with 100 to 10,000 employees. This target market includes over 290,000 businesses in the United States according to Dun & Bradstreet. Historically, Kanawha concentrated on employers having less than 200 individual employees. We believe that with our enhanced marketing organization and sales force, we are equipped to serve larger employer sponsor groups. Targeting groups with larger numbers of employees or members should enable us to cross-sell more insurance products with lower sales, marketing, administrative and other overhead costs per premium dollar, which should improve our profit margins on worksite insurance products.
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        Offer performance-based equity compensation incentives. We offer performance-based equity compensation incentives for our sales and marketing employees that emphasize profitability, sales volume, cross-selling our products and services and bundling packages of the products that we market. These incentives include equity incentive awards, such as awards of options to purchase our common stock. Generally, our competitors do not offer similar broad-based equity incentive awards, which gives us an advantage in continuing to hire and retain talented sales and marketing personnel. We believe that offering performance-based equity incentives increases our sales and profitability by aligning the interests of our marketing employees with our sales and profitability objectives.
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        Collaborate with key third parties.  We have hired senior sales management professionals who have experience interacting with the many constituencies involved in our product distribution efforts. We believe that it is important to our success that senior sales management interact with our sales force, sponsoring employers, benefit advisors and other product intermediaries and independent agents. We believe relationships between these parties, as well as with our insurance businesses and our third-party administration business, can be expanded to enhance our product packaging capabilities and cross-selling abilities, including the bundling of insurance and related products and services from our insurance businesses, our third-party administration business and other insurance carriers.
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        Target specific market niches for small employers nationwide. Historically, Kanawha targeted small employers and groups in the southeastern United States generally having less than 200 individual employees or members through a network of independent agents. We are growing our presence in this niche market by expanding the geographic focus of our independent sales agents to focus on select markets nationwide.
  Expand the types and varieties of insurance products and related services that we offer. In addition to developing a more effective marketing organization, we are focusing on our product development and offerings strategy. We believe that it is not only the individual products that we offer that differentiate us from our competition in the worksite insurance market, but also the breadth of our product mix. Our objective is to expand our existing product mix and add complementary products that together will provide a suite of product offerings that cannot easily be duplicated by our competitors. This differentiated product set should allow our sales force the ability to offer our employer sponsors and our distribution partners bundled packages of multiple insurance products and services that are tailored to meet our customers unique needs.  Our strategy for increasing our product mix includes the following:   8  
        Provide enhanced and additional group and voluntary insurance products. We intend to enhance and expand our product offerings by offering additional types of worksite life and health insurance products as well as additional unique variations of the types of insurance that we currently offer.
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        In-sourced product offerings.  Presently, we do not intend to in-source additional insurance products underwritten by other insurance carriers.  However, as we continue to seek to grow our product mix, bundled solutions and geographic marketing scope, there may be instances where potential customers have needs that we cannot satisfy with products underwritten by our insurance businesses.  In those instances, we may consider marketing insurance products underwritten by other insurance carriers.
  Develop client-focused strategy. We believe that long-term success in the worksite market is predicated on a client-driven strategy often missing in the market today. We focus on the unique requirements of sponsoring employers and worksite intermediaries. To satisfy our customers individual insurance requirements, we are working to offer more bundled packages of multiple insurance products and services that are tailored to meet our customers needs. These bundled solutions are to be marketed by our internal sales force and independent agents and will include both group policies as well as voluntary policies traditionally marketed by independent agents. Many of these bundled solutions will utilize products and services provided by both our worksite benefits business and our third-party administration business. For example, we can provide a full insurance
solution for an employer that is self insuring its employees by bundling:  (1) administration and claims handling services relating to the self-insured plan; (2) a medical stop-loss product which caps our clients self-insured exposure; (3) group and voluntary insurance product offerings underwritten by us as part of an employee benefit package; and (4) insurance products from other insurance carriers structured to fulfill group and voluntary insurance product needs that we do not underwrite ourselves.  Improve the efficiency of our third-party administration business. Our business strategy is to grow our third-party administration business primarily by having it administer an increasing number of policies and products that we anticipate will be sold by our worksite insurance business. We believe that our third-party administration business has the capacity to administer additional policies and that as this business administers a higher volume of policies, our per policy administration costs will decrease and our consolidated net profits will increase. We continue to enhance our performance by improving our use of technology in ways that are aimed at reducing our administrative costs and becoming more efficient in providing both enrollment and policy maintenance services. For example, most of our worksite products are available through electronic enrollment
platforms that allow for increased efficiency and employer satisfaction.  While increasing the volume of insurance products administered for unrelated third parties will not be a primary growth initiative for this business, as our national worksite marketing business develops we intend to opportunistically market our third-party administration and case management services to other insurance carriers and reinsurers, as well as our traditional end client base, such as self-insured plans, stop loss insurers, pharmacy benefit organizations and various managed care service providers.  Manage capital effectively.We manage our capital prudently relative to our risk exposure to enhance risk-adjusted returns on investments and long-term growth in shareholder value. Our capital management strategy is to maintain financial strength through conservative and disciplined risk management practices. We do this through product design, strong underwriting and risk selection and prudent claims management and pricing. In addition, we maintain a conservative investment portfolio management philosophy and manage our invested assets so their maturities match the duration of our insurance product liabilities. We strive to manage our business segments so that they have the appropriate level of capital required to obtain the ratings necessary to operate in their markets and to satisfy various regulatory requirements.  Maintain a disciplined risk management approach. We maintain a disciplined risk management approach through specific underwriting and pricing strategies, diversification of products, industry, geography and customers and the use of reinsurance. We are focused on profitable products and markets and a flexible approach to product design. We closely align the financial and sales goals to foster a collaborative effort between our sales and underwriting teams that we believe permits us to opportunistically take advantage of sales opportunities and underwrite profitable policies. We continuously evaluate the profitability of our products and pursue pricing strategies and adjust our mix of business by geography and by product so that we can maintain attractive pricing and margins. We seek to price our products at levels which help us achieve our target profit objectives.  Pursue acquisitions opportunistically. While our primary focus is organic growth of our existing businesses by expanding our product and marketing capabilities, we evaluate opportunities to grow through strategic alliances and acquisitions of blocks of business and/or companies that are compatible with our core businesses.  9  Risk Management and Underwriting  We manage our risks through (1) diversification of products, industry, geography and customers, (2) disciplined underwriting and product pricing practices and (3) the use of reinsurance. To account for and manage our risks, we establish and carry as liabilities actuarially determined reserves that we believe will be sufficient to meet our future obligations.  Diversification.We diversify our earnings from premiums by selling a diverse set of voluntary life and health, indemnity health, critical illness, group life, long- and short-term disability, stop loss insurance and other coverages. These products all have different pricing considerations, market cycles and risk characteristics. The underwriting risk on life insurance is generally diversified because the mortality of any specific individual is typically relatively independent of other individuals. Natural and man-made catastrophes, such as terrorist attacks, are the one exception where numerous life insurance claims may occur at once. Understanding the concentration of risk and promoting geographic diversity of insureds is generally the best protection from such risks. The federal terrorism act provides a backstop to the insurance industry but excludes life
insurance exposures. In addition to the increased risk due to terrorism, there is significant risk from epidemics such as the avian bird flu, SARS or West Nile viruses or other diseases that can spread quickly around the world given the increasing levels of individual travel, commerce and interdependency between nations involved in a global economy. We could be materially impacted by any one of these events if they were to strike a significant block of our insureds within a short period of time. Our worksite products in force are predominantly spread among different employers throughout the southeastern United States, although we are diversifying our risk with new sales occurring throughout the country.  We will continue to monitor these macro issues on an ongoing basis and will evaluate concentrations of risk as part of our underwriting process to optimize the diversification of risk exposures. Our product and geographic diversification should continue to improve as we
implement our strategy to develop a nationwide worksite insurance business with expanded product offerings.  Underwriting and Pricing.We manage the risk associated with the insurance policies that we place by implementing disciplined underwriting and product pricing practices that are tailored by product. Underwriting and pricing are centralized in one department containing two underwriting teams that specialize in group or voluntary products.  Strategies are aligned and integrated to enhance sales and financial outcomes.  We have developed standard rating systems for each product line based on past experience and relevant industry experience.  Based on target markets and risk selection criteria, we will select the groups or requests for proposals that fit our strategies.  Our uniform underwriting policies require evidence of insurability or a medical inquiry if coverage exceeds prescribed parameters such as age and benefit amounts. Pricing of group insurance products
is based on the expected payment of benefits under the policies that are calculated using assumptions for mortality, morbidity, interest, expenses, demographics, persistency and specific product features.  Our individual life and disability insurance underwriters follow detailed and uniform policies and procedures to assess and quantify the risk of our individual insurance products. We may require the applicant to take a variety of underwriting tests, such as medical examinations, electrocardiograms, blood tests, urine tests, chest x-rays and consumer investigative reports, depending on the age of the applicant and the amount of insurance requested.  In certain states, particularly Florida, consistent with other carriers offering long-term care insurance policies, our long-term care insurance claims have exceeded those anticipated when our predecessor first priced the policies. Our cumulative claims experience for long-term care products in the state of Florida has been approximately 25% higher than expected and approximately 50% higher than our average claims rates for all other states in which we have long-term care policies in force. We have filed for and obtained rate increases in the range of 5.0% to 18.5% on policies in force in the majority of states in which we have long-term care policies in force. These rate increases have generally taken effect on each policyholders next anniversary date. Rates for our newest generation of long-term care policies are from 20% to 35% higher than for earlier generations. We believe that
the rate increases we have obtained on older generations should eventually bring their rates in line with the newest generation. We intend to continue to monitor our long-term care insurance in force and make further pricing adjustments to these policies as contractually permitted and as experience justifies, subject to receiving approval from state insurance departments. While we can provide no assurance, we expect that actions already taken and which we foresee in the near future will allow us to improve the profitability of our long-term care business.  Reinsurance.Generally, we purchase reinsurance coverage for the following major business purposes:  10



        Protection from underwriting risks. As part of our overall risk and capacity management strategy, we purchase reinsurance for some of our insurance risks.
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        Dispositions of insured business. We use reinsurance to facilitate the sale or exit of product lines and/or blocks of business. This is common in the insurance industry because each insurer offers a distinct set of product lines, which complicates the acquisition and disposition of stand-alone legal entities, and in certain cases, large blocks of insurance business. In general, a disposition through a reinsurance transaction will include a 100% co-insurance agreement under which 100% of the policy benefit reserves and related assets of the subject business will be transferred to the reinsurer. Also, given the fact that the primary insurer is still legally obligated under the policies reinsured, these agreements generally require some degree of credit support including bank letters of credit, reinsurer deposits with the reinsured
party and trust agreements under which the assets backing the liabilities of the reinsured business are held in a trust along with excess collateral and the reinsurer is obligated to fund the trust if the value of the assets is deemed insufficient to fund the liabilities.
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        Capital management. We purchase reinsurance as a capital management tool. State insurance regulations and accounting regulations permit us to reduce our required capital when underwriting risks are appropriately offset by reinsurance, which allows us to free up capital to enable us to write additional business.
  Reinsurance is either provided on a treaty basis or a facultative basis, and is generally structured in the proportional form or an excess of loss basis for both individual losses and losses in the aggregate. In an indemnity reinsurance transaction offered on a treaty basis, a reinsurer agrees to indemnify another insurer for part or all of its liability under a policy or policies it has issued for an agreed upon premium. These agreements provide for recovery of a portion of losses and associated loss expenses from reinsurers. These losses and loss expenses refer to the expenses of settling claims, including legal and other fees and the portion of general expenses allocated to claim settlement costs plus losses incurred with respect to claims. The terms of these agreements, which are typical for agreements of this type, generally provide, among other things, for the automatic acceptance by
the reinsurer of ceded risks in excess of our retention limits (the amount of loss per individual or in the aggregate that we are willing to absorb). For excess of loss coverage, we pay premiums to the reinsurers based on rates negotiated and stated in the treaties. For proportional reinsurance, we pay premiums to the reinsurers based upon percentages of premiums received by us on the business reinsured and the reinsurer accepts a proportional percentage of the risk on the reinsured business. These agreements are generally terminable as to new risks by us or by the reinsurer with appropriate notice; however, termination does not affect risks ceded during the term of the agreement, which generally remain with the reinsurer. The other common form of reinsurance is referred to as facultative reinsurance in which a specific risk is insured, such as upon the cession of a specific portion of a large insurance policy. In this form of reinsurance the reinsurer has the option to accept or
decline the risk.  In most cases in which we choose to reinsure an underlying exposure, we expect to purchase reinsurance on a treaty basis and either in the form of proportional or excess of loss coverage, depending on the underlying properties of the insurance products. In select cases, we may purchase reinsurance on a facultative basis in cases in which we have high exposures on specific individual insured risks.  Our significant reinsurance includes the following:  
        Individual and group life. Historically, Kanawha reinsured its directly written in force individual life insurance policies on an excess of loss per risk and aggregate basis above identified retention limits. This reinsurance was with subsidiaries of G.E. Employers Re and Scottish Re. G.E. Employers Re notified our predecessor that, effective February 29, 2004, it no longer accepts new business under this treaty. The treaty, however, remains in effect with respect to business previously reinsured under the treaty. Scottish Re replaced G.E. Employers Re as the reinsurer for all new business. We also reinsure much of our acquired individual life insurance risk with Reassure America Life Insurance Company (a subsidiary of Swiss Re). We reinsure our True Group and Trust Product group life and accidental death and dismemberment
insurance policies with Munich American Reassurance Corporation on an excess of retention basis. Individual and group worksite term life insurance (life insurance written for a specified period and under which no cash value is generally available on surrender) products are reinsured on a 50% coinsurance basis with Hannover Re, which means that Hannover Re bears the risk for 50% of any claims losses and costs incurred with respect to these policies. We intend to continue to monitor our risk retention
  11  levels on our life insurance policies and will seek to maintain a reasonable balance between reinsured and retained risk. 
        Group medical stop loss. We reinsure our specific stop loss insurance policies with Lloyds of London Syndicate 2987 above specified levels of retention. This treaty was effective June 1, 2005, renewed in 2006 and contains an experience refund provision. The availability of excess reinsurance for aggregate stop loss insurance policies is very limited and in most cases has unattractive terms.  We have not transferred our risk using reinsurance but rather mitigated or limited our risk exposure by establishing appropriate attachment points on each case, requiring specific stop loss and offering maximums no greater than $1 million per policy.
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        New group term life. We reinsure our group term life and accidental death and dismemberment insurance policies sold to employers, and supplemental group term life and accidental death and dismemberment  with Swiss Re on an excess of retention basis. These treaties were effective July 1, 2005 and include an experience refund provision.
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        New group disability. We reinsure our group disability insurance policies, both long-term and short-term with Group Reinsurance Plus, a division of Hartford. The treaty was effective on January 1, 2006 on a quota share basis.
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        Fixed annuity block. Kanawha discontinued underwriting new fixed annuity products effective December 31, 2003, and we intend to in-source these products from other life and health insurance carriers. All in force deferred annuity products as of December 31, 2003, were ceded via a 100% coinsurance agreement with Madison National Life Insurance Company, a subsidiary of Independence Holding Company. Madison National assumed all product administration of this block of business in early 2004. All risks and profits generated by the reinsured business have been transferred to Madison National; however, we are still liable on a primary basis for this business should Madison National fail to honor its reinsurance obligations.
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        Long-term care. We have reinsured 15% of the risk on the earlier generations of our long-term care insurance with Employers Re and GenRe on a quota share basis, which means that we are responsible for 85% of all losses under these policies. We have reinsured 60% of the risk on our later generations of long-term-care product with Munich American Re on a quota share basis, which means that we are responsible for 40% of all losses under these policies.
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        Group critical illness. Group critical illness products are 50.0% reinsured with Hannover Re on a quota share basis, which means that we are responsible for 50.0% of all losses under these policies.
  Under reinsurance transactions in which we are the ceding insurer, we have retained primary liability for the underlying policy claims of the insured risks if the assuming company fails to meet its obligations. To limit this risk, we have control procedures in place to evaluate the financial condition of reinsurers and to monitor the concentration of credit risk to minimize this exposure. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. At December 31, 2006, over 99% of our reinsurance recoverables were due from reinsurers rated A- or better by A.M. Best. We now seek to purchase reinsurance from only those entities rated A- or better by S&P or A.M. Best and we regularly monitor collectibility of our reinsurance recoverables, making reserve provisions for amounts we consider potentially
uncollectible and requesting collateral where necessary. We apply the same financial analysis and approval processes to the selection of reinsurance and other financial protection counterparties as we do to the underwriting of our own primary insurance products.  Our management intends to conduct ongoing reviews of the pricing and operational characteristics of each of the products that we offer, our current reinsurance agreements in force, acceptable risk retentions and reinsurance alternatives, and the availability and cost of reinsurance applicable to our products.  Gross Annualized Premium in Force, Ceded Portion and Net Amount Retained  The following table details our gross annualized premium in force segregated by product type, the portion that was ceded to reinsurers and the net amount retained as of December 31, 2006.     12   Gross
        
        Ceded
        
        Net
        
        PercentageRetainedLife insurance and annuities
        
        $
        15,907,727
        
        $
        1,149,536
        
        $
        14,758,191
        
        92.8
        %Group life insurance
        
        
        7,553,367
        
        
        393,723
        
        
        7,159,644
        
        94.8Group accident and health
        
        
        43,364,229
        
        
        8,845,571
        
        
        34,518,658
        
        79.6Individual accident and health insurance
        
        
        98,527,295
        
        
        14,314,876
        
        
        84,212,419
        
        85.5Total consolidated
        
        $
        165,352,618
        
        $
        24,703,706
        
        $
        140,648,912
        
        85.1
        %
  Assumed Reinsurance.We have also assumed blocks of reinsurance on both an indemnity and assumption basis. We do not currently intend to acquire additional blocks of reinsurance, but some of the reinsurance previously purchased by us remains in force and will affect our future earnings depending on the future experience of these blocks of business. The most significant of these blocks of business include coverages for waiver of premium benefits associated with certain life policies underwritten by AXA Financial, Inc., individual health insurance business from Metropolitan Life Insurance Company and life insurance business from ING Groep N.V. Other smaller life and accident and health insurance blocks of business were also assumed during the period 1985 through 1998.  Policy Benefit Reserves.We establish and carry as liabilities, actuarially determined reserves that we believe will meet our future obligations. In accordance with industry and accounting practices and applicable insurance laws and regulatory requirements, we establish policy benefit reserves to recognize our future benefit obligations for our in force life, disability and other related policies. We base the amounts of these reserves on actuarially recognized methods using prescribed morbidity and mortality tables in general use in the United States, which we modify to reflect our actual experience when appropriate. Reserves also include claims and claims expenses (the expenses of settling claims, including legal and other fees and the portion of general expenses allocated to claim settlement costs) reported but not yet paid, claims incurred but not reported and
claims in the process of settlement.  Policy benefit reserves, whether calculated under United States generally accepted accounting principles, or GAAP or statutory accounting principles, or SAP, do not represent an exact calculation of future policy benefits and expenses but are instead estimates made using actuarial and statistical procedures. We cannot assure you that any such reserves will be sufficient to fund our future liabilities in all circumstances. Future loss developments could require reserves to be increased, which would adversely affect earnings in current and/or future periods. Adjustments to reserve amounts may be required in the event of changes from the assumptions regarding future morbidity, the incidence of disability claims and the rate of recovery, taking into account the effects of inflation and other societal and economic factors, persistency, mortality, loss severity and the interest rates used in
calculating the reserve amounts. The reserves reflected in our consolidated financial statements are calculated in accordance with GAAP.  We regularly review and update policy benefit reserves, using current information. Any adjustments are reflected in current results of operations. However, because the establishment of reserves is an inherently uncertain process, we cannot assure you that ultimate losses will not exceed existing reserves.  Investments  Investment returns are an important part of our overall profitability. For the year ended December 31, 2006, our net investment income was approximately $29.9 million and our net realized gains on investments were approximately $1.2 million, which collectively accounted for approximately 17.3 % of our total revenues during this period. As of December 31, 2006, much of our portfolio consisted of fixed maturity securities, such as corporate and government bonds, United States Treasury securities and asset backed debt securities, and less than 1% of our investments were equity securities.  Significant fluctuations in the fixed income market, such as changes in interest rates could impair our profitability, financial condition and/or cash flows. In addition, the natural volatility of claims may force us to liquidate securities prior to maturity, which may cause us to incur capital losses. Of our fixed maturity securities, as  13  of December 31, 2006, (1) 99% were scheduled to mature in more than twelve months and had a weighted-average interest rate of 6.22% and (2) 1% were scheduled to mature in less than twelve months and had a weighted-average interest rate of 5.75%. We have attempted to structure our investment portfolio so that its interest rate and maturity schedule is appropriately matched with our expected insurance liabilities to ensure that cash flows are available to pay claims as they become due. We are modifying our asset/liability matching strategy to reduce the adverse effects of interest rate volatility and have engaged asset/liability management specialists to manage our asset/liability matching strategy. However, these strategies will not be able to completely eliminate, and may fail to significantly reduce, the adverse effects of interest rate volatility, and we cannot precisely predict the timing and
magnitude of all claims. Accordingly, we cannot assure you that significant fluctuations in the level of interest rates and the unforeseen timing and magnitude of claims will not have a material adverse effect on our business, results of operations and financial condition.  We are subject to credit risk in our investment portfolio, primarily from our investments in corporate bonds and preferred stocks. Defaults by third parties in the payment or performance of their obligations could reduce our investment income and realized investment gains or result in investment losses. Further, the value of any particular fixed maturity security is subject to impairment based on the creditworthiness of the issuer. As of December 31, 2006, we held approximately $520.6   million of fixed maturity securities, or approximately 93.2% of the carrying value of our total invested assets at that date. Our fixed maturity portfolio also includes below investment grade securities, which comprised approximately 1.8% of the carrying value of our total fixed maturity securities at December 31, 2006. These investments generally provide higher expected returns but present greater risk and
can be less liquid than investment grade securities. A significant increase in defaults and impairments on our fixed maturity securities portfolio could materially adversely affect our results of operations and financial condition. Our other-than-temporary impairment losses on available-for-sale securities were approximately $0 million for the year ended December 31, 2006.  As of December 31, 2006, less than 1% of the carrying value of our total investments was invested in common stock; however, our predecessor had higher percentages of common stock in its portfolio in the past and we may increase the percentage of our portfolio that is invested in common stock in the future. Investments in common stock generally provide higher total returns, but present greater risk to preservation of principal than fixed income investments.  We have in the past invested, and we may in the future invest, in relatively illiquid securities including certain infrequently traded public fixed maturity securities, privately placed fixed maturity securities, mortgage loans, policy loans, limited partnership interests and real estate investments. These asset classes represented approximately 6.7% of the carrying value of our total cash and invested assets as of December 31, 2006. If we require significant amounts of cash on short notice in excess of our normal cash requirements, we may have difficulty selling these investments in a timely manner, be forced to sell them for less than we otherwise would have been able to realize, or both. Our inability to quickly dispose of illiquid investments could have an adverse effect on our business, results of operations and financial condition.  Members of our senior management team establish our investment strategy, policies and guidelines for hiring external investment managers. Our management, with the assistance of external managers, implements our investment strategy. The policies and guidelines set by our senior management team will specify minimum criteria on the overall credit quality, liquidity and risk-return characteristics of our investment portfolio and include limitations on the size of particular holdings, as well as restrictions on investments in different asset classes. The senior management team monitors our overall investment returns, reviews compliance with our investment guidelines and reports overall investment results to our board of directors on a quarterly basis.  Management of our investment portfolio is a critical part of our business strategy and materially affects our profitability. Investment decision making is guided mainly by the nature and timing of our expected liability payouts, managements forecast of our cash flows and the possibility of unexpected cash demands such as unexpected insured losses. However, to the extent our insurance liabilities are correlated with an asset class outside our minimum criteria, our investment guidelines allow us to deviate from those minimum criteria provided such deviations reduce overall risk. Our fundamental investment philosophy is to manage assets within our stated risk parameters to generate consistent levels of investment income with competitive risk-adjusted returns over the long-term. In accordance with our investment strategy, we seek to:   14  
        preserve principal and maintain liquidity while generating above-average returns on a risk-adjusted basis, through a high quality, diversified portfolio;
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        manage credit, interest rate, prepayment and market risks;
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        mandate that our investment portfolio consist mainly of highly rated and liquid fixed income securities, with adequate diversification among asset classes, industry concentrations and individual issuers; and
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        adhere to all applicable regulatory requirements and laws.
  Historically, we have not used financial futures, forwards, options, swaps or other derivative financial instruments. Without the approval of our board of directors, we will not purchase financial futures, forwards, options, swaps and other derivatives, except for purposes of hedging capital market risks or replication transactions, which are defined as a set of derivative and securities transactions that, when combined, produce the equivalent economic results of an investment meeting our minimum criteria.  Regulation  Our insurance operations are subject to regulation and supervision in each state in which we conduct our insurance business. We are regulated by the insurance department of South Carolina, the state in which our insurance subsidiary is domiciled, and by the insurance department of each state in which we are licensed to sell insurance products. At the present time, we are licensed to sell insurance products in 46 states and the District of Columbia and we are an authorized reinsurer in the State of New York.  Generally, state insurance departments have broad administrative powers to grant and revoke licenses to transact business, license agents, approve forms of insurance policies, regulate trade practices and market conduct, establish reserve requirements and permitted investments, make assessments for guaranty funds formed to compensate people insured by insolvent insurance companies and, in general, regulate all insurance activities.  State insurance laws and regulations also require insurance companies to file detailed reports on a statutory accounting basis with the state insurance departments where they do business. See Note 10 to our consolidated financial statements included in this report regarding statutory accounting principles, including differences between SAP and GAAP accounting. State insurance departments may examine the business and accounts of an insurance company at any time. Under the rules of the National Association of Insurance Commissioners, or NAIC, and state laws, the insurance departments of one or more states examine an insurance company periodically, typically at three to five year intervals.  South Carolina has enacted insurance holding company regulations that require our insurance subsidiary to be registered as a member of an insurance holding company system.  These regulations require, among other things, prior approval of an acquisition of control of a domestic insurer, some transactions between affiliates and the payment of extraordinary dividends or distributions.  In addition to state law, we are also subject to various federal laws and regulations affecting our business in the areas of health care, pension regulation, discrimination, financial services regulation, securities regulation, privacy laws, terrorism and federal taxation.  Employees  As of December 31, 2006, we had approximately 505 employees, a significant number of which are based in our Lancaster, South Carolina facilities. We plan to hire additional sales personnel and related employees to staff regional and field offices in select locations throughout the United States as we continue to develop our nationwide worksite marketing business. We expect that we will continue to hire additional employees as we expand our business.  Risks and Uncertainties  The information presented in Items 1A and 7 to this report is incorporated herein by reference.  Environmental Compliance   15  We have invested, and we intend to invest, in real estate and maintain a mortgage loan portfolio. As of December 31, 2006, 2.5% of our investment assets were mortgage loans and we did not have any real estate investments, although we do own and occupy a group of buildings in Lancaster, South Carolina where our primary operations are located and an office building in Fort Mill, South Carolina. Liability resulting from environmental problems at properties securing our mortgage loan portfolio and real estate investments or other owned real estate may harm our financial strength and reduce our profitability. Under the laws of several states, contamination of a property may give rise to a lien on the property to secure recovery of the costs of the cleanup. In some states, this kind of lien has priority over the lien of an existing mortgage against the property, which would impair our ability to
foreclose on that property should the related loan be in default. In addition, under the laws of some states and under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), under certain circumstances, we may be liable for costs of addressing releases or threatened releases of hazardous substances that require remedy at a property securing a mortgage loan held by us. We also may face this liability after foreclosing on a property securing a mortgage loan held by us after a loan default.  Under CERCLA and other applicable environmental laws, we will be liable for environmental conditions, damages and remediation of property owned by us, even if the liability arises from the actions or conduct of previous owners of the property, including the actions or conduct of Kanawha prior to our acquisition of all of its capital stock. Although the former shareholders and optionholders of Kanawha have agreed to indemnify us for some environmental losses we incur with respect to the real property that we acquired when we acquired Kanawha, this protection is limited, and we will be exposed to liability for environmental conditions existing on real property prior to our acquisition of Kanawha to the extent this liability exceeds such indemnification coverage or to the extent that we are not indemnified against this liability.  Financial Strength Ratings  Ratings by independent agencies are an important factor in establishing the competitive position of insurance companies and will continue to be important to our ability to market and sell our products in the future. Rating organizations continually review the financial positions of insurers, including Kanawha, our insurance subsidiary. Insurance companies are assigned financial strength ratings by independent rating agencies based upon factors relevant to policyholders. Ratings provide both industry participants and insurance consumers meaningful information on specific insurance companies and are an important factor in establishing the competitive position of insurance companies. Kanawha is currently rated by A.M. Best and Standard & Poors. A.M. Best maintains a letter scale rating system ranging from A++ (superior) to F (in liquidation) while S&P maintains a letter scale
rating system ranging from AAA (extremely strong) to R (under regulatory supervision).  Currently, Kanawha has an A.M. Best financial strength rating of A- (excellent), with a stable outlook, which is the second highest of ten categories within the A.M. Best rating system and the lowest in the category excellent.  S&Ps current financial strength rating for Kanawha is A- (strong), with a stable outlook, which is the third highest of nine categories and the lowest within the category based on modifiers (i.e., A+, A and A- are strong).  The objective of A.M. Bests and S&Ps ratings systems is to assist policyholders and to provide an opinion of an insurers financial strength, operating performance, competitive position and ability to meet ongoing obligations to its policyholders. These ratings reflect the opinions of A.M. Best and S&P of our ability to pay policyholder claims and are not a recommendation to buy, sell or hold any security, including our common stock. These ratings are subject to periodic review by and may be revised upward, downward or revoked at the sole discretion of A.M. Best and S&P.  Administration  We believe one of the factors that enables us to compete effectively against other worksite insurance providers is our third-party administration business, which administers both our underwritten insurance products and products underwritten by other insurance companies. We anticipate that for the foreseeable future, various administrative functions of ours will continue to be performed internally given our expertise in administrative services and relatively low-cost operating locations in South Carolina.  Our predecessor entered into an agreement in 2003 to outsource a substantial portion of its information technology and document management functions to CGI Information Systems & Management Consultants, Inc., after giving consideration to the relative cost implications of retaining these functions internally or outsourcing them to a third-party.  The term of this agreement is 10
years, and it may be terminated by us without cause starting November 2006 upon six months notice and at any time upon 30 days notice for cause that remains uncured. We believe the combination of our internal administrative capabilities and our outsourced administrative functions will provide us with an optimal mix of flexibility and cost efficiencies.   16


Trademarks and Intellectual Property  As standard practice, we and our predecessor have obtained the legal protections believed to be appropriate for our intellectual property. We do not believe any of our intellectual property rights are material to our business. We are not aware of any legal proceedings that have been brought against us for infringement of intellectual property rights.  Seasonality and Cyclicality  We have observed that our earnings in the first and second quarters of our fiscal year are typically less than our earnings in the third and fourth quarters of our fiscal year.  This seasonality is due, in part, to the fact that a majority of our outstanding long term care insurance policies have anniversary dates in the first half of the fiscal year, and policy reserve increases, (which are reflected as an expense on our statement of operations) are made as of the policy anniversary date. We expect that this seasonality effect will diminish as our long term care policies become a smaller portion of our total liabilities, although we anticipate this seasonality effect will occur again in 2007.  Also contributing to the seasonality effect is that more of our voluntary benefit sales occur in the second half of our fiscal year, which increases our revenue for that period.  This seasonality
effect is due, in large part, to a significant number of employers offering their employees open enrollment for benefits purchases during the last half of the calendar year.  Pricing in the medical excess risk insurance market has proven to be cyclical, with periods of competitively lower pricing and periods of competitively higher pricing.  Over the past two years, we have experienced a cycle where the market is offering this product line at competitively low prices.  In order to compete in the market, we must consider offering our medical excess risk insurance product at lower prices, which may reduce our profit margins.  We have seen evidence of the excess risk insurance market firming over the past few quarters, which suggests a developing trend towards higher competitive pricing for this product line.  AVAILABILITY OF REPORTS, CERTAIN COMMITTEE CHARTERS AND OTHER INFORMATION  Our Internet website address is www.kmgamerica.com. We make available free of charge on this website, via a link to the SECs website, access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports, as well as other documents that we file with or furnish to the SEC pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such documents are filed with, or furnished to, the SEC. The information on our website is not, and shall not be deemed to be, a part of this report or incorporated into any other filings we make with the SEC.  The charters for our Audit, Compensation, and Corporate Governance and Nominating Committees, as well as our Code of Business Conduct and Ethics (which applies to all employees, officers and directors of our company) and Corporate Governance Guidelines, are available on our website at www.kmgamerica.com. We will also provide without charge printed copies of these materials, including any exhibits thereto, to any shareholder, upon request to KMG America Corporation, 12600 Whitewater Drive, Suite 150, Minnetonka, Minnesota 55343, Attention:  General Counsel. Our telephone number is (952) 930-4800.  ITEM 1A.
        RISK FACTORS.
  You should consider the following risk factors in evaluating us, our business and an investment in our securities. Any of the following risks, as well as other risks and uncertainties, could harm our business and financial results and cause the value of our securities to decline. The risks below are not the only ones facing our company. Additional risks not currently known to us or that we currently deem immaterial also may impair our business.  Risks Relating To Our Business  We rely on independent agents and brokers and on internal sales representatives to market many of our products, and an inability to attract or retain these independent agents and brokers or internal sales representatives could impair our ability to compete and market our insurance products and services.  We distribute most of our insurance products and services through a variety of distribution channels, including:  17   
        an internal sales force;
 
        independent employee benefits specialists;
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        brokers;
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        benefit consultants;
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        managing general agents;
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        life agents;
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        association groups; and
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        other third-party marketing organizations.
  We have internal sales representatives whose roles in the distribution process vary by segment. We depend in large part on our sales representatives to develop and maintain client relationships. Our inability to attract and retain effective sales representatives could materially adversely affect our business, results of operations and financial condition.  While one of the primary objectives of our business strategy is using an internal sales force to market our worksite insurance products to large employers nationwide, we intend to continue Kanawhas practice of using independent insurance agents and brokers to market worksite insurance products to small employers. Our relationships with these various distributors are significant both for our revenues and profits. An interruption in, or changes to, our relationships with various third-party distributors could impair our ability to compete and market our insurance products and services and materially adversely affect our business, results of operations and financial condition.  We depend on our key executives and sales staff. We may not be able to hire and retain key employees or successfully integrate our new management team to fully implement our business strategy, which could delay or prevent us from fully implementing our business strategy and could significantly and negatively affect our business.  Our success depends largely on our senior management. While we already employ a number of key managers, we will need to attract additional managers for many of the product lines we intend to offer in order to fully implement our business strategy. Further, we must attract and retain additional experienced underwriters, actuarial staff and risk analysis and modeling personnel in order to successfully operate and grow our businesses. The number of available, qualified personnel in the insurance and reinsurance industry available to fill these positions may be limited. Our inability to attract and retain these additional personnel or the loss of the services of any of our senior executives or key employees could delay or prevent us from fully implementing our business strategy and could significantly and negatively affect our business.  We cannot assure you that we will successfully integrate
our executive or other personnel. In addition, we may attempt to hire executives or other personnel, individually or in groups, from other companies in the insurance and reinsurance industry that may seek to retain, or prevent us from hiring, their executives and other personnel. These companies may have agreements that restrict those persons from soliciting employees of these companies and working for competitors. We cannot assure you that we will be successful in hiring any executives or other personnel who are subject to these restrictions or whose employer seeks to prevent us from hiring them or that we will not be subject to litigation or incur liabilities in connection with our hiring, or attempting to hire, such executives or other personnel.  We have employment agreements with our executive officers and certain key employees.  These agreements have terms of one to three years. Generally, either the employee or we may terminate these agreements with or without cause subject to applicable severance provisions and restrictive covenants, including non-compete and non-solicitation provisions.  The financial strength of Kanawha, our insurance subsidiary, is rated by A.M. Best and S&P, and a decline in these ratings would likely negatively affect our standing in the insurance industry, cause our sales and earnings to decrease and our results of operations and financial condition would likely be materially adversely affected.  Kanawha has an A.M. Best financial strength rating of A- (excellent), which is the second highest of ten categories and the lowest within the category based on modifiers (i.e., A and A- are excellent).   18  S&Ps current financial strength rating for Kanawha is A- (strong), with a stable outlook, which is the third highest of nine categories and the lowest within the category based on modifiers (i.e., A+, A and A- are strong).  Rating agencies review their ratings periodically and Kanawhas current ratings may not be maintained in the future. If Kanawhas ratings are reduced from their current levels by A.M. Best or S&P, or placed under surveillance or review with possible negative implications, our competitive position in the insurance industry would likely suffer and we would likely lose customers. If our financial strength ratings are reduced, our cost of borrowing would likely increase, our sales and earnings would likely decrease and our results of operations and financial condition would likely be materially adversely affected.  For example, a minimum A.M. Best rating of A- is generally required to participate in the group life and disability and excess risk insurance markets.  If Kanawhas A.M. Best rating of A- is reduced or placed under surveillance or review with possible negative implications, we likely will be precluded from participating in those markets, which are key to our growth and financial strength.  Factors that could cause the rating agencies to reduce Kanawhas ratings include:  
        a continuation of statutory losses in the future;
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        claims experience in excess of expectations;
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        decline in the share price of our common stock, which could jeopardize our ability to raise capital to fund Kanawhas financial and growth needs;
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        a continuation of current competitive environment in the insurance industry, particularly in the medical excess risk insurance markets;
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        the inherent uncertainty in determining reserves for future claims, which may cause us to increase our reserve for claims;
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        possible changes in the methodology or criteria applied by the rating agencies;
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        inability to maintain our existing sales organization or recruit additional sales representatives; and
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        our financial performance compared to other similarly rated companies.
  The methodology, criteria and judgment applied by the ratings agencies in performing their financial strength evaluations are proprietary to each ratings agency and cannot be replicated by us to predict what rating they may assign to Kanawha in the future.  Moreover, the ratings agencies may change the methodology, criteria and judgment they apply at any time, without advance notice to us.  Further, they may apply their methodology, criteria and judgment uniformly across all companies in the insurance industry or they may choose to apply different methodology, criteria and judgment to individual companies.  Accordingly, there can be no assurance that the rating agencies will maintain Kanawhas current ratings.  In addition to the financial strength ratings of our insurance subsidiary, A.M. Best also publishes an indicative credit rating, which reflects its opinion of our ability to repay our indebtedness.  The indicative credit rating may have an impact on the interest rates we pay on the money we borrow.  Therefore, a downgrade in this indicative credit rating would increase our cost of borrowing and have an adverse effect on our results of operations and financial condition.  The financial strength ratings of Kanawha, our insurance subsidiary, are not evaluations for the benefit of investors in our common stock and are not recommendations to buy, sell or hold shares of our common stock.  The financial strength ratings of Kanawha, our insurance subsidiary, reflect each rating agencys current opinion of Kanawhas financial strength, operating performance and ability to meet obligations to policyholders and contractholders. These factors are of concern to policyholders, contractholders, agents, sales intermediaries and lenders. Ratings are not evaluations for the benefit of investors in our common stock. They are not ratings of our common stock and should not be relied upon when making a decision to buy, hold or sell our shares of common stock or any other security.  We may require additional capital in the future which may not be available on favorable terms or at all. If we cannot obtain adequate capital, we may not be able to fund our growth in accordance with our business strategy.   19  We may need to raise additional funds through financings in order to fully implement our business plan. On December 21, 2006, we entered into a credit agreement with Wachovia Bank, National Association (Wachovia), which provides us with a $15,000,000 unsecured revolving credit facility from which we borrowed $14,000,000 to repay the subordinated promissory note we issued in connection with the acquisition of Kanawha.  The credit agreement restricts our ability to incur additional debt because it requires us to comply with certain covenants, including, among others, maintaining a maximum ratio of consolidated indebtedness to total capitalization of 30%, a minimum available dividend amount for Kanawha and a minimum A.M. Best financial strength rating for Kanawha.  KMG America must also comply with limitations on any additional debt obligations and restrictions on creating or
allowing certain liens on its assets. The amount and timing of our capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover our losses. In the future, we or our operating subsidiaries may enter into term or additional revolving credit facilities with one or more syndicates of lenders. However, we currently have no commitment from any lender with respect to an additional credit facility. Any equity or debt financing, if available at all, may be on terms that are not favorable to us. If we are able to raise capital through equity financings, the interest of holders of our common stock will be diluted, and the securities we issue may have rights, preferences and privileges that are senior to our common stock. If we cannot obtain adequate capital, our business, results of operations and financial condition will be adversely affected.  If we are unable to implement our business strategy or operate our business as we currently expect, our growth and profitability will be adversely affected.  KMG America was formed in 2004 to acquire Kanawha and to operate and grow Kanawhas insurance and other related businesses. We have limited name recognition or reputation in the insurance industry outside of Kanawhas historic geographic market in the southeastern United States. Our business plan is to grow Kanawhas worksite insurance marketing and distribution business into a national business targeting larger employers by hiring experienced sales personnel, marketing our products nationwide and introducing new life and health insurance products. Our ability to fully implement our business plan will be affected by market conditions, legislative and regulatory changes and other factors, many of which are beyond our control, and we cannot assure you that we will be able to successfully complete this nationwide expansion.  Businesses, such as ours, which are small and growing, present substantial business and financial risks and may suffer significant losses.  We have had to and must continue to hire and train many key employees and other staff, develop business relations, establish operating procedures, obtain additional facilities, implement new systems and complete other tasks necessary for the conduct of our intended business activities. If we are unable to implement these actions in a timely and cost-effective manner, our business, results of operations or financial condition may be adversely affected. As a result of industry factors or factors specific to us, we may have to alter our anticipated methods of conducting our business, such as the nature, amount and types of risks we assume.  We may be unable to accurately predict benefits, claims and other costs or to manage those costs through our loss limitation methods, which could result in our incurring greater claims losses than we anticipate.  Our profitability depends in large part on accurately predicting benefits, claims and other costs, including medical and dental costs, as well as the frequency and magnitude of claims on our disability and other coverages. It also depends on our ability to manage future benefit and other costs through product design, underwriting criteria, utilization review or claims management (our efforts to mitigate the extent of losses incurred by those insured under our policies and the corresponding benefit costs) and, in health and dental insurance, negotiation of favorable provider contracts.  Our ability to predict and manage costs and claims, as well as our results of operations and financial condition may be adversely affected by:  
        changes in health and dental care practices;
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        inflation;
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        new technologies;
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        the cost of prescription drugs;
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        clusters of high cost cases;
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        changes in the regulatory environment;
  20  
        economic factors;
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        inherent claims volatility in new insurance products with little actual claims history, such as our employer excess risk insurance (which we sometimes refer to as employer medical stop loss insurance);
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        the occurrence of catastrophes; and
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        numerous other factors affecting the cost of health and dental care and the frequency and severity of claims in all our business segments.
  The judicial and regulatory environments, changes in the composition of the kinds of work available in the economy, market conditions and numerous other factors may also materially adversely affect our ability to manage claim costs. As a result of one or more of these factors or other factors, claims could substantially exceed our expectations, which could have a material adverse effect on our results of operations and financial condition. We also may be limited in our ability to respond to such changes by insurance regulations, existing contract terms, contract filing requirements, market conditions or other factors.  Our actual claims losses may exceed our reserves for claims, which may require us to establish additional reserves that may materially reduce our earnings, profitability and capital.  We maintain reserves to cover our estimated ultimate exposure for claims and claim adjustment expenses with respect to reported claims as well as claims that have been incurred but not yet reported to us as of the end of each accounting period. Reserves, whether calculated under United States generally accepted accounting principles (GAAP) or statutory accounting principles (SAP) (rules and procedures prescribed or permitted by state insurance regulatory authorities which, in general, reflect a liquidity, rather than going concern, concept of accounting), do not represent an exact calculation of our exposure. Instead, they represent our best estimates, generally involving actuarial projections at a given time, of what we expect the ultimate settlement and administration of a claim or group of claims will cost based on our assessment of facts and circumstances then known. The adequacy of
reserves is impacted by future trends in claims severity, frequency, judicial theories of liability and other factors. These variables are affected by both external and internal events over which we have little or no control, such as:  
        changes in the economic cycle;
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        emerging medical perceptions regarding physiological or psychological causes of disability or the need for long-term care services;
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        emerging health issues and new methods of treatment or accommodation;
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        inflation;
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        judicial trends;
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        legislative changes;
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        inherent claims volatility in new insurance products with little actual claims history, such as our employer excess risk insurance (which we sometimes refer to as employer medical stop loss insurance); and
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        claims handling procedures.
 Many of these items are not directly quantifiable, particularly on a prospective basis. Reserve estimates are refined as experience develops.  Adjustments to reserves, both positive and negative, are reflected in the statement of operations of the period in which such estimates are updated. Because establishment of reserves is an inherently uncertain process involving estimates of future losses, we cannot assure you that our ultimate losses will not exceed existing claims reserves. Moreover, future loss development could require reserves to be increased, which could have a material adverse effect on our earnings in the periods in which such increases are made.  Policy and claim reserves were $531 million, and $548 million and $572 million as of December 31, 2004, 2005 and 2006, respectively. These reserves are reevaluated each year, and we determined to increase our policy and claim reserves by $2.2 million as of December 31, 2006 to adjust for higher than estimated claims experience on our employer group excess risk insurance policies sold during the fourth quarter of 2005 and the first, second and third quarters of 2006.  We may incur losses if there are significant deviations from our assumptions regarding the period that our existing insurance policies will remain in force.  The prices and expected future profitability of our life insurance, long-term care insurance, and group life and health insuranceare based in part upon expected patterns of premiums, expenses and benefits, using a number  21  of assumptions, including those related to persistency, which is the probability that a policy or contract will remain in force from one period to the next.  The effect of persistency on profitability varies for different products. For most of our life insurance, group life and health insurance products, actual persistency that is lower than our persistency assumptions could have an adverse impact on profitability, especially in the early years of a policy or contract, primarily because we would be required to accelerate the amortization of expenses we deferred in connection with the acquisition of the policy or contract.  For our long-term care insurance and some other health insurance policies, actual persistency that is higher than our persistency assumptions could have a negative impact on profitability. If these policies remain in force longer than we assumed, we could be required to make greater benefit payments than we anticipated when we priced these products.  Historically, as has generally been the case throughout the long-term care insurance industry, we have been adversely affected by deviations from our assumptions about how many of our long-term care insurance policies would remain in force from year to year. More policies than expected have remained in force. While this has increased premium income, it has also required higher reserves for anticipated future claims, the net effect of which has been to reduce profitability.  Because our assumptions regarding persistency experience are inherently uncertain, reserves for future policy benefits and claims may prove to be inadequate if actual persistency experience is different from those assumptions. Although some of our products permit us to increase premiums during the life of the policy or contract, we cannot guarantee that these increases will be sufficient to maintain profitability. Moreover, many of our products do not permit us to increase premiums or limit those increases during the life of the policy or contract. Significant deviations in experience from pricing expectations regarding persistency could have an adverse effect on the profitability of our products.  We are incurring increased costs not incurred by our predecessor as a result of being a public company.  As a public company, we have incurred and will incur significant legal, accounting and other expenses that neither we nor our predecessor incurred as private companies prior to our initial public offering, including costs associated with our public company reporting requirements. We are incurring costs associated with corporate governance requirements, including requirements under the Sarbanes-Oxley Act of 2002, as well as new rules implemented by the Securities and Exchange Commission and the New York Stock Exchange, because our common stock is listed on such exchange. These rules and regulations are increasing our legal and financial compliance costs and making some activities more time-consuming and costly. These rules and regulations may also make it more difficult for us to obtain director and officer liability insurance, which may make it more difficult for us to attract and retain
qualified individuals to serve on our board of directors or as executive officers.  Our future performance cannot be predicted based on the financial information included in our Form 10-K.  As a relatively newly formed company, whose insurance-related operations did not commence until December 21, 2004, KMG America has a short operating history on which you can base an estimate of our future earnings prospects. Kanawhas business is intended to be only a portion of our consolidated business in the future and our predecessors business is not representative of our primary business strategy. As a result, the historical results of our predecessor presented in our Form 10-K are not comparable with or representative of the actual results that we expect to achieve once we fully implement our business strategy and will not be helpful in helping you make investment decisions with respect to shares of our common stock.  Our services may expose us to professional liability in excess of our insurance coverage, which could cause us to incur material losses.  We may have liability to clients for errors or omissions in the services we perform. These liabilities could exceed our insurance coverage and the fees we derive from those services. We maintain general liability insurance, umbrella and professional liability insurance. The cost of maintaining these insurance policies is rising. We cannot assure you that this insurance will be sufficient to cover any liabilities we incur or that we will be able to maintain our insurance at reasonable rates or at all. If we terminate our policies and do not obtain retroactive coverage, we will be uninsured for claims made after termination even if these claims are based on events or acts that occurred during the term of the policy. In addition, we cannot assure you that we will be able to obtain insurance coverage for the new services or areas into which we expand on favorable terms or at all.  Our investment portfolio is subject to several risks that may diminish the value of our invested assets and affect our sales and profitability.   22


See Investments of Item 1. Business of this Report, incorporated herein by reference, for a discussion of the risk associated with our investment portfolio.  We may incur environmental liability as a result of our mortgage loan portfolio and real estate investments or as a result of our ownership of real property.  See Environmental Compliance of Item  1. Business of this Report, incorporated herein by reference, for a discussion of the risk associated with our environmental liability.  The indemnification available to us under the Kanawha purchase agreement may not be sufficient to cover all our losses, claims or liabilities arising from breaches of the purchase agreement.  The former shareholders and optionholders of Kanawha have agreed to indemnify us for losses we incur as a result of breaches of the representations, warranties and covenants made by the former Kanawha shareholders and optionholders in the purchase agreement pursuant to which we acquired all of the stock of Kanawha. However, there are significant limitations on this indemnification. For example, (1) some losses are not indemnifiable after they exceed indemnification limits, and (2) our right to indemnification for most losses, claims or liabilities arising from breaches of the purchase agreement expires between June 21, 2006 and December 21, 2008. We cannot assure you that the indemnification available to us under the purchase agreement is sufficient to cover all losses, claims or liabilities arising from potential breaches of the representations, warranties and covenants made by
the former Kanawha shareholders and optionholders in the purchase agreement.  A failure to effectively maintain and modernize our information systems could cause us to experience adverse consequences, including: inadequate information on which to base pricing, underwriting and reserving decisions; the loss of existing, or difficulties in attracting new, agents, brokers and customers; litigation exposure; or increases in administrative expenses, all of which could adversely affect our business.  Our business depends upon our ability to remain current with technological advances. This is particularly important in our third party administration business, where our systems, including our ability to keep our systems fully integrated with those of our clients, are critical to the operation of our business. Our failure to update our systems to reflect technological advancements or to protect our systems may adversely affect our relationships and ability to do business with our clients.  In addition, our business depends significantly on effective information systems. We will have to commit significant resources to maintain and enhance our existing information systems and develop new information systems to keep pace with continuing changes in information processing technology, evolving industry and regulatory standards and changing customer preferences. If we pursue acquisitions, we may acquire additional information systems. Our failure to maintain effective and efficient information systems, or our failure to efficiently and effectively consolidate our information systems to eliminate redundant or obsolete applications, could have a material adverse effect on our results of operations and financial condition. If we do not maintain adequate systems we could experience adverse consequences, including:  
        inadequate information on which to base pricing, underwriting and reserving decisions;
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        the loss of existing agents, brokers and customers;
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        difficulty in attracting new agents, brokers and customers;
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        customer, provider and agent disputes;
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        regulatory problems, such as failure to meet prompt payment obligations;
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        litigation exposure; or
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        increases in administrative expenses.
  In 2003, a subsidiary of Kanawha entered into an agreement to outsource a substantial portion of its information technology and document management functions to CGI Information Systems & Management Consultants, Inc. (CGI Group). The term of this agreement is 10 years, and it may be terminated by Kanawhas subsidiary without cause starting in November 2006 upon six months notice and at any time upon 30 days notice for cause that remains uncured. We paid $5.0 million in 2004, $6.8 million in 2005 and $7.5 million in 2006 to maintain and modernize our information systems, including payments under our agreement with CGI Group. In  23  2007, we expect to pay over $7.7 million for the same purposes.  These cost estimates, as well as future cost estimates, may underestimate the costs necessary to maintain and modernize our information systems, and the fees we pay to CGI Group may exceed the costs we would have incurred had we not outsourced certain functions to CGI Group.  As a public company, we are subject to extensive financial and reporting requirements that apply to public companies. Our management information, internal control and financial reporting systems have required and may require further enhancements and development to satisfy the financial and other reporting requirements that we must comply with as a public company.  Failure to protect our clients confidential information and privacy could result in the loss of customers, reduce our profitability and/or subject us to fines and penalties.  A number of our businesses are subject to privacy regulations and to confidentiality obligations. For example, the collection and use of patient data in our third-party administration business is the subject of national and state legislation, including the Health Insurance Portability and Accountability Act, or HIPAA, and some of our activities are subject to the privacy regulations of the Gramm-Leach-Bliley Act. We also have contractual obligations to protect certain confidential information that we obtain from our existing vendors and clients, generally in the same manner and to the same extent as we protect our own confidential information.  We developed, implemented and are maintaining a comprehensive written information security program with appropriate administrative, technical and physical safeguards to protect such confidential information. If we do not properly comply with privacy and security regulations and protect confidential information, we could experience adverse consequences, including regulatory problems, loss of reputation and client litigation.  We may be required to accelerate the amortization of deferred acquisition costs and value of business acquired, which would increase our expenses and reduce our profitability.  Deferred acquisition costs, or DAC, represent costs which vary with and are primarily related to the sale and issuance of our insurance policies and investment contracts that are deferred and amortized over the estimated life of the related insurance policies. These costs include commissions in excess of ultimate renewal commissions, direct mail and printing costs, sales material and some support costs, such as underwriting and policy and contract issuance expenses. Under GAAP, DAC is deferred and recognized over the expected life of the policy or contract in relation to either the premiums or gross profits from the underlying contracts. In addition, when we acquire a block of insurance policies or investment contracts, we assign a portion of the purchase price to the right to receive future net cash flows from existing insurance and investment contracts and policies. This intangible asset,
called value of business acquired, or VOBA, represents the actuarially estimated present value of future cash flows from the acquired policies. We amortize the value of this intangible asset in a manner similar to the amortization of DAC. Our amortization of DAC and VOBA generally depends upon anticipated profits from investments, surrender and other policy and contract charges and mortality and maintenance expense margins. Unfavorable experience with regard to expected expenses, investment returns, mortality, morbidity or withdrawals or lapses may cause us to accelerate the amortization of DAC or VOBA, or both, or to record a charge to increase benefit reserves.  We review DAC and VOBA on a reported business segment level at least annually to determine if they are recoverable from future income. If we determine that these costs are not recoverable, they are charged to expenses in the financial period in which we make this determination. For example, if we determine that we are unable to recover DAC from future cash flows over the life of a segment of insurance products aggregated and reported at the business segment level due to adverse deviation in factors such as earned interest, persistency or claim costs, we have to realize the additional DAC amortization as a current-period expense.  We may not find suitable acquisition candidates or new insurance ventures, and even if we do, we may not successfully integrate any acquired companies or successfully invest in new ventures, which may limit our potential for growth or have a material adverse effect on our results of operations and financial condition.  While our primary focus is organic growth of our existing businesses by expanding our product and marketing capabilities, we evaluate opportunities to grow through strategic alliances and acquisitions of blocks of business and/or companies that are compatible with our core businesses. Accordingly, we intend to evaluate from time to time possible acquisition transactions and the start-up of complementary businesses, and at any given time,  24  we may be engaged in discussions with respect to possible acquisitions and new ventures. While our business model is not dependent upon acquisitions or new insurance ventures, the time frame for achieving or further improving upon our desired market positions can be significantly shortened through opportune acquisitions or new insurance ventures. We cannot assure you that we will be able to identify suitable acquisition transactions or insurance ventures, that such transactions will be financed and completed on acceptable terms or that our future acquisitions or ventures will be successful. The process of integrating any companies we do acquire or investing in new ventures could have a material adverse effect on our results of operations and financial condition.  In addition, implementation of an acquisition strategy may entail a number of risks, including among other things:  
        inaccurate assessment of liabilities;
 
        difficulties in realizing projected efficiencies, synergies and cost savings;
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        failure to achieve anticipated revenues, earnings or cash flow; and
 
        an increase in our indebtedness and limitations upon our ability to access additional capital when needed.
  Our failure to adequately address these acquisition risks could materially adversely affect our results of operations and financial condition.  The inability of Kanawha to pay dividends to us in sufficient amounts could harm our ability to meet our obligations and pay shareholder dividends.  See Dividends of Item 5.  Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities of this report, incorporated herein by reference, for a discussion of the risk associated with the inability of Kanawha to pay dividends to us.  We may face losses if morbidity rates or mortality rates differ significantly from our pricing expectations.  We set prices for our insurance products based upon expected claims and payment patterns, using assumptions for morbidity rates and mortality rates of our policyholders and contractholders. The long-term profitability of these products depends upon how our actual experience compares with our pricing assumptions. For example, if morbidity rates are higher, or mortality rates are lower, than our pricing assumptions, we could be required to make greater payments under long-term care insurance policies than we had projected. Similarly, if mortality rates are higher than our pricing assumptions, we could be required to make greater payments under our life insurance policies with guaranteed death benefits than we had projected.  Our and our predecessors experience with our paycheck protector disability income plan is one example of a product that failed to meet our and our predecessors pricing assumptions with regard to morbidity or mortality rates in the past. The paycheck protector disability income plan provides insured individuals with a percentage of their income in the event they become disabled. The policies provide supplemental coverage in addition to all other disability benefits and coverages, and their terms are tailored for different occupations. Our and our predecessors cumulative claims experience for this product has been 97% higher than expected. This is due primarily to higher than expected claims due to higher than expected morbidity and mortality rates in one large group of policies issued to employees of a single employer. This groups experience has produced claims
approximately 185% higher than expected.  The risks of a deviation of the actual morbidity and mortality rates from the expected rates are particularly significant for our long-term care insurance products. Long-term care insurance policies provide for long-duration coverage and, therefore, our actual claims experience will emerge over many years after pricing assumptions have been established. Moreover, as a relatively new product in the market, long-term care insurance does not have the extensive claims experience history of life insurance, and as a result, our ability to forecast future claim rates for long-term care insurance is more limited than for life insurance.  Consistent with other carriers offering long-term care insurance in the life and health insurance industry, our and our predecessors claims in certain states have exceeded those anticipated when the long-term care products were developed. Most significantly, our and our predecessors cumulative claims experience for long-term care  25  products in the state of Florida has been 16% higher than expected which is an improvement from 2005 which was 22% higher than expected.  Our ability to retain existing long-term care insurance policyholders may be adversely affected if we raise premiums on our in force long-term care insurance products.  Although the terms of many of our long-term care insurance policies permit us to increase premiums during the premium-paying period, any implementation of a premium increase could have an adverse effect on our ability to retain existing policyholders.  Conversely, failure to obtain regulatory approval to increase rates could have an adverse effect on our profitability.  Risks Relating To Our Industry  Recent governmental investigations and litigation alleging the illegal use of bid-rigging schemes and contingent commissions by insurance companies and brokers may adversely affect our industry and us (1)by negatively impacting the level and volatility of stock prices of companies operating in the insurance industry, (2) if we become the subject of investigations or related litigation of this type, or (3)if industry regulation, practices and customs change in ways that are detrimental to the success of our business strategy.  Within the last three years, the New York State Attorney General and other state agencies have filed lawsuits accusing several large insurance brokers of fraudulent behavior, including alleged participation in bid-rigging schemes and acceptance of improper payments from insurers in exchange for agreeing not to shop for competitive quotes for customers of the insurers. The New York State Attorney Generals office and other state regulatory agencies have and are investigating a number of property and casualty and health and life insurers for alleged participation in these schemes, as well as arrangements whereby a particular insurer pays an insurance broker additional or contingent commissions for placing a particular volume of insurance or insurance which leads to a certain level of insurer profitability. This lawsuit and these investigations have resulted in negative publicity and
increased price volatility for securities of insurance companies.  While we have not been subpoenaed or named in a lawsuit, we cannot assure you that we will not become involved in an investigation or be named as a defendant in an enforcement action or lawsuit.  One possible result of these investigations and attendant lawsuits is that many insurance industry practices and customs may change, including, but not limited to, the manner in which insurance is marketed and distributed through independent brokers and agents. Our business strategy requires us to rely heavily on both independent brokers and agents and our internal sales force to market and distribute insurance products. We cannot predict how industry regulation, customs and practices with respect to the use of brokers and agents may change. Such changes, however, could adversely affect our ability to implement our business strategy, which could materially affect our growth and profitability.  Consolidation in the insurance and reinsurance industry could lead to lower margins for us and less demand for our products and services.  The insurance and reinsurance industry is undergoing a process of consolidation as industry participants seek to enhance their product and geographic reach, client base, operating efficiency and market share through merger and acquisition activities. The larger entities resulting from these merger and acquisition activities may seek to use the benefits of consolidation to, among other things, implement price reductions for their products and services. If competitive pressures compel us to reduce our prices, our operating margins will decrease.  As the insurance industry consolidates, competition for customers may become more intense and the importance of obtaining and properly servicing each customer will become greater. We could incur greater expenses in connection with obtaining and retaining customers, which could reduce our operating margins and profitability.  Our business, results of operations and financial condition may be adversely affected by many factors beyond our control, including factors affecting the insurance and reinsurance industry as a whole and general economic, financial market and political conditions, all of which may cause the market price of our common stock to decline.   26  The results of operations of companies in the insurance and reinsurance industry historically have been subject to significant fluctuations and uncertainties. Our profitability may be affected significantly by the following:  
        Differences between actual and expected losses that we cannot reasonably anticipate using historical loss data and other identifiable factors at the time we price our products.
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        Volatile and unpredictable developments, including man-made, weather-related and other natural catastrophes or terrorist attacks, or large court awards for particular damages resulting from claims against us.
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        Changes in the level of reinsurance capacity. For example, in the aftermath of the September 11, 2001, terrorist attacks, the reinsurance markets for many products have been restricted, and Kanawha has experienced increased costs related to catastrophe reinsurance and some other annually renewable reinsurance.
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        Changes in the amount of our loss reserves (which are the liabilities we will establish to reflect the estimated cost of claims payments and related expenses that we will ultimately be required to pay in respect of insurance we write) resulting from new types of claims and new or changing judicial interpretations relating to the scope of insurers liabilities.
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        Fluctuations in equity markets, interest rates, credit risk and foreign currency exposure, inflationary pressures and other changes in the investment environment, which affect returns on invested assets and may impact the ultimate payout of losses. For example, the investment environment of the past several years adversely affected our predecessors investment portfolio, which had significant credit losses in 2001 and 2002 and rates of return on its bond portfolio lower than its original expectations.
  In addition, the demand for the types of insurance we offer can vary significantly, rising as the overall level of economic activity increases and falling as that activity decreases, which will cause our revenues to fluctuate. These fluctuations in results of operations and revenues may cause the price of our common stock to decline and to be volatile.  Our results of operations and financial condition may be materially adversely affected from time to time by general economic, financial market and political conditions. These conditions include:  
        Levels of employment. As unemployment increases, employers have fewer employees requiring insurance.
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        Levels of consumer lending. As consumer lending decreases, individuals have less disposable cash and may choose not to purchase our insurance products, may terminate existing policies or permit them to lapse or may choose to reduce the amount of coverage purchased.
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        Levels of inflation. We are exposed to inflation risk because we invest substantial funds in nominal assets, which are not indexed to the level of inflation, but the underlying liabilities are indexed to the level of inflation. Life insurance policies with reserves of approximately $6.5 million as of December 31, 2006 (representing 1.2 % of our total reserves), have death benefits that are guaranteed to grow based on inflation-linked indices. In times of rapidly rising inflation, the growth in amount of credited death benefit on these liabilities increases relative to the investment income earned on the nominal assets, resulting in an adverse impact on earnings. In addition, we are exposed to inflation risk with respect to some major medical insurance policies to the extent that medical costs increase with inflation at a greater pace than our ability to increase
premiums. Inflation may also effect the adequacy of our reserves, making them inadequate and requiring us to increase our reserves.
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        Insurance industry cycles. The life and health industry is occasionally affected by moderate pricing cycles, and in these periods it may become difficult to underwrite policies at premium levels that are profitable.
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        Movements of the financial markets. Unpredictable movements and volatility in the financial markets may diminish the value of, and returns on, our portfolio of investment assets.
  Fluctuations in interest rates, monetary policy, demographics, and legislative and competitive factors may also influence our performance. During periods of economic downturn:  
        individuals and businesses may choose not to purchase our insurance products and other related products and services, may terminate existing policies or contracts or permit them to lapse or may choose to reduce the amount of coverage purchased;
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        businesses may have fewer employees requiring insurance coverage due to rising unemployment levels;
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        new disability insurance claims and claims on other specialized insurance products tend to rise;
  27  
        insureds tend to increase their utilization of health and dental benefits if they anticipate becoming unemployed or losing benefits.
  The insurance and related businesses in which we operate may be subject to periodic negative publicity, which may negatively impact our financial condition and operating results.  Due to the nature of the market for the insurance and related products and services we provide, we interact with and distribute our products and services ultimately to individual consumers. There may be a perception that these purchasers are unsophisticated and need consumer protection. Accordingly, from time to time, consumer advocate groups or the media may focus attention on our products and services and subject our industry to negative publicity. We may also be negatively impacted if another company in our industry engages in practices resulting in increased public attention to our businesses. Negative publicity may also result in increased regulation and legislative scrutiny of industry practices as well as increased litigation, which may further increase our costs of doing business and adversely affect our profitability by impeding our ability to market our products and services,
requiring us to change our products or services or increasing the regulatory burdens under which we will operate.  Catastrophe losses, including man-made catastrophe losses, could cause unanticipated increases in claims frequency and severity, which could materially reduce our profitability and have a material adverse effect on our results of operations and financial condition.  Our insurance operations expose us to claims arising out of catastrophes. In the future, we may experience catastrophe losses that may materially reduce our profitability or have a material adverse effect on our results of operations and financial condition. Catastrophes can be caused by various natural events, including hurricanes, disease, earthquakes, fires and epidemics, or can be man-made catastrophes, including terrorist attacks or accidents such as airplane crashes. The frequency and severity of catastrophes are inherently unpredictable, and catastrophe losses can vary widely. It is possible that both the frequency and severity of man-made catastrophes will increase and that we will not be able to implement exclusions from coverage in our policies or obtain reinsurance for losses from catastrophes. The extent of losses from a catastrophe is a function of both the total amount of
insured exposure in the area affected by the event and the severity of the event.  Claims resulting from natural or man-made catastrophes could cause substantial volatility in our financial results for any fiscal quarter or year and could materially reduce our profitability or harm our financial condition. Our ability to write new business also could be affected. Increases in healthcare costs and the geographic concentration of our insureds and the effects of inflation could increase the severity of claims from catastrophes in the future.  Our voluntary life and health insurance operations could be materially impacted by catastrophes such as terrorist attacks or by an epidemic that causes a widespread increase in mortality, morbidity or disability rates or that causes an increase in the need for medical care. The mortality rate refers to the relationship of the frequency of deaths of individual members of a group to the entire group membership over a specified period of time. The morbidity rate refers to the relationship of the incidence of disease or disability contracted by individual members of a group to the entire group membership over a specified period of time. Losses due to catastrophes could have a material adverse effect on our results of operations and financial condition.  Our ability to manage these risks depends in part on our successful utilization of catastrophic life reinsurance to limit the size of life insurance losses from a single event or multiple events, and life and disability reinsurance to limit the size of life or disability insurance exposure on an individual insured life. It also depends in part on state regulations that may prohibit us from excluding such risks or from withdrawing from or increasing premium rates in catastrophe-prone areas. Catastrophe reinsurance may not be available at commercially acceptable rates in the future. This means that the occurrence of a catastrophe could materially reduce our profitability and have a material adverse effect on our results of operations and financial condition.   28


Reinsurance arrangements and any derivative instruments we use to hedge our business risks may not be available or adequate to protect us against our business risks, and we will be subject to the risk that the counterparties to our reinsurance arrangements and derivative instruments may default on their obligations, all of which could adversely affect our business, results of operations and financial condition.  As part of our overall risk and capacity management strategy, we purchase reinsurance for some risks underwritten by our various business segments. Market conditions beyond our control will determine the availability and cost of the reinsurance protection we purchase. For example, after the terrorist assaults of September 11, 2001, reinsurance for man-made catastrophes became generally unavailable due to capacity constraints and, to the limited extent available, much more expensive. The high cost of reinsurance or lack of affordable coverage could adversely affect our results of operations and financial condition. If we fail to obtain sufficient reinsurance, it could adversely affect our ability to write future business.  As part of our business, we reinsure some life and health risks with reinsurers. Although these reinsurers are liable to us to the extent of the ceded reinsurance (the portion of an insurance policy liability that has been reinsured), we remain liable as the direct insurer on all risks reinsured. As a result, ceded reinsurance arrangements do not eliminate our obligation to pay claims. We are subject to credit risk with respect to our ability to recover amounts due from reinsurers. Our reinsurers may not pay the reinsurance recoverables that they owe to us or they may not pay such recoverables on a timely basis. A reinsurers insolvency, underwriting results or investment returns may affect its ability to fulfill reinsurance obligations.  Our reinsurance facilities generally are subject to annual renewal with respect to new insurance policies written. Reinsurance for policies previously reinsured generally remains in effect even if the reinsurance carrier elects not to reinsure new insurance policies. We may not be able to maintain our current reinsurance facilities and, even where highly desirable or necessary, we may not be able to obtain other reinsurance facilities in adequate amounts or at favorable rates. If we are unable to renew our expiring facilities or to obtain new reinsurance facilities, either our net exposures would increase or, if we are unwilling to bear an increase in net exposures, we may have to reduce the level of our underwriting commitments. Either of these potential developments could materially adversely affect our results of operations and financial condition.  In addition, Kanawha has sold businesses through reinsurance ceded to third parties. For example, in December 2003, Kanawha ceded all of its in force deferred annuity products through 100% coinsurance contracts, which are arrangements in which the coverage ceded to the reinsurer on an individual policy is in the same form as that of the direct policy issued to the policyholder, to Madison National Life Insurance Company. However, we would be responsible for administering this business in the event of a default by the reinsurer. We may not have the administrative systems and capabilities to process this business. Accordingly, we may need to obtain those capabilities in the event of an insolvency of one or more of the reinsurers of these businesses. We might be forced to obtain such capabilities on unfavorable terms, with a resulting material adverse effect on our results of operations
and financial condition.  While we do not currently use derivative instruments to hedge business risks, we may use derivative instruments in the future to hedge various business risks. We may enter into a variety of derivative instruments, including options, forwards, interest rate and currency swaps and options to enter into interest rate and currency swaps with a number of counterparties. If our counterparties fail to honor their obligations under the derivative instruments, our hedges of the related risk will be ineffective. That failure could have an adverse effect on our financial condition and results of operations.  We face significant competitive pressures in our businesses, which may reduce premium rates and prevent us from pricing our products at rates that enable us to earn a profit.  In each of our lines of business, we compete with other insurance companies or service providers, depending on the line and product. Competitors include insurance companies and financial institutions. Our main competitors include life and health insurance companies and the Blue Cross & Blue Shield affiliates in the states in which we write business. Commercial competitors include benefits and life insurance companies as well as not-for-profit dental plans. We are among the smallest competitors in terms of national market share in our business lines and in some cases there are one or more major market players in a particular line of business.   29  Competition in the businesses we pursue is based on many factors, including quality of service, product features, price, scope of distribution, scale, financial strength ratings and name recognition. We compete for customers and distributors with many insurance companies and other financial services companies. We compete not only for business and individual customers, employer and other group customers, but also for agents and distribution relationships. Some of our competitors may offer a broader array of products than we do, may have a greater diversity of distribution resources, may have better brand recognition, may from time to time have more competitive pricing, may have lower cost structures or, with respect to insurers, may have higher financial strength or claims paying ratings. Some may also have greater financial resources with which to compete. Also, as a result of the
Gramm-Leach-Bliley Act, which was enacted in November 1999, financial institutions are now able to affiliate with other insurance companies to offer services similar to our own. This has resulted in new competitors with significant financial resources entering some of our target markets. Moreover, some of our competitors may have a lower target for returns on capital allocated to their business than we do, which may lead them to price their products and services lower than we do. In addition, from time to time, companies enter and exit the markets in which we operate, which increases competition at times when there are new entrants. For example, several large insurance companies have recently entered the market for individual health insurance products. We may lose business to competitors offering competitive products at lower prices or for other reasons, which could materially adversely affect our results of operations and financial condition.  In some markets, we compete with organizations that have substantial market share. In addition, organizations with sizable market share or provider-owned plans may be able to obtain favorable financial arrangements from health care providers that are not available to us. Without our own similar arrangements, we may not be able to compete effectively in such markets.  New competition could also cause the supply of insurance to change, which could affect our ability to price our products at attractive rates and adversely affect our underwriting results. Although there are some impediments facing potential competitors who wish to enter the markets we serve, new competitors may still enter our target markets, affording our customers significant flexibility in moving to other insurance providers.  Our business is subject to risks related to litigation and regulatory actions that could have a material adverse effect on our business, results of operations and financial condition.  In addition to the occasional employment-related litigation to which all businesses are subject, we are a defendant in actions arising out of insurance and other related business operations. In addition, we are involved in various regulatory investigations and examinations relating to our operations. We may from time to time be subject to a variety of legal and regulatory actions relating to current and past business operations, including, but not limited to:  
        disputes over coverage or claims adjudication;
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        disputes regarding sales practices, disclosures, premium refunds, licensing, regulatory compliance and compensation arrangements;
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        disputes with our agents, producers or network providers over compensation and termination of contracts and related claims;
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        disputes relating to premiums charged or changes to premiums charged;
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        disputes concerning past premiums charged by companies acquired by us for coverage that may have been based on factors such as race;
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        disputes with customers regarding the ratio of premiums to benefits in our various business segments;
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        disputes with taxing authorities regarding our tax liabilities; and
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        disputes relating to some businesses acquired or disposed of by us.
  In addition, plaintiffs continue to bring new types of legal claims against insurance and related companies. Current and future court decisions and legislative activity may increase our exposure to these types of claims. Multiparty or class action claims may present additional exposure to substantial economic, non-economic or punitive damage awards. The loss of even one of these claims, if it resulted in a significant damage award or a judicial ruling that was otherwise detrimental, could have a material adverse effect on our results of operations and financial condition. This risk of potential liability may make reasonable settlements of claims more difficult to obtain. We cannot determine with any certainty what new theories of recovery may evolve or what their impact may be on our businesses.  30   We are subject to extensive governmental regulation, which increases our costs and could restrict how we conduct our business.  Our operating subsidiaries are subject to extensive regulation and supervision in the jurisdictions in which they do business. This regulation is generally designed to protect the interests of policyholders, as opposed to shareholders and other investors. To that end, the laws of the various states establish insurance departments with broad powers with respect to such matters as:  
        licensing companies to transact business;
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        authorizing lines of business;
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        mandating capital and surplus requirements;
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        imposing dividend limitations;
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        regulating changes in control;
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        licensing agents and distributors of insurance products;
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        placing limitations on the minimum and maximum size of life insurance contracts;
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        restricting companies ability to enter and exit markets;
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        admitting statutory assets (which are assets determined in accordance with statutory accounting principles);
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        mandating some insurance benefits;
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        restricting companies ability to terminate or cancel coverage;
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        requiring companies to provide various types of coverage;
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        regulating premium rates, including the ability to increase premium rates;
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        approving policy forms;
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        regulating trade and claims practices;
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        imposing privacy and security requirements;
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        establishing reserve requirements and solvency standards;
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        restricting certain transactions between affiliates;
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        regulating the type, amounts and valuation of investments;
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        mandating assessments or other surcharges for guaranty funds (which are state mandated funds funded by contributions from insurance companies operating in a particular state and maintained to cover the obligations to policyholders of insolvent insurance companies);
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        regulating market conduct and sales practices of insurers and agents; and
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        restricting contact with consumers, such as the national do not call list, and imposing consumer protection measures.
  Some jurisdictions require us to provide coverage to persons who would not otherwise be considered eligible by insurers. Each of these jurisdictions dictates the types of insurance and the level of coverage that must be provided to such involuntary risks. Our share of these involuntary risks is mandatory and generally a function of our respective share of the voluntary market by line of insurance in each jurisdiction. We are exposed to risk of losses in connection with mandated participation in such schemes in those jurisdictions in which they are effective. In addition, HIPAA requires us to comply with insurance reform provisions as well as requirements relating to the privacy of individuals. HIPAA guarantees the issuance and renewability of certain health insurance coverage for individuals and small groups (generally 50 or fewer employees) and limits exclusions based on pre-existing
conditions. Most of the insurance reform provisions of HIPAA became effective for plan years beginning July 1, 1997.  If regulatory requirements impede our ability to raise premium rates, utilize new policy forms or terminate, deny or cancel coverage in any of our businesses, our results of operations and financial condition could be materially adversely affected. The capacity for an insurance companys growth in premiums is in part a function of its statutory surplus. Maintaining appropriate levels of statutory surplus, as measured by statutory accounting principles, is considered important by insurance regulatory authorities and the private agencies that rate insurers claims-paying abilities and financial strength. Failure to maintain specified levels of statutory surplus could result in increased regulatory scrutiny and enforcement, action by regulatory authorities or a downgrade by rating agencies.  We may be unable to obtain or maintain all required licenses and approvals, and our business may not fully comply with the wide variety of applicable laws and regulations or the relevant authoritys interpretation of the laws  31  and regulations. Some regulatory authorities have relatively broad discretion to grant, renew or revoke licenses and approvals. If we do not have the requisite licenses and approvals or do not comply with applicable regulatory requirements, the insurance regulatory authorities could prohibit or temporarily suspend us from carrying on some or all of our activities or impose a monetary penalty on us. That type of action could materially adversely affect our results of operations and financial condition.  Changes in regulation may reduce our profitability and limit our growth.  Legislation or other regulatory reforms that increase the regulatory requirements imposed on us or that change the way we are able to do business may significantly harm our business, results of operations or financial condition. For example, some states, including the states in which we currently do most of our business and most of the states in which we intend to do business in the future, have imposed new time limits for the payment of uncontested covered claims and require health care and dental service plans to pay interest on uncontested claims not paid promptly within the required time period. Some of these states have also granted their insurance regulatory agencies additional authority to impose monetary penalties and other sanctions on health and dental plans engaging in certain unfair payment practices.  If we were unable for any reason to comply with these
requirements, it could result in substantial costs to us and may materially adversely affect our business, results of operations and financial condition.  Legislative or regulatory changes that could significantly harm us and our subsidiaries include, but are not limited to:  
        legislation that holds insurance companies or managed care companies liable for adverse consequences of medical or dental decisions;
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        limitations on premium levels or the ability to raise premiums on existing policies;
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        increases in minimum capital, reserves and other financial viability requirements;
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        imposition of fines, taxes or other penalties for improper licensing, the failure to promptly pay claims, however defined, or other regulatory violations;
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        increased licensing requirements;
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        prohibitions or limitations on provider financial incentives and provider risk-sharing arrangements;
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        imposition of more stringent standards of review of our coverage determinations;
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        new benefit mandates;
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        increased regulation relating to the use of associations and trusts in the sale of individual health insurance;
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        limitations on our ability to build appropriate provider networks and, as a result, manage health care and utilization due to any willing provider legislation, which requires us to take any provider willing to accept our reimbursement;
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        limitations on the ability to manage health care and utilization due to direct access laws that allow insureds to seek services directly from specialty medical providers without referral by a primary care provider; and
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        restriction on solicitation of pre-funded funeral insurance consumers by funeral board laws.
  Potential Changes in State Regulations  State legislatures regularly enact laws that alter and, in many cases, increase state authority to regulate insurance companies and insurance holding companies. Further, state insurance regulators regularly reinterpret existing laws and regulations, and the National Association of Insurance Commissioners, or NAIC, regularly undertakes regulatory projects, all of which can affect our operations. In recent years, the state insurance regulatory framework has come under increased federal scrutiny and some state legislatures have considered or enacted laws that may alter or increase state authority to regulate insurance companies and insurance holding companies. Further, the NAIC and state insurance regulators are re-examining existing laws and regulations, specifically focusing on modifications to holding company regulations, interpretations of existing laws and the development of new laws.  Potential Changes in Federal Regulations  Although the United States federal government does not directly regulate the insurance business, changes in federal legislation and administrative policies in several areas, including changes in the Gramm-Leach-Bliley Act, financial services regulation and federal taxation, could significantly harm the insurance industry and us. Federal legislation and administrative policies in areas such as employee benefit plan regulation, financial services  32  regulation and federal taxation can reduce our profitability. In addition, state legislatures and the United States Congress continue to focus on health care issues. There are many aspects of employee benefits plans that state laws may not regulate because the federal Employee Retirement Income Security Act, or ERISA, and the rules and regulations thereunder, in many instances prohibit or preempt any state laws governing employee benefit plans that would conflict with the provisions of ERISA. There have been recent legislative attempts to limit ERISAs preemptive effect on state laws and, in addition, courts have read the rules promulgated under ERISA to preempt state laws less broadly in recent years than they did in the past. For example, the United States Congress has, from time to time, considered legislation relating to changes in ERISA to permit application of state law remedies, such as
consequential and punitive damages, in lawsuits for wrongful denial of benefits, which, if adopted, could increase our liability for damages in future litigation. Additionally, new interpretations of existing laws and the passage of new legislation may harm our ability to sell new policies and increase our claims exposure on policies we issued previously.  A number of legislative proposals have been made at the federal level over the past several years that could impose added burdens on us. These proposals would, among other things, mandate benefits with respect to certain diseases or medical procedures, require plans to offer an independent external review of certain coverage decisions and establish a national health insurance program. Any of these proposals, if implemented, could adversely affect our results of operations or financial condition. Federal changes in Medicare and Medicaid that reduce provider reimbursements could have negative implications for the private sector due to cost shifting. When the government reduces reimbursement rates for Medicare and Medicaid, providers often try to recover shortfalls by raising the prices charged to privately insured customers. State small employer group and individual health insurance market
reforms to increase access and affordability for consumers could also reduce our profitability by precluding us from appropriately pricing for risk in our individual and small employer group health insurance policies.  In addition, the United States Congress and some federal agencies from time to time investigate the current condition of insurance regulation in the United States to determine whether to impose federal regulation or to allow an optional federal incorporation, similar to banks. Bills have been introduced in the United States Congress from time to time that would provide for a federal scheme of chartering insurance companies or an optional federal charter for insurance companies. Meanwhile, the federal government has granted charters in years past to insurance-like organizations that are not subject to state insurance regulations, such as risk retention groups. It is difficult to predict the likelihood of a federal chartering scheme and its impact on the industry or on us.  We cannot predict with certainty the effect any proposed or future legislation, regulations or NAIC initiatives may have on how we will conduct our business. In addition, the insurance laws or regulations adopted or amended from time to time may be more restrictive or may result in materially higher costs than current requirements.  The continued threat of terrorism, the occurrence of terrorist acts and ongoing military actions could adversely affect our business, results of operations and financial condition.  The continued threat of terrorism and ongoing military actions, as well as heightened security measures in response to these threats and actions, may cause significant volatility in global financial markets, disruptions to commerce and reduced economic activity. These consequences could have an adverse effect on the value of the assets in our investment portfolio. We cannot predict whether, or the extent to which, companies in which we invest may suffer losses as a result of financial, commercial or economic disruptions, or how any such disruptions might affect the ability of those companies to pay interest or principal on their securities. The continued threat of terrorism also could result in increased reinsurance prices and potentially cause us to retain more risk than we otherwise would retain if we were able to obtain reinsurance at lower prices. In addition, the occurrence of terrorist
actions could result in higher claims under our insurance policies than we anticipate.  Genetic mapping research and other medical advances could adversely affect the financial performance of our life insurance and long-term care insurance businesses.  Genetic mapping research includes procedures focused on identifying key genes that render an individual predisposed to specific diseases, such as cancer or Alzheimers disease. Other medical advances, such as diagnostic imaging technologies, also may be used to detect the early onset of diseases such as cancer and heart disease. We believe that if individuals learn through genetic testing or other medical advances that they are predisposed to particular conditions that may reduce life longevity or require long-term care, they will be more likely to purchase  33  our life insurance policies or not permit existing life and long-term care polices to lapse. In contrast, if individuals learn that they are genetically unlikely to develop the conditions that reduce longevity or require long-term care, they will be less likely to purchase our life insurance products. In addition, such individuals that are existing policyholders will be more likely to permit their life and long-term care policies to lapse.  If we had access to the same genetic or other medical information as our prospective policyholders and contractholders, then we would be able to take this information into account in pricing our life and long-term care insurance policies. However, there are a number of regulatory proposals that would make genetic and other medical information confidential and unavailable to insurance companies. Legislators in some states have recently introduced similar legislation. If these regulatory proposals were enacted, prospective policyholders and contractholders would only disclose this information if they chose to do so voluntarily. These factors could lead us to reduce sales of products affected by these regulatory proposals and could result in a deterioration of the risk profile of our portfolio, which could lead to payments to our policyholders and contractholders that are higher than we anticipated.  Risks Relating To Our Common Stock  Future offerings of debt securities, which would be senior to our common stock upon liquidation, and future offerings of equity securities, which would dilute our existing shareholders and may be senior to our common stock for the purposes of dividend distributions, may adversely affect the market price of our common stock.  In the future, we may attempt to increase our capital resources by offering debt securities or offering additional equity securities, including commercial paper, medium-term notes, senior or subordinated notes and series of preferred stock or common stock. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to our other borrowings will receive a distribution of our available assets prior to the holders of our common stock. Additional equity offerings may dilute the holdings of our existing shareholders or reduce the market price of our common stock, or both. Our preferred stock, if issued, could have a preference on liquidating distributions or a preference on dividend payments that could limit our ability to make a dividend distribution to the holders of our common stock. Because our decision to issue securities in any future offering will
depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Holders of our common stock bear the risk of our future offerings reducing the market price of our common stock and diluting their stock holdings in us.  We do not currently intend to pay dividends and any determination to pay dividends in the future will be at the discretion of our board of directors. Consequently, it is uncertain when, if ever, we will declare dividends to our shareholders.  We currently intend to retain any profits to provide capacity to write insurance and reinsurance and to accumulate reserves and surplus for the payment of claims. As a result, our board of directors currently does not intend to declare dividends or make any other distributions. Our board of directors plans to periodically reevaluate our dividend policy. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon our results of operations, financial condition and other factors deemed relevant by our board of directors. Consequently, it is uncertain when, if ever, we will declare dividends to our shareholders.  Applicable insurance laws and anti-takeover provisions under Virginia state law and in our amended and restated articles of incorporation and our bylaws may make it difficult to effect a change of control of us or change our board of directors and officers, which may negatively affect the price per share of our common stock.  The Virginia Stock Corporation Act, our amended and restated articles of incorporation and our bylaws contain various provisions that may make it more difficult for a third party to acquire, or may discourage acquisition bids for, our company. These provisions include provisions that, among other things:  
        divide our board of directors into three classes of directors serving staggered three-year terms;
 
        permit our board of directors to issue one or more series of preferred stock;
 
        limit the ability of shareholders to remove directors;
 
        limit the ability of shareholders to fill vacancies on our board of directors;
  34



        impose advance notice requirements for shareholder proposals and nominations of directors to be considered at shareholder meetings;
 
        require the affirmative vote of holders of more than two-thirds of our outstanding shares of common stock to amend the provisions of our amended and restated articles of incorporation;
 
        require the affirmative vote of holders of more than two-thirds of our outstanding shares of common stock to approve mergers and consolidations or the sale of all or substantially all of our assets; and
 
        require approval of material acquisition transactions (such as mergers, share exchanges, and material dispositions of corporate assets not in the ordinary course of business) between our company and any holder of more than 10 percent of any class of our outstanding voting shares by the holders of at least two-thirds of the remaining voting shares of our company.
  These provisions could have the effect of discouraging a potential acquirer from making a tender offer or otherwise attempting to obtain control of our company and could limit the price that investors would be willing to pay in the future for shares of our common stock.  Before a person can acquire control of a United States insurance company, prior written approval must be obtained from the insurance commissioner of the state where the domestic insurer is domiciled. State statutes in South Carolina, where Kanawha, our insurance subsidiary, is domiciled, provide that control over a domestic insurer is presumed to exist if any person, directly or indirectly, owns, controls, holds with the power to vote, or holds proxies representing, 10% or more of the voting securities of the domestic insurer. Prior to granting approval of an application to acquire control of a domestic insurer, a state insurance commissioner will typically consider such factors as the financial strength of the applicant, the integrity of the applicants board of directors and executive officers, the applicants plans for the future operations of the domestic insurer and any
anti-competitive results that may arise from the consummation of the acquisition of control. These state laws could have the effect of discouraging a potential acquiror from making a tender offer or otherwise attempting to obtain control of our company and could limit the price that investors would be willing to pay in the future for shares of our common stock.  In addition, the applicable insurance laws and anti-takeover provisions of Virginia law, our amended and restated articles of incorporation and bylaws may make it more difficult for our shareholders to change our directors or officers or the strategies and policies implemented by our directors and officers.  Our stock and the stock of other companies in the insurance industry are subject to stock price and trading volume volatility, and you may be unable to resell your shares of our common stock at or above the price you paid for them.  From time to time, the stock price and the number of shares traded of companies in the insurance industry experience periods of significant volatility. Company-specific matters, such as fluctuations in our operating performance as well as developments generally in the insurance industry and in the regulatory environment may cause this volatility. Accordingly, broad market and industry fluctuations may adversely affect the trading price of our common stock, regardless of our actual operating performance, and you may be unable to resell your shares of our common stock at or above the price you paid for them.  Recently, stock prices of companies in the insurance industry have experienced substantial volatility as a result of civil complaints filed in the last three years by the Attorney General of the State of New York and investigations initiated by several other state agencies against several large insurance brokers. Also contributing to this volatility have been subsequent press reports indicating that these ongoing investigations of the insurance industry are expanding to include additional companies and practices. The recent volatility in insurance industry stocks may continue for the foreseeable future and may affect the price of our stock.  ITEM 1B.
        UNRESOLVED STAFF COMMENTS.
  None.
     35


ITEM 2.
        PROPERTIES.
  We own six office buildings in Lancaster, South Carolina, where most of our operations are located. We also own an office building in Fort Mill, South Carolina. Our owned properties had an aggregate book value of approximately $7.1 million as of December 31, 2006. We also lease our principal executive offices in Minnetonka, Minnesota, a suburb of Minneapolis, where some members of our executive management team, some holding company and underwriting operations and a regional sales office are located. We lease offices in Greenville, South Carolina, where a processing center of our third-party administration business is located. We lease facilities in 16 other locations throughout the United States that house regional and field offices of our sales organization.  ITEM 3.
        LEGAL PROCEEDINGS.
  We are not involved in any material legal proceedings nor, to our knowledge, are any material legal proceedings pending or threatened against us. We are typically subject to routine actions and administrative proceedings, which we expect, in the aggregate, not to have a material adverse effect on our business or financial position, results of operations or cash flows.  On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York, both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore, and Gibb are officers of KMG America and former employees of the plaintiffs. The complaint alleges misappropriation of trade secrets, conversion, tortious interference with business and employment relationships, breach of fiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive relief and unspecified monetary damages. On August 24, 2005, the plaintiffs amended their complaint to add Scott H. DeLong III and Thomas D. Sass as
defendants. Messrs. DeLong and Sass are officers of KMG America and former employees of the plaintiffs. The plaintiffs amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentations and civil theft. On August 9, 2005, a hearing was held before the court to consider plaintiffs motion for a temporary injunction and on August 26, 2005, the court issued a ruling denying plaintiffs motion. The plaintiffs filed a notice of appeal of the courts ruling with the Minnesota Court of Appeals. On September 5, 2006, the Minnesota Court of Appeals issued a ruling affirming the district courts denial of plaintiffs motion for a temporary injunction.  On December 21, 2006, the defendants filed a motion for summary judgment with the district court and a hearing on the motion was held on January 19, 2007.  We expect a ruling from the Court in the second quarter of 2007.  We
believe plaintiffs allegations are without merit and intend to defend the action vigorously. While the outcome of legal actions cannot be predicted with certainty, we believe the outcome of this matter will not have a material adverse effect on our consolidated financial position or results of operations.  The Company has been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will, subject to the terms, conditions and limitations of the insurance policy, reimburse the Company for a significant portion of future defense costs and potential damages, losses and liabilities resulting from this litigation.  The Company also has received partial reimbursement under the insurance policy for defense costs incurred to date.  As a result, the Company expects that the ongoing defense cost reimbursements and reimbursements of any damages, losses or liabilities under the directors and officers insurance policy should reduce
the risk that future defense costs and any damages, losses or liabilities may have a material adverse effect on our consolidated financial position or results of operations.  ITEM 4.
        SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
  There were no matters submitted to a vote of our shareholders during the fourth quarter of 2006.  PART II  ITEM 5.
        MARKET FOR REGISTRANTS COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.
  Market Information  Our common shares began trading on the New York Stock Exchange on December 16, 2004, under the symbol KMA.  As of December 29, 2006, the last reported closing price per common share on the New York  36


Stock Exchange was $9.59. The following table sets forth the high and low sales price per common share reported on the New York Stock Exchange as traded and the dividends paid on the common shares from January 1, 2005, through December 31, 2006.  Price Range
        
        Cash Dividend Per ShareHigh
        
        Low2005First Quarter
        
        $
        11.30
        
        $
        9.24
        
        $
        0.00Second Quarter
        
        $
        10.40
        
        $
        8.70
        
        $
        0.00Third Quarter
        
        $
        10.39
        
        $
        7.84
        
        $
        0.00Fourth Quarter
        
        $
        9.18
        
        $
        7.91
        
        $
        0.002006First Quarter
        
        $
        10.70
        
        $
        7.60
        
        $
        0.00Second Quarter
        
        $
        9.42
        
        $
        7.85
        
        $
        0.00Third Quarter
        
        $
        8.80
        
        $
        6.36
        
        $
        0.00Fourth Quarter
        
        $
        9.73
        
        $
        6.92
        
        $
        0.00
  Shareholder Information  As of February 23, 2007, we had 317 holders of record of our common shares.  Our registrar and transfer agent is American Stock Transfer & Trust Company.  Dividends  As a holding company whose principal asset is the capital stock of Kanawha and our indirect subsidiaries, we rely primarily on dividends and other statutorily permissible payments from our subsidiaries to meet our obligations for payment of interest and principal on outstanding debt obligations, dividends to shareholders (including any dividends on our common stock) and corporate expenses. The ability of Kanawha and our other subsidiaries to pay dividends and to make such other payments in the future will depend on their statutory surplus (which is the excess of assets over liabilities as determined in accordance with statutory accounting principles set by state insurance regulatory authorities), future statutory earnings (which are earnings as determined in accordance with statutory accounting principles) and regulatory restrictions.  Kanawha is subject to state insurance laws and regulations and extensive regulatory oversight, including regulations that limit the amount of dividends and other distributions it can pay to KMG America, and consequently, that KMG America can pay to its shareholders. The payment of dividends to KMG America by Kanawha in excess of a certain amount (i.e., extraordinary dividends) must be approved by the State of South Carolina Department of Insurance. Extraordinary dividends, for which regulatory approval is required, include dividends whose fair market value together with that of other dividends made within the preceding twelve months: (1) when paid from other than earned surplus, exceed the lesser of (a) ten percent of the insurers surplus as regards policyholders or (b) the net gain from operations, not including net realized capital gains or losses; or (2) when paid from earned
surplus, exceed the greater of (a) ten percent of the insurers surplus as regards policyholders or (b) the net gain from operations, not including net realized capital gains or losses. If insurance regulators determine that payment of an ordinary dividend or any other payments by our insurance subsidiary to us (such as payments under a tax sharing agreement or payments for employee or other services) would be adverse to policyholders or creditors, the regulators may block such payments that would otherwise be permitted without prior approval. We cannot assure you that there will not be further regulatory actions restricting the ability of our insurance subsidiary to pay dividends. If the ability of our insurance subsidiary to pay dividends or make other payments to us is materially restricted by regulatory requirements, it could adversely affect our ability to pay any dividends on our common stock and/or service our debt and pay our other corporate expenses.  Our non-insurance subsidiary generally is not subject to state insurance laws, regulations and oversight. However, because our non-insurance subsidiary is owned, directly or indirectly, by Kanawha, any dividends or distributions that Kanawha receives from it are subject to state insurance regulations that limit dividends and  37


distributions that Kanawha can make to KMG America, and consequently, that KMG America can pay to its shareholders.  We currently intend to retain any profits to provide capacity to write insurance and reinsurance and to accumulate reserves and surplus for the payment of claims. As a result, our board of directors currently does not intend to declare dividends or make any other distributions. Our board of directors plans to periodically reevaluate our dividend policy. Any determination to pay dividends in the future will be at the discretion of our board of directors and will depend upon our results of operations, financial condition and other factors deemed relevant by our board of directors. Consequently, it is uncertain when, if ever, we will declare dividends to our shareholders.  Common Stock Authorized for Issuance Under Our 2004 Equity Incentive Plan  Prior to our initial public offering, our shareholders approved an equity compensation plan, the KMG America Corporation 2004 Equity Incentive Plan. The following table summarizes information with respect to the plan as of December 31, 2006:  Equity Compensation Plan Information  Plan Category
        
        Number ofsecurities to beissued uponexercise ofoutstandingoptions, warrantsand rights
        
        
        Weighted-averageexercise price ofoutstandingoptions, warrantsand rights
        
        
        Number ofsecurities whichremain availablefor futureissuance underthe equitycompensationplans (excludingsecuritiesreflected incolumn (a))(a)
        
        
        
        (b)
        
        
        (c)Equity compensation plans approved by security holders
        
        1,913,425
        
        
        $
        9.16
        
        
        774,127Equity compensation plans not approved by security holders
        
        
        
        
        
        
        
        
        Total
        
        1,913,425
        
        
        $
        9.16
        
        
        774,127
  We have no equity compensation plan that has not been approved by our shareholders.  38


Performance Graph The following graph is presented to compare the cumulative total return for the Corporations Common Stock to the cumulative total returns of the Dow Jones US Insurance Index and the S&P Smallcap 600 Index for the period from December 31, 2004 (the end of the Corporations short fiscal year following its initial public offering of Common Stock on December 16, 2004), through the close of the market on December 31, 2006, assuming an investment of $100 was made in the Corporations Common Stock and in each index on December 31, 2004, and that all dividends were reinvested.   Summary  Name
        December 31, 2004
        December 31, 2005
        December 31, 2006KMG America Corporation
        100.00
        83.46
        87.18S&P Smallcap 600 Index
        100.00
        106.65
        121.66Dow Jones US Insurance Index
        100.00
        111.53
        121.72
     39


ITEM 6.
        SELECTED FINANCIAL DATA.
  The following table presents:  
        Selected historical consolidated financial and other data as of December 31, 2002, 2003, and 2004 for our predecessor. The historical consolidated financial data as of December 31, 2003, and for each of the two years ended December 31, 2003 have been derived from, and should be read together with, our predecessors audited consolidated financial statements and the related notes;
  
        Selected historical financial and other data for the period from January 21, 2004 (KMG Americas date of inception), to December 31, 2004, for KMG America. For such period, KMG America had insignificant operations and cash flows. See KMG Americas audited financial statements and the related notes included in this report; and
  
        Selected historical consolidated financial and other data as of and for the year ended December 31, 2005 and 2006 for KMG America. The historical consolidated financial data as of December 31, 2005 and 2006, for KMG America have been derived from, and should be read together with, KMG Americas audited consolidated balance sheet and the related notes included in this report.
  For GAAP accounting purposes, Kanawha is treated as our predecessor entity and is referred to in this table as our predecessor.  For financial reporting purposes, we have treated the Kanawha acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, selected historical consolidated financial and other data as of any date prior to, or for any period ending on or prior to, December 31, 2004, are reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition. Selected historical financial data and other data as of any date on or after, or for any period ending after, December 31, 2004, reflect GAAP purchase accounting adjustments made as of December 31, 2004,
reflecting the acquisition.  While Kanawha is our predecessor for accounting purposes, we caution you that the financial information presented in this report is neither comparable with nor representative of the actual results that we expect to achieve in the future. Many factors may cause our actual results to differ materially from our predecessors historical results including, but not limited to, the following:  
        the businesses of our predecessor are intended to be only a portion of our business in the future and are not entirely representative of the principal business strategy we plan to pursue; and
 
        our acquisition of Kanawha was subject to GAAP purchase accounting, which caused us to adjust the recorded amounts of our predecessors assets and liabilities to fair value following the acquisition; and
 
        the risk factors described in Item 1A of this report.
  The financial data set forth below should be read in conjunction with, and is qualified in its entirety by reference to Item 7, Managements Discussion and Analysis of Financial Condition and Results of Operations, and our predecessors and our audited financial statements and the related notes included in this report.    40


KMG AMERICA CORPORATION AND PREDECESSOR SELECTED CONSOLIDATED FINANCIAL DATA  KMG America
        
        
        PredecessorYear Ended December 31,
        
        
        For the Period from January 21 through December 31,
        
        
        Year Ended December 31,2006
        
        
        2005
        
        
        2004
        
        
        2004
        
        
        2003
        
        
        2002Selected earnings data:
        
        
        (in thousands, except per share data)Revenue:Insurance premiums
        
        $
        127,969
        
        $
        106,887
        
        $
        
        
        $
        102,836
        
        $
        106,416
        
        $
        98,643Net investment income(1)
        
        
        29,946
        
        
        27,745
        
        
        18
        
        
        25,202
        
        
        27,073
        
        
        27,160Commission and fee income
        
        
        16,505
        
        
        14,565
        
        
        
        
        
        13,475
        
        
        13,018
        
        
        12,975Realized investment gains (losses)
        
        
        1,218
        
        
        358
        
        
        
        
        
        9,433
        
        
        7,601
        
        
        (3,004
        )Gain on extinguishment of debt
        
        
        1,021
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        4,451
        
        
        3,868
        
        
        
        
        
        3,108
        
        
        2,317
        
        
        1,869Total revenue
        
        
        181,110
        
        
        153,423
        
        
        18
        
        
        154,054
        
        
        156,425
        
        
        137,643Benefits and Expenses:Policyholder benefits
        
        
        99,842
        
        
        84,288
        
        
        
        
        
        90,175
        
        
        89,261
        
        
        81,285Insurance commissions
        
        
        12,725
        
        
        9,635
        
        
        
        
        
        9,690
        
        
        9,074
        
        
        7,351General insurance expenses
        
        
        45,465
        
        
        41,905
        
        
        284
        
        
        27,795
        
        
        29,538
        
        
        28,407Insurance taxes, licenses and fees
        
        
        5,347
        
        
        4,677
        
        
        4
        
        
        4,678
        
        
        4,708
        
        
        3,927Depreciation and amortization
        
        
        2,558
        
        
        2,839
        
        
        
        
        
        2,492
        
        
        3,005
        
        
        2,919Amortization of policy acquisition costs and value of business acquired
        
        
        4,106
        
        
        3,467
        
        
        
        
        
        9,468
        
        
        9,589
        
        
        9,515Total benefits and expenses
        
        
        170,043
        
        
        146,811
        
        
        288
        
        
        144,298
        
        
        145,175
        
        
        133,404Income before income taxes (benefit)
        
        
        11,067
        
        
        6,612
        
        
        (270
        )
        
        9,756
        
        
        11,250
        
        
        4,239Provision for income taxes (benefit)
        
        
        (3,848
        )
        
        (2,128
        )
        
        94
        
        
        (3,566
        )
        
        (3,499
        )
        
        (1,157
        )Income before cumulative effects of changes in accounting principle
        
        
        7,219
        
        
        4,484
        
        
        (176
        )
        
        6,190
        
        
        7,751
        
        
        3,082Cumulative effect of change in accounting principle
        
        
        
        
        
        176
        
        
        
        
        
        
        
        
        
        
        
        Net Income
        
        $
        7,219
        
        $
        4,660
        
        $
        (176
        )
        $
        6,190
        
        $
        7,751
        
        $
        3,082Net income per share:BasicIncome per share before cumulative effects of changes in accounting principle
        
        $
        .33
        
        $
        .20
        
        $
        (.01
        )
        $
        2,369.27
        
        $
        2,966.25
        
        $
        1,179.36Cumulative effects of change in accounting principle
        
        
        
        
        
        .01
        
        
        
        
        
        
        
        
        
        
        
        Basic Net Income per share
        
        $
        .33
        
        $
        .21
        
        $
        (.01
        )
        $
        2,369.27
        
        $
        2,966.25
        
        $
        1,179.36DilutedIncome per share before cumulative effects  of changes in accounting principle
        
        $
        .33
        
        $
        .20
        
        $
        (.01
        )
        $
        2,132.71
        
        $
        2,679.87
        
        $
        1,066.87Cumulative effects of changes in accounting principle
        
        
        
        
        
        .01
        
        
        
        
        
        
        
        
        
        
        
        Diluted Net Income per share
        
        $
        .33
        
        $
        .21
        
        $
        (.01
        )
        $
        2,132.71
        
        $
        2,679.87
        
        $
        1,066.87Cash dividends paid per share:Basic
        
        $
        
        
        $
        
        
        $
        
        
        $
        
        
        $
        669.77
        
        $
        669.77Diluted
        
        $
        
        
        $
        
        
        $
        
        
        $
        
        
        $
        605.11
        
        $
        605.89Weighted-average shares outstanding:Basic
        
        
        22,187,830
        
        
        22,085,585
        
        
        22,071,641
        
        
        2,612.83
        
        
        2,612.83
        
        
        2,612.83Diluted
        
        
        22,201,731
        
        
        22,090,944
        
        
        22,241,550
        
        
        2,902.64
        
        
        2,892.04
        
        
        2,888.30
   (1)
        Net investment income for the year ended December 31, 2004, was negatively impacted by a $1.6 million incentive payment to one of our predecessors outside investment managers at the conclusion of the contract period. There are no other incentive arrangements of this type in effect, and this contract was terminated upon the closing of KMG Americas acquisition of Kanawha.
   41   KMG America
        
        
        PredecessorAs of December 31,2006
        
        
        2005
        
        
        2004
        
        
        2003
        
        
        2002Balance Sheet Data:Cash and investments
        
        $
        580,080
        
        $
        575,890
        
        $
        578,541
        
        $
        484,405
        
        $
        486,616Accrued investment income
        
        
        6,503
        
        
        5,917
        
        
        4,912
        
        
        5,387
        
        
        5,929Deferred acquisition costs (DAC)
        
        
        28,454
        
        
        14,032
        
        
        
        
        
        80,657
        
        
        71,723Value of business acquired (VOBA)
        
        
        70,766
        
        
        72,639
        
        
        74,481
        
        
        29,605
        
        
        33,582Goodwill
        
        
        
        
        
        
        
        
        
        
        
        1,258
        
        
        1,258Other assets
        
        
        145,911
        
        
        128,887
        
        
        112,117
        
        
        83,858
        
        
        62,792Total assets
        
        $
        831,714
        
        $
        797,365
        
        $
        770,051
        
        $
        685,170
        
        $
        661,900Total policy and contract liabilities
        
        $
        572,364
        
        $
        547,894
        
        $
        530,915
        
        $
        462,015
        
        $
        440,824Deferred income taxes
        
        
        14,735
        
        
        13,061
        
        
        6,502
        
        
        22,827
        
        
        19,792Other liabilities
        
        
        52,563
        
        
        48,927
        
        
        44,846
        
        
        26,851
        
        
        34,550Total liabilities
        
        
        639,662
        
        
        609,882
        
        
        582,263
        
        
        511,693
        
        
        495,166Total shareholders equity
        
        
        192,052
        
        
        187,483
        
        
        187,788
        
        
        173,477
        
        
        166,734Total liabilities and shareholders equity
        
        $
        831,714
        
        $
        797,365
        
        $
        770,051
        
        $
        685,170
        
        $
        661,900
  ITEM 7.
        MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
  You should read the following discussion and analysis of our financial condition and results of operations in conjunction with our audited financial statements and related notes included in this report. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those discussed below and elsewhere in this report, particularly in Items 1 and 1A of this report.  Overview  KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. We commenced our operations shortly before we completed our initial public offering of common stock on December 21, 2004, and our shares trade on the New York Stock Exchange under the symbol KMA.  Concurrently with the completion of our initial public offering, we completed our acquisition of Kanawha and its subsidiaries, which are our primary operating subsidiaries and which underwrite and sell life and health insurance products.  For GAAP accounting purposes, Kanawha is treated as KMG Americas predecessor entity and is referred to herein as our predecessor.  For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, in the following discussion any financial information as of any date prior to, or for any period ending on or prior to, December 31, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition, and any financial information as of any date on or after, or for any period ending after, December 31, 2004, reflects GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.  Worksite insurance business. Our worksite insurance business is a provider of life and health insurance products to employers and their employees.  Our predecessor's marketing and sales efforts were primarily in the southeastern United States, predominately in Florida, South Carolina and North Carolina.  Since acquiring our predecessor, we have begun to implement our business strategy to market our products nationwide. The primary insurance products that we underwrite include: life insurance; short-term disability insurance; dental insurance; indemnity health insurance; critical illness insurance; and employer excess risk insurance. For the year ended December 31, 2006, our  worksite insurance business produced premiums, commissions and fees, excluding  42  intercompany payments, of $83.8 million, which accounted for 58.0% of our premiums, commissions and fees, excluding intercompany payments in that period. Our business strategy is to operate our existing worksite insurance business efficiently while developing a new worksite marketing and distribution organization that targets larger employer groups nationwide with an expanded variety of life and health insurance products which have added a new set of employer-paid life insurance, disability and health products to our existing voluntary products. Since December 2004, we have opened sales offices hosting regional sales managers in Boston, Massachusetts and Irvine, California, a Los Angeles suburb and we have opened regional sales offices in Tampa, Florida; Chicago, Illinois; Morristown, New Jersey; Atlanta, Georgia; Dallas, Texas; Kansas City, Missouri; Cleveland, Ohio; Philadelphia, Pennsylvania; New Orleans,
Louisiana; San Diego and San Francisco, California; Phoenix, Arizona; Denver, Colorado; and Minneapolis, Minnesota. We will base future expansion of our sales organization on developing market trends and our profit margins.  The costs associated with any expansion of our sales organization will be recognized before we recognize revenues resulting from new sales activity.  Consequently, we expect negative cash flow and operating losses in the short term.  Senior market insurance business. Our senior market insurance business has been a provider in the southeastern United States of individual insurance products tailored to the needs of older individuals. The primary insurance product included in this business is long-term care insurance that we underwrote. For the year ended December 31, 2006, our senior market insurance business produced premiums, commissions and fees, excluding intercompany payments, of  $41.5 million, which accounted for 28.7% of our premiums, commissions and fees, excluding intercompany payments, in that period.  Effective January 1, 2006, we ceased actively underwriting long-term care insurance policies. Significant factors that contributed to our decision to cease actively underwriting long-term care insurance policies include, among others:  (1) sales for this business were significantly lower than originally projected; and (2) the lack of strategic fit between the underwriting and distribution of long-term care products and our current strategy of focusing on worksite marketing of life and health insurance products.  We intend to retain and actively manage the existing block of in-force long-term care insurance policies (including the right to receive future premiums and the liability for future claims).  Third-party administration business. Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services. This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business. Our third-party administration business also provides administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, reinsurers and managed care plans. For the year ended December 31, 2006, our third-party administration business produced commissions and fees, excluding intercompany payments, of $16.1 million, which accounted for 11.2% of our premiums, commissions and fees, excluding intercompany payments, in that period. Our primary business
strategy for this business is to grow this business as it administers the increasing volume of policies and products that we anticipate will be sold by the worksite insurance business as we attempt to grow that business. In addition, as our national worksite marketing business develops, we intend to opportunistically market our third-party administration services to self-insured plans, stop loss insurers, pharmacy benefit organizations, managed care service providers, other insurance carriers and reinsurers nationwide. It is expected that any incremental costs associated with this expanded marketing will be modest and will be funded out of the operations of our third-party administration business.  In addition, we have retained our predecessors closed block of life and health insurance business reported in the acquired business segment and the investment and marketing activities reported in the corporate and other segment. While acquisitions of books of business from other insurance carriers is not one of our principal growth strategies, we will consider making acquisitions on an opportunistic basis if we can complete the acquisitions on favorable financial terms that we expect to be generally accretive to earnings per share and return on equity while maintaining our financial strength ratings.  We expect to realize earnings from our investment portfolio. Insurance companies in both the life and health and property and casualty insurance industries earn profits on the investment float, which reflects the investment income earned on the premiums paid to the insurer between the time of receipt and the time benefits are paid-out under the policy. Volatility in the capital markets, changes in interest rates and changes in economic conditions can all impact the amount of earnings that we will realize from our investment portfolio.   43  Marketplace Conditions and Trends  Described below are some of the significant recent events and trends affecting the life and health insurance industry and the possible effects they may have on our operations in the future.  
        The trend to shift health care costs to employees and rising healthcare costs in general are causing individuals to purchase a wider array of life and health insurance products. We believe these trends will result in greater demand for our voluntary worksite insurance products.
 
        The worksite insurance industry is increasingly focused on integration, coordination and simplification of products and services.  Human resource departments often have limited resources with which to address the significant administrative complexity associated with many worksite insurance products.  Our technology based administrative solutions and coordination of sales and service of voluntary group insurance products are designed to address these issues.
 
        Insurance intermediaries are consolidating throughout the United States.  This increases the focus on revenue growth by intermediaries, which creates demand for our unique voluntary benefit products.
 
        The volatility in the equity markets over the past few years has posed a number of problems for some participants in the life and health insurance industry. Even though the capital markets have recovered, not all companies have participated evenly in the recovery. We and our predecessor have historically had minimal equity exposure (less than 1% of total invested assets as of December 31, 2006) and we plan to continue to manage equity asset allocations conservatively in the future.
 
        Corporate bond defaults and credit downgrades, which have resulted in other than temporary impairment in the value of many securities, have had a material impact on life and health insurers in the past few years. While our debt investments have not been immune to corporate credit problems, losses from defaults have historically not been material to our predecessors financial condition. We intend to manage our investment portfolio conservatively in the future to attempt to mitigate the risk of losses from defaults.
 
        Some life and health insurance companies have suffered significant reductions in capital and will have to improve their capital adequacy ratios to support their business or divest a portion of their business. We expect these trends to have a positive impact on our competitive position in the industry as carriers become more disciplined with product pricing and/or exit markets or product lines in which we will compete.
 
        Many of the events and trends affecting the life and health insurance industry have had an equal (or greater) impact on the life and health reinsurance industry. These events led to a decline in the availability of reinsurance. While we currently cede a limited amount of our primary insurance business to reinsurers, and we plan to continue this practice, diminishing reinsurance capacity has negatively impacted our predecessor in the past and may further negatively impact our operations in the future. If we cannot obtain affordable reinsurance coverage, either our net exposures will increase or we will have to reduce our underwriting commitments.
 
        There is a trend of consolidation of insurance carriers, product lines and services in the insurance marketplace, which increases the likelihood that insureds or their employers will elect not to renew existing policies with their existing carrier and will purchase new policies with another carrier.  This trend benefits new entrants to the insurance markets, such as KMG America, by increasing the opportunities to place new policies.  Consolidation in the insurance market also reduces the number of products and service choices, which creates opportunities for insurance companies to grow by creating new and specialized insurance products to fill niches.
 
        We have observed that our earnings in the first and second quarters of our fiscal year are typically less than our earnings in the third and fourth quarters of our fiscal year.  This seasonality is due, in part, to the fact that a majority of our outstanding long term care insurance policies have anniversary dates in the first half of the fiscal year, and policy reserve increases, (which are reflected as an expense on our statement of operations) are made as of the policy anniversary date. We expect that this seasonality effect will diminish as our long term care policies become a smaller portion of our total liabilities, although we anticipate this seasonality effect will occur again in 2007.  Also contributing to the seasonality effect is that more of our voluntary benefit sales occur in the second half of our fiscal year, which increases our revenue for that
period.  This seasonality effect is due, in large part, to a significant number of employers offering their employees open enrollment for benefits purchases during the last half of the calendar year.
 
        Pricing in the medical excess risk insurance market has proven to be cyclical, with periods of competitively lower pricing and periods of competitively higher pricing.  Over the past two years, we have experienced a cycle where the market is offering this product line at competitively low prices.  In order to compete in the market, we must consider offering our medical excess risk insurance product at lower prices, which may
  44  reduce our profit margins.  We have seen evidence of the excess risk insurance market firming over the past few quarters, which suggests a developing trend towards higher competitive pricing for this product line.  Critical Factors Affecting Results  Our profitability depends on the adequacy of our product pricing and underwriting, the accuracy of assumptions about future experience used in establishing reserves for future policyholder benefits and claims, returns on invested assets and our ability to manage our costs and expenses. Factors affecting these items may have a material adverse effect on our business, results of operations or financial condition. In addition, our profitability depends in large part on accurately predicting benefits, claims and other costs, including medical and dental costs. It also depends on our ability to manage future benefit and other costs through product design, underwriting criteria, utilization review or claims management and, in health and dental insurance, negotiation of favorable provider contracts. Changes in market conditions and numerous other factors may also materially adversely affect our
ability to manage claim costs. As a result of one or more of these factors or other factors, claims could substantially exceed our expectations, which could have a material adverse effect on our business, results of operations or financial condition. Critical Accounting Policies  We consider the following accounting policies to be critical due to the amount of judgment and uncertainty inherent in the application of these policies. In calculating financial statement estimates, the use of different assumptions could produce materially different estimates. In addition, if factors such as those described in Item 1A of this report cause actual events to differ from the assumptions used in applying the accounting policies and calculating financial estimates, our business, results of operations, financial condition and liquidity could be materially adversely affected.  Revenues.We derive our revenues primarily from the sale of our insurance policies and, to a lesser extent, fee income from administrative services and commissions on the placement of third-party insurance products. Sales of insurance policies are recognized in revenue when earned as insurance premiums, while sales of administrative services and commission income are recognized as fee income on our consolidated statements of operations when earned.  Our premium, fee and commission income is supplemented by income earned from our investment portfolio. We recognize revenue from interest payments, dividends and sales of investments when earned. Our investment portfolio is currently primarily invested in fixed maturity securities. Both investment income and realized capital gains on these investments can be significantly impacted by changes in interest rates.  Interest rate volatility can reduce unrealized gains or create unrealized losses in our portfolios. Interest rates are highly sensitive to many factors, including governmental monetary policies, domestic and international economic and political conditions and other factors beyond our control. Fluctuations in interest rates affect our returns on, and the market value of, fixed maturity and short-term investments.  The fair market value of the fixed maturity securities in our portfolio and the investment income from these securities fluctuate depending on general economic and market conditions. The fair market value generally increases or decreases in an inverse relationship with fluctuations in interest rates, while net investment income realized by us from future investments in fixed maturity securities will generally increase or decrease with interest rates. In addition, actual net investment income and/or cash flows from investments that carry prepayment risk, such as mortgage-backed and other asset-backed securities, may differ from those anticipated at the time of investment as a result of interest rate fluctuations. In periods of declining interest rates, mortgage prepayments generally increase and mortgage-backed securities, mortgage loan obligations and bonds in our investment portfolio are
more likely to be prepaid or redeemed as borrowers seek to borrow at lower interest rates, and we may be required to reinvest funds in lower interest-bearing investments.  Expenses.Our expenses primarily consist of policyholder benefits, insurance commissions, premium taxes, licenses, fees, amortization of deferred acquisition costs, or DAC, and value of business acquired, or VOBA, and general insurance operating expenses.  Reserves.Policy benefit reserves and other claim reserves are established according to generally accepted actuarial principles and are based on a number of factors. These factors include historical claim payments experience  45  and actuarial assumptions used to estimate expected future claims experience. These assumptions and other factors include trends in claims severity, frequency and other factors discussed below, the incidence of incurred claims, the extent to which all claims have been reported and internal claims processing changes. The methods of making these estimates and establishing the related reserves are periodically reviewed and updated.  Policy benefit and claim reserves do not represent an exact calculation of our ultimate liability, but instead represent our probability-based estimate of what we expect the ultimate settlement and administration of a claim or group of claims will cost based on our assessment of facts and circumstances then known. Policy benefit reserves represent reserves established for claims not yet incurred. Claim reserves represent liabilities established for claims that have been incurred and have future benefits to be paid as of the balance sheet date. The adequacy of reserves will be impacted by future trends in claims severity, frequency and other factors including:  
        changes in the economic cycle;
 
        the level of market interest rates and inflation;
 
        emerging medical perceptions regarding physiological or psychological causes of disability;
 
        emerging health issues and new methods of treatment or accommodation;
 
        legislative changes and changes in taxation;
 
        inherent claims volatility in a new book of business, such as our employer excess risk insurance; and
 
        claims handling procedures.
  Many of these items are not directly quantifiable, particularly on a prospective basis. Reserve estimates are refined as experience develops. Adjustments to reserves, both positive and negative, are reflected in the consolidated statements of operations of the period in which such estimates are updated. Because establishment of reserves is an inherently uncertain process involving estimates of future losses, there can be no certainty that ultimate losses will not exceed existing reserves. Future loss development could require reserves to be increased, which could have a material adverse effect on earnings in the periods in which such increases are made.  Reserving Methodology.Policy benefit reserves for life insurance, long-term care insurance, individual and group accident and health insurance, disability insurance and group life and health insurance are recorded at the present value of future benefits to be paid to policyholders less the present value of the future net premiums (this method is called the net level premium method). These amounts are estimated and include assumptions made when the policy is issued as to the expected investment yield, inflation, mortality, morbidity, claim termination rates, awards for social security and withdrawal rates, as well as other assumptions that are based on our experience. These assumptions reflect anticipated trends and include provisions for possible unfavorable deviations. Throughout the life of the policy, reserves are based on these original
assumptions and cannot be modified pursuant to GAAP unless policy reserves prove inadequate. We also record an unearned premium reserve which represents the portion of premiums collected or due and unpaid which is intended to pay for insurance coverage in a period after the current accounting period.  Loss recognition testing of our policy benefit reserves is performed annually. This testing involves a comparison of our actual net liability position (all liabilities less DAC and VOBA) to the present value of future net cash flows calculated using then-current assumptions. These assumptions are based on our best estimate of future experience. To the extent a premium deficiency exists, it would be recognized immediately by a charge to the statement of operations and a corresponding reduction in DAC or VOBA. Any additional deficiency would be recognized as a premium deficiency reserve. Historically, loss recognition testing has not resulted in an adjustment to DAC or reserves. These adjustments would occur only if economic, mortality and/or morbidity conditions significantly deviated from the underlying assumptions.  In accordance with GAAP purchase accounting requirements, our predecessors policy and contract reserves were recorded at fair value upon the closing of the Kanawha acquisition. The policy and contract reserves were calculated as the present value of future benefits and expenses less the present value of future net premiums. These values were actuarially determined and were based upon assumed future interest rates, administrative expenses, mortality, morbidity and policy lapse rates as appropriate for the particular benefit on the purchase date. For long-term care insurance, assumptions for the present value of net premiums in the fair value calculation are consistent with current and anticipated premium increases, including those approved in the last twelve to eighteen months in certain jurisdictions for policies currently in force. These assumptions now serve as the original
assumptions described in the first paragraph above.  46


Reserve interest assumptions (i.e., discount rates) used by us in establishing our current policy benefit reserves were modified on the purchase date. The valuation interest rate is determined by taking into consideration actual and expected earned rates on our asset portfolio. Benefit reserves for limited payment policies take into account, where necessary, any deferred profits to be recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred.  The discount rate is the interest rate at which future net cash flows are discounted to determine the present value of such cash flows. If the discount rate chosen is higher than actual future investment returns, our investment returns will be insufficient to support the interest rate assumed when reserves were established. In this case, the reserves may eventually be insufficient to support future benefit payments. Alternatively, if a discount rate is chosen that is lower than actual future investment results, the reserves, and, for products such as long-term care insurance, the claims incurred in the current period will be overstated and profits will be accumulated in the reserves rather than reported as current earnings. We set our discount rate assumptions in conjunction with the current and expected future investment income rate of the assets supporting the reserves. If the investment
yield at which new investments are purchased is below or above the investment yield of the existing investment portfolio, it is likely that the discount rate chosen at future financial reporting dates will vary accordingly.  Deferred Acquisition Costs.The costs of acquiring new business that vary with and are primarily related to the production of new business have been deferred to the extent that these costs are deemed recoverable from future premiums or gross profits and are amortized into income as discussed below. Acquisition costs primarily consist of commissions, policy issuance expenses and some direct marketing expenses.  For most insurance products, amortization of DAC and VOBA is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. DAC is amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.  A premium deficiency is recognized immediately by a charge to the statement of operations as a reduction of DAC to the extent that future policy premiums, including anticipated interest income, are not adequate to recover all DAC and related claims, benefits and expenses. If the premium deficiency is greater than unamortized DAC, a liability will be accrued for the excess deficiency.  We eliminated all of our predecessors DAC upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. We began recording DAC prospectively on January 1, 2005.  Value of Business Acquired.VOBA is the value assigned to the insurance in force of acquired insurance companies or blocks of business at the date of acquisition. The amortization of VOBA is recognized using amortization schedules established at the time of the acquisitions based upon expected patterns of premiums, mortality, policy lapses, and morbidity as adjusted to take into account variances between expected and actual costs. VOBA is amortized over the expected life of the underlying business reinsured (or acquired).  We eliminated all of our predecessors historical VOBA upon the closing of the Kanawha acquisition as part of our application of GAAP purchase accounting requirements. We simultaneously re-established VOBA for the value of our predecessors in force business. VOBA interest rate assumptions to amortize the VOBA were also reset upon the closing of the Kanawha acquisition and the rate was approximately 6.0% on both December 31, 2005 and December 31, 2006.  Under our assumptions as of December 31, 2006, we estimate that the amortization of VOBA, for the next five years will be as follows:  Year Ended December 31:
        Amortization2007
        4.96%2008
        4.932009
        5.242010
        5.232011
        5.14
   47   If actual lapse and mortality experience is higher or lower than assumed for the table above, then actual amortization will be faster or slower, respectively, than indicated in the table.  Investments.We regularly monitor our investment portfolio to ensure that investments that may be other than temporarily impaired are identified in a timely fashion and properly valued and that any impairment is charged against earnings in the proper period. Our investment portfolio is managed by an external asset management firm, with the exception of certain invested assets that are managed internally. Our methodology used to identify potential impairments requires judgment by us in conjunction with our investment managers.  Changes in individual security values are monitored on a monthly basis in order to identify potential problem credits. In addition, pursuant to our impairment testing process, each month the portfolio holdings are reviewed with additional screening for securities whose market price is equal to 80% or less of their original purchase price. Management then makes an assessment as to which of these securities are other than temporarily impaired. Assessment factors include, but are not limited to, the financial condition and rating of the issuer, any collateral held and the length of time the market value of the security has been below cost. Each month the watch list is distributed to our investment committee and the outside investment managers, and discussions are held as needed in order to make any impairment decisions. Each quarter any security deemed to have been other than temporarily
impaired is written down to its then current market value, with the amount of the write-down reflected in the statement of operations for that quarter. Previously impaired issues are also monitored monthly, with additional write-downs taken quarterly if necessary.  There are risks and uncertainties involved in making these judgments. Changes in circumstances and critical factors such as a continued weak economy, a pronounced economic downturn or unforeseen events which affect one or more companies, industry sectors or countries could result in additional write-downs in future periods for impairments that are deemed to be other-than-temporary.  Reinsurance.As part of our overall risk and capacity management strategy, we purchase reinsurance for loss protection to manage individual and aggregate risk exposure and concentration, to free up capital to allow us to write additional business and, in some cases, effect business dispositions. We utilize ceded reinsurance for those product lines where there is exposure on a per risk basis or in the aggregate which exceeds our internal risk retention and concentration management guidelines.  Reinsurance recoverables represent the portion of the policy and contract liabilities that are covered by reinsurance. These liabilities include reserves for life, annuity, accident and health, policy and contract claims and other policyholder liabilities as shown in the consolidated balance sheets. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the policies reinsured. Amounts recoverable from reinsurers are estimated in a manner consistent with the methods used to determine the underlying liabilities reported in our and our predecessors consolidated balance sheets.  Under indemnity reinsurance transactions in which we are the ceding insurer, we remain liable for policy claims if the assuming company fails to meet its obligations. In the event one or more assuming companies were to default on its obligations, it could have an adverse effect on our business, results of operations and financial condition. To limit this risk, we have implemented procedures to evaluate the financial condition of reinsurers and to monitor the concentration of credit risk to minimize this exposure. In some cases, the reinsurers have placed amounts in trust that would be the equivalent of the recoverable amount and for which we are the beneficiary. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations
of balances due from reinsurers, reinsurer solvency, management experience and current economic conditions. As of December 31, 2006, 2005 and 2004, there were no allowances for doubtful accounts.  Results of Operations  Consolidated Overview.  The following table presents:  
        Historical consolidated financial information for the year ended December 31, 2004 for our predecessor.
  48  
        Historical consolidated financial information for the period from January 21, 2004 (KMG Americas date of inception), to December 31, 2004 and for the years ended December 31, 2005 and 2006, for KMG America.
  For financial reporting purposes, we have treated the Kanawha acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, in the following discussion any financial information as of any date prior to, or for any period ending on or prior to, December 31, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition, and any financial information as of any date on or after, or for any period ending after, December 31, 2004, reflects GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.  49   KMG America
        
        
        PredecessorYear Ended December 31,
        
        
        For the Period from January 21 through December 31,
        
        
        Year Ended December 31,2006
        
        
        2005
        
        
        2004
        
        
        2004(dollars in thousands)Revenues:Insurance premiums
        
        $
        127,968.7
        
        $
        106,887.5
        
        $
        
        
        $
        102,835.6Net investment income(1)
        
        
        29,945.8
        
        
        27,744.9
        
        
        18.4
        
        
        25,202.4Commission and fees
        
        
        16,504.7
        
        
        14,564.6
        
        
        
        
        
        13,475.5Net realized gains
        
        
        1,218.5
        
        
        358.3
        
        
        
        
        
        9,432.6Gain on extinguishment of debt
        
        
        1,020.8
        
        
        
        
        
        
        
        
        Other income
        
        
        4,451.6
        
        
        3,867.9
        
        
        
        
        
        3,108.2Total revenues
        
        
        181,110.1
        
        
        153,423.2
        
        
        18.4
        
        
        154,054.3Benefits and expenses:Policyholder benefits
        
        
        99,842.3
        
        
        84,287.7
        
        
        
        
        
        90,175.0Commissions
        
        
        12,724.7
        
        
        9,635.2
        
        
        
        
        
        9,690.1General expenses
        
        
        45,465.0
        
        
        41,904.7
        
        
        284.4
        
        
        27,795.0Taxes, licenses and fees
        
        
        5,347.4
        
        
        4,677.4
        
        
        4.1
        
        
        4,677.6Depreciation and amortization
        
        
        2,558.0
        
        
        2,838.7
        
        
        
        
        
        2,491.9Amortization of DAC
        
        
        4,105.6
        
        
        3,467.5
        
        
        
        
        
        9,468.3Total benefits and expenses
        
        
        170,043.0
        
        
        146,811.2
        
        
        288.5
        
        
        144,297.9Income (loss) before income taxes
        
        
        11,067.1
        
        
        6,612.0
        
        
        (270.1
        )
        
        9,756.4Income taxes (benefit)
        
        
        (3,848.2
        )
        
        (2,128.2
        )
        
        94.5
        
        
        (3,565.9
        )Income (loss) before cumulative effects of changes in accounting principle
        
        
        7,218.9
        
        
        4,483.8
        
        
        (175.6
        )
        
        6,190.5Cumulative effect of accounting change
        
        
        
        
        
        175.7
        
        
        
        
        
        Net Income (Loss)
        
        $
        7,218.9
        
        $
        4,659.5
        
        $
        (175.6
        )
        $
        6,190.5Benefits to premiums ratio(2)
        
        
        78.0
        %
        
        78.9
        %
        
        N/A
        
        
        87.7
        %
  (1)
        Net investment income for the year ended December 31, 2004, was negatively impacted by a $1.6 million incentive payment to one of our predecessors outside investment managers at the conclusion of the contract period. There are no other incentive arrangements of this type in effect, and this contract was terminated upon the closing of KMG Americas acquisition of Kanawha.
 (2)
        The benefits to premiums ratio is equal to policyholder benefits divided by insurance premiums.
  Discussion of Results by Business Segment  The following section discusses significant factors that impact our revenues and insurance underwriting results segregated into the following five business segments:  Worksite insurance business. The worksite insurance business provides life and health insurance products to employers and their employees. This business segment includes worksite business as well as individual insurance business sold directly to the end consumer and not considered part of the senior market business. The primary insurance products sold by this business include life, short-term disability, long-term disability, dental, indemnity health, employer excess risk and critical illness. The earnings reported in any period for our worksite insurance business generally depends on growth in underwritten business, business mix, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues are generated primarily from new and renewal premiums. The worksite insurance business also includes business sold through our career agency
distribution channel, which is a group of agents and managers that are our employees that sell life and health insurance products directly to individuals and small businesses.  Senior market insurance business. Throughout the reporting period, the senior market insurance business provided individual insurance products, primarily long-term care insurance, tailored to the needs of older  50  individuals. The level of operating earnings reported in any period during the reporting period for our senior market insurance business generally depended on growth in underwritten business, business mix, risk concentration, the ability to adjust premium rates, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues were generated primarily from new and renewal premiums. As a result of our decision to cease actively underwriting long-term care insurance after December 31, 2005, operating earnings from this business segment will be dependent on our ability to adjust premium rates, persistency of business in force, benefit payouts and administrative expenses incurred. Revenues will be generated primarily from renewal premiums.  Third-party administration business. The third-party administration business provides administrative services to both the worksite insurance business and the senior insurance market business, as well as to third parties such as employers with self-funded insured health plans, other insurance carriers who do not administer the plans they offer, reinsurers and managed care plans. Fees paid by our insurance operations to our third-party administrative services subsidiary are eliminated in our consolidated financial statements. Fees received from third parties for these services are recorded as commissions and fee income in our consolidated statements of operations. Costs associated with the operation of this business primarily reflect general overhead expenses and related information technology costs that are reflected in our consolidated statements of operations as
general insurance expenses.  Acquired business. Our predecessor obtained over time through assumption and indemnity reinsurance transactions, a number of blocks of life and health insurance business in which it has since elected to discontinue accepting new business. Revenue from this business reflects renewal premiums and other considerations on business in force that will continue to decline over time as policies lapse. The earnings generated by acquired blocks of business in any period will be affected by, among other things, historical pricing levels together with approved premium rate increases if any, diversification of the underlying insurance policies, persistency and loss frequency and severity.  Corporate and other. The corporate and other segment includes investment income earned on the investment portfolio related to capital and surplus not allocated to the insurance segments. This segment also includes marketing allowances, commissions and related expenses pertaining to product sales for other insurance carriers, which are currently not material. In addition, this segment includes certain unallocated expenses, primarily deferred compensation and incentive compensation costs, and other unallocated immaterial items. The results of this business segment are reflected in the following discussions of net investment income, realized investment gains and losses, and general insurance expenses.  Definitions of Insurance Terms  The following list includes definitions of insurance terms used in the discussion of our consolidated results of operations. Terms are listed in alphabetical order.  
        Amortization of DAC and VOBA:  DAC relating to most insurance products is amortized over the premium-paying period of related policies in a manner consistent with the establishment of benefit reserves. The amortization of VOBA is comparable to the amortization of DAC and is recognized using amortization schedules established at the time of acquisition based upon expected patterns of premiums, mortality, policy lapses and morbidity, and adjustments are made to take into account certain variances between expected and actual costs.
 
        Assumed Premiums:  Assumed premiums represent premiums written and issued by other insurance companies and subsequently reinsured by us.
 
        Benefits and expenses:  Benefits and expenses consist primarily of policyholder benefits, insurance commissions, general insurance expenses, insurance taxes, licenses and fees, depreciation and amortization and the amortization of DAC and VOBA.
 
        Benefits to premiums ratio:  Benefits to premiums ratio equals policyholder benefits divided by net premiums. In general, an increase in the ratio indicates a decrease in underwriting margins of the relevant business segment. Conversely, a decrease in the ratio generally indicates an increase in underwriting margins for the relevant business segment. Our management believes that this ratio is more meaningful in evaluating the changes in underwriting margins on our products from period to period than comparing absolute dollar changes in premiums and reserves because growth in net premiums produces corresponding increases in reserves.
  51  
        Ceded Premiums:  Ceded premiums represent premiums either written by or assumed by us and subsequently reinsured by other insurance companies.
 
        Commission and fee income:  Commission and fee income consists of the commissions received by our insurance marketing business for the sale by us of insurance products underwritten by other insurance companies and fees generated by our third-party administration business. In addition, both of these businesses provide services to us. The commission and fee income for services that these businesses provide to us is eliminated from the financial statement amounts referenced in this report.
 
        Depreciation and amortization:  This item includes depreciation of fixed assets such as information technology hardware and amortization of intangible assets such as software licenses. This item is not discussed in detail in this Managements Discussion and Analysis of Financial Condition and Results of Operations because it does not generally fluctuate significantly from period to period and is not a significant performance statistic considered by our management.
 
        Direct Premiums:  Direct premiums represent premiums on insurance products written and issued by us.
 
        General insurance expenses:  General insurance expenses include primarily selling, general and administrative expenses incurred by corporate headquarters personnel in conducting operations including marketing, policy set-up, administration, adjudication and customer service.
 
        Insurance commissions:  Insurance commissions represent renewal commissions on products after the first anniversary date as well as first year commissions that are not deferred.
 
        Insurance taxes, licenses and fees:  Insurance taxes, licenses and fees are primarily comprised of employment taxes, premium taxes and various filing fees required by the jurisdictions in which we do business.
 
        Net premiums:Net premiums represent the sum of direct premiums and assumed premiums, less ceded premiums.
 
        New premiums:New premiums represent premiums collected within the first twelve months following the initial policy date.
 
        New sales:New sales represent annualized premiums on new policies issued.
 
        Other income:Other income is comprised primarily of commission and expense allowances from reinsurance companies relating to insurance ceded from us to the reinsurance companies.
 
        Other Operating Measures:These are measures that do not appear in the consolidated statement of operations, but are used by our management to evaluate our operating results.
 
        Policyholder benefits:Policyholder benefits consist of the policy benefit claims paid to policyholders and the increase or decrease in benefit reserves. The primary factors affecting policyholder benefits are premium growth, claims experience and reserve assumptions including persistency, morbidity, mortality and interest rates.
 
        Premiums:Premiums are categorized as direct, assumed, ceded, and net. Each of these categories are further categorized as new or renewal.
 
        Renewal premiums:Renewal premiums represent the premiums derived from policies greater than twelve months from the original policy date.
 
        Revenues:Revenues consist primarily of premiums, net investment income, commission and fee income, realized investment gains and losses and other income.
  Consolidated Results of Operations  The following discussion reflects our and our predecessors results for the years ended December 31, 2006, 2005, and 2004.  We were incorporated on January 21, 2004, and completed our initial public offering of common stock on December 21, 2004.  Concurrently with the completion of our initial public offering, we completed the acquisition of Kanawha and its subsidiaries. For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material.  Our future results may not be consistent with the historical results of our predecessor. The following discussion should be read in conjunction with our consolidated financial statements and the related notes included elsewhere in this report.   52


The following represents a summary of our and our predecessors statement of operations and asset composition by reportable segment. Except as noted, the financial statement information of the Predecessor set forth below is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition of the predecessor.  During the quarter ended June 30, 2006, the Company implemented the use of seriatim PGAAP reserve factors.  While the implementation of seriatim PGAAP factors did not change total reserves of the Company, it did result in a reallocation of reserves among the worksite insurance, senior market insurance and acquired business segments.  This reallocation has been reflected in the current results of the affected segments.  The result of the reallocation of reserves between business segments was to strengthen reserves by $37.5 million in the senior market insurance business segment.  This was offset by a reduction in reserves of $31.2 million in the acquired business segment and $6.3 million in the worksite segment.  No material effect to overall policy reserves or to earnings results from the reallocation.  Subsequent reserve adequacy testing of policy reserves by segment indicates that the resulting alignment of reserves is sufficient in each segment.  This reallocation of reserves between business segments does impact the comparability of the current reported policyholder benefits and the resulting reported benefit ratios by segment.  53   KMG America
        
        
        PredecessorFor Year Ended December 31,
        
        
        For the Period from January 21 through December 31,
        
        
        For the Year EndedDecember 31,2006
        
        
        2005
        
        
        2004
        
        
        2004Worksite Insurance BusinessInsurance premiums
        
        $
        83,795,394
        
        $
        60,528,639
        
        $
        
        
        $
        56,308,493Net investment income
        
        
        7,180,951
        
        
        6,524,218
        
        
        
        
        
        5,028,355Commission and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        395,735
        
        
        172,142
        
        
        
        
        
        263,734Total revenues
        
        
        91,372,080
        
        
        67,224,999
        
        
        
        
        
        61,600,582Policyholder benefits
        
        
        55,650,934
        
        
        43,556,110
        
        
        
        
        
        44,292,442Commissions
        
        
        7,203,019
        
        
        3,741,433
        
        
        
        
        
        3,779,844Expenses, taxes, fees and depreciation
        
        
        17,633,880
        
        
        16,327,059
        
        
        
        
        
        9,966,881Amortization of DAC and VOBA
        
        
        2,712,883
        
        
        3,657,962
        
        
        
        
        
        6,208,791Total benefits and expenses
        
        
        83,200,716
        
        
        67,282,564
        
        
        
        
        
        64,247,958Income (loss) before Federal income tax
        
        $
        8,171,364
        
        $
        (57,565
        )
        $
        
        
        $
        (2,647,376
        )Total assets
        
        $
        170,761,006
        
        $
        166,401,638
        
        $
        
        
        $
        169,760,986
        (1)Senior Market Insurance BusinessInsurance premiums
        
        $
        41,486,187
        
        $
        42,239,844
        
        $
        
        
        $
        42,060,326Net investment income
        
        
        7,868,932
        
        
        4,641,343
        
        
        
        
        
        3,878,429Commission and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        3,180,609
        
        
        2,935,257
        
        
        
        
        
        2,346,577Total revenues
        
        
        52,535,728
        
        
        49,816,444
        
        
        
        
        
        48,285,332Policyholder benefits
        
        
        68,737,309
        
        
        35,355,291
        
        
        
        
        
        35,829,058Commissions
        
        
        5,155,456
        
        
        5,494,810
        
        
        
        
        
        5,481,986Expenses, taxes, fees and depreciation
        
        
        2,957,915
        
        
        3,995,699
        
        
        
        
        
        3,695,003Amortization of DAC and VOBA
        
        
        1,586,879
        
        
        553,539
        
        
        
        
        
        641,079Total benefits and expenses
        
        
        78,437,559
        
        
        45,399,339
        
        
        
        
        
        45,647,126Income(loss) before Federal income tax
        
        $
        (25,901,831
        )
        $
        4,417,105
        
        $
        
        
        $
        2,638,206Total assets
        
        $
        259,132,462
        
        $
        193,889,081
        
        $
        
        
        $
        160,381,684
        (1)Third-Party Administration BusinessInsurance premiums
        
        $
        
        
        $
        
        
        $
        
        
        $
        Net investment income
        
        
        
        
        
        
        
        
        
        
        
        Commission and fees
        
        
        16,126,591
        
        
        14,263,603
        
        
        
        
        
        13,295,120Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        504
        
        
        3,052
        
        
        
        
        
        798Total revenues
        
        
        16,127,095
        
        
        14,266,655
        
        
        
        
        
        13,295,918Policyholder benefits
        
        
        
        
        
        
        
        
        
        
        
        Commissions
        
        
        
        
        
        
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        14,049,613
        
        
        12,838,087
        
        
        
        
        
        12,200,228Amortization of DAC and VOBA
        
        
        
        
        
        
        
        
        
        
        
        Total benefits and expenses
        
        
        14,049,613
        
        
        12,838,087
        
        
        
        
        
        12,200,228Income (loss) before Federal income tax
        
        $
        2,077,482
        
        $
        1,428,568
        
        $
        
        
        $
        1,095,690Total assets
        
        $
        9,755,772
        
        $
        11,102,572
        
        $
        
        
        $
        8,186,306
        (1)
    54   KMG America
        
        
        PredecessorFor the Year Ended December 31,
        
        
        For the Period from January 21 through December 31,
        
        
        For the Year Ended December 31,2006
        
        
        2005
        
        
        2004
        
        
        2004Acquired BusinessInsurance premiums
        
        $
        2,687,116
        
        $
        4,119,035
        
        $
        
        
        $
        4,466,726Net investment income
        
        
        8,056,398
        
        
        7,807,899
        
        
        
        
        
        8,507,129Commissions and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        70,945
        
        
        69,072
        
        
        
        
        
        115,613Total revenues
        
        
        10,814,459
        
        
        11,996,006
        
        
        
        
        
        13,089,468Policyholder benefits
        
        
        (24,545,954
        )
        
        5,376,325
        
        
        
        
        
        10,053,493Commissions
        
        
        366,172
        
        
        398,989
        
        
        
        
        
        428,247Expenses, taxes, fees and depreciation
        
        
        2,519,477
        
        
        2,740,522
        
        
        
        
        
        2,829,686Amortization of DAC and VOBA
        
        
        (194,140
        )
        
        (744,002
        )
        
        
        
        
        2,618,432Total benefits and expenses
        
        
        (21,854,445
        )
        
        7,771,834
        
        
        
        
        
        15,929,858Income (loss) before Federal income tax
        
        $
        32,668,904
        
        $
        4,224,172
        
        $
        
        
        $
        (2,840,390
        )Total assets
        
        $
        161,089,271
        
        $
        204,288,455
        
        $
        
        
        $
        215,850,711
        (1)Corporate and OtherInsurance premiums
        
        $
        
        
        $
        
        
        $
        
        
        $
        Net investment income
        
        
        6,839,525
        
        
        8,771,411
        
        
        18,408
        
        
        7,788,499Commissions and fees
        
        
        378,073
        
        
        301,024
        
        
        
        
        
        180,402Net realized gains
        
        
        1,218,465
        
        
        358,318
        
        
        
        
        
        9,432,585Gain on extinguishment of debt
        
        
        1,020,839
        
        
        
        
        
        
        
        
        Other income
        
        
        803,849
        
        
        688,349
        
        
        
        
        
        381,505Total revenues
        
        
        10,260,751
        
        
        10,119,102
        
        
        18,408
        
        
        17,782,991Policyholder benefits
        
        
        
        
        
        
        
        
        
        
        
        Commissions
        
        
        
        
        
        
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        16,209,552
        
        
        13,519,416
        
        
        288,489
        
        
        6,272,750Amortization of DAC and VOBA
        
        
        
        
        
        
        
        
        
        
        
        Total benefits and expenses
        
        
        16,209,552
        
        
        13,519,416
        
        
        288,489
        
        
        6,272,750Income (loss) before Federal income tax
        
        $
        (5,948,801
        )
        $
        (3,400,314
        )
        $
        (270,081
        )
        $
        11,510,241Total assets
        
        $
        230,975,335
        
        $
        221,683,323
        
        $
        770,051,331
        
        $
        157,714,248
        (1)Total Company:Insurance premiums
        
        $
        127,968,697
        
        $
        106,887,518
        
        $
        
        
        $
        102,835,545Net investment income
        
        
        29,945,806
        
        
        27,744,871
        
        
        18,408
        
        
        25,202,412Commissions and fees
        
        
        16,504,664
        
        
        14,564,627
        
        
        
        
        
        13,475,522Net realized gains
        
        
        1,218,465
        
        
        358,318
        
        
        
        
        
        9,432,585Gain on extinguishment of debt
        
        
        1,020,839
        
        
        
        
        
        
        
        
        Other income
        
        
        4,451,642
        
        
        3,867,872
        
        
        
        
        
        3,108,227Total revenues
        
        
        181,110,113
        
        
        153,423,206
        
        
        18,408
        
        
        154,054,291Policyholder benefits
        
        
        99,842,289
        
        
        84,287,726
        
        
        
        
        
        90,174,993Commissions
        
        
        12,724,647
        
        
        9,635,232
        
        
        
        
        
        9,690,077Expenses, taxes, fees and depreciation
        
        
        53,370,437
        
        
        49,420,783
        
        
        288,489
        
        
        34,964,548Amortization of DAC and VOBA
        
        
        4,105,622
        
        
        3,467,499
        
        
        
        
        
        9,468,302Total benefits and expenses
        
        
        170,042,995
        
        
        146,811,240
        
        
        288,489
        
        
        144,297,920Income (loss) before Federal income tax
        
        $
        11,067,118
        
        $
        6,611,966
        
        $
        (270,081
        )
        $
        9,756,371Total assets
        
        $
        831,713,846
        
        $
        797,365,069
        
        $
        770,051,331
        
        $
        N/A(2)
  (1)KMG America at December 31, 2004, adjusted for purchase accounting adjustments to reflect the Kanawha acquisition. (2)Aggregate total assets for our predecessor as of December 31, 2004, is not reported because our predecessor had been acquired by KMG America at that date and our predecessors assets had been consolidated into the KMG America balance sheet at that date.  55  Year Ended December 31, 2006, Compared to Year Ended December 31, 2005  Financial Results Overview.Net income for the year ended December 31, 2006, increased $ 2.5 million, or 53.2%, to $ 7.2 million from net income of $ 4.7 million in 2005.The increase in net income was primarily due to increases in premiums, net investment income, and net realized gains, offset by increases in policyholder benefits and general expenses, all of which are described in greater detail below.  Revenues.Total revenues for the year ended December 31, 2006, increased $27.7 million, or 18.1%, to $181.1 million from total revenues of $153.4 million in 2005. The primary factors causing the fluctuations are explained below under the captions Premiums, Net Investment Income Commission and Fee Income Realized Investment Gains and Losses and Other Income.  Premiums.The following table presents the distribution of premiums by type and business segment.  For the year ended December31, 2006
        
        For the year ended December31, 2005
        
        Increase (decrease)Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        Total(dollars in millions)DirectNew
        
        $
        44.7
        
        $
        0.7
        
        $
        
        
        $
        45.4
        
        $
        18.6
        
        $
        1.8
        
        $
        
        
        $
        20.4
        
        $
        26.1
        
        $
        (1.1
        )
        $
        
        
        $
        25.0Renewal
        
        
        45.6
        
        
        55.0
        
        
        
        
        
        100.6
        
        
        45.0
        
        
        54.2
        
        
        
        
        
        99.2
        
        
        0.6
        
        
        0.8
        
        
        
        
        
        1.4Total
        
        
        90.3
        
        
        55.7
        
        
        
        
        
        146.0
        
        
        63.6
        
        
        56.0
        
        
        
        
        
        119.6
        
        
        26.7
        
        
        (0.3
        )
        
        
        
        
        26.4AssumedNew
        
        
        2.7
        
        
        
        
        
        
        
        
        2.7
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        2.7
        
        
        
        
        
        
        
        
        2.7Renewal
        
        
        0.7
        
        
        
        
        
        2.7
        
        
        3.4
        
        
        
        
        
        
        
        
        4.1
        
        
        4.1
        
        
        0.7
        
        
        
        
        
        (1.4
        )
        
        (0.7
        )Total
        
        
        3.4
        
        
        
        
        
        2.7
        
        
        6.1
        
        
        
        
        
        
        
        
        4.1
        
        
        4.1
        
        
        3.4
        
        
        
        
        
        (1.4
        )
        
        2.0CededNew
        
        
        (8.8
        )
        
        (0.4
        )
        
        
        
        
        (9.2
        )
        
        (2.1
        )
        
        (1.0
        )
        
        
        
        
        (3.1
        )
        
        (6.7
        )
        
        0.6
        
        
        
        
        
        (6.1
        )Renewal
        
        
        (1.1
        )
        
        (13.8
        )
        
        
        
        
        (14.9
        )
        
        (1.0
        )
        
        (12.8
        )
        
        0.0
        
        
        (13.8
        )
        
        (0.1
        )
        
        (1.0
        )
        
        
        
        
        (1.1
        )Total
        
        
        (9.9
        )
        
        (14.2
        )
        
        
        
        
        (24.1
        )
        
        (3.1
        )
        
        (13.8
        )
        
        0.0
        
        
        (16.9
        )
        
        (6.8
        )
        
        (0.4
        )
        
        
        
        
        (7.2
        )NetNew
        
        
        38.6
        
        
        0.3
        
        
        
        
        
        38.9
        
        
        16.5
        
        
        0.8
        
        
        
        
        
        17.3
        
        
        22.1
        
        
        (0.5
        )
        
        
        
        
        21.6Renewal
        
        
        45.2
        
        
        41.2
        
        
        2.7
        
        
        89.1
        
        
        44.0
        
        
        41.4
        
        
        4.1
        
        
        89.5
        
        
        1.2
        
        
        (0.2
        )
        
        (1.4
        )
        
        (0.4
        )Total
        
        
        83.8
        
        
        41.5
        
        
        2.7
        
        
        128.0
        
        
        60.5
        
        
        42.2
        
        
        4.1
        
        
        106.8
        
        
        23.3
        
        
        (0.7
        )
        
        (1.4
        )
        
        21.2
  Worksite net new premiums increased $22.1 million, or 133.9%, to $38.6 million for the year ended December 31, 2006, from $16.5 million for the year ended December 31, 2005, due to increased sales volumes generated by the new KMG America sales force. There were direct new premiums of $44.7 million, offset by $8.8 million of ceded new premiums.  In addition, there was $2.7 million of new reinsurance assumed premium for the block acquisition of voluntary term life insurance and universal life insurance policies from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.  Effective September 1, 2006, KMG Americas subsidiaries Kanawha and Kanawha HealthCare Solutions entered into a reinsurance and administrative arrangement with Columbian Life Insurance Company (CLIC) and Columbian Mutual Life Insurance Company (CMLIC).  CLIC and CMLIC are affiliates of each other.  Under the arrangement, Kanawha reinsures 100% of the risk of a block of voluntary term life insurance policies and universal life insurance policies from CLIC and CMLIC.  Kanawha HealthCare Solutions, Inc. will assume responsibility for the administration of these policies.  As part of the transaction, CLIC and CMLIC also assigned key trademarks to Kanawha for these insurance policies and their marketing brand, UNIQ Benefit Solutions.  Senior market net new premiums decreased $0.5 million, or 62.5%, to $0.3 million for the year ended December 31, 2006, from $0.8 million for the year ended December 31, 2005 due to decreased sales volumes as the Company effective December 31, 2005, ceased actively underwriting new long term care policies. Sales in 2006 result from business submitted prior to December 31, 2005 and issued in 2006, as well as the exercise of guaranteed purchase options on in force policies. Net renewal premiums decreased $ 0.2 million, or 0.5% to $41.2 million for the year ended December 31, 2006, from $41.4 million for the year ended December 31, 2005. This business represents the insurance in force created by prior year sales.  Acquired business premiums decreased $1.4 million, or 34.1%, to $2.7 million for the year ended December 31, 2006 from $4.1 million for the year ended December 31, 2005.  We have not acquired any blocks of business in this segment since 1999 and the decline is a result of policy lapses.   56  Net Investment Income.Net investment income increased $2.2 million, or 7.9%, to $29.9 million in the year ended December 31, 2006, from $27.7 million in the year ended December 31, 2005. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The increase in investment income in 2006 occurred primarily as a result of investing in longer term securities in combination with higher interest rates in 2006. Cash and invested assets on an amortized cost basis increased $7.3 million, or 1.3%, to $590.9 million as of December 31, 2006, from $583.6 million as of December 31, 2005. Generally, an increase in invested assets is due to retention of premiums to establish policy reserves for the payment of future policyholder benefits.  The average yield on cash and invested assets on an amortized cost basis was 5.06 % for the year ended December 31, 2006, compared to an average yield of 4.78 % for the year ended December 31, 2005. This increase resulted from higher interest rates combined with the significantly lesser amount of assets held in cash during 2006.  Net investment income is allocated to our various business segments on a pro rata basis based on the invested assets attributed to the business segment. Assets attributed to the senior market insurance segment continue to increase as a result of policy reserve increases in this segment, while assets attributed to the acquired segment continue to decline as this business lapses. In addition, the reallocation of reserves has a corresponding reallocation of attributed assets between business segments. This balance sheet impact is further discussed in Note 16 Business Segments, of the Notes to Consolidated Financial Statements included in this report, which is incorporated herein by reference.  Commission and Fee Income.Commission and fee income increased $1.9 million, or 13.0%, to $16.5 million for the year ended December 31, 2006, from $14.6 million for the year ended December 31, 2005. Most of the commission and fee income was from administrative fees relating to third-party administration. The increase was due to an increase in business in force resulting from increased sales of our administrative services.  Realized Investment Gains and Losses.Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain in the year ended December 31, 2006 increased by $0.8 million to $1.2 million from $0.4 million in the year ended December 31, 2005. The net loss realized on fixed maturity securities in the year ended December 31, 2006, totaled $0.6 million compared to a net gain realized on fixed maturity securities of $0.1 million in the year ended December 31, 2005.  The capital losses recognized in 2006 resulted from the sale of assets as is necessary from time to time in order to keep the portfolio properly structured.  Offsetting these capital losses in 2006 were capital gains of $0.6 million which were recognized due to marking to market investments held in the Companys trading account. These
investments represent the assets purchased to support the deferred compensation liability of the Company, and realized gains and/ or losses are directly offset with increases and /or decreases in compensation expenses.  Also, there was recognition of $1.3 million of additional capital gains in 2006 as the result of the sale of our investment in a limited liability company owned by a subsidiary of Kanawha Insurance Company.  Realized investment gains and losses are allocated entirely to the corporate and other business segment.  Gain on extinguishment of debt.In the fourth quarter of 2006 the Company realized a $1.0 million gain on the payoff of its subordinated promissory note to the former owners of Kanawha.  Other Income.Other income increased $0.6 million, or 15.4%, to $4.5 million in the year ended December 31, 2006, from $3.9 million in the year ended December 31, 2005, reflecting increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums. Also, there was $0.2 million of other income from the new reinsurance assumed universal life policies premium loads and fees for the block acquisition from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.  Benefits and Expenses.Total benefits and expenses increased $23.2 million, or 15.8 %, to $170.0 million in the year ended December 31, 2006, from $146.8 million in the year ended December 31, 2005. The primary factors causing this increase are explained below under the captions Policyholder Benefits, Insurance Commissions, General Insurance Expenses, Insurance Taxes, Licenses and Fees and Amortization of DAC and VOBA.  Policyholder Benefits.Policyholder benefits increased $15.5 million, or 18.4 %, to $99.8 million in the year ended December 31, 2006, from $84.3 million in the year ended December 31, 2005. This produced a benefits to premium ratio of 78.0 % in 2006 compared to 78.9 % in 2005. The primary drivers behind the benefits to premium ratio change by segment is discussed in the next three paragraphs.  57   Worksite marketing policyholder benefits increased $12.1 million, or 27.8%, to $55.7 million for the year ended December 31, 2006, from $43.6 million for the year ended December 31, 2005. This produced a benefits to premium ratios of 66.4% for the year ended December 31, 2006, compared to 72.0% for the year ended December 31, 2005. The 2006 ratio is impacted by the $6.3 million conversion adjustment to PGAAP seriatim reserve factors from the aggregate method which was completed as of June 30, 2006 , and resulted in decreased benefits coupled with an increase in new premiums with more favorable benefit ratios. The 2006 benefits to premium ratio excluding the reserve conversion impact would be 73.9%. The unfavorable benefit experience in the worksite segment is driven by a few factors. The Company increased loss reserves on its stop loss cases by $2.0 million in the fourth quarter of
2006 related to the continued transition from formula reserving to actual claims experience as claims associated with cases written in 2005 and early 2006 continue to exceed pricing expectations. The Company had also recognized additional loss reserves of $0.9 million in the third quarter of 2006. Volatility, both favorable and unfavorable, is not uncommon in small, growing books of business. Cases giving rise to these excess claims have since been re- priced or did not renew.  Senior market policyholder benefits increased $33.3 million, or 94.1%, to $68.7 million for the year ended December 31, 2006, from $35.4 million for the year ended December 31, 2005. This produced a benefits to premium ratios of 165.7% for the year ended December 31, 2006, compared to 83.7% for the year ended December 31, 2005. The 2006 ratio is impacted by the $37.5 million conversion adjustment to PGAAP seriatim reserve factors from the aggregate method which was completed as of June 30, 2006, and resulted in increased benefits.  The 2006 benefits to premium ratio excluding the reserve conversion impact would be 75.3%.  Acquired business policyholder benefits decreased $29.9 million to $(24.5) million for the year ended December 31, 2006, from $5.4 million for the year ended December 31, 2005. This produced benefits to premium ratios of (913.5)% for the year ended December 31, 2006, compared to 130.5% for the year ended December 31, 2005.  The 2006 ratio is impacted by the $31.2 million conversion adjustment to PGAAP seriatim reserve factors from the aggregate method which was completed as of June 30, 2006, and resulted in decreased benefits. Also, coupled with this is the fact that these benefits to premium ratios are impacted by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. The 2006 benefits to premium ratio excluding the reserve conversion impact would be 248.9%.  Insurance Commissions.Commission expenses increased $3.1 million, or 32.3%, to $12.7 million in the year ended December 31, 2006, from $9.6 million in the year ended December 31, 2005. The increase consists of normal increases related to increased renewal premiums, in addition to an increase in first year commissions that were not deferred, a large portion of which relates to the increased sales of excess risk products.  General Insurance Expenses.General insurance expenses increased $3.5 million, or 8.4%, to $45.4 million in the year ended December 31, 2006, from $41.9 million in the year ended December 31, 2005. The increased expenses in the year ended December 31, 2006, are primarily attributable to increases in salaries and related benefits due to the additional staff associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel. Also, there was the recognition of employee and director stock option and common stock expense of $1.4 million as a result of the adoption of SFAS123(R)  Share Based Compensation. Fourth quarter 2006 expenses include a one-time pretax benefit of $1.0 million related to the discount associated with retiring and replacing the Company's $15 million subordinated note with
bank debt.  Insurance Taxes, Licenses and Fees.Insurance taxes, licenses and fees increased $0.6 million, or 12.8%, to $5.3 million in the year ended December 31, 2006 from $4.7 million in the year ended December 31, 2005. The increase is driven by employment taxes related to additional staffing and additional premium taxes due to the increased premiums primarily as a result of new business in the worksite segment.  Amortization of DAC and VOBA.First year commissions and general insurance expenses associated with the acquisition of new business are deferred and amortized over the premium-paying period of the related policies. The total deferrals of policy acquisition costs were $15.6 million and $15.0 million for the years ended December 31, 2006 and 2005, respectively. The increase in deferrals was primarily due to the increase in net new premiums and the associated increase in commissions and expenses in the worksite segment somewhat offset by the decrease in net new long-term care premiums in the senior segment.   58


The amortization of deferred acquisition costs (DAC) and the value of business acquired (VOBA) increased $0.6 million, or 17.1%, to $4.1 million for the year ended December 31, 2006, from $3.5 million for the year ended December 31, 2005. The DAC balance at December 31, 2006 has increased by $14.5 million, or 103.6%, over the balance at December 31, 2005. This is due to the fact that our predecessors DAC balance was eliminated at December 31, 2004, when the acquisition was completed. Therefore, as of December 31, 2005 there was only one year of deferrals compared to two years of deferrals as of December 31, 2006. The increase in the DAC balance accounts for the related increase in amortization expense.  Provision for Income Taxes.Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carry forwards available. The effective income tax rates for the years ended December 31, 2006, and 2005 were 34.8 % and 32.2 % respectively. The variations in these rates are due to the fact that a portion of our consolidated income for the years ended December 31, 2006 and December 31, 2005 resulted from a subsidiary that has net operating loss carry forwards available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the
consolidated company. The variation in the overall consolidated rate between periods is driven by the level of the subsidiarys contribution to total income.  Year Ended December 31, 2005, Compared to Year Ended December 31, 2004  Financial Results Overview.Net income for the year ended December 31, 2005, decreased $1.5 million, or 24.2%, to $4.7 million from net income of $6.2 million in 2004. The decrease in net income was primarily due to decreases in revenues as the result of decreases in net realized gains offset by increases in premiums. In addition there were increases in expenses offset by decreases in policyholder benefits, all of which are described in greater detail below.  Revenues.Total revenues for the year ended December 31, 2005, decreased $0.7 million, or 0.5%, to $153.4 million from total revenues of $154.1 million in 2004. The primary factors causing the fluctuations are explained below under the captions Premiums, Net Investment Income Commission and Fee Income Realized Investment Gains and Losses and Other Income.  Premiums.The following table presents the distribution of premiums by type and business segment.  For the year ended December31, 2005
        
        For the year ended December31, 2004
        
        Increase (decrease)Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        Total(dollars in millions)DirectNew
        
        $
        18.6
        
        $
        1.8
        
        $
        
        
        $
        20.4
        
        $
        13.6
        
        $
        4.4
        
        $
        
        
        $
        18.0
        
        $
        5.0
        
        $
        (2.6
        )
        $
        
        
        $
        2.4Renewal
        
        
        45.0
        
        
        54.2
        
        
        
        
        
        99.2
        
        
        44.7
        
        
        50.6
        
        
        
        
        
        95.3
        
        
        0.3
        
        
        3.6
        
        
        
        
        
        3.9Total
        
        
        63.6
        
        
        56.0
        
        
        
        
        
        119.6
        
        
        58.3
        
        
        55.0
        
        
        
        
        
        113.3
        
        
        5.3
        
        
        1.0
        
        
        
        
        
        6.3AssumedNew
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        Renewal
        
        
        
        
        
        
        
        
        4.1
        
        
        4.1
        
        
        
        
        
        
        
        
        4.6
        
        
        4.6
        
        
        
        
        
        
        
        
        (0.5
        )
        
        (0.5
        )Total
        
        
        
        
        
        
        
        
        4.1
        
        
        4.1
        
        
        
        
        
        
        
        
        4.6
        
        
        4.6
        
        
        
        
        
        
        
        
        (0.5
        )
        
        (0.5
        )CededNew
        
        
        (2.1
        )
        
        (1.0
        )
        
        
        
        
        (3.1
        )
        
        (0.9
        )
        
        (2.8
        )
        
        0.0
        
        
        (3.7
        )
        
        (1.2
        )
        
        1.8
        
        
        
        
        
        0.6Renewal
        
        
        (1.0
        )
        
        (12.8
        )
        
        0.0
        
        
        (13.8
        )
        
        (1.1
        )
        
        (10.1
        )
        
        (0.1
        )
        
        (11.3
        )
        
        0.1
        
        
        (2.7
        )
        
        0.1
        
        
        (2.5
        )Total
        
        
        (3.1
        )
        
        (13.8
        )
        
        0.0
        
        
        (16.9
        )
        
        (2.0
        )
        
        (12.9
        )
        
        (0.1
        )
        
        (15.0
        )
        
        (1.1
        )
        
        (0.9
        )
        
        0.1
        
        
        (1.9
        )NetNew
        
        
        16.5
        
        
        0.8
        
        
        
        
        
        17.3
        
        
        12.7
        
        
        1.6
        
        
        0.0
        
        
        14.3
        
        
        3.8
        
        
        (0.8
        )
        
        
        
        
        3.0Renewal
        
        
        44.0
        
        
        41.4
        
        
        4.1
        
        
        89.5
        
        
        43.6
        
        
        40.5
        
        
        4.5
        
        
        88.6
        
        
        0.4
        
        
        0.9
        
        
        (0.4
        )
        
        0.9Total
        
        
        60.5
        
        
        42.2
        
        
        4.1
        
        
        106.8
        
        
        56.3
        
        
        42.1
        
        
        4.5
        
        
        102.9
        
        
        4.2
        
        
        0.1
        
        
        (0.4
        )
        
        3.9
  Worksite net new premiums increased $3.8 million, or 29.9%, to $16.5 million for the year ended December 31, 2005, from $12.7 million for the year ended December 31, 2004, due to increased sales volumes. New sales increased $1.7 million, or 12.8%, to $15.0 million in the year ended December 31, 2005, from $13.3 million in the year ended December 31, 2004, due to increased emphasis on this core business segment. Net renewal premiums increased $0.4 million, or 0.9%, due to the increased amount of insurance in force created by prior year sales.  Senior market net new premiums decreased $0.8 million, or 50.0%, to $0.8 million for the year ended December 31, 2005, from $1.6 million for the year ended December 31, 2004, due to a decrease in new sales. New  59  sales decreased $1.7 million, or 53.1%, to $1.5 million in the year ended December 31, 2005, from $3.2 million in the year ended December 31, 2004. A sales decline that began in mid-2003, resulting from the discontinuance of an older product and the introduction of a new product with significantly higher premiums, continued into 2005. In addition, decisions were made to no longer actively underwrite long term care insurance policies after December 31, 2005 and to close our primary long term care distribution office in October, 2005. We intend to retain and actively manage the existing in force block of long term care. Net renewal premiums increased $0.9 million, or 2.2%, due to the increased amount of insurance in force created by prior year sales. This increase is reflected in both the direct renewal premiums and the ceded renewal premiums.  Acquired business premiums decreased $0.5 million, or 10.9%, to $4.1 million for the year ended December 31, 2005, from $4.6 million for the year ended December 31, 2004. Neither we nor our predecessor has acquired any blocks of business since 1999 and the decline is a result of policy lapses.  Net Investment Income.Net investment income increased $2.5 million, or 9.9%, to $27.7 million in the year ended December 31, 2005, from $25.2 million in the year ended December 31, 2004. Net investment income for 2004 was negatively impacted by a non-recurring $1.6 million incentive payment to one of Kanawhas outside investment managers at the conclusion of the contract period. Excluding this item, net investment income increased $0.9 million in the year ended December 31, 2005.  Net investment income is primarily affected by changes in levels of invested assets and interest rates. The increase in investment income in 2005 occurred as a result of an increase in total cash and investments of approximately $58.0 million that occurred in conjunction with the completion of our initial public offering on December 21, 2004. These proceeds were held in short
term investments or cash equivalents for the majority of 2005, which produced lower effective yields for that portion of the portfolio. Invested assets increased by $82.2 million or 17.8%, to $543.3 million as of December 31, 2005, from $461.1 million as of December 31, 2004, reflecting the investment of cash generated by 2004 asset sales and our initial public offering. Generally, increases in cash and invested assets are due to retention of premiums to establish policy reserves for the payment of future policyholder benefits.  The average yield on cash and invested assets on an amortized cost basis was 4.78% for the year ended December 31, 2005, compared to an average yield of 5.14% for the year ended December 31, 2004, excluding the effects of the non-recurring $1.6 million incentive payment to one of Kanawhas outside investment managers. This decline resulted from lower interest rates combined with the significantly larger amount of assets held in cash for a significant period of time during the year ended December 31, 2005. The incentive payment made in 2004 was charged directly to the corporate and other segment, while all other net investment income is allocated to our various business segments on a pro rata basis based on the invested assets attributed to the business segment.  In conjunction with the application of GAAP purchase accounting requirements, assets attributed to the worksite insurance business, the senior insurance business and the acquired business all increased at December 31, 2004. For 2005, total assets attributed to the worksite insurance business have not experienced any significant fluctuations. Total assets attributed to the senior market insurance business have increased significantly due to the accumulation of long-term care insurance premiums retained to establish policy reserves for the payment of future policyholder benefits. Assets attributed to the third-party administration business consist primarily of operating cash and receivables with respect to administrative claims payments awaiting settlement. These assets are subject to significant variations due to timing of payments made, and there is no investment income attributed to them.
Assets attributed to the acquired business have declined since 1999 as a result of policy lapses and the fact that no blocks of business have been acquired since 1999. Assets attributed to the corporate and other segment are subject to significant fluctuations because changes in unrealized gains are all allocated to the corporate and other segment.  Commission and Fee Income.Commission and fee income increased $1.1 million, or 8.1%, to $14.6 million for the year ended December 31, 2005, from $13.5 million for the year ended December 31, 2004. Most of the commission and fee income was from administrative fees relating to third-party administration. The increase was due to an increase in business in force resulting from increased sales of our administrative services.  Realized Investment Gains and Losses.Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain in the year ended December 31, 2005 decreased by $9.0 million to $0.4 million from $9.4 million in the year ended December 31, 2004. The net gain realized on fixed maturity securities in the year ended December 31, 2005, totaled $0.1million compared to a net gain realized on fixed maturity securities of $7.1 million in the year ended December 31, 2004. In 2004, our predecessors investment committee elected to take advantage of favorable market conditions for fixed maturity securities by  60  selling certain fixed maturity securities to recognize gains. Realized gains on fixed maturity securities in 2005 and 2004 were negatively impacted by impairment charges of $0.2 million and $0.5 million, respectively. The net gain realized on equity securities in the year ended December 31, 2005, totaled $0.0 million compared to a net gain realized on equity securities of $2.4 million for the year ended December 31, 2004. The 2004 gains on equity securities were due to our predecessors investment committees election to take advantage of favorable market conditions by selling certain common stocks to recognize gains on these sales. Realized gains on equity securities in 2005 and 2004 were negatively impacted by impairment charges of $0.0 million and $0.2 million, respectively. The net gain realized on other investments in the year ended December 31, 2005, totaled $0.2 million compared to a net gain
realized on other investments of $0.4 million for the year ended December 31, 2004. Other investments represent the assets purchased to support the deferred compensation liability of the company, and realized gains and or losses are directly offset with increases and or decreases in compensation expenses. Realized investment gains and losses are allocated entirely to the corporate and other business segment.  Other Income.Other income increased $0.8 million, or 25.8%, to $3.9 million in the year ended December 31, 2005, from $3.1million in the year ended December 31, 2004. In 2005, other income includes $0.3 million of proceeds from litigation settlements, resulting from our participation in various class action litigation matters. The remaining increases reflect increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums.  Benefits and Expenses.Total benefits and expenses increased $2.5 million, or 1.7%, to $146.8 million in the year ended December 31, 2005, from $144.3 million in the year ended December 31, 2004. The primary factors causing this increase are explained below under the captions Policyholder Benefits, Insurance Commissions, General Insurance Expenses, Insurance Taxes, Licenses and Fees and Amortization of DAC and VOBA.  Policyholder Benefits.Policyholder benefits decreased $5.9 million, or 6.5 %, to $84.3 million in the year ended December 31, 2005, from $90.2 million in the year ended December 31, 2004. This produced a benefits to premium ratio of 78.9% in 2005 compared to 87.7% in 2004. The benefits to premium ratio declined primarily as a result of the GAAP purchase accounting adjustments described in the next three paragraphs.  Worksite marketing policyholder benefits decreased $0.7 million, or 1.6 %, to $43.6 million for the year ended December 31, 2005, from $44.3 million for the year ended December 31, 2004. This produced benefits to premium ratios of 72.0 % for the year ended December 31, 2005, compared to 78.7% for the year ended December 31, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves.  Senior market policyholder benefits decreased $0.4 million, or 1.1 %, to $35.4 million for the year ended December 31, 2005, from $35.8 million for the year ended December 31, 2004. This produced benefits to premium ratios of 83.7% for the year ended December 31, 2005, compared to 85.2% for the year ended December 31, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves, partially offset by an increase in open active claims due to an increase in the number of policies in force and the aging of our policyholders, which resulted in increases in actual
claims paid and additional claims reserves.  Acquired business policyholder benefits decreased $4.7 million, or 46.5%, to $5.4 million for the year ended December 31, 2005, from $10.1 million for the year ended December 31, 2004. This produced benefits to premium ratios of 130.5% for the year ended December 31, 2005, compared to 225.1% for the year ended December 31, 2004. These benefits to premium ratios are affected by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves.   61  Insurance Commissions.Commission expenses decreased $0.1 million, or 1.0 %, to $9.6 million in the year ended December 31, 2005, from $9.7 million in the year ended December 31, 2004. This change resulted from normal fluctuations related to renewal premiums.  General Insurance Expenses.General insurance expenses increased $14.1million, or 50.7%, to $41.9 million in the year ended December 31, 2005, from $27.8 million in the year ended December 31, 2004. General insurance expenses for 2005 include approximately $13.3 million  of incremental costs associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel, occupancy costs, infrastructure development, back-office expenses, director and officer and related types of insurance coverage, and costs associated with being a public company. Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other
relevant factors. During 2005, we incurred $0.7 million in defense costs related to the ReliaStar litigation and shut down costs of $0.3 million associated with the sale of our Ft. Myers based senior market insurance agency office. We also incurred deferred compensation expenses of $0.2 million associated with the increase in market value of the deferred compensation plan assets. The deferred compensation expenses are directly offset with realized investment gains of the same amount.  Insurance Taxes, Licenses and Fees.Insurance taxes, licenses and fees were unchanged at $4.7 million in the years ended December 31, 2005 and 2004. Premium income, which drives premium taxes, was relatively flat between 2005 and 2004.  Amortization of DAC and VOBA.First year commissions and general insurance expenses associated with the acquisition of new business are deferred and amortized over the premium-paying period of the related policies. The total deferrals of policy acquisition costs were $15.0 million and $13.1 million for the years ended December 31, 2005 and 2004, respectively. The increase in deferrals was primarily due to the increase in net new premiums in the worksite segment somewhat offset by the decrease in net new long-term care premiums in the senior market.  Our predecessor assigned a value to the insurance in force of acquired companies or blocks of insurance business at the date of acquisition. No companies or blocks of business were acquired in 2005 or 2004.  The amortization of DAC and VOBA decreased $6.0 million, or 63.2%, to $3.5 million for the year ended December 31, 2005, from $9.5 million for the year ended December 31, 2004. In accordance with GAAP purchase accounting requirements, our predecessors DAC and VOBA were eliminated, and a new VOBA was established for the value of the in-force business as of December 31, 2004. This adjustment resulted in decreased DAC and VOBA balances, which cause smaller amortization charges going forward.  Provision for Income Taxes.Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carry forwards available. The effective income tax rates for the years ended December 31, 2005, and 2004 were 32.2% and 36.5%, respectively. The variations in these rates is due to the fact that a portion of our consolidated income for the year ended December 31, 2005 resulted from a subsidiary that has net operating loss carry forwards available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the consolidated company.  62  Investments
  The following table shows the carrying value of our investments by type of security as of the dates indicated.  As of December 31,2006
        
        
        
        2005(dollars in thousands)Fixed maturity securities
        
        $
        520,624.9
        
        93.2
        %
        
        $
        498,157.4
        
        91.7
        %Equity securities
        
        
        103.6
        
        0.0
        
        
        
        286.8
        
        0.1Mortgage loans on real estate
        
        
        13,921.0
        
        2.5
        
        
        
        17,606.7
        
        3.2Policy loans
        
        
        18,163.2
        
        3.3
        
        
        
        21,803.4
        
        4.0Other investments
        
        
        5,523.2
        
        1.0
        
        
        
        5,452.2
        
        1.0Total investments
        
        $
        558,335.9
        
        100
        %
        
        $
        543,306.5
        
        100
        %
  Of the fixed maturity securities shown above, 77.3% and 77.6% (based on total carrying value), were invested in securities rated A or better as of December 31, 2006, and 2005, respectively.  The following table provides the cumulative net unrealized gains (pre-tax) on the Companys fixed maturity securities and equity securities as of the dates indicated.  As of December 31,2006
        
        2005(dollars in thousands)Fixed maturity securities:Amortized cost
        
        $
        531,477.5
        
        $
        505,848.8Unrealized gains
        
        
        1,483.4
        
        
        1,811.8Unrealized losses
        
        
        (12,336.0
        )
        
        (9,503.2
        )Carrying value
        
        $
        520,624.9
        
        $
        498,157.4Equities:Cost
        
        $
        101.9
        
        $
        286.8Unrealized gains
        
        
        1.6
        
        
        Unrealized losses
        
        
        
        
        
        Carrying value
        
        $
        103.5
        
        $
        286.8
  Net unrealized losses on fixed maturity securities were $10.9 million as of December 31, 2006 and $7.7 million as of December 31, 2005.  Effective December 31, 2004, our investments were recorded at fair value, thereby eliminating all unrealized gains and losses, as part of the application of GAAP purchase accounting requirements.  As a result, the mark to market adjustments to the investment portfolio occurred at a time when very low market interest rates prevailed.  Therefore, as interest rates rise, we would expect substantial unrealized investment losses.  Due to the long range nature of our liabilities, the majority of these interest related unrealized losses are not expected to materialize into realized losses, and therefore should not have an adverse effect on our operations.  Unrealized losses were reviewed for other than temporary impairment in conjunction with our investment policies. Impairment charges of $0.0 million and $0.2 million were taken in 2006 and 2005, respectively.  Loss Impairment. All fixed maturity securities are classified as available-for-sale and marked to market through other comprehensive income. All securities with gross unrealized losses at the consolidated balance sheet date are subjected to our process for identifying other-than-temporary impairments. Securities deemed to be other-than-temporarily impaired are written down to fair value in the period the securities are deemed to be so impaired. The assessment of whether such impairment has occurred is based on managements case-by-case evaluation of the underlying reasons for the decline in fair value. Management considers a wide range of factors, as described below, about the issuer of the security and uses its best judgment in evaluating the cause of the decline in  63  the estimated fair value of the security and in assessing its prospects for near term recovery. Inherent in managements evaluation of the security are assumptions and estimates about the operations of the issuer and its future earnings potential.  Considerations used by management in the impairment evaluation process include, but are not limited to, the following:  
        length of time and the extent to which the market value of the security has been below amortized cost;
 
        when the issuer is experiencing significant financial difficulties, a review of all securities of the issuer, including its known subsidiaries and affiliates;
 
        conditions of the industry sector or subsector in which the issuer operates;
 
        economic conditions in the issuers geographic location;
 
        catastrophic loss suffered by the issuer or the industry in which the issuer operates; and
 
        other subjective factors, including information obtained from regulators and rating agencies.
  The review of fixed maturity securities for impairments includes an analysis of the total gross unrealized losses for three categories of securities: (1) securities where the estimated fair value had declined and remained below amortized cost by less than 20%; (2) securities where the estimated fair value had declined and remained below amortized cost by 20% or more for less than six months; and (3) securities where the estimated value had declined and remained below amortized cost by 20% or more for six months or greater. Securities in the first two categories have generally been adversely impacted by the downturn in the financial markets, overall economic conditions and certain industry trends. The first category generally includes securities that have declined in value as a result of fluctuations in interest rates, rather than due to difficulties experienced by the issuer of the
securities. While all of these securities are monitored for potential impairment, our experience indicates that securities in the first two categories do not present as great a risk of impairment and securities in these categories often recover their fair value over time as the factors that caused the declines improve. In addition, the Company has the intent and ability to hold these securities until they recover in value.  Writedowns are recorded as investment losses and the cost bases of the securities are adjusted accordingly. The revised cost basis is not changed for subsequent recoveries in value. Writedowns of fixed maturities were $0.0 million and $0.2 million for the years ended December 31, 2006 and 2005, respectively. The writedowns in 2005 reflected other than temporary impairments on Delta Airlines and Triton Aviation fixed income securities. Both of these securities were impacted by the negative conditions affecting the airline industry generally.  Reserves  The following table presents insurance policy benefit and contract-related liabilities information as of the dates indicated, by reserve type:  As of December 31,2006
        
        2005(dollars in thousands)Life and annuity reserves
        
        $
        252,658.2
        
        $
        299,454.2Accident and health reserves
        
        
        294,581.0
        
        
        227,705.6Policy and contract claims
        
        
        14,530.8
        
        
        10,008.3Other policyholder liabilities
        
        
        10,594.2
        
        
        10,726.2Total policy liabilities
        
        $
        572,364.2
        
        $
        547,894.3
  Life and annuity reserves decreased by $46.8 million, or 15.6%, to $252.7 million as of December 31, 2006, from $299.5 million as of December 31, 2005. A large portion of the life and annuity reserves relates to acquired blocks of business that are lapsing at a steady pace because no new blocks of business have been acquired since 1999, and therefore represents a significant portion of the decrease in reserves for the year ended December 31, 2006 as well as the conversion to PGAAP seriatim reserves ( Refer to Note 16  Business Segments, of the Notes to Consolidated Financial Statements included in this report, which is incorporated herein by reference for further explanation).   Accident and health reserves increased by $66.9 million or 29.4%, to $294.6 million as of December 31, 2006, from $227.7 million as of December 31, 2005. These reserve increases are consistent with  64


growth in the underlying business, with the majority of the reserve growth being accumulated from long-term care renewal premiums received as well as the conversion to PGAAP seriatim reserves (refer to Note 16  Business Segments, of the Notes to Consolidated Financial Statements included in this report, which is incorporated herein by reference for further explanation).  Policy and contract claims, which represent liabilities for actual claims reported and payable, increased by $4.5 million, or 45.2%, to $14.5 million as of December 31, 2006, from $10.0 million as of December 31, 2005. The majority of the increase represents claim reserves established for the new excess risk business sold in 2005 and early 2006. Although there are always fluctuations in policy and contract claim reserves from period to period, we are not aware of other significant events or trends for the periods discussed in this paragraph that would produce any material changes in our claim reserves.  Other policyholder liabilities, which are comprised primarily of dividend accumulations and advance premiums, decreased by $0.1 million, or 1.2%, to $10.6 million as of December 31, 2006, from $10.7 million as of December 31, 2005.  Participating Policies  Policyholder dividends are recognized over the term of the related policies. Participating business represents approximately 30% and 30%, respectively, of the Companys total ordinary life insurance in force at December 31, 2006, and 2005. Dividends paid to policyholders in 2006, 2005, and 2004 were approximately $1.5 million, $2.1 million and $2.2 million, respectively. Participating premiums as a percentage of direct life premiums were 39% in 2006, 46% in 2005, and 51% in 2004.  Ceded Reinsurance  As part of our overall risk and capacity management strategy, we purchase reinsurance for loss protection, to manage individual and aggregate risk exposure and concentration, to free up capital to allow us to write additional business and, in some cases, effect business dispositions. We utilize ceded reinsurance for those product lines where there is exposure on a per risk basis or in the aggregate which exceeds our internal risk retention and concentration management guidelines.  Reinsurance recoverables represent the portion of the policy and contract liabilities that are covered by reinsurance. These liabilities include reserves for life, annuity, accident and health, policy and contract claims and other policyholder liabilities as shown in the consolidated balance sheets. The cost of reinsurance is accounted for over the terms of the underlying reinsured policies using assumptions consistent with those used to account for the policies reinsured. Amounts recoverable from reinsurers are estimated in a manner consistent with the methods used to determine the underlying liabilities reported in the consolidated balance sheets.  The following table sets forth reinsurance recoverables by category as of the dates indicated:  As of December 31,2006
        
        2005(dollars in thousands)Ceded future policyholder benefits and expense
        
        $
        86,296.1
        
        $
        77,086.6Ceded claims and benefits payable
        
        
        2,795.1
        
        
        1,209.5Reinsurance recoverables
        
        $
        89,091.2
        
        $
        78,296.1
  Reinsurance recoverables increased by $10.8 million, or 13.8 %, to $89.1 million as of December 31, 2006, from $78.3 million as of December 31, 2005.  The increase in the recoverable balance is attributable to underlying business growth, specifically the growth in long-term care and excess risk business reinsured.  Under indemnity reinsurance transactions in which we are the ceding insurer, we remain liable for policy claims if the assuming company fails to meet its obligations. In the event one or more assuming companies were to default on its obligations, it could have an adverse effect on our business, results of operations and financial condition. To limit this risk, we have implemented procedures to evaluate the financial condition of reinsurers and to  65  monitor the concentration of credit risk to minimize this exposure. In some cases, the reinsurers have placed amounts in trust that would be the equivalent of the recoverable amount and for which we are the beneficiary. The selection of reinsurance companies is based on criteria related to solvency and reliability and, to a lesser degree, diversification. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balances due from reinsurers, reinsurer solvency, management experience and current economic conditions. As of December 31, 2006 and 2005, there was no allowance for doubtful accounts.  The following table sets forth our individual reinsurance recoverables exposure to specific reinsurers and their corresponding A.M. Best financial strength rating as of December 31, 2006:  Reinsurer
        
        Recoverable Amount
        
        
        
        A.M. Best Rating(dollars in thousands)Reassure America
        
        $
        20,706.8
        
        
        
        A
        +Madison National
        
        
        12,102.5
        
        
        
        A
        -GE ERC
        
        
        17,065.8
        
        
        
        AGeneral & Cologne Re
        
        
        16,548.3
        
        
        
        A
        +Munich Re
        
        
        16,453.4
        
        
        
        A
        +Reliance Standard
        
        
        1,219.5
        
        
        
        ALloyds of London
        
        
        3,372.9
        
        
        
        ALincoln National Life
        
        
        287.0
        
        
        
        A
        +Hanover Life Re
        
        
        642.8
        
        
        
        ASwiss Re Life and Health America
        
        
        175.9
        
        
        
        A
        +Transamerica Financial
        
        
        111.0
        
        
        
        A
        +Hartford Life and Accident
        
        
        152.6
        
        
        
        A
        +All other
        
        
        252.7Less: Allowance for uncollectible
        
        
        Total recoverable
        
        $
        89,091.2
  Liquidity and Capital Resources  KMG America is a holding company and had minimal operations of its own prior to the completion of its initial public offering and the Kanawha acquisition. KMG Americas assets consist primarily of the capital stock of Kanawha and its non-insurance subsidiary. Accordingly, KMG Americas cash flows depend upon the availability of dividends and other statutorily permissible payments, such as payments under tax allocation agreements and under management agreements, from Kanawha. Kanawhas ability to pay dividends and to make other payments is limited primarily by applicable laws and regulations of South Carolina, the state in which Kanawha is domiciled, which subjects insurance operations to significant regulatory restrictions. These laws and regulations require, among other things, that Kanawha, KMG Americas insurance subsidiary, maintain minimum solvency requirements and
limit the amount of dividends it can pay to the holding company. Solvency regulations, capital requirements, types of insurance offered and rating agency status are some of the factors used in determining the amount of capital available for dividends. In general, South Carolina will permit annual dividends from insurance operations equal to the greater of (1) the most recent calendar years statutory net income or (2) 10% of total capital and surplus of the insurance operations at the end of the previous calendar year, provided that the dividend payment does not exceed earned surplus, in which case further limitations apply.  For 2007, the maximum amount of dividends that Kanawha can pay to KMG America under applicable laws and regulations without prior regulatory approval is $7.2 million. If KMG America is able to successfully execute its business plan and accelerate Kanawhas earnings growth in its insurance operations, KMG America expects that the maximum allowable dividend from Kanawha to the holding company will increase at an accelerated rate year-over-year. If the ability of Kanawha to pay dividends or make other payments to KMG America is materially restricted by regulatory requirements, it could adversely affect KMG Americas ability to pay any dividends on its common stock and/or service its debt and pay its other corporate expenses.   66  The primary sources of funds for KMG Americas subsidiaries consist of insurance premiums and other considerations, fees and commissions collected, proceeds from the sales and maturity of investments and investment income. Cash is primarily used to pay insurance claims, agent commissions, operating expenses, product surrenders and withdrawals and taxes. KMG America generally invests its subsidiaries excess funds in order to generate income. The primary use of dividends and other distributions from subsidiaries to KMG America will be to pay certain expenses of the holding company. We currently have no intention of paying dividends to our shareholders and will reinvest cash flows from operations into our businesses for the foreseeable future.  On December 21, 2006, the Company entered into a credit agreement with Wachovia, which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the five-year subordinated promissory note we issued to fund a portion of the purchase price for the Kanawha acquisition.  The remaining $1.0 million available under the credit facility may be used to finance the Companys working capital, liquidity needs and general working requirements and those of its subsidiaries.  Amounts outstanding under the credit agreement will bear interest at a rate calculated according to, at the Companys option, a base rate or the LIBOR rate plus an applicable percentage.  The applicable percentage is based on the A.M. Best financial strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans and from 1.25% to 1.35% for LIBOR rate loans. In
the case of LIBOR rate loans, interest on amounts outstanding is payable at the end of the interest period, which can be one, two, three or six months, as selected by the Company in its notice of borrowing.  Wachovias obligation to fund the credit agreement terminates, and all principal outstanding under the credit agreement is due and payable, no later than December 31, 2007.  As of December 31, 2006, the $14.0 million outstanding under the credit agreement was a LIBOR rate plus applicable percentage loan with an initial interest rate of 6.60%.  The credit agreement requires the Company to comply with certain covenants, including, among others, maintaining a maximum ratio of consolidated indebtedness to total capitalization, a minimum available dividend amount for Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha.  The Company must also comply with limitations on certain payments, additional debt obligations, dispositions of assets and its lines of business.  The credit agreement also restricts the Company from creating or allowing certain liens on its assets and from making certain investments.  On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York ("ReliaStar"), both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb.  Messrs. Kuk, Kraemer, Moore and Gibb are officers of KMG America and former employees of the plaintiffs.  We believe the plaintiffs' allegations are without merit and intend to defend the action vigorously.  While the outcome of legal actions cannot be predicted with certainty, management believes the outcome of this matter will not have a material adverse effect on our consolidated financial position or results of operations.  We have been advised by the insurance carrier for its primary directors and officers insurance
policy that the insurance carrier will, subject to the terms, conditions and limitations of the insurance policy, reimburse us for a significant portion of future defense costs and potential damages, losses and liabilities resulting from this litigation.  We also have received partial reimbursement under the insurance policy for defense costs incurred to date.  As a result, we expect that the ongoing defense cost reimbursements and reimbursements of any damages, losses or liabilities under the directors and officers insurance policy should reduce the risk that future defense costs and any damages, losses or liabilities may have a material adverse effect on the Companys future consolidated financial position or results of operations.  For a discussion of the litigation involving ReliaStar, see the fourth paragraph of "Note 13 Commitments and Contingencies" of the "Notes to Consolidated Financial Statements" included in this report, which is incorporated hereby by
reference.  While our primary focus is organic growth of our existing businesses by expanding our product and marketing capabilities, we do evaluate opportunities to grow through strategic alliances and acquisitions of blocks of business and/or companies that are compatible with our core businesses.  If such opportunities arise we may make significant capital expenditures or acquisitions in 2007 or subsequent years. However, our primary focus is on significantly expanding outlays relating to marketing and sales activities over the next several years including outlays required to continue to build a national sales organization, which is a key component of our strategy. These outlays will include expenses such as salaries and cash incentive compensation, employee benefits, occupancy and information technology expenses of additional sales personnel, advertising and marketing costs, consulting and
recruiting. The execution of our business plan will require additional outlays associated with the development of a national insurance company including home office expenses for executive management and additional financial,  67  actuarial and underwriting personnel, infrastructure development and back-office expenses, as well as costs associated with our being a public company.  We anticipate that these costs will be offset over time by increased sales production resulting from hiring additional sales personnel and increased cross-selling, as well as efficiencies resulting from greater scale.  Analysis of Change in Financial Condition and Cash Flows  The nature of the life insurance business is that premiums are collected and invested and will be used for the payment of claims when they arise, and policy reserve liabilities are established in anticipation of these future claims.  As a result, the change in financial condition directly corresponds to the cash flows and they are discussed here in tandem.  We monitor cash flows at both the consolidated and subsidiary levels. Cash flow forecasts at the consolidated and subsidiary levels are provided on a monthly basis, and we use trend and variance analyses to project future cash needs, making adjustments to the forecasts when needed.  The table below shows the Companys and our predecessors recent net cash flows:
  For The Year Ended December 31,2006
        
        2005
        
        2004(dollars in thousands)Net cash provided by (used in):Operating activities
        
        $
        14,089.8
        
        $
        11,199.2
        
        $
        19,998.9Investing activities
        
        
        (24,928.6
        )
        
        (96,016.4
        )
        
        22,631.2Financing activities
        
        
        
        
        
        
        
        
        9,432.9Net change in cash
        
        $
        (10,838.8
        )
        $
        (84,817.2
        )
        $
        52,063.0
  Cash Flows for the Years Ended December31, 2006, 2005 and 2004. In the table shown above, increases in net cash provided by operating activities generally result from collected premiums while decreases in net cash flow provided by investing activities generally are a result of the investment of collected premiums. Policy and contract liabilities increase when premiums collected are retained to establish policy reserves. The portions of these liabilities that are reinsured by reinsurance companies are reflected in reinsurance balances recoverable.  As a function of our third party administration business, we manage insurance funds for our clients. These funds are held in suspense accounts pending appropriate disposition, and the balances held in suspense vary on a day-to-day basis as insurance funds are received and applied by us.  Other changes in cash flows for the years ended December 31, 2006, 2005, and 2004 are as follows:  2006:We held approximately $32.6 million in cash and cash equivalents at December 31, 2005, primarily consisting of investments in short term commercial paper. We invested a significant portion of this in longer term securities during 2006, resulting in the net cash outflow from investing activities of $24.9 million for the year ended December 31, 2006. This produced a corresponding increase in invested assets.  Excluding the offset to other comprehensive income for the adoption of SFAS158, other assets increased by $4.7 million in 2006, primarily as a result of claims reimbursements due from self funded Administrative Services Only (ASO) clients increasing $3.4 million. These claims are not actually disbursed until receipt of these funds, so there is nothing at risk with these assets, and fluctuations from day to day are typical. The balance of the increase in other assets can be attributed to an increase in uncollected premiums of $1.3 million due primarily to the timing of reinsurance settlements.  Accounts payable and accrued expenses increased by $4.4 million in 2006, primarily due to increases in our reinsurance settlements related to the acquired business.   68  Notes payable including interest decreased $1.7 million as the Company entered into a credit agreement with Wachovia on December 21, 2006 which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the previous five year subordinated promissory note at a discount.  (See Note 13  Commitments and Contingencies of Item 8 of this report, which is incorporated herein by reference). Federal income tax recoverable remained constant from the December 31, 2005 balance. There was a federal income tax accrued liability established for $0.5 million at the year ended December 31, 2006.  The deferred tax asset increased by $0.6 million and the deferred tax liability increased by $1.6 million. The combination of these items resulted in a net increase in tax liabilities of $1.5 million, inclusive of a decrease of $3.8 million related to the decrease in fair market value of the invested assets and a decrease of $1.1 million related to the pension liability established for SFAS 158. Share based compensation expense of $1.4 million was also recognized for the year ended December 31, 2006 as we adopted SFAS 123(R). 2005:We held approximately $117.4 million in cash at December 31, 2004, primarily consisting of cash proceeds from sales and maturities of our invested assets and from our initial public offering of common stock.  We invested a significant portion of this cash in fixed maturity securities in 2005, resulting in the net cash outflow from investing activities of $96.0 million.  This produced a corresponding increase in invested assets.  Other assets increased by $0.8 million in 2005, primarily representing a $2.9 million prepaid pension assets, offset by the receipt of a $2.2 million receivable for a securities trade that had not settled as of December 31, 2004.  Accounts payable and accrued expenses increased by $1.3 million in 2005, primarily due to a $1.6 million increase in reinsurance settlements due to the acquired business.  The liability for benefits for employers and agents increased by $1.5 million in 2005, primarily resulting from additional pension plan liability accruals of $1.0 million established to fund future payments under the pension plan as well as additional deferred compensation balances of $0.3 million.  Federal income tax recoverable increased by $0.9 million in 2005 as a result of losses incurred in Kanawha that will be carried back to prior years.  The deferred tax asset increased by $5.8 million and the deferred tax liability increased by $6.6 million.  The combination of the three items results in a net decrease in tax liabilities of $0.1 million, inclusive of a decrease of $2.7 million related to the decrease in fair market value of invested assets.  2004:Accounts payable and accrued expenses increased by $4.5 million in 2004, primarily due to an increase in reinsurance payables of $6.8 million relating to acquired business, and a decrease in accrued compensation expense of $1.8 million relating to payments of accrued compensation that were made in 2004.  Other assets decreased by $2.2 million in 2004, primarily due to the timing of payments and receipts from our reinsurers.  The liability for benefits for employees and agents decreased by $2.1 million in 2004 as the result of payments for accrued pension plan contributions of $3.1 million. The remaining increase is attributable to additional pension plan liability accruals of $1.2 million established to fund future payments under the pension plan.  In 2004, our predecessor had realized gains of $9.4 million primarily due to its decision to sell its convertible bond portfolio and the majority of its equity securities.  In connection with our acquisition of Kanawha in 2004, outstanding Kanawha stock options were exercised, resulting in cash receipts of $6.1 million and a tax benefit of $3.3 million. The exercise of these outstanding stock options produced the majority of the $3.8 million increase in federal income tax recoverable.  Commitments and Contingencies  We have obligations and commitments to third parties as a result of our operations. These obligations and commitments, as of December 31, 2006, are detailed in the following table:   69    Total
        
        Less thanone year
        
        1-3 years
        
        3-5 years
        
        After5 years(dollars in thousands)Contractual obligations:Operating leases
        
        $
        544.0
        
        $
        188.0
        
        $
        356.0
        
        $
        
        
        $
        Information technology and document management outsourcing contract(1)
        
        
        61,554.0
        
        
        7,689.0
        
        
        16,655.0
        
        
        17,966.0
        
        
        19,244.0Credit Agreement with Wachovia Bank  Note Payable
        
        
        14,050.4
        
        
        14,050.4
        
        
        
        
        
        
        
        
        Policy and contract liabilities(2)
        
        
        572,364.2
        
        
        9,060.0
        
        
        25,412.2
        
        
        29,613.6
        
        
        508,278.4Total obligations and commitments
        
        $
        648,512.6
        
        $
        30,987.4
        
        $
        42,423.2
        
        $
        47,579.6
        
        $
        527,522.4
   (1)
        The information technology and document management outsourcing contract is a ten-year contract that began in November 2003. This contract is subject to cancellation by us at any time starting in November 2006, with the payment of a termination penalty that is based on the number of months remaining in the contract.
   (2)
        The development of these anticipated payments by period entailed the use of actuarial projections of expected future benefits and expected future net premiums from current in force business.
   Recently Issued Accounting Standards  See Note 2  Significant Accounting Policies  Recently Issued Accounting Standards of Item 8 of this report, which is incorporated herein by reference, for a discussion of Recently Issued Accounting Standards.  ITEM 7A.
        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
  Market Risk Disclosures  As a provider of insurance products, effective risk management is fundamental to our ability to protect both our customers and shareholders interests. We are exposed to potential loss from various market risks, in particular interest rate risk and credit risk. Additionally, we are exposed to inflation risk and, to a small extent, to foreign currency exchange risk and equity price risk.  Interest rate risk is the possibility that the fair value of liabilities will change more or less than the market value of investments in response to changes in interest rates, including changes in the slope or shape of the yield curve and changes in spreads due to credit risk and other factors.  Equity price risk represents the risk associated with investments in equity securities that expose us to changes in equity prices.  Credit risk is the possibility that counterparties may not be able to meet payment obligations when they become due. We assume counterparty credit risk in many forms. A counterparty is any person or entity from which cash or other forms of consideration are expected to extinguish a liability or obligation to us. Primarily, our credit risk exposure is concentrated in our fixed income investment portfolio and, to a lesser extent, in our reinsurance recoverables.  Inflation risk is the possibility that a change in domestic price levels produces an adverse effect on earnings. This typically happens when only one of invested assets or liabilities is indexed to inflation.  Foreign currency exchange risk is the possibility that changes in exchange rates produce an adverse effect on earnings and equity when measured in domestic currency. This risk is most significant when assets backing liabilities payable in one currency are invested in financial instruments of another currency.   70


Interest Rate Risk.We invest substantial funds in interest-sensitive fixed income assets, such as fixed maturity investments, mortgage-backed and asset-backed securities and mortgage loans, primarily in the United States. We are exposed to two forms of interest rate risk-price risk and reinvestment risk. Price risk occurs when fluctuations in interest rates have a direct impact on the market valuation of these investments. As interest rates rise, the market value of these investments falls, and conversely, as interest rates fall, the market value of these investments rises. Reinvestment risk occurs when fluctuations in interest rates have a direct impact on expected cash flows from mortgage-backed and asset-backed securities. As interest rates fall, an increase in prepayments on these assets results in earlier than expected receipt of cash flows, forcing us to
reinvest the proceeds in an unfavorable lower interest rate environment, and conversely as interest rates rise, a decrease in prepayments on these assets results in later than expected receipt of cash flows, forcing us to forgo reinvesting in a favorable higher interest rate environment. As of December 31, 2006 we held $520.6 million of fixed maturity securities at fair market value and $13.9 million of mortgage loans for a combined total of 95.7 % of total invested assets.  We are also exposed to interest rate risk in establishing our policy benefit reserves. Life insurance, disability and other policy benefit reserves are discounted at the valuation date using a valuation interest rate. The valuation interest rate is determined by taking into consideration actual and expected earned rates on our asset portfolio, with adjustments for investment expenses and provisions for adverse deviation.  Equity Price Risk.We manage equity price risk on an integrated basis with other risks through our asset and liability management strategies. Risk exposures to equity securities are also managed through industry and issuer diversification and asset allocation.  Asset and Liability Management.We evaluate interest rate risk by periodically projecting our asset and liability cash flows to evaluate the potential sensitivity of our securities investments and liabilities to interest rate movements. Creating these projections involves evaluating the potential gain or loss on most of our in-force business under various increasing and decreasing interest rate environments. We manage interest rate risk and attempt to mitigate against a mismatch greater than acceptable tolerance levels in the duration of our assets and liabilities by selecting investments with characteristics such as duration, yield, currency and liquidity that are tailored to allow us to meet the anticipated cash outflow characteristics of our insurance and reinsurance liabilities. We believe that the duration of our invested assets are appropriate for our
business given the nature of our liabilities and the current interest rate environment.  Liability durations cannot be calculated precisely due to the uncertainty of the timing and amount of liability cash flows. As a result, there is no generally recognized method of computation of liability durations.  For acquired blocks of business and other products, the average duration of the associated assets is within or close to the liability duration range. For long-term care, the liability duration range is longer than the average duration of the associated assets. This duration mismatch results in reinvestment risk when assets mature prior to the termination of the associated liabilities and funds must be reinvested, but does not result in liquidity risk. However, we do not believe that this reinvestment risk is significant given our belief that future investment conditions will be at least as favorable as present conditions.  As a result of the duration profile of our investment portfolio and product liabilities, as well as our internal cash flow projections, we do not anticipate having to dispose of investment securities at inopportune times and/or market prices or access credit facilities to obtain required liquidity in the future.  The interest rate sensitivity of our fixed maturity security assets is assessed using hypothetical test scenarios that assume several positive and negative parallel shifts of the underlying yield curve. The individual securities are repriced under each scenario using a valuation model. For investments such as mortgage-backed and asset-backed securities, a prepayment model was used in conjunction with a valuation model. Our actual experience may differ from the results noted below if actual experience differs from assumptions utilized or if events occur that were not included in the assumptions. The following table summarizes the results of this analysis for fixed maturity securities held in our investment portfolio:     71  Interest Rate Movement Analysis of Market Value of Fixed Maturity Securities Investment Portfolio As of December 31, 2006  Basis Point Change
        
        -100
        
        
        -50
        
        0
        
        50
        
        100(dollars in millions)Total market value
        $
        557.2
        
        $
        538.7
        
        $
        520.6
        
        $
        502.8
        
        $
        485.4% Change in market value from base case
        
        7.03
        %
        
        3.47
        %
        
        0.00
        %
        
        (3.42)
        %
        
        (6.76)
        %$ Change in market value from base case
        $
        36.6
        
        $
        18.1
        
        $
        0
        
        $
        (17.8)
        
        $
        (35.2)
  Asset and liability management is currently the responsibility of our investment committee and chief actuary, which are responsible for setting a broad asset and liability management policy and strategy, reviewing and approving target portfolios, establishing investment guidelines and limits and providing oversight of the portfolio management process.  The portfolio managers and asset sector specialists that have been assigned by our third-party investment managers and who have responsibility on a day-to-day basis for risk management of their respective investing activities implement the goals and objectives established by our investment committee. The goals of the investment process are to optimize after-tax, risk-adjusted current investment income and after-tax, risk-adjusted total return while ensuring that the assets and liabilities are managed on a cash flow and duration basis. The risk management objectives established by our investment committee stress quality, diversification, asset/liability matching, liquidity and investment return.  Credit Risk.We are exposed to credit risk primarily as a holder of fixed income securities and as a party to reinsurance cessions.  Our risk management strategy and investment policy is to invest in debt instruments of issuers with high credit ratings and to limit the amount of credit exposure with respect to any one issuer. We attempt to limit our credit exposure by imposing fixed maturity portfolio limits on individual issuers based upon credit ratings. Currently, our portfolio limits are 2.00 % for issuers rated AAA, 1.5 % for issuers rated AA- to AA+, 1.00 % for issuers A- to A+, 0.50 % for issuers rated BBB- to BBB+ and 0.25 % for issuers rated BB- to BB+. These portfolio limits are further reduced for some issuers with whom we have credit exposure on reinsurance agreements. We use the lower of Moodys or Standard & Poors ratings to determine an issuers rating.  The following table presents our fixed maturity investment portfolio by ratings of the nationally recognized securities rating organizations as of December 31, 2006: Rating
        
        Carrying Value
        
        Percentage of Total(dollars in thousands)AAA/AA/A
        
        $
        402,449.4
        
        77.3
        %BBB
        
        
        109,282.0
        
        21.0BB
        
        
        2,884.9
        
        0.5B and lower
        
        
        6,008.6
        
        1.2Total
        
        $
        520,624.9
        
        100.0
        %
  We are also exposed to the credit risk of our reinsurers. When we reinsure, we are still liable to our insureds regardless of whether we receive reimbursement from our reinsurer. In the event one or more of our reinsurers defaults on its obligations, it could adversely affect our financial condition and the results of our operations. As part of our overall risk and capacity management strategy, we purchase reinsurance for some risks underwritten by our various businesses.  Approximately 40% of our $89.1 million of reinsurance recoverables at December 31, 2006, are protected from credit risk because the reinsurer has placed amounts in a trust account that is pledged to us. The trust account values are at least equal to the recoverable amounts from the underlying reinsurance agreements. For recoverables that are not protected by these mechanisms, we depend solely on the credit of the reinsurer. Substantially all of our reinsurance exposure has been ceded to companies rated A- or better by A.M. Best.  72   Inflation Risk.We are exposed to inflation risk because we invest substantial funds in nominal assets, which are not indexed to the level of inflation, but the underlying liabilities are indexed to the level of inflation. Life insurance policies with reserves of approximately $6.5 million as of December 31, 2006 (representing 1.2% of our total reserves), have death benefits that are guaranteed to grow based on inflation linked indices. Substantially all of these policies are subject to caps that limit the amount by which the death benefits can grow each year. In times of rapidly rising inflation the credited death benefit growth on these liabilities increases relative to the investment income earned on the nominal assets, resulting in an adverse impact on earnings.  In addition, we are exposed to inflation risk with respect to some major medical insurance policies to the extent that medical costs increase with inflation at a greater pace than our ability to increase premiums.  Foreign Currency Exchange Risk.We have no exposure to foreign exchange risk arising from our insurance and other business operations. We also have little foreign currency exchange exposure in our investment portfolio. Total invested assets from foreign issuers were less than 10% of our total invested assets at December 31, 2006, but all of these foreign investments were denominated in dollars.  Derivatives.Derivatives are financial instruments whose values are derived from interest rates, foreign exchange rates, financial indices or the prices of securities or commodities. Derivative financial instruments may be exchange-traded or contracted in the over-the-counter market and include swaps, futures, options and forward contracts.  Under insurance statutes, insurance companies may use derivative financial instruments to hedge actual or anticipated changes in their assets or liabilities, to replicate cash market instruments or for some income-generating activities. These statutes generally prohibit the use of derivatives for speculative purposes.  Prior to the completion of the Kanawha acquisition, our predecessor historically had not used derivative financial instruments. However, we are considering and in the future may elect to utilize derivatives in order to hedge some exposures.  ITEM 8.
        FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
  Report of Management on the Consolidated Financial Statements and Managements Assessment of Internal Control Over Financial ReportingReport of Independent Registered Public Accounting Firm on Internal Control over Financial ReportingReport of Independent Registered Public Accounting FirmConsolidated Balance Sheets for KMG America Corporation as of  December 31, 2006, and 2005Consolidated Statements of Operations for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for Kanawha Insurance Company (the Predecessor) for the year ended December 31, 2004Consolidated Statements of Shareholders Equity for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004Consolidated Statements of Cash Flow for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004Notes to Consolidated Financial StatementsSchedule III  Supplementary Insurance Information**All other required financial statement schedules are omitted because the information required is either not applicable or is included in the financial statements or the related notes included in this report.
   73  REPORT OF MANAGEMENT ON THE CONSOLIDATED FINANCIAL STATEMENTS AND MANAGEMENTS ASSESSMENT OF INTERNAL CONTROL OVER FINANCIAL REPORTING  The management of KMG America Corporation (KMG) is responsible for the preparation, integrity and fair presentation of Consolidated Financial Statements of KMG and for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rule 13(a)  15(f). The accompanying Consolidated Financial Statements, including Notes to Financial Statements, have been prepared by management in accordance with U.S. generally accepted accounting principles (GAAP), and reflect managements estimates and judgments, the use of which are inherent in the preparation of financial statements. In the opinion of management, the accompanying Consolidated Financial Statements present fairly KMGs financial position and results of operations, giving due consideration to materiality.  KMGs internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.  KMG's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of KMG's assets; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that KMG's receipts and expenditures are being made only in accordance with authorization of KMG's management and directors; and (3) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of KMG's assets that could have a material effect on the financial statements.  All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.  Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements.  Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.  KMG management conducted an evaluation of the effectiveness of KMG's internal control over financial reporting as of December 31, 2006. In making this evaluation, it used the framework set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control  Integrated Framework. Based on the evaluation under the framework in Internal Control  Integrated Framework, our management concluded, that as of December 31, 2006, KMG's internal control over financial reporting was effective.  KMGs Consolidated Financial Statements and assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 have been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their reports which appear on pages 75 and page 76, respectively.  By:/s/ Kenneth U. Kuk
Kenneth U. KukPrincipal Executive OfficerDate:  March 14, 2007By:/s/ Scott H. DeLong III
Scott H. DeLong IIIPrincipal Financial OfficerDate:  March 14, 2007
   74  REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM ON INTERNAL CONTROL OVER FINANCIAL REPORTING  The Board of Directors and Shareholders of KMG America Corporation  We have audited managements assessment, included in the accompanying Report of Management on the Consolidated Financial Statements and Managements Assessment of Internal Control over Financial Reporting, that KMG America Corporation maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). KMG America Corporations management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on managements assessment and an opinion on the effectiveness of the Companys internal control over financial reporting based on our audit.  We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating managements assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.  A companys internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A companys internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the companys assets that could have a material effect on the financial statements.  Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with policies or procedures may deteriorate.  In our opinion, managements assessment that KMG America Corporation maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, KMG America Corporation, maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.  We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of KMG America Corporation as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders equity and cash flow for the years ended December 31, 2006 and 2005, and for the period January 21, 2004 (inception) through December 31, 2004, and our report dated March 8, 2007, expressed an unqualified opinion thereon.  /s/ Ernst & Young, LLP Charlotte, North Carolina March 8, 2007  75  REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM  The Board of Directors and Shareholders of KMG America Corporation  We have audited the accompanying consolidated balance sheets of KMG America Corporation as of December 31, 2006 and 2005, and the related consolidated statements of operations, shareholders equity and cash flow of KMG America Corporation for the years ended December 31, 2006 and 2005 and the period January 21, 2004 (inception) through December 31, 2004, and the consolidated statements of operations, shareholders equity and cash flow of the Predecessor, as defined in Note 1, for the year ended December 31, 2004. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and schedule are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.  We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.  In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of KMG America Corporation at December 31, 2006 and 2005, and the consolidated results of KMG America Corporations operations and cash flow for the years ended December 31, 2006 and 2005, and for the period January 21, 2004 (inception) through December 31, 2004, and the Predecessors consolidated results of operations and cash flow for the year ended December 31, 2004, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.  As discussed in Note 2 to the consolidated financial statements, in 2006 the Company changed its method of accounting for share based payments and defined benefit pension plan and has adopted Financial Accounting Standards Board Statement No. 123(R),Share Based Paymentsand Financial Accounting Standards Board Statement No. 158,Employers' Accounting for Defined Benefit Pension and Other Postretirement Plans.  We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of KMG America Corporations internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control  Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, and our report dated March 8, 2007 expressed an unqualified opinion thereon.  /s/ Ernst & Young, LLP
 Charlotte, North Carolina March 8, 2007  76


KMG AMERICA CORPORATION CONSOLIDATED BALANCE SHEETS  December 31,2006
        
        2005AssetsInvestments:Fixed maturity securities available for sale, at fair value (amortized cost of $531,477,537 and $505,848,751 for 2006 and 2005, respectively)
        
        $
        520,624,942
        
        $
        498,157,355Equity securities available for sale, at fair value (cost of $101,945 and $286,809 for 2006 and 2005, respectively)
        
        
        103,545
        
        
        286,809Mortgage loans
        
        
        13,921,019
        
        
        17,606,746Policy loans
        
        
        18,163,223
        
        
        21,803,430Other investments
        
        
        5,523,232
        
        
        5,452,198Total investments
        
        
        558,335,961
        
        
        543,306,538Cash and cash equivalents
        
        
        21,744,137
        
        
        32,582,964Reinsurance balances recoverable
        
        
        89,091,232
        
        
        78,296,057Accrued investment income
        
        
        6,502,801
        
        
        5,917,136Real estate and equipment (net of accumulated depreciation of $3,652,073 and $1,748,519  for 2006 and 2005, respectively)
        
        
        15,068,506
        
        
        11,723,869Federal income tax recoverable
        
        
        5,111,539
        
        
        5,111,539Deferred income tax asset
        
        
        6,578,604
        
        
        6,015,462Amounts due from reinsurers
        
        
        2,906,176
        
        
        2,284,343Deferred policy acquisition costs
        
        
        28,453,929
        
        
        14,031,875Value of business acquired
        
        
        70,766,211
        
        
        72,638,967Other assets
        
        
        27,154,750
        
        
        25,456,319Total assets
        
        $
        831,713,846
        
        $
        797,365,069
  See accompanying notes.   77  KMG AMERICA CORPORATION CONSOLIDATED BALANCE SHEETS (Continued)  December 31,2006
        
        2005Liabilities and shareholders equityLiabilities:Policy and contract liabilities:Life and annuity reserves
        
        $
        252,658,190
        
        $
        299,454,172Accident and health reserves
        
        
        294,581,002
        
        
        227,705,619Policy and contract claims
        
        
        14,530,782
        
        
        10,008,352Other policyholder liabilities
        
        
        10,594,225
        
        
        10,726,188Total policy and contract liabilities
        
        
        572,364,199
        
        
        547,894,331Accounts payable and accrued expenses
        
        
        24,497,525
        
        
        20,105,386Taxes, other than federal income taxes
        
        
        1,037,508
        
        
        926,776Federal income taxes accrued
        
        
        523,889
        
        
        Deferred income taxes
        
        
        14,735,262
        
        
        13,061,136Liability for benefits for employees and agents
        
        
        5,847,970
        
        
        5,667,297Funds held in suspense
        
        
        4,832,579
        
        
        4,671,388Notes payable
        
        
        14,000,000
        
        
        15,000,000Interest payable
        
        
        50,350
        
        
        773,733Other liabilities
        
        
        1,773,077
        
        
        1,781,899Total liabilities
        
        
        639,662,359
        
        
        609,881,946Shareholders equity:Common Stock:  par value $0.01 per share, 75,000,000 shares authorized and 22,211,589 and 22,125,998 shares issued and outstanding at December 31, 2006 and 2005, respectively
        
        
        222,116
        
        
        221,260Paid-in capital
        
        
        189,150,959
        
        
        188,223,636Deferred stock based compensation
        
        
        
        
        
        (450,703
        )Retained earnings
        
        
        11,702,929
        
        
        4,483,979Accumulated other comprehensive loss
        
        
        (9,024,517
        )
        
        (4,995,049
        )Total shareholders equity
        
        
        192,051,487
        
        
        187,483,123Total liabilities and shareholders equity
        
        $
        831,713,846
        
        $
        797,365,069
  See accompanying notes.   78  KMG AMERICA CORPORATION AND PREDECESSOR CONSOLIDATED STATEMENTS OF OPERATIONS  KMG America
        
        
        PredecessorYear Ended December 31,
        
        
        For the Period from January 21 through December 31,
        
        
        Year Ended December 31,2006
        
        
        2005
        
        
        2004
        
        
        2004Revenue:Insurance premiums
        
        $
        127,968,697
        
        $
        106,887,518
        
        $
        
        
        $
        102,835,545Net investment income
        
        
        29,945,806
        
        
        27,744,871
        
        
        18,408
        
        
        25,202,412Commission and fee income
        
        
        16,504,664
        
        
        14,564,627
        
        
        
        
        
        13,475,522Realized investment gains
        
        
        1,218,465
        
        
        358,318
        
        
        
        
        
        9,432,585Gain on extinguishment of debt
        
        
        1,020,839
        
        
        
        
        
        
        
        
        Other income
        
        
        4,451,642
        
        
        3,867,872
        
        
        
        
        
        3,108,227Total revenues
        
        
        181,110,113
        
        
        153,423,206
        
        
        18,408
        
        
        154,054,291Benefits and expenses:Policyholder benefits
        
        
        99,842,289
        
        
        84,287,726
        
        
        
        
        
        90,174,993Insurance commissions, net of deferrals
        
        
        12,724,647
        
        
        9,635,232
        
        
        
        
        
        9,690,077General insurance expenses, net of deferrals
        
        
        45,464,991
        
        
        41,904,678
        
        
        284,434
        
        
        27,794,989Insurance taxes, licenses and fees
        
        
        5,347,422
        
        
        4,677,388
        
        
        4,055
        
        
        4,677,617Depreciation and amortization
        
        
        2,558,024
        
        
        2,838,717
        
        
        
        
        
        2,491,942Amortization of deferred policy acquisition costs and value of business acquired
        
        
        4,105,622
        
        
        3,467,499
        
        
        
        
        
        9,468,302Total benefits and expenses
        
        
        170,042,995
        
        
        146,811,240
        
        
        288,489
        
        
        144,297,920Income (loss) before income taxes
        
        
        11,067,118
        
        
        6,611,966
        
        
        (270,081
        )
        
        9,756,371(Provision) benefit for income taxes
        
        
        (3,848,168
        )
        
        (2,128,208
        )
        
        94,528
        
        
        (3,565,872
        )Income before cumulative effect of change in accounting principle
        
        
        7,218,950
        
        
        4,483,758
        
        
        (175,553
        )
        
        6,190,499Cumulative effect of change in accounting for equity based method investment, net of tax
        
        
        
        
        
        175,774
        
        
        
        
        
        Net Income (loss)
        
        $
        7,218,950
        
        $
        4,659,532
        
        $
        (175,553
        )
        $
        6,190,499Net income per share:Basic:Income (loss) per share before cumulative effect of accounting change
        
        $
        0.33
        
        $
        0.20
        
        $
        (0.01
        )
        $
        2,369.27Cumulative effect of accounting change
        
        
        
        
        
        0.01
        
        
        
        
        
        Basic Net Income (loss) per share
        
        $
        0.33
        
        $
        0.21
        
        $
        (0.01
        )
        $
        2,369.27Diluted:Income (loss) per share before cumulative effect of accounting change
        
        $
        0.33
        
        $
        0.20
        
        $
        (0.01
        )
        $
        2,132.71Cumulative effect of accounting change
        
        
        
        
        
        0.01
        
        
        
        
        
        Diluted Net Income (loss) per share
        
        $
        0.33
        
        $
        0.21
        
        $
        (0.01
        )
        $
        2,132.71Weighted-average shares outstanding:Basic
        
        
        22,187,830
        
        
        22,085,585
        
        
        22,071,641
        
        
        2,612.83Diluted
        
        
        22,201,731
        
        
        22,090,944
        
        
        22,241,550
        
        
        2,902.64
  See accompanying notes.  79  KMG AMERICA CORPORATION AND PREDECESSOR CONSOLIDATED STATEMENTS OF SHAREHOLDERS EQUITY  Predecessor from January 1, 2004, through December 31, 2004, and KMG America Corporation from January 21, 2004, through December 31, 2006  Common Stock
        
        
        Paid-In Capital
        
        
        Deferred Stock Based Compensation
        
        
        Retained Earnings
        
        
        Accumulated Other Comprehensive Income (Loss)
        
        
        Total Shareholders' EquityPredecessor:Balance at January 1, 2004
        $
        4,048,393
        
        $
        21,722,289
        
        $
        (207,067
        )
        $
        134,114,967
        
        $
        13,797,947
        
        $
        173,476,529Net income
        
        
        
        
        
        
        
        
        
        
        6,190,499
        
        
        
        
        
        6,190,499Change in net unrealized gains (losses)
        
        
        
        
        
        
        
        
        
        
        
        
        
        (1,652,222
        )
        
        (1,652,222
        )Minimum pension liability
        
        
        
        
        
        
        
        
        
        
        
        
        
        31,151
        
        
        31,151Comprehensive income
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        4,569,428Stock option compensation expense
        
        
        
        
        
        
        
        207,067
        
        
        
        
        
        
        
        
        207,067Stock options exercised
        
        576,076
        
        
        5,571,627
        
        
        
        
        
        
        
        
        
        
        
        6,147,703Tax benefit of stock options exercised
        
        
        
        
        1,512,877
        
        
        
        
        
        
        
        
        
        
        
        1,512,877Balance at December 31, 2004
        $
        4,624,469
        
        $
        28,806,793
        
        $
        
        
        $
        140,305,466
        
        $
        12,176,876
        
        $
        185,913,604KMG America:Incorporation and initial public offering
        $
        220,716
        
        $
        187,742,702
        
        $
        
        
        $
        
        
        $
        
        
        $
        187,963,418Net loss
        
        
        
        
        
        
        
        
        
        
        (175,553
        )
        
        
        
        
        (175,553
        )Balance at December 31, 2004
        
        220,716
        
        
        187,742,702
        
        
        
        
        
        (175,553
        )
        
        
        
        
        187,787,865Net income
        
        
        
        
        
        
        
        
        
        
        4,659,532
        
        
        
        
        
        4,659,532Change in net unrealized gains (losses)
        
        
        
        
        
        
        
        
        
        
        
        
        
        (4,995,049
        )
        
        (4,995,049
        )Comprehensive loss
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        (335,517
        )Share based compensation expense
        
        544
        
        
        480,934
        
        
        (450,703
        )
        
        
        
        
        
        
        
        30,775Balance at December 31, 2005
        
        221,260
        
        
        188,223,636
        
        
        (450,703
        )
        
        4,483,979
        
        
        (4,995,049
        )
        
        187,483,123Net income
        
        
        
        
        
        
        
        
        
        
        7,218,950
        
        
        
        
        
        7,218,950Change in net unrealized gains (losses)
        
        
        
        
        
        
        
        
        
        
        
        
        
        (2,058,098
        )
        
        (2,058,098
        )Pension liability
        
        
        
        
        
        
        
        
        
        
        
        
        
        (1,971,370
        )
        
        (1,971,370
        )Comprehensive income
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        3,189,482Adoption of SFAS 123(R)
        
        
        
        
        (450,703
        )
        
        450,703
        
        
        
        
        
        
        
        
        Share based compensation expense
        
        856
        
        
        1,378,026
        
        
        
        
        
        
        
        
        
        
        
        1,378,882Balance at December 31, 2006
        $
        222,116
        
        $
        189,150,959
        
        $
        
        
        $
        11,702,929
        
        $
        (9,024,517
        )
        $
        192,051,487
  See accompanying notes.  80  KMG AMERICA CORPORATION AND PREDECESSOR CONSOLIDATED STATEMENTS OF CASH FLOW  KMG America
        
        
        PredecessorYear Ended December 31,
        
        
        Period from January 21 through December 31,
        
        
        Year Ended December 31,2006
        
        
        2005
        
        
        2004
        
        
        2004Net income (loss)
        
        $
        7,218,950
        
        $
        4,659,532
        
        $
        (175,553
        )
        $
        6,190,499Adjustments to reconcile net income (loss) to net cash provided by operating activities:Depreciation and amortization
        
        
        4,606,726
        
        
        3,858,785
        
        
        
        
        
        2,904,235Policy acquisition costs deferred and value of business acquired
        
        
        (16,654,920
        )
        
        (15,013,275
        )
        
        
        
        
        (13,124,972
        )Amortization of deferred policy acquisition costs and value of business acquired
        
        
        4,105,622
        
        
        3,467,499
        
        
        
        
        
        9,468,302Realized investment gains, net
        
        
        (1,218,465
        )
        
        (358,318
        )
        
        
        
        
        (9,432,585
        )Deferred income tax expense
        
        
        3,280,697
        
        
        3,469,593
        
        
        (94,528
        )
        
        4,355,232Changes in operating assets and liabilities:Reinsurance balances recoverable
        
        
        (10,795,175
        )
        
        (6,941,259
        )
        
        
        
        
        (6,675,012
        )Accrued investment income
        
        
        (585,665
        )
        
        (1,004,920
        )
        
        (3,013
        )
        
        477,935Federal income tax recoverable
        
        
        
        
        
        (871,633
        )
        
        
        
        
        (3,762,332
        )Receivable from affiliates
        
        
        
        
        
        
        
        
        
        
        
        34,055Other assets (excluding offset to other comprehensive income)
        
        
        (4,731,308
        )
        
        (813,486
        )
        
        (22,019
        )
        
        2,165,349Amounts due from reinsurers
        
        
        (621,833
        )
        
        (343,440
        )
        
        
        
        
        (111,501
        )Policy and contract liabilities
        
        
        24,469,868
        
        
        16,978,894
        
        
        
        
        
        24,638,984Accounts payable and accrued expenses
        
        
        4,392,139
        
        
        1,310,464
        
        
        1,213,508
        
        
        4,531,863Notes payable
        
        
        (1,000,000
        )
        
        
        
        
        
        
        
        Interest payable
        
        
        (723,383
        )
        
        751,130
        
        
        
        
        
        Stock based compensation expense
        
        
        1,378,882
        
        
        30,775
        
        
        
        
        
        207,067Taxes, other than federal income taxes
        
        
        110,732
        
        
        398,514
        
        
        
        
        
        28,627Federal income taxes accrued
        
        
        523,889Funds held in suspense
        
        
        161,191
        
        
        (52,616
        )
        
        
        
        
        (276,281
        )Liability for benefits for employees and agents
        
        
        180,673
        
        
        1,508,879
        
        
        
        
        
        (2,126,937
        )Other liabilities
        
        
        (8,822
        )
        
        164,121
        
        
        
        
        
        506,378Net cash provided by operating activities
        
        
        14,089,798
        
        
        11,199,239
        
        
        918,395
        
        
        19,998,906Investing activitiesSecurities available for sale:Sales
        
        
        48,522,206
        
        
        61,600,657
        
        
        
        
        
        101,856,930Maturities, calls and redemptions
        
        
        29,033,153
        
        
        5,885,921
        
        
        
        
        
        6,604,630Purchases
        
        
        (104,561,727
        )
        
        (165,983,287
        )
        
        
        
        
        (94,233,206
        )Repayments of mortgage loans
        
        
        3,685,727
        
        
        6,071,893
        
        
        
        
        
        9,965,210Mortgage loans originated
        
        
        
        
        
        
        
        
        
        
        
        (792,951
        )Decrease in policy loans, net
        
        
        3,640,207
        
        
        817,371
        
        
        
        
        
        319,520Sale of real estate and property and equipment
        
        
        
        
        
        85,564
        
        
        
        
        
        Purchases of real estate, property and equipment
        
        
        (5,248,191
        )
        
        (3,850,779
        )
        
        
        
        
        (1,088,897
        )Acquisition of the Predecessor, net of cash acquired
        
        
        
        
        
        (643,771
        )
        
        (71,481,657
        )
        
        Net cash provided by (used in) investing activities
        
        
        (24,928,625
        )
        
        (96,016,431
        )
        
        (71,481,657
        )
        
        22,631,236Financing activitiesProceeds of initial public offering
        
        
        
        
        
        
        
        
        187,963,418
        
        
        Capital contributions
        
        
        
        
        
        
        
        
        
        
        
        9,432,845Payoff subordinated note
        
        
        (14,000,000
        )
        
        
        
        
        
        
        
        Revolving credit facility borrowing
        
        
        14,000,000Net cash provided by financing activities
        
        
        
        
        
        
        
        
        187,963,418
        
        
        9,432,845Net increase (decrease) in cash and cash equivalents
        
        
        (10,838,827
        )
        
        (84,817,192
        )
        
        117,400,156
        
        
        52,062,987Cash and cash equivalents at beginning of year
        
        
        32,582,964
        
        
        117,400,156
        
        
        
        
        
        7,204,805Cash and cash equivalents at end of year
        
        $
        21,744,137
        
        $
        32,582,964
        
        $
        117,400,156
        
        $
        59,267,792Supplemental disclosures of cash flow informationFederal income taxes paid
        
        $
        43,582
        
        $
        
        
        $
        
        
        $
        600,000
 See accompanying notes.  81  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  1.
        Organization, Kanawha Acquisition, Initial Public Offering, and Nature of Operations
  Unless the context requires otherwise, references to we, us, our, KMG America or the Company are intended to mean KMG America Corporation and its consolidated subsidiaries, including, without limitation, Kanawha Insurance Company (Kanawha). References to our predecessor mean Kanawha prior to it being acquired by KMG America.  KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. KMG America commenced operations shortly before it completed its initial public offering of common stock on December 21, 2004, and its shares trade on the New York Stock Exchange under the symbol KMA.  Concurrently with the completion of its initial public offering, KMG America completed its acquisition of Kanawha and its subsidiaries, which are KMG Americas primary operating subsidiaries and which underwrite and sell life and health insurance products.  Kanawha, the primary operating subsidiary of KMG America, is licensed to issue life and accident and health insurance. Kanawha is domiciled in South Carolina. Kanawha has one wholly owned subsidiary, Kanawha HealthCare Solutions, Inc., a third-party administrator with operations in Lancaster and Greenville, South Carolina.  The primary insurance products that the Company underwrites include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. The Company ceased actively underwriting new long-term care insurance policies after December 31, 2005.  The Company intends to retain and actively manage the Company's existing block of in force long-term care policies. The Company's third-party administration and medical management businesses include a wide array of services with the primary emphasis on the offering of administrative service-only products.  The Company's sales historically have been primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina, but are now expanding nationwide. Sales are made through an internal sales force, full-time agents, general agents and brokers. Under the Companys current business strategy, the Company expects group lines of business to account for an increasing percentage of the Company's premium revenues.  Effective September 1, 2006, KMG Americas subsidiaries Kanawha and Kanawha HealthCare Solutions, Inc. entered into a reinsurance and administrative arrangement with Columbian Life Insurance Company (CLIC) and Columbian Mutual Life Insurance Company (CMLIC).  CLIC and CMLIC are affiliates of each other.  Under the arrangement, Kanawha reinsures 100% of the risk of a block of voluntary term life insurance policies and universal life insurance policies from CLIC and CMLIC.  Kanawha HealthCare Solutions, Inc. will assume responsibility for the administration of these policies. As part of the transaction, CLIC and CMLIC also assigned key trademarks to Kanawha for these insurance policies and their marketing brand, UNIQ Benefit Solutions.  This transaction is expected to enhance KMG Americas presence in the voluntary term life market, create access to additional distribution and is expected to favorably impact the financial results.  2.
        Significant Accounting Policies
  Basis of Presentation  For accounting purposes, Kanawha is treated as KMG Americas predecessor entity and is referred to in these Notes as the Predecessor.  For financial reporting purposes, management has treated the acquisition of the Predecessor as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material to the Predecessors consolidated statements of operations, cash flows, and changes in shareholders equity for the year ended December 31, 2004. Accordingly, financial information in the following discussion that relates to the Predecessors consolidated results of operations, cash flows and changes in shareholders equity for the year ended December 31, 2004 is reported on a historical basis without GAAP (generally
accepted accounting principles in the United States) purchase accounting adjustments reflecting the acquisition of the Predecessor. Financial information  82


relating to the Companys financial position as of December 31, 2004, has been adjusted for GAAP purchase accounting adjustments reflecting the Predecessors acquisition.  The accompanying consolidated financial statements include the accounts of the Company and the Predecessor after elimination of all significant intercompany balances and transactions. The Company also submits financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting practices (SAP) and are significantly different from financial statements prepared in accordance with GAAP (see Note 10).  Use of Estimates and Assumptions  The presentation of the accompanying consolidated financial statements requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein.  Cash and Cash Equivalents  The Company includes with cash and cash equivalents its holdings of highly liquid investments with maturities of three months or less from the date of acquisition.  Investments  Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Fixed Maturity and Equity Securities, requires that all fixed maturity and equity securities be classified into one of three categoriesheld to maturity, available-for-sale, or trading. The Company has no securities classified as held to maturity. Management determines the appropriate classification of fixed maturities at the time of purchase. Investments are reported on the following basis:  Fixed maturities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders equity as accumulated other comprehensive income. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services.  Equity securities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders equity as accumulated other comprehensive income.  Assets supporting the deferred compensation plan are classified as trading and are included in other investments. Trading account assets are held for resale in anticipation of short-term market movements. Trading account assets, consisting of mutual funds, are stated at fair value. Gains and losses, both realized and unrealized, are included in realized gains and losses.  Mortgage loans on real estate are stated at unpaid balances, net of allowances for unrecoverable amounts. Valuation allowances for mortgage loans are established when the Company determines it is probable that it will be unable to collect all amounts (both principal and interest) due according to the contractual terms of the loan agreement. Such allowances are based on the present value of expected future cash flows discounted at the loans effective interest rate or, if foreclosure is probable, on the estimated fair value of the underlying real estate.  Policy loans are stated at their unpaid balances.  Interest on loans is generally recorded over the term of the loan based on the unpaid principal balance. Accrual of interest is discontinued when either principal or interest becomes 90 days past due or when, in managements opinion, collection of such interest is doubtful. In addition, any previously accrued interest is reversed when the loan becomes 90 days past due.  Other investments are stated at fair value, or the lower of cost or fair value, as appropriate.  83   Amortization of premiums and accrual of discounts on investments in fixed maturity securities is reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Realized gains and losses on dispositions of securities are determined by the specific-identification method.  The Company regularly reviews its investment portfolio to identify securities that may have suffered impairments in value that will not be recovered, termed potentially distressed securities. In identifying potentially distressed securities, the Company first screens for all securities that have a fair value to cost or amortized cost ratio of less than 80%. Additionally, as part of this identification process, the Company utilizes the following information:  
        length of time the fair value was below amortized cost;
 
        industry factors or conditions related to a geographic area negatively affecting the security;
 
        downgrades by a rating agency;
 
        past due interest or principal payments or other violation of covenants; and
 
        deterioration of the overall financial condition of the specific issuer.
  In analyzing its potentially distressed securities list for other-than-temporary impairments, the Company pays special attention to securities that have been on the list for a period greater than six months. The Company assumes that, absent reliable contradictory evidence, a security that is potentially distressed for a continuous period greater than twelve months has incurred an other-than-temporary impairment. Reliable contradictory evidence might include, among other factors, a liquidation analysis performed by the Companys investment advisors or outside consultants, improving financial performance of the issuer, or valuation of underlying assets specifically pledged to support the credit.  Should the Company conclude that the decline is other-than-temporary, the security is written down to fair value through a charge to realized investment gains and losses. The Company adjusts the amortized cost for securities that have experienced other-than-temporary impairments to reflect fair value at the time of the impairment. The Company considers factors that lead to an other-than-temporary impairment of a particular security in order to determine whether these conditions have impacted other similar securities.  Real Estate and Equipment  Company-occupied real estate, primarily buildings, is carried at cost less accumulated depreciation and are depreciated principally by the straight-line method over estimated useful lives generally ranging from 15 to 30 years. Equipment is stated at cost, less accumulated depreciation, and depreciated principally by the straight-line method over their estimated useful lives, generally 3 to 5 years.  Expenditures for improvements are capitalized, and expenditures for maintenance and repairs are charged to operations as incurred. Upon sale or retirement, the cost and related accumulated depreciation and amortization are removed from the accounts and the resulting gain or loss, if any, is reflected in operations. For the years ending December 31, 2006, 2005 and 2004, total depreciation expense was approximately $1.9 million, $1.8 million and $2.5 million, respectively.  Deferred Policy Acquisition Costs  Acquisition costs incurred by the Predecessor and the Company in the process of acquiring new business are deferred and amortized into income as discussed below. Costs deferred consist primarily of commissions and certain policy underwriting, issue and agency expenses that vary with and are primarily related to production of new business.  For most insurance products, the amortization of deferred acquisition costs is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. Deferred acquisition costs are amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.  84  Value of Business Acquired  Value of business acquired is the value assigned to the insurance in force of acquired insurance companies or blocks of insurance business at the date of acquisition.  The amortization of value of business acquired is recognized using amortization schedules established at the time of the acquisitions based upon expected annual premium. Certain of these amortization schedules include actual to expected adjustments to reflect actual experience as it emerges. The value of business acquired is amortized over the premium-paying period of the policies.  Impairment of Long-Lived Assets  Long-lived assets include property and equipment, other intangible assets, systems development and other deferred costs and other assets. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), the Company regularly evaluates whether events and circumstances have occurred which indicate that the carrying amount of long-lived assets may warrant revision or may not be recoverable. When factors indicate that long-lived assets should be evaluated for possible impairment, the Company uses an estimate of the future undiscounted net cash flows of the related business over the remaining life of the asset in measuring whether the carrying amount of the related asset is recoverable. To the extent these projections indicate that future undiscounted net cash flows are not sufficient to recover the carrying amounts of the related assets, the
underlying assets are written down by charges to expense so that the carrying amount is equal to fair value, primarily determined based on future discounted cash flows. In the opinion of management, the Companys long-lived assets are appropriately valued at December 31, 2006 and 2005.  Benefit Reserves  Insurance reserves for individual life insurance, individual accident and health insurance, group life insurance and group accident and health insurance are associated with earned premiums so as to recognize profits over the premium-paying period. This association is accomplished by recognizing the liabilities for insurance reserves on a net level premium method based on assumptions deemed appropriate at the date of issue as to future investment yield, mortality, morbidity, withdrawals and maintenance expenses, and including margins for adverse deviations. Interest assumptions are based on the Companys experience. Mortality, morbidity and withdrawal assumptions are based on recognized actuarial tables or the Companys experience, as appropriate. Life reserves are calculated using mean reserve factors. Accident and health reserves are calculated using mid-terminal reserve factors.
Benefit reserves for investment products are computed under a retrospective deposit method and represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policy account balances.  Benefit reserves as reported are shown on a GAAP purchase accounting basis (PGAAP). Prior to the quarter ending June 30, 2006, this conversion was based on an adjustment to benefit reserves developed on a historical GAAP basis. Effective June 30, 2006, a refinement in methodology was implemented whereby the benefit reserves are now being developed directly on a purchase GAAP basis. This seriatim factor approach was not implemented in prior quarters because of the significant amount of time it has taken to develop the complete set of reserve factors that was needed. The refinement of the methodology to use seriatim developed reserves had no material impact on income but does have an impact on the balance sheet on a segment by segment basis. This balance sheet impact is further discussed in Note 16 (Business Segments).  Loss recognition testing of the Companys policy benefit reserves is performed annually. This testing involves a comparison of the Companys actual net liability position (all liabilities less DAC) to the present value of future liabilities calculated using then-current assumptions. These assumptions are based on the Companys best estimate of future experience. To the extent a premium deficiency exists, it would be recognized immediately by a charge to the statement of operations and a corresponding reduction in DAC. Any additional deficiency would be recognized as a premium deficiency reserve. Historically, loss recognition testing has not resulted in an adjustment to DAC or reserves. These adjustments would occur only if economic, mortality and/or morbidity conditions significantly deviated from the underlying assumptions.  85  Claims and Claim Adjustment Expenses  Claim reserves relating to short duration contracts generally are recorded when insured events occur. The liability is based on the expected ultimate cost of settling the claims. The claims and benefits payable reserves include: (1) case base reserves for known but unpaid claims as of the balance sheet date; (2) incurred but not reported (IBNR) reserves for claims where the insured event has occurred but has not been reported as of the balance sheet date; and (3) loss adjustment expense reserves for the expected handling costs of settling the claims. Case base reserves and the IBNR reserves are recorded at an amount equal to the net present value of the expected future claims payments. Factors considered when setting IBNR reserves include patterns in elapsed time from claim incidence to claim reporting, and elapsed time from claim reporting to claim payment. Claim reserves
generally equal the Companys estimate, at the end of the current reporting period, of the present value of the liability for future benefits and expenses to be paid on claims incurred as of that date. A claim reserve for a specific claim is based on assumptions derived from historical experience as to claim duration, as well as the specific characteristics of the claimant such as benefits available under the policy, the benefit period, and the age and occupation of the claimant. Although considerable variability is inherent in such estimates, management believes that the reserves for claims and claim adjustment expenses are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known; such adjustments are included in current operations.  Reinsurance  Reinsurance premiums, benefits and reserves are accounted for on bases consistent with those used in accounting for the original policies issued and the terms of the insurance contracts. Benefit reserves and claim liabilities are reported gross of reinsured amounts. An estimated allowance for doubtful accounts is recorded on the basis of periodic evaluations of balance due from reinsurers, reinsurer solvency, Company experience and current economic conditions.  Recognition of Revenue  Premiums on life insurance products are reported as revenue when due unless received in advance of the due date. Premiums on accident and health insurance are reported as earned over the contract period. A reserve is provided for the portion of premiums written which relate to unexpired coverage terms.  Revenue from annuity and interest sensitive products including universal life products includes charges for the cost of insurance, for initiation and administration of the policy and for surrender of the policy. Revenue from these products is recognized in the year assessed to the policyholder, except that any portion of an assessment, which relates to services to be provided in future years, is deferred and recognized over the period during which services are provided.  Revenue from commission and fee income is recognized over the related contract periods.  Realized Capital Gains (Losses)  Realized capital gains and losses are reported in the income statement on a pretax basis in the period that the asset giving rise to the gain or loss is sold. Impairment writedowns are recorded when there has been a decline in value deemed other than temporary, in which case the write down for such impairments is charged to income.  Recognition of Benefits  Benefits related to traditional life and accident and health insurance products are recognized when incurred in a manner designed to match them with related premiums and spread income recognition over expected policy lives. For annuity and interest sensitive products including universal life products, benefits include interest credited to policyholders accounts, which is recognized as it accrues.   86  Pension Costs  The Company has adopted the provisions of SFAS 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans  An Amendment of FASB Statements No. 87, 88, 106, and 132R. SFAS 158 required the Company to recognize a pension liability of $3,032,877 and a prepaid pension asset of $3,127,725 as of December 31, 2006. The reported net asset of $94,848 represented the overfunded status of the defined benefit pension plan. Also, as the pension liability was established the recognized change was reported in accumulated other comprehensive income which after tax effects was $1,971,370.  Share-Based Compensation  On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including stock options and restricted common stock based on estimated fair values. SFAS 123(R) supersedes the Companys previous accounting for periods beginning in 2006. The Company had adopted the disclosure-only requirements of SFAS No. 123,Accounting for Stock-Based Compensation(SFAS 123), as amended by FASB Statement No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure(SFAS 148) through December 31, 2005. As permitted by the provisions of this Statement, the Predecessor accounted for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and Related Interpretations("APB No. 25").  Accordingly, the Company recognized no compensation expense for stock option awards to employees or directors when the option exercise price was not less than the market value of the
stock at the date of award. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).  The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Companys fiscal year 2006.  The Companys Consolidated Financial Statements as of December 31, 2006 reflect the impact of SFAS 123(R).  In accordance with the modified prospective transition method, the Companys Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R). Share-based compensation expense recognized under SFAS 123(R) as of December 31, 2006 was $1,378,882, which consisted of share-based compensation expense related to director and employee stock options and common stock grants.  SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The Company has used a Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Companys Consolidated Statement of Operations.  Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Companys Consolidated Statement of Operations as of December 31, 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). As stock-based compensation expense recognized in the Consolidated Statement of Operations for the year ended December 31, 2006 is based on awards ultimately expected to vest,
it has been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Companys pro forma information required under SFAS 123 for the periods prior to 2006, the Company accounted for forfeitures as they occurred.  87  On November 10, 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 123(R)-3 Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.  The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance.  Income Taxes  Income taxes are computed using the liability method required by SFAS No. 109, Accounting for Income Taxes. Under this Statement, deferred tax assets and liabilities are determined based on the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Recorded amounts are adjusted to reflect changes in income tax rates and other tax law provisions as they become enacted.  Participating Policies  Policyholder dividends are recognized over the term of the related policies. Participating business represents approximately 30% and 30%, respectively, of the Companys total ordinary life insurance in force at December 31, 2006 and 2005. Dividends paid to policyholders in 2006, 2005 and 2004 were approximately $1.5 million, $2.1 million and $2.2 million, respectively. Participating premiums as a percentage of direct life premiums were 39% in 2006, 46% in 2005 and 51% in 2004.  Recently Issued Accounting Standards  In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans  An Amendment of FASB Statements No. 87, 88, 106, and 132R (SFAS No. 158).  SFAS No. 158 requires companies to (1) recognize as an asset or liability, the overfunded or underfunded status of defined pension and other postretirement benefit plans; (2) recognize changes in the funded status through other comprehensive income in the year in which the changes occur; (3) measure the funded status of defined pension and other postretirement benefit plans as of the date of the companys fiscal year-end; and (4) provide enhanced disclosures.  The provisions of SFAS No. 158 are effective for the Companys year-ending December 31, 2006.  The Company adopted SFAS 158 at December 31, 2006.  In June 2006, the Financial Accounting Standards Board (FASB), issued Interpretation (FIN) No.48, Accounting for Uncertainty in Income Taxes  an interpretation of FASB Statement 109. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company is currently assessing the impact of FIN 48 on its financial statements. In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position 05 -1 (SOP 05 -1), Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. SOP 05 -1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (SFAS) No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from Sale of Investments. SOP 05 -1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by
amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05 -1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006 with earlier adoption encouraged. Retrospective application of SOP 05 -1 to previously issued financial statements is not permitted. The Company is currently assessing the impact of SOP 05-1 on its financial statements.  88


KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  3.
        Investments
  Aggregate amortized cost, aggregate fair value and gross unrealized gains and losses of investments in fixed maturity and equity securities are summarized in the following table.  Amortized Cost
        
        GrossUnrealizedGains
        
        GrossUnrealizedLosses
        
        FairValueAvailable for sale securities at December 31, 2006:U.S. treasuries
        
        $
        8.476,904
        
        $
        
        
        $
        211,357
        
        $
        8,265,547U.S. government agencies
        
        
        19,607,009
        
        
        15,071
        
        
        224,498
        
        
        19,397,582States and political subdivisions
        
        
        13,520,186
        
        
        36,546
        
        
        294,219
        
        
        13,262,513Foreign bonds
        
        
        34,707,840
        
        
        21,622
        
        
        1,017,565
        
        
        33,711,897Corporate bonds
        
        
        224,564,657
        
        
        815,095
        
        
        6,678,784
        
        
        218,700,968Mortgage/asset-backed securities
        
        
        207,269,733
        
        
        466,652
        
        
        3,541,243
        
        
        204,195,142Preferred stocksredeemable
        
        
        23,331,208
        
        
        128,422
        
        
        368,337
        
        
        23,091,293Subtotal, fixed maturity securities
        
        
        531,477,537
        
        
        1,483,408
        
        
        12,336,003
        
        
        520,624,942Equity securities
        
        
        101,945
        
        
        1,600
        
        
        
        
        
        103,545Securities available for sale
        
        $
        531,579,482
        
        $
        1,485,008
        
        $
        12,336,003
        
        $
        520,728,487Available for sale securities at December 31, 2005:U.S. treasuries
        
        $
        8,089,875
        
        $
        
        
        $
        149,802
        
        $
        7,940,073U.S. government agencies
        
        
        27,038,940
        
        
        3,559
        
        
        345,741
        
        
        26,696,758States and political subdivisions
        
        
        14,307,480
        
        
        51,442
        
        
        82,818
        
        
        14,276,104Foreign bonds
        
        
        47,066,142
        
        
        252,937
        
        
        761,201
        
        
        46,557,878Corporate bonds
        
        
        205,820,552
        
        
        852,960
        
        
        5,031,101
        
        
        201,642,411Mortgage/asset-backed securities
        
        
        197,031,280
        
        
        650,909
        
        
        2,867,794
        
        
        194,814,395Preferred stocksredeemable
        
        
        6,494,482
        
        
        
        
        
        264,746
        
        
        6,229,736Subtotal, fixed maturity securities
        
        
        505,848,751
        
        
        1,811,807
        
        
        9,503,203
        
        
        498,157,355Equity securities
        
        
        286,809
        
        
        
        
        
        
        
        
        286,809Securities available for sale
        
        $
        506,135,560
        
        $
        1,811,807
        
        $
        9,503,203
        
        $
        498,444,164
  The amortized cost and fair value of fixed maturity securities at December 31, 2006, by contractual maturity are shown below. Expected maturities may differ from contractual maturities because certain borrowers have the right to call or prepay obligations with or without call or prepayment penalties.  AmortizedCost
        
        FairValueMaturity:One year or less
        
        $
        5,856,076
        
        $
        5,825,739After year one through five years
        
        
        27,986,311
        
        
        27,438,868After five years through ten years
        
        
        103,278,689
        
        
        101,581,213After ten years
        
        
        163,755,520
        
        
        158,492,686Mortgage/asset-backed securities
        
        
        207,269,733
        
        
        204,195,143Preferred stocksredeemable
        
        
        23,331,208
        
        
        23,091,293Total fixed maturity securities
        
        $
        531,477,537
        
        $
        520,624,942
  Proceeds from the sales of investments in fixed maturity securities during the years ending December 31, 2006, 2005 and 2004 were $47.1 million, $61.6 million and $99.2 million, respectively. Gross gains of $0.0 million and gross losses of $0.6 million were realized in 2006 on those sales. Gross gains of $0.8 million and gross losses of $0.6 million were realized in 2005 on those sales. Gross gains of $7.9 million and gross losses of $0.7 million were realized in 2004 on those sales.  Proceeds from the sale of investments in equity securities during the years ended December 31, 2006, 2005 and 2004, were $1.4 million, $0.0 million and $2.7 million, respectively. Gross gains of $1.3 million and gross  89  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  losses of $0.0 million were realized from those sales in 2006.  These gains were due to the sale of Kanawha Healthcare Solutions, Inc.'s investment in the limited liability company, Risk Based Solutions, Inc. in 2006. Gross gains of $2.6 million and gross losses of $0.0 million were realized in 2004 on those sales.  Net gains of $0.6 million, $0.2 million, and $0.4 million were realized on the trading portfolio in 2006, 2005, and 2004, respectively.  At December 31, 2006, fixed maturity securities and short-term investments with an amortized cost of $4.7 million and fair value of $4.8 million were on deposit with state insurance departments to satisfy regulatory requirements. At December 31, 2006, the Company held bonds with an amortized cost of $102.6 million and fair value of $102.2 million in trust accounts for our reinsurance assumed treaties with Equitable Life, Metropolitan Life, and Security Benefit Life (part of reinsurance assumed reserves in Note 8, which is incorporated herein by reference).  Changes during the years ended December 31, 2006, 2005 and 2004, in amounts affecting the net unrealized gains and losses, reduced by deferred income taxes, included in shareholders equity as accumulated other comprehensive income are as follows:  Year Ended December31, 2004Net Unrealized Gains (Losses)FixedMaturitySecurities
        
        EquitySecurities
        
        TotalUnrealized gains (losses) arising during the period, before taxes
        $
        6,687,843
        
        $
        (128,017
        )
        $
        6,559,826Income taxes
        
        (2,340,745
        )
        
        44,806
        
        
        (2,295,939
        )4,347,098
        
        
        (83,211
        )
        
        4,263,887Less reclassification adjustment:Gains realized in net income
        
        6,740,108
        
        
        2,361,598
        
        
        9,101,706Income taxes
        
        (2,359,038
        )
        
        (826,559
        )
        
        (3,185,597
        )Reclassification adjustment for gains realized in net income
        
        4,381,070
        
        
        1,535,039
        
        
        5,916,109Other comprehensive loss
        $
        (33,972
        )
        $
        (1,618,250
        )
        $
        (1,652,222
        )
  Year Ended December31, 2005Net Unrealized Gains (Losses)FixedMaturitySecurities
        
        EquitySecurities
        
        TotalUnrealized (losses) arising during the period, before taxes
        $
        (7,542,066
        )
        $
        (26,000
        )
        $
        (7,568,066
        )Income taxes
        
        2,639,723
        
        
        9,100
        
        
        2,648,823(4,902,343
        )
        
        (16,900
        )
        
        (4,919,243
        )Less reclassification adjustment:Gains (losses)  realized in net income
        
        142,625
        
        
        (26,000
        )
        
        116,625Income taxes
        
        (49,919
        )
        
        9,100
        
        
        (40,819
        )Reclassification adjustment for gains (losses) realized in net income
        
        92,706
        
        
        (16,900
        )
        
        75,806Other comprehensive loss
        $
        (4,995,049
        )
        $
        
        
        $
        (4,995,049
        )
   90  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS   Year Ended December31, 2006Net Unrealized Gains (Losses)FixedMaturitySecurities
        
        EquitySecurities
        
        TotalUnrealized gains (losses) arising during the period, before taxes
        $
        (3,795,849
        )
        $
        1,600
        
        $
        (3,794,249
        )Income taxes
        
        1,328,547
        
        
        (560
        )
        
        1,327,987(2,467,302
        )
        
        1,040
        
        
        (2,466,262
        )Less reclassification adjustment:Gains (losses)  realized in net income
        
        (627,945
        )
        
        
        
        
        (627,945
        )Income taxes
        
        219,781
        
        
        
        
        
        219,781Reclassification adjustment for gains (losses) realized in net income
        
        (408,164
        )
        
        
        
        
        (408,164
        )Other comprehensive income (loss)
        $
        (2,059,138
        )
        $
        1,040
        
        $
        (2,058,098
        )
  At December 31, 2006, the Company held certain fixed income investments with unrealized losses. Information regarding these investments is as follows:  Number of Issues
        
        AggregateUnrealized Losses
        
        AggregateEstimated Fair Value(dollars in thousands)Fixed Maturity Securities which have been in an unrealized loss position for:Less than 12 months
        148
        
        $
        (3,086.4
        )
        $
        157,653.5Greater than 12 months
        3313
        
        $
        (9,249.6
        )
        $
        264,630.8
  Management has reviewed these securities which either have been in an unrealized loss position for more than twelve months or have significant unrealized losses relative to cost and have concluded that these securities have not experienced an other-than-temporary impairment. Factors considered in making this evaluation included issue-specific drivers of the decrease in price, near-term prospects of the issuer, the length of time the value has been depressed, and the financial condition of the industry. Based on this review, no unrealized losses were considered to be other than temporary during 2006. Unrealized losses of $0.2 million and $0.7 million were considered to be other-than-temporary for this review and were recognized as realized losses during 2005 and 2004, respectively.  91  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  Major categories of the Companys and Predecessors net investment income for the years ended December 31, 2006, 2005 and 2004, are summarized as follows:  Year Ended December 31,2006
        
        2005
        
        2004Income:Bonds
        $
        27,937,201
        
        $
        24,154,644
        
        $
        22,629,014Preferred stocks
        
        218,739
        
        
        280,295
        
        
        1,002,311Common stocks, unaffiliated
        
        
        
        
        
        
        
        70,665Mortgage loans
        
        968,017
        
        
        1,253,382
        
        
        1,952,089Policy loans
        
        1,164,509
        
        
        1,251,152
        
        
        1,420,052Short-term investments and cash
        
        563,426
        
        
        1,342,146
        
        
        146,091Other
        
        152,865
        
        
        635,445
        
        
        536,388Total investment income
        
        31,004,757
        
        
        28,917,064
        
        
        27,756,610Expenses:Investment expenses
        
        944,690
        
        
        1,072,327
        
        
        2,548,777Investment taxes, licenses and fees
        
        114,261
        
        
        99,866
        
        
        5,421Total investment expenses
        
        1,058,951
        
        
        1,172,193
        
        
        2,554,198Net investment income
        $
        29,945,806
        
        $
        27,744,871
        
        $
        25,202,412
  There were no new mortgage loans originated in 2006. At the issuance of a loan, the percentage of loan to value on any one loan does not exceed 75%. All properties covered by mortgage loans have fire insurance equal to at least the loan excess over the maximum loan that would be allowed on the land without the building.  The Companys mortgage loan portfolio is comprised of conventional real estate mortgages collateralized primarily by office (3.6%), apartments (4.6%) and residential (91.8%) properties. Mortgage loan underwriting standards emphasize the credit status of a prospective borrower, quality of the underlying collateral and conservative loan-to-value ratios. Approximately 97.3% of the loans are on properties located in the South Atlantic region.  Other geographic regions include mortgaged property representing 2.7% of the aggregate principal amount of the Companys mortgage loans as of December 31, 2006.  Interest is recognized as revenue when earned according to the terms of the loans and when, in the opinion of management, it is collectible. The accrual of interest on the loans is discontinued at the time the loan is 90 days past due or when, in managements opinion, collection of such interest is doubtful. Past due status is based on the contractual terms of the loan. Loans are placed on non-accrual or charged off at an earlier date if collection of principal or interest is considered doubtful. The Company maintains an allowance for potentially uncollectible loans. Additions to the allowance are based on assessments of certain factors, including but not limited to historical loan loss experience of similar types of loans, the Companys loan loss experience, the amount of past due and non-performing loans and current and anticipated economic and interest rate conditions.
Evaluation of these factors involves subjective estimates and judgments that may change. Additions to the allowance are provided through a charge to earnings. There was no balance in the allowance account at December 31, 2004. There were no additions to the allowance for the years ended December 31, 2006 and 2005.  At December 31, 2006 the Company held $0.1 million in residential mortgage loans with interest overdue more than 90 days.  4.
        Other Intangible Assets
  Under FAS No. 142, goodwill and intangible assets with indefinite useful lives are not amortized. Effective December 31, 2004, historical goodwill of the Predecessor was eliminated as a part of the application of GAAP purchase accounting requirements. The fair value of net assets of the Predecessor was greater than the acquisition purchase price, therefore no goodwill was recorded, effective December 31, 2004. Certain other intangibles were recorded as a result of the acquisition effective December 31, 2004. The weighted-average useful life, gross carrying  92  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  value, accumulated amortization and net carrying value of other intangible assets, which are included in other assets in the consolidated balance sheet, as of December 31, 2006, and 2005, were as follows:  Weighted-
        
        KMG America
December 31, 2006Average
        
        Gross Carrying
        
        Accumulated
        
        Net CarryingUseful Life
        
        Value
(in millions)
        
        Amortization
(in millions)
        
        Value
(in millions)Customer Relationships
        
        10 years
        
        $
        4.90
        
        
        $
        1.0
        
        
        $
        3.90Trademarks and Trade
Name
        
        indefinite
        
        
        6.11
        
        
        
        0
        
        
        
        6.11Product Approvals
        
        35 years
        
        
        2.83
        
        
        
        .2
        
        
        
        2.63State Licenses
        
        indefinite
        
        
        3.66
        
        
        
        0
        
        
        
        3.66Total
        
        
        
        $
        17.50
        
        
        $
        1.2
        
        
        $
        16.30Weighted-
        
        KMG America
December 31, 2005Average
        
        Gross Carrying
        
        Accumulated
        
        Net CarryingUseful Life
        
        Value
(in millions)
        
        Amortization
(in millions)
        
        Value
(in millions)Customer Relationships
        
        10 years
        
        $
        4.90
        
        
        $
        .5
        
        
        $
        4.40Trademarks and Trade
Name
        
        indefinite
        
        
        6.11
        
        
        
        0
        
        
        
        6.11Product Approvals
        
        35 years
        
        
        2.83
        
        
        
        .1
        
        
        
        2.73State Licenses
        
        indefinite
        
        
        3.66
        
        
        
        0
        
        
        
        3.66Total
        
        
        
        $
        17.50
        
        
        $
        .6
        
        
        $
        16.9
  Amortization expense relating to intangible assets was $0.57 million in 2006, $0.57 million in 2005, and $0.0 million in 2004. Estimated future amortization expense relating to intangible assets for the years ending December 31 are as follows:  (in millions)
        
        2007
        
        2008
        
        2009
        
        2010
        
        2011Estimated future amortization
expense relating to intangible assets
        
        $
        0.57
        
        
        $
        0.57
        
        
        $
        0.57
        
        
        $
        0.57
        
        
        $
        0.57
  5.
        Real Estate and Equipment
  Real estate and equipment consist of the following at December 31:  2006
        
        2005Real estate
        
        $
        7,652,969
        
        $
        7,105,384Equipment
        
        
        11,067,610
        
        
        6,367,004Total
        
        
        18,720,579
        
        
        13,472,388Less accumulated depreciation
        
        
        3,652,073
        
        
        1,748,519$
        15,068,506
        
        $
        11,723,869
  6.
        Deferred Policy Acquisition Costs and Value of Business Acquired
  In connection with the Kanawha acquisition, the Company recorded the value of business acquired for the value of the Predecessors in force business.  The interest rate assumption used to amortize the value of business acquired was approximately 6.0% at December 31, 2006.  Information about deferred policy acquisition costs and value of business acquired are summarized below:     93  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS   KMG America Corporation
        
        PredecessorDecember 31,
        
        December 31,2006
        
        2005
        
        2004
        
        2004Deferred policy acquisition costs:Beginning balance
        
        $
        14,031,875
        
        $
        
        
        $
        
        
        $
        80,656,518Deferral:
        
        
        
        
        
        
        
        
        Commissions
        
        
        8,883,132
        
        
        7,893,558
        
        
        
        
        
        5,374,915Expenses
        
        
        6,751,388
        
        
        7,119,717
        
        
        
        
        
        7,750,057Total deferral
        
        
        15,634,520
        
        
        15,013,275
        
        
        
        
        
        13,124,972Gross amortization
        
        
        2,054,378
        
        
        981,400
        
        
        
        
        
        11,749,911Interest accrued
        
        
        (841,912
        )
        
        
        
        
        
        
        
        (5,307,199
        )Net amortization
        
        
        1,212,466
        
        
        981,400
        
        
        
        
        
        6,442,712Ending balance
        
        $
        28,453,929
        
        $
        14,031,875
        
        $
        
        
        $
        87,338,778Value of business acquired:Beginning balance
        
        $
        72,638,967
        
        $
        74,481,295
        
        $
        
        
        $
        29,604,632Deferral:Cost of acquisition
        
        
        1,020,400
        
        
        643,771
        
        
        74,481,295
        
        
        Total deferral
        
        
        1,020,400
        
        
        643,771
        
        
        74,481,295
        
        
        Gross amortization
        
        
        7,251,494
        
        
        6,954,977
        
        
        
        
        
        5,097,914Interest accrued
        
        
        (4,358,338
        )
        
        (4,468,878
        )
        
        
        
        
        (2,072,324
        )Net amortization
        
        
        2,893,156
        
        
        2,486,099
        
        
        
        
        
        3,025,590Ending balance
        
        $
        70,766,211
        
        $
        72,638,967
        
        $
        74,481,295
        
        $
        26,579,042
  The Company accounts for value of business acquired in a manner similar to deferred acquisition costs. The interest rates used to amortize deferred acquisition costs were 6.00%, 6.06 % and 6.58 % in 2006, 2005 and 2004, respectively.  The interest rate used in 2004 to amortize value of business acquired was approximately 7.0%. Periodically, the Company performs tests to determine whether the value of business acquired remains recoverable from future premiums on the acquired business. No write-offs were incurred in 2004, 2005 or 2006 from impairments as a result of such recoverability tests. The interest rate assumption used to amortize the value of business acquired was reset upon the closing of the Kanawha acquisition and the rate was approximately 6.0% at December 31, 2004. Under the Companys assumptions, as of December 31, 2006, the Company estimated that the amortization of value of business acquired for the next five years will be as follows:  Year ending December 31:
        Amortization2007
        4.96%2008
        4.932009
        5.242010
        5.232011
        5.14
  If actual lapse and mortality experience is higher or lower than assumed for the table above, then actual amortization will be faster or slower than indicated in the table.  7.
        Benefit Reserves
  Insurance reserves for individual life insurance, individual accident and health insurance, group life insurance and group accident and health insurance are computed using the net level premium method, including  94


KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  assumptions based on our experience, modified as necessary to reflect anticipated trends and to include provisions for possible unfavorable deviations. Reserve interest assumptions are graded and range from 3.0% to 8.5% for historical GAAP purposes and for current Purchase GAAP the interest assumptions range from 5.75% to 6.60%   The weighted average assumed investment yield for all life and accident and health policy reserves was 6.07% in 2006, 6.04% in 2005 and 6.84% in 2004.   Benefit reserves for limited-payment policies take into account, where necessary, any deferred profits to be recognized in income over the policy term. Policy benefit claims are charged to expense in the period that the claims are incurred.  Interest crediting rates for investment products ranged from 3.5% to 5.0% in 2006, 2005, 2004, respectively.  During the quarter ended June 30, 2006, the Company implemented the use of seriatim PGAAP reserve factors.  While the implementation of seriatim PGAAP factors did not change total reserves of the Company, it did result in a reallocation of reserves among the worksite insurance, senior market insurance and acquired business segments.  This reallocation has been reflected in the second quarter results of the affected segments.  The result of the reallocation of reserves between business segments was to strengthen reserves by $37.5 million in the senior market insurance business segment. This was offset by a reduction in reserves of $31.2 million in the acquired business segment and $6.3 million in the worksite segment. No material effect to overall policy reserves or to earnings resulted from the reallocation. Subsequent reserve adequacy testing of policy reserves by segment indicates that the resulting alignment of reserves is sufficient in each segment.  8.
        Reinsurance
  Certain premiums and benefits are assumed from and ceded to other insurance companies under various reinsurance agreements. The assumption agreements provide the Company with increased economies of scale and the ceded agreements provide the Company with increased capacity to write larger risks and maintain its exposure to loss within its capital resources and, in some cases, effect business dispositions. However, if the assuming reinsurer is unable to meet its obligations, the Company remains contingently liable. The Company evaluates the financial condition of reinsurers and monitors concentration of credit risk to minimize this exposure.  All reinsurers for which we hold an amount recoverable have a financial strength rating from A.M. Best of at least an A- (excellent) (with the exception of Scottish Re, which is rated B, but to which we have limited exposure as the current amount
recoverable as of December 31, 2006 is $125,619) and the majority of our reinsurers have a rating of A+ (superior).  In some cases, reinsurers have placed amounts in trusts equivalent to the amount recoverable from the reinsurer.  The following represent reinsurance amounts included in the accompanying financial statements:  95  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS   KMG AmericaDecember 31,2006
        
        2005Balance sheet amounts-assets (liabilities)Policy and contract liabilities:Aggregate life, annuity, and accident and health reserves:Direct
        
        $
        (404,665,195
        )
        $
        (342,240,185
        )Assumed
        
        
        (142,573,997
        )
        
        (184,919,606
        )Aggregate life, annuity, and accident and health reserves
        
        $
        (547,239,192
        )
        $
        (527,159,791
        )Policy and contract claims:Direct
        
        $
        (13,014,693
        )
        $
        (8,588,956
        )Assumed
        
        
        (1,516,089
        )
        
        (1,419,396
        )Policy and contract claims
        
        $
        (14,530,782
        )
        $
        (10,008,352
        )Reinsurance balances recoverable:Life, annuity, and accident and health reserves ceded
        
        $
        86,296,091
        
        $
        77,086,526Policy and contract claims ceded
        
        
        2,795,141
        
        
        1,209,531Reinsurance balances recoverable
        
        $
        89,091,232
        
        $
        78,296,057Experience refunds payable
        
        $
        (18,621,587
        )
        $
        (16,684,844
        )Premiums due
        
        $
        (1,401,793
        )
        $
        (2,230,179
        )Premiums received in advance
        
        $
        (114,416
        )
        $
        (117,088
        )
   KMG America
        
        
        PredecessorDecember 31,
        
        
        December 31,2006
        
        
        2005
        
        
        2004Statement of operations amounts  (revenue) expensePremiums and benefits paid or provided:Insurance premiumsDirect
        
        $
        (146,051,669
        )
        $
        (119,604,850
        )
        $
        (113,222,042
        )Assumed
        
        
        (6,133,954
        )
        
        (4,065,908
        )
        
        (4,561,459
        )Ceded
        
        
        24,216,926
        
        
        16,783,240
        
        
        14,947,956Net insurance premiums
        
        $
        (127,968,697
        )
        $
        (106,887,518
        )
        $
        (102,835,545
        )Policyholder benefits:Direct
        
        $
        140,007,503
        
        $
        92,863,244
        
        $
        93,524,974Assumed
        
        
        (19,981,934
        )
        
        6,299,288
        
        
        11,183,934Ceded
        
        
        (20,183,280
        )
        
        (14,874,806
        )
        
        (14,533,915
        )Net policyholder benefits
        
        $
        99,842,289
        
        $
        84,287,726
        
        $
        90,174,993Commissions assumed
        
        $
        479,564
        
        $
        398,989
        
        $
        428,247Commission allowance on reinsurance ceded
        
        $
        (4,398,203
        )
        $
        (4,371,076
        )
        $
        (4,825,569
        )
   96  9.
        Federal Income Taxes
  Income taxes as reported in the consolidated statements of operations for the years ended December 31, 2006, 2005 and 2004, are summarized as follows:  KMG America
        
        
        Predecessor2006
        
        
        2005
        
        
        2004
        
        
        2004Current expense (benefit)
        
        $
        567,471
        
        $
        (1,283,678
        )
        $
        
        
        $
        (789,362
        )Deferred expense (benefit)
        
        
        3,280,697
        
        
        3,411,886
        
        
        (94,528
        )
        
        4,355,234Income tax expense (benefit)
        
        $
        3,848,168
        
        $
        2,128,208
        
        $
        (94,528
        )
        $
        3,565,872
  The provision for federal income taxes incurred is different from that which would be obtained by applying the statutory Federal income tax rate to income before income taxes. The significant items causing this difference are:  PredecessorFor the Year Ended December 31, 2006
        
        EffectiveTax Rate
        
        
        
        For the Year Ended December 31, 2005
        
        EffectiveTax Rate
        
        
        
        For the Year Ended December 31, 2004
        
        EffectiveTax RatePre-tax book income
        
        $
        11,067,118
        
        
        
        
        
        $
        6,611,966
        
        
        
        
        
        $
        9,756,371Provision computed at statutory rate
        
        $
        3,762,820
        
        34.00
        
        %
        
        $
        2,248,068
        
        34.00
        
        %
        
        $
        3,317,166
        
        34.00
        
        %Dividend received deduction
        
        
        (26,950
        )
        (0.24
        )
        %
        
        
        (68,672
        )
        (1.04
        )
        %
        
        
        (87,500
        )
        (0.90
        )
        %Tax exempt investment income
        
        
        (14,390
        )
        (0.13
        )
        %
        
        
        (13,711
        )
        (0.21
        )
        %
        
        
        (70,000
        )
        (0.72
        )
        %Other
        
        
        126,688
        
        1.14
        
        %
        
        
        (37,477
        )
        (0.56
        )
        %
        
        
        406,206
        
        4.17
        
        %Total
        
        $
        3,848,168
        
        34.77
        
        %
        
        $
        2,128,208
        
        32.19
        
        %
        
        $
        3,565,872
        
        36.55
        
        %
  The tax effects of temporary differences that result in significant deferred income tax assets and deferred income tax liabilities at December 31 are as follows:  2006
        
        2005Deferred tax liabilities:Deferred policy acquisition costs
        
        $
        5,480,162
        
        $
        157,717Value of business acquired
        
        
        23,499,989
        
        
        24,010,585GAAP/Tax difference in asset basis
        
        
        5,907,014
        
        
        6,696,316Other
        
        
        7,350,834
        
        
        7,528,204Total deferred tax liabilities
        
        
        42,237,999
        
        
        38,392,822Deferred tax assets:Policy benefit reserves
        
        
        8,490,767
        
        
        17,247,379Deferred compensation
        
        
        1,933,131
        
        
        1,908,654Unrealized investment losses recognized in equity
        
        
        3,797,848
        
        
        2,689,642Net operating loss carryforward
        
        
        16,926,457
        
        
        7,887,975Other
        
        
        2,933,138
        
        
        1,824,728Total deferred tax assets
        
        
        34,081,341
        
        
        31,558,378Less: valuation allowance
        
        
        
        
        
        (211,230
        )Deferred tax assets net of valuation allowance
        
        
        34,081,341
        
        
        31,347,148Net deferred income tax liabilities
        
        $
        8,156,658
        
        $
        7,045,674
    97   2006
        
        
        2005Reconciliation to balance sheet:Deferred income tax liabilities
        
        $
        14,735,262
        
        $
        13,061,136Less: deferred income tax asset
        
        
        6,578,604
        
        
        6,015,462Net deferred income tax liabilities
        
        $
        8,156,658
        
        $
        7,045,674
  The Predecessors federal income tax returns for all years through 2000 are closed. In the opinion of management, recorded income tax liabilities adequately provide for all remaining open years.  The Company and its subsidiaries have filed separate federal income tax returns as required by regulations regarding the consolidation for tax purposes of life insurance and non-life insurance companies.  The Company and its subsidiaries have incurred net operating losses which will expire between 2024 and 2026. Under SFAS No. 109, management must provide a valuation allowance for any deferred tax amounts that it does not believe will be realized. Management believes that there is more likely than not that these net operating losses will be realized; therefore, no valuation allowance has been established. The valuation allowance decreased by $0.2 million and $1.6 million in 2006 and 2005, respectively. The Company paid income taxes of $0.0 million and $0.0 million, during the years ended December 31, 2006 and 2005, respectively.  Prior to 1984, a portion of the Predecessors income was not taxed, but was set aside in a special tax account designated as Policyholders Surplus.  Kanawha, the Companys insurance subsidiary, has approximately $4.3 million of untaxed Policyholders Surplus on which no payment of federal income taxes will be required unless it is distributed as a dividend, or under other specified conditions. The Company does not believe that any significant portion of the account will be taxed in the foreseeable future and no related deferred tax liability has been recognized. If the entire balance of the account became taxable under the current federal rate, the tax would approximate $1.5 million.  10.
        Statutory Financial Information
  State insurance laws and regulations prescribe accounting practices for determining statutory net income and equity for insurance companies. In addition, state regulators may permit statutory accounting practices that differ from prescribed practices. The Company does not have any permitted accounting practices that differ from prescribed practices.  Statutory accounting practices (SAP) prescribed or permitted by regulatory authorities for the Company differ from GAAP. Shareholders equity and net loss, as determined in accordance with statutory accounting practices, for Kanawha are summarized as follows:  Net (loss) for the year ended December 31, 2006
        
        $
        (14,717,792
        )Capital and surplus as of December 31, 2006
        
        $
        72,283,775Net (loss) for the year ended December 31, 2005
        
        $
        (8,887,046
        )Capital and surplus as of December 31, 2005
        
        $
        85,063,165Net (loss) for the year ended December 31, 2004
        
        $
        (1,745,291
        )Capital and surplus as of December 31, 2004
        
        $
        83,707,749
  Under South Carolina insurance regulations, Kanawha is required to maintain minimum capital of $1.2 million and minimum surplus of $1.2 million. Additionally, Kanawha is restricted as to amounts that can be transferred in the form of dividends, loans, or advances without the approval of the South Carolina Insurance Commissioner. Under these restrictions, during 2007, dividends, loans or advances by Kanawha in excess of $7.2 million will require the approval of the South Carolina Insurance Commissioner.  Risk-Based Capital (RBC) requirements promulgated by the NAIC require life insurers to maintain minimum capitalization levels that are determined based on formulas incorporating credit risk pertaining to its  98  investments, insurance risk, interest rate risk and general business risk. As of December 31, 2006, the Companys adjusted SAP capital and surplus exceeded its authorized control level RBC.  11.
        Unpaid Claims
  The following table provides a reconciliation of the beginning and ending balances of unpaid accident and health claim liabilities, net of reinsurance recoverables, for years ended December 31:  2006
        
        
        2005
        
        
        2004Unpaid accident and health claims at beginning of year
        
        $
        31,226,917
        
        $
        25,380,187
        
        $
        22,703,423Less reinsurance recoverables
        
        
        5,571,595
        
        
        4,474,339
        
        
        3,896,612Net balance at beginning of year
        
        
        25,655,322
        
        
        20,905,848
        
        
        18,806,811Add provision for claims occurring in:Current year
        
        
        69,478,729
        
        
        54,175,099
        
        
        50,308,966Prior years
        
        
        (622,038
        )
        
        217,926
        
        
        (670,441
        )Incurred losses during the current year
        
        
        68,856,691
        
        
        54,393,025
        
        
        49,638,525Deduct payments for claims occurring in:Current year
        
        
        44,375,012
        
        
        36,435,423
        
        
        35,075,480Prior years
        
        
        15,299,157
        
        
        13,208,128
        
        
        12,464,008Claim payments during the current year
        
        
        59,674,169
        
        
        49,643,551
        
        
        47,539,488Net balance at end of year
        
        
        34,837,844
        
        
        25,655,322
        
        
        20,905,848Plus reinsurance recoverables
        
        
        8,733,357
        
        
        5,571,595
        
        
        4,474,339Unpaid accident and health claims at end of year
        
        $
        43,571,201
        
        $
        31,226,917
        
        $
        25,380,187Unpaid accident and health claims at end of year
        
        $
        43,571,201
        
        $
        31,226,917
        
        $
        25,380,187Life policy and contract claims
        
        
        1,475,570
        
        
        1,190,986
        
        
        1,323,144Accident and health policy reserves
        
        
        264,065,013
        
        
        205,296,068
        
        
        183,442,027$
        309,111,784
        
        $
        237,713,971
        
        $
        210,145,358Accident and health reserves per balance sheet
        
        $
        294,581,002
        
        $
        227,705,619
        
        $
        200,801,846Policy and contract claims per balance sheet
        
        
        14,530,782
        
        
        10,008,352
        
        
        9,343,512$
        309,111,784
        
        $
        237,713,971
        
        $
        210,145,358
  The foregoing reconciliation reflects a redundancy in the December 31, 2005 and 2004, reserves of $0.6 million, and a deficiency in the December 31, 2004 reserves of $0.2 million that emerged in 2006 and 2005, respectively. The changes in those reserves were primarily the result in changes in estimates as more information became available.  12.
        Employee Benefits
  The Company adopted the Predecessors defined benefit retirement plan, defined contribution plan, and deferred compensation plan. These plans were amended during 2006.  These changes are discussed in detail below.  Defined Benefit Retirement Plan
  The Companys defined benefit retirement plan complies with two principal standards: the Employee Retirement Income Security Act of 1974, as amended (ERISA), which, in conjunction with the Internal Revenue Code, determines legal minimum and maximum deductible funding requirements; and Statement of Financial Accounting Standards No.158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans  An Amendment of FASB Statements No. 87,88,106, and 132R (SFAS No. 158) which was issued in September 2006 and effective for the Company as of  December 31, 2006.  The measurement date for the Companys defined benefit plan is December 31.  99   Plan benefits are based on years of service and compensation during the last five years of service. The Companys funding policy is to make the minimum annual contributions required by applicable regulations, including amortization of unfunded prior service costs over the maximum period allowed by ERISA. The assets of the plan are held in a trust account and are invested in equity securities, debt securities and related instruments, and cash and cash equivalents.  On January 31, 2006, the Company adopted two amendments to the defined benefit retirement plan that froze participation in the plan and froze accrual of any additional benefits under the plan. As of March 31, 2006, no new participants were allowed to enter the plan. Effective as of September 30, 2006, no additional benefits accrue under the plan with respect to service after that date. As a result, final average earnings will be determined as of September 30, 2006, for all future benefit payments, and will not be adjusted for future changes in employee compensation.  Beneficiaries may elect to receive benefits in the form of lump-sum distribution, subject to certain dollar limitations, or through one of several annuity options. Based on the plans current funding status and ERISA guidelines, no required contributions to the plan are anticipated for 2007.  The net periodic retirement benefit cost of the plan included the following components:  KMG America
        
        
        PredecessorYear Ended December 31,2006
        
        
        2005
        
        
        2004Components of net periodic benefit cost:Service cost
        
        $
        191,110
        
        $
        841,468
        
        $
        910,317Interest cost
        
        
        930,039
        
        
        948,027
        
        
        912,685Expected return on plan assets
        
        
        (1,238,563
        )
        
        (1,094,236
        )
        
        (829,537
        )Amortization of transition liability
        
        
        1,448
        
        
        17,373
        
        
        17,373Recognized net actuarial loss
        
        
        210,584
        
        
        205,330
        
        
        170,431Net periodic benefit cost
        
        $
        94,618
        
        $
        917,962
        
        $
        1,181,269
  Expected benefit payments are as follows for the years ended December 31:  2007
        
        2008
        
        2009
        
        2010
        
        2011
        
        2012-2016$
        565,000
        
        $
        630,000
        
        $
        719,000
        
        $
        721,000
        
        $
        753,000
        
        $
        5,061,000
    100


KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  The defined benefit plans change in benefit obligation, change in plan assets, funded status and amounts recognized in the Companys consolidated balance sheets are as follows:  KMG America2006
        
        
        
        2005Change in Projected Benefit ObligationObligation at January 1
        
        $
        17,227,851
        
        
        $
        15,387,719Service cost
        
        
        191,110
        
        
        
        841,468Interest cost
        
        
        930,039
        
        
        
        948,027Actuarial loss
        
        
        624,382
        
        
        
        455,585Benefit payments
        
        
        (568,376
        )
        
        
        (404,948
        )Curtailments
        
        
        (2,140,546
        )
        
        
        0Obligation at December 31
        
        $
        16,264,460
        
        
        $
        17,227,851Reconciliation of Fair Value of Plan Assets:Fair Value of plan assets at January 1
        
        $
        15,068,718
        
        
        $
        13,346,989Actual return on plan assets
        
        
        1,408,966
        
        
        
        (373,323
        )Employer contributions
        
        
        450,000
        
        
        
        2,500,000Benefit payments
        
        
        (568,376
        )
        
        
        (404,948
        )Fair value of plan assets at December 31
        
        $
        16,359,308
        
        
        $
        15,068,718Funded Status of the PlanFunded status at December 31
        
        $
        94,848
        
        
        $
        (2,159,133
        )
  Amounts recognized in the Statement of Financial Position consists of:   Noncurrent Assets Net
        
        $
        94,848Current Liabilities
        
        
        0Noncurrent Liabilities
        
        
        0Net Amount Recognized
        
        $
        94,848
  Amounts recognized in Accumulated Other Comprehensive Income consists of:  Net Actuarial Loss
        
        $
        3,032,877
        
        (Before tax effects)Prior Service Cost / (Credit)
        
        
        0Total
        
        
        3,032,877Net Amount Recognized
        
        $
        1,971,370
        
        (After tax effects)
  The initial amount recognized in accumulated other comprehensive income of $1,971,370 after tax is the result of adopting SFAS No. 158 as of December 31, 2006. An additional pension liability of $3,032,877 was established as the result of the requirement to recognize the funding status of the defined benefit pension plan on the balance sheet as of December 31, 2006. Previously, under SFAS No. 87 and 132R the Company only needed to recognize its pension obligation to the extent of the minimum liability represented by the accumulated benefit obligation. The Company had historically funded the plan to the extent of the minimum liability, thus to avoid the adjustment to other comprehensive income prior to 2006 year end which would have been required under SFAS 132R if the Company was under funded. The newly adopted accounting pronouncement required the recognition of the full projected benefit
obligation when measuring the funded status as of December 31, 2006. The net position of the prepaid pension asset and the pension liability results in the amount recognized in the statement of financial position of $94,848 representing the Companys over funded status of the defined benefit pension plan.   101  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  The estimated net loss and prior service cost for the defined benefit pension plan that will be amortized from accumulated other comprehensive income into periodic benefit cost over the next fiscal year are $172,000 and $0, respectively.  The projected benefit obligation, accumulated benefit obligation, and fair value of plan assets for the retirement plans with accumulated benefit obligations in excess of plan assets were as follows:  2006
        
        2005Projected benefit obligation
        
        $
        16,264,460
        
        $
        17,227,851Accumulated benefit obligation
        
        
        16,264,460
        
        
        14,924,457Fair value of plan assets
        
        $
        16,359,308
        
        $
        15,068,718
  The expected long-term rate of return on plan assets is estimated based on input from the Companys actuaries and the Companys investment committee using a variety of factors including long-term historical returns, inflation assumptions, targeted allocation of plan assets and expectations regarding future market returns for both equity and debt securities.  The key assumptions used in the calculation of the benefit obligations above for years ended December 31 are as follows:  Measurement Date
        
        2006
        
        2005
        
        2004Weighted-average assumptions:Discount rate
        
        6.00
        %
        6.00
        %
        6.25
        %Rate of compensation increase
        
        3.75
        %
        3.75
        %
        4.00
        %
  The key assumptions used to determine Net Periodic Benefit Cost for years ended December 31:
  2006
        
        2005
        
        2004Discount rate
        
        6.00
        %
        6.25
        %
        6.75
        %Expected return on plan assets
        
        8.50
        %
        8.50
        %
        8.50
        %Rate of compensation increase
        
        3.75
        %
        4.00
        %
        4.50
        %
  The actuarial present value of accumulated plan benefits does not reflect the actual benefits that will be paid on retirement, but rather the liability that would exist if the Plan were terminated as of the valuation date.  The pension plan asset allocation at December 31, 2006, and 2005 by asset category is as follows:  Percent of Plan AssetsDecember312006
        
        2005Equity securities
        
        77
        %
        0
        %Debt securities
        
        19
        %
        Cash and equivalents
        
        4
        %
        100
        %Total
        
        100
        %
        100
        %
  The Companys investment strategy for pension plan assets is for approximately one-half of the equity investments to be invested in a large capitalization diversified equity portfolio. During the fourth quarter of 2005, the Company terminated Morgan Stanley as investment manager of the equity portfolio and redeemed the portfolios investment in an absolute return hedge fund, the Mangan & McColl Offshore Arbitrage Fund.  Defined Contribution Plan   102  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  The Company offers a 401(k) qualified savings plan for which substantially all employees and agents are eligible.  Plan participants may contribute up to 15% of pretax annual compensation, which includes overtime, bonuses and commissions. Participants may also contribute amounts representing distributions from other qualified defined benefit or defined contribution plans.  Until October 1, 2006, the Company contributed 25% of the first 6% of base compensation that a participant contributed to the Plan. The Company also could make an additional contribution up to 25% at its discretion.  Effective as of October 1, 2006, the Company matches 100% of the first 3% of salary deferral contributions that a participant contributes to the plan and 50% of the next 2% of salary deferral contributions a participant contributes to the plan. Effective January 1, 2007, participants will be 100% vested in all matching contributions made by the Company to the plan on and after that date.  Deferred Compensation Plan  The Company has a non-qualified deferred compensation plan for senior management that allows the deferment of a portion of their compensation until their services with the Company have terminated. The plan includes deferred contributions, which were not elected by employees to be transferred to the 401(k) plan upon adoption of the 401(k) plan. The plans investments include mutual funds and are recorded in investments as held for trading. The corresponding deferred obligations to participants are recorded in other liabilities.  The Predecessors Stock Option Plan  The Predecessor followed Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25) and related interpretations in accounting for its stock options issued to senior management. Under APB 25, for options issued where the exercise price of the issuers stock option equals the market value of the underlying stock on the date of grant, no compensation expense is recognized. Conversely, for options issued where the exercise price of the option is less than the market value on the date of grant, the difference between the exercise price and the market value on the date of the grant is recognized as unearned compensation, included as a component of shareholders equity and amortized over the vesting period.  The Predecessor granted options for a total of 371.8 shares of the Predecessors common stock. Stock options for 191 shares were granted in 1985 and the exercise price was 100% of the estimated fair market value of the common stock on the date of the grant, $16,534 per share. These options were fully vested at the closing of the Companys acquisition of the Predecessor. In 1998, options for the remaining 180.8 shares were granted with an exercise price of $16,536 per share, and an estimated fair market value at the grant date of $45,688 per share. Approximately $5.3 million of compensation expense was recorded as unearned upon the issuance of these options. These options generally vested 30% in 1998 and 10% annually thereafter. Amortization of deferred stock option compensation expense of approximately $0.2 million was recognized in 2004.  Pro forma information regarding net income and net income per share is required by SFAS 123, as amended by SFAS 148, and has been determined as if the Predecessor had accounted for its employee stock options under the fair value method of SFAS 123 as of its effective date. The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:  Riskfree Interest Rate
        
        5.71
        %Expected Dividend Yield
        
        Expected Volatility
        
        35.00
        %Expected life (years)
        
        5
  In connection with the closing of the acquisition of the Predecessor, on December 21, 2004, all 371.8 options became 100% vested and were exercised and the Predecessor stock option plan was terminated. No additional stock options can be granted under the Predecessors plan.  KMG America 2004 Equity Incentive Plan   103  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  SFAS 123 required the presentation of pro forma information as if the Company had accounted for its employee and director stock options granted after December 31, 1994, under the fair value method of that Statement.  The following is a reconciliation of reported net income and pro forma information as if the Company and the Predecessor had adopted SFAS 123 for its employee and director stock option awards:  KMG America Corporation
        
        PredecessorDecember 31,
        
        December 31,2005
        
        2004
        
        2004Net income (loss) as reported
        
        $
        4,659,532
        
        $
        (175,553
        )
        $
        6,190,499Add: Stock-based employee compensation expense included in reported net income, net of related tax effects
        
        
        
        
        
        
        
        
        134,594Deduct: Total stock-based employee compensation determined under fair value based method for all awards, net of related tax effects
        
        
        (687,962
        )
        
        (30,974
        )
        
        (164,071
        )Pro forma net income (loss) available to common stockholders
        
        $
        3,971,570
        
        $
        (206,527
        )
        $
        6,161,022Net income (loss) per share-basic:As reported
        
        $
        .21
        
        $
        (0.01
        )
        $
        2,369.27Pro forma
        
        $
        .18
        
        $
        (0.01
        )
        $
        2,357.99Net income (loss) per share-diluted:As reported
        
        $
        .21
        
        $
        (0.01
        )
        $
        2,132.71Pro forma
        
        $
        .18
        
        $
        (0.01
        )
        $
        2,122.56
  The Company also followed APB 25 for 2005 and 2004 and related interpretations in accounting for its stock options issued to senior management.  During 2005, the Company issued options to purchase a total 229,250 shares of Company common stock, at a weighted average exercise price of $9.35 per share, which is equal to 100% of the estimated fair market value of the common stock on the date of the grant. These options generally vest with respect to one fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant. During 2005, 61,500 shares were forfeited.  During 2005, the Company also issued 54,357 shares of restricted common stock at a weighted average of $8.86, which is equal to 100% of the estimated fair market value of the common stock on the date of grant. These shares of restricted stock generally vest with respect to one fourth of the shares granted on each of the first, second, third and fourth anniversaries of grant.  On December 15, 2004, the Company issued
options to purchase a total of 1,246,000 shares of Company common stock at an exercise price of $9.50 per share, which is equal to 100% of the estimated fair market value of the common stock on the date of grant. These options generally vest with respect to one fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant. Options to purchase 310,000 shares, however, generally vest one third on each of the first, second and third anniversaries of the date of grant.  Pro forma information regarding net income and net income per share is required by SFAS 123, as amended by SFAS 148, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS 123 as of its effective date. The fair value for these options was estimated at the date of grant using a Black-Scholes option-pricing model with the following weighted-average assumptions:  Riskfree Interest Rate
        
        4.35
        %Expected Dividend Yield
        
        Expected Volatility
        
        20.00
        %Expected life (years)
        
        5
  As of December 31, 2005, 321,458 options to purchase shares of the Companys common stock were exercisable. All options granted under the Plan are exercisable for ten years from the date of grant, subject to earlier termination of the optionholders rights to exercise such options under the terms of the plan and the option agreements relating to such options.   104  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  The Company adopted SFAS 123(R) as of January 1, 2006. Below is the presentation of the Companys employee and director stock options and common stock grants under the fair value method.  Common Stock Grants  The activity related to the common stock grants is set forth below:
  Common Stock Grants Outstanding
        
        Weighted Average Grant Date Fair Value Per Share of Common Stock Grants OutstandingNonvested
        
        Vested
        
        Nonvested
        
        VestedOutstanding as of December 31, 2005
        
        54,357
        
        0
        
        $
        8.86
        
        $
        0Granted
        
        76,750
        
        13,199
        
        
        8.03
        
        
        8.07Vested
        
        (12,707
        )
        12,707
        
        
        8.84
        
        
        8.84Forfeited
        
        (4,358
        )
        0
        
        
        9.03
        
        
        0Outstanding as of December 31, 2006
        
        114,042
        
        25,906
        
        $
        8.29
        
        $
        8.45
  Stock Options  Black-Scholes option-pricing model assumptions used:
  Average Risk-free Interest Rate
        
        4.96
        %Expected Dividend Yield
        
        Expected Volatility
        
        20.0
        %Expected Life (years)
        
        5
  The activity related to the stock options is set forth below:  Options Outstanding
        
        Weighted Average Exercise Price
        
        Aggregate Intrinsic Value
        
        Weighted Average Remaining Life (in years)Outstanding as of December 31, 2005
        
        1,413,750
        
        $
        9.47Granted
        
        518,175
        
        
        8.30Exercised
        
        0
        
        
        0Forfeited
        
        (18,500
        )
        
        8.77Outstanding as of December 31, 2006
        
        1,913,425
        
        
        9.16
        
        $
        4,683,636
        
        8.49Exercisable as of December 31, 2006
        
        699,479
        
        $
        9.49
        
        $
        1,718,884
        
        8.04
  The following table sets forth share-based compensation and the related tax benefit:  Year Ended
December 31, 2006Total Share-Based CompensationIncluded in income before income taxes
        $
        1,378,882Included in net income, net of tax effects
        $
        896,273Excess tax benefits related to options exercised
        $
        0Excess tax benefits related to share-based compensation (1)
        $
        0
  (1) Represents the tax benefit, recognized in additional paid-in-capital for stock options exercised.  As of December 31, 2006, there was $3,474,667 of total unrecognized compensation cost related to nonvested share-based compensation arrangements.  Performance Share Plan   105  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  On January 1, 2000, the Predecessor established its Performance Share Plan and authorized the issuance of up to 80,000 stock units to attract and retain quality employees and to allow such employees to participate in the growth of the Predecessor. Awards could be made to participants in the form of stock units. The Performance Share Plan provided for vesting over the 10 years subsequent to date of grant (10% per year). Compensation expense was recorded based on the vesting and the change in the book value of the Predecessors common stock from the date of grant to the date of exercise, adjusted for dividends, stock redemption proceeds and capital contributions subsequent to the date of grant. Eligible participants under the Performance Share Plan included executives or key employees of the Predecessor.  During 2004, 7,354 units were forfeited or redeemed resulting in 65,864 outstanding
units at December 20, 2004. The plan continued in effect through the closing of the Companys acquisition of the Predecessor on December 21, 2004, when it terminated and all outstanding stock units were redeemed. No additional stock units may be awarded under the plan. The Company does not intend to implement a stand-alone successor performance share plan, but the Companys 2004 Equity Incentive Plan permits the Company to award performance shares.  13.
        Commitments and Contingencies
  On December 21, 2004, the Company entered into a $15.0 million five-year subordinated promissory note to fund a portion of the purchase price for the Kanawha acquisition.  Interest on the promissory note accrued at 5% per annum and was added to the principal balance on December 31 of each year.  On December 21, 2006, the Company entered into a credit agreement with Wachovia, which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the five-year subordinated promissory note we issued to fund a portion of the purchase price for the Kanawha acquisition.  The remaining $1.0 million available under the credit facility may be used to finance the Companys working capital, liquidity needs and general working requirements and those of its subsidiaries.  Amounts outstanding under the credit agreement will bear interest at a rate calculated according to, at the Companys option, a base rate or the LIBOR rate plus an applicable percentage.  The applicable percentage is based on the A.M. Best financial strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans and from 1.25% to 1.35% for LIBOR rate loans. In
the case of LIBOR rate loans, interest on amounts outstanding is payable at the end of the interest period, which can be one, two, three or six months, as selected by the Company in its notice of borrowing.  Wachovias obligation to fund the credit agreement terminates, and all principal outstanding under the credit agreement is due and payable, no later than December 31, 2007.  As of December 31, 2006, the $14.0 million outstanding under the credit agreement was a LIBOR rate plus applicable percentage loan with an initial interest rate of 6.60%.  The credit agreement requires the Company to comply with certain covenants, including, among others, maintaining a maximum ratio of consolidated indebtedness to total capitalization, a minimum available dividend amount for Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha.  The Company must also comply with limitations on certain payments, additional debt obligations, dispositions of assets and its lines of business.  The credit agreement also restricts the Company from creating or allowing certain liens on its assets and from making certain investments.  Fourth quarter 2006 expenses include a pretax benefit of $1.0 million related to the discount associated with retiring and replacing the Company's $15 million subordinated note with bank debt.  The Company is occasionally named as a defendant in various legal actions arising principally from claims made under insurance policies and contracts. Those actions are considered by the Company in estimating the policy and contract liabilities and management believes adequate reserves have been established for such cases. Management believes that the resolution of those actions will not have a material effect on the Companys financial position or results of operations.  On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York (ReliaStar), both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore and Gibb are officers of KMG America and former employees of the plaintiffs.  The complaint alleges misappropriation of trade secrets, conversion, tortious interference contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive relief and unspecified monetary damages. On August 24, 2005, the plaintiffs amended their complaint to add Scott H. DeLong III and Thomas D. Sass as defendants. Messrs. DeLong and Sass are officers of KMG America and former
 employees of the plaintiffs. The plaintiffs amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentations and civil theft. On August 9, 2005, a hearing was held before the court to consider plaintiffs motion for a temporary injunction and on August 26, 2005, the court issued a ruling denying plaintiffs motion. The plaintiffs filed a notice of appeal of the courts ruling with the Minnesota Court of Appeals.   On September 5, 2006, the Minnesota Court of Appeals issued a ruling affirming the district courts denial of plaintiffs' motion for a temporary injunction. On December 21, 2006, the defendants filed a motion for summary judgment with the district court and a hearing on the motion was held on January 19, 2007.  We expect a ruling from the Court in the second quarter of 2007. The Company believes plaintiffs allegations are without merit and intends to defend the action vigorously.
 While the outcome of legal actions cannot be predicted with certainty, management believes the outcome of this matter will not have a material adverse effect on the Companys consolidated financial position or results of operations.  The Company has been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will, subject to the terms, conditions and limitations of the insurance policy, reimburse the Company for a significant portion of future defense costs and potential damages, losses and liabilities resulting from this litigation.  The Company also has received partial reimbursement under the insurance policy for defense costs incurred to date.  As a result, the Company expects that the ongoing defense cost reimbursements and reimbursements of any damages, losses or liabilities under the directors and officers insurance policy should reduce the risk that future defense costs and any damages, losses or liabilities may have a
material adverse effect on the Companys future consolidated financial position or results of operations.  The Company had no commitments to fund mortgage loans at December 31, 2006.  The Company is assessed amounts by state guaranty funds to cover losses to policyholders of insolvent or rehabilitated insurance companies. Those mandatory assessments may be partially recovered through a reduction in future premium taxes in certain states. The Company recognizes its obligation for guaranty fund assessments and records an estimated accrual for any potential assessment. There were no such accruals as of December 31, 2005, and 2006.  The Company leases office equipment under noncancellable leases. Total rental expense amounted to $0.1 million in 2004 and $0.2 million in 2005 and $0.2 million in 2006. As of December 31, 2006, future minimum lease payments under noncancellable operating leases with initial or remaining terms in excess of one year are as follows:  2007
        $
        188,0002008
        
        180,0002009
        
        176,000$
        544,000
  During February 2005, the Company entered into a lease agreement, pursuant to which it has agreed to pay an aggregate of $551,250 to lease its principal executive offices located in Minnetonka, Minnesota for the period from April 1, 2005, through June 30, 2010. This lease is not cancelable by the Company except in connection with specified events that are generally beyond the Companys control.  During November 2003, the Predecessor entered into a contract for IT and document management. Expenses incurred during 2004, 2005, and 2006 were $5.0 million, $6.8 million, and $7.5 million respectively. This ten-year contract is subject to cancellation by the Company at any time after 42 months, with the payment of a termination penalty that is subject to the number of months remaining in the contract. The document management portion of the agreement is variable by transaction volume. Future payments under this contract are as follows:  107  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS   2007
        $
        7,689,0002008
        
        8,121,0002009
        
        8,534,0002010
        
        8,829,0002011
        
        9,137,000Thereafter
        
        19,244,000Total 2006 through 2013
        $
        61,554,000
  14.
        Concentrations of Credit Risk
  At December 31, 2006 and 2005, the Company had no significant exposure to unrated or less-than-investment grade bonds.  The Companys investment in mortgage loans principally involves residential and commercial real estate primarily in South Carolina and North Carolina. Such investments consist primarily of first mortgage liens on single-family residences; the mortgage outstanding on any individual property does not exceed $1.1 million.  15.
        Fair Values of Financial Instruments
  The following methods and assumptions were used by the Company in estimating the fair value disclosures for financial instruments in the accompanying financial statements and notes thereto:  Cash and Cash Equivalents:  The carrying amounts reported in the accompanying balance sheets for these financial instruments approximate their fair values.  Investment Securities:  The carrying amount for fixed maturity and equity securities classified as available-for-sale is fair value, which is based on quoted market prices, where available. For fixed maturity and equity securities that are not actively traded, fair values are estimated using values obtained from independent pricing services.  Mortgage Loans:  The fair values for mortgage loans are estimated using discounted cash flow analyses based on interest rates currently being offered for similar loans to borrowers with similar credit ratings. Loans with similar characteristics are aggregated for purposes of the calculations.  Policy Loans:  The carrying amounts reported in the accompanying balance sheets for these financial instruments approximate their fair values.  Investment Contracts:  The fair values of the Companys liabilities under investment-type insurance contracts are estimated using discounted cash flow calculations, based on interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued.  The fair values of the Companys insurance contracts other than investment contracts are not required to be disclosed. However, the fair values of liabilities under all insurance contracts are taken into consideration in the Companys overall management of interest rate risk, such that the Companys exposure to changing interest rates is minimized through the matching of investment maturities with amounts due under insurance contracts.  Additional data with respect to fair values of the Companys investments is disclosed in Note 3.   KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  108  The carrying amounts and fair values of the Companys cash and investments at December 31 are summarized in the following table.  KMG America2006
        
        2005CarryingAmount
        
        FairValue
        
        CarryingAmount
        
        FairValueCash and cash equivalents
        
        $
        21,744,137
        
        $
        21,744,137
        
        $
        32,582,964
        
        $
        32,582,964Equity securities
        
        
        103,545
        
        
        103,545
        
        
        286,809
        
        
        286,809Fixed maturity securities
        
        
        520,624,942
        
        
        520,624,942
        
        
        498,157,355
        
        
        498,157,355Mortgage loans
        
        
        13,921,019
        
        
        13,051,275
        
        
        17,606,746
        
        
        16,787,742Policy loans
        
        
        18,163,223
        
        
        18,163,223
        
        
        21,803,430
        
        
        21,803,430
  The carrying amounts and fair values of the Companys liabilities for investment-type insurance contracts at December 31 are summarized in the following table.  KMG America2006
        
        2005CarryingAmount
        
        FairValue
        
        CarryingAmount
        
        FairValueIndividual and group annuities
        
        $
        6,430,586
        
        $
        6,446,389
        
        $
        6,633,215
        
        $
        6,633,215Other policyholder funds left on deposit
        
        
        7,138,535
        
        
        7,138,535
        
        
        7,226,213
        
        
        7,226,213Total
        
        $
        13,569,121
        
        $
        13,584,924
        
        $
        13,859,428
        
        $
        13,859,428
  16.
        Business Segments
  The Company has five reportable segments that are differentiated by their respective methods of distribution and the nature of the related products: worksite insurance business, senior market insurance business, third party administration business, acquired business and corporate and other. Management makes decisions regarding the Companys business based on these segment classifications. The worksite insurance business provides life and health insurance products to employers and employees. The primary insurance products that the Company underwrites include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. This segment also includes business sold through the career agency distribution channel, which is a group of agents and managers that are employees of the Company or its subsidiaries.  The senior market insurance business consists primarily of the Companys in-force block of long-term care insurance policies that the Company actively manages, including the right to receive renewal premiums and liability for future claims. The Company ceased actively underwriting long-term care insurance policies after December 31, 2005. The third party administration business provides fee-based administrative and managed care services to employers with self funded health care plans, insurance carriers, reinsurance companies and others. The acquired business represents closed blocks of life and health insurance business that have been acquired through reinsurance transactions over a period of years. The corporate and other segment includes investment income earned on the investment portfolio allocated to capital and surplus, as well as all realized capital gains and losses, which are not allocated by line of business.  109  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  This segment also includes marketing allowances, commissions and related expenses pertaining to product sales for other insurance carriers, which are currently not material. In addition, this segment includes certain unallocated expenses, primarily costs associated with being a public company, deferred compensation, incentive compensation and stock based compensation, and other non-allocated items such as the costs associated with the litigation with ReliaStar.  During the quarter ended June 30, 2006, the Company implemented the use of seriatim PGAAP reserve factors.  While the implementation of seriatim PGAAP factors did not change total reserves of the Company, it did result in a reallocation of reserves among the worksite insurance, senior market insurance and acquired business segments.  This reallocation has been reflected in the current results of the affected segments.  The result of the reallocation of reserves between business segments was to strengthen reserves by $37.5 million in the senior market insurance business segment. This was offset by a reduction in reserves of $31.2 million in the acquired business segment and $6.3 million in the worksite segment. No material effect to overall policy reserves or to earnings resulted from the reallocation. Subsequent reserve adequacy testing of policy reserves by segment indicates that the resulting alignment of reserves is sufficient in each segment.  This reallocation of reserves between the business segments does impact the comparability of the current reported policyholder benefits and the resulting reported benefit ratios by segment.  The following represents a summary of the Companys and Predecessors statement of operations and asset composition by reportable segment. Except as noted, the financial statement information of the Predecessor set forth below is reported on a historical basis without GAAP purchase accounting adjustments reflecting the Companys acquisition of the Predecessor.  110  KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS   KMG America
        
        
        PredecessorFor the Year Ended December 31,
        
        
        For the Period from January 21 through December 31,
        
        
        For the Year EndedDecember 31,2006
        
        
        2005
        
        
        2004
        
        
        2004Worksite Insurance BusinessInsurance premiums
        
        $
        83,795,394
        
        $
        60,528,639
        
        $
        
        
        $
        56,308,493Net investment income
        
        
        7,180,951
        
        
        6,524,218
        
        
        
        
        
        5,028,355Commission and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        395,735
        
        
        172,142
        
        
        
        
        
        263,734Total revenues
        
        
        91,372,080
        
        
        67,224,999
        
        
        
        
        
        61,600,582Policyholder benefits
        
        
        55,650,934
        
        
        43,556,110
        
        
        
        
        
        44,292,442Commissions
        
        
        7,203,019
        
        
        3,741,433
        
        
        
        
        
        3,779,844Expenses, taxes, fees and depreciation
        
        
        17,633,880
        
        
        16,327,059
        
        
        
        
        
        9,966,881Amortization of DAC and VOBA
        
        
        2,712,883
        
        
        3,657,962
        
        
        
        
        
        6,208,791Total benefits and expenses
        
        
        83,200,716
        
        
        67,282,564
        
        
        
        
        
        64,247,958Income (loss) before Federal income tax
        
        $
        8,171,364
        
        $
        (57,565
        )
        $
        
        
        $
        (2,647,376
        )Total assets
        
        $
        170,761,006
        
        $
        166,401,638
        
        $
        
        
        $
        169,760,986
        (1)Senior Market Insurance BusinessInsurance premiums
        
        $
        41,486,187
        
        $
        42,239,844
        
        $
        
        
        $
        42,060,326Net investment income
        
        
        7,868,932
        
        
        4,641,343
        
        
        
        
        
        3,878,429Commission and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        3,180,609
        
        
        2,935,257
        
        
        
        
        
        2,346,577Total revenues
        
        
        52,535,728
        
        
        49,816,444
        
        
        
        
        
        48,285,332Policyholder benefits
        
        
        68,737,309
        
        
        35,355,291
        
        
        
        
        
        35,829,058Commissions
        
        
        5,155,456
        
        
        5,494,810
        
        
        
        
        
        5,481,986Expenses, taxes, fees and depreciation
        
        
        2,957,915
        
        
        3,995,699
        
        
        
        
        
        3,695,003Amortization of DAC and VOBA
        
        
        1,586,879
        
        
        553,539
        
        
        
        
        
        641,079Total benefits and expenses
        
        
        78,437,559
        
        
        45,399,339
        
        
        
        
        
        45,647,126Income (loss) before Federal income tax
        
        $
        (25,901,831
        )
        $
        4,417,105
        
        $
        
        
        $
        2,638,206Total assets
        
        $
        259,132,462
        
        $
        193,889,081
        
        $
        
        
        $
        160,381,684
        (1)Third-Party Administration BusinessInsurance premiums
        
        $
        
        
        $
        
        
        $
        
        
        $
        Net investment income
        
        
        
        
        
        
        
        
        
        
        
        Commission and fees
        
        
        16,126,591
        
        
        14,263,603
        
        
        
        
        
        13,295,120Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        504
        
        
        3,052
        
        
        
        
        
        798Total revenues
        
        
        16,127,095
        
        
        14,266,655
        
        
        
        
        
        13,295,918Policyholder benefits
        
        
        
        
        
        
        
        
        
        
        
        Commissions
        
        
        
        
        
        
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        14,049,613
        
        
        12,838,087
        
        
        
        
        
        12,200,228Amortization of DAC and VOBA
        
        
        
        
        
        
        
        
        
        
        
        Total benefits and expenses
        
        
        14,049,613
        
        
        12,838,087
        
        
        
        
        
        12,200,228Income (loss) before Federal income tax
        
        $
        2,077,482
        
        $
        1,428,568
        
        $
        
        
        $
        1,095,690Total assets
        
        $
        9,755,772
        
        $
        11,102,572
        
        $
        
        
        $
        8,186,306
        (1)
   111   KMG America
        
        
        PredecessorFor the Year Ended December 31,
        
        
        For the Period from January 21 through December 31,
        
        
        For the Year Ended December 31,2006
        
        
        2005
        
        
        2004
        
        
        2004Acquired BusinessInsurance premiums
        
        $
        2,687,116
        
        $
        4,119,035
        
        $
        
        
        $
        4,466,726Net investment income
        
        
        8,056,398
        
        
        7,807,899
        
        
        
        
        
        8,507,129Commissions and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        70,945
        
        
        69,072
        
        
        
        
        
        115,613Total revenues
        
        
        10,814,459
        
        
        11,996,006
        
        
        
        
        
        13,089,468Policyholder benefits
        
        
        (24,545,954
        )
        
        5,376,325
        
        
        
        
        
        10,053,493Commissions
        
        
        366,172
        
        
        398,989
        
        
        
        
        
        428,247Expenses, taxes, fees and depreciation
        
        
        2,519,477
        
        
        2,740,522
        
        
        
        
        
        2,829,686Amortization of DAC and VOBA
        
        
        (194,140
        )
        
        (744,002
        )
        
        
        
        
        2,618,432Total benefits and expenses
        
        
        (21,854,445
        )
        
        7,771,834
        
        
        
        
        
        15,929,858Income (loss) before Federal income tax
        
        $
        32,668,904
        
        $
        4,224,172
        
        $
        
        
        $
        (2,840,390
        )Total assets
        
        $
        161,089,271
        
        $
        204,288,455
        
        $
        
        
        $
        215,850,711
        (1)Corporate and OtherInsurance premiums
        
        $
        
        
        $
        
        
        $
        
        
        $
        Net investment income
        
        
        6,839,525
        
        
        8,771,411
        
        
        18,408
        
        
        7,788,499Commissions and fees
        
        
        378,073
        
        
        301,024
        
        
        
        
        
        180,402Net realized gains
        
        
        1,218,465
        
        
        358,318
        
        
        
        
        
        9,432,585Gain on extinguishment of debt
        
        
        1,020,839
        
        
        
        
        
        
        
        
        Other income
        
        
        803,849
        
        
        688,349
        
        
        
        
        
        381,505Total revenues
        
        
        10,260,751
        
        
        10,119,102
        
        
        18,408
        
        
        17,782,991Policyholder benefits
        
        
        
        
        
        
        
        
        
        
        
        Commissions
        
        
        
        
        
        
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        16,209,552
        
        
        13,519,416
        
        
        288,489
        
        
        6,272,750Amortization of DAC and VOBA
        
        
        
        
        
        
        
        
        
        
        
        Total benefits and expenses
        
        
        16,209,552
        
        
        13,519,416
        
        
        288,489
        
        
        6,272,750Income (loss) before Federal income tax
        
        $
        (5,948,801
        )
        $
        (3,400,314
        )
        $
        (270,081
        )
        $
        11,510,241Total assets
        
        $
        230,975,335
        
        $
        221,683,323
        
        $
        770,051,331
        
        $
        157,714,248
        (1)Total Company:Insurance premiums
        
        $
        127,968,697
        
        $
        106,887,518
        
        $
        
        
        $
        102,835,545Net investment income
        
        
        29,945,806
        
        
        27,744,871
        
        
        18,408
        
        
        25,202,412Commissions and fees
        
        
        16,504,664
        
        
        14,564,627
        
        
        
        
        
        13,475,522Net realized gains
        
        
        1,218,465
        
        
        358,318
        
        
        
        
        
        9,432,585Gain on extinguishment of debt
        
        
        1,020,839
        
        
        
        
        
        
        
        
        Other income
        
        
        4,451,642
        
        
        3,867,872
        
        
        
        
        
        3,108,227Total revenues
        
        
        181,110,113
        
        
        153,423,206
        
        
        18,408
        
        
        154,054,291Policyholder benefits
        
        
        99,842,289
        
        
        84,287,726
        
        
        
        
        
        90,174,993Commissions
        
        
        12,724,647
        
        
        9,635,232
        
        
        
        
        
        9,690,077Expenses, taxes, fees and depreciation
        
        
        53,370,437
        
        
        49,420,783
        
        
        288,489
        
        
        34,964,548Amortization of DAC and VOBA
        
        
        4,105,622
        
        
        3,467,499
        
        
        
        
        
        9,468,302Total benefits and expenses
        
        
        170,042,995
        
        
        146,811,240
        
        
        288,489
        
        
        144,297,920Income (loss) before Federal income tax
        
        $
        11,067,118
        
        $
        6,611,966
        
        $
        (270,081
        )
        $
        9,756,371Total assets
        
        $
        831,713,846
        
        $
        797,365,069
        
        $
        770,051,331
        
        $
        N/A(2)
  (1)KMG America at December 31, 2004, adjusted for purchase accounting adjustments to reflect the Kanawha acquisition. (2)Aggregate total assets for the Predecessor as of December 31, 2004 is not reported because the Predecessor had been acquired by KMG America at that date and the Predecessors assets had been consolidated into the KMG America balance sheet at that date.  112


KMG AMERICA CORPORATION AND PREDECESSOR NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  17.
        Selected Quarterly Financial Data (Unaudited)
  The following is a summary of the unaudited quarterly results of operations for the years ended December 31, 2006 and 2005:  2006Quarter EndedMarch 31
        
        June 30
        
        September 30
        
        December 31Premiums, fees and other income
        
        $
        35,016,274
        
        $
        35,701,899
        
        $
        39,527,381
        
        $
        38,679,449Net investment income, realized gains and brokerage income, and gain on extinguishment of debt
        
        
        7,417,175
        
        
        7,504,069
        
        
        7,459,133
        
        
        9,804,733Total revenue
        
        
        42,433,449
        
        
        43,205,968
        
        
        46,986,514
        
        
        48,484,182Benefits, expenses, and federal income taxes
        
        
        41,197,252
        
        
        42,188,934
        
        
        44,960,834
        
        
        45,544,143Net income excluding cumulative effect adjustments
        
        $
        1,236,197
        
        $
        1,017,034
        
        $
        2,025,680
        
        $
        2,940,039Basic income per share of common stock
        
        $
        .06
        
        $
        .05
        
        $
        .09
        
        $
        .13Diluted income per share of common stock
        
        $
        .06
        
        $
        .05
        
        $
        .09
        
        $
        .13
  2005Quarter EndedMarch 31
        
        June 30
        
        September 30
        
        December 31Premiums, fees and other income
        
        $
        30,557,255
        
        $
        31,465,810
        
        $
        31,395,792
        
        $
        31,901,160Net investment income, realized gains and brokerage income
        
        
        6,680,365
        
        
        6,819,149
        
        
        7,367,149
        
        
        7,236,526Total revenue
        
        
        37,237,620
        
        
        38,284,959
        
        
        38,762,941
        
        
        39,137,686Benefits, expenses, and federal income taxes
        
        
        36,217,622
        
        
        37,571,748
        
        
        37,424,495
        
        
        37,725,584Net income excluding cumulative effect adjustments
        
        $
        1,019,998
        
        $
        713,211
        
        $
        1,338,446
        
        $
        1,412,102Basic income per share of common stock
        
        $
        .05
        
        $
        .03
        
        $
        .06
        
        $
        .06Diluted income per share of common stock
        
        $
        .05
        
        $
        .03
        
        $
        .06
        
        $
        .06
    113  KMG AMERICA CORPORATION AND PREDECESSOR AND SUBSIDIARY SCHEDULE IIISUPPLEMENTAL INSURANCE INFORMATION  Segment
        DAC andVOBAAsset
        PolicyReservesLiability
        UnearnedPremiumsLiability
        ContractClaimsand OtherPolicyLiabilities
        InsurancePremiums
        NetInvestmentIncome
        PolicyholderBenefits
        AmortizationofDAC andVOBA
        OtherExpensesYear Ended December31, 2006Worksite insurance
        $38,094,067
        $151,811,850
        $781,654
        $18,170,549
        $83,795,394
        $7,180,951
        $55,650,934
        $2,712,883
        $24,836,899Senior market insurance
        40,256,998
        247,085,789
        7,692,034
        4,354,639
        41,486,187
        7,868,932
        68,737,309
        1,586,879
        8,113,371Third party administration
        
        
        
        
        
        
        
        
        14,049,613Acquired  business
        20,869,075
        139,400,374
        467,491
        2,599,819
        2,687,116
        8,056,398
        (24,545,954)
        (194,140)
        2,885,649Corporate and other
        
        
        
        
        
        6,839,525
        
        
        15,188,713Total
        $99,220,140
        $538,298,013
        $8,941,179
        $25,125,007
        $127,968,697
        $29,945,806
        $99,842,289
        $4,105,622
        $65,074,245Year Ended December31, 2005Worksite insurance
        $24,415,261
        $151,625,690
        $916,931
        $13,859,018
        $60,528,639
        $6,524,218
        $43,556,110
        $3,657,962
        $20,068,492Senior market insurance
        41,580,646
        181,949,150
        7,748,415
        4,191,516
        42,239,844
        4,641,343
        35,355,291
        553,539
        9,490,509Third party administration
        
        
        
        
        
        
        
        
        12,838,087Acquired  business
        20,674,935
        184,050,462
        869,143
        2,684,006
        4,119,035
        7,807,899
        5,376,325
        (744,002)
        3,139,511Corporate and other
        
        
        
        
        
        8,771,411
        
        
        13,519,416Total
        $86,670,842
        $517,625,302
        $9,534,489
        $20,734,540
        $106,887,518
        $27,744,871
        $84,287,726
        $3,467,499
        $59,056,015Year-ended December 31, 2004*Worksite insurance
        $  14,134,393
        $156,098,046
        $        964,052
        $  12,698,888
        $  56,308,493
        $5,028,355
        $  44,292,442
        $  6,208,791
        $  13,746,725Senior market insurance
        40,586,764
        148,442,031
        7,750,320
        4,189,333
        42,060,326
        3,878,429
        35,829,058
        641,079
        9,176,989Third party administration
        
        
        
        
        
        
        
        
        12,200,228Acquired business
        19,760,138
        196,461,950
        1,025,732
        3,285,085
        4,466,726
        8,507,129
        10,053,493
        2,618,432
        3,257,933Corporate and other
        
        
        
        
        
        7,788,499
        
        
        6,272,750Total
        $ 74,481,295
        $501,002,027
        $    9,740,104
        $  20,173,306
        $  102,835,545
        $25,202,412
        $  90,174,993
        $  9,468,302
        $  44,654,625
  *Balance sheet amounts at December 31, 2004 are those of KMG America. Statement of operations for the year ended December 31, 2004 are those of the Predecessor.
  ITEM 9.
        CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES.
 None.  ITEM 9A.
        CONTROLS AND PROCEDURES.
  Conclusion Regarding the Effectiveness of Disclosure Controls and Procedures  We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decision regarding required disclosure.  An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of December 31, 2006. Based upon that evaluation, our
management, including our Chief Executive Officer and our Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of December 31, 2006. There was no change in our internal control over financial reporting during the fourth quarter of 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.    114  Managements Report on Internal Control over Financial Reporting  See Managements Report on Internal Control over Financial Reporting in Item 8, which is incorporated herein by reference.  ITEM 9B.
        OTHER INFORMATION.
  Not applicable.
  PART III  ITEM 10.
        DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE.
  The information presented under the captions Information Concerning Nominees, Directors Continuing in Office, Section 16(a) Beneficial Ownership Reporting Compliance and Executive Officers of our definitive Proxy Statement for our Annual Meeting of Shareholders to be held May 3, 2007 (the 2007 Proxy Statement) and the information presented under the caption Availability of Reports, Certain Committee Charters and Other Information of Item 1. Business of this report is incorporated herein by reference.  Because our common stock is listed on the NYSE, our Chief Executive Officer is required to make an annual certification to the NYSE stating that he is not aware of any violation by us of the corporate governance listing standards of the NYSE. Our Chief Executive Officer made his annual certification to that effect for 2006 on July 18, 2006. In addition, we have filed, as an exhibit to this Annual Report on Form 10-K, the certification of our principal executive officer and principal financial officer required under Section 302 of the Sarbanes Oxley Act of 2002 to be filed with the Securities and Exchange Commission regarding the quality of our public disclosure.  We have a separately designated standing Audit Committee established in accordance with Section 3(a)58(A) of the Securities Exchange Act of 1934.  Information regarding the members of the Audit Committee and the Audit Committee financial expert is reported under the captions Corporate Governance and Committees of the Board of our 2007 Proxy Statement, and is incorporated herein by reference.  ITEM 11.
        EXECUTIVE COMPENSATION.
  The information presented under the captions Director Compensation for 2006, Executive Compensation and Compensation Committee Interlocks and Insider Participation and Compensation Committee Report of our 2007 Proxy Statement is incorporated herein by reference.  ITEM 12.
        SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
  The information presented under the caption Security Ownership of Certain Beneficial Owners and Management of our 2007 Proxy Statement is incorporated herein by reference.  The information presented under the caption Market for the Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities  Common Stock Authorized for Issuance Under Our 2004 Equity Incentive Plan in Part II of this Form 10-K is incorporated herein by reference.  ITEM 13.
        CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE.
  The information presented under the captions Transactions with Related Persons and "Corporate Governance" of our 2007 Proxy Statement is incorporated herein by reference.    115  ITEM 14.
        PRINCIPAL ACCOUNTANT FEES AND SERVICES.
  The information presented under the captions Audit Committee Pre-Approval Policy and Fees of the Corporations Independent Registered Public Accounting Firm of our 2007 Proxy Statement is incorporated herein by reference.  PART IV  ITEM 15.
        EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
  (1)  The following documents are filed as part of Item 8 of this report:Report of Management on Consolidated Financial Statements and Management's Assessment of Internal Control Over Financial Reporting.Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting.Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements.Consolidated Balance Sheets for KMG America Corporation as of December 31, 2006, and 2005.Consolidated Statements of Operations for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for Kanawha Insurance Company (the Predecessor) for the year ended December 31, 2004.Consolidated Statements of Shareholders Equity for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004.Consolidated Statements of Cash Flow for KMG America Corporation for the period January 21, 2004 (inception) through December 31, 2004, and for the years ended December 31, 2005 and 2006, and for the Predecessor for the year ended December 31, 2004.Notes to Consolidated Financial Statements.(2)  The following financial statement schedules are filed as part of Item 8 of this report:Schedule III - Supplementary Insurance Information.**  All other required financial statement schedules are omitted because the information required is either not applicable or is included in the financial statements or the related notes included in this report.(3)  Exhibits.The exhibits that are required to be filed or incorporated by reference herein are listed in the Exhibit Index beginning on page 119 hereof. Exhibits 10.01  10.19 hereto constitute management contracts or compensatory plans or arrangements required to be filed as exhibits hereto.
   116  SIGNATURES  Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.  KMG AMERICA CORPORATION
(Registrant)By:
        /s/ Kenneth U. KukName: Kenneth U. Kuk
Title: Chairman, President & Chief Executive OfficerDate: March 14, 2007
   Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. Signature
        TitleBy:/s/ Kenneth U. Kuk
Kenneth U. Kuk
        Director and Chairman, President & Chief Executive Officer
(Principal Executive Officer)By:/s/ Scott H. DeLong III
Scott H. DeLong III
        Director and Senior Vice President & Chief Financial Officer
(Principal Financial Officer)By:/s/ John H. FlittieJohn H. Flittie
        DirectorBy:/s/ Stanley D. JohnsonStanley D. Johnson
        Director and Chairman & Chief Executive Officer of KanawhaBy:/s/ Robert L. LaszewskiRobert L. Laszewski
        DirectorBy:/s/ Dennis M. MathisenDennis M. Mathisen
        DirectorBy:/s/ James J. RitchieJames J. Ritchie
        DirectorBy:/s/ Glenn S. SackettGlenn S. Sackett
        Vice President & Controller(Principal Accounting Officer)
  Each of the above signatures is affixed as of March 14, 2007.  117  EXHIBIT INDEX 2.01
        Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A and KMG America Corporation (incorporated by reference from Exhibit 2.01 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).2.02
        Amendment No. 1 to Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A to the Amended and Restated Stock Purchase Agreement and KMG America Corporation (incorporated by reference from Exhibit 2.02 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).2.03
        Amendment No. 2 to Amended and Restated Stock Purchase Agreement by and among the shareholders and optionholders of Kanawha Insurance Company identified on Schedule A to the Amended and Restated Stock Purchase Agreement and KMG America Corporation (incorporated by reference from Exhibit 2.03 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).3.01
        Amended and Restated Articles of Incorporation (incorporated by reference from Exhibit 3.01 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).3.02
        Bylaws (incorporated by reference from Exhibit 3.02 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).4.01
        Form of Common Stock Share Certificate (incorporated by reference from Exhibit 4.01 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).4.02
        Form of Restricted Stock Award Agreement (incorporated by reference from Exhibit 10.04 attached to KMG America Corporations Current Report on Form 8-K filed with the Securities and Exchange Commission on August 17, 2005).4.04
        Credit Agreement between KMG America Corporation, as Borrower, and Wachovia Bank, a National Association, as Lender (incorporated by reference from Exhibit 10.01 attached to the KMG America Corporations Current Report on Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).10.01
        KMG America Corporation 2004 Equity Incentive Plan, as amended April 18, 2006 (incorporated by reference from Exhibit 10.01 attached to KMG America Corporations Current Report on Form 8-K filed with the Securities and Exchange Commission on April 21, 2006).10.02
        Form of Nonqualified Stock Option Agreement (incorporated by reference from Exhibit 10.01 from KMG America Corporations Current Report on Form 8-K filed with the Securities and Exchange Commission on April 21, 2006).10.03
        Employment Agreement between KMG America Corporation and Kenneth U. Kuk (incorporated by reference from Exhibit 10.02 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).10.04
        Amendment, dated December 21, 2004, to the Employment Agreement between KMG America Corporation and Kenneth U. Kuk dated December 21, 2004 (incorporated by reference from Exhibit 10.05 attached to KMG America Corporation's Annual Report on Form 10-K for the year ended December 31, 2005).
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10.05
        Employment Agreement between KMG America Corporation and Scott H. DeLong III (incorporated by reference from Exhibit 10.03 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).10.06
        Amendment, dated December 21, 2004, to the Employment Agreement between KMG America Corporation and Scott H. DeLong III dated December 21, 2004 (incorporated by reference from Exhibit 10.07 attached to KMG America Corporation's Annual Report on Form 10-K from the year ended December 31, 2005)..10.07
        Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Thomas D. Sass (incorporated by reference from Exhibit 10.09 attached to KMG America Corporations Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).10.08
        Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Thomas D. Sass dated December 21, 2004.10.09
        Employment Agreement, dated December 21, 2004, among KMG America Corporation, Kanawha Insurance Company and Paul F. Kraemer (incorporated by reference from Exhibit 10.06 attached to KMG America Corporations Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).10.10
        Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Paul F. Kraemer dated December 21, 2004. (incorporated by reference from Exhibit 10.07 attached to KMG America Corporations Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).10.11
        Employment Agreement, dated December 21, 2004, among KMG America Corporation, Kanawha Insurance Company and Paul P. Moore (incorporated by reference from Exhibit 10.08 attached to KMG America Corporations Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).10.12
        Amendment, dated December 21, 2004, to the Employment Agreement among KMG America Corporation, Kanawha Insurance Company and Paul P. Moore dated December 21, 2004.10.13
        KMG America Corporation Supplemental Retirement and Deferred Compensation Plan, Restated and Amended (incorporated by reference from Exhibit 10.10 attached to KMG America Corporations Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).10.14
        2007 Base Salaries and other compensation for Named Executive Officers and Directors.10.15
        Outsourcing Services Agreement, dated November 11, 2003, between CGI Information Systems & Management Consultants, Inc. and Kanawha HealthCare Solutions, Inc (incorporated by reference from Exhibit 10.07 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).10.16
        Amendment No. 1 to the Outsourcing Services Agreement, dated April 1, 2004, between CGI Information Systems & Management Consultants, Inc. and Kanawha HealthCare Solutions, Inc. (incorporated by reference from Exhibit 10.08 attached to KMG America Corporations Registration Statement on Form S-1 (Registration No. 333-117911)).
   119
   10.17
        Lease Agreement, dated February 2, 2005, between KMG America Corporation and Metropolitan Life Insurance Company in respect of KMG America Corporations principal executive offices located in Minnetonka, Minnesota (incorporated by reference from Exhibit 10.13 attached to KMG America Corporations Form 10-K filed with the Securities and Exchange Commission on March 31, 2005).10.18
        $15,000,000 Credit Agreement, dated December 21, 2006, between KMG America Corporation and Wachovia Bank, National Association (incorporated by reference from Exhibit 10.01 attached to KMG America Corporations Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).10.19
        $15,000,000 Note, dated December 21, 2006, made by KMG America Corporation payable to the order of Wachovia Bank, National Association (incorporated by reference from Exhibit 10.03 attached to KMG America Corporations Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).10.20
        Note Settlement Agreement, dated December 21, 2006, by and among KMG America Corporation, The Springs Company, Stanley D. Johnson, SDJ Partners, LP and Elliott S. Close (incorporated by reference from Exhibit 10.02 attached to KMG America Corporations Form 8-K filed with the Securities and Exchange Commission on December 27, 2006).21.01
        List of Subsidiaries of the Registrant.23.01
        Consent of Ernst & Young, LLP.31.01
        Rule 13a-14(a) / 15d-14(a) Certifications of Chairman, President & Chief Executive Officer.31.02
        Rule 13a-14(a) / 15d-14(a) Certifications of Senior Vice President & Chief Financial Officer.32.01
        Section 1350 Certification of Chairman, President & Chief Executive Officer.32.02
        Section 1350 Certification of Senior Vice President & Chief Financial Officer.
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