**UNITED STATES SECURITIES AND        EXCHANGE COMMISSION**

**Washington, D.C.        20549**

 

         

**FORM        10-K** 

         

**ANNUAL REPORT PURSUANT TO SECTION 13 or 15(D)        OF**

**THE SECURITIES EXCHANGE ACT OF        1934**

|                                                      |   |                                                                              |
|----------------------------------------------------------------|--------|-----------------------------------------------------------------------------------|
| **For Fiscal Year Ended                    December 31, 2007** |   | **Commission File Number                    0-18649**

                      |

 

 

 

**The National Security        Group, Inc.**

**(Exact        name of registrant as specified in its charter)**

 

         

 

| **Delaware**                                                                                                          |   | **63-1020300**                                                                           |
|-----------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------|
|  

**(State or Other                    Jurisdiction of**

**Incorporation or                    Organization)** |   |  

**(IRS                    Employer**

**Identification                    No.)** |
|                                                                                                             |   |                                                                                     |
| **661 East Davis                    Street**

**Elba,                    Alabama**                                    |   | **36323**                                                                                |
|  

**(Address of principal                    executive offices)**                                               |   |  

**(Zip-Code)**                                                                   |

 

**Registrant’s Telephone Number        including Area Code (334) 897-2273**

 

 

**Securities registered pursuant to        Section 12 (b) of the Act:**

 

**None**

 

**Securities registered pursuant to        Section 12 (g) of the Act:**

 

**Common Stock, par value $1.00        per share****The NASDAQ Global Market (EXCHANGE)**

 

         

 

Indicate by check mark if the        registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.        Yes  o    No    x

 

Indicate by check mark if the        registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the        Act.  Yes  o    No    x

 

Indicate by check mark whether the        registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the        Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period        that the registrant was required to file such reports), and (2) has been subject to such        filing requirements for the past 90 days.   Yes          x    No   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 filer          o   Non-accelerated filer   x

 

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

 

The aggregate market value of the        voting stock held by nonaffiliates of the Registrant as of February 28, 2008, (based upon        the bid price of these shares on NASDAQ on such date) was $17,395,859

 

Indicate the number of shares        outstanding of each of the issuer’s classes of Common Stock, as of the close of the        period covered by this report.

 

| **Class**

                         

                     

                      |   | **Outstanding December 31, 2007**

                     

                         

                     

                      |
|---------------------------------------------------------------------------------------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Common Stock, $1.00 par value**                                                                 |   | **2,466,600 shares**                                                                                                                                  |

  

 

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

1. Portions        of the Registrant’s Proxy Statement for the 2008 Annual Meeting of Shareholders to be        held May 1, 2008 are incorporated by reference into Part III of this Form 10-K Report        which will be filed with the Securities and Exchange Commission no later than 120 days from        December 31, 2007.

 

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**Table of        Contents**

 

 

| **Part I**   |     |                                                                                                                                                     | **Page** |
|--------------|----------|----------------------------------------------------------------------------------------------------------------------------------------------------------|----------|
|         |     |                                                                                                                                                     |     |
|         | Item 1.  | Business

                                                                                                                                          | 4        |
|         | Item 1A. | Risk                    Factors                                                                                                                          | 13       |
|         | Item 1B. | Unresolved Staff                    Comments                                                                                                             | 17       |
|         | Item 2.  | Properties                                                                                                                                               | 17       |
|         | Item 3.  | Legal                    Proceedings                                                                                                                     | 17       |
|         | Item 4.  | Submission of Matters                    to a Vote of Security Holders                                                                                   | 17       |
|         |     |                                                                                                                                                     |     |
| **Part II**  |     |                                                                                                                                                     |     |
|         |     |                                                                                                                                                     |     |
|         | Item 5.  | Market for                    Registrant’s Common Equity, Related Stockholder Matters and Issuer                    Purchases of Equity Securities | 18       |
|         | Item 6.  | Selected Financial                    Data                                                                                                               | 19       |
|         | Item 7.  | Management’s                    Discussion and Analysis of Financial Condition and Results of                    Operations                        | 20       |
|         | Item 7A. | Quantitative and                    Qualitative Disclosures About MarketRisk                                                                             | 35       |
|         | Item 8.  | Consolidated Financial                    Statements and Supplementary Data                                                                              | 37       |
|         | Item 9.  | Changes in and                    Disagreements with Accountants on Financial                    Disclosure                                              | 75       |
|         | Item 9A. | Controls and                    Procedures                                                                                                               | 75       |
|         | Item 9B. | Other                    Information                                                                                                                     | 75       |
|         |     |                                                                                                                                                     |     |
| **Part III** |     |                                                                                                                                                     |     |
|         |     |                                                                                                                                                     |     |
|         | Item 10. | Directors, Officers and                    Corporate Governance                                                                                          | 76       |
|         | Item 11. | Executive                    Compensation                                                                                                                | 76       |
|         | Item 12. | Security Ownership of                    Certain Beneficial Owners and Management and Related Stockholder                    Matters                     | 76       |
|         | Item 13. | Certain Relationships                    and Related Transactions, and Director Independence                                                             | 76       |
|         | Item 14. | Principal Accountant                    Fees and Services                                                                                                | 76       |
|         |     |                                                                                                                                                     |     |
| **Part IV.** |     |                                                                                                                                                     |     |
|         |     |                                                                                                                                                     |     |
|         | Item 15. | Exhibits, Financial                    Statement Schedules and Reports of Form 8-K                                                                       | 77       |
|         |     |                                                                                                                                                     |     |
|         |     | Signature                    Page                                                                                                                        | 78       |
|         |     |                                                                                                                                                     |     |
|         |     | Certifications                                                                                                                                           | 79       |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2

 

 

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**Note        Regarding Forward-Looking Statements**

 

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

 

| **•** | The insurance industry is highly competitive and the Company                    encounters significant competition in all lines of business from other                    insurance companies. Many of the competing companies have more abundant                    financial resources than the Company. |
|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

         

| **•** | Insurance is a highly regulated industry. It is possible that                    legislation may be enacted which would have an adverse effect on the                    Company’s business. |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| **•** | The Company is subject to regulation by state governments for                    each of the states in which it conducts business. The Company cannot predict                    the subject of any future regulatory initiative(s) or its (their) impact on the                    Company’s business. |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

         

| **•** | The Company is rated by various insurance rating agencies. If a                    rating is downgraded from its current level by one of these agencies, sales of                    the Company’s products and stock could be adversely impacted. |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| **•** | The Company’s financial results are adversely affected by                    increases in policy claims received by the Company. While a manageable risk,                    this fluctuation is often unpredictable. |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| **•** | The Company’s investments are subject to a variety of                    risks. Investments are subject to defaults and changes in market value. Market                    value can be affected by changes in interest rates, market performance and the                    economy. |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

         

| **•** | The Company mitigates risk associated with life policies through                    implementing effective underwriting and reinsurance strategies. These factors                    mitigate, not eliminate, risk related to mortality and morbidity exposure. The                    Company has established reserves for claims and future policy benefits based on                    amounts determined by independent actuaries. There is no assurance that these                    estimated reserves will prove to be sufficient or that the Company will not                    incur claims exceeding reserves, which could result in operating                    losses. |
|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

         

| **•** | The Company mitigates risk associated with property and casualty                    policies through implementing effective underwriting and reinsurance                    strategies. The Company obtains reinsurance which increases underwriting                    capacity and limits the risk associated with policy claims. The Company is                    subject to credit risk with regard to reinsurers as reinsurance does not                    alleviate the Company’s liability to its insureds for the ceded risks.                    The Company utilizes a third party to develop a reinsurance treaty with                    reinsurers who are reliable and financially stable. However, there is no                    guarantee that booked reinsurance recoverables will actually be recovered. A                    reinsurer’s insolvency or inability to make payments due could have a                    material adverse impact on the financial condition of the Company. |
|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| **•** | The Company’s ability to continue to pay dividends to                    shareholders is contingent upon profitability and capital adequacy of the                    insurance subsidiaries. The insurance subsidiaries operate under regulatory                    restrictions that could limit the ability to fund future dividend payments of                    the Company. An adverse event or series of events could materially impact the                    ability of the insurance subsidiaries to fund future dividends and consequently                    the Board of Directors would have to suspend the declaration of dividends to                    shareholders. |
|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

 

 

3

 

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**PART I**

 

**Item        1. Business**

 

Summary Description of The National Security Group, Inc.

 

The        National Security Group, Inc. (the Company, NSG, we, us, our), an insurance holding        company, was incorporated in Delaware on March 20, 1990. The Company, through its three        wholly owned subsidiaries, operates in two industry segments; property and casualty, and        life insurance. The property and casualty subsidiaries of the Company, National Security        Fire and Casualty (NSFC), and Omega One Insurance Company (Omega), primarily write personal        lines coverage including dwelling fire and windstorm, homeowners, mobile homeowners, and        personal non-standard automobile lines of insurance in eleven states. Property-casualty        insurance is the most significant industry segment accounting for 89% of total premium        revenues. The Company’s life insurance subsidiary, National Security Insurance        Company, offers a basic line of life and health and accident insurance products in six        states.

 

The        Company’s common stock is traded on the NASDAQ Global Market under the symbol        NSEC.

 

The        Company’s website address is:www.nationalsecuritygroup.com

 

Industry Segment and Geographical Area Information

 

**Property and Casualty Insurance Segment**

 

The        Company’s property and casualty insurance business is conducted through National        Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company        organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of        National Security Fire & Casualty Company organized in 1992. This segment will be        referred to throughout this report as NSFC, property-casualty segment or P&C segment.        NSFC is licensed to write insurance in Alabama, Arkansas, Florida, Georgia, Kentucky,        Mississippi, Oklahoma, South Carolina, Tennessee and West Virginia, and operates on a        surplus lines basis in the states of Louisiana, Missouri, and Texas. Omega is licensed to        write insurance in Alabama and Louisiana. The following table indicates allocation        percentages of direct written premium by state for the three years ended December 31, 2007,        2006 and 2005:

 

 

| State          |   | Percent of direct written premium |
|----------------|--------|-----------------------------------|
|           |   | 2007                              | 2006 | 2005 |
| Alabama        |   | 32.87%                            | 35.43% | 35.46% |
| Arkansas       |   | 8.23%                             | 8.79% | 9.74% |
| Georgia        |   | 7.08%                             | 6.02% | 6.42% |
| Louisiana      |   | 10.74%                            | 10.20% | 5.29% |
| Mississippi    |   | 15.73%                            | 17.01% | 21.38% |
| South Carolina |   | 10.16%                            | 8.32% | 8.68% |
| Florida        |   | 0.20%                             | 0.23% | 0.34% |
| Missouri       |   | 1.07%                             | 1.67% | 2.20% |
| Oklahoma       |   | 5.44%                             | 4.20% | 4.15% |
| Tennessee      |   | 6.80%                             | 6.66% | 4.98% |
| Texas          |   | 1.68%                             | 1.47% | 1.36% |
|           |   | 100.00%                           | 100.00% | 100.00% |

 

 

 

 

 

 

 

 

4

 

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In        general, the property-casualty insurance business involves the transfer by the insured, to        an insurance company of all or a portion of certain risks for the payment, by the insured,        of a premium to the insurance company. A portion of such risks is often retained by the        insured in the form of deductibles, which vary from policy to policy, but are typically in        the range of $500 to $1,000 on NSFC and Omega’s primary dwelling and automobile lines        of business.

 

The        premiums or payments to be made by the insured for direct products of the property and        casualty subsidiaries are based upon expected costs of providing benefits, writing and        administering the policies. In determining the premium to be charged, the property and        casualty subsidiaries utilize data from past claims experience and anticipated claims        estimates along with commissions and general expenses.

 

The        operating results of the property-casualty insurance industry are subject to significant        fluctuations from quarter to quarter and from year to year. These fluctuations are often        due to the effect of competition on pricing, unpredictable losses incurred in connection        with weather-related and other catastrophic events, general economic conditions, and other        factors, such as changes in tax laws and the regulatory environment.

 

The        following table sets forth the premiums earned and pre-tax income during the periods        reported for the property and casualty insurance segment:

 

|                              |   |   | Year Ended December 31 |
|-----------------------------------|--------|--------|------------------------|
|                              |   |   | (Amounts In Thousands) |
|                              |   |   | 2007                   |   | 2006 |   | 2005 |
| Net premiums earned:              |   |   |                   |   |   |   |   |
| Fire, Allied lines and Homeowners |   | $      | 49,460                 | $ | 44,871 | $ | 38,671 |
| Automobile                        |   |   | 4,504                  |   | 6,327 |   | 6,990 |
| Other                             |   |   | 1,255                  |   | 1,126 |   | 1,668 |
|                              |   | $      | 55,219                 | $ | 52,324 | $ | 47,329 |
|                              |   |   |                   |   |   |   |   |
| Income before taxes               |   | $      | 8,594                  | $ | 8,598 | $ | 2,687 |

 

 

*Property and Casualty Loss Reserves*

 

Our        property and casualty insurance subsidiaries are required to maintain reserves to cover        their ultimate liability for losses and adjustment expenses. Our staff periodically        conducts reviews throughout the year of projected loss development information in order to        adjust estimates. The liability for loss and adjustment expense reserves consists of an        estimated liability for the ultimate settlement of claims that have been reported as well        as an estimate of loss and adjustment expenses for incurred claims that have not yet been        reported (IBNR). IBNR estimates are based primarily on historical development patterns        using quantitative data generated from statistical information and qualitative analysis of        legal developments, economic conditions and development caused by events deemed to be        infrequent in occurrence. The reserves are based on an estimate made by management.        Management estimates are based on an analysis historical paid and incurred loss development        patterns for the previous ten loss years. Prior year period-to-period loss development        factors are applied to latest reported loss reserve estimates in order to estimate the        ultimate incurred losses for each given loss year. The amount of loss reserves estimated in        excess of current reported case losses are recorded as IBNR reserves.

 

In        addition to loss and loss adjustment expense reserves for specific claims, both reported        and unreported, we establish reserves for loss adjustment expenses that are not        attributable to specific claims. These reserves consist of estimates for Defense and Cost        Containment (DCC) and Adjusting and Other Expenses (AO). These reserves are established for        the estimated expenses of internal claims staff and the cost of outside experts, such as        attorneys representing our interest, in the final settlement of incurred claims that are        still in process of settlement.

 

We        engage a consulting actuary to issue an opinion as to the adequacy of statutory insurance        reserves that are estimated by management. These opinions are filed with the various        insurance regulatory jurisdictions in which we are licensed. In addition to the annual        review, we conduct interim reviews during the year in order to insure that no significant        changes have occurred in our loss development that might adversely impact our loss        reserving methodology.

 

5

 

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The        following Loss Reserve Re-estimates table illustrates the change over time of the net        reserves established for property-liability insurance claims and claims expense at the end        of the last 10 calendar years. The first section shows the reserves as originally reported        at the end of the stated year. The second section, reading down, shows retroactive        re-estimates of the original recorded reserve as of the end of each successive year. These        re-estimates are the result of the Company’s expanded awareness of additional facts        and circumstances that pertain to the unsettled claims. The third section, reading down,        shows the cumulative amounts paid as of the end of successive years with respect to that        year’s reserve liability. The last section compares the latest re-estimated reserve        to the reserve originally established, and indicates whether the original reserve was        adequate to cover the estimated costs of unsettled claims. The Loss Reserve Re-estimates        table is cumulative and, therefore, ending balances should not be added since the amount at        the end of each calendar year includes activity for both the current and prior        years.

 

While        the information in the table provides a historical perspective on the adequacy of unpaid        losses and loss adjustment expenses established in previous years, it should not be assumed        to be predictive of redundancies or deficiencies on current year unpaid losses in future        periods. Company management believes that the reserves established at the end of 2007 are        adequate. However, due to inherent uncertainties in the loss reserve estimation process,        management cannot guarantee that current year reserve balances will prove to be adequate.        Due to the short tail nature of the property and casualty subsidiaries claim liabilities,        the Company does not discount loss reserves for the time value of money. Dollar amounts are        in thousands.

 

 

 

 

 

 

 

 

 

 

 

 

6

 

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|                              | 1997           | 1998    | 1999   | 2000    | 2001   | 2002    | 2003   | 2004    | 2005   | 2006    | 2007   |
|-----------------------------------|----------------|---------|--------|---------|--------|---------|--------|---------|--------|---------|--------|
| Gross unpaid losses per           |           |    |   |    |   |    |   |    |   |
| Consolidated Balance Sheet        | $              | 21,869  | $      | 21,528  | $      | 18,463  | $      | 15,409  | $      | 11,489  | $      | 11,513 | $ | 11,343 | $ | 13,094 | $ | 19,511 | $ | 12,498 | $ | 11,973 |
| Ceded reserves                    |           | (7,148) |   | (5,889) |   | (3,899) |   | (3,092) |   | (2,396) |   | (1,555) |   | (1,232) |   | (2,611) |   | (8,560) |   | (1,783) |   | (555) |
| Net unpaid losses                 | $              | 14,721  | $      | 15,639  | $      | 14,564  | $      | 12,317  | $      | 9,093   | $      | 9,958 | $ | 10,111 | $ | 10,483 | $ | 10,951 | $ | 10,715 | $ | 11,418 |
|                              |           |    |   |    |   |    |   |    |   |    |
|                              |           |    |   |    |   |    |   |    |   |    |   |
| Liability re-estimated:           | 1 year later   | $       | 14,158 | $       | 14,637 | $       | 11,067 | $       | 8,847  | $       | 6,805  | $ | 7,334 | $ | 9,186 | $ | 9,042 | $ | 11,844 | $ | 11,817 |   |
|                              | 2 years later  |    | 14,570 |    | 12,067 |    | 9,261  |    | 7,863  |    | 6,017  |   | 7,165 |   | 8,607 |   | 9,118 |   | 11,827 |   |   |
|                              | 3 years later  |    | 13,161 |    | 11,350 |    | 8,931  |    | 7,460  |    | 5,856  |   | 6,906 |   | 8,098 |   | 8,669 |   |   |   |
|                              | 4 years later  |    | 12,936 |    | 11,496 |    | 8,556  |    | 7,236  |    | 5,699  |   | 6,509 |   | 7,863 |   |   |   |   |
|                              | 5 years later  |    | 13,271 |    | 11,121 |    | 8,422  |    | 7,240  |    | 5,436  |   | 6,499 |   |   |   |   |   |
|                              | 6 years later  |    | 13,034 |    | 11,087 |    | 8,519  |    | 6,995  |    | 5,413  |   |   |   |   |   |   |
|                              | 7 years later  |    | 13,104 |    | 11,202 |    | 8,264  |    | 6,961  |    |   |   |   |   |   |   |
|                              | 8 years later  |    | 13,193 |    | 10,968 |    | 8,245  |    |   |    |   |   |   |   |   |
|                              | 9 years later  |    | 13,005 |    | 10,972 |    |   |    |   |    |   |   |   |   |
|                              | 10 years later |    | 13,033 |    |   |    |   |    |   |    |   |   |   |
|                              |           |    |   |    |   |    |   |    |   |    |   |   |
|                              |           |    |   |    |   |    |   |    |   |    |   |   |
| Net deficiency (redundancy)       | $              | (1,688) | $      | (4,667) | $      | (6,319) | $      | (5,356) | $      | (3,680) | $      | (3,459) | $ | (2,248) | $ | (1,814) | $ | 876 | $ | 1,102 |   |
|                              |           |    |   |    |   |    |   |    |   |    |   |   |
|                              |           |    |   |    |   |    |   |    |   |    |   |
|                              |           |    |   |    |   |    |   |    |   |    |   |
| Cumulative payments:              | 1 year later   | $       | 7,176  | $       | 5,997  | $       | 4,423  | $       | 3,907  | $       | 3,362  | $ | 4,342 | $ | 5,567 | $ | 5,584 | $ | 7,384 | $ | 6,438 |   |
|                              | 2 years later  |    | 9,961  |    | 8,079  |    | 5,758  |    | 5,643  |    | 4,416  |   | 5,520 |   | 6,765 |   | 7,006 |   | 9,063 |   |   |
|                              | 3 years later  |    | 10,887 |    | 8,997  |    | 7,266  |    | 6,359  |    | 5,076  |   | 5,865 |   | 7,038 |   | 7,521 |   |   |   |
|                              | 4 years later  |    | 11,566 |    | 10,371 |    | 7,744  |    | 6,737  |    | 5,221  |   | 5,945 |   | 7,274 |   |   |   |   |
|                              | 5 years later  |    | 12,522 |    | 10,557 |    | 8,039  |    | 6,837  |    | 5,106  |   | 6,136 |   |   |   |   |   |
|                              | 6 years later  |    | 12,657 |    | 10,779 |    | 8,139  |    | 6,731  |    | 5,164  |   |   |   |   |   |   |
|                              | 7 years later  |    | 12,892 |    | 10,874 |    | 8,028  |    | 6,773  |    |   |   |   |   |   |   |
|                              | 8 years later  |    | 12,972 |    | 10,763 |    | 8,067  |    |   |    |   |   |   |   |   |
|                              | 9 years later  |    | 12,860 |    | 10,804 |    |   |    |   |    |   |   |   |   |
|                              | 10 years later |    | 12,866 |    |   |    |   |    |   |    |   |   |   |
|                              |           |    |   |    |   |    |   |    |   |
|                              |           |    |   |    |   |    |   |    |   |
| Net deficiency (redundancy) above | $              | (1,688) | $      | (4,667) | $      | (6,319) | $      | (5,356) | $      | (3,680) | $      | (3,459) | $ | (2,248) | $ | (1,814) | $ | 876 | $ | 1,102 |   |

 

7

 

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**Life        Insurance Segment**

 

National        Security Insurance Company (NSIC), a wholly owned subsidiary organized in 1947, conducts        the Company’s life insurance business. This segment will be referred to throughout        this report as NSIC, Life Company, or Life segment. NSIC is licensed to write insurance in        six states: Alabama, Florida, Georgia, Mississippi, South Carolina, and Texas. The        following table indicates NSIC’s percentage of direct premiums collected by state for        the three years ended December 31, 2007, 2006 and 2005.

| State          |   | Percentage of Total Direct Premiums |
|----------------|--------|-------------------------------------|
|           |   | 2007                                |   | 2006 |   | 2005 |
| Alabama        |   | 56.95%                              |   | 58.86% |   | 60.62% |
| Georgia        |   | 22.08%                              |   | 21.05% |   | 20.55% |
| Mississippi    |   | 10.04%                              |   | 9.89% |   | 9.82% |
| South Carolina |   | 6.28%                               |   | 5.37% |   | 4.17% |
| Florida        |   | 1.96%                               |   | 2.02% |   | 2.35% |
| Texas          |   | 2.69%                               |   | 2.81% |   | 2.49% |
|           |   | 100.00%                             |   | 100.00% |   | 100.00% |

 

 

NSIC has        two primary methods of distribution of insurance products, home service (career) agents and        independent agents. The home service distribution method of life insurance products        accounts for 37.2% of total premium revenues in the life insurance segment. Home service        life products consist of products marketed directly at the home or other premises of the        insured by an employee agent. The home service distribution method has been the        Company’s primary method of distribution since the founding of NSIC in 1947. However,        over the past seven years, the Company has placed its primary emphasis for future growth on        alternative methods of distribution. The Company employed 11 career agents and one regional        manager at December 31, 2007. The independent agent distribution method accounts for 53.7%        of total premium revenue in the life insurance segment. Since NSIC began marketing life,        accident and health products through independent agents in 1999 this distribution channel        has become the Company’s fastest growing and primary method of distribution.        Approximately 917 agents of the Company’s independent agents produced new business        during 2007. The remaining 9.1% of premium revenue consists of the following:  a book        of premium acquired from a state guaranty association in 2000 (1.8%), premium generated        through direct sales of school accident insurance (1.1%), and other miscellaneous business        serviced directly through the home office (6.2%).

 

NSIC’s primary products are life insurance, both term and whole life,        and health and accident insurance. NSIC does not sell annuities, interest sensitive whole        life or universal life insurance products. Term life insurance policies provide death        benefits if the insured’s death occurs during the specific premium paying term of the        policy. The policies generally do not provide a savings or investment element included as        part of the policy premium. Whole-life insurance policies demand a higher premium than term        life, but provide death benefits which are payable under effective policies regardless of        the time of the insured’s death and have a savings and investment element which may        result in the accumulation of a cash surrender value. Our accident and health insurance        policies provide coverage for losses sustained through sickness or accident and include        individual hospitalization and accident policies, group supplementary health policies, and        specialty products, such as cancer policies. Our line of health and accident products        feature specified fixed benefits, so rapidly rising health care costs do not have as great        an impact on our health and accident line as they do on comparable products offered by        other companies.

 

The        following table displays a schedule of 2007 life segment premium produced by product and        distribution method (dollars in thousands):

 

| **Line of Business**                 |   | **Home Service Agent** |   | **Independent Agent** |   | **Other** |
|--------------------------------------|--------|------------------------|--------|-----------------------|--------|-----------|
| Industrial                           | $      | 123                    | $      | -                     | $      | 69        |
| Ordinary                             |   | 2,026                  |   | 2,861                 |   | 296       |
| Group Life                           |   | -                      |   | 34                    |   | 86        |
| A&H Group                        |   | -                      |   | -                     |   | 92        |
| A&H Other                        |   | 384                    |   | 990                   |   | 70        |
| Total Premium by Distribution Method | $      | 2,533                  | $      | 3,885                 | $      | 613       |

 

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The        following table sets forth certain information with respect to the development of the Life        Company’s business:

 

 

|                                           |                               |        |         |        | Year Ended December 31 |
|-------------------------------------------|-------------------------------|--------|---------|--------|------------------------|
|                                      |                          |   |    |   | (Amounts In Thousands) |
|                                      |                          |   |    |   | 2007                   |   | 2006 |   | 2005 |
| Life insurance in force at end of period: |                          |   |    |   |
|                                      | Ordinary-whole Life           | $      | 174,800 | $      | 140,800                | $ | 137,100 |
|                                      | Term Life                     |   |    |   | 26,000                 |   | 46,400 |   | 38,400 |
|                                      | Industrial life               |   |    |   | 29,000                 |   | 30,000 |   | 28,100 |
|                                      | Other                         |   |    |   | -                      |   | - |   | - |
|                                      |                          |   |    | $      | 229,600                | $ | 217,200 | $ | 203,600 |
|                                      |                          |   |    |   |                   |   |   |   |   |
| Life insurance issued:                    |                          |   |    |   |                   |   |
|                                      | Ordinary-whole life           | $      | 36,700  | $      | 39,100                 | $ | 35,600 |
|                                      | Term Life                     |   |    |   | 9,400                  |   | 8,000 |   | 3,500 |
|                                      | Industrial                    |   |    |   | -                      |   | - |   | - |
|                                      | Other                         |   |    |   | -                      |   | - |   | - |
|                                      |                          |   |    | $      | 46,100                 | $ | 47,100 | $ | 39,100 |
|                                      |                          |   |    |   |                   |   |   |   |   |
|                                      |                          |   |    |   |                   |   |   |   |   |
|                                      | Net premiums earned:          |   |    |   |                   |   |   |
|                                      | Life insurance                |   |    | $      | 5,495                  | $ | 5,065 | $ | 4,819 |
|                                      | Accident and health insurance |   | 1,536   |   | 1,485                  |   | 1,415 |
|                                      |                          |   |    | $      | 7,031                  | $ | 6,550 | $ | 6,234 |

 

*Life        Insurance Segment Reserves*

 

We        engage a consulting actuary to calculate our reserves for traditional life insurance        products. The methodology used requires that the present value of future benefits to be        paid under life insurance policies less the present value of future net premiums be        calculated. The calculation uses assumptions including estimates of any adverse deviation,        investment yields and changes in investment yields, mortality, maintenance expenses and any        non-forfeiture options or termination benefits. The assumptions determine the level and        sufficiency of reserves and reserves are calculated and reviewed by our consulting actuary        at the end of each quarter. The independent consulting actuary also reviews our estimates        for other insurance products including claims reserves under accident and health contracts.        Management believes that the reserve amounts reflected in the accompanying financial        statements are adequate.

 

**Investments**

 

A        significant percentage of the total income for the Company is tied to the performance of        its investments. Assets that will eventually be used to pay reserve liabilities and other        policyholder obligations along with Company capital are invested to generate investment        income while held by the Company. Our investment income is comprised primarily of interest        and dividend income on debt and equity securities and realized capital gains and losses        generated by debt and equity securities. At December 31, 2007, investments comprise 80% of        total assets and investment income (including realized gains) comprises 9% of total        revenues evidencing the significant impact investments can have on financial results.        Because the Company’s insurance subsidiaries are regulated as to the types of        investments they may make and the amount of funds they may maintain in any one type of        investment, the Company has developed a conservative value oriented investment philosophy,        in order to meet regulatory requirements. The Company’s investment goals are to        conserve capital resources and assets, obtain the necessary investment income threshold to        meet reserves, and provide a reasonable return. Current yield from invested assets and        capital appreciation of investments create this return.

 

The        single most significant investment for the Company was The Mobile Attic, Inc. (Mobile        Attic), a joint venture with a local manufacturing firm established in the fourth quarter        of 2001. The Company sold the majority of its 50% stake in Mobile Attic in April of 2007,        retaining a 5% interest. The Company realized a net of tax gain on the disposal of        $1,460,000.

 

 

 

 

 

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**Marketing and Distribution**

 

As        mentioned earlier in this report, NSIC products are marketed through a field force of        agents and career agents who are employees of the Life Company and through a network of        independent agents. The Company’s use of independent agents is expected to be more        cost effective in the long term and has become the fastest growing method of distribution.        In an effort to boost productivity and better educate agents on the products and services        of NSIC, the Life Company marketing team travels extensively throughout our service areas        holding training sessions for agents. We also offer our best agents opportunities to attend        retreats at least twice a year to network with the home office staff that help serve them        and our policyholders. In addition, the retreats provide agents with additional knowledge        of the products we offer, and serve as a forum for feedback on how we can better serve our        agency force and policyholders.

 

NSFC and        Omega products are marketed through a network of independent agents and brokers, who are        independent contractors and generally maintain relationships with one or more competing        insurance companies. NSFC employs three field marketing representatives who visit in the        offices of our independent agent force regularly to give the agents opportunities for        feedback. Our NSFC marketing representatives also host training seminars throughout our        service area. The goal of these seminars is to educate the independent agent sales force        about our products and services.

 

Agents        receive compensation for their sales efforts. In the case of life insurance agents,        compensation is paid in the form of sales commissions plus a servicing commission.        Commissions paid by NSIC in 2007 averaged approximately 22% of premiums. Commissions paid        by NSFC in 2007 averaged approximately 14% of premiums. During 2007, no one independent        agent accounted for more than 10% of total net earned premium of the property-casualty        insurance subsidiaries. NSFC also offers a “profit sharing bonus plan” to        independent agents in order to promote better field underwriting and encourage retention of        profitable business. This plan not only rewards our agents but also enhances profitability        by giving the agent a vested interest in our success and also aids in maintaining price        stability for all our customers as agents have a financial incentive to use good field        underwriting practices when completing an application for insurance.

 

At        December 31, 2007, NSIC employed 11 career agents and one regional manager. NSIC also had        approximately 550 independent agents actively producing new business.

 

At        December 31, 2007, NSFC had contracts with approximately 1,300 independent agencies in        eleven states.

 

**Competition**

 

In both        of our insurance segments, we operate in a very competitive environment. There are numerous        insurance companies competing in the various states in which we offer our products. Many of        the companies with which we compete are much larger, have significantly larger volumes of        business, offer much broader ranges of products and have more significant financial        resources than we do. We compete directly with many of these companies, not only in the        sale of products to consumers, but also in the recruitment and retention of qualified        agents. We believe the main areas in which a smaller company, like us, can compete is in        the areas of providing niche products in underserved areas of the insurance market at        competitive prices while providing excellent service to our agents and policyholders during        the entire insurance product lifecycle from policy issuance to final payment of a claim. We        pride ourselves on being accessible to our independent agent force and maintain a presence        through the efforts of a field marketing staff and easy access to any and all home office        staff. We believe we have made significant advancements in developing a competitive        advantage, especially over the last decade. We also have longstanding relationships with        many of our agents. We believe we compete effectively within the markets we serve and        continue to evolve our processes and procedures in order to garner further competitive        advantages.

 

NSFC and        Omega’s primary insurance products are dwelling fire, homeowners, including mobile        homeowners, and private passenger auto coverage. Dwelling fire and homeowners, collectively        referred to as the dwelling property line of business, is the largest segment of property        and casualty operations composing 94% of total property and casualty premium revenue. We        focus on providing niche insurance products within the markets we serve. We are in the top        twenty dwelling property insurance carriers in our two largest states, Alabama and        Mississippi. However, due to the large concentration of business among the top five        carriers our total combined market share in these two states is less than 2%.

 

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We have        actively sought competitive advantages over the last five years in the area of        technological advancement. We have replaced our primary policy administration systems in        both our property and casualty and life insurance subsidiaries. We replaced our legacy        policy administration system in our life subsidiary in 2002. In late 2006 and throughout        2007 we began the process in transitioning to a new policy administration system in our        property and casualty subsidiary.

 

The new        property and casualty administration system is an internally developed end-to-end system        that we believe will significantly enhance our ability to compete with larger carriers in        the market we serve. The system features a web based portal that allows our independent        agents to rate, quote and issue policies directly in their office. The new system        streamlines the underwriting process with automation of many previous manual processes and        greatly enhances our agents ability to provide excellent service to their clients. The        system also enhances the efficiency of our underwriting process allowing for a more        thorough evaluation of risks. While the conversion process will continue into 2008, we        believe this new system will greatly enhance our ability to remain competitive in the        markets we serve.

 

**Regulation**

 

Our        insurance subsidiaries are directly regulated by the insurance department in our state of        domicile, Alabama. We are subject to the Alabama Insurance Holding Company System        Regulatory Act and report to the Alabama Department of Insurance. Consequently, we are        subject to periodic examination and regulation under Alabama Insurance Laws.

 

Our        insurance subsidiaries are also subject to licensing and supervision by the various        governmental agencies in the jurisdictions in which we do business. The nature and extent        of such regulation varies, but generally has its source in state statutes which bestow        regulatory, supervisory and administrative authority to State Insurance Commissioners and        their respective insurance departments. The regulations may require the Company to meet and        maintain standards of solvency, comply with licensing requirements, periodically examine        market conditions and financial activities and report on the condition of operations and        finances. In addition, most of our insurance rates are subject to regulation and approval        by regulatory authorities within the respective states in which we offer our        products.

 

Our        insurance subsidiaries are subject to various statutory restrictions and limitations        relating to the payment of dividends or distributions to stockholders. The restrictions are        generally based on certain levels of surplus, net income or operating income as determined        by statutory accounting practices. Alabama law permits dividends in any year which,        together with other dividends made within the preceding 12 months that do not exceed the        greater of (1) 10% of statutory surplus as of the end of the preceding year or (2) for        property and casualty insurers, statutory net income for the preceding year or for life        companies, statutory net gain from operations. Dividends in excess of the restricted        amounts are payable only after obtaining regulatory approval. Future dividends from the        insurance subsidiaries may be limited by business or regulatory considerations. The Group        relies on the ability of the insurance subsidiaries to pay dividends to fund quarterly        stockholder dividends and for payment of most operating expenses of the group, including        interest and principal payments on debt. We are not currently under any regulatory dividend        limitations that may limit our liquidity in the Group. Further discussion of dividend        payment capacity of subsidiaries can be found in Note 12 of the Consolidated Financial        Statements included herein.

 

Our        insurance subsidiaries are subject to risk based capital requirements adopted by the        National Association of Insurance Commissioners (NAIC). These requirements direct our        insurance companies to calculate and report information according to a risk based formula        which attempts to measure statutory capital and surplus needs based on the risk in our        product mix and investment portfolio. The formula is designed to allow state insurance        regulators to identify companies that are potentially inadequately capitalized. Under the        formula, the Company calculates Risk Based Capital (RBC) by taking into account certain        risks inherent in an insurer’s assets, including investments and an insurer’s        liabilities. Risk based capital rules provide for different levels of action depending on        the ratio of a company’s total adjusted capital to its “authorized control        level” RBC. Based on calculations made by each of our insurance subsidiaries at        December 31, 2007, each subsidiary significantly exceeds any levels that would require        regulatory actions.

 

 

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**A.M.        Best Rating**

 

A.M.        Best Company is a leading provider of insurance company financial strength ratings and        insurance company issuer credit ratings. Best’s financial strength ratings and issuer        credit ratings provide an independent opinion based on comprehensive quantitative and        qualitative evaluation of a company’s balance sheet strength, operating performance        and business profile. The property and casualty companies currently carry an A.M. Best        group financial strength rating of B++ (Good) with a stable outlook. This rating has        remained the same for the past ten years. The property and casualty group maintains an        issuer credit rating of “bbb” with a stable outlook. National Security        Insurance Company maintains a company specific financial strength rating of B (Fair) with a        stable outlook and an issuer credit rating of “bb” with a stable outlook. For        the latest ratings, accesswww.ambest.com.

 

**Employees**

 

The        Company itself has no management or operational employees. Instead all human resource        activities are held by subsidiary National Security Insurance Company. NSIC employed 164        staff members as of December 31, 2007. The Company and its property and casualty subsidiary        have a Management Service Agreement (“Agreement”) with The National Security        Insurance Company whereby the Company and the property and casualty subsidiaries reimburse        NSIC for salaries and expenses of employees provided under the Agreement. Involved are        employees in the areas of Underwriting, Customer Service, Policy Services, Accounting,        Marketing, Administration, Document Management, Data Processing, Programming, Personnel,        Claims, and Management. The Company, through NSIC, is represented by 14 employee agents in        Alabama. The Company’s property and casualty subsidiaries had over 1,300 independent        agents producing business at December 31, 2007.

 

The        success of the Company is largely dependent upon its relations with its employees. High        employee morale is critical to the accomplishment of our mission. Our mission statement        declares that we will strive to: 1) Provide financial assurance to policyholders in times        of emergencies, crisis or financially difficult times such as fires, natural disasters,        accidents, sickness, death, and retirement; 2) Provide a rate of return on invested capital        to shareholders equal to or better than industry standards; and 3) Provide an environment        in which all employees are enabled, encouraged, and stimulated to perform continuously at        their highest level of productivity and creativity thereby attaining the highest possible        level of job satisfaction.

 

The        Company has placed an increased emphasis on employee education in recent years. This has        resulted in the Company offering financial incentives to employees desiring to further        their education, and the establishment of a Plan for Employee Progress (PEP) program. The        PEP program rewards employees who take advantage of training opportunities and who excel in        the performance of their duties. The potential rewards for successful participants in the        program include salary increases and promotions within the Company.

 

**Additional information with respect to The National Security        Group’s business**

 

We        maintain a website        (www.nationalsecuritygroup.com). The National Security Group, Inc.’s annual reports on Form 10-K,        quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to such        reports that we file or furnish pursuant to Section 13(a) of the Securities Exchange Act of        1934 are available through our Internet website, free of charge, as soon as reasonably        practical upon having been electronically filed or furnished to the Securities and Exchange        Commission.

 

Our code        of ethical conduct is also available on our website and in print to any stockholder who        requests copies by contacting The National Security Group, Attn: Investor Relations, P. O.        Box 703, Elba, AL 36323.

 

Any of        the materials we file with the SEC may also be read and copied at the SEC’s Public        Reference Room at 100 F Street, NE, Washington, D.C. 20549. Information on the operation of        the SEC’s Public Reference Room may be obtained by calling the SEC at 1.800.SEC.0330.        Our periodic reports filed with the SEC, which include Forms 3, 4 and 5, Form 10-K, Form        10-Q, Form 8-K and any amendments thereto may also be accessed free of charge from the        SEC’s website atwww.sec.gov.

 

 

 

 

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**Item        1A. Risk Factors**

 

Risk        factors are events and uncertainties over which the Company has limited or no control and        which can have a material adverse impact on our financial condition or results of        operations. We are subject to a variety of risk factors. The following information sets        forth our evaluation of the risk factors we deem to be most material. We work to actively        manage these risks, but the reader should be cautioned that we are only able to mitigate        the impact of most risk factors, not eliminate the risk. Also, there may be other risks        which we do not presently deem material that may become material in the future.

 

*Underwriting and product pricing*

 

The        insurance subsidiaries maintain underwriting departments that seek to evaluate the risks        associated with the issuance of an insurance policy. NSIC accepts standard risks and, to an        extent, substandard risks and engages medical doctors who review certain applications for        insurance. In the case of the property and casualty subsidiaries, the underwriting staff        attempts to assess, in light of the type of insurance sought by an applicant, the risks        associated with a prospective insured or insurance situation. Depending upon the type of        insurance involved, the process by which the risks are assessed will vary. In the case of        automobile liability insurance, the underwriting staff assesses the risks involved in        insuring a particular driver, and in the case of dwelling insurance, the underwriting staff        assesses the risks involved in insuring a particular dwelling. Where possible, the        underwriting staff of the property-casualty insurance subsidiary utilizes standard        procedures as guides that quantify the hazards associated with a particular occupancy. In        general, the property and casualty subsidiaries specialize in writing nonstandard        risks.

 

The        nonstandard market in which the property and casualty subsidiaries operate reacts to        general economic conditions in much the same way as the standard market. When        insurers’ profits and equity are strong, companies sometimes cut rates or do not seek        increases. Also, underwriting rules are less restrictive. As profit and/or capital fall,        companies may tighten underwriting rules, and seek rate increases. Premiums in the        nonstandard market are higher than the standard market because of the increased risk of the        insured, which generally comprises more frequent claims. Drivers of autos who have prior        traffic convictions are one such increased risk that warrants higher premiums. Lower valued        dwellings and mobile homes also warrant higher premiums because of the nature of the risk.        The costs of placing such nonstandard policies and making risk determinations are similar        to those of the standard market. The added costs due to more frequent claims servicing is        reflected in the generally higher premiums that are charged.

 

Our        ability to maintain profitability is contingent upon our ability to actively manage our        rates and underwriting procedures. Premium rate inadequacy may not become apparent quickly        and we will incur lag-time to correct. If our rates or underwriting processes become        inadequate, our results of operations and financial condition could be adversely        impacted.

 

*Approval of rates*

 

Most        lines of business written by our property and casualty insurers are subject to prior        approval of premium rates in the majority of the states in which we operate. The process of        obtaining regulatory approval can be expensive and time consuming and can impair our        ability to make necessary rate adjustments due to changes in loss experience, cost of        reinsurance or other factors. If our requests to regulatory bodies for rate increases are        not approved in an adequate or timely manner, our results of operations and financial        condition may be adversely impacted.

 

*Reinsurance*

 

Both        insurance subsidiaries customarily reinsure with other insurers certain portions of the        insurance risk. The primary purpose of such reinsurance arrangements is to enable the        Company to limit its risk on individual policies, and in the case of property insurance,        limit its risk in the event of a catastrophe in various geographic areas. A reinsurance        arrangement does not discharge the issuing company from primary liability to the insured,        and the issuing company is required to discharge its liability to the insured even if the        reinsurer is unable to meet its obligations under the reinsurance arrangements.        Reinsurance, however, does make the reinsurer liable to the issuing company to the extent        of any reinsurance in force at the time of the loss. Reinsurance arrangements also decrease        premiums retained by the issuing company since that company pays the reinsuring company a        portion of total premiums based upon the amount of liability reinsured.

 

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NSIC        generally reinsures all risks in excess of $50,000 with respect to any one insured. NSFC        and Omega generally reinsure with third parties any liability in excess of $225,000 on any        single policy. In addition, the property and casualty subsidiaries have catastrophe excess        reinsurance, which provided protection in part with respect to aggregate property losses        arising out of a single catastrophe, such as a hurricane. In 2007, the property and        casualty subsidiaries had catastrophe protection up to a $47.5 million loss. Under the        property and casualty subsidiaries reinsurance arrangement in force during 2007, the        Company retained the first $3.5 million of insured losses from any single catastrophic        event. The next $17.5 million in insured losses from any single event was 95% reinsured        with the Company’s net retention being 5%. The third layer of reinsurance protection        provided coverage for 100% of insured losses exceeding $17.5 million and up to $42.5        million. In July of 2007, the Company added an additional layer of coverage to the        reinsurance program. The fourth layer of reinsurance protection provided coverage for 100%        of insured losses in excess of $42.5 million up to $47.5 million. The amount of catastrophe        reinsurance protection purchased by the Company was based on computer modeling of actual        Company exposure. The Company generally seeks catastrophe protection for scenarios based on        the computer modeling that mitigates losses up to a near term 1 in 100 year event, further        described as an amount at which the probability of not exceeding is not less than 99%. NSFC        and Omega had a provision for one reinstatement (coverage for two catastrophic events)        during 2007.

 

Our        inability to procure reinsurance, primarily catastrophe reinsurance, could adversely impact        our ability to maintain our level or premium revenue.

 

*Risk        of loss from catastrophic events and geographic concentration*

 

As        described above, we maintain catastrophe reinsurance in amounts that provides protection to        the Company’s financial condition in all but the most remote likelihood of        occurrences. Our most critical catastrophe risk is from hurricanes due to our proximity to        the Atlantic Ocean and the Gulf of Mexico. Our results of operations are very likely to be        materially impacted in the event of the landfall of a major hurricane striking the Northern        Gulf Coast or Southern Atlantic Coast in Georgia or South Carolina where we maintain        significant concentrations of business. We are also exposed to the risk of significant        tornado activity in many of the states in which we operate. Our most significant        catastrophic event risk is the risk of a loss in excess of the Company’s upper        catastrophe limit which could adversely impact the Company’s financial condition if        such an event occurs. We are also subject to assessments from windstorm underwriting pools        in various states. These risks are often difficult to measure and in the event of a major        catastrophe, could exceed the upper limits of our available reinsurance        protection.

 

*Reserve liabilities*

 

NSIC        maintains life insurance reserves for future policy benefits to meet future obligations        under outstanding policies. These reserves are calculated to be sufficient to meet policy        and contract obligations as they arise. Liabilities for future policy benefits are        calculated using assumptions for interest, mortality, morbidity, expense and withdrawals        determined at the time the policies were issued. As of December 31, 2007, the total        reserves of NSIC (including the reserves for accident and health insurance) were        approximately $28.5 million. We believe that such reserves for future policy benefits are        adequate to provide for future policy benefits.

 

The        property and casualty subsidiaries are also required to maintain loss reserves (claim        liabilities) for all lines of insurance. Such reserves are intended to cover the probable        ultimate cost of settling all claims, including those incurred but not yet reported. The        reserves of the property and casualty subsidiaries reflect estimates of the liability with        respect to incurred claims and are determined by evaluating reported claims on an ongoing        basis and by estimating liabilities for incurred but not reported claims. Such reserves        include adjustment expenses to cover the cost of investigating losses and defending        lawsuits. The establishment of accurate reserves is complicated by the fact that claims in        some lines of insurance are settled many years after the policies have been issued, thus        raising the possibility that inflation may have a significant effect on the amount of        ultimate loss payment, especially when compared to initial loss estimates. The        subsidiaries, however, attempt to restrict their writing to risks that settle within one to        four years of issuance of the policy. As of December 31, 2007, the property and casualty        subsidiaries had reserves for unpaid claims of approximately $12 million before subtracting        unpaid claims, due from reinsurers of $560 thousand leaving net unpaid claims of $11.5        million. The reserves are not discounted for the time value of money. No changes were made        in the assumptions used in estimating the reserves during the years ending December 31,        2007, 2006 or 2005. The Company believes such reserves are adequate to provide for        settlement of claims.

 

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We incur        the risk that we may experience excessive losses due to unanticipated claims frequency,        severity or both that may not be factored into our loss reserve liabilities. Unexpected        frequency and severity can be adversely impacted by outcomes of claims litigation; adverse        jury verdicts related to claims settlements and adverse interpretations of insurance policy        provisions which results in increased liabilities. We are also subject to the risk of        unanticipated assessments from state underwriting associations or windstorm pools related        to losses in excess of the associations or pool’s ability to pay. Such costs are        often allocated to companies operating in the jurisdiction of the association or windstorm        pool and the likelihood and amount of such assessments are difficult to predict. These        events could adversely impact our historical loss reserving methodology and cause financial        adjustments that could materially impact our financial condition and results of        operations.

 

*Financial Ratings*

 

The        insurance subsidiaries are rated by AM Best Company, an insurance company-rating agency.        NSFC is rated B++ (Good), Omega is rated B+ (Good) and NSIC is rated B (Fair) by AM Best        Company. A downgrade in our AM Best ratings could adversely impact our ability to maintain        existing business or generate new business.

 

*Regulation*

 

The        insurance subsidiaries are each subject to regulation by the insurance departments of those        states in which they are licensed to conduct business. Although the extent of regulation        varies from state to state, the insurance laws of the various states generally establish        supervisory departments having broad administrative powers with respect to, among other        matters: the granting and revocation of licenses to transact business, the licensing of        agents, the establishment of standards of financial solvency (including reserves to be        maintained), the nature of investments and in most cases premium rates, the approval of        forms and policies, and the form and content of financial statements. The primary purpose        of these regulations is the protection of policyholders. Compliance with regulations does        not necessarily confer a benefit upon shareholders.

 

Many        states, in which the insurance subsidiaries operate, including Alabama, have laws requiring        that insurers become members of guaranty associations. These associations guarantee that        benefits due policyholders of insurance companies will continue to be provided even if the        insurance company which wrote the business is financially unable to fulfill its        obligations. To provide these benefits, the associations assess the insurance companies        licensed in a state that write the line of insurance for which coverage is guaranteed. The        amount of an insurer’s assessment is generally based on the relationship between that        company’s premium volume in the state and the premium volume of all companies writing        the particular line of insurance in the state. The Company has paid no material amounts to        guaranty associations over the past three years. These payments, when made, are principally        related to association costs incurred due to the insolvency of various insurance companies.        Future assessments depend on the number and magnitude of insurance company insolvencies and        such assessments are therefore difficult to predict.

 

Most        states have enacted legislation or adopted administrative rules and regulations covering        such matters as the acquisition of control of insurance companies, transactions between        insurance companies and the persons controlling them. The National Association of Insurance        Commissioners has recommended model legislation on these subjects and all states where the        Company’s subsidiaries transact business have adopted, with some modifications, that        model legislation. Among the matters regulated by such statutes are the payments of        dividends. These regulations have a direct impact on the Company since its cash flow is        substantially derived from dividends from its subsidiaries. However, the Company has not        had nor does it foresee a problem obtaining the necessary funds to operate because of the        regulation. Statutory limitations of dividend payments by subsidiaries are disclosed in        Note 12 to the accompanying Consolidated Financial Statements.

 

While        most regulation is at the state level, the federal government has increasingly expressed an        interest in regulating aspects of the insurance industry. All of these regulations at        various levels of government increase the cost of conducting business through increased        compliance expenses. Also, existing regulations are constantly evolving through        administrative and court interpretations and new regulations are often adopted. It is        difficult to predict what impact changes in regulation may have on the Company in the        future. Changes in regulations could occur that might adversely impact our ability to        achieve acceptable levels of profitability and limit our growth.

 

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*Competition*

 

The        insurance subsidiaries are engaged in a highly competitive business and compete with many        insurance companies of substantially greater financial resources, including stock and        mutual insurance companies. Mutual insurance companies return profits, if any, to        policyholders rather than shareholders; therefore, mutual insurance companies may be able        to charge lower net premiums than those charged by stock insurers. Accordingly, stock        insurers must attempt to achieve competitive premium rates through greater volume,        efficiency of operations and control of expenses.

 

NSIC        primarily markets its life and health insurance products through the home service system        and independent producers. Direct competition comes from home service companies and other        insurance companies that utilize independent producers to sell insurance products, of which        there are many. NSIC’s life and health products also compete with products sold by        ordinary life companies. NSIC writes policies primarily in Alabama, Georgia and        Mississippi. The market share of the total life and health premiums written is small        because of the number of insurers in this highly competitive field. The primary methods of        competition in the field are service and price.

 

Because        of the increased costs associated with a home service company, premium rates are generally        higher than ordinary products, as a result competition from these ordinary insurers must be        met through service. Initial costs of distribution through independent agents are generally        more than through home service distribution methods, but lower commissions are paid in        years subsequent to the first year of the policy so costs decline rapidly as policies renew        after the first year. The primary factor in controlling cost under the independent agent        distribution method is maintaining a high persistency rate. The persistency rate is the        rate at which new business is maintained in renewal periods subsequent to the first year.        If a high persistency rate can be maintained, the overall costs of distribution are lowered        due to lower commission rate payments on policies in force subsequent to the first        year.

 

The        property and casualty subsidiaries market their products through independent agents and        brokers, concentrating primarily on dwelling fire, homeowners and nonstandard auto        coverage. NSFC, though one of the larger writers of lower value dwelling fire insurance in        Alabama, nevertheless faces a number of competitors in this niche. Moreover, larger general        line insurers also compete with NSFC. The market share in states other than Alabama is        small. Price is the primary method of competition. Because the Company utilizes independent        agents, commission rates and service to the agent are also important factors in whether the        independent agent agrees to offer NSFC products over those of its competitors.

 

Significant changes in the competitive environment in which we operate could        materially impact our financial condition or results of operations.

 

*Inflation*

 

The        Company shares the same risks from inflation as other companies. Inflation causes operating        expenses to increase and erodes the purchasing power of the Company’s assets. A large        portion of the Company’s assets is invested in fixed maturity investments. The        purchasing power of these investments will be less at maturity because of inflation. This        is generally offset by the reserves that are a fixed liability and will be paid with        cheaper dollars. Also, inflation tends to increase investment yields, which may reduce the        impact of the increased operating expenses caused by inflation.

 

*Investment Risk and Liquidity*

 

Our        invested assets are managed by company personnel. The majority of these investments consist        of fixed maturity securities. These securities are subject to price fluctuations due to        changes in interest rates and unfavorable changes could materially reduce the market value        of the Company’s investment portfolio and adversely impact our financial condition        and results of operations. Fixed maturity investments are managed in light of anticipated        liquidity needs. Should we experience a significant change in liquidity needs for any        reason, we may be forced to sell fixed maturity securities at a loss to cover these        liquidity needs. Changes in general economic conditions, the stock market and various other        external factors could also adversely impact the value of our investments and consequently        our results of operations and financial condition.

 

16

 

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*Dependence of the Company on Dividends from Insurance        Subsidiaries*

 

The        Company is an insurance holding company with no significant operations. The primary asset        of the Company is its stock in the insurance subsidiaries. The Company relies on dividends        from the insurance subsidiaries in order to pay operating expenses and to provide liquidity        for the payment of dividends to shareholders. The ability of the insurance subsidiaries to        pay dividends is subject to regulatory restrictions discussed in detail in note 12 of the        consolidated financial statements included herein. Should the insurance subsidiaries become        subject to restrictions imposed by insurance regulations regarding the payment of        dividends, the ability of the Company to pay expenses, meet debt service requirements and        pay cash dividends to shareholders could be adversely impacted.

 

*Technology*

 

Our        insurance subsidiaries are dependent on computer technology and internet based platforms in        the delivery of insurance products. Our ability to innovate and manage technological change        is a key to remaining competitive in the insurance industry. A breakdown in major systems        or failure to maintain up to date technology could adversely impact our ability to write        new business and service existing policyholders which would adversely impact our results of        operations and financial condition.

 

*Key        Personnel*

 

As a        small company within the insurance industry, we could be adversely impacted by the loss of        key personnel. Our ability to remain competitive is contingent upon our ability to attract        and retain qualified personnel in all aspects of our operations.

 

*Accounting Standards*

 

Our        financial statements are prepared based upon generally accepted accounting standards issued        by the Financial Accounting Standards Board along with standards set by other regulatory        organizations. We are required to adopt newly issued or revised accounting standards that        are issued periodically. Future changes could impact accounting treatment applied to        financial statements and could have a material adverse impact on the Company’s        results of operations and financial conditions. Potential changes in accounting standards        that are currently expected to impact the Company are disclosed in the Notes to Financial        Statements included herein.

 

**Item 1B. Unresolved Staff Comments**

 

None

 

**Item 2. Properties**

 

Our        principal executive offices, owned by NSIC, are located at 661 East Davis Street, Elba,        Alabama. The executive offices are shared by the insurance subsidiaries. The building was        constructed in 1977 and is approximately 30,700 square feet. The Company completed a major        expansion and renovation project in early 2008, adding an additional 4,684 square feet and        renovating 3,017 square feet of the existing structure. The Company believes this space to        be adequate for its immediate needs.

 

The        Company’s subsidiaries own certain real estate properties, including approximately        2,700 acres of timberland in Alabama.

 

**Item 3. Legal Proceedings**

 

The        Company and its subsidiaries are named as parties to litigation related to the conduct of        their insurance operations. Further information regarding details of pending suits can be        found in Note 15 to the consolidated financial statements.

 

**Item 4. Submission of Matters to a Vote of Security        Holders**

 

There        were no matters submitted to a vote of security holders during the three months ended        December 31, 2007.

 

 

 

 

17

 

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**PART II**

 

**Item        5. Market for Registrant’s Common Equity and Related Stockholder Matters and Issuer        Purchases of Equity Securities**

 

The        capital stock of the Company is traded in the NASDAQ Global Market. Quotations are        furnished by the National Association of Security Dealers Automated Quotations System        (NASDAQ). The trade symbol is NSEC.

 

The        following table sets forth the high and low sales prices per share, as reported by NASDAQ        during the period indicated:

 

 

|           |   | Stock Closing Prices |
|----------------|--------|----------------------|
|           |   | High                 |   | Low |
| 2007           |   |                 |   |   |
| First Quarter  | $      | 18.25                | $ | 16.75 |
| Second Quarter |   | 19.87                |   | 17.31 |
| Third Quarter  |   | 19.00                |   | 15.76 |
| Fourth Quarter |   | 18.72                |   | 16.68 |
|           |   |                 |   |   |
| 2006           |   |                 |   |   |
| First Quarter  | $      | 18.25                | $ | 15.70 |
| Second Quarter |   | 18.11                |   | 15.77 |
| Third Quarter  |   | 17.90                |   | 15.40 |
| Fourth Quarter |   | 17.47                |   | 15.64 |

 

 

**Shareholders**

The        number of shareholders of the Company’s capital stock as of January 31, 2008, was        approximately 1,400.

 

**Dividends**

The        following table sets forth quarterly dividend payment information for the Company for the        periods indicated:

 

 

 

|           | Dividends |
|----------------|-----------|
|           | Per Share |
| 2007           |      |
| First Quarter  | 0.225     |
| Second Quarter | 0.225     |
| Third Quarter  | 0.225     |
| Fourth Quarter | 0.225     |
|           |      |
| 2006           |      |
| First Quarter  | 0.220     |
| Second Quarter | 0.220     |
| Third Quarter  | 0.220     |
| Fourth Quarter | 0.225     |

 

 

 

Discussion regarding dividend restrictions may be found on page 32 of the        Managements’ Discussion and Analysis as well as in Note 12 of the consolidated        financial statements.

 

The        payment of shareholder dividends is subject to the discretion of our Board of Directors and        is dependent upon many factors including our operating results, financial condition,        capital requirements and general economic conditions. Total shareholder dividends paid in        2007 totaled $2,220,000 which was primarily funded by the insurance subsidiaries. Dividends        from the insurance subsidiaries are subject to approval of the regulator in the state of        domicile, the Alabama Department of Insurance.

 

There is        a present expectation that dividends will continue to be paid in the future but future        dividends are dependent on future earnings, the Company’s financial condition and        other factors evaluated periodically by management and the Board of Directors.

 

 

18

 

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**Item        6. Selected Financial Data**

 

Five-Year Financial Information:

 

| (Amounts in thousands, except per share) |
|------------------------------------------|

 

| Operating results             |   | 2007   |   | 2006   |   | 2005   |   | 2004   |   | 2003   |
|-------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
|                          |   |   |   |   |   |   |   |   |   |   |
| Net premiums earned           | $      | 62,250 | $      | 58,874 | $      | 53,563 | $      | 52,985 | $      | 47,536 |
| Net investment income         |   | 4,749  |   | 4,463  |   | 3,964  |   | 4,230  |   | 4,023  |
| Net realized investment gains |   | 1,493  |   | 2,565  |   | 3,493  |   | 2,162  |   | 1,416  |
| Other income                  |   | 1,071  |   | 1,211  |   | 1,416  |   | 1,312  |   | 1,395  |
| Total revenues                | $      | 69,563 | $      | 67,113 | $      | 62,436 | $      | 60,689 | $      | 54,370 |
| Net Income                    | $      | 6,040  | $      | 4,250  | $      | 1,558  | $      | 3,113  | $      | 4,090  |
| Net income per share          | $      | 2.45   | $      | 1.72   | $      | 0.63   | $      | 1.26   | $      | 1.66   |

 

 

 

 

 

 

 

 

 

 

 

 

| Other Selected Financial Data    |   | 2007    |   | 2006    |   | 2005    |   | 2004    |   | 2003    |
|----------------------------------|--------|---------|--------|---------|--------|---------|--------|---------|--------|---------|
| Total shareholders’ equity | $      | 48,447  | $      | 45,379  | $      | 43,556  | $      | 46,676  | $      | 45,872  |
| Book value per share             | $      | 19.64   | $      | 18.39   | $      | 17.66   | $      | 18.92   | $      | 18.60   |
| Dividends per share              | $      | 0.900   | $      | 0.885   | $      | 0.865   | $      | 0.845   | $      | 0.825   |
| Net change in unrealized         |   |    |   |    |   |    |   |    |   |    |
| capital gains (net of tax)       | $      | (664)   | $      | (244)   | $      | (2,544) | $      | (225)   | $      | 1,658   |
| Total assets                     | $      | 135,585 | $      | 134,911 | $      | 139,226 | $      | 128,631 | $      | 127,236 |

 

 

 

 

 

 

 

 

 

Quarterly information:

 

|    | Premiums |        | Investment & Other Income |        | Realized Investment Gains or Losses |        | Benefits |   | Net Income (Loss) |   | Net Income (Loss) Per Share |
|---------|----------|--------|-------------------------------|--------|-------------------------------------|--------|----------|--------|-------------------|--------|-----------------------------|
| 2007    |     |   |                          |   |                                |   |     |   |              |   |                        |   |
| 1st QTR | $        | 15,557 | $                             | 1,514  | $                                   | 206    | $        | 9,208  | $                 | 1,183  | $                           | 0.48 |
| 2nd QTR |     | 14,892 |                          | 1,458  |                                | 327    |     | 10,124 |              | 1,800  |                        | 0.73 |
| 3rd QTR |     | 15,913 |                          | 1,477  |                                | (4)    |     | 8,927  |              | 1,505  |                        | 0.61 |
| 4th QTR |     | 15,888 |                          | 1,371  |                                | 964    |     | 9,419  |              | 1,552  |                        | 0.63 |
|    | $        | 62,250 | $                             | 5,820  | $                                   | 1,493  | $        | 37,678 | $                 | 6,040  | $                           | 2.45 |
|    |     |   |                          |   |                                |   |     |   |              |   |                        |   |
|    |     |   |                          |   |                                |   |     |   |              |   |                        |   |
| 2006    |     |   |                          |   |                                |   |     |   |              |   |                        |   |
| 1st QTR | $        | 14,491 | $                             | 1,492  | $                                   | 560    | $        | 10,680 | $                 | (141)  | $                           | (0.06) |
| 2nd QTR |     | 14,755 |                          | 1,347  |                                | 540    |     | 9,566  |              | 970    |                        | 0.39 |
| 3rd QTR |     | 15,297 |                          | 1,452  |                                | 770    |     | 9,026  |              | 1,836  |                        | 0.74 |
| 4th QTR |     | 14,331 |                          | 1,383  |                                | 695    |     | 8,724  |              | 1,585  |                        | 0.65 |
|    | $        | 58,874 | $                             | 5,674  | $                                   | 2,565  | $        | 37,996 | $                 | 4,250  | $                           | 1.72 |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

19

 

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**Item        7. Management’s Discussion and Analysis of Financial Condition and Results of        Operations**

 

OVERVIEW

 

The        following discussion highlights significant factors influencing the consolidated financial        position and results of operations of The National Security Group, Inc. (referred to in        this document as we, our, us, the Company or NSG) and its subsidiaries for the three years        ended December 31, 2007. This discussion and analysis of the consolidated results of        operations and financial condition of the Company should be read in conjunction with the        Selected Financial Data and Consolidated Financial Statements and related notes included        elsewhere herein. Please refer to our note regarding forward-looking statements on page 3        of this report.

 

Financial results for the year 2007 marked the second consecutive year of        considerable improvement. Results for 2005 were marred by losses incurred from Hurricanes        Dennis, Katrina and Rita. Two primary major factors contributed to our improved results in        2007. First, our property and casualty insurance operations continued to improve as the        year was, for the most part, free of significant storm activity other than some early        spring tornadoes. Second, we realized a one time gain on the disposition of the majority of        our interest in a 50% owned subsidiary, The Mobile Attic, Inc. in April of 2007. Through        this transaction, we posted a gain on disposal of $1.5 million pushing our consolidated net        income to a record $6.04 million easily topping 2006 results.

 

We also        continued to restore capital and build assets lost during the 2004 and 2005 hurricane        seasons. We ended the year with shareholders’ equity of $48.45 million which pushed        us past pre-hurricane levels last seen in mid-2004. Invested assets increased $3 million        due to positive cash flows of $3.8 million from our insurance operations.

 

**RESULTSOFOPERATIONS**

 

The        following analysis of the Results of Operations should be read in conjunction with the        Consolidated Financial Statements, which begin on Page 37 of this Form 10-K. Primary        reference is made to the Consolidated Statements of Income on page 41 and related Notes to        Consolidated Financial Statements which begin on Page 44.

 

*Consolidated Results of Operations:*

**Year        Ended December 31, 2007 Compared to Year Ended December 31, 2006**

We        reached another milestone in premium revenue in 2007 posting a seventh consecutive year of        record premium revenue, an increase of 5.7% over 2006 levels. Growth in the dwelling fire        and homeowners lines of business in the property and casualty subsidiaries were the primary        contributors to the growth in premium revenue. While the rate of growth is significantly        below our 15% annualized growth rate experienced since 2000, the reduction of our growth        rate has been necessitated by market conditions. As discussed last year, the more moderate        growth rate is in-line with our expectations and is expected to persist over the next two        years as we continue to build capital and recover from the adverse operating conditions        caused by the unprecedented hurricane activity experienced in 2005 and 2004.

 

Consolidated income before taxes increased 10.15% from $6,254,000 in 2006 to        $6,889,000 in 2007. Just as in 2006, increased earnings in the property and casualty        subsidiary were the primary contributor to the increase in earnings for 2007. Life segment        operations had modest income before taxes in 2007 of $108,000, compared to a net loss        before taxes in 2006 of $(1,122,000). The improvement in life segment operations is        primarily due to the 2006 settlement of longstanding litigation. Non-insurance operations        consist of the operations of The National Security Group, Inc.

 

Net        income for the year increased 42.12% to $6,040,000, or $2.45 per share, compared with net        income of 4,250,000, or $1.72 per share for 2006. Net income from continuing operations was        $4,721,000 compared to $4,439,000 in 2006, an increase of 6.35%. Again, increased earnings        in the property and casualty subsidiaries were the primary contributor to the increase in        net income from continuing operations. A decline in realized investment gains from        $2,565,000 in 2006 to $1,493,000 in 2007 was primarily due to fewer disposals in the equity        investment portfolio of the company. The decline in realized capital gains was offset by        net income from discontinued operations of $1,319,000 which consisted of a gain on disposal        of the majority of a 50% investment in Mobile Attic, Inc. in the second quarter of 2007.        The Company maintained a 5% interest in Mobile Attic at 12/31/2007.

 

20

 

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**Year        Ended December 31, 2006 Compared to Year Ended December 31, 2005**

 

The year        2006 marked the sixth consecutive year of record premium revenue for the Company. Our        premium revenue for 2006 increased 9.9% over levels achieved in 2005. However, premium        revenue in 2005 was reduced by catastrophe reinsurance reinstatement premium totaling        $2,400,000 as a result of reinstatement provisions of our catastrophe reinsurance contract        triggered by Hurricane Katrina. We did not incur any hurricane losses in 2006 and therefore        incurred no reduction in earned premium due to charges for catastrophe reinstatement        premium. Without the impact of the reduction in 2005 premium revenue for catastrophe        reinstatement premium, year over year premium revenue increased by 5.2%.

 

Consolidated income before income taxes increased 212% from $2,002,000 in        2005 to $6,254,000 in 2006. A significant improvement in our property-casualty segment        operations due to the lack of hurricane activity was the primary factor contributing to the        improved consolidated results. Life segment operations incurred a net loss before taxes in        2006 of $(658,000), significantly higher than the loss incurred in 2005 of $(297,000).        Upward revisions in a litigation settlement adversely impacted life operations for both        years. However, the longstanding litigation was settled in 2006.

 

Consolidated net income for 2006 was $4,250,000 compared to $1,558,000 in        2005. On a per share basis, net income was $1.72 in 2006 compared to $0.63 in 2005.        Hurricane losses reduced our 2005 net income by $6,804,000 or $2.76 per share. Despite the        lack of hurricane activity in 2006, we still incurred losses from catastrophic events in        the form of tornado and hail losses that totaled $1,386,000 net of tax and reduced 2006 net        income by $0.56 per share. These tornado and hail losses were incurred during the January        through April time period of 2006. Partially offsetting 2005 hurricane losses, we realized        investment gains of $3,493,000 resulting from the sale of investment securities. Realized        investment gains in 2006 totaled $2,565,000, down 27% compared to 2005. Our decisions to        sell securities and therefore realize investment gains on our investments is dictated by        considerations of market conditions, short term liquidity needs and tax implications, among        other factors, and are subject to significant fluctuation from period to period.

 

*Industry Segment Data*

 

Certain        financial information for The National Security Group’s three segments (Life segment,        property and casualty segment, and other non-insurance) is summarized as follows (amounts        in thousands) :

 

| Premium revenues:                   |   |   |   |    |   |   |   |    |   |   |   |    |
|-------------------------------------|--------|--------|--------|---------|--------|--------|--------|---------|--------|--------|--------|---------|
|                                |   | 2007   |   | %       |   | 2006   |   | %       |   | 2005   |   | %       |
| Life, accident and health insurance | $      | 7,031  |   | 11.29%  | $      | 6,550  |   | 11.13%  | $      | 6,234  |   | 11.64%  |
| Property and casualty insurance     |   | 55,219 |   | 88.71%  |   | 52,324 |   | 88.87%  |   | 47,329 |   | 88.36%  |
|                                | $      | 62,250 |   | 100.00% | $      | 58,874 |   | 100.00% | $      | 53,563 |   | 100.00% |

 

 

 

21

 

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***Life        and Accident and Health Insurance Operations:***

 

The        Company’s life, accident and health insurance business is conducted through National        Security Insurance Company (NSIC), a wholly owned subsidiary of the Company organized in        1947. Our life segment is the smaller of our insurance segments contributing 11% of total        insurance premium revenue for both 2007 and 2006. Premium revenues and operating income for        the life segment for the years ended December 31, 2007, 2006 and 2005 are summarized        below:

 

 

|                                                                    |                                              |   | **2007** |   | **2006** |   | **2005** |
|-------------------------------------------------------------------------|---------------------------------------------------|--------|----------|--------|----------|--------|----------|
| **REVENUE**                                                             |                                              |   |     |   |     |   |
|                                                                    | Net premiums earned                               | $      | 7,031    | $      | 6,550    | $      | 6,234    |
|                                                                    | Net investment income                             |   | 1,796    |   | 1,785    |   | 1,619    |
|                                                                    | Net realized investment gains                     |   | 143      |   | 582      |   | 215      |
|                                                                    | Other income                                      |   | 6        |   | 2        |   | 52       |
|                                                                    |                                              |   | 8,976    |   | 8,919    |   | 8,120    |
|                                                                    |                                              |   |     |   |     |   |     |
| **BENEFITS AND EXPENSES**                                               |                                              |   |     |   |     |   |
|                                                                    | Policyholder benefits paid or provided            |   | 5,489    |   | 5,535    |   | 3,904    |
|                                                                    | Amortization of deferred policy acquisition costs |   | (715)    |   | (500)    |   | 448      |
|                                                                    | Commissions                                       |   | 1,565    |   | 1,418    |   | 1,384    |
|                                                                    | General and administrative expenses               |   | 2,168    |   | 3,217    |   | 2,283    |
|                                                                    | Insurance taxes, licenses and fees                |   | 293      |   | 288      |   | 372      |
|                                                                    | Interest expense                                  |   | 68       |   | 83       |   | 114      |
|                                                                    |                                              |   | 8,868    |   | 10,041   |   | 8,505    |
|                                                                    |                                              |   |     |   |     |   |     |
| **Income Before Income Taxes and Minority                    Interest** | 108                                               |   | (1,122)  |   | (385)    |
|                                                                    |                                              |   |     |   |     |   |     |
| **INCOME TAX EXPENSE (BENEFIT)**                                        |                                              |   |     |   |     |   |
|                                                                    | Current                                           |   | 734      |   | (332)    |   | (228)    |
|                                                                    | Deferred                                          |   | (603)    |   | (132)    |   | 140      |
|                                                                    |                                              |   | 131      |   | (464)    |   | (88)     |
|                                                                    |                                              |   |     |   |     |   |     |
| **Income From Continuing Operations**                                   |                                              | (23)   |     | (658)  |     | (297)  |
| **Net Income from Discontinued Operations**                             | -                                                 |   | -        |   | -        |
|                                                                    |                                              |   |     |   |     |   |     |
| **NET INCOME**                                                          | $                                                 | (23)   | $        | (658)  | $        | (297)  |

 

 

**Year        Ended December 31, 2007 Compared to Year Ended December 31, 2006:**

 

Premium        revenue in the life and accident and health segment totaled $7,031,000 in 2007 compared to        $6,550,000 in 2006, an increase of over 7%. Continued growth in the independent agent        method of distribution was the primary contributing factor with an increase in premium        revenue just under 15%. The growth in the independent agent distribution method helped        offset the moderate decrease in premium revenue of 3% in the traditional home service        method of distribution.

 

While        the overall rate of premium revenue growth in the life segment has moderated, the quality        of business has continued to improve. The lapse rate is a measure of the percentage of        business in force that is cancelled during the year due to non-payment of premium or        surrender for cash value by the policyholder. In our traditional home service market, the        lapse rate has often approached 50%; however, with the shift to the independent agent        method of distribution we have experienced significant improvement in our lapse rate. The        lapse rate for 2007 was 14.9% a significant improvement over our lapse rate in 2006 of        19.6%. Our lapse rates will generally be higher than the insurance market as a whole        because our products are primarily intended for low to middle income consumers that may        face other economic pressures from time to time. With decreases in disposable income during        economic downturns, often life and supplemental health insurance products are among the        first items to be trimmed from household budgets. Also, lapse rates are significantly        higher in the first year after an insurance policy is sold to a consumer. We remain        cautious about our ability to continue to show improvement in our lapse rate as the current        economic downturn we are experiencing could adversely impact our ability to retain        business.

 

 

22

 

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NSIC        posted a net loss of $23,000 in 2007 compared to a net loss of $658,000 in 2006. Increased        charges associated with a litigation settlement were the primary factor contributing to the        higher net loss in 2006. Results for 2007 were adversely impacted by higher claims        settlements with approximately $300,000 associated with a program discontinued in early        2007 and another $250,000 associated with final charges associated with the litigation        settlement reached during 2006.

 

**Year        Ended December 31, 2006 Compared to Year Ended December 31, 2005:**

 

Premium        revenue increased 5% to $6,550,000 in 2006 compared to $6,234,000 in 2005. Insurance        products sold through independent agents now account for 50% of total premium revenue,        while the home service method of distribution accounts for 41% of total premium revenue.        Premium revenue through the independent agent distribution method continues to grow at a        healthy pace, with revenue increasing 15% in 2006 compared to 2005. Home service premium        revenue has continued its consistent rate of decline, dropping 5.3% in 2006 compared to        2005.

 

The        lapse rate for 2006 was 19.6% a marginal improvement over our lapse rate in 2005 of 20.4%.        As was discussed last year, during 2005 we became more selective in the appointment of new        agents and terminated agreements with agents that produced little new business or had very        high lapse rates. We believe these efforts are beginning to show results as our lapse rate        continues to improve.

 

Commission expense, including field servicing cost from the home service        method of distribution, as a percent of premium revenue had a moderate decrease of 0.6% in        2006 compared to 2005. Independent agent commission expense and other costs of distribution        declined 4.9 percentage points in 2006 compared to 2005. Life insurance commission rates        for independent agents are typically front loaded. This means that higher commissions are        paid in the early years of a policy and commission rates decline as the policy ages.        Because the independent agent method of distribution is a relatively new method of        distribution, overall commission rates are skewed higher because the majority of in force        policies are still paying the higher commission rates of the early years. Management is        continuing to focus on reducing commissions through improving the rate of retention of new        and existing business.

 

NSIC        incurred a net loss of $(658,000) in 2006 compared to a net loss of $(297,000) in 2005.        Litigation expenses totaling over $1.1 million and $375,000 in 2006 and 2005 respectively        were the primary factors contributing to the poor results. The litigation related expenses        are primarily related to a longstanding class action lawsuit that was settled in 2006. Due        to the nature of this litigation, it was difficult to predict the ultimate outcome over the        last five years and consequently, we have experienced several upward revisions in our        estimates.

 

 

 

 

 

 

 

 

 

 

 

23

 

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***Property & Casualty Operations:***

 

The        Company’s property and casualty insurance business is conducted through National        Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company        organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of        National Security Fire & Casualty Company organized in 1992. Property and casualty        operations constitute our largest segment composing 89% of our total premium revenue in        2007 and 2006. Premium revenues and operating income for the life segment for the years        ended December 31, 2007, 2006 and 2005 are summarized below:

 

|                                                                    |                                              |   | **2007** |   | **2006** |   | **2005** |
|-------------------------------------------------------------------------|---------------------------------------------------|--------|----------|--------|----------|--------|----------|
| **REVENUE**                                                             |                                              |   |     |   |     |   |
|                                                                    | Net premiums earned                               | $      | 55,219   | $      | 52,324   | $      | 47,329   |
|                                                                    | Net investment income                             |   | 2,823    |   | 2,591    |   | 2,323    |
|                                                                    | Net realized investment gains                     |   | 1,350    |   | 1,983    |   | 3,278    |
|                                                                    | Other income                                      |   | 1,065    |   | 1,208    |   | 1,364    |
|                                                                    |                                              |   | 60,457   |   | 58,106   |   | 54,294   |
|                                                                    |                                              |   |     |   |     |   |     |
| **BENEFITS AND EXPENSES**                                               |                                              |   |     |   |     |   |
|                                                                    | Policyholder benefits paid or provided            |   | 32,189   |   | 32,461   |   | 34,337   |
|                                                                    | Amortization of deferred policy acquisition costs |   | 3,274    |   | 2,478    |   | 2,256    |
|                                                                    | Commissions                                       |   | 7,788    |   | 7,503    |   | 7,603    |
|                                                                    | General and administrative expenses               |   | 6,580    |   | 5,625    |   | 5,525    |
|                                                                    | Insurance taxes, licenses and fees                |   | 2,032    |   | 1,441    |   | 1,871    |
|                                                                    | Interest expense                                  |   | -        |   | -        |   | 15       |
|                                                                    |                                              |   | 51,863   |   | 49,508   |   | 51,607   |
|                                                                    |                                              |   |     |   |     |   |     |
| **Income Before Income Taxes and Minority                    Interest** | 8,594                                             |   | 8,598    |   | 2,687    |
|                                                                    |                                              |   |     |   |     |   |     |
| **INCOME TAX EXPENSE (BENEFIT)**                                        |                                              |   |     |   |     |   |
|                                                                    | Current                                           |   | 1,718    |   | 2,623    |   | 571      |
|                                                                    | Deferred                                          |   | 869      |   | 130      |   | (6)      |
|                                                                    |                                              |   | 2,587    |   | 2,753    |   | 565      |
|                                                                    |                                              |   |     |   |     |   |     |
| **Income From Continuing Operations**                                   |                                              | 6,007  |     | 5,845  |     | 2,122  |
| **Net Income from Discontinued Operations**                             | -                                                 |   | -        |   | -        |
|                                                                    |                                              |   |     |   |     |   |     |
| **NET INCOME**                                                          | $                                                 | 6,007  | $        | 5,845  | $        | 2,122  |

 

 

**Year        Ended December 31, 2007 Compared to Year Ended December 31, 2006:**

 

Property        and casualty premium revenues totaled $55,219,000 in 2007 compared to $52,324,000 in 2006,        an increase of 5.5%.

 

A        primary focus in 2007 was working toward improving profitability in all dwelling property        lines. The mobile homeowners program showed significant improvement from an underwriting        loss of $(237,063) in 2006 to an underwriting income of $583,760 in 2007. The dwelling fire        program ended 2007 with underwriting income up almost 60% compared to the same period last        year. In addition, the ocean marine program made a significant turnaround ending 2007 with        an underwriting income of $371,538 compared to a loss from underwriting of $(393,434) in        2006.

 

NSFC        ended 2006 with four dwelling lines operating with an underwriting loss. During 2007 the        company focused on rate adjustments where needed as well as an in-depth analysis of        profitability by product which decreased the number of programs with underwriting losses        from four in 2006 to two in 2007. The two programs experiencing underwriting losses were        the limited homeowners program and the St. Louis taxicab program. The limited homeowners        program and taxicab program ended 2007 with underwriting losses of $(2,238,721) and        $(261,769), respectively compared to $(2,234,888) and $(72,707), respectively for the same        period last year. A primary reason for the significant losses in the limited homeowners        program was a high frequency of fire related losses. The taxicab program settled several        large litigation claims which negatively impacted the results for this line of business. A        primary focus in 2008 will be working toward improving results in the        limited homeowners line of business as well as continued profitability in the other lines        of business.

 

24

 

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Due to        the unprecedented hurricane activity in 2004 and 2005, we have experienced a significant        increase in the cost of our catastrophe reinsurance over the last three years. Our        catastrophe reinsurance rate increased 12.8% from 2006 to 2007. In order to minimize the        impact of the rate increase, we increased our reinsurance deductible by 50% to $3 million        in 2006 and 16.7% to $3.5 million in 2007. We also added an additional layer of reinsurance        protection during 2007 which increased our coverage from an ultimate loss payout of $42.5        million to $47.5 million. Reinsurance rates are not subject to review by state insurance        regulators and are more market driven allowing reinsurers to react more rapidly to changing        market conditions. Consequently, we incur significant lag time between the time we incur an        increase in our cost of reinsurance and the time we are able to reflect these increased        costs in our rates. Our rates are subject to review and approval by state regulators and        consequently we often experience significant delays in our ability to adjust rates. These        delays result in lag times of at least six months and can last up to 18 months. Also, we        have experienced political climates in some states that make it difficult for us to factor        in the full impact of our increased cost of claims and reinsurance especially in many        coastal areas of the Southeast US. However, we made significant progress in adjusting our        rates in 2007 and experienced some moderation in our catastrophe reinsurance rates for        2008, so we expect a more favorable pricing environment in 2008 particularly in our        homeowners program which has significantly underperformed.

 

Several        of the property and casualty programs showed improved results with a decline in the loss        ratio. The core line of business is the dwelling fire program which ended 2007 with a loss        ratio of 56.2% compared to 59.5% for the same period last year. Additional noteworthy        programs were the mobile homeowners and ocean marine lines of business which ended 2007        with loss ratios of 55.6% and 31%, respectively compared to 70% and 91.5%, respectively for        2006.

 

We        routinely evaluate our claims frequency and severity statistics in order to better        understand the nature of our risks and aid in the loss reserve liability evaluation        process. Claims frequency is a measure of the number of claims incurred during a        measurement period regardless of amount. Claims severity is a measure of the average dollar        amount of claims during a measurement period.

 

Throughout 2007, the frequency of claims declined as compared to 2006        however the severity of claims increased. During 2007, the company incurred 5,633 dwelling        and homeowner claims compared to 6,469 for the same period last year; a decrease of 836        claims. Gross claims for 2007 totaled $28,662,000 which was $1,021,000 more than 2006. The        severity of claims increased from an average claim payment of $4,272 in 2006 to $5,088 in        2007 primarily due to an increase in larger fire losses.

 

Due to        the increased cost of litigation associated with Hurricane Katrina claims in the states of        Louisiana and Mississippi, we continued to incur adverse claims development associated with        this storm. At December 31, 2007 our total projected (paid and unpaid) claims associated        with Katrina were expected to exceed our available catastrophe reinsurance protection by        approximately $300,000. The total remaining open claims total less than one tenth of 1% of        the total claims reported during Hurricane Katrina. These remaining open claims (less than        100 claims) are in various stages of litigation. While we believe current reserves are        adequate to cover remaining costs associated with settlement of these claims, due to the        uncertainty of the litigation environment related to Hurricane Katrina claims we can not be        certain that we will not have any additional adverse development.

 

Property        and casualty income before income taxes was $8,594,000 for 2007 compared to $8,598,000 in        2006. Our combined ratio for 2007 was 94.2% compared to 95.7% in 2006. The combined ratio        for 2007 of 94.2% included catastrophe related tornado and hail storm losses totaling over        $921,000 and adding 1.7% to our combined ratio. The primary reason for the reduction in the        combined ratio was a decline in catastrophe related losses. In 2006 catastrophe related        tornado and hail storm losses totaled $1,386,000.

 

 

25

 

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**Year        Ended December 31, 2006 Compared to Year Ended December 31, 2005:**

 

Property        and casualty premium revenues totaled $52,324,000 in 2006 compared to $47,329,000 in 2005,        an increase of 10.6%. Catastrophe reinstatement premium charges totaling $2,400,000 reduced        2005 premium revenue by five percentage points. We did not experience any losses that        exceeded our catastrophe reinsurance retention limit of $3,000,000 per event in 2006, so no        catastrophe reinstatement premium charges were incurred in 2006. Without the reinstatement        premium charge in 2005, premium revenue in 2006 increased 5.2% over 2005.

 

Overall        premium revenue growth has moderated significantly over the past two years, compared to our        17% compound annual growth rate experienced since 2000. We expect the trend of more        moderate growth to continue in 2007 as we focus on improvement in profitability of all        lines of business, institute rate increases dictated by the significant increase in our        catastrophe reinsurance protection and rebuild capital levels after the adverse impact of        the 2004 and 2005 hurricane seasons.

 

While        the lack of hurricane activity in the Gulf of Mexico and Atlantic Coast were the primary        drivers of our improved operating performance, we still incurred significant losses in our        two primary lines of business. Our dwelling and homeowners lines of business incurred $2.0        million in tornado and hail storm related losses in the first half of 2006 ($1,386,000 net        of tax). These events increased our combined ratio for the year by four percentage points.        However, these amounts were within our expectations of losses to be incurred in a more        normal year and losses from catastrophe related events were down significantly compared to        2005 and 2004.

 

The        primary line of business in which we are continuing to adjust rates in order to improve        profitability is our homeowners line of business. This line of business composes 23% of our        total property and casualty premium revenue. The line of business has not performed to our        expectations with a combined ratio of 112% in 2006.

 

Our core        dwelling fire line of business produced solid results in 2006 with a combined ratio of 93%.        The dwelling fire line of business produces 41% of total property and casualty premium        revenue and is our largest contributor to underwriting profits.

 

Claims        frequency decreased significantly in 2006 compared to 2005. In 2006, we incurred 6,500        claims compared to over 15,800 claims in 2005. Claims frequency in 2005 was higher due to        8,450, 1,600 and 500 claims from Hurricanes Katrina, Rita and Dennis. Non-hurricane related        claims in 2005 totaled 5,250. The increase in claims, not counting hurricanes, from 2005 to        2006 is primarily related to early season hail storm and tornado losses experienced in the        first half of 2006. Hail storms significantly increase frequency but usually carry a        relatively low severity while tornado claims carry a lower frequency than hurricanes but        usually carry a higher average severity than hurricanes.

 

While        the overall frequency of claims declined significantly in 2006 compared to 2005, the more        severe spring storm season resulted in a higher frequency of tornado losses elevating the        average severity of claims in the dwelling fire and homeowners line of business. The        average severity for 2006 was $4,272 per claim compared to $4,086 per claim in 2005. Again,        the increase is primarily attributable to the increased tornado related losses in the first        half of 2006 compared to 2005.

 

While        this event had no material impact on our earnings, we did incur an additional assessment        from the Mississippi Windstorm Underwriting Association (MWUA) in 2006 totaling over        $6,200,000. This assessment was in addition to assessments totaling over $3,000,000 paid in        2005. This assessment was for additional losses incurred by MWUA from Hurricane Katrina in        2005. MWUA is a form of residual market or pooling arrangement that provides coverage to        those that are unable to find private insurers willing to insure them. All licensed        property and casualty insurers writing applicable coverage are required to participate in        these pooling entities. Should the pooling entity incur losses in excess of its ability to        pay, the industry participants in the respective states are assessed for the excess losses.        Due to the extensive growth and development in the coastal regions of the Gulf of Mexico        over the last decade, many of the pools in the states in which we operate, particularly        Alabama and Mississippi, have experienced extensive growth. Fortunately, in the case of the        MWUA assessment we had adequate reinsurance protection in place and this assessment was        covered 100% by our catastrophe reinsurance. We did incur an additional charge for pro-rata        reinstatement premium due to the assessment. However, this charge was not material to our        earnings.

 

 

26

 

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While        the MWUA assessment was covered by our catastrophe coverage and had no impact on 2006        earnings, it is still noteworthy because it brings to light the magnitude of risk that        companies incur from coastal pools. First of all, this charge further depleted our        remaining reinsurance protection available to cover claims we pay directly for Hurricane        Katrina. The assessment brought us to within less than $1,000,000 of depleting our final        layer of reinsurance protection. While we do not expect any additional material development        associated with Katrina, should we exceed our final layer of coverage, we would incur        additional charges to earnings for the losses in excess of our catastrophe reinsurance        protection. Also, this assessment exposes the magnitude to which many of the coastal pools        maintain inadequate catastrophe reinsurance protection. While some states in which we        operate are pursuing changes in the structure of their coastal underwriting pools and        seeking additional reinsurance protection, our risk in these pools remains difficult to        quantify. We continue to actively pursue options to better manage this risk, however, as        discussed earlier in our risk factors section of this report, organizational structure and        equitability of state underwriting pools remain a primary concern and focus for us going        forward.

 

Property        and casualty income before income taxes was $8,598,000 for 2006 compared to $2,687,000 in        2005. Our combined ratio for 2006 was 95.7% compared to 106.6% in 2005. The combined ratio        for 2006 of 95.7% included catastrophe related tornado and hail storm losses totaling over        $2,100,000 which added 4.0% to our combined ratio. Without the impact of hurricanes in        2005, our combined ratio was 89.9%. As discussed previously and as indicated by evaluation        of our combined ratio, the significant decline in catastrophe losses was the primary driver        of the improved results.

 

***Property & Casualty Combined Ratio:***

 

A        measure used to analyze a property/casualty insurer’s underwriting performance is the        combined ratio. It is the sum of two ratios:

 

| a. | The loss and loss expense ratio, which measures losses and loss                    adjustment expenses incurred as a percentage of premium revenue. |
|----|-----------------------------------------------------------------------------------------------------------------------------------------------------|

 

| b. | The underwriting expense ratio, which measures underwriting                    expenses incurred (e.g., agents’ commissions, premium taxes, and other                    administrative underwriting expenses) as a percentage of premium                    revenue. |
|----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

The        results of these ratios for the past three years were:

 

|                       | **2007** | **2006** | **2005** |
|----------------------------|----------|----------|----------|
| Loss and LAE Ratio         | 53.3%    | 63.5%    | 74.4%    |
| Underwriting Expense Ratio | 40.9%    | 32.2%    | 32.2%    |
| Combined Ratio             | 94.2%    | 95.7%    | 106.6%   |

 

 

Maintaining a combined ratio below 100%, which indicates that the company is        making an underwriting profit, depends upon many factors including hurricane activity in        the Gulf of Mexico and the southern Atlantic coast, strict underwriting of risks, and        adequate and timely premium rates. A major hurricane hitting the coast of Alabama, Georgia,        South Carolina, Mississippi, Louisiana, or Texas could cause the combined ratio to        fluctuate materially from prior years. The property and casualty subsidiaries maintain        catastrophe reinsurance to minimize the effect of a major catastrophe.

 

The        combined ratio for 2007 improved slightly at 94.2% compared to 95.7% in 2006. No hurricane        activity was experienced in 2007 along with reduced tornado and hail storm losses led to        the reduction in the combined ratio.

 

The        combined ratio for 2006 compared to 2005 improved 10.9 percentage points. No hurricane        activity during 2006 led to the reduction in the combined ratio.

 

 

27

 

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***Non-insurance Operations:***

 

|                                                                    |                                              |    | **2007** |   | **2006** |   | **2005** |
|-------------------------------------------------------------------------|---------------------------------------------------|---------|----------|--------|----------|--------|----------|
| **REVENUE**                                                             |                                              |    |     |   |     |   |
|                                                                    | Net premiums earned                               | $       | -        | $      | -        | $      | -        |
|                                                                    | Net investment income                             |    | 130      |   | 87       |   | 22       |
|                                                                    | Net realized investment gains                     |    | -        |   | -        |   | -        |
|                                                                    | Other income                                      |    | -        |   | 1        |   | -        |
|                                                                    |                                              |    | 130      |   | 88       |   | 22       |
|                                                                    |                                              |    |     |   |     |   |     |
| **BENEFITS AND EXPENSES**                                               |                                              |    |     |   |     |   |
|                                                                    | Policyholder benefits paid or provided            |    | -        |   | -        |   | -        |
|                                                                    | Amortization of deferred policy acquisition costs |    | -        |   | -        |   | -        |
|                                                                    | Commissions                                       |    | -        |   | -        |   | -        |
|                                                                    | General and administrative expenses               |    | 931      |   | 299      |   | 103      |
|                                                                    | Insurance taxes, licenses and fees                |    | -        |   | -        |   | -        |
|                                                                    | Interest expense                                  |    | 1,012    |   | 1,011    |   | 219      |
|                                                                    |                                              |    | 1,943    |   | 1,310    |   | 322      |
|                                                                    |                                              |    |     |   |     |   |     |
| **Income Before Income Taxes and Minority                    Interest** | (1,813)                                           |    | (1,222)  |   | (300)    |
|                                                                    |                                              |    |     |   |     |   |     |
| **INCOME TAX EXPENSE (BENEFIT)**                                        |                                              |    |     |   |     |   |
|                                                                    | Current                                           |    | (641)    |   | (384)    |   | 188      |
|                                                                    | Deferred                                          |    | 91       |   | (90)     |   | (84)     |
|                                                                    |                                              |    | (550)    |   | (474)    |   | 104      |
|                                                                    |                                              |    |     |   |     |   |     |
| **Income From Continuing Operations**                                   |                                              | (1,263) |     | (748)  |     | (404)  |
| **Net Income from Discontinued Operations**                             | 1,319                                             |    | (189)    |   | 137      |
|                                                                    |                                              |    |     |   |     |   |     |
| **NET INCOME**                                                          | $                                                 | 56      | $        | (937)  | $        | (267)  |

 

 

The        non-insurance operations of the Company consist of our parent company, The National        Security Group, Inc. The National Security Group has no material sources of revenue and        relies almost entirely on dividends from the insurance operations to pay expenses. These        dividends are eliminated upon consolidation of the subsidiaries in the audited financials        included herein. The expenses of the group consist of expenses associated with the public        listing of our stock, taxes and fees, and directors’ fees. The most significant        expense of the group is interest expense associated with $12,372,000 in debt. This debt is        composed of two trust preferred securities offerings, the first being $9,279,000 issued in        the December 2005 and the second being $3,093,000 issued in June 2007. The primary use for        these proceeds was to add capital to the property and casualty subsidiaries to allow        flexibility in continuing to increase new business production at a moderate rate. Total        interest expense for the Group associated with these borrowings in 2007 was $1,012,000        compared to $1,011,000 in 2006.

 

***Discontinued Operations:***

 

Discontinued operations consist of the operations of Mobile Attic Inc. On        April 5, 2007, The National Security Group, Inc. entered into an agreement with a private        investment group to sell ninety percent of its fifty percent equity interest in Mobile        Attic, Inc. Total cash proceeds from the sale were $2,700,000 and the net gain on the        disposal totaled $1,460,000. Under the terms of the agreement, NSG transferred assets of        approximately $11,688,000 consisting primarily of portable storage leasing equipment. NSG        was also released from debt obligations totaling $10,251,000 consisting primarily of short        term debt used to finance portable storage leasing equipment.

 

For        2007, total net income from discontinued operations totaled $1,319,000 compared to a net        loss from discontinued operations of $189,000 in 2006. The gain on disposal of Mobile Attic        was the primary difference contributing to net income from discontinued operations in        2007.

 

 

 

28

 

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For 2006,        Mobile Attic posted a net loss from discontinued operations of $189,000 compared to net        income of $137,000 in 2005. A decline in leasing revenues due to a decline in rental rates        of a major customer was the primary factor contributing to the decline in profitability        from 2005 to 2006.

 

**Asset        Portfolio Review:**

 

The life        insurance and property/casualty subsidiaries primarily invest in highly liquid investment        grade debt and equity securities. At December 31, 2007, the company’s holdings in        debt securities amounted to 77.7% of total investments and 62% of total assets. The        following is a breakdown of the bond portfolio quality according to the nationally        recognized rating organization equivalents of  Standard and Poor’s:

 

| **Investment Portfolio**      |
|-------------------------------|
|                          |   |
|                          |   |
| S&P or Equivalent Ratings | % of Total Bond Portfolio |
| AAA                           | 81.67% |
| AA                            | 0.25% |
| AA-                           | 1.71% |
| A+                            | 1.56% |
| A                             | 5.70% |
| A-                            | 0.59% |
| BBB+                          | 1.83% |
| BBB                           | 2.86% |
| BBB-                          | 2.54% |
| BB+                           | 0.29% |
| BB                            | 0.00% |
| BB-                           | 0.00% |
| B+                            | 0.00% |
| B                             | 0.28% |
| B-                            | 0.73% |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

29

 

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The        Company classifies fixed maturity securities in accordance with Financial Accounting        Standards Board Statement 115 and has classified a portion of its fixed maturity securities        portfolio as “available-for-sale,” with the remainder being classified as        “held-to-maturity.” The fixed maturity securities classified as        “available-for-sale” are carried at fair value and changes in fair values, net        of related income taxes, are charged or credited to shareholders’ equity (see Note 4        to the consolidated financial statements).

 

The        insurance subsidiaries’ fixed maturity securities include mortgage-backed bonds,        primarily collateralized mortgage obligations (CMO’s), of $24.2 million and $21.6        million at December 31, 2007 and 2006 respectively. The mortgage-backed bonds are subject        to risks associated with variable prepayments of the underlying mortgage loans. Prepayments        cause those securities to have different actual maturities than were expected at the time        of purchase. Securities that are purchased at a premium to par value and prepay faster than        expected will incur a reduction in yield or loss. Securities that are purchased at a        discount to par value and prepay faster than expected will generate an increase in yield or        gain. The degree to which a security is susceptible to either gains or losses is influenced        by the difference between amortized cost and par value, the relative sensitivity of the        underlying mortgages backing the assets to prepayments in a changing interest rate        environment and the repayment priority of the securities in the overall securitization        structure. In order to minimize risk associated with prepayments on collateralized mortgage        obligations, the Company typically invests primarily in more predictable planned        amortization class (PAC) structures of CMO’s and typically avoids investment in        CMO’s priced at significant premiums above par value.

 

At        December 31, 2007 less than 1% of total investments in the fixed income portfolio was        classified as below investment grade. Due to the high concentration of government and        agency securities, we have experienced no material write-downs during 2007 in values of        investments in the fixed income portfolio.

 

The        results with respect to the foregoing investments are as follows:

 

 

|                                             |   |   |   |    |   | Year Ended December 31 |
|--------------------------------------------------|--------|--------|--------|---------|--------|------------------------|
|                                             |   |   |   |    |   | 2007                   |   | 2006 |   | 2005 |
| Net investment income                            |   |   | $      | 4,749   | $      | 4,463                  | $ | 3,964 |
| Average current yield on investments             |   | 4.5%   |   | 4.4%    |   | 4.0%                   |
| Total return on investments                      |   |   | 4.8%   |    | 6.3%   |                   | 3.8% |
| Net realized gains on investments (before taxes) | $      | 1,493  | $      | 2,565   | $      | 3,493                  |
| Changes in net unrealized gains on investments   |   |   |   |    |
| (before income taxes)                            |   |   | $      | (1,103) | $      | (366)                  | $ | (3,689) |

 

 

 

As of        December 31, 2007, the maturity schedule for all bonds and notes held by the Company,        stated at amortized cost, was as follows:

 

Maturity        Schedule (Amounts in thousands)

 

| Maturity                     |   | Available for sale |   | Held to Maturity |   | Total  |   | Percentage of Total |
|------------------------------|--------|--------------------|--------|------------------|--------|--------|--------|---------------------|
| Maturity in less than 1 year | $      | 4,203              | $      | 325              | $      | 4,528  |   | 5.3%                |
| Maturity in 1-5 years        |   | 10,857             |   | 2,778            |   | 13,635 |   | 16.1%               |
| Maturity in 5-10 years       |   | 19,951             |   | 7,303            |   | 27,254 |   | 32.2%               |
| Maturity after 10 years      |   | 32,377             |   | 6,904            |   | 39,281 |   | 46.4%               |
|                         | $      | 67,388             | $      | 17,310           | $      | 84,698 |   | 100.0%              |

 

 

It        should be noted that the above table is maturities based on stated maturity. Due to call        and prepayment features inherent in some debt securities, actual repayment will differ from        stated maturities. The Company routinely evaluates the impact of changing interest rates on        the projected maturities of bonds in the portfolio and actively manages the portfolio in        order to minimize the impact of interest rate risk.

 

 

 

30

 

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*Liquidity and Capital Resources*

 

Due to        regulatory restrictions, the majority of the Company’s cash is required to be        invested in investment-grade securities to provide ample protection for policyholders. The        liabilities of the property and casualty insurance subsidiaries are of various terms and,        therefore, those subsidiaries invest in securities with various maturities spread over        periods usually not exceeding 10 years. The liabilities of the life insurance subsidiary        are typically of a longer duration, and therefore, a higher percentage of securities in the        life insurance subsidiary are invested for periods exceeding 10 years.

 

The        liquidity requirements for the Company are primarily met by funds generated from operations        of the life insurance and property/casualty insurance subsidiaries. Premium and investment        income as well as maturities and sales of invested assets provide the primary sources of        cash for both the life and property/casualty businesses, while applications of cash are        applied by both businesses to the payment of policy benefits, the cost of acquiring new        business (principally commissions), operating expenses, purchases of new investments, and        in the case of life insurance, policy loans.

 

The        National Security Group’s consolidated statement of cash flows indicates that        operating activities provided (used) cash of $3,833,000, $7,802,000, and $(5,449,000) in        2007, 2006, and 2005, respectively. The considerable decrease in cash flow from operating        activities in 2007 is primarily due to reduction in amounts recovered under reinsurance        contracts by the property and casualty subsidiaries. The significant increase in cash flow        from operating activities in 2006 was primarily due to the improvement in underwriting        results in the property and casualty subsidiaries and significant recoveries from        reinsurers associated with prior year hurricanes. The negative cash flow from operations in        2005 was due to the significant increase in hurricane losses.

 

The        consolidated statement of cash flows also reflects a (decrease) increase in cash from        financing activities of $(364,000), $(4,264,000), and $4,934,000, respectively. Cash flows        from financing activities in 2007 reflect proceeds from a trust preferred securities        offering of $3,093,000, repayment of debt of $2,171,000 and shareholder dividends of        $2,220,000. The decrease in cash flow from financing activities in 2006 reflects the        reduction of debt held by Mobile Attic of $1,779,000 and the payment of shareholder        dividends of $2,183,000. Cash flow from financing activities in 2005 reflects proceeds from        a trust preferred securities offering of $9,279,000, repayment of Mobile Attic debt of        $2,209,000 and payment of shareholder dividends of $2,134,000.

 

|                                 |   |                   |   |             |   |      |   |      |   |              |
|--------------------------------------|--------|------------------------|--------|------------------|--------|-----------|--------|-----------|--------|-------------------|
|                                 |   | Payments due by period |
|                                 |   | ($ in thousands)       |
| Contractual Obligations              |   | Total                  |   | Less than 1 year |   | 1-3 years |   | 3-5 years |   | More than 5 years |
| Debt Obligations                     | $      | 13,272                 | $      | 900              | $      | -         | $      | -         | $      | 12,372            |
| Property and casualty claim reserves | $      | 11,973                 | $      | 7,302            | $      | 3,830     | $      | 599       | $      | 242               |

 

 

Short        term debt obligations consist of a $900,000 revolving line of credit. The line of credit is        due in April 2008 and management anticipates repaying the line of credit at        maturity.

 

Included        in long term debt held by the Company is the issuance of $9,279,000 in subordinated        debentures completed on December 15, 2005. The proceeds from the debentures were used to        make a $6,000,000 capital infusion in the P&C subsidiary National Security Fire and        Casualty with the remainder to be held for general corporate purposes. The subordinated        debentures mature December 15, 2035. It is anticipated that principal payments will not be        made until the expiration of the fixed rate period on the debt in 2015. Also included in        long-term debt is the issuance of $3,093,000 in subordinated debentures completed June 21,        2007. The proceeds from the debentures were used to fund general corporate expenses thereby        reducing the amount of dividends to the Group paid by the P&C subsidiary National        Security Fire & Casualty thereby continuing to restore capital in the P&C        subsidiary National Security Fire and Casualty to pre-hurricane levels. The second issue        matures June 15, 2037 and may be redeemed following the fifth anniversary of issuance. For        further discussion of the subordinated debentures please review Note 8 to the consolidated        financial statements and Form 8-Ks filed June 14, 2007 and December 12, 2005, which is        incorporated herein by reference.

 

 

31

 

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In        estimating the time interval for payment of property and casualty claim reserves, the        Company utilized historical payment patterns. By the nature of the insurance contracts        under which these liabilities exist, there can be no certainty that actual payments will        fall in the periods indicated above. However, management feels that current liquidity and        capital resources are sufficient to pay these obligations as they come due. Also, due to        the relatively short-tail nature of the majority of the Company’s claim liabilities,        management can conclude with a reasonable level of confidence that historical patterns        indicate that approximately 70% of claim liabilities at the end of a given year are settled        within the following two year period.

 

The        ability of the Company to meet its commitments for timely payment of claims and other        expenses depends, in addition to current cash flow, on the liquidity of its investments. On        December 31, 2007, the Company had no known impairments of assets or changes in operation,        which would have a material adverse effect upon liquidity. Approximately 76% of the        Company’s insurance subsidiary assets are invested in cash, investment grade fixed        income securities, short-term investments and broadly traded equity securities, which are        highly liquid. The values of these investments are subject to the conditions of the markets        in which they are traded. Past fluctuations in these markets have had little effect on the        liquidity of the Company. The Company has relatively little exposure to lower grade fixed        income investments which might be especially subject to liquidity problems due to thinly        traded markets.

 

Except        as discussed in Note 15 to the consolidated financial statements, the Company is aware of        no known trends, events, or uncertainties reasonably likely to have a material effect on        its liquidity, capital resources, or operations. Additionally, the Company has not been        made aware of any recommendations of regulatory authorities, which if implemented, would        have such an effect.

 

As        disclosed in Note 12 to the consolidated financial statements, in 2008, the amount that The        National Security Group’s insurance subsidiaries can transfer in the form of        dividends to the parent company is limited to $889,000 in the life insurance subsidiary and        $4,609,000 in the property/casualty insurance subsidiary. However, that condition poses no        current short-term or long-term liquidity concerns for the parent company.

 

*Off-Balance Sheet Arrangements*

 

The        Company has no material off balance sheet arrangements.

 

*Statutory Risk-Based Capital of Insurance Subsidiaries*

 

The NAIC        has adopted Risk-Based Capital (RBC) requirements for life/health and property/casualty        insurance companies to evaluate the adequacy of statutory capital and surplus in relation        to investment and insurance risks such as asset quality, mortality and morbidity, asset and        liability matching, benefit and loss reserve adequacy, and other business factors. State        insurance regulators will use the RBC formula as an early warning tool to identify, for the        purpose of initiating regulatory action, insurance companies that potentially are        inadequately capitalized. In addition, the formula defines minimum capital standards that        will supplement the current system of low fixed minimum capital and surplus requirements on        a state-by-state basis. Regulatory compliance is determined by a ratio of the        company’s regulatory total adjusted capital, as defined by the NAIC, to its        authorized control level RBC, as defined by the NAIC. Companies below specific trigger        points or ratios are classified within levels, each of which requires corrective        action.

 

The        levels and ratios are as follows:

 

 

| Ratio of Total Adjusted Capital to                                                                                                                                                                                                                                                                                                                                                                                                             |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| Authorized Control Level RBC                                                                                                                                                                                                                                                                                                                                                                                                                   |
| Regulatory Event(Less Than or                    Equal to)                                                                                                                                                                                                                                                                                                                                                                                     |
| Company action                    level                                                                                                  2.0 |
| Regulatory action                    level                                                                                                1.5          |
| Authorized control                    level                                                                                              1.0                     |
| Mandatory control                    level                                                                                               0.7                |

 

 

 

 

 

 

 

 

 

32

 

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The        ratios of Total Adjusted Capital to Authorized Control Level RBC for The National Security        Group’s life/health and property/casualty insurance subsidiaries are all in excess of        5.3 to 1 at December 31, 2007.

 

National        Security Insurance Company (life insurer) has regulatory adjusted capital of $9.9 and $10.3        million at December 31, 2007 and 2006, respectively, and a ratio of regulatory total        adjusted capital to authorized control level RBC of 11.8 and 11.7 at December 31, 2007 and        2006 respectively. Accordingly, National Security Insurance Company exceeds the minimum RBC        requirements.

 

National        Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted        capital of $34.1 million and $32.6 million at December 31, 2007 and 2006, respectively, and        a ratio of regulatory total adjusted capital to authorized control level RBC of 5.3 and 6.2        at December 31, 2007 and 2006 respectively. Accordingly, National Security Fire &        Casualty Company exceeds the minimum RBC requirements.

 

Omega        One Insurance Company (property/casualty insurer), which began writing business in late        1995, has regulatory adjusted capital of $9.6 million and $9.0 million at December 31, 2007        and 2006, respectively, and a ratio of regulatory total adjusted capital to authorized        control level RBC of 24.4 and 21.8 at December 31, 2007 and 2006, respectively.        Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.

 

*Application of Critical Accounting Policies*

 

Our consolidated financial statements are based upon the development and        application of accounting policies that require management to make significant estimates        and assumptions. Accounting policies may be based on (including but not limited to) GAAP        authoritative literature, statutory authoritative literature, regulations and industry        standards. The Company’s financial results would be directly impacted by changes in        assumptions and judgments used to select and apply our accounting policies. It is        management’s opinion that the following are some of the more critical judgment areas        in regards to the application of our accounting policies and their affect on our financial        condition and results of operations.

 

| **•**      Reinsurance                    Receivables                         |
|------------------------------------------------------------------------------------------------------------------|
|                                                                                                             |
| **•**      Deferred                    Policy Acquisition Costs               |
|                                                                                                             |
| **•**      Deferred                    Taxes                                  |
|                                                                                                             |
| **•**      Valuation                    of Investments                        |
|                                                                                                             |
| **•**      Reserves                    for losses and loss adjustment expense |
|                                                                                                             |
| **•**      Recognition                    of Revenue                          |
|                                                                                                             |
| **•**      Evaluation                    of Litigation                        |

 

*Reinsurance*

 

As part        of our risk management strategy, we routinely cede risks associated with insurance policies        we underwrite to reinsurers pursuant to contractual agreements. Reinsurance provides        protection for individual loss occurrences, including catastrophes, to alleviate        fluctuation in the results of our underwriting activities and to limit our net liability        for individual risks. The estimated reinsurance recoverable on paid losses, including an        estimate for losses incurred but not reported, and amounts paid to reinsurers applicable to        unexpired terms of policies in force are reported as assets.

 

A        reinsurance arrangement does not discharge the issuing company from primary liability to        the insured, and the issuing company is required to discharge its liability to the insured        even if the reinsurer is unable to meet its obligations under the reinsurance arrangements.        Reinsurance, however, does make the reinsurer liable to the issuing company to the extent        of any reinsurance in force at the time of the loss. Reinsurance arrangements also decrease        premiums retained by the issuing company since that company pays the reinsuring company a        portion of total premiums based upon the amount of liability reinsured.

 

 

33

 

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When a        claim is made under a policy we have reinsured, we initially pay the full amount owed to        the policyholder or claimant. Subsequently, we initiate the process to recover any amounts        due from reinsurers in accordance with the terms of applicable reinsurance treaties. The        estimated recoverable is recorded as an asset on the financial statements.

 

At        December 31, 2007, the estimated reinsurance recoverable recorded was $917,000. The Company        does not anticipate any issues with collection of the recorded amount.

 

The        reinsurance related amounts recorded have been estimated based upon management’s        interpretation of the related reinsurance treaty. Areas in which judgment has been used        regarding said estimates include: assessing the financial viability and credit quality of        each reinsurer as well as the ability of each reinsurer to pay amounts owed.

 

There is        a possibility that the actual amounts recovered from reinsurers could be materially less        than the estimates recorded. This possibility could result in a material adverse impact on        our financial condition and results of operations. Reinsurers may dispute claims under        reinsurance treaties, such as the calculated amount of reinsurance recoverable. Management        does not anticipate any issues with recoverability of reinsurance balances based on current        evaluations of collectability.

 

NSIC        generally reinsures all risks in excess of $50,000 with respect to any one        insured.

 

NSFC and        Omega generally reinsure with third parties any liability in excess of $225,000 on any        single policy. In addition, the property and casualty subsidiaries have catastrophe excess        reinsurance, which protects it in part with respect to aggregate property losses arising        out of a single catastrophe, such as a hurricane. In 2007, the property and casualty        subsidiaries had catastrophe protection up to a $47.5 million loss with a        retention/deductible of $3.5 million. This provided protection up to at least a 100 year        “near term” event as depicted in catastrophe modeling results. The “near        term” catastrophe modeling results reflect a predicted increase in storm activity        given the current weather pattern and various factors projected to impact our weather        patterns in the near term. We believe that maintaining protection to at least a 100 year        near term event will be comparable with our past practice of maintaining catastrophe        reinsurance protection up to a 250 year event under the previous models. Based on an        evaluation using actual NSFC and Omega exposures and catastrophe modeling based on a 100        year loss, that is a probable maximum loss in which we have a 99% probability of not        exceeding in any given year, the property and casualty subsidiaries would pay (pre-tax)        approximately $8.7 million in losses and reinstatement and reinsurers would pay (pre-tax)        $42.3 million. No significant changes in reinsurance coverage are expected during 2008.        However, we will continue to evaluate the cost of expanding the upper limits of our        coverage with a goal of lowering our value at risk related to probable maximum losses as        upper limit coverage becomes more cost effective.

 

For more        information regarding reinsurance, please see Note 10 to our consolidated financial        statements.

 

*Deferred Policy Acquisition Costs*

 

Deferred        policy acquisition costs (DAC) are those costs incurred in connection with acquiring new        business or renewing existing business. DAC is primarily comprised of commissions and other        costs related to issuing insurance policies, net of amounts ceded to reinsurers. In        accordance with generally accepted accounting principles, these costs are not expensed in        their entirety, rather they are recorded as an asset and amortized over the lives of the        policies.

 

A        reduction in DAC is recognized if the sum of the expected loss and loss adjustment        expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned        premiums and projected investment income. Management reviews DAC calculations throughout        the year to establish and assess their recoverability. Changes in management’s        assumptions, estimates or judgment with respect to calculating DAC could materially impact        our financial statements and financial condition. Changes in loss ratios, projected        investment income, premium rates or overall expense levels could negatively impact the        recoverability of DAC.

 

At        December 31, 2007, we had recorded $8,993,000 as an asset for DAC in our financial        statements. We do not foresee any issues related to recoverability of these capitalized        costs. For more information regarding deferred policy acquisition costs, please see Note 1        to our financial statements.

 

 

34

 

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*Deferred Income Taxes*

 

Deferred        income taxes are created when there are differences between assets and liabilities for tax        and financial reporting purposes, as well as tax credits, net operating losses and other        carry forwards. SFAS 109 “Accounting for Income Taxes,” requires that deferred        tax assets be reduced by a valuation allowance if, based on the available evidence, it is        more likely than not that all of the recorded deferred tax assets will not be realized in        future periods. This standard requires management to exercise judgment in determining        whether or not the deferred tax asset is realizable.

 

At        December 31, 2007, there is no evidence to suggest to management that any deferred tax        asset is unrealizable. For more information regarding deferred income taxes, please see        Note 7 to our financial statements.

 

*Valuation of Investments*

 

Investments are recorded at fair value based upon quoted prices when        available. Quoted prices are available for every investment debt and equity security        included in the financial statements. Periodically, the carrying values of an individual        investment may become temporarily impaired because of time value, volatility, credit        quality and existing market conditions. Management evaluates investments to determine        whether the impairment is other-than-temporary. Evaluation criteria include credit quality        of security, severity of decrease between cost and market value, length of time of the        impairment and likelihood that the impairment will reverse in the near future. This        evaluation requires significant assumptions, estimates and judgments by management. If the        impairment is determined to be other-than-temporary, the investment is written down to the        current fair value and a realized loss is recorded on the income statement. We have very        limited exposure to less liquid and difficult to value investments such as collateralized        debt obligations and private label mortgage backed securities.

 

At        December 31, 2007, there were no other-than-temporary impairments. For more information        regarding valuation of investments, see Note 1 to our financial statements.

 

*Loss        and Loss Adjustment Expense*

 

Property        and casualty loss reserves are maintained to cover the estimated unpaid liability for        losses and loss adjustment expenses with respect to reported and unreported incurred        claims. Loss reserves are an estimation based on actuarial projection techniques common in        the insurance industry. Reserves are management’s expectations of what the settlement        and administration of claims will cost. Management estimated reserves are based on        historical settlement patterns, estimated salvage and subrogation, and an appraisal of the        related facts and circumstances. Management’s reserve estimates are reviewed by        consulting actuaries to determine their adequacy and reasonableness.

 

At        December 31, 2007, the recorded liability for loss and loss and adjustment expense was        $11,973,000. We believe this estimate of unpaid losses and loss adjustment expense to be        sufficient based on currently available information and a review of our historical        reserving practices. For more information regarding loss and loss adjustment expense, see        Note 9 to our financial statements.

 

****Item 7A.** Quantitative and        Qualitative Disclosures About Market Risk**

 

The        Company’s primary objectives in managing its investment portfolio are to maximize        investment income and total investment returns while minimizing overall credit risk.        Investment strategies are developed based on many factors including changes in interest        rates, overall market conditions, underwriting results, regulatory requirements and tax        position. Investment decisions are made by management and reviewed by the Board of        Directors. Market risk represents the potential for loss due to adverse changes in fair        value of securities. The three potential risks related to the Company’s fixed        maturity portfolio are interest rate risk, prepayment risk and default risk. The primary        risk related to the Company’s equity portfolio is equity price risk.

 

Since        the Company’s assets and liabilities are largely monetary in nature, the        Company’s financial position and earnings are subject to risks resulting from changes        in interest rates at varying maturities, changes in spreads over U.S. Treasuries on new        investment opportunities and changes in the yield curve and equity pricing        risks.

 

35

 

----

 

 

 

The        Company is exposed to equity price risk on its equity securities. The Company holds common        stock with a fair value of $15 million. Based on an evaluation of the historical risk        measure of our portfolio relative to the S&P 500, if the market value of the S & P        500 Index decreased 10% from its December 31, 2007 value, the fair value of the        Company’s common stock would decrease by approximately $1.34 million.

 

Certain        fixed interest rate market risk sensitive instruments may not give rise to incremental        income or loss during the period illustrated but may be subject to changes in fair values.        Note 1 in the consolidated financial statements presents additional disclosures concerning        fair values of Financial Assets and Financial Liabilities and is incorporated by reference        herein.

 

The        Company limits the extent of its market risk by purchasing securities that are backed by        stable collateral, the majority of the assets are issued by U.S. government sponsored        entities. Also, the majority of all of the subsidiaries’ CMO’s are Planned        Amortization Class (PAC) bonds. PAC bonds are typically the lowest risk CMO’s, and        provide greater cash flow predictability. Such securities with reduced risk typically have        a lower yield, but higher liquidity, than higher-risk mortgage backed bonds. To reduce the        risk of losing principal should prepayments exceed expectations, the Company does not        purchase mortgage backed securities at significant premiums over par value.

 

The        Company’s investment approach in the equity markets is based primarily on a        fundamental analysis of value. This approach requires the investment committee to invest in        well managed, primarily dividend paying companies, which have a low debt to capital ratio,        above average return on capital for a sustained period of time, and low volatility rating        (beta) relative to the market. The dividends provide a steady cash flow to help pay current        claim liabilities, and it has been the Company’s experience that by following this        investment strategy, long term investment results have been superior to those offered by        bonds, while keeping the risk of loss of capital to a minimum relative to the overall        equity market.

 

As for        shifts in investment allocations, the company has moderately increased allocations to        corporate and tax free bonds. The improved yield spreads on corporate bonds has made this        segment more attractive and the risk of investing in corporate bonds versus government        bonds is more appropriately priced in our opinion. We have also increased our allocation to        tax free securities to further enhance after tax returns given our improved earnings        performance over the last two years.

 

 

 

 

 

36

 

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******Item 8.****Consolidated Financial Statements and Supplementary Data**

 

 

| Index to Financial Statements                                                                   |   |   |
|-------------------------------------------------------------------------------------------------|--------|--------|
|                                                                                            |   |   |
| Consolidated Financial Statements:                                                              |   |   |
|                                                                                            |   |   |
| Report of Independent Registered Public Accounting                    Firm                      |   | 38     |
|                                                                                            |   |   |
| Consolidated Balance Sheets –                                                             |   |   |
| December 31, 2007 and 2006                                                                      |   | 39     |
|                                                                                            |   |   |
| Consolidated Statements of Income –                                                       |   |   |
| Years Ended December 31, 2007, 2006, and 2005                                                   |   | 41     |
|                                                                                            |   |   |
| Consolidated Statements of Shareholders’ Equity                    –                |   |   |
| Years Ended December 31, 2007, 2006, and 2005                                                   |   | 42     |
|                                                                                            |   |   |
| Consolidated Statements of Cash Flows –                                                   |   |   |
| Years Ended December 31, 2007, 2006, and 2005                                                   |   | 43     |
|                                                                                            |   |   |
| Notes to Consolidated Financial Statements –                                              |   |   |
| December 31, 2007                                                                               |   | 44     |
|                                                                                            |   |   |
| Financial Statement Schedules:                                                                  |   |   |
|                                                                                            |   |   |
| Schedule I. Summary of Investments –                                                      |   |   |
| December 31, 2007 and 2006                                                                      |   | 67     |
|                                                                                            |   |   |
| Schedule II. Condensed Financial Information of Registrant                    –           |   |   |
| December 31, 2007 and 2006                                                                      |   | 68     |
|                                                                                            |   |   |
| Schedule III. Supplementary Insurance Information                    –                    |   |   |
| December 31, 2007, 2006, and 2005                                                               |   | 72     |
|                                                                                            |   |   |
| Schedule IV. Reinsurance –                                                                |   |   |
| Years Ended December 31, 2007, 2006, and 2005                                                   |   | 73     |
|                                                                                            |   |   |
| Schedule V. Allowance for Uncollected Premiums and Other                    Receivables – |   |
| Years Ended December 31, 2007, 2006, and 2005                                                   |   | 74     |
| *All other Schedules are not required under related                    instructions or are*     |
| *inapplicable and therefore have been omitted.*                                                 |
|                                                                                                 |        |        |  |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

37

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING        FIRM

 

To the        Board of Directors and Shareholders

The        National Security Group, Inc.

Elba,        Alabama

 

We have        audited the accompanying consolidated balance sheets of The National Security Group, Inc.        and subsidiaries as of December 31, 2007 and 2006 and the related consolidated statements        of income, shareholders’ equity, and cash flows for each of the years in the        three-year period ended December 31, 2007. Our audits also included the financial statement        schedules listed in the Index at page 37. These consolidated financial statements and        schedules are the responsibility of the company’s management. Our responsibility is        to express an opinion on these consolidated financial statements and schedules 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 consolidated financial statements are free        of material misstatement. The company is not required to have, nor were we engaged to        perform, an audit of its internal control over financial reporting. Our audit included        consideration of internal control over financial reporting as a basis for designing audit        procedures that are appropriate in the circumstances, but not for the purpose of expressing        an opinion on the effectiveness of the company’s internal control over financial        reporting. Accordingly, we express no such opinion. An audit also includes examining, on a        test basis, evidence supporting the amounts and disclosures in the consolidated financial        statements, 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 consolidated financial statements referred to above present fairly, in all        material respects, the financial position of The National Security Group, Inc. and        subsidiaries as of December 31, 2007 and 2006, and the results of their operations and        their cash flows for each of the years in the three-year period ended December 31, 2007 in        conformity with accounting principles generally accepted in the United States of America.        Also, in our opinion, the related financial statement schedules, when considered in        relation to the basic financial statements taken as a whole, present fairly in all material        respects the information set forth therein.

 

/s/        Barfield, Murphy, Shank & Smith, P.C.

 

 

Birmingham, Alabama

March        28, 2008

 

 

 

38

 

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| **The National Security Group,                    Inc.**                                           |
|----------------------------------------------------------------------------------------------------|
|                                                                                               |   |   |   |   |   |   |   |   |
| CONSOLIDATED BALANCE SHEETS                                                                        |
|                                                                                               |   |   |   |   |   |   |   |   |
|                                                                                               |   |   |   | (Dollars in thousands) |
|                                                                                               |   |   |   | December 31, |
| **ASSETS**                                                                                         |   |   | 2007 |   |   | 2006 |
|                                                                                               |   |   |   |   |   |   |   |   |
| Investments                                                                                        |   |   |   |   |   |   |
|                                                                                               | Fixed maturities held-to-maturity, at amortized cost (estimated                    fair value: 2007 - $17,155; |   |   |   |   |   |   |
|                                                                                               |   | 2006 - $18,172) |   | $ | 17,310 |   | $ | 18,764 |
|                                                                                               | Fixed maturities available-for-sale, at estimated fair value                    (cost: 2007 - $67,388; |   |   |   |   |   |   |
|                                                                                               |   | 2006- $62,980) |   |   | 66,777 |   |   | 61,935 |
|                                                                                               | Equity securities available-for-sale, at estimated fair value                    (cost: 2007 - $7,635 |   |   |   |   |   |   |
|                                                                                               |   | 2006 - $7,224) |   |   | 14,991 |   |   | 16,119 |
|                                                                                               | Mortgage loans on real estate, at cost |   |   | 492 |   |   | 504 |
|                                                                                               | Investment real estate, at book value (accumulated depreciation:                    2007 - $18; 2006 - $18) |   |   | 4,586 |   |   | 4,154 |
|                                                                                               | Policy loans |   |   | 920 |   |   | 845 |
|                                                                                               | Other invested assets |   |   | 2,103 |   |   | 2,346 |
|                                                                                               | Short-term investments |   |   | 1,027 |   |   | 508 |
|                                                                                               |   |   |   |   |   |   |   |   |
|                                                                                               |   | **Total Investments** |   |   | 108,206 |   |   | 105,175 |
|                                                                                               |   |   |   |   |   |   |   |   |
| Cash                                                                                               |   |   | 3,299 |   |   | 1,106 |
| Accrued investment income                                                                          |   |   | 794 |   |   | 786 |
| Policy receivables, less allowance for credit losses (2007 -                    $110; 2006 - $110) |   |   | 8,801 |   |   | 3,098 |
| Accounts receivable, less allowance for credit losses (2007 -                    $0; 2006- $10)    |   |   | 570 |   |   | 2,047 |
| Inventory                                                                                          |   |   | - |   |   | 447 |
| Reinsurance recoverable                                                                            |   |   | 917 |   |   | 2,242 |
| Deferred policy acquisition costs                                                                  |   |   | 8,993 |   |   | 7,922 |
| Property and equipment, net                                                                        |   |   | 2,930 |   |   | 11,242 |
| Other assets                                                                                       |   |   | 1,075 |   |   | 846 |
|                                                                                               |   |   |   |   |   |   |   |   |
|                                                                                               |   | **Total Assets** |   | $ | 135,585 |   | $ | 134,911 |

 

 

See        accompanying notes to consolidated financial statements

 

 

 

 

39

 

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| **The National Security Group, Inc.**           |
|-------------------------------------------------|
|                                            |   |   |   |   |   |   |   |   |
| CONSOLIDATED BALANCE SHEETS                     |
|                                            |   |   |   |   |   |   |   |   |
|                                            |   |   |   | (Dollars in thousands) |
|                                            |   |   |   | December 31, |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**  |   |   | 2007 |   |   | 2006 |
|                                            |   |   |   |   |   |   |   |   |
| Property and casualty benefit and loss reserves |   | $ | 11,973 |   | $ | 12,498 |
| Accident and health benefit and loss reserves   |   |   | 926 |   |   | 824 |
| Life and annuity benefit and loss reserves      |   |   | 27,538 |   |   | 26,265 |
| Unearned premiums                               |   |   | 22,442 |   |   | 17,818 |
| Policy and contract claims                      |   |   | 608 |   |   | 412 |
| Other policyholder funds                        |   |   | 1,309 |   |   | 1,275 |
| Short-term debt                                 |   |   | 900 |   |   | 11,580 |
| Long-term debt                                  |   |   | 12,372 |   |   | 9,279 |
| Accrued income taxes                            |   |   | 1,079 |   |   | 1,205 |
| Other liabilities                               |   |   | 6,760 |   |   | 5,645 |
| Deferred income tax                             |   |   | 1,231 |   |   | 2,031 |
|                                            |   |   |   |   |   |   |   |   |
|                                            |   | **Total Liabilities** |   |   | 87,138 |   |   | 88,832 |
|                                            |   |   |   |   |   |   |   |   |
| Contingencies                                   |   |   | - |   |   | - |
|                                            |   |   |   |   |   |   |   |   |
| Minority interest                               |   |   | - |   |   | 700 |
|                                            |   |   |   |   |   |   |   |   |
| Shareholders’ Equity                      |   |   |   |   |   |   |
|                                            | Preferred stock, $1 par value, 500,000 shares authorized, none                    issued or outstanding |   |   | - |   |   | - |
|                                            | Class A common stock, $1 par value, 2,000,000 shares authorized,                    none issued or outstanding |   |   | - |   |   | - |
|                                            | Common stock, $1 par value, 10,000,000 shares                    authorized |   |   |   |   |   |   |
|                                            |   | 2,466,600 shares issued and outstanding |   |   | 2,467 |   |   | 2,467 |
|                                            | Additional paid-in capital |   |   | 4,951 |   |   | 4,951 |
|                                            | Accumulated other comprehensive income |   |   | 4,864 |   |   | 5,616 |
|                                            | Retained earnings |   |   | 36,165 |   |   | 32,345 |
|                                            |   |   |   |   |   |   |   |   |
|                                            |   | **Total Shareholders’ Equity** |   |   | 48,447 |   |   | 45,379 |
|                                            |   |   |   |   |   |   |   |   |
|                                            |   | **Total Liabilities and Shareholders’                    Equity** |   | $ | 135,585 |   | $ | 134,911 |

 

 

See        accompanying notes to consolidated financial statements

 

40

 

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|                                                                       | **The National Security Group,                    Inc.**                         |
|----------------------------------------------------------------------------|----------------------------------------------------------------------------------|
|                                                                       |
| CONSOLIDATED STATEMENTS OF INCOME                                          |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
|                                                                       |                                                                             |   | (Dollars in thousands |
|                                                                       |                                                                             |   | except per share amounts) |
|                                                                       |                                                                             |   | Year Ended December 31, |
|                                                                       |                                                                             |   |   | 2007 |   |   | 2006 |   |   | 2005 |
| **REVENUES**                                                               |                                                                             |   |   |   |   |   |   |   |   |
|                                                                       | Net premiums earned                                                              |   | $ | 62,250 |   | $ | 58,874 |   | $ | 53,563 |
|                                                                       | Net investment income                                                            |   |   | 4,749 |   |   | 4,463 |   |   | 3,964 |
|                                                                       | Net realized investment gains                                                    |   |   | 1,493 |   |   | 2,565 |   |   | 3,493 |
|                                                                       | Other income                                                                     |   |   | 1,071 |   |   | 1,211 |   |   | 1,416 |
|                                                                       |                                                                             |   |   | 69,563 |   |   | 67,113 |   |   | 62,436 |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
| **BENEFITS AND EXPENSES**                                                  |                                                                             |   |   |   |   |   |   |   |   |
|                                                                       | Policyholder benefits paid or provided                                           |   |   | 37,678 |   |   | 37,996 |   |   | 38,241 |
|                                                                       | Amortization of deferred policy acquisition costs                                |   |   | 2,559 |   |   | 1,978 |   |   | 2,704 |
|                                                                       | Commissions                                                                      |   |   | 9,353 |   |   | 8,921 |   |   | 8,987 |
|                                                                       | General and administrative expenses                                              |   |   | 9,679 |   |   | 9,141 |   |   | 7,911 |
|                                                                       | Insurance taxes, licenses and fees                                               |   |   | 2,325 |   |   | 1,729 |   |   | 2,243 |
|                                                                       | Interest expense                                                                 |   |   | 1,080 |   |   | 1,094 |   |   | 348 |
|                                                                       |                                                                             |   |   | 62,674 |   |   | 60,859 |   |   | 60,434 |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
| **Income from Continuing Operations**                                      |                                                                             |   |   |   |   |   |   |   |   |
| **Before Income Tax Expense**                                              |                                                                             |   | 6,889 |   |   | 6,254 |   |   | 2,002 |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
| **INCOME TAX EXPENSE (BENEFIT)**                                           |                                                                             |   |   |   |   |   |   |   |   |
|                                                                       | Current                                                                          |   |   | 1,811 |   |   | 1,907 |   |   | 531 |
|                                                                       | Deferred                                                                         |   |   | 357 |   |   | (92) |   |   | 50 |
|                                                                       |                                                                             |   |   | 2,168 |   |   | 1,815 |   |   | 581 |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
|                                                                       | **Income From Continuing Operations**                                            |   |   | 4,721 |   |   | 4,439 |   |   | 1,421 |
|                                                                       | (Loss) Income from Discontinued Operations, Net of Income                    Tax |   |   |   |   |   |   |   |   |   |
|                                                                       | Expense Before Minority Interest                                                 |   |   | (282) |   |   | (378) |   |   | 274 |
|                                                                       | Minority Interest in Discontinued Operations                                     |   |   | 141 |   |   | 189 |   |   | (137) |
|                                                                       | Gain from Disposal of Discontinued Operations                                    |   |   | 1,460 |   |   | - |   |   | - |
|                                                                       | **Net Income (Loss) from Discontinued Operations**                               |   |   | 1,319 |   |   | (189) |   |   | 137 |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
|                                                                       | **Net Income**                                                                   |   | $ | 6,040 |   | $ | 4,250 |   | $ | 1,558 |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
|                                                                       |                                                                             |   |   |   |   |   |   |   |   |   |
| **Basic and Diluted Earnings (Loss) Per Common                    Share:** |                                                                             |   |   |   |   |   |   |   |   |
| Earnings Per Share from Continuing Operations                              |                                                                             | $ | 1.91 |   | $ | 1.80 |   | $ | 0.58 |
| Earnings (Loss) Per share from Discontinued                    Operations  |                                                                             |   | 0.54 |   |   | (0.08) |   |   | 0.05 |
| **Net Earnings Per Common Share**                                          |                                                                             | $ | 2.45 |   | $ | 1.72 |   | $ | 0.63 |

 

 

See        accompanying notes to consolidated financial statements

 

41

 

----

 

 

 

 

| **THE NATIONAL SECURITY GROUP,                    INC.** |
|----------------------------------------------------------|
| CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY    |
| (Dollars in thousands)                                   |
|                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   | Accumulated |   |   |   |   |
|                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   | Other |   |   |   |   |   |   |   |
|                                                     |   |   |   |   |   |   |   | Comprehensive | Retained |   |   | Comprehensive | Common | Paid-in |   |
|                                                     |   |   |   | Total |   | Income (Loss) |   | Earnings |   |   | Income |   |   | Stock |   | Capital |   |
|                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Balance at December 31, 2004                             | $ | 46,676 |   |   |   |   |   |   | $ | 30,854 |   | $ | 8,404 |   | $ | 2,467 |   | $ | 4,951 |   |
| Comprehensive loss:                                      |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     | Net income for 2005 |   | 1,558 |   |   |   | 1,558 |   |   |   | 1,558 |   |   | - |   |   | - |   |   | - |   |
|                                                     | Other comprehensive loss, net of tax |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |   | Unrealized loss on securities, net |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |   | of reclassification adjustment of $2,504 | (2,544) |   |   |   | (2,544) |   |   |   | - |   |   | (2,544) |   |   | - |   |   | - |   |
| Comprehensive loss                                       |   |   |   |   |   | (986) |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     | Cash dividends ($0.865 per share) | (2,134) |   |   |   |   |   |   |   | (2,134) |   |   | - |   |   | - |   |   | - |   |
|                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Balance at December 31, 2005                             | 43,556 |   |   |   |   |   |   |   | 30,278 |   |   | 5,860 |   |   | 2,467 |   |   | 4,951 |   |
| Comprehensive income:                                    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     | Net income for 2006 |   | 4,250 |   |   |   | 4,250 |   |   |   | 4,250 |   |   | - |   |   | - |   |   | - |   |
|                                                     | Other comprehensive loss, net of tax |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |   | Unrealized loss on securities, net |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |   | of reclassification adjustment of $1,845 | (244) |   |   |   | (244) |   |   |   | - |   |   | (244) |   |   | - |   |   | - |   |
| Comprehensive income                                     |   |   |   |   |   | 4,006 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     | Cash dividends ($0.885 per share) | (2,183) |   |   |   |   |   |   |   | (2,183) |   |   | - |   |   | - |   |   | - |   |
|                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Balance at December 31, 2006                             | 45,379 |   |   |   |   |   |   |   | 32,345 |   |   | 5,616 |   |   | 2,467 |   |   | 4,951 |   |
| Comprehensive income:                                    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     | Net income for 2007 |   | 6,040 |   |   |   | 6,040 |   |   |   | 6,040 |   |   | - |   |   | - |   |   | - |   |
|                                                     | Other comprehensive loss, net of tax |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |   | Unrealized loss on securities, net |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     |   | of reclassification adjustment of$1,014 | (664) |   |   |   | (664) |   |   |   | - |   |   | 664 |   |   | - |   |   | - |   |
|                                                     |   | Unrealized loss on interest rate swap | (88) |   |   |   | (88) |   |   |   | - |   |   | (88) |   |   | - |   |   | - |   |
| Comprehensive income                                     |   |   |   |   | 5,288 |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                     | Cash dividends ($0.90 per share) | (2,220) |   |   |   |   |   |   |   | (2,220) |   |   | - |   |   | - |   |   | - |   |
|                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Balance at December 31, 2007                             | $ | 48,447 |   |   |   |   |   |   | $ | 36,165 |   | $ | 6,192 |   | $ | 2,467 |   | $ | 4,951 |   |

 

See        accompanying notes to consolidated financial statements.

 

42

 

----

 

 

 

 

 

 

 

| **THE                    NATIONAL SECURITY GROUP, INC.**                                                        |
|-----------------------------------------------------------------------------------------------------------------|
| CONSOLIDATED STATEMENTS OF                    CASH FLOWS                                                        |
|                                                                                                            |
|                                                                                                            | (Dollars in thousands) |
|                                                                                                            | Year ended December 31, |
|                                                                                                            | 2007 | 2006 | 2005 |
| Cash flows from operating                    activities:                                                        |
| Income from continuing                    operations                                                            | $ | 4,721 | $ | 4,439 | $ | 1,421 |
|                                                                                                            |   |   |   |
| Adjustments to reconcile                    income from continuing operations to net cash provided by (used in) |   |   |
|                                                                                                            | operating                    activities: |   |   |   |
|                                                                                                            | Change in accrued                    investment income |   | (8) |   | (85) |   | 43 |
|                                                                                                            | Change in reinsurance                    recoverable |   | 1,325 |   | 7,951 |   | (6,875) |
|                                                                                                            | Amortization of deferred                    policy acquisition costs |   | 2,559 |   | 1,978 |   | 2,704 |
|                                                                                                            | Change in receivable for                    securities |   | - |   | 677 |   | (677) |
|                                                                                                            | Net realized gains on                    investments |   | (1,493) |   | (2,565) |   | (3,493) |
|                                                                                                            | Policy acquisition costs                    deferred |   | (3,630) |   | (3,333) |   | (3,054) |
|                                                                                                            | Change in prepaid                    reinsurance premiums |   | 13 |   | 196 |   | 271 |
|                                                                                                            | Depreciation expense and                    amortization/accretion |   | 363 |   | 536 |   | 590 |
|                                                                                                            | Change in policy                    liabilities and claims |   | 850 |   | (5,051) |   | 8,073 |
|                                                                                                            | Change in income tax                    payable |   | (126) |   | 1,106 |   | 99 |
|                                                                                                            | Deferred income                    taxes |   | (357) |   | 92 |   | (50) |
|                                                                                                            | Change in other                    liabilities |   | 1,115 |   | (1,540) |   | (691) |
|                                                                                                            | Change in accounts                    receivable of discontinued operations |   | 266 |   | 801 |   | (2,103) |
|                                                                                                            | Change in inventory of                    discontinued operations |   | 19 |   | 791 |   | (1,016) |
|                                                                                                            | Other operating cash                    provided by discontinued operations |   | (101) |   | 653 |   | 207 |
|                                                                                                            | Other, net |   | (1,683) |   | 1,156 |   | (898) |
|                                                                                                            |   |   |   |
| **Net cash provided by                    (used in) operating activities**                                      |   |   | 3,833 |   | 7,802 |   | (5,449) |
|                                                                                                            |   |   |   |
| Cash flows from investing                    activities:                                                        |   |   |   |
|                                                                                                            | Purchases of                    held-to-maturity securities |   | - |   | (1,484) |   | (1,193) |
|                                                                                                            | Purchases of                    available-for-sale securities |   | (25,875) |   | (24,396) |   | (23,037) |
|                                                                                                            | Proceeds from maturities of                    held-to-maturity securities |   | 1,082 |   | 909 |   | 2,770 |
|                                                                                                            | Proceeds from sales of                    available-for-sale securities |   | 22,429 |   | 19,569 |   | 22,576 |
|                                                                                                            | Proceeds from sales of real                    estate held for investment |   | 570 |   | 838 |   | 189 |
|                                                                                                            | Purchases of real estate                    held for investment |   | (722) |   | (821) |   | (2,451) |
|                                                                                                            | Purchase of other invested                    assets |   | - |   | - |   | - |
|                                                                                                            | Proceeds from sales of                    other invested assets |   | 243 |   | 259 |   | 368 |
|                                                                                                            | Net (purchases) proceeds                    from sale of short-term investments |   | (519) |   | 191 |   | (449) |
|                                                                                                            | Advances on policy loans,                    net |   | (75) |   | (52) |   | (22) |
|                                                                                                            | Capitalized software                    development costs |   | - |   | (234) |   | - |
|                                                                                                            | Purchase of property and                    equipment |   | (1,147) |   | (330) |   | (339) |
|                                                                                                            | Proceeds from sale of                    property and equipment |   | 5 |   | 5 |   | 309 |
|                                                                                                            | Proceeds from sale of                    property and equipment of discontinued operations |   | 33 |   | 764 |   | 3,784 |
|                                                                                                            | Net cash provided by                    investing activities of discontinued operations |   | 2,700 |   | - |   | - |
|                                                                                                            |   |   |   |
| **Net cash (used in)                    provided by investing activities**                                      |   |   | (1,276) |   | (4,782) |   | 2,505 |
|                                                                                                            |   |   |   |
| Cash flows from financing                    activities:                                                        |   |   |   |
|                                                                                                            | Proceeds from short-term                    debt |   | 900 |   | - |   | - |
|                                                                                                            | Proceeds from issuance of                    long-term debt |   | 3,093 |   | - |   | 9,279 |
|                                                                                                            | Payments on debt |   | (2,171) |   | (2,047) |   | (2,209) |
|                                                                                                            | Change in other                    policyholder funds |   | 34 |   | (34) |   | (2) |
|                                                                                                            | Dividends paid |   | (2,220) |   | (2,183) |   | (2,134) |
|                                                                                                            |   |   |   |
| **Net cash (used in)                    provided by financing activities**                                      |   |   | (364) |   | (4,264) |   | 4,934 |
|                                                                                                            |   |   |   |
| **Net increase (decrease)                    in cash**                                                          |   |   | 2,193 |   | (1,244) |   | 1,990 |
|                                                                                                                 |  |  |  |  |  |  |  |  |  |

 

 

See        accompanying notes to consolidated financial statements.

 

 

 

 

 

 

43

 

----

**Note 1 - SIGNIFICANT ACCOUNTING POLICIES**

 

| **(a)** | **Principles of Consolidation** |
|---------|---------------------------------|

 

The accompanying consolidated financial statements include the accounts of        The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries: National        Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and        NATSCO, Inc. (NATSCO). NSFC includes a wholly-owned subsidiary - Omega One Insurance        Company (Omega). All significant intercompany transactions and accounts have been        eliminated.

         

| **(b)** | **Description of Major Products** |
|---------|-----------------------------------|

NSIC is licensed in the states of Alabama, Florida, Georgia, Mississippi,        South Carolina and Texas and was organized in 1947 to provide life and burial insurance        policies to the homeservice market. Business is now produced by both company and        independent agents. Primary products include ordinary life, accident and health,        supplemental hospital, and cancer insurance products.

 

NSFC is licensed in Alabama, Arkansas, Florida, Georgia, Kentucky,        Mississippi, Oklahoma, South Carolina, Tennessee and West Virginia. In addition NSFC        operates on a surplus lines basis in Louisiana, Missouri, and Texas. NSFC operates in        various property and casualty lines, the most significant of which are dwelling property        fire and extended coverage, homeowners, mobile homeowners, ocean marine, nonstandard        automobile physical damage and liability and commercial auto liability.

         

Omega is licensed in the states of Alabama and Louisiana. Omega operates in        property and casualty lines, the most significant of which are homeowners and nonstandard        automobile physical damage and liability.

 

**(c) Basis of Presentation**

The significant accounting policies followed by the Company and subsidiaries        that materially affect financial reporting are summarized below. The accompanying        consolidated financial statements have been prepared in accordance with generally accepted        accounting principles (GAAP) which, as to the subsidiary insurance companies, differ from        statutory accounting practices permitted by regulatory authorities.

 

| **(d)** | **Use of Estimates** |
|---------|----------------------|

The preparation of financial statements in conformity with generally        accepted accounting principles requires management to make estimates and assumptions that        affect the reported amounts of assets and liabilities and disclosure of contingent assets        and liabilities at the date of the financial statements and the reported amounts of        revenues and expenses during the reporting period. Among the more significant estimates        included in these financial statements are reserves for future policy benefits, losses and        loss adjustment expenses and deferred policy acquisition costs. Actual results could differ        from those estimates.

         

| **(e)** | **Investments** |
|---------|-----------------|

The Company’s securities are classified in two categories and        accounted for as follows:

 

| **•** | Securities Held-to-Maturity. Bonds, notes and redeemable                    preferred stock for which |
|------------|-------------------------------------------------------------------------------------------------------|

the Company has the positive intent and ability to hold to maturity are        reported at cost, adjusted for amortization of premiums and accretion of discounts which        are recognized in interest income using methods which approximate level yields over the        period to maturity.

         

| **•** | Securities Available-for-Sale. Bonds, notes, common stock and                    non-redeemable |
|------------|-------------------------------------------------------------------------------------------------|

         

 

 

44

 

----

 

 

**NOTE        1 - SIGNIFICANT ACCOUNTING POLICIES – CONTINUED**

         

preferred stock not classified as either held-to-maturity, or trading are        reported at fair value, adjusted for other-than-temporary declines in fair        value.

         

| **•** | Trading Securities. The Company and its subsidiaries have no                    trading securities. |
|------------|-----------------------------------------------------------------------------------------------------|

         

Unrealized holding gains and losses, net of tax, on securities        available-for-sale are reported as a net amount in a separate component of        shareholders’ equity until realized.

 

Realized gains and losses on the sale of investments available-for-sale are        determined using the specific-identification method.

 

| Generally, realized gains and losses on sales of other                    investments are recognized in net income |
|--------------------------------------------------------------------------------------------------------------------|
| using the specific identification method.                                                                          |   |

 

Mortgage loans and policy loans are stated at the unpaid principal balance        of such loans. Investment real estate is reported at cost, less allowances for depreciation        computed on the straight-line basis. Short-term investments are carried at cost, which        approximates market value. Investments with other than temporary impairment in value are        written down to estimated realizable values and losses recognized in the determination of        net income.

 

Other invested assets consist principally of state sponsored investments        with a portion of the investment yield derived from insurance premium tax credits. These        investments are reported at the unpaid principal balance.

 

| **(f)** | **Receivable from Agents** |
|---------|----------------------------|

Agent balances are reported at unpaid balances, less a provision for credit        losses.

 

| **(g)** | **Accounts Receivable** |
|---------|-------------------------|

Accounts receivable are reported at net realizable value. Management        determines the allowance for doubtful accounts based on historical losses and current        economic conditions. On a continuing basis, management analyzes delinquent receivables and,        once these receivables are determined to be uncollectible, they are written off through a        charge against an existing allowance account or against earnings.

         

| **(h)** | **Inventory** |
|---------|---------------|

Inventory consists of finished goods inventory and is carried at the lower        of cost (first-in, first-out

method) or market.

 

| **(i)** | **Property and Equipment** |
|---------|----------------------------|

Property and equipment is carried at cost less accumulated depreciation and        includes expenditures that substantially increase the useful lives of existing property and        equipment. Significant cost incurred for internally developed software are capitalized and        amortized over estimated useful lives of 3 years. Maintenance, repairs, and minor        renovations are charged to expense as incurred. Upon sale or retirement of property and        equipment, the costs and related accumulated depreciation are eliminated from the        respective account and the resulting gain or loss is included in the results of operations.        The Company provides for depreciation of property and equipment using the straight-line        method designed to amortize costs over estimated useful lives. Estimated useful lives range        up to 40 years for buildings and from 3-8 years for electronic data processing equipment        and furniture and fixtures.

 

| **(j)** | **Fair Value of Financial Instruments** |
|---------|-----------------------------------------|

The table below presents the carrying value and fair value of the        Company’s financial instruments, as defined in accordance with applicable        requirements. Fair values of the Company’s financial instruments are estimated by        reference to quoted prices from market sources and financial institutions, as well as other        valuation techniques. In cases where quoted

 

 

 

 

45

         

----

**NOTE        1 - SIGNIFICANT ACCOUNTING POLICIES - CONTINUED**

         

market prices are not available, fair values are estimated using present        value or other valuation techniques. The fair value estimates are made at a specific point        in time, based on available market

         

information and judgments about the financial instrument, such as estimates        of timing and amount of expected future cash flows. Such estimates do not reflect any        premium or discount that could result from offering for sale at one time the        Company’s entire holdings of a particular financial instrument, nor do they consider        the tax impact of the realization of unrealized gains or losses. In many cases, the fair        value estimates cannot be substantiated by comparison to independent markets, nor can the        disclosed value be realized in immediate settlement of the instrument.

 

Certain financial instruments, particularly insurance liabilities other than        financial guarantees and investment contracts are excluded from the disclosures. In        evaluating the Company’s management of interest rate and liquidity risk, the fair        values of all assets and liabilities should be taken into consideration.

 

The fair values of cash, cash equivalents, short-term investments and        balances due on accounts from agents, reinsurers and others approximate their carrying        amounts as reflected in the consolidated balance sheet due to their short-term availability        or maturity.

         

|                                    | In Thousands of Dollars at December 31, |
|-----------------------------------------|-----------------------------------------|
|                                    | 2007                                    |   | 2006 |
|                                    | Carrying                                |   | Estimated |   | Carrying |   | Estimated |
|                                    | Value                                   |   | Fair Value |   | Value |   | Fair Value |
| **Assets and related instruments**      |                                    |   |   |   |   |   |   |   |   |
| Debt and equity securities              | $                                       | 99,078 | $ | 98,923 |   | $ | 95,136 | $ | 94,545 |
| Mortgage loans                          |                                    | 492 |   | 492 |   |   | 504 |   | 504 |
| Policy loans                            |                                    | 920 |   | 920 |   |   | 845 |   | 845 |
| Other invested assets                   |                                    | 2,103 |   | 2,103 |   |   | 2,346 |   | 2,346 |
|                                    |                                    |   |   |   |   |   |   |   |   |
| **Liabilities and related instruments** |                                    |   |   |   |   |   |   |   |   |
| Other policyholder funds                |                                    | 1,309 |   | 1,309 |   |   | 1,275 |   | 1,275 |
| Short-term debt                         |                                    | 900 |   | 900 |   |   | 11,580 |   | 11,580 |
| Long-term debt                          |                                    | 12,372 |   | 12,372 |   |   | 9,279 |   | 9,279 |

         

| **(k)** | **Statement of Cash Flows** |
|---------|-----------------------------|

For purposes of reporting cash flows, cash includes cash-on-hand, demand        deposits with banks and overnight investments.

 

         

| **(l)** | **Revenue Recognition** |
|---------|-------------------------|

Life insurance premiums are recognized as revenues when due. Property and        casualty insurance premiums, less amounts ceded to reinsurers, are recognized on a pro rata        basis over the terms of the policies. Reinsurance premiums assumed are recognized as        reported by the ceding company.

 

| **(m)** | **Deferred Policy Acquisition Costs** |
|---------|---------------------------------------|

The costs of acquiring new insurance business are deferred and amortized        over the lives of the policies. Deferred costs include commissions, other agency        compensation and expenses, and other underwriting expenses directly related to the level of        new business produced.

         

Acquisition costs relating to life contracts are amortized over the premium        paying period of the contracts, or the first renewal period of term policies, if earlier.        Assumptions utilized in amortization are consistent with those utilized in computing policy        liabilities.

 

The method of computing the deferred policy acquisition costs for property        and casualty policies limits the amount deferred to a percentage of related unearned        premiums.

 

 

 

:

 

 

46

 

----

**NOTE        1 - SIGNIFICANT ACCOUNTING POLICIES - CONTINUED**

 

| **(n)** | **Policy Liabilities** |
|---------|------------------------|

The liability for future life insurance policy benefits is computed using a        net level premium method including the following assumptions

 

                                                       

| **Years of Issue** | **Interest Rate** |
|--------------------|-------------------|
| 1947 - 1968        | 4%                |
| 1969 - 1978        | 6% graded to 5%   |
| 1979 - 2007        | 7% graded to 6%   |

 

Mortality assumptions include various percentages of the 1955-60 and 1965-70        Select and Ultimate Basic Male Mortality Table. Withdrawal assumptions are based on the        Company’s experience.

 

| **(o)** | **Claim Liabilities** |
|---------|-----------------------|

The liability for unpaid claims represents the estimated liability for        claims reported to the Company and its subsidiaries plus claims incurred but not yet        reported and the related adjustment expenses. The liabilities for claims and related        adjustment expenses are determined using case-basis evaluations and statistical analyses        and represent estimates of the ultimate net cost of all losses incurred through December 31        of each year. Although considerable variability is inherent in such estimates, management        believes that the liabilities for unpaid claims and related adjustment expenses are        adequate. The estimates are continually reviewed and adjusted as necessary; such        adjustments are included in current operations.

 

| **(p)** | **Earnings Per Share** |
|---------|------------------------|

Earnings per share of common stock is based on the weighted average number        of shares outstanding during each year. The adjusted weighted average shares outstanding        were 2,466,600 (2,466,600 in 2006 and 2005).

 

| **(q)** | **Reinsurance** |
|---------|-----------------|

In the normal course of business, NSFC seeks to reduce the loss that may        arise from catastrophes or other events that cause unfavorable underwriting results by        reinsuring certain levels of risk in various areas of exposure with other insurance        enterprises or reinsurers. In 2007, NSFC maintained a catastrophe reinsurance agreement to        cover losses from catastrophic events, primarily hurricanes. Under the agreement, the        Company pays the first $3.5 million in covered losses from a catastrophic event. Under        layer 1 of the reinsurance program, reinsurers pay 95% of covered losses in excess of $3.5        million up to $10 million. Under layer 2 of the reinsurance program, reinsurers pay 95% of        covered losses in excess of $10 million up to $17.5 million. Under layer 3 of the        reinsurance program, reinsurers pay 100% of covered losses in excess of $17.5 million up to        $42.5 million. In July of 2007, the Company added an additional layer of coverage to the        reinsurance program. Under layer 4, reinsurers pay 100% of covered losses in excess of        $42.5 million up to $47.5 million. All reinsurers under the program carry A.M. Best ratings        of A- (Excellent) or higher.

         

Amounts recoverable from reinsurers are estimated in a manner consistent        with the claim liability associated with the reinsured policy. Amounts paid for prospective        reinsurance contracts are reported as prepaid reinsurance premiums and amortized over the        remaining contract period. In the normal course of business, NSIC seeks to limit its        exposure to loss on any single insured and to recover a portion of benefits paid by ceding        reinsurance to other insurance enterprises or reinsurers under excess coverage contracts.        NSIC retains a maximum of $50,000 of coverage per individual life. The cost of reinsurance        is amortized over the contract period of the reinsurance.

 

| **(r)** | **Reclassifications** |
|---------|-----------------------|

Certain reclassifications have been made in the previously reported        financial statements to make the prior year amounts comparable to those of the current        year. Such reclassifications had no effect on the previously reported net income or        shareholders’ equity.

         

 

 

 

47

 

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**NOTE        1 - SIGNIFICANT ACCOUNTING POLICIES – CONTINUED**

 

| **(s)** | **Advertising** |
|---------|-----------------|

The Company expenses advertising costs as incurred. Advertising costs        charged to expense were $193,000 for the year ended December 31, 2007 ($195,000 and        $113,000 for the years ended December 31, 2006 and 2005, respectively).

 

 

| **(t)** | **Concentration of Credit Risk** |
|---------|----------------------------------|

The Company maintains cash depository accounts which, at times, may exceed        federally insured limits. These amounts represent actual account balances held by financial        institutions at the end of the period, and unlike the balance reported in the financial        statements, the account balances do not reflect timing delays inherent in reconciling items        such as outstanding checks and deposits in transit. The Company has not experienced any        losses in such accounts. The Company believes it is not exposed to any significant credit        risk on cash and cash equivalents.

         

Reinsurance contracts do not relieve the Company of its obligations to        policyholders. A failure of a reinsurer to meet their obligation could result in losses to        the insurance subsidiaries. Allowances for losses are established if amounts are believed        to be uncollectible. At December 31, 2007 and 2006, no amounts were deemed uncollectible.        The Company, at least annually, evaluates the financial condition of all reinsurers and        evaluates any potential concentrations of credit risk. At December 31, 2007, management        does not believe the Company is exposed to any significant credit risk related to its        reinsurance program.

 

| **(u)** | **Recently Issued Accounting Standards** |
|---------|------------------------------------------|

During 2007, the Financial Accounting Standards Board (FASB) issued the        following pronouncements:

         

SFAS No. 141 (revised 2007),*Business        Combinations,*SFAS No. 141 (revised 2007) establishes principles        and requirements for how the acquirer recognizes and measures in its financial statements        the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest        in the acquiree; recognizes and measures the goodwill acquired in the business combination        or a gain from a bargain purchase; and determines what information to disclose to enable        users of the financial statements to evaluate the nature and financial effects of the        business combination. This statement is effective for business combinations for which the        acquisition date is on or after the beginning of the first annual reporting period on or        after December 15, 2008. The adoption of this statement is not expected to have a material        impact on the Company’s financial position or results of operations.

         

SFAS No. 160,*Noncontrolling Interests in        Consolidated Financial Statements—an amendment of ARB No. 51*amends ARB 51 to establish accounting and reporting standards for the        noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. SFAS        No. 160 (revised 2007) also amends consolidation procedures in ARB 51 for consistency with        the requirements of SFAS No. 160. This statement is effective for fiscal years, and interim        periods within those fiscal years, beginning on or after December 15, 2008. The adoption of        this statement is not expected to have a material impact on the Company’s financial        position or results of operations.

         

**NOTE        2 – VARIABLE INTEREST ENTITIES**

 

In        December 2003, the FASB issued Revised FIN 46 (FIN 46R) to clarify certain aspects of        FIN 46 including the determination of who is the primary beneficiary of a variable interest        entity (VIE). FIN 46R postponed the effective date as to when companies are required to        apply the provisions prospectively for all variable interest entities in existence prior to        January 31, 2003 until the first financial reporting period that ends after        March 15, 2004. However, for entities that are considered to be special purpose        entities, the effective date of FIN 46R is financial reporting periods after        December 15, 2003. The Company does not have an interest in any special purpose        entities. See note 16 for information regarding the Company’s investment in Mobile        Attic, Inc.

 

In        December 2005, the Company formed National Security Capital Trust I (the Trust), a        statutory trust created under the Delaware Statutory Trust Act, for the sole purpose of        issuing, in private placement transactions, $9 million of trust preferred securities (TPS)        and using the proceeds thereof, together with the equity proceeds received from the Company        in the initial formation of the Trust, to purchase $9.3 million of variable rate        subordinated debentures issued by the Company. The Company owns all voting securities of        the Trust and the

 

 

48

 

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**NOTE        2 – VARIABLE INTEREST ENTITIES – CONTINUED**

 

subordinated debentures are the sole assets of the Trust. The Trust will        meet the obligations of the TPS with the interest and principal paid on the subordinated        debentures. The Company received net proceeds from the

 

TPS        transactions, after commissions and other costs of issuance, of $9.005 million. The Company        also holds all the voting securities issued by the Trust and such trusts are considered to        be VIE’s. The Trust is not consolidated because the Company is not the primary        beneficiary of the trust. The Subordinated Debentures, disclosed in Note 8 are reported in        the accompanying Consolidated Balance Sheet as a component of long-term debt. The        Company’s equity investments in the Trust total $279,000 and are included in Other        Assets.

 

In June        2007, the Company formed National Security Capital Trust II for the sole purpose of        issuing, in private placement transactions, $3 million of trust preferred securities (TPS)        and using the proceeds thereof, together with the equity proceeds received from the Company        in the initial formation of the Trust, to purchase $3.093 unsecured junior subordinated        deferrable interest debentures. The Company owns all voting securities of the Trust and the        subordinated debentures are the sole assets of the Trust. The Trust will meet the        obligations of the TPS with the interest and principal paid on the subordinated debentures.        The Company received net proceeds from the TPS transactions, after commissions and other        costs of issuance, of $2.995 million. The Company also holds all the voting securities        issued by the Trust and such trusts are considered to be VIE’s. The Trust is not        consolidated because the Company is not the primary beneficiary of the trust. The        Subordinated Debentures, disclosed in Note 8 are reported in the accompanying Consolidated        Balance Sheet as a component of long-term debt. The Company’s equity investments in        the Trust total $93,000 and are included in Other Assets.

 

**NOTE        3 - STATUTORY ACCOUNTING PRACTICES**

 

The        accompanying consolidated financial statements have been prepared in conformity with        generally accepted accounting principles (GAAP) which vary in certain respects from        reporting practices prescribed or permitted by insurance regulatory authorities. The        significant differences for statutory reporting include: (a) acquisition costs of acquiring        new business are charged to operations as incurred, (b) life policy liabilities are        established utilizing interest and mortality factors specified by regulatory authorities,        (c) the Asset Valuation Reserve (AVR) and the Interest Maintenance Reserve (IMR) are        recorded as liabilities, and (d) non-admitted assets (furniture and equipment,        agents’ debit balances and prepaid expenses) are charged directly to        surplus.

 

Statutory net gains (losses) from operations and capital and surplus,        excluding intercompany transactions, are summarized as follows:

 

 

|                                   |                                                                                                       |   | 2007   |   | 2006    |   | 2005   |
|----------------------------------------|------------------------------------------------------------------------------------------------------------|--------|--------|--------|---------|--------|--------|
|                                   | NSIC - including realized capital gains of $193, $561, and $129,                    respectively           | $      | (351)  | $      | (1,580) | $      | (101)  |
|                                   | NSFC - including realized capital gains of $1,368, $1,803, and                    $3,098, respectively     | $      | 4,609  | $      | 4,222   | $      | 729    |
|                                   | Omega - including realized capital (losses) gains of $(6), $180,                    and $180, respectively | $      | 697    | $      | 621     | $      | 645    |
|                                   |                                                                                                       |   |   |   |    |   |   |
| Statutory risk-based adjusted capital: |                                                                                                       |   |   |   |    |   |
|                                   | NSIC - including AVR of $1,022, $ 955, and $845,                    respectively                           | $      | 9,912  | $      | 10,298  | $      | 10,776 |
|                                   | NSFC                                                                                                       | $      | 34,122 | $      | 32,583  | $      | 27,209 |
|                                   | Omega                                                                                                      | $      | 9,640  | $      | 9,038   | $      | 8,016  |

 

 

The        above amounts exclude allocation of overhead from the Company. NSIC, NSFC and Omega are in        compliance with statutory restrictions with regard to minimum amounts of surplus and        capital.

 

49

 

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**NOTE 4        - INVESTMENT SECURITIES**

 

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

 

|                           |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |   |   |
|--------------------------------|--------------------------------------------------|-------------------------------------------|--------|--------|------------------------|------------|------------|--------|--------|--------|--------|--------|--------|--------|
|                           |                                             |                                      |   |   | (Dollars in thousands) |
|                           |                                             |                                      |   |   | December 31, 2007      |
|                           |                                             |                                      |   |   |                   |       |       | Gross  |   |   | Gross  |   |   |   |
|                           |                                             |                                      |   |   | Amortized              | Unrealized | Unrealized | Fair   |
|                           |                                             |                                      |   |   | Cost                   |       |       | Gains  |   |   | Losses |   |   | Value  |
| Available-for-sale securities: |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |
|                           | Corporate debt securities                        |                                      | $      | 5,365  |                   | $          | 86         |   | $      | 554    |   | $      | 14,897 |
|                           | Mortgage backed securities                       |                                      |   | 18,762 |                   |       | 70         |   |   | 365    |   |   | 18,467 |
|                           | Obligations of states and political subdivisions |                                      |   | 10,144 |                   |       | 35         |   |   | 144    |   |   | 10,035 |
|                           | U.S. Treasury securities and obligations of      |                                      |   |   |                   |       |       |   |   |   |   |   |   |
|                           |                                             | U.S. Government corporations and agencies | 23,117 |   |                   | 288        |       |   | 27     |   |   | 23,378 |
| Total fixed maturities         |                                             |                                      | 67,388 |   |                   | 479        |       |   | 1,090  |   |   | 66,777 |
| Equity securities              |                                             |                                      | 7,635  |   |                   | 8,098      |       |   | 742    |   |   | 14,991 |
|                           |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |   |   |
|                           |                                             | **Total**                                 |   | $      | 75,023                 |       | $          | 8,577  |   | $      | 1,832  |   | $      | 81,768 |
|                           |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |   |   |
| Held-to-maturity securities:   |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |
|                           | Corporate debt securities                        |                                      | $      | 170    |                   | $          | 6          |   | $      | -      |   | $      | 176    |
|                           | Mortgage backed securities                       |                                      |   | 5,688  |                   |       | 5          |   |   | 187    |   |   | 5,506  |
|                           | Obligations of states and political subdivisions |                                      |   | 2,710  |                   |       | 27         |   |   | 34     |   |   | 2,703  |
|                           | U.S. Treasury securities and obligations of      |                                      |   |   |                   |       |       |   |   |   |   |   |   |
|                           |                                             | U.S. Government corporations and agencies | 8,742  |   |                   | 54         |       |   | 26     |   |   | 8,770  |
|                           |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |   |   |
|                           |                                             | **Total**                                 |   | $      | 17,310                 |       | $          | 92     |   | $      | 247    |   | $      | 17,155 |
|                           |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |   |   |
|                           |                                             |                                      |   |   | December 31, 2006      |
|                           |                                             |                                      |   |   |                   |       |       | Gross  |   |   | Gross  |   |   |   |
|                           |                                             |                                      |   |   | Amortized              | Unrealized | Unrealized | Fair   |
|                           |                                             |                                      |   |   | Cost                   |       |       | Gains  |   |   | Losses |   |   | Value  |
| Available-for-sale securities: |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |
|                           | Corporate debt securities                        |                                      | $      | 11,521 |                   | $          | 39         |   | $      | 133    |   | $      | 11,427 |
|                           | Mortgage backed securities                       |                                      |   | 15,183 |                   |       | 2          |   |   | 373    |   |   | 14,812 |
|                           | Obligations of states and political subdivisions |                                      |   | 5,650  |                   |       | 23         |   |   | 92     |   |   | 5,581  |
|                           | U.S. Treasury securities and obligations of      |                                      |   |   |                   |       |       |   |   |   |   |   |   |
|                           |                                             | U.S. Government corporations and agencies | 30,626 |   |                   | 58         |       |   | 569    |   |   | 30,115 |
| Total fixed maturities         |                                             |                                      | 62,980 |   |                   | 122        |       |   | 1,167  |   |   | 61,935 |
| Equity securities              |                                             |                                      | 7,224  |   |                   | 9,261      |       |   | 366    |   |   | 16,119 |
|                           |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |   |   |
|                           |                                             | **Total**                                 |   | $      | 70,204                 |       | $          | 9,383  |   | $      | 1,533  |   | $      | 78,054 |
|                           |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |   |   |
| Held-to-maturity securities:   |                                             |                                      |   |   |                   |       |       |   |   |   |   |   |
|                           | Corporate debt securities                        |                                      | $      | 244    |                   | $          | 6          |   | $      | -      |   | $      | 250    |
|                           | Mortgage backed securities                       |                                      |   | 6,750  |                   |       | 9          |   |   | 239    |   |   | 6,520  |
|                           | Obligations of states and political subdivisions |                                      |   | 2,787  |                   |       | 22         |   |   | 54     |   |   | 2,755  |
|                           | U.S. Treasury securities and obligations of      |                                      |   |   |                   |       |       |   |   |   |   |   |   |
|                           |                                             | U.S. Government corporations and agencies | 8,983  |   |                   | 2          |       |   | 338    |   |   | 8,647  |
|                           |                                             | **Total**                                 |   |   |                   |       |       |   |   |   |   |   |   |   |
|                           |                                             |                                      |   | $      | 18,764                 |       | $          | 39     |   | $      | 631    |   | $      | 18,172 |

 

 

50

 

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**NOTE        4 - INVESTMENT SECURITIES – CONTINUED**

 

The        amortized cost and aggregate fair value of debt securities at December 31, 2007, by        contractual maturity, are as follows. Expected maturities will differ from contractual        maturities because borrowers may have the right to call or prepay obligations with or        without call or prepayment penalties.

 

|                           |                                   |   |   |   |   |                   |      |   |   |   |
|--------------------------------|----------------------------------------|--------|--------|--------|--------|------------------------|-----------|--------|--------|--------|
|                           |                                   |   |   |   |   | (Dollars in Thousands) |
|                           |                                   |   |   |   |   |                   | Amortized | Fair   |
| Available-for-sale securities: |                                   |   |   | Cost   |   |                   | Value     |
|                           | Due in one year or less                |   |   | $      | 4,203  |                   | $         | 4,200  |
|                           | Due after one year through five years  |   |   | 10,857 |   |                   | 10,793    |
|                           | Due after five years through ten years |   |   | 19,951 |   |                   | 19,720    |
|                           | Due after ten years                    |   |   |   | 32,377 |                   |      | 32,064 |
|                           |                                   |   |   |   |   |                   |      |   |   |   |

 

|                         |  

**Total**                      |   |   |   |   | $      | 67,388 |   | $      | 66,777 |
|------------------------------|----------------------------------------|--------|--------|--------|--------|--------|--------|--------|--------|--------|
|                         |                                   |   |   |   |   |   |   |   |   |   |
| Held-to-maturity securities: |                                   |   |   |   |   |   |   |
|                         | Due in one year or less                |   |   | $      | 325    |   | $      | 324    |
|                         | Due after one year through five years  |   |   | 2,778  |   |   | 2,782  |
|                         | Due after five years through ten years |   |   | 7,303  |   |   | 7,331  |
|                         | Due after ten years                    |   |   |   | 6,904  |   |   | 6,718  |
|                         |                                   |   |   |   |   |   |   |   |   |   |
|                         | **Total**                              |   |   |   |   | $      | 17,310 |   | $      | 17,155 |

 

 

For        2007, gross gains of $1,466,000 ($2,637,000 for 2006 and $3,793,000 for 2005) and gross        losses of $207,000 ($86,000 for 2006 and $66,000 for 2005) were realized on sales of        available-for-sale-securities.

 

A        summary of securities available-for-sale with unrealized losses as of December 31, 2007 and        2006 along with the related fair value, aggregated by the length of time that investments        have been in a continuous unrealized loss position, is as follows:

 

|              | (Dollars in thousands)         | December 31, 2007   |
|-------------------|--------------------------------|---------------------|
|              | Less than 12 months            | 12 months or longer | Total |
|              | Gross                          |                | Gross |   | Gross | Total |
|              | Fair                           | Unrealized          | Fair | Unrealized | Fair | Unrealized | Securities in a |
|              | Value                          | Losses              | Value | Losses | Value | Losses | Loss Position |
| Fixed maturities  |
|              | Corporate                      | $                   | 2,873 | $ | 130 | $ | 5,751 | $ | 424 | $ | 8,624 | $ | 554 |   | 27 |
|              | Mortgage backed securities     |                | 6,953 |   | 232 |   | 6,824 |   | 133 |   | 13,777 |   | 365 |   | 36 |
|              | Obligations of state and       |                |   |   |   |   |   |   |
|              | political subdivisions         |                | 2,750 |   | 88 |   | 3,643 |   | 56 |   | 6,393 |   | 144 |   | 21 |
|              | U.S. Treasury securities and   |                |   |   |   |   |   |   |
|              | obligations of U.S. government |                |   |   |   |   |   |   |
|              | corporations and agencies      |                | - |   | - |   | 5,137 |   | 27 |   | 5,137 |   | 27 |   | 12 |
| Equity securities |                           | 802                 |   | 176 |   | 1,173 |   | 566 |   | 1,975 |   | 742 |   | 9 |
|              | $                              | 13,378              | $ | 626 | $ | 22,528 | $ | 1,206 | $ | 35,906 | $ | 1,832 |   | 105 |
|                   |                                |                     |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

 

 

 

51

 

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**NOTE        4 - INVESTMENT SECURITIES – CONTINUED**

 

 

 

|              |                           | (Dollars in thousands) | December 31, 2006 |
|-------------------|--------------------------------|------------------------|-------------------|
|              |                           | Less than 12 months    |              | 12 months or longer |   | Total |
|              |                           |                   | Gross             |   |   | Gross |   |   | Gross | Total |
|              |                           | Fair                   |              | Unrealized |   | Fair |   | Unrealized |   | Fair |   | Unrealized | Securities in a |
|              |                           | Value                  |              | Losses |   | Value |   | Losses |   | Value |   | Losses | Loss Position |
| Fixed maturities  |                           |                   |              |   |   |   |   |
|              | Corporate                      | $                      | -                 | $ | - | $ | 7,780 | $ | 133 | $ | 7,780 | $ | 133 |   | 22 |
|              | Mortgage backed securities     |                   | -                 |   | - |   | 14,610 |   | 373 |   | 14,610 |   | 373 |   | 36 |
|              | Obligations of state and       |                   |              |   |   |   |   |   |
|              | political subdivisions         |                   | -                 |   | - |   | 4,817 |   | 92 |   | 4,817 |   | 92 |   | 19 |
|              | U.S. Treasury securities and   |                   |              |   |   |   |   |   |
|              | obligations of U.S. government |                   |              |   |   |   |   |   |
|              | corporations and agencies      |                   | -                 |   | - |   | 25,446 |   | 569 |   | 25,446 |   | 569 |   | 61 |
| Equity securities |                           | -                      |              | - |   | 1,571 |   | 366 |   | 1,571 |   | 366 |   | 9 |
|              | $                              | -                      | $                 | - | $ | 54,224 | $ | 1,533 | $ | 54,224 | $ | 1,533 |   | 147 |

 

 

 

 

A        summary of securities held-to-maturity with unrealized losses as of December 31, 2007and        2006 along with the related fair value, aggregated by the length of time that investments        have been in a continuous unrealized loss position, is as follows:

 

|             |                           | (Dollars in thousands) | December 31, 2007 |                |
|------------------|--------------------------------|------------------------|-------------------|---------------------|
|             |                           | Less than 12 months    |              | 12 months or longer |   | Total |   |
|             |                           |                   | Gross             |                |   | Gross |   |   | Gross |   | Total |   |
|             |                           | Fair                   |              | Unrealized          |   | Fair |   | Unrealized |   | Fair |   | Unrealized |   | Securities in a |   |
|             |                           | Value                  |              | Losses              |   | Value |   | Losses |   | Value |   | Losses |   | Loss Position |   |
| Fixed maturities |                           |                   |              |                |   |   |   |   |
|             | Corporate                      | $                      | -                 | $                   | - | $ | - | $ | - | $ | - | $ | - |   | - |   |
|             | Mortgage backed securities     |                   | -                 |                | - |   | 4,733 |   | 187 |   | 4,733 |   | 187 |   | 17 |   |
|             | Obligations of state and       |                   |              |                |   |   |   |   |   |
|             | political subdivisions         |                   | 290               |                | 9 |   | 906 |   | 25 |   | 1,196 |   | 34 |   | 5 |   |
|             | U.S. Treasury securities and   |                   |              |                |   |   |   |   |   |
|             | obligations of U.S. government |                   |              |                |   |   |   |   |   |
|             | corporations and agencies      |                   | -                 |                | - |   | 4,579 |   | 26 |   | 4,579 |   | 26 |   | 12 |   |
|             | $                              | 290                    | $                 | 9                   | $ | 10,218 | $ | 238 | $ | 10,508 | $ | 247 |   | 34 |   |

 

 

|             |                           | (Dollars in thousands) | December 31, 2006 |
|------------------|--------------------------------|------------------------|-------------------|
|             |                           | Less than 12 months    |              | 12 months or longer |   | Total |
|             |                           |                   | Gross             |   |   | Gross |   |   | Gross |   | Total |
|             |                           | Fair                   |              | Unrealized |   | Fair |   | Unrealized |   | Fair |   | Unrealized |   | Securities in a |
|             |                           | Value                  |              | Losses |   | Value |   | Losses |   | Value |   | Losses |   | Loss Position |
| Fixed maturities |                           |                   |              |   |   |   |   |
|             | Corporate                      | $                      | -                 | $ | - | $ | - | $ | - | $ | - | $ | - |   | - |
|             | Mortgage backed securities     |                   | -                 |   | - |   | 6,075 |   | 239 |   | 6,075 |   | 239 |   | 19 |
|             | Obligations of state and       |                   |              |   |   |   |   |   |
|             | political subdivisions         |                   | -                 |   | - |   | 2,222 |   | 54 |   | 2,222 |   | 54 |   | 8 |
|             | U.S. Treasury securities and   |                   |              |   |   |   |   |   |
|             | obligations of U.S. government |                   |              |   |   |   |   |   |
|             | corporations and agencies      |                   | -                 |   | - |   | 8,415 |   | 338 |   | 8,415 |   | 338 |   | 24 |
|             | $                              | -                      | $                 | - | $ | 16,712 | $ | 631 | $ | 16,712 | $ | 631 |   | 51 |

 

 

 

52

 

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**NOTE        4 - INVESTMENT SECURITIES – CONTINUED**

 

All        unrealized losses are reviewed to determine whether the losses are other than temporary.        Factors considered include whether the securities are backed by the U.S. Government or its        agencies and concerns surrounding the recovery of full principal. Management has evaluated        each security in a significant unrealized loss position. Most unrealized losses in the        fixed income portfolio are interest rate driven as opposed to credit quality driven and        management believes no ultimate loss will be realized. The Company has no material exposure        to sub-prime mortgage loans and less than 1% of the fixed income investment portfolio is        rated below investment grade.

 

**NOTE 5        - NET INVESTMENT INCOME**

 

Major        categories of investment income are summarized as follows:

 

|                                              |                                 |                    | (Dollars in thousands)  |
|---------------------------------------------------|--------------------------------------|-------------------------|-------------------------|
|                                              |                                 |                    | Year ended December 31, |
|                                              |                                 |                    |                    | 2007 |   |   | 2006 |   |   | 2005 |
| Fixed maturities                                  |                                 | $                       | 4,182                   |   | $ | 3,706 |   | $ | 3,505 |
| Equity securities                                 |                                 |                    | 335                     |   |   | 333 |   |   | 408 |
| Mortgage loans on real estate                     |                                 |                    | 39                      |   |   | 28 |   |   | 22 |
| Investment real estate                            |                                 |                    | 132                     |   |   | 60 |   |   | 23 |
| Policy loans                                      |                                 |                    | 63                      |   |   | 58 |   |   | 56 |
| Other, principally short-term investments         |                                 |                    | 409                     |   |   | 399 |   |   | 95 |
|                                              |                                 |                    |                    | 5,160 |   |   | 4,584 |   |   | 4,109 |
| Less: Investment expenses                         |                                 |                    | 411                     |   |   | 121 |   |   | 145 |
| Net investment income                             |                                 | $                       | 4,749                   |   | $ | 4,463 |   | $ | 3,964 |
| An analysis of investment gains (losses) follows: |                                 | Year ended December 31, |
|                                              |                                 |                    |                    | 2007 |   |   | 2006 |   |   | 2005 |
| Net realized investment (losses) gains:           |                                 |                    |                    |   |   |   |   |   |   |
|                                              | Fixed maturities                     |                    | $                       | (85) |   | $ | 99 |   | $ | 132 |
|                                              | Other, principally equity securities |                    |                    | 1,578 |   |   | 2,466 |   |   | 3,361 |
|                                              |                                 |                    | $                       | 1,493 |   | $ | 2,565 |   | $ | 3,493 |

 

 

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

 

|                                                |                                    |   | (Dollars in thousands)  |
|-----------------------------------------------------|-----------------------------------------|--------|-------------------------|
|                                                |                                    |   | Year ended December 31, |
|                                                |                                    |   |                    | 2007 |   |   | 2006 |   |   | 2005 |
|                                                |
| Net change in unrealized appreciation on available- |                                    |   |                    |   |   |   |   |   |   |
|                                                | for-sale securities before deferred tax |   | $                       | (1,103) |   | $ | (366) |   | $ | (3,689) |
| Deferred income tax                                 |                                    |   | 439                     |   |   | 122 |   |   | 1,145 |
|                                                |                                    |   |                    |   |   |   |   |   |   |   |
| Net change in unrealized appreciation on available- |                                    |   |                    |   |   |   |   |   |   |
|                                                | for-sale securities                     |   | $                       | (664) |   | $ | (244) |   | $ | (2,544) |

 

 

 

 

53

 

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**NOTE        6 - PROPERTY AND EQUIPMENT**

 

At        December 31, property and equipment consisted of the following:

 

|                                                                        |   | (Dollars in Thousands) |
|-----------------------------------------------------------------------------|--------|------------------------|
|                                                                        |   | 2007                   |   |   | 2006 |
| Building and improvements                                                   | $      | 2,994                  |   | $ | 1,957 |
| Electronic data processing equipment                                        |   | 2,333                  |   |   | 2,093 |
| Furniture and fixtures                                                      |   | 1,044                  |   |   | 1,021 |
|                                                                        |   | 6,371                  |   |   | 5,071 |
| Less accumulated depreciation                                               |   | 3,441                  |   |   | 2,834 |
|                                                                        |   | 2,930                  |   |   | 2,237 |
| Property and equipment of discontinued operations                           |   | -                      |   |   | 9,932 |
| Less accumulated depreciation of discontinued                    operations |   | -                      |   |   | 927 |
|                                                                        | $      | 2,930                  |   | $ | 11,242 |

 

 

Depreciation expense for the year ended December 31, 2007 was $538,000        ($486,000 for the year ended December 31, 2006 and $551,000 for the year ended December 31,        2005).

 

**NOTE 7        - INCOME TAXES**

 

The        Company adopted the provisions of FASB Interpretation (FIN) No. 48 effective January 1,        2007. As of the date of adoption, the company did not have any gross unrecognized tax        benefits that would exceed a materiality threshold and therefore, there was no reduction to        Retained Earnings in the Company’s Consolidated Balance Sheet at January 1, 2007. The        Company recognizes tax-related interest and penalties as a component of tax expense. The        Company does not have any interest or penalties accrued for unrecognized tax benefits at        December 31, 2007. The Company files income tax returns in the U.S. federal jurisdiction        and various states. The Company is not subject to examinations by authorities related to        its U.S. federal or state income tax filings for years prior to 2003. No income tax returns        are currently under examination by the Internal Revenue Service or any state or local        taxing authority.

 

Net        deferred tax liabilities are determined based on the estimated future tax effects of        differences between the financial statement and tax basis of assets and liabilities given        the provisions of the enacted tax laws.

 

The tax        effect of significant differences representing deferred tax assets and liabilities are as        follows:

 

 

 

|                                              | (Dollars in Thousands) |
|---------------------------------------------------|------------------------|
|                                              |                   | December 31, |   | December 31, |
|                                              |                   | 2007 |   | 2006 |
| General insurance expenses                        | $                      | 838 | $ | 707 |
| Unearned premiums                                 |                   | 1,523 |   | 1,212 |
| Claims liabilities                                |                   | 258 |   | 243 |
| Deferred tax assets                               |                   | 2,619 |   | 2,162 |
|                                              |                   |   |   |   |
| Depreciation                                      |                   | (158) |   | (216) |
| Deferred policy acquisition costs                 |                   | (1,899) |   | (1,745) |
| Unrealized gains on securities available-for-sale |                   | (1,793) |   | (2,232) |
| Deferred tax liabilities                          |                   | (3,850) |   | (4,193) |
|                                              |                   |   |   |   |
| Net deferred tax liability                        | $                      | (1,231) | $ | (2,031) |

 

 

 

 

54

 

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**NOTE 7        - INCOME TAXES – CONTINUED**

 

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

 

|                                                 |   |   | (Dollars in thousands)  |
|------------------------------------------------------|--------|--------|-------------------------|
|                                                 |   |   | Year ended December 31, |
|                                                 |   |   |                    | 2007 |   |   | 2006 |   |   | 2005 |
|                                                 |   |   |                    |   |   |   |   |   |   |   |
| Federal income tax rate applied to pre-tax income    |   | $      | 2,342                   |   | $ | 2,126 |   | $ | 681 |
| Dividends received deduction and tax-exempt interest |   |   | (196)                   |   |   | (149) |   |   | (183) |
| Other, net                                           |   |   | 22                      |   |   | (162) |   |   | 83 |
|                                                 |   |   |                    |   |   |   |   |   |   |   |
| Federal income tax expense                           |   | $      | 2,168                   |   | $ | 1,815 |   | $ | 581 |

 

The        appropriate income tax effects of changes in temporary differences are as        follows:

 

|                              | Year ended December 31, |
|-----------------------------------|-------------------------|
|                              |                    | 2007 |   |   | 2006 |   |   | 2005 |
|                              |                    |   |   |   |   |   |   |   |
| Deferred policy acquisition costs | $                       | (154) |   | $ | (488) |   | $ | 117 |
| Policy liabilities                |                    | - |   |   | 70 |   |   | 70 |
| Unearned premiums                 |                    | 311 |   |   | (151) |   |   | (88) |
| General insurance expenses        |                    | 131 |   |   | 526 |   |   | (55) |
| Depreciation                      |                    | 53 |   |   | (61) |   |   | (38) |
| Claim liabilities                 |                    | 16 |   |   | 12 |   |   | 44 |
|                              | $                       | 357 |   | $ | (92) |   | $ | 50 |

 

 

Under        pre-1984 life insurance company tax laws, a portion of NSIC’s gain from operations        was not subject to current income taxation, but was accumulated for tax purposes in a        memorandum account designated “policyholders’ surplus”. The aggregate        balance in this account, $3,720,000 at December 31, 2007, would be taxed at current rates        only if distributed to shareholders or if the account exceeded a prescribed minimum. The        Deficit Reduction Act of 1984 eliminated additions to policyholders’ surplus        for1984 and thereafter. Deferred taxes have not been provided on        amounts designated as policyholders’ surplus. The deferred income tax liability not        recognized is approximately $1,270,000 at December 31, 2007.

 

 

 

 

 

 

 

 

55

 

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**NOTE        8 – NOTES PAYABLE AND LONG-TERM DEBT**

 

Short-term        debt consisted of the following as of December 31, 2007 and December 31, 2006:

 

|                                                                                                                                                                                                                                                                                                                          |   | (Dollars in thousands) |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|
|                                                                                                                                                                                                                                                                                                                          |   | 2007                   |   |   | 2006 |
|                                                                                                                                                                                                                                                                                                                          |   |                   |   |   |   |
| Revolving credit facility of subsidiary National Security                    Insurance Company in the amount of $900. Facility used to finance office                    expansion project. Interest rate of Prime minus 50 basis points (6.75% at                    December 31, 2007) and maturing April, 2008. Unsecured. | $      | 900                    |   | $ | - |
|                                                                                                                                                                                                                                                                                                                          |   |                   |   |   |   |
| Note payable to bank with an interest rate based on LIBOR (8.10%                    at December 31, 2006) dated March, 2002; maturity March, 2007. Payments of $113                    due quarterly with balloon payment at maturity. Unsecured.                                                                             |   | -                      |   |   | 2,171 |
|                                                                                                                                                                                                                                                                                                                          |   |                   |   |   |   |
| Note payable to bank with an interest rate based on prime minus                    25 basis points (8.00% at December 31, 2006) dated June, 2004; maturity June,                    2007. Interest payments due quarterly. Secured by $9,005 of leasing                    equipment.                                         |   | -                      |   |   | 9,409 |
|                                                                                                                                                                                                                                                                                                                          | $      | 900                    |   | $ | 11,580 |

 

 

Long-term        debt consisted of the following as of December 31, 2007 and December 31, 2006:

 

|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |   | (Dollars in thousands) |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------|
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |   | 2007                   |   |   | 2006 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |   |                   |   |   |   |
| Subordinated debentures issued on December 15, 2005 with fixed                    interest rate of 8.83% each distribution period thereafter until December 15,                    2015 when the coupon rate shall equal the 3-month LIBOR plus 3.75% applied to                    the outstanding principal; maturity December, 2035. Interest payments due                    quarterly. All may be redeemed at any time following the tenth anniversary of                    issuance. Unsecured. | $      | 9,279                  |   | $ | 9,279 |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |   |                   |   |   |   |
| Subordinated debentures issued on June 21, 2007 with a floating                    interest rate equal to the 3 Month LIBOR plus 3.40% applied to the outstanding                    principal; maturity June 15, 2037. Interest payments due quarterly. All may be                    redeemed at any time following the fifth anniversary of issuance.                    Unsecured.                                                                                                                 |   | 3,093                  |   |   | - |
|                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   | $      | 12,372                 |   | $ | 9,279 |

 

 

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

 

The        subordinated debentures (debentures) have the same maturities and other applicable terms        and features as the associated trust preferred securities (TPS). Payment of interest may be        deferred for up to 20 consecutive quarters; however, stockholder dividends cannot be paid        during any extended interest payment period or any time the debentures are in default. All        have stated maturities of thirty years. None of the securities require the Company to        maintain minimum financial covenants. The Company has guaranteed that amounts paid to the        Trusts (discussed in Note 2) will be remitted to the holders of the associated TPS. This        guarantee, when taken together with the obligations of the Company under the debentures,        the Indentures pursuant to which the debentures were issued, and the related        trust agreement (including obligations to pay related trust fees, expenses, debt and other        obligations with respect to the TPS), provides a full and unconditional guarantee of        amounts due the Trusts. The amount guaranteed is not expected to at any time exceed the        obligations of the TPS, and no additional liability has been recorded related to the        guarantee.

 

 

 

 

56

 

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**NOTE        8 – NOTES PAYABLE AND LONG-TERM DEBT – CONTINUED**

 

 

 

On        September 13, 2007, The Company entered into a 5 year swap effective September 17, 2007        with a notional amount of $3 million and designated the swap as a hedge against changes in        cash flows attributable to changes in the benchmark interest rate (LIBOR) associated with        the subordinated debentures issued on June 21, 2007. Commencing December 17, 2007, under        the terms of the swap, the Company will pay interest at the three-month LIBOR rate plus        3.4% and receive interest at the fixed rate of 8.34%. A loss of $88,000 is included in        other comprehensive income related to the swap agreement.

 

**NOTE        9 - POLICY AND CLAIM RESERVES**

 

The        following table is a reconciliation of beginning and ending property and casualty reserve        balances for claims and claim adjustment expense for the years ended December        31:

 

      

|                                        |   | (Dollars in thousands) |
|---------------------------------------------|--------|------------------------|
|                                        |   | 2007                   |   | 2006 |   | 2005 |
| Claims and claim adjustment expense         |   |                   |   |   |   |   |
| reserves at beginning of year               | $      | 12,498                 | $ | 19,511 | $ | 13,094 |
| Less reinsurance recoverables on            |   |                   |   |   |   |   |
| unpaid losses                               |   | 1,783                  |   | 8,560 |   | 2,611 |
| Net balances at beginning of year           |   | 10,715                 |   | 10,951 |   | 10,483 |
| Provision for claims and claim adjustment   |   |                   |   |   |   |   |
| expenses for claims arising in current year |   | 31,831                 |   | 32,311 |   | 36,660 |
| Estimated claims and claim adjustment       |   |                   |   |   |   |   |
| expenses for claims arising in prior years  |   | 1,096                  |   | 1,092 |   | (1,599) |
| Total increases                             |   | 32,927                 |   | 33,403 |   | 35,061 |
| Claims and claim adjustment expense         |   |                   |   |   |   |   |
| payments for claims arising in:             |   |                   |   |   |   |   |
| Current year                                |   | 25,792                 |   | 26,056 |   | 29,168 |
| Prior years                                 |   | 6,432                  |   | 7,583 |   | 5,425 |
| Total payments                              |   | 32,224                 |   | 33,639 |   | 34,593 |
| Net balance at end of year                  |   | 11,418                 |   | 10,715 |   | 10,951 |
| Plus reinsurance recoverables on            |   |                   |   |   |   |   |
| unpaid losses                               |   | 555                    |   | 1,783 |   | 8,560 |
| Claims and claim adjustment expense         |   |                   |   |   |   |   |
| reserves at end of year                     | $      | 11,973                 | $ | 12,498 | $ | 19,511 |

 

 

The        increase in provision for claims and claim adjustment expenses for prior years (net of        reinsurance recoveries) for 2007 is primarily related to losses from Hurricane Katrina        exceeding catastrophe reinsurance coverage. The 2006 increase in provision for claims and        claim adjustment expenses for prior years (net of reinsurance recoveries) was caused by        adverse development related to significant storm related losses in a concentrated coverage        area in December of 2005 with the ultimate settlement of these claims exceeding preliminary        estimates and due to adverse development of a single commercial auto policy with a loss        occurring in 2004. Increases in reserves on these claims were made in late 2006.

 

The        Company has a geographic exposure to catastrophe losses in certain areas of the country.        Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes,        hail, severe winter weather, explosions and fires, and the incidence and severity of        catastrophes are inherently unpredictable. 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. Most catastrophe losses are restricted to small geographic        areas; however,

 

 

 

 

 

57

 

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**NOTE 9 - POLICY AND CLAIM RESERVES –        CONTINUED**

 

hurricanes and earthquakes may produce significant damage in large, heavily        populated areas. The Company generally seeks to reduce its exposure to catastrophes through        individual risk selection and the purchase of catastrophe reinsurance. At December 31,        2007, the Company’s estimate of unpaid losses and adjustment expenses for hurricane        related claims incurred in prior years totaled $690,000 before reinsurance. Because the        Company has exhausted its catastrophe coverage for Hurricane Katrina any additional        development will not be covered by reinsurance. The Company maintains case reserves of        $300,000 for losses in excess of catastrophe reinsurance.

 

**NOTE 10        – REINSURANCE**

 

The        Company’s insurance operations participate in reinsurance in order to limit losses,        minimize exposure to large risks, provide additional capacity for future growth and effect        business-sharing arrangements. Life reinsurance is accomplished through yearly renewable        term. Property and casualty reinsurance is placed on both a quota-share and excess of loss        basis. Reinsurance ceded arrangements do not discharge the insurance subsidiaries as the        primary insurer, except for cases involving a novation. Failure of reinsurers to honor        their obligations could result in losses to the insurance subsidiaries. The

insurance subsidiaries evaluate the financial conditions of their reinsurers        and monitor concentrations of credit risk arising from similar geographic regions,        activities, or economic characteristics of the reinsurers to minimize their exposure to        significant losses from reinsurance insolvencies. At December 31, 2007, reinsurance        receivables with a carrying value of $14,000 ($175,000 at December 31, 2006) and prepaid        reinsurance premiums of $3,000 ($16,000 at December 31, 2006) were associated with a single        reinsurer. The amounts of recoveries pertaining to reinsurance contracts that were deducted        from losses incurred during 2007, 2006 and 2005 were approximately $383,000, $7,525,000,        and $32,613,000, respectively. The Company did not incur any losses from an event occurring        in 2007. Amounts reported as ceded incurred losses in 2007 were due to development of        losses from prior year catastrophic losses primarily associated with prior year        catastrophes.

 

 

 

 

 

 

 

 

 

 

 

 

 

58

 

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**NOTE 10        – REINSURANCE – CONTINUED**

 

The        effect of reinsurance on premiums written and earned was as follows:

 

 

|    | (Dollars in Thousands) |
|---------|------------------------|
|    | 2007                   |
|    | Life                   |   | Property & Casualty |
|    | Written                | Earned | Written | Earned |
|    |                   |   |   |   |   |   |   |   |   |   |   |
| Direct  | $                      | 6,893 |   | $ | 7,081 |   | $ | 65,004 |   | $ | 60,442 |
| Assumed |                   | - |   |   | - |   |   | - |   |   | - |
| Ceded   |                   | (50) |   |   | (50) |   |   | (5,211) |   |   | (5,223) |
| Net     | $                      | 6,843 |   | $ | 7,031 |   | $ | 59,793 |   | $ | 55,219 |
|    |                   |   |   |   |   |   |   |   |   |   |   |
|    |                   |   |   |   |   |   |   |   |   |   |   |
|    | 2006                   |
|    | Life                   |   | Property & Casualty |
|    | Written                | Earned | Written | Earned |
|    |                   |   |   |   |   |   |   |   |   |   |   |
| Direct  | $                      | 6,476 |   | $ | 6,592 |   | $ | 58,712 |   | $ | 56,669 |
| Assumed |                   | - |   |   | - |   |   | - |   |   | - |
| Ceded   |                   | (42) |   |   | (42) |   |   | (4,165) |   |   | (4,345) |
| Net     | $                      | 6,434 |   | $ | 6,550 |   | $ | 54,547 |   | $ | 52,324 |
|    |                   |   |   |   |   |   |   |   |   |   |   |
|    |                   |   |   |   |   |   |   |   |   |   |   |
|    | 2005                   |
|    | Life                   |   | Property & Casualty |
|    | Written                | Earned | Written | Earned |
|    |                   |   |   |   |   |   |   |   |   |   |   |
| Direct  | $                      | 6,148 |   | $ | 6,280 |   | $ | 54,692 |   | $ | 53,718 |
| Assumed |                   | - |   |   | - |   |   | - |   |   | - |
| Ceded   |                   | (46) |   |   | (46) |   |   | (6,117) |   |   | (6,389) |
| Net     | $                      | 6,102 |   | $ | 6,234 |   | $ | 48,575 |   | $ | 47,329 |

 

 

 

**NOTE 11        - EMPLOYEE BENEFIT PLAN**

 

In 1989,        the Company and its subsidiaries established a retirement savings plan (401K Plan) and        transferred the assets from the defined contribution profit sharing plan into the new plan.        All full-time employees who have completed six months of service the beginning of any        calendar quarter are eligible to participate and all employee contributions are fully        vested for employees who have completed 1,000 hours of service in the year of contribution.        Company matching contributions for 2007, 2006, and 2005 amounted to $229,000, $207,000, and        $217,000, respectively. The Company contributes matching contributions up to 5% of        compensation subject to government limitations.

 

59

 

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**NOTE 11        - EMPLOYEE BENEFIT PLAN – CONTINUED**

 

In 1987,        the Company established a non-qualified deferred compensation plan for its Board of        Directors. The Board members had an option of deferring their fees to a cash account or to        a stock account and allshare deferrals are recorded at the fair        market value on the date of the award. The directors’ non-qualified deferred        compensation plan was frozen on December 31, 2004, and deferrals are no longer allowed. A        new non-qualified plan became effective January 1, 2006 under which directors are allowed        to defer all or a portion of directors’ fees into various investment options. Costs        of the deferred compensation plan for 2007, 2006, and 2005 amounted to approximately        ($23,000), $147,000, and ($259,000), respectively.

 

**NOTE        12 - REGULATORY REQUIREMENTS AND DIVIDEND RESTRICTIONS**

 

The        amount of dividends paid from NSIC to the Company in any year may not exceed, without prior        approval of regulatory authorities, the greater of 10% of statutory surplus as of the end        of the preceding year, or the statutory net gain from operations for the preceding year. At        December 31, 2007, NSIC’s retained earnings unrestricted for the payment of dividends        in 2008 amounted to $889,000.

 

NSFC is        similarly restricted in the amount of dividends payable to the Company; dividends may not        exceed the greater of 10% of statutory surplus as of the end of the preceding year, or net        income for the preceding year. At December 31, 2007, NSFC’s retained earnings        unrestricted for the payment of dividends in 2008 amounted to $4,609,000.

 

At        December 31, 2007, securities with market values of $3,357,000 ($3,827,000 at December 31,        2006) were deposited with various states pursuant to statutory requirements.

 

Under        applicable Alabama insurance laws and regulations, NSFC is required to maintain a minimum        total surplus (to include both paid-in and contributed and unassigned surplus) of        $100,000.

 

Under        applicable Alabama insurance laws and regulations, NSIC is required to maintain a minimum        total surplus (to include both paid-in and contributed and unassigned surplus) of        $200,000.

 

Under        applicable Alabama insurance laws and regulations, Omega is required to maintain a minimum        total surplus (to include both paid-in and contributed and unassigned surplus) of        $500,000.

 

**NOTE        13 - SHAREHOLDERS’ EQUITY**

 

**Preferred Stock**

The        Preferred Stock may be issued in one or more series as shall from time to time be        determined and authorized by the Board of Directors. The directors may make specific        provisions regarding (a) the voting rights, if any (b) whether such dividends are to be        cumulative or noncumulative (c) the redemption provisions, if any (d) participating rights,        if any (e) any sinking fund or other retirement provisions (f) dividend rates (g) the        number of shares of such series and (h) liquidation preference.

 

**Common Stock**

The        holders of the Class A Common Stock will have one-twentieth of one vote per share, and the        holders of the common stock will have one vote per share.

 

In the        event of any liquidation, dissolution or distribution of the assets of the Company        remaining after the payments to the holders of the Preferred Stock of the full preferential        amounts to which they may be entitled as provided in the resolution or resolutions creating        any series thereof, the remaining assets of the Company shall be divided and distributed        among the holders of both classes of common stock, except as may otherwise be provided in        any such resolution or resolutions.

 

 

 

 

 

60

 

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**NOTE        14 - INDUSTRY SEGMENTS**

 

The Company        and its subsidiaries operate primarily in the insurance industry. Selected balance sheet        information by industry segment for the years ended December 31, 2007 and 2006 is        summarized below:

 

|                              |   |    |   |                         |   |                      |   |                     |
|-----------------------------------|--------|---------|--------|------------------------------|--------|---------------------------|--------|--------------------------|
| (Dollars in thousands)            |   |    |   |                         |   |                      |   |                     |
|                              |   | Total   |   | P&C Insurance Operations |   | Life Insurance Operations |   | Non-Insurance Operations |
| December 31, 2007                 |   |    |   |                         |   |                      |   |                     |
|                              |   |    |   |                         |   |                      |   |                     |
| *Selected Assets*                 |   |    |   |                         |   |                      |   |                     |
| Investments                       | $      | 108,206 | $      | 67,322                       | $      | 38,859                    | $      | 2,025                    |
|                              |   |    |   |                         |   |                      |   |                     |
| Reinsurance recoverable           | $      | 917     | $      | 917                          | $      | -                         | $      | -                        |
|                              |   |    |   |                         |   |                      |   |                     |
| Deferred policy acquisition costs | $      | 8,993   | $      | 3,312                        | $      | 5,681                     | $      | -                        |
|                              |   |    |   |                         |   |                      |   |                     |
| Total Assets                      | $      | 135,585 | $      | 81,354                       | $      | 48,182                    | $      | 6,049                    |
|                              |   |    |   |                         |   |                      |   |                     |
| Total Liabilities                 | $      | 87,138  | $      | 40,259                       | $      | 32,801                    | $      | 14,078                   |

 

 

 

|                              |   |    |   |                         |   |                      |   |                     |
|-----------------------------------|--------|---------|--------|------------------------------|--------|---------------------------|--------|--------------------------|
| (Dollars in thousands)            |   |    |   |                         |   |                      |   |                     |
|                              |   | Total   |   | P&C Insurance Operations |   | Life Insurance Operations |   | Non-Insurance Operations |
| December 31, 2007                 |   |    |   |                         |   |                      |   |                     |
|                              |   |    |   |                         |   |                      |   |                     |
| *Selected Assets*                 |   |    |   |                         |   |                      |   |                     |
| Investments                       | $      | 105,175 | $      | 66,800                       | $      | 38,375                    | $      | -                        |
|                              |   |    |   |                         |   |                      |   |                     |
| Reinsurance recoverable           | $      | 2,242   | $      | 2,242                        | $      | -                         | $      | -                        |
|                              |   |    |   |                         |   |                      |   |                     |
| Deferred policy acquisition costs | $      | 7,922   | $      | 3,273                        | $      | 4,649                     | $      | -                        |
|                              |   |    |   |                         |   |                      |   |                     |
| Total Assets                      | $      | 134,911 | $      | 75,893                       | $      | 45,247                    | $      | 13,771                   |
|                              |   |    |   |                         |   |                      |   |                     |
| Total Liabilities                 | $      | 88,832  | $      | 37,530                       | $      | 29,882                    | $      | 21,420                   |

 

61

 

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**NOTE 14        - INDUSTRY SEGMENTS – CONTINUED**

 

Premium        revenues and operating income by industry segment for the years ended December 31, 2007,        2006 and 2005 are summarized below:

 

| (Dollars in thousands)                                                  |                                              |   |   |   |                         |   |                      |    |
|-------------------------------------------------------------------------|---------------------------------------------------|--------|--------|--------|------------------------------|--------|---------------------------|---------|
|                                                                    |                                              |   | Total  |   | P&C Insurance Operations |   | Life Insurance Operations |    | Non-Insurance Operations |
| Year ended December 31, 2007                                            |                                              |   |   |   |                         |   |                      |    |
| **REVENUE**                                                             |                                              |   |   |   |                         |   |                      |    |
|                                                                    | Net premiums earned                               | $      | 62,250 | $      | 55,219                       | $      | 7,031                     | $       | - |
|                                                                    | Net investment income                             |   | 4,749  |   | 2,823                        |   | 1,796                     |    | 130 |
|                                                                    | Net realized investment gains                     |   | 1,493  |   | 1,350                        |   | 143                       |    | - |
|                                                                    | Other income                                      |   | 1,071  |   | 1,065                        |   | 6                         |    | - |
|                                                                    |                                              |   | 69,563 |   | 60,457                       |   | 8,976                     |    | 130 |
|                                                                    |                                              |   |   |   |                         |   |                      |    |   |
| **BENEFITS AND EXPENSES**                                               |                                              |   |   |   |                         |   |                      |    |
|                                                                    | Policyholder benefits paid or provided            |   | 37,678 |   | 32,189                       |   | 5,489                     |    | - |
|                                                                    | Amortization of deferred policy acquisition costs |   | 2,559  |   | 3,274                        |   | (715)                     |    | - |
|                                                                    | Commissions                                       |   | 9,353  |   | 7,788                        |   | 1,565                     |    | - |
|                                                                    | General and administrative expenses               |   | 9,679  |   | 6,580                        |   | 2,168                     |    | 931 |
|                                                                    | Insurance taxes, licenses and fees                |   | 2,325  |   | 2,032                        |   | 293                       |    | - |
|                                                                    | Interest expense                                  |   | 1,080  |   | -                            |   | 68                        |    | 1,012 |
|                                                                    |                                              |   | 62,674 |   | 51,863                       |   | 8,868                     |    | 1,943 |
|                                                                    |                                              |   |   |   |                         |   |                      |    |   |
| **Income Before Income Taxes and Minority                    Interest** |                                              | 6,889  |   | 8,594  |                         | 108    |                      | (1,813) |
|                                                                    |                                              |   |   |   |                         |   |                      |    |   |
| **INCOME TAX EXPENSE (BENEFIT)**                                        |                                              |   |   |   |                         |   |                      |    |
|                                                                    | Current                                           |   | 1,811  |   | 1,718                        |   | 734                       |    | (641) |
|                                                                    | Deferred                                          |   | 357    |   | 869                          |   | (603)                     |    | 91 |
|                                                                    |                                              |   | 2,168  |   | 2,587                        |   | 131                       |    | (550) |
|                                                                    |                                              |   |   |   |                         |   |                      |    |   |
| **Income From Continuing Operations**                                   | 4,721                                             |   | 6,007  |   | (23)                         |   | (1,263)                   |
| **Net Income from Discontinued Operations**                             | 1,319                                             |   | -      |   | -                            |   | 1,319                     |
|                                                                    |                                              |   |   |   |                         |   |                      |    |   |
| **NET INCOME**                                                          | $                                                 | 6,040  | $      | 6,007  | $                            | (23)   | $                         | 56      |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

62

 

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**NOTE 14        - INDUSTRY SEGMENTS – CONTINUED**

 

| (Dollars in thousands)                                                  |                                              |   |   |   |                         |    |                      |    |
|-------------------------------------------------------------------------|---------------------------------------------------|--------|--------|--------|------------------------------|---------|---------------------------|---------|
|                                                                    |                                              |   | Total  |   | P&C Insurance Operations |    | Life Insurance Operations |    | Non-Insurance Operations |
| Year ended December 31, 2006                                            |                                              |   |   |   |                         |    |                      |    |
| **REVENUE**                                                             |                                              |   |   |   |                         |    |                      |    |
|                                                                    | Net premiums earned                               | $      | 58,874 | $      | 52,324                       | $       | 6,550                     | $       | - |
|                                                                    | Net investment income                             |   | 4,463  |   | 2,591                        |    | 1,785                     |    | 87 |
|                                                                    | Net realized investment gains                     |   | 2,565  |   | 1,983                        |    | 582                       |    | - |
|                                                                    | Other income                                      |   | 1,211  |   | 1,208                        |    | 2                         |    | 1 |
|                                                                    |                                              |   | 67,113 |   | 58,106                       |    | 8,919                     |    | 88 |
|                                                                    |                                              |   |   |   |                         |    |                      |    |   |
| **BENEFITS AND EXPENSES**                                               |                                              |   |   |   |                         |    |                      |    |
|                                                                    | Policyholder benefits paid or provided            |   | 37,996 |   | 32,461                       |    | 5,535                     |    | - |
|                                                                    | Amortization of deferred policy acquisition costs |   | 1,978  |   | 2,478                        |    | (500)                     |    | - |
|                                                                    | Commissions                                       |   | 8,921  |   | 7,503                        |    | 1,418                     |    | - |
|                                                                    | General and administrative expenses               |   | 9,141  |   | 5,625                        |    | 3,217                     |    | 299 |
|                                                                    | Insurance taxes, licenses and fees                |   | 1,729  |   | 1,441                        |    | 288                       |    | - |
|                                                                    | Interest expense                                  |   | 1,094  |   | -                            |    | 83                        |    | 1,011 |
|                                                                    |                                              |   | 60,859 |   | 49,508                       |    | 10,041                    |    | 1,310 |
|                                                                    |                                              |   |   |   |                         |    |                      |    |   |
| **Income Before Income Taxes and Minority                    Interest** |                                              | 6,254  |   | 8,598  |                         | (1,122) |                      | (1,222) |
|                                                                    |                                              |   |   |   |                         |    |                      |    |   |
| **INCOME TAX EXPENSE (BENEFIT)**                                        |                                              |   |   |   |                         |    |                      |    |
|                                                                    | Current                                           |   | 1,907  |   | 2,623                        |    | (332)                     |    | (384) |
|                                                                    | Deferred                                          |   | (92)   |   | 130                          |    | (132)                     |    | (90) |
|                                                                    |                                              |   | 1,815  |   | 2,753                        |    | (464)                     |    | (474) |
|                                                                    |                                              |   |   |   |                         |    |                      |    |   |
| **Income From Continuing Operations**                                   | 4,439                                             |   | 5,845  |   | (658)                        |    | (748)                     |
| **Net Income from Discontinued Operations**                             | (189)                                             |   | -      |   | -                            |    | (189)                     |
|                                                                    |                                              |   |   |   |                         |    |                      |    |   |
| **NET INCOME**                                                          | $                                                 | 4,250  | $      | 5,845  | $                            | (658)   | $                         | (937)   |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

63

 

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**NOTE 14        - INDUSTRY SEGMENTS – CONTINUED**

 

| (Dollars in thousands)                                                  |                                              |   |   |   |                         |   |                      |   |
|-------------------------------------------------------------------------|---------------------------------------------------|--------|--------|--------|------------------------------|--------|---------------------------|--------|
|                                                                    |                                              |   | Total  |   | P&C Insurance Operations |   | Life Insurance Operations |   | Non-Insurance Operations |
| Year ended December 31, 2005                                            |                                              |   |   |   |                         |   |                      |   |
| **REVENUE**                                                             |                                              |   |   |   |                         |   |                      |   |
|                                                                    | Net premiums earned                               | $      | 53,563 | $      | 47,329                       | $      | 6,234                     | $      | - |
|                                                                    | Net investment income                             |   | 3,964  |   | 2,323                        |   | 1,619                     |   | 22 |
|                                                                    | Net realized investment gains                     |   | 3,493  |   | 3,278                        |   | 215                       |   | - |
|                                                                    | Other income                                      |   | 1,416  |   | 1,364                        |   | 52                        |   | - |
|                                                                    |                                              |   | 62,436 |   | 54,294                       |   | 8,120                     |   | 22 |
|                                                                    |                                              |   |   |   |                         |   |                      |   |   |
| **BENEFITS AND EXPENSES**                                               |                                              |   |   |   |                         |   |                      |   |
|                                                                    | Policyholder benefits paid or provided            |   | 38,241 |   | 34,337                       |   | 3,904                     |   | - |
|                                                                    | Amortization of deferred policy acquisition costs |   | 2,704  |   | 2,256                        |   | 448                       |   | - |
|                                                                    | Commissions                                       |   | 8,987  |   | 7,603                        |   | 1,384                     |   | - |
|                                                                    | General and administrative expenses               |   | 7,911  |   | 5,525                        |   | 2,283                     |   | 103 |
|                                                                    | Insurance taxes, licenses and fees                |   | 2,243  |   | 1,871                        |   | 372                       |   | - |
|                                                                    | Interest expense                                  |   | 348    |   | 15                           |   | 114                       |   | 219 |
|                                                                    |                                              |   | 60,434 |   | 51,607                       |   | 8,505                     |   | 322 |
|                                                                    |                                              |   |   |   |                         |   |                      |   |   |
| **Income Before Income Taxes and Minority                    Interest** |                                              | 2,002  |   | 2,687  |                         | (385)  |                      | (300)  |
|                                                                    |                                              |   |   |   |                         |   |                      |   |   |
| **INCOME TAX EXPENSE (BENEFIT)**                                        |                                              |   |   |   |                         |   |                      |   |
|                                                                    | Current                                           |   | 531    |   | 571                          |   | (228)                     |   | 188 |
|                                                                    | Deferred                                          |   | 50     |   | (6)                          |   | 140                       |   | (84) |
|                                                                    |                                              |   | 581    |   | 565                          |   | (88)                      |   | 104 |
|                                                                    |                                              |   |   |   |                         |   |                      |   |   |
| **Income From Continuing Operations**                                   | 1,421                                             |   | 2,122  |   | (297)                        |   | (404)                     |
| **Net Income from Discontinued Operations**                             | 137                                               |   | -      |   | -                            |   | 137                       |
|                                                                    |                                              |   |   |   |                         |   |                      |   |   |
| **NET INCOME**                                                          | $                                                 | 1,558  | $      | 2,122  | $                            | (297)  | $                         | (267)  |

 

 

**NOTE        15 - CONTINGENCIES**

 

**Litigation**

 

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

 

On December        12, 2005, the United States District court for the Middle District of Alabama (the        “Court”) entered an order preliminarily approving a proposed settlement of a        case pending against a subsidiary of the Company styled Mary W. Williams, et al v. National        Security Insurance Company (“Williams Litigation”) and preliminarily certifying        such case as a class action. The Williams Litigation related primarily to claims that a        subsidiary of the Company sold industrial burial insurance policies to racial minorities on        which it charged higher premiums or provided inferior benefits than premiums charged to or        policy benefits provided to similarly situated non-minority policyholders.

         

 

64

 

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**NOTE        15 – CONTINGENCIES – CONTINUED**

 

The        Company’s subsidiary has not sold industrial burial insurance for more than 20 years.        Following a fairness hearing held on August22, 2006, the Court, in        an order dated August 30, 2006, granted final approval to the proposed settlement. The        effective date of the settlement was September 30, 2006, with an implementation date of        December 29, 2006. The settlement provided for the Company’s subsidiary to, among        other matters, provide additional policyholder benefits, including premium adjustments and        benefit enhancements on existing policies and additional benefits on matured policies and        pay attorneys fees. The Company had previously established litigation reserves with respect        to this matter and had taken a policy reserve charge with respect to adjustments to the        subject policies that were voluntarily made in 2000. The remaining costs associated with        this settlement, including costs associated with prospective enhancements, are fully        reflected in the attached financial statements for the period ending December 31, 2006. The        class, as certified, did not permit any class members to opt out of the settlement and        enjoined all similar litigation against the Company’s subsidiary. In the settlement,        the Company’s subsidiary denied all claims and allegations made in the        lawsuit.

 

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

The        company establishes and maintains reserves on contingent liabilities. In many instances,        however, it is not feasible to predict the ultimate outcome with any degree of accuracy.        While a resolution of these matters may significantly impact consolidated earnings and the        Company’s consolidated financial position, it remains management’s opinion,        based on information presently available, that the ultimate resolution of these matters        will not have a material impact on the Company’s consolidated financial        position.

 

**NOTE        16 – DISCONTINUED OPERATIONS**

 

In the        first quarter of 2007, the Company classified its investment in consolidated subsidiary        Mobile Attic as available for sale as it became apparent that a transfer would occur within        one year and consequently reclassified the results of the operations of Mobile Attic to        discontinued operations in accordance with the provisions of SFAS No. 144,*Accounting for the Impairment or Disposal of Long-Lived        Assets.*In April of 2007, the Company entered into an agreement        to sell the majority of its interest in Mobile Attic. Under the terms of the agreement, the        Company will retain a minority ownership interest in Mobile Attic, not to exceed 5%. The        Company will no longer be involved in the operations of Mobile Attic. Under the terms of        the agreement, assets outlined below along with other immaterial amounts were transferred        to the acquirer. Also, the acquirer refinanced all outstanding debt, also disclosed below,        of Mobile Attic releasing the Company from all debt guarantees. Total net cash proceeds        received by the Company in conjunction with the sale totaled $2,700,000.

 

Assets        and liabilities available for sale at December 31, 2006 related to Mobile Attic are as        follows:

 

($ in        thousands)

 

|                           |   | December 31, |
|--------------------------------|--------|--------------|
|                           |   | 2006         |
| Assets available for sale      | $      | 11,688       |
| Liabilities available for sale | $      | 10,251       |

 

 

65

 

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**NOTE        16 – DISCONTINUED OPERATIONS – CONTINUED**

 

The        assets of Mobile Attic available for sale consist primarily of portable storage leasing        equipment. The liabilities of Mobile Attic available for sale consist primarily of short        term debt. The transaction to dispose of Mobile Attic was completed in April 2007,        consequently, no material assets or liabilities associated with Mobile Attic remained on        the Balance Sheet at December 31, 2007.

 

**NOTE 17        - SUPPLEMENTAL CASH FLOW INFORMATION**

 

Cash        paid for interest during 2007 was $1,072,000 ($1,846,000 in 2006 and $1,139,000 in 2005).        Cash paid for income taxes in 2007 was $2,330,000 ($300,000 in 2006 and $400,000 in 2005).        Significant noncash transactions included $1,781,000 reduction in accounts receivable of        discontinued operations; $428,000 reduction of inventory of discontinued operations;        $8,844,000 reduction in property and equipment of discontinued operations; and $9,409,000        reduction of notes payable of discontinued operations.

 

 

 

 

 

 

 

 

 

 

 

66

 

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| THE NATIONAL SECURITY GROUP, INC.                                                                                        |
|--------------------------------------------------------------------------------------------------------------------------|
| SCHEDULE I. SUMMARY OF INVESTMENTS (CONSOLIDATED)                                                                        |
|                                  (Dollars in Thousands) |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     |   |   |   | December 31, 2007 |   | December 31, 2006 |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     |   |   |   |   |   |   |   | Amount per |   |   |   |   |   | Amount per |
|                                                                                                                     |   |   |   |   |   | Fair |   | the Balance |   | Fair |   | the Balance |
|                                                                                                                     |   |   |   | Cost |   | Value |   | Sheet |   | Cost |   | Value |   | Sheet |
| Securities Held to Maturity:                                                                                             |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     | United States government | $ | 8,742 | $ | 8,770 | $ | 8,742 | $ | 8,983 | $ | 8,647 | $ | 8,983 |
|                                                                                                                     | States, municipalities and |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     |   | political subdivisions  |   | 2,710 |   | 2,703 |   | 2,710 |   | 2,787 |   | 2,755 |   | 2,787 |
|                                                                                                                     | Mortgage backed securities |   | 5,688 |   | 5,506 |   | 5,688 |   | 6,750 |   | 6,520 |   | 6,750 |
|                                                                                                                     | Public Utilities |   | - |   | - |   | - |   | - |   | - |   | - |
|                                                                                                                     | Industrial and Miscellaneous |   | 170 |   | 176 |   | 170 |   | 244 |   | 250 |   | 244 |
|                                                                                                                     | Total Securities Held to Maturity | $ | 17,310 | $ | 17,155 | $ | 17,310 | $ | 18,764 | $ | 18,172 | $ | 18,764 |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Securities Available for Sale:                                                                                           |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Equity Securities:                                                                                                       |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     | Public utilities | $ | - | $ | - | $ | - | $ | 156 | $ | 424 | $ | 424 |
|                                                                                                                     | Banks and insurance companies |   | 1,918 |   | 3,900 |   | 3,900 |   | 1,819 |   | 3,809 |   | 3,809 |
|                                                                                                                     | Industrial and all other |   | 5,717 |   | 11,091 |   | 11,091 |   | 5,249 |   | 11,886 |   | 11,886 |
|                                                                                                                     | Total equity securities | $ | 7,635 | $ | 14,991 | $ | 14,991 | $ | 7,224 | $ | 16,119 | $ | 16,119 |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Debt Securities:                                                                                                         |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     | United States government . | $ | 23,117 | $ | 23,378 | $ | 23,378 | $ | 30,626 | $ | 30,115 | $ | 30,115 |
|                                                                                                                     | States, municipalities and |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     |   | political subdivisions |   | 10,144 |   | 10,035 |   | 10,035 |   | 5,650 |   | 5,581 |   | 5,581 |
|                                                                                                                     | Mortgage backed securities |   | 18,762 |   | 18,467 |   | 18,467 |   | 15,183 |   | 14,812 |   | 14,812 |
|                                                                                                                     | Public Utilities |   | 1,944 |   | 1,852 |   | 1,852 |   | 1,649 |   | 1,649 |   | 1,649 |
|                                                                                                                     | Industrial and Miscellaneous |   | 13,421 |   | 13,045 |   | 13,045 |   | 9,872 |   | 9,778 |   | 9,778 |
|                                                                                                                     | Total Debt Securities  | $ | 67,388 | $ | 66,777 | $ | 66,777 | $ | 62,980 | $ | 61,935 | $ | 61,935 |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     | Total Available for Sale  | $ | 75,023 | $ | 81,768 | $ | 81,768 | $ | 70,204 | $ | 78,054 | $ | 78,054 |
|                                                                                                                     |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                     | Total Securities | $ | 92,333 | $ | 98,923 | $ | 99,078 | $ | 88,968 | $ | 96,226 | $ | 96,818 |
| Mortgage loans on real estate                                                                                       |   | 492 |   | - |   | 492 |   | 504 |   | - |   | 504 |
| Investment real estate                                                                                              |   | 4,586 |   | - |   | 4,586 |   | 4,154 |   | - |   | 4,154 |
| Policy loans                                                                                                        |   | 920 |   | - |   | 920 |   | 845 |   | - |   | 845 |
| Other invested assets                                                                                                    | 2,103 |   | - |   | 2,103 |   | 2,346 |   | - |   | 2,346 |
| Short term investments                                                                                              |   | 1,027 |   | - |   | 1,027 |   | 508 |   | - |   | 508 |
|                                                                                                                     |   | Total investments  | $ | 101,461 | $ | 98,923 | $ | 108,206 | $ | 97,325 | $ | 96,226 | $ | 105,175 |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

67

 

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| THE NATIONAL SECURITY GROUP, INC. (PARENT                    COMPANY)          |
|--------------------------------------------------------------------------------|
| SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF                    REGISTRANT |
| BALANCE SHEETS                                                                 |
| (Amounts in thousands)                                                         |
|                                                                           |   |   |   |   |   |
|                                                                           |   |   | December 31, |
|                                                                           |   |   | 2007 |   | 2006 |
| **Assets**                                                                     |   |   |   |   |
|                                                                           | Cash | $ | 832 | $ | 144 |
|                                                                           | Investment in subsidiaries (equity method) |   |   |   |   |
|                                                                           | eliminated upon consolidation |   | 55,991 |   | 54,523 |
|                                                                           | Other assets |   | 5,515 |   | 3,424 |
|                                                                           |   |   |   |   |   |
|                                                                           | **Total Assets** | $ | 62,338 | $ | 58,091 |
|                                                                           |   |   |   |   |   |
| **Liabilities and Shareholders' Equity**                                       |   |   |   |   |
|                                                                           | Accrued general expenses | $ | 1,519 | $ | 1,262 |
|                                                                           | Notes payable |   | 12,372 |   | 11,450 |
|                                                                           |   |   |   |   |   |
|                                                                           | **Total Liabilities** | $ | 13,891 | $ | 12,712 |
|                                                                           |   |   |   |   |   |
|                                                                           | **Total Shareholders' Equity** | $ | 48,447 | $ | 45,379 |
|                                                                           |   |   |   |   |   |
|                                                                           | **Total Liabilities and Shareholders' Equity** | $ | 62,338 | $ | 58,091 |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

68

 

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| THE NATIONAL SECURITY GROUP, INC. (PARENT COMPANY)                             |
|--------------------------------------------------------------------------------|
| SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF                    REGISTRANT |
| STATEMENTS OF INCOME                                                           |
| (Amounts in thousands)                                                         |
|                                                                           |   |   |   |   |   |   |   |
|                                                                           |   |   | For the Years Ended December 31, |
|                                                                           |   |   | 2007 |   | 2006 |   | 2005 |
| **Income**                                                                     |   |   |   |   |   |   |
|                                                                           |   |   |   |   |   |   |   |
|                                                                           | Dividends (eliminated upon consolidation) | $ | 3,000 | $ | 1,500 | $ | 2,500 |
|                                                                           | Other income |   | 316 |   | 414 |   | 395 |
|                                                                           |   |  | 3,316 |  | 1,914 |  | 2,895 |
|                                                                           |   |   |   |   |   |   |   |
| **Expenses**                                                                   |   |   |   |   |   |   |
|                                                                           | State taxes |   | 1 |   | 2 |   | 24 |
|                                                                           | Other expenses |   | 1,978 |   | 1,434 |   | 483 |
|                                                                           |   |   | 1,979 |   | 1,436 |   | 507 |
| Income before income taxes and equity in                                       |   |   |   |   |   |   |
|                                                                           | undistributed earnings of subsidiaries |   | 1,337 |   | 478 |   | 2,388 |
| Income tax expense (benefit)                                                   |   | 129 |   | (475) |   | 105 |
|                                                                           |   |   |   |   |   |   |   |
| Income before equity in undistributed earnings                                 |   |   |   |   |   |   |
|                                                                           | of subsidiaries and discontinued operations |   | 1,208 |   | 953 |   | 2,283 |
| Equity in undistributed (losses) earnings of                    subsidiaries   |   | 3,513 |   | 3,486 |   | (862) |
| Net income from discontinued operations                                        |   | 1,319 |   | (189) |   | 137 |
|                                                                           |   |   |   |   |   |   |   |
|                                                                           | **Net income** | $ | 6,040 | $ | 4,250 | $ | 1,558 |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

69

 

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| THE NATIONAL SECURITY GROUP, INC. (PARENT COMPANY)                                      |
|-----------------------------------------------------------------------------------------|
| SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF                    REGISTRANT          |
| STATEMENTS OF CASH FLOWS                                                                |
| (Amounts in thousands)                                                                  |
|                                                                                    |   |   |   |   |   |   |   |   |
|                                                                                    |   |   |   | For the Years Ended December 31, |
|                                                                                    |   |   |   | 2006 |   | 2006 |   | 2005 |
| **Cash flows from operating activities:**                                               |   |   |   |   |   |   |
| Income from continuing operations                                                       |   | $ | 4,721 | $ | 4,439 | $ | 1,421 |
| Adjustments to reconcile net income to net                                              |   |   |   |   |   |   |
| cash provided by operating activities:                                                  |   |   |   |   |   |   |
| Equity in undistributed (income) loss of subsidiaries                                   |   | (3,513) |   | (3,486) |   | 862 |
|                                                                                    |   |   |   |   |   |   |   |   |
| Change in other assets                                                                  |   | (2,091) |   | (1,399) |   | (321) |
| Change in other liabilities                                                             |   | 169 |   | 88 |   | (246) |
|                                                                                    |   | **Net cash (used in) provided by** |   |   |   |
|                                                                                    |   | **operating activities** |   | (714) |   | (358) |   | 1,716 |
|                                                                                    |   |   |   |   |   |   |   |   |
|                                                                                    |   |   |   |   |   |   |   |   |
| **Cash flows from investing activities:**                                               |   |   |   |   |   |   |
| Capital contribution to subsidiary                                                      |   | - |   | - |   | (6,000) |
| Net cash provided by investing activities of discontinued                    operations |   | 2,700 |   | - |   | - |
|                                                                                    |   | **Net cash provided by (used in)** |   |   |   |
|                                                                                    |   | **investing activities** |   | 2,700 |   | - |   | (6,000) |
|                                                                                    |   |   |   |   |   |   |   |   |
|                                                                                    |   |   |   |   |   |   |   |   |
| **Cash flows from financing activities:**                                               |   |   |   |   |   |   |
| Proceeds from notes payable                                                             |   | 3,093 |   | - |   | 9,279 |
| Payments on notes payable                                                               |   | (2,171) |   | (267) |   | (572) |
| Cash dividends                                                                          |   |   | (2,220) |   | (2,183) |   | (2,134) |
| **Net cash (used in) provided by**                                                      |   |   |   |   |   |   |
|                                                                                    |   | **financing activities** |   | (1,298) |   | (2,450) |   | 6,573 |
|                                                                                    |   |   |   |   |   |   |   |   |
| Net increase (decrease) in cash and cash equivalents                                    |   | 688 |   | (2,808) |   | 2,289 |
|                                                                                    |   |   |   |   |   |   |   |   |
| Cash at beginning of year                                                               |   | 144 |   | 2,952 |   | 663 |
|                                                                                    |   |   |   |   |   |   |   |   |
| **Cash at end of year**                                                                 | $ | 832 | $ | 144 | $ | 2,952 |

 

 

 

 

 

 

 

 

 

 

 

 

70

 

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|  

                     

                     

THE NATIONAL SECURITY GROUP, INC. (PARENT COMPANY) |
|--------------------------------------------------------------------------------------------------------------------|
| Notes to Condensed Financial Information of                    Registrant                                          |
|                                                                                                               |   |   |   |   |   |   |   |   |
|                                                                                                               |   |   |   |   |   |   |   |   |
| **Note 1-Basis of Presentation**                                                                                   |   |   |   |   |   |   |
|                                                                                                               | Pursuant to the rules and regulations of the Securities and                    Exchange Commission, the Condensed |
|                                                                                                               | Financial Information of the Registrant does not include all of                    the information and notes normally |
|                                                                                                               | included with financial statements prepared in accordance with                    generally accepted accounting |
|                                                                                                               | principles. It is, therefore, suggested that this Condensed                    Financial Information be read in |
|                                                                                                               | conjunction with the Consolidated Financial Statements and Notes                    thereto included in the |
|                                                                                                               | Registrant’s Annual Report as referenced in Form 10-K,                    Part II, Item 8, page 37. |   |   |
|                                                                                                               |   |   |   |   |   |   |   |   |
| **Note 2-Cash Dividends from Subsidiaries**                                                                        |   |   |   |   |   |   |
|                                                                                                               | Dividends of $3.0 million in 2007, $1.5 million in 2006, and                    $2.5 million in 2005, were paid to the |
|                                                                                                               | Registrant by its subsidiaries. |   |   |   |   |   |   |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

71

 

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| THE NATIONAL SECURITY GROUP, INC.                                                                                             |
|-------------------------------------------------------------------------------------------------------------------------------|
| SCHEDULE III SUPPLEMENTARY INSURANCE INFORMATION                    (CONSOLIDATED)                                            |
| (Amounts in thousands)                                                                                                        |
|                                                                                                                          |
|                                                                                                                          |
|                                                                                                                          | **Deferred** | **Future** |   |
|                                                                                                                          | **Acquisition** | **Policy** | **Unearned** |
|                                                                                                                          | **Costs** | **Benefits** | **Premiums** |
| At December 31, 2007:                                                                                                         |
|                                                                                                                          | Life and accident and health insurance . . . . . . . . . . . . .                    . . | $ | 5,681 | $ | 29,072 | $ | - |
|                                                                                                                          | Property and casualty insurance . . . . . ... . . . . . . . . .                    . . . |  | 3,312   |   | -   |  | 22,442 |
|                                                                                                                          | Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                    . . . . . . . . . . | $ | 8,993 | $ | 29,072 | $ | 22,442 |
|                                                                                                                          |
| At December 31, 2006:                                                                                                         |
|                                                                                                                          | Life and accident and health insurance . . . . . . . . . . . . .                    . . | $ | 4,649 | $ | 27,501 | $ | - |
|                                                                                                                          | Property and casualty insurance . . . . . ... . . . . . . . . .                    . . . |  | 3,723   |  | -    |  | 17,818 |
|                                                                                                                          | Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                    . . . . . . . . . . | $ | 7,922 | $ | 27,501 | $ | 17,818 |
|                                                                                                                          |
| At December 31, 2005:                                                                                                         |
|                                                                                                                          | Life and accident and health insurance . . . . . . . . . . . . .                    . . | $ | 4,089 | $ | 25,478 | $ | - |
|                                                                                                                          | Property and casualty insurance . . . . . ... . . . . . . . . .                    . . . | 15,791 |
|                                                                                                                          | Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . .                    . . . . . . . . . . | $ | 6,567 | $ | 25,478 | $ | 15,791 |
|                                                                                                                          |
|                                                                                                                          | **Commissions,** |   |
|                                                                                                                          | **Benefits,** | **Amortization** | **General** |
|                                                                                                                          | **Claims,** | **of Deferred** | **Expenses,** |
|                                                                                                                          | **Net** | **Losses and** | **Policy** | **Taxes,** |
|                                                                                                                          | **Premium** | **Investment** | **Other** | **Settlement** | **Acquisition** | **Licenses** |
|                                                                                                                          | **Revenue** | **Income** | **Income** | **Expenses** | **Costs** | **and Fees** |
| For the year ended December 31, 2007:                                                                                         |
|                                                                                                                          | Life and accident and health insurance | $ | 7,031 | $ | 1,796 | $ | 6 | $ | 5,489 | $ | 850 | $ | 2,529 |
|                                                                                                                          | Property and casualty insurance . . . . . . |  | 55,219   |   | 2,823   |   | 1,065   |  | 32,189   |  | 11,062   |  | 8,612   |
|                                                                                                                          | Other . . . . . . . . . | - |   | 130 | - |   | - |   | - |   | 1,943 |
|                                                                                                                          | Total . . . .. . . . | $ | 62,250 | $ | 4,749 | $ | 1,071 | $ | 37,678 | $ | 11,912 | $ | 13,084 |
|                                                                                                                          |
| For the year ended December 31, 2006:                                                                                         |
|                                                                                                                          | Life and accident and health insurance | $ | 6,550 | $ | 1,785 | $ | 2 | $ | 5,535 | $ | 918 | $ | 3,588 |
|                                                                                                                          | Property and casualty insurance . . . . . . |  | 52,234   |   | 2,591   |   | 1,208   |  | 32,461   |  | 9,981   |  | 7,066   |
|                                                                                                                          | Other . . . . . . . . . |  | - | - | 1 |   | - |   | - |   | 1,310 |
|                                                                                                                          | Total . . . .. . . . | $ | 58,874 | $ | 4,463 | $ | 1,211 | $ | 37,996 | $ | 10,899 | $ | 11,964 |
|                                                                                                                          |
| For the year ended December 31, 2005:                                                                                         |
|                                                                                                                          | Life and accident and health insurance | $ | 6,234 | $ | 1,619 | $ | 52 | $ | 3,904 | $ | 1,832 | $ | 2,769 |
|                                                                                                                          | Property and casualty insurance . . . . . . |  | 47,329   |   | 2,323   |   | 1,364   |  | 34,337   |  | 9,859   |  | 7,411   |
|                                                                                                                          | Other . . . . . . . . . | - | - | - |   | - |   | - |   | 322 |
|                                                                                                                          | Total . . . .. . . . | $ | 53,563 | $ | 3,964 | $ | 1,416 | $ | 38,241 | $ | 11,691 | $ | 10,502 |
|                                                                                                                          |
| Note: Investment income and other operating expenses are                    reported separately by segment and not allocated. |

 

 

 

 

 

 

 

 

 

 

72

 

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| THE NATIONAL SECURITY GROUP, INC.                                                                      |
|--------------------------------------------------------------------------------------------------------|
| SCHEDULE IV. REINSURANCE (CONSOLIDATED)                                                                |
| (Amounts in thousands)                                                                                 |
|                                                                                                   |
|                                                                                                   |   | **Percentage** |
|                                                                                                   |   |   | **Ceded** |   | **Assumed** |   |   | **of Amount** |
|                                                                                                   |   | **Gross** |   | **to Other** |   | **from Other** |   | **Net** |   | **Assumed** |
|                                                                                                   |   | **Amount** |   | **Companies** |   | **Companies** |   | **Amount** |   | **to Net** |
|                                                                                                   |   |   |   |   |   |
| For the year ended December 31, 2007                                                                   |   |   |   |   |   |
| Life insurance in force . . . . . . . . . . . . . . . . . . . .                    . . . . . . . . . . | $ | 240,691 | $ | 11,061 | $ | - | $ | 229,630 |   | 0.00% |   |
|                                                                                                   |   |   |   |   |   |
| Premiums:                                                                                              |   |   |   |   |   |
|                                                                                                   | Life insurance and accident and health insurance . . . . . .                    . |   | 7,081 |   | 50 |   | - |   | 7,031 |   | 0.00% |   |
|                                                                                                   | Property and casualty insurance . . . . . . . . . . . . . . . .                    . . . . |   | 60,442 |   | 5,223 |   | - |   | 55,219 |   | - |   |
|                                                                                                   |   |   |   |   |   |
|                                                                                                   | Total premiums . . . . . . . . . . . . . . . . . . . . . . . . .                    . . . . . . | $ | 67,523 | $ | 5,273 | $ | - | $ | 62,250 |   | 0.00% |   |
|                                                                                                   |   |   |   |   |   |
| For the year ended December 31, 2006                                                                   |   |   |   |   |   |
| Life insurance in force . . . . . . . . . . . . . . . . . . . .                    . . . . . . . . . . | $ | 228,257 | $ | 11,076 | $ | - | $ | 217,181 |   | 0.00% |   |
|                                                                                                   |   |   |   |   |   |
| Premiums:                                                                                              |   |   |   |   |   |
|                                                                                                   | Life insurance and accident and health insurance . . . . . .                    . |   | 6,592 |   | 42 |   | - |   | 6,550 |   | 0.00% |   |
|                                                                                                   | Property and casualty insurance . . . . . . . . . . . . . . . .                    . . . . |   | 56,669 |   | 4,345 |   | - |   | 52,324 |   | _ |   |
|                                                                                                   |   |   |   |   |   |
|                                                                                                   | Total premiums . . . . . . . . . . . . . . . . . . . . . . . . .                    . . . . . . | $ | 63,261 | $ | 4,387 | $ | - | $ | 58,874 |   | 0.00% |   |
|                                                                                                   |   |   |   |   |   |
| For the year ended December 31, 2005:                                                                  |   |   |   |   |   |
| Life insurance in force . . . . . . . . . . . . . . . . . . . .                    . . . . . . . . . . | $ | 217,152 | $ | 13,541 | $ | - | $ | 203,611 |   | 0.00% |   |
|                                                                                                   |   |   |   |   |   |
| Premiums:                                                                                              |   |   |   |   |   |
|                                                                                                   | Life insurance and accident and health insurance . . . . . .                    . |   | 6,280 |   | 46 |   | - |   | 6,234 |   | 0.00% |   |
|                                                                                                   | Property and casualty insurance . . . . . . . . . . . . . . . .                    . . . . |   | 53,718 |   | 6,389 |   | - |   | 47,329 |   | - |   |
|                                                                                                   |   |   |   |   |   |
|                                                                                                   | Total premiums . . . . . . . . . . . . . . . . . . . . . . . . .                    . . . . . . | $ | 59,998 | $ | 6,435 | $ | - | $ | 53,563 |   | 0.00% |   |

 

 

 

 

 

 

73

 

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|                                                                                                       |   |                   |   |   |   |   |   |   |   |
|------------------------------------------------------------------------------------------------------------|--------|------------------------|--------|--------|--------|--------|--------|--------|--------|
| Schedule V — Allowance for                    Uncollectible Premiums and Other Receivables |
| For the years ended December 31, 2007, 2006 and                    2005                               |
|                                                                                                       |   |                   |   |   |   |   |   |   |   |
|                                                                                                       |   |                   |   |   |   |   |   |   |   |
|                                                                                                       |   | 2007                   |   | 2006   |   | 2005   |
|                                                                                                       |   | (Dollars in thousands) |
|                                                                                                       |   |                   |   |   |   |   |   |   |   |
| Balance, January 1                                                                                         |   | $                      | 120    |   | $      | 158    |   | $      | 110    |
| Additions                                                                                                  |   |                   | 0      |   |   | 0      |   |   | 48     |
| Deletions                                                                                                  |   |                   | 10     |   |   | 38     |   |   | 0      |
|                                                                                                       |   |                   |   |   |   |   |   |   |   |
| Balance, December 31                                                                                       |   | $                      | 110    |   | $      | 120    |   | $      | 158    |

 

 

 

 

 

 

 

 

74

 

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| ****
**Item 9.**

                      | **Changes in and Disagreements with Accountants on Accounting                    and Financial Disclosure** |
|----------------------------------------------|-------------------------------------------------------------------------------------------------------------|

 

None.

 

****Item 9A.** Controls and        Procedures**

 

Company        management, including the Chief Executive Officer and Chief Financial Officer, have        conducted an evaluation of the effectiveness of disclosure controls and procedures pursuant        to Exchange Act Rule 13a-14. Based on that evaluation, the Chief Executive Officer and        Chief Financial Officer concluded that the disclosure controls and procedures are effective        in ensuring that all material information required to be filed in this annual report has        been made known to them in a timely fashion. There have been no significant changes in        internal controls, or in factors that could significantly affect internal controls,        subsequent to the date the Chief Executive Officer and Chief Financial Officer completed        their evaluation.

 

***Management’s Report on Internal Control over Financial        Reporting***

 

Management of The National Security Group, Inc. is responsible for        establishing and maintaining effective internal control over financial reporting. The        Company’s internal control system was designed to provide reasonable assurance to        management and board of directors regarding the reliability of financial reporting and the        preparation of financial statements for external purposes in accordance with generally        accepted accounting principles (GAAP).

 

The        Company’s internal control over financial reporting includes those policies and        procedures that pertain to the maintenance of records that, in reasonable detail,        accurately and fairly reflect the transactions and dispositions of the assets of the        company; provide reasonable assurance that transactions are recorded as necessary to permit        preparation of financial statements in accordance with GAAP, and that receipts and        expenditures of the company are being made only in accordance with authorizations of        management and directors of the company; and 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 the policies or procedures may        deteriorate.

 

Management conducted an evaluation of the effectiveness of internal control        over financial reporting based on the framework in Internal Control—Integrated        Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission        (COSO). Based on this evaluation, management concluded that the company’s internal        control over financial reporting was effective as of December 31, 2007.

 

This        annual report does not include an attestation report of the company’s registered        public accounting firm regarding internal control over financial reporting.        Management’s report was not subject to attestation by the company’s registered        public accounting firm pursuant to temporary rules of the Securities and Exchange        Commission that permit the company to provide only management’s report in this annual        report.

 

 

| ****Item 9B.**                    Other Information** |
|-------------------------------------------------------|

 

None

 

 

 

75

 

----

**PART        III**

 

****Item 10.** Directors,        Executive Officers and Corporate Governance**

 

| *Executive Officers*  |
|----------------------------|

 

JACK E.        BRUNSON (50) has served as a director since 1999 and as President of NSFC since 1997. He        also serves on the Boards of Directors of NSFC and Omega. He joined the Company in 1982.        Mr. Brunson is a Chartered Property and Casualty Underwriter.

 

W. L.        BRUNSON, JR. (49) has served as a director since 1999 and as President and Chief Executive        Officer of the Company since 2000. He also holds the position of President of NSIC. He        joined the Company in 1983. Mr. Brunson is also a director of NSFC, NATSCO, NSIC, and        Omega. Mr. Brunson is a member of the Alabama State Bar.

 

MICKEY        L. MURDOCK (65) has served as a director since 1976 and is currently Senior Vice President        of NSIC. From 2002 to 2007 he served as Chief Operating Officer of the Company. From 1982        to 2002 he served as Chief Financial Officer and Treasurer of the Company. Prior to that        time, he served as Vice President and Controller of the Company. He joined the Company in        1970. Mr. Murdock is also a Director of NSIC, NSFC, Omega and NATSCO. Mr. Murdock        is a Certified Public Accountant.

 

BRIAN R.        MCLEOD (39) currently serves as Vice President, Chief Financial Officer and Treasurer of        the Company. From 1992-2002 he served as controller. He joined the Company in 1992.        Mr. McLeod is also a Director of NSIC, NSFC, Omega and NATSCO. Mr. McLeod is also        a member of the Board of Directors for Trinity Bank, a community bank in Dothan, Alabama.        Mr. McLeod is a Certified Public Accountant.

 

The        information contained on pages 4-5 of The National Security Group’s Proxy Statement        dated March 31, 2008, with respect to directors of the Company and Corporate Governance, is        incorporated herein by reference in response to this item.

 

The        information contained on page 6 of The National Security Group’s Proxy Statement        dated March 31, 2008, with respect to Audit Committee and Audit Committee financial expert,        is incorporated herein by reference in response to this item.

 

The        information contained on page 14 of The National Security Group’s Proxy Statement        dated March 31, 2008, with respect to information on the beneficial ownership reporting for        directors and executive officers, is incorporated herein by reference in response to this        item.

 

****Item 11.** Executive        Compensation**

 

The        information contained on pages 9-11 of The National Security Group’s Proxy Statement        dated March 31, 2008, with respect to executive compensation and transactions, is        incorporated herein by reference in response to this item.

 

****Item 12.** Security        Ownership of Certain Beneficial Owners and Management and Related Stockholder        Matters**

 

The        information contained on page 7 of The National Security Group’s Proxy Statement        dated March 31, 2008, with respect to security ownership of certain beneficial owners and        management, is incorporated herein by reference to this item.

 

****Item 13.** Certain        Relationships and Related Transactions and Director Independence**

 

The        information contained on page 8 of The National Security Group’s Proxy Statement        dated March 31, 2008, with respect to certain relationships and related transactions, is        incorporated herein by reference in response to this item.

****Item 14.** Principal        Accountant Fees and Services**

The        information contained on page 8 of The National Security Group’s Proxy Statement        dated March 31, 2008, with respect to principal accountant fees and services, is        incorporated herein by reference in response to this item.

 

 

 

 

 

76

 

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**PART        IV**

 

****Item 15** Exhibits and        Financial Statement Schedules**

 

 

(a) The        following documents are filed as part of this report:

 

| 1. | Consolidated financial statements, notes thereto and related                    information of The National Security Group, Inc. (the “Company”)                    are included in Item 8 beginning on page 37: |
|----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| **•** | Report of Independent Registered Public Accounting                    Firm |
|------------|----------------------------------------------------------------------------|

 

| **•** | Consolidated Statements of Income |
|------------|-----------------------------------|

 

| **•** | Consolidated Balance Sheets |
|------------|-----------------------------|

 

| **•** | Consolidated Statements of Shareholders’ Equity |
|------------|-------------------------------------------------------|

 

| **•** | Consolidated Statements of Cash Flows |
|------------|---------------------------------------|

 

| **•** | Consolidated Notes to the Financial Statements |
|------------|------------------------------------------------|

 

         

|                                  | 2.                                                                                          | Additional financial statement schedules and report of                    independent registered accounting firm are furnished herewith pursuant to the                    requirements of Form 10-K: |
|---------------------------------------|---------------------------------------------------------------------------------------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                  |                                                                                        |                                                                                                                                                                                                  |   |   |
| **The National Security Group, Inc.** |                                                                                        | **Page**                                                                                                                                                                                              |   |
| Schedule I                            | Summary of Investments                                                                      |                                                                                                                                                                                                  | 67 |   |
| Schedule II                           | Condensed Financial Information of the Registrant                                           |                                                                                                                                                                                                  | 68 |   |
| Schedule III                          | Supplementary Insurance Information (Consolidated)                                          |                                                                                                                                                                                                  | 72 |   |
| Schedule IV                           | Reinsurance (Consolidated)                                                                  |                                                                                                                                                                                                  | 73 |   |
| Schedule V                            | Allowance for Uncollective Premiums and Other Receivables                    (Consolidated) |                                                                                                                                                                                                  | 74 |   |
|                                       |                                                                                             |                                                                                                                                                                                                       |  |  |  |  |

 

 

 

 

 

 

 

 

 

 

 

 

| 3. | Exhibits filed as                    part of this Form 10-K: |
|----|--------------------------------------------------------------|

 

| 3. | Amended Certificate of Incorporation filed with the Secretary of                    State of Delaware on August 2, 2004 and By-Laws. |
|----|--------------------------------------------------------------------------------------------------------------------------------------|

         

| 11.    | Computation of Earnings Per Share Filed Herewith, See Note 1 to                    Consolidated Financial |
|--------|-----------------------------------------------------------------------------------------------------------|
|   | Statements                                                                                                |   |
|        |                                                                                                           |  |  |

 

| 14. | Code of Ethics, see additional information on page 9 of this                    report. |
|-----|-----------------------------------------------------------------------------------------|

 

| 21. | Subsidiaries of the registrant. |
|-----|---------------------------------|

         

| 31.1 | Certification Pursuant to 18 U. S. C. Section 1350, as Adopted                    Pursuant to Section 302 of the |
|------|------------------------------------------------------------------------------------------------------------------|

Sarbanes-Oxley Act of 2002

 

| 31.2 | Certification Pursuant to 18 U. S. C. Section 1350, as Adopted                    Pursuant to Section 302 of the |
|------|------------------------------------------------------------------------------------------------------------------|

Sarbanes-Oxley Act of 2002

 

| 32.    | Certification Pursuant to 18 U. S. C. Section 1350, as Adopted                    Pursuant to Section 906 of the |
|--------|------------------------------------------------------------------------------------------------------------------|
|   | Sarbanes-Oxley Act of 2002                                                                                       |   |
|        |                                                                                                                  |  |  |

 

 

|               | (b)    | During the last fiscal quarter of the period covered by this                    Report, the Company filed the following Current Reports on Form 8-K: |
|--------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Date of Report** |   | **Date Filed**                                                                                                                                       |   | **Description** |   |
|               |   |                                                                                                                                                 |   |   |   |   |   |   |   |   |
| November 13, 2007  |   | November 13, 2007                                                                                                                                    |   | Press release, dated November 13, 2007, issued by The National                    Security Group, Inc. |   |
|                    |        |                                                                                                                                                      |  |  |  |  |  |  |  |  |  |  |

 

 

 

77

 

----

 

 

**SIGNATURE**

 

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.

 

THE        NATIONAL SECURITY GROUP, INC.

 

| /s/ Brian R. McLeod         |   | /s/ William L. Brunson, Jr. |
|-----------------------------|--------|-----------------------------|
| Brian R. McLeod             |   | William L. Brunson, Jr.     |
| Chief Financial Officer and |   | President, Chief Executive  |
| Treasurer                   |   | Officer and Director        |

 

Date:        March 28, 2008

 

**POWER OF        ATTORNEY**

Know all by these present, that the        undersigned hereby constitutes and appoints Brian R. McLeod, with full power of        substitution and/or revocation, the undersigned’s true and lawful attorney-in-fact:        to execute for and on behalf of the undersigned, in the undersigned’s capacity as a        director of National Security Group, inc. (the “Company”), any and all forms        (including, without limitation Form 10-K) required or desired to be executed by or on        behalf of the Company pursuant to section 13 or 15(D) of the Securities Exchange Act of        1934, as amended, after said form has been approved by the Company’s audit committee;        to do and perform any and all acts for and on behalf of the undersigned which may be        necessary or desirable to complete and execute any such Form and timely file such Form with        the appropriate governmental authority (including, without limitation, the United States        Securities and Exchange Commission) and any stock exchange or similar authority; and Take        any other action of any type whatsoever in connection with the foregoing which, in the        opinion of such attorney-in-fact, may be of benefit to, in the best interest of, or legally        required by, the undersigned, it being understood that the documents executed by any such        attorney-in-fact on behalf of the undersigned pursuant to this Power of Attorney shall be        in such form and shall contain such terms and conditions as such attorney-in-fact may        approve in such attorney-in-fact’s discretion.

The undersigned hereby grants to each        such attorney-in-fact full power and authority to do and perform any and every act and        thing whatsoever requisite, necessary, or proper to be done in the exercise of any of the        rights and powers herein granted, as fully to all intents and purposes as the undersigned        might or could do if personally present, with full power of substitution or revocation,        hereby ratifying and confirming all that such attorney-in-fact, or such        attorney-in-fact’s substitute or substitutes, shall lawfully do or cause to be done        by virtue of this Power of Attorney and the rights and powers herein granted. The        undersigned acknowledges that the foregoing attorneys-in-fact, and each of them, in serving        in such capacity at the request of the undersigned, are not assuming, nor is the Company        assuming, any of the undersigned’s responsibilities to comply withsection 13 or 15(D) of the Securities        Exchange Act of 1934, as amended.

 

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 their capacity as a        Director of The National Security Group, Inc. on March 28, 2008.

 

**SIGNATURE**

| /s/ Winfield Baird          | /s/ Mickey L. Murdock   |
|-----------------------------|-------------------------|
| /s/ Carolyn Brunson         | /s/ Donald Pittman      |
| /s/ Jack E. Brunson         | /s/ Fleming Brooks      |
| /s/ William L. Brunson, Jr. | /s/ Paul C. Wesch       |
| /s/ Fred D. Clark, Jr.      | /s/ L. Brunson White    |
| /s/ Frank B. O’Neil   | /s/ Walter P. Wilkerson |

 

 

 

 

 

78

 

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**Exhibit        31.1**

 

**CERTIFICATION OF CHIEF EXECUTIVE OFFICER**

**PURSUANT TO SECTION 302**

**OF THE        SARBANES-OXLEY ACT OF 2002**

 

I, William        L. Brunson, Jr., certify that:

 

1. I        have reviewed this Annual Report on Form 10-K of The National Security Group,        Inc.;

 

2. Based        on my knowledge, this report does not contain any untrue statement of a material fact or        omit to state a material fact necessary to make the statements made, in light of the        circumstances under which such statements were made, not misleading with respect to the        period covered by this report;

 

3. Based        on my knowledge, the financial statements, and other financial information included in this        report, fairly present in all material respects the financial condition, results of        operations and cash flows of the registrant as of, and for, the periods presented in this        report;

 

4. The        registrant’s other certifying officer and I are responsible for establishing and        maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)        and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act        Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 

a.        Designed such disclosure controls and procedures, or caused such disclosure controls and        procedures to be designed under our supervision, to ensure that material information        relating to the registrant, including its consolidated subsidiaries, is made known to us by        others within those entities, particularly during the period in which this report is being        prepared;

 

b.        Designed such internal control over financial reporting, or caused such internal control        over financial reporting to be designed under our supervision, 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;

 

c.        Evaluated the effectiveness of the registrant’s disclosure controls and procedures        and presented in this report our conclusions about the effectiveness of the disclosure        controls and procedures, as of the end of the period covered by this report based on such        evaluation; and

 

d.        Disclosed in this report any change in the registrant’s internal control over        financial reporting that occurred during the registrant’s most recent fiscal quarter        that has materially affected, or is reasonably likely to materially affect, the        registrant’s internal control over financial reporting; and

 

5. The        registrant’s other certifying officer and I have disclosed, based on our most recent        evaluation of internal control over financial reporting, to the registrant’s auditors        and the audit committee of the registrant’s board of directors:

 

a. All        significant deficiencies and material weaknesses in the design or operation of internal        control over financial reporting which are reasonably likely to adversely affect the        registrant’s ability to record, process, summarize and report financial information;        and

 

b. Any        fraud, whether or not material, that involves management or other employees who have a        significant role in the registrant’s internal control over financial        reporting.

 

|                                  |
|---------------------------------------|
| Dated: March 28, 2008            |
|                                  |
| /s/ William L. Brunson, Jr.           |
| William L. Brunson, Jr.               |
| President and Chief Executive Officer |

 

79

 

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**Exhibit        31.2**

 

**CERTIFICATION OF CHIEF FINANCIAL OFFICER**

**PURSUANT TO SECTION 302**

**OF THE        SARBANES-OXLEY ACT OF 2002**

 

I, Brian R.        McLeod, certify that:

 

1. I        have reviewed this Annual Report on Form 10-K of The National Security Group,        Inc.;

 

2. Based        on my knowledge, this report does not contain any untrue statement of a material fact or        omit to state a material fact necessary to make the statements made, in light of the        circumstances under which such statements were made, not misleading with respect to the        period covered by this report;

 

3. Based        on my knowledge, the financial statements, and other financial information included in this        report, fairly present in all material respects the financial condition, results of        operations and cash flows of the registrant as of, and for, the periods presented in this        report;

 

4. The        registrant’s other certifying officer and I are responsible for establishing and        maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)        and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act        Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

 

a.        Designed such disclosure controls and procedures, or caused such disclosure controls and        procedures to be designed under our supervision, to ensure that material information        relating to the registrant, including its consolidated subsidiaries, is made known to us by        others within those entities, particularly during the period in which this report is being        prepared;

 

b.        Designed such internal control over financial reporting, or caused such internal control        over financial reporting to be designed under our supervision, 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;

 

c.        Evaluated the effectiveness of the registrant’s disclosure controls and procedures        and presented in this report our conclusions about the effectiveness of the disclosure        controls and procedures, as of the end of the period covered by this report based on such        evaluation; and

 

d.        Disclosed in this report any change in the registrant’s internal control over        financial reporting that occurred during the registrant’s most recent fiscal quarter        that has materially affected, or is reasonably likely to materially affect, the        registrant’s internal control over financial reporting; and

 

5. The        registrant’s other certifying officer and I have disclosed, based on our most recent        evaluation of internal control over financial reporting, to the registrant’s auditors        and the audit committee of the registrant’s board of directors:

 

a. All        significant deficiencies and material weaknesses in the design or operation of internal        control over financial reporting which are reasonably likely to adversely affect the        registrant’s ability to record, process, summarize and report financial information;        and

 

b. Any        fraud, whether or not material, that involves management or other employees who have a        significant role in the registrant’s internal control over financial        reporting.

 

|                       |
|----------------------------|
| Dated: March 28, 2008 |
|                       |
| /s/ Brian R. McLeod        |
| Brian R. McLeod            |
| Chief Financial Officer    |

 

 

80

 

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**Exhibit        32**

 

**CERTIFICATION PURSUANT TO**

**18        U.S.C. SECTION 1350,**

**AS        ADOPTED PURSUANT TO**

**SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002**

 

We, W.        L. Brunson, Jr., President and Chief Executive Officer of The National Security Group, Inc.        and Brian R. McLeod, Chief Financial Officer of the Company, certify, pursuant to        Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350,        that:

 

1) The Annual Report on Form 10-K of the Company for the annual period        December 31, 2007 (the “Report”) fully complies with the requirements of        Section 13(a) or 15(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78m);        and

 

2) The information contained in the Report fairly presents, in all material        respects, the financial condition and results of operations of the Company.

 

|                                                                                                                                                  |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|
| /s/ William L. Brunson, Jr.                                                                                                                           |
| William L. Brunson, Jr.                                                                                                                               |
| President and Chief Executive Officer

                     

                     

                     

                      |
|                                                                                                                                                  |
|                                                                                                                                                  |
| /s/Brian R. McLeod                                                                                                                                    |
| Brian. R. McLeod                                                                                                                                      |
| Chief Financial Officer                                                                                                                               |
|                                                                                                                                                  |
| Dated: March 28, 2008                                                                                                                            |

 

 

 

81

 

 

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