UNITED
        STATES SECURITIES AND EXCHANGE COMMISSION
 Washington,
        D.C. 20549
  **Form
        10-Q**
  **QUARTERLY
        REPORT PURSUANT TO SECTION 13 OR 15(d)**
 **OF
        THE SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)**
  **For
        the Quarterly Period Ended September 30, 2005**
  **Commission
        File Number 0-4690**
  **Financial
        Industries Corporation**
 (Exact
        name of registrant as specified in its charter)
  **TEXAS**
              
              **74-2126975**State
                  of Incorporation
              
              (I.R.S.
                  Employer Identification number)
 
 **6500
        River Place Boulevard, Building I, Austin, Texas 78730**
 (Address
        including Zip Code of Principal Executive Offices)
  **(512)
        404-5000**
 (Registrant's
        Telephone Number)
  Securities
        Registered pursuant to Section 12(b) of the Act: None
  Securities
        Registered pursuant to Section 12(g) of the Act:
  Common
        Stock, $.20 par value
 (Title
        of
        Class)
  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  ̈ NO x
 
 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 ̈
              
              Accelerated
                  filerx
              
              Non-accelerated
                  filer ̈
 
 Indicate
        by check mark whether the Registrant is a shell company (as defined in Rule
        12b-2 of the Act).
 YES  ̈ NO x
  The
        number of shares outstanding of Registrant's common stock on December 31,
        2006,
        was 10,208,339.
  
 
  **Forward-Looking
        Statements**
 
 Except
        for historical factual information set forth in this Form 10-Q of Financial
        Industries Corporation (the “Company” or “FIC”), the statements, analyses, and
        other information contained in this report relating to trends in the Company’s
        operations and financial results, the markets for our products, future results,
        the future development of our business, and the contingencies and uncertainties
        to which we may be subject, as well as other statements including words such
        as
“anticipate,” “believe,” “plan,” “budget,” “could,” “designed,” “estimate,”
“expect,” “intend,” “forecast,” “predict,” “project,” “may,” “might,” “should”
and other similar expressions constitute forward-looking statements under
        the
        Private Securities Litigation Reform Act of 1995. Such statements are made
        based
        upon management’s current expectations and beliefs concerning financial results
        and economic conditions and are subject to known and unknown risks,
        uncertainties and other factors contemplated by the forward-looking statements.
        These factors include, among other things: (1) general economic conditions
        and
        other factors, including prevailing interest rate levels and stock market
        performance, which may affect the ability of FIC to sell its products, the
        market value of FIC’s investments and the lapse rate and profitability of
        policies; (2) FIC’s ability to achieve anticipated levels of operational
        efficiencies and cost-saving initiatives; (3) customer response to new products,
        distribution channels and marketing initiatives; (4) mortality, morbidity
        and
        other factors that may affect the profitability of FIC’s insurance products; (5)
        FIC’s ability to develop and maintain effective risk management policies and
        procedures and to maintain adequate reserves for future policy benefits and
        claims; (6) changes in the federal income tax laws and regulations that may
        affect the relative tax advantages of some of FIC’s products; (7) increasing
        competition in the sale of insurance; (8) the effect of regulation and
        regulatory changes or actions, including those relating to regulation of
        insurance products and insurance companies; (9) ratings assigned to FIC’s
        insurance subsidiaries by independent rating organizations such as A.M. Best
        Company, which FIC believes are particularly important to the sale of
        accumulation-type products; (10) the performance of our investment
        portfolios; (11) the effect of changes in standards of accounting; (12) the
        effects and results of litigation; (13) business risks and factors described
        elsewhere in this report, including, but not limited to, Item 2-Management’s
        Discussion and Analysis of Financial Condition and Results of Operations
        and
        Item 3-Quantitative and Qualitative Disclosures about Market Risks in Part
        1,
        and Item 1-Legal Proceedings in Part 2, and (14) other factors discussed
        in the
        Company’s other filings with the SEC, which are available free of charge on the
        SEC’s website at www.sec.gov. You should read carefully the above factors and
        all of the other information contained in this report. Should one or more
        of
        these risks or uncertainties materialize, or should underlying assumptions
        prove
        incorrect, actual results may vary materially from those indicated. All
        subsequent written and oral forward-looking statements attributable to the
        Company or to persons acting on our behalf are expressly qualified in their
        entirety by reference to these risks and uncertainties. There can be no
        assurance that other factors not currently anticipated by management will
        not
        also materially and adversely affect our results of operations. Each
        forward-looking statement speaks only as of the date of the particular statement
        and the Company undertakes no obligation to update or revise any forward-looking
        statement.
  
  **FINANCIAL
        INDUSTRIES CORPORATION AND
        SUBSIDIARIES**
 
 **INDEX**
 Page
                      No.**Part
                      I - Financial Information**Item
                      1. Financial Statements (Unaudited)Condensed
                      Consolidated Balance SheetsSeptember
                      30, 2005 and December 31, 2004
                  4Condensed
                      Consolidated Statements of OperationsFor
                      the three and nine month periods endedSeptember
                      30, 2005 and September 30, 2004
                  6Condensed
                      Consolidated Statements of Cash FlowsFor
                      the nine month periods endedSeptember
                      30, 2005 and September 30, 2004
                  10Notes
                      to Condensed Consolidated Financial
                      Statements
                  12Item
                      2. Management’s Discussion and Analysis ofFinancial
                      Condition and Results of
                      Operations
                  23Item
                      3. Quantitative and Qualitative DisclosuresAbout
                      Market Risk
                  32Item
                      4. Controls and Procedures
                  32**Part
                      II - Other Information**Item
                      1. Legal Proceedings
                  33Item
                      2. Changes in Securities and Use of
                      Proceeds
                  37Item
                      3. Defaults Upon Senior Securities
                  37Item
                      4. Submission of Matters to a Vote of Security
                      Holders
                  37Item
                      5. Other Information
                  37Item
                      6. Exhibits and Reports on Form 8-K
                  37
  *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND
        SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED BALANCE SHEETS**
 (In
        thousands) (Unaudited)
 
 September
                  30,
                2005
              
              December
                  31,
                2004
                  (1)ASSETSInvestments:Fixed
                  maturity securities available for sale, at fair value (amortized
                  cost of
                  $590,822 and $500,701 at September 30, 2005 and December 31, 2004,
                  respectively)
              
              $
              582,513
              
              $
              499,155Fixed
                  maturity securities held for trading, at fair value
              
              
              -
              
              
              1,057Equity
                  securities, at fair value (cost of $8,384 and $6,311 at September
                  30, 2005
                  and December 31, 2004, respectively)
              
              
              10,671
              
              
              8,502Policy
                  loans
              
              
              38,207
              
              
              39,855Investment
                  real estate
              
              
              -
              
              
              76,580Real
                  estate held for sale
              
              
              160
              
              
              589Short-term
                  investments
              
              
              4,202
              
              
              62,514Total
                  investments
              
              
              635,753
              
              
              688,252Cash
                  and cash equivalents
              
              
              86,953
              
              
              52,044Deferred
                  policy acquisition costs
              
              
              51,114
              
              
              50,640Present
                  value of future profits of acquired business
              
              
              16,007
              
              
              17,905Agency
                  advances and other receivables, net of allowances for doubtful
                  accounts of
                  $3,437 and $3,334 as of September 30, 2005 and December 31,
                  2004
              
              
              8,913
              
              
              10,539Reinsurance
                  receivables
              
              
              37,018
              
              
              36,912Real
                  estate held for use
              
              
              -
              
              
              13,559Accrued
                  investment income
              
              
              6,810
              
              
              5,652Due
                  premiums
              
              
              2,159
              
              
              2,045Property
                  and equipment, net
              
              
              1,157
              
              
              1,244Other
                  assets
              
              
              2,052
              
              
              2,089Separate
                  account assets
              
              
              346,819
              
              
              359,876Total
                  assets
              
              $
              1,194,755
              
              $
              1,240,757
 
 (1)
        Derived from audited financial statements
 
 The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  4
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED BALANCE SHEETS, Continued**
 (In
        thousands) (Unaudited)
 
 September
                  30,
                2005
              
              December
                  31,
                2004
                  (1)LIABILITIES
                  AND SHAREHOLDERS’ EQUITYLiabilities:Policy
                  liabilities and contractholder deposit funds:Contractholder
                  deposit funds
              
              $
              546,905
              
              $
              572,090Future
                  policy benefits
              
              
              157,201
              
              
              160,175Other
                  policy claims and benefits payable
              
              
              14,290
              
              
              12,939Notes
                  payable
              
              
              15,000
              
              
              15,000Deferred
                  federal income taxes
              
              
              2,357
              
              
              3,549Other
                  liabilities
              
              
              26,018
              
              
              29,585Separate
                  account liabilities
              
              
              346,819
              
              
              359,876Total
                  liabilities
              
              
              1,108,590
              
              
              1,153,214Commitments
                  and contingencies (See Note 7)Shareholders’
                  equity:Common
                  stock, $.20 par value, 25,000 shares authorized in 2005 and 2004,
                  12,517
                  shares issued in 2005 and 2004; 9,843 and 9,804 shares outstanding
                  in 2005
                  and 2004
              
              
              2,504
              
              
              2,504Additional
                  paid-in capital
              
              
              70,376
              
              
              70,398Accumulated
                  other comprehensive loss
              
              
              (7,379
              )
              
              (4,667
              )Retained
                  earnings
              
              
              43,667
              
              
              42,650Common
                  treasury stock, at cost, 2,674 and 2,713 shares in 2005 and 2004
              
              
              (23,003
              )
              
              (23,342
              )Total
                  shareholders’ equity
              
              
              86,165
              
              
              87,543Total
                  liabilities and shareholders’ equity
              
              $
              1,194,755
              
              $
              1,240,757
  (1)
        Derived from audited financial
        statements
  The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  5
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND
        SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS**
 (In
        thousands except per share data) (Unaudited)
 
 Three
                  Months Ended September 30,2005
              
              2004Revenues:Premiums,
                  net
              
              $
              5,925
              
              $
              5,410Earned
                  insurance charges
              
              
              9,919
              
              
              10,559Net
                  investment income
              
              
              8,108
              
              
              7,257Real
                  estate income
              
              
              16
              
              
              477Net
                  realized investment gains
              
              
              (703
              )
              
              454Other
              
              
              636
              
              
              486Total
                  revenues
              
              
              23,901
              
              
              24,643Benefits
                  and expenses:Policyholder
                  benefits and expenses
              
              
              11,923
              
              
              12,083Interest
                  expense on contractholders deposit funds
              
              
              5,434
              
              
              5,765Amortization
                  of deferred policy acquisition costs
              
              
              2,078
              
              
              2,531Amortization
                  of present value of future profits of acquired business
              
              
              715
              
              
              819Operating
                  expenses
              
              
              7,228
              
              
              7,947Interest
                  expense
              
              
              297
              
              
              213Total
                  benefits and expenses
              
              
              27,675
              
              
              29,358Loss
                  from continuing operations before federal income taxes
              
              
              (3,774
              )
              
              (4,715
              )Provision
                  (benefit) for federal income taxes
              
              
              (1,252
              )
              
              130Net
                  loss
              
              $
              (2,522
              )
              $
              (4,845
              )
 
 The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  6
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS, Continued**
 (In
        thousands except per share data) (Unaudited)
 
 Three
                  Months Ended September 30,2005
              
              2004Net
                  Loss Per Share:Basic:Weighted
                  average common shares outstanding
              
              
              9,823
              
              
              9,798Basic
                  loss per share
              
              $
              (0.26
              )
              $
              (0.49
              )Diluted:Weighted
                  average common shares and common share equivalents
              
              
              9,823
              
              
              9,798Diluted
                  loss per share
              
              $
              (0.26
              )
              $
              (0.49
              )
 
 The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  7
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS**
 (In
        thousands except per share data) (Unaudited)
 
 Nine
                  Months Ended September 30,2005
              
              2004Revenues:Premiums,
                  net
              
              $
              17,906
              
              $
              17,845Earned
                  insurance charges
              
              
              30,253
              
              
              31,455Net
                  investment income
              
              
              22,856
              
              
              23,890Real
                  estate income
              
              
              563
              
              
              1,319Net
                  realized investment gains
              
              
              8,567
              
              
              2,308Other
              
              
              1,882
              
              
              1,622Total
                  revenues
              
              
              82,027
              
              
              78,439Benefits
                  and expenses:Policyholder
                  benefits and expenses
              
              
              31,859
              
              
              36,432Interest
                  expense on contractholders deposit funds
              
              
              16,581
              
              
              17,511Amortization
                  of deferred policy acquisition costs
              
              
              7,745
              
              
              8,678Amortization
                  of present value of future profits of acquired business
              
              
              2,038
              
              
              2,517Operating
                  expenses
              
              
              21,815
              
              
              25,096Interest
                  expense
              
              
              829
              
              
              624Total
                  benefits and expenses
              
              
              80,867
              
              
              90,858Income
                  (loss) from continuing operations before federal income taxes and
                  cumulative effect of change in accounting principle
              
              
              1,160
              
              
              (12,419
              )Provision
                  (benefit) for federal income taxes
              
              
              143
              
              
              (1,278
              )Income
                  (loss) from continuing operations before cumulative effect of change
                  in
                  accounting principle
              
              
              1,017
              
              
              (11,141
              )Cumulative
                  effect of change in accounting principle
              
              
              -
              
              
              229Net
                  income (loss)
              
              $
              1,017
              
              $
              (10,912
              )
 
 The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  8
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF OPERATIONS, Continued**
 (In
        thousands except per share data) (Unaudited)
 
 Nine
                  Months Ended September 30,2005
              
              2004Net
                  Income (Loss) Per Share:Basic:Weighted
                  average common shares outstanding
              
              
              9,813
              
              
              9,795Basic
                  earnings per share:Income
                  (loss) from continuing operations before cumulative effect of change
                  in
                  accounting principle
              
              $
              0.10
              
              $
              (1.13
              )Cumulative
                  effect of change in accounting principle
              
              
              -
              
              
              0.02Net
                  income (loss) per share
              
              $
              0.10
              
              $
              (1.11
              )Diluted:Weighted
                  average common shares and common share equivalents
              
              
              9,813
              
              
              9,795Diluted
                  earnings per share:Income
                  (loss) from continuing operations before cumulative effect of change
                  in
                  accounting principle
              
              $
              0.10
              
              $
              (1.13
              )Cumulative
                  effect of change in accounting principle
              
              
              -
              
              
              0.02Net
                  income (loss) per share
              
              $
              0.10
              
              $
              (1.11
              )
 
 The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  9
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS**
 (In
        thousands) (Unaudited)
 
 Nine
                  Months Ended September 30,2005
              
              2004CASH
                  FLOWS FROM OPERATING ACTIVITIES:Net
                  income (loss)
              
              $
              1,017
              
              $
              (10,912
              )Adjustments
                  to reconcile net income (loss) to net cash provided by (used in)
                  operating
                  activities:Amortization
                  of deferred policy acquisition costs
              
              
              7,745
              
              
              8,678Amortization
                  of present value of future profits of acquired business
              
              
              2,038
              
              
              2,517Net
                  realized gains on investments
              
              
              (9,606
              )
              
              (2,308
              )Depreciation
              
              
              1,763
              
              
              2,374(Increase)
                  decrease in accrued investment income
              
              
              (1,158
              )
              
              224Decrease
                  in agent advances and other receivables
              
              
              1,520
              
              
              2,254Decrease
                  (increase) in due premiums
              
              
              (114
              )
              
              126Increase
                  in deferred policy acquisition costs
              
              
              (5,802
              )
              
              (4,800
              )Decrease
                  in other assets
              
              
              37
              
              
              949Increase
                  (decrease) in policy liabilities and accruals
              
              
              779
              
              
              (2,322
              )Increase
                  (decrease) in other liabilities
              
              
              (3,567
              )
              
              4,445Increase
                  in deferred federal income taxes
              
              
              1,258
              
              
              1,502Net
                  activity from trading securities
              
              
              (759
              )
              
              3,164Other,
                  net
              
              
              (1,218
              )
              
              301Net
                  cash provided by (used in) operating activities
              
              
              (6,067
              )
              
              6,192CASH
                  FLOWS FROM INVESTING ACTIVITIES:Fixed
                  maturities purchased
              
              
              (151,494
              )
              
              (114,481
              )Real
                  estate capital expenditures
              
              
              (544
              )
              
              (114
              )Proceeds
                  from sales and maturities of fixed maturities
              
              
              59,880
              
              
              188,471Proceeds
                  from sales of invested real estate
              
              
              101,067
              
              
              2,022Net
                  (increase) decrease in short-term investments
              
              
              58,312
              
              
              (128,565
              )Net
                  decrease in policy loans
              
              
              1,648
              
              
              802Purchase
                  of property and equipment
              
              
              (307
              )
              
              (346
              )Net
                  cash provided by (used in) investing activities
              
              
              68,562
              
              
              (52,211
              )
  (Continued)
  The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  10
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **CONDENSED
        CONSOLIDATED STATEMENTS OF CASH FLOWS,** **Continued**
 (In
        thousands) (Unaudited)
 
 Nine
                  Months Ended September 30,2005
              
              2004CASH
                  FLOW FROM FINANCING ACTIVITIES:Contractholder
                  fund deposits
              
              $
              25,376
              
              $
              31,727Contractholder
                  fund withdrawals
              
              
              (52,962
              )
              
              (54,136
              )Net
                  cash used in financing activities
              
              
              (27,586
              )
              
              (22,409
              )Net
                  increase (decrease) in cash
              
              
              34,909
              
              
              (68,428
              )Cash
                  and cash equivalents, beginning of year
              
              
              52,044
              
              
              82,436Cash
                  and cash equivalents, end of period
              
              $
              86,953
              
              $
              14,008Supplemental
                  Cash Flow Disclosures:Income
                  taxes paid (refunded)
              
              $
              -
              
              $
              (1,093
              )Interest
                  paid
              
              $
              805
              
              $
              627
 
 The
        accompanying notes are an integral part of these condensed consolidated
        financial statements.
  11
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND
        SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**
 
 **Basis
        of Presentation and Consolidation**
 
 The
        financial statements included herein have been presented to conform to the
        requirements of Form 10-Q.
 
 Because
        of the gap in our public reporting and the significant changes we have made
        to
        our business in the interim, we have included certain information relating
        to
        our business, current directors, current officers, and related matters which
        have occurred subsequent to September 30, 2005.
 
 The
        accompanying unaudited condensed consolidated financial statements reflect
        all
        adjustments (including normal recurring adjustments) necessary to present
        fairly
        the consolidated financial position of the Company at September 30, 2005,
        its
        consolidated results of operations for the three months and nine months ended
        September 30, 2005 and 2004, and its consolidated cash flows for the nine
        months
        ended September 30, 2005 and 2004 in conformity with accounting principles
        generally accepted in the United States of America (“GAAP”). Interim results are
        not necessarily indicative of full year performance. The December 31, 2004
        condensed consolidated balance sheet data was derived from the audited financial
        statements included in the Company’s 2004 Annual Report on Form 10-K filed with
        the SEC (“2004 Annual Report”), which includes all disclosures required by GAAP.
        Therefore, these unaudited condensed consolidated financial statements should
        be
        read in conjunction with the consolidated financial statements of the Company
        included in the 2004 Annual Report.
 
 The
        consolidated financial statements include the accounts of Financial Industries
        Corporation (“FIC”) and its wholly owned subsidiaries. All significant
        intercompany items and transactions have been eliminated.
 
 **1.
        Accumulated Other Comprehensive Income (Loss) and Comprehensive Income
        (Loss)**
 
 The
        following is a reconciliation of accumulated other comprehensive income (loss)
        from December 31, 2004 to September 30, 2005 (in thousands):
 
 Net
                  Unrealized Appreciation (Depreciation) of Equity
                  Securities
              
              Net
                  Unrealized Gain (Loss) on Fixed Maturities Available for
                  Sale
              
              Other
              
              Total
                  Accumulated Other Comprehensive Income (Loss)Balance
                  at December 31, 2004
              
              $
              1,446
              
              $
              (1,017
              )
              $
              (5,096
              )
              $
              (4,667
              )Current
                  Period Change
              
              
              64
              
              
              (2,776
              )
              
              -
              
              
              (2,712
              )Balance
                  at September 30, 2005
              
              $
              1,510
              
              $
              (3,793
              )
              $
              (5,096
              )
              $
              (7,379
              )
 
 The
        comprehensive income (loss) for the three and nine months ending September
        30,
        2005 and 2004 is summarized as follows (in thousands):
 
 Three
                  Months Ended September 30,
              
              Nine
                  Months Ended September 30,2005
              
              2004
              
              2005
              
              2004Net
                  income (loss)
              
              $
              (2,522
              )
              $
              (4,845
              )
              $
              1,017
              
              $
              (10,912
              )Other
                  comprehensive income, net of tax:Unrealized
                  gains on securities:Unrealized
                  holdings gains (losses) arising during the period
              
              
              (4,332
              )
              
              7,223
              
              
              (2,401
              )
              
              (637
              )Reclassification
                  adjustments for gains (losses) included in net loss
              
              
              (683
              )
              
              294
              
              
              (311
              )
              
              515Total
                  other comprehensive income (loss)
              
              
              (5,015
              )
              
              7,517
              
              
              (2,712
              )
              
              (122
              )Comprehensive
                  income (loss)
              
              $
              (7,537
              )
              $
              2,672
              
              $
              (1,695
              )
              $
              (11,034
              )
  12
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 **2.
        Change in Accounting Principles**
 
 The
        Company adopted the provisions of Statement of Position (“SOP”) 03-01,
“Accounting and Reporting by Insurance Enterprises for Certain Non-traditional
        Long-Duration Contracts and for Separate Accounts” on January 1, 2004, resulting
        in an increase to income as a cumulative effect of a change in accounting
        principle totaling $229,000, net of taxes, as reflected in the accompanying
        2004
        condensed consolidated statement of operations for the nine months ended
        September 30, 2004. The Company has certain universal life insurance products
        that are credited with bonus interest after applicable qualifying periods.
        The
        adoption of the new accounting principle resulted in a change in the pattern
        of
        recognition of the bonus interest expense.
 
 **3.
        Earnings Per Share**
 
 The
        following table reflects the calculation of basic and diluted earnings (loss)
        per share (amounts in thousands, except per share amounts):
 
 Three
                  Months Ended September 30,
              
              Nine
                  Months Ended September 30,2005
              
              2004
              
              2005
              
              2004(in
                  thousands except per share data)BASIC:Income
                  (loss) before cumulative effect of change in accounting
                  principle
              
              $
              (2,522
              )
              $
              (4,845
              )
              $
              1,017
              
              $
              (11,141
              )Weighted
                  average common shares outstanding
              
              
              9,823
              
              
              9,798
              
              
              9,813
              
              
              9,795Basic
                  income (loss) per share
              
              $
              (0.26
              )
              $
              (0.49
              )
              $
              0.10
              
              $
              (1.13
              )DILUTED:Income
                  (loss) before cumulative effect of change in accounting
                  principle
              
              $
              (2,522
              )
              $
              (4,845
              )
              $
              1,017
              
              $
              (11,141
              )Weighted
                  average common shares outstanding
              
              
              9,823
              
              
              9,798
              
              
              9,813
              
              
              9,795Common
                  stock options
              
              
              -
              
              
              -
              
              
              -
              
              
              -Common
                  stock and common stock equivalents
              
              
              9,823
              
              
              9,798
              
              
              9,813
              
              
              9,795Diluted
                  income (loss) per share
              
              $
              (0.26
              )
              $
              (0.49
              )
              $
              0.10
              
              $
              (1.13
              )
  **4.
        Net Realized Investment Gains**
 
 On
        June
        1, 2005, the Company sold the River Place Pointe office complex to a
        non-affiliated party in an all-cash transaction for a gross purchase price
        of
        $103 million. The office complex is located in Austin, Texas. Under the terms
        of
        the sale agreement, the Company entered into a lease with the purchaser with
        respect to all of the space in Building One (approximately 76,000 square
        feet)
        for a five-year term at a rate of $28.00 per square foot, which was the
        prevailing rental rate at the time that FIC and its subsidiaries occupied
        the
        building in July 2000. The lease provides the Company with a right of
        cancellation of the lease at March 31, 2008. The Company will realize a gain
        of
        $10.6 million on the sale, which includes both a current realized gain of
        $8.5
        million and a deferred gain of $2.1 million to be recognized as a reduction
        of
        office lease expenses over the period from the sale date through March 31,
        2008.
 
 During
        the third quarter of 2005, the Company identified a fixed maturity security
        which was considered impaired and reduced its carrying value by $1
        million.
  13
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 **5.  
        Retirement Plans**
 
 A.
        Family
        Life
 
 Family
        Life has a non-contributory defined benefit pension plan (“Family Life Pension
        Plan”), which covers employees who have completed one year or more of service.
        Under the Family Life Pension Plan, benefits are payable upon retirement
        based
        on earnings and years of credited service.
 
 a.
              The
                  Normal Retirement Date for all employees is the first day of the
                  month
                  coinciding with or next following the later of attainment of age
                  65 or the
                  fifth anniversary of employment.
 
 b.
              The
                  Normal Retirement Benefit is the actuarial equivalent of a life
                  annuity,
                  payable monthly, with the first payment commencing on the Normal
                  Retirement Date. The life annuity is equal to the sum of (1) plus
                  (2):
 
 (1)
              Annual
                  Past Service Benefit: 1.17% of the first $10,000 of Average Final
                  Earnings
                  plus 1 1/2% of the excess of Average Final Earnings over $10,000,
                  all
                  multiplied by the participant’s Credited Past Service. For these purposes,
                  “credited past service” is service prior to April 1, 1967, with respect to
                  employees who were plan participants on December 31,
                  1975.
 
 (2)
              Annual
                  Future Service Benefit: 1.5578% of the first $10,000 of Average
                  Final
                  Earnings plus 2% of the excess of Average Final Earnings over $10,000,
                  all
                  multiplied by the participant’s Credited Future
                  Service.
 
 c.
              Effective
                  April 1, 1997, the Family Life Pension Plan was amended to provide
                  that
                  the accrual rate for future service is 1.57% of Final Average Earnings
                  multiplied by Credited Service after March 31, 1997, less 0.65%
                  of Final
                  Average Earnings up to Covered Compensation. With respect to service
                  prior
                  to April 1, 1997, the accrual rate described in paragraph (b),
                  above, is
                  applicable, with Average Final Earnings taking into account a
                  participant’s earnings subsequent to April 1,
                  1997.
 
 d.
              Effective
                  March 31, 2004, all employees covered under the plan were terminated.
                  No
                  new employees are permitted to enter or re-enter the plan.
 
 Average
        Final Earnings are the highest average Considered Earnings during any five
        consecutive years while an active participant. Total Credited Past Service
        plus
        Credited Future Service is limited to 30 years.
 
 A
        curtailment occurred on January 1, 2004 when the decision was made to terminate
        the employment of all active participants in the plan as discussed in item
        (d)
        above. Because the
        plan’s unrecognized losses exceeded the decrease in projected benefit obligation
        (“PBO”) caused by the curtailment as of January 1, 2004, the SFAS No. 88
        curtailment charge recognized in the 2004 expense was zero. (The plan was
        subsequently amended to prevent any new or rehired employee from entering
        or
        reentering the plan in the future. Thus, the plan is now frozen.)
 
 A
        settlement occurred on December 31, 2004 due to the settlement of several
        former
        employees’ plan obligations through the payment of lump sums. A settlement
        occurs whenever the lump sums paid during the year exceed the sum of the
        plans
        Service Cost and Interest Cost components of expense for that year. The
        settlement resulted in the recognition of a $399,000 charge to expense for
        2004.
  14
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 The
        pension costs for the Family Life Pension Plan include the following components
        at September 30, 2005:
 
 Three
                  Months Ended Sept. 30,
              
              Nine
                  Months Ended Sept. 30,2005
              
              2004
              
              2005
              
              2004Service
                  cost for benefits earned during the year
              
              $
              -
              
              $
              -
              
              $
              -
              
              $
              -Interest
                  cost on projected benefit obligation
              
              
              116,054
              
              
              126,983
              
              
              348,162
              
              
              380,949Expected
                  return on plan assets
              
              
              (101,268
              )
              
              (108,056
              )
              
              (303,805
              )
              
              (324,168
              )Amortization
                  of unrecognized prior service cost
              
              
              -
              
              
              -
              
              
              -
              
              
              -Amortization
                  of unrecognized (gains)/losses
              
              
              26,225
              
              
              19,276
              
              
              78,677
              
              
              57,828Recognition
                  of net loss due to settlement
              
              
              -
              
              
              -
              
              
              -
              
              
              -Net
                  periodic benefit cost
              
              $
              41,011
              
              $
              38,203
              
              $
              123,034
              
              $
              114,609
 
 B.
        ILCO
 
 ILCO
        maintains a retirement plan (“ILCO Pension Plan”) covering substantially all
        employees of the Company and its subsidiaries. The ILCO Pension Plan is a
        non-contributory, defined benefit pension plan, which covers each eligible
        employee who has attained 21 years of age and has completed one year or more
        of
        service. Each participating subsidiary company contributes an amount necessary
        (as actuarially determined) to fund the benefits provided for its participating
        employees.
 
 The
        ILCO
        Pension Plan’s basic retirement income benefit at normal retirement age is 1.57%
        of the participant’s average annual earnings less 0.65% of the participant’s
        final average earnings up to covered compensation multiplied by the number
        of
        his/her years of credited service. For participants who previously participated
        in the ILCO Pension Plan maintained by ILCO for the benefit of former employees
        of the IIP Division of CIGNA Corporation (the IIP Plan), the benefit formula
        described above applies to service subsequent to May 31, 1996. With respect
        to
        service prior to that date, the benefit formula provided by the IIP Plan
        is
        applicable, with certain exceptions applicable to former IIP employees who
        are
        classified as highly compensated employees.
 
 Former
        eligible IIP employees commenced participation automatically. The ILCO Pension
        Plan also provides for early retirement, postponed retirement, and disability
        benefits to eligible employees. Participant benefits become fully vested
        upon
        completion of five years of service, as defined, or attainment of normal
        retirement age, if earlier.
 
 A
        curtailment occurred on December 31, 2004 when the plan was amended to freeze
        accrued benefits for all participants except for Rule of 68 Non-Highly
        Compensated Employees (NHCEs). ( A
        Rule of
        68 Participant is a Participant who was an Employee on December 31, 2004
        and for
        whom the sum of the Participant’s age in years and fractions thereof and service
        in years and fractions thereof was greater than or equal to 68 years as of
        December 31, 2004. A Rule
        of
        68 NHCE is a Rule of 68 Participant who was not a Highly Compensated Employee,
        as defined under IRC Section 414(q), as of December 31, 2004.) Because the
        plan’s unrecognized losses exceeded the decrease in PBO caused by the
        curtailment as of December 31, 2004, the SFAS No. 88 curtailment charge
        recognized in the 2004 expense was zero.
  15
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 The
        pension costs for the ILCO Pension Plan include the following components
        at
        September 30, 2005:
 
 Three
                  Months Ended Sept. 30,
              
              Nine
                  Months Ended Sept. 30,2005
              
              2004
              
              2005
              
              2004Service
                  cost for benefits earned during the year
              
              $
              11,448
              
              $
              145,556
              
              $
              34,344
              
              $
              436,668Interest
                  cost on projected benefit obligation
              
              
              261,812
              
              
              283,352
              
              
              785,436
              
              
              850,056Expected
                  return on plan assets
              
              
              (344,766
              )
              
              (342,053
              )
              
              (1,034,298
              )
              
              (1,026,159
              )Amortization
                  of unrecognized prior service cost
              
              
              -
              
              
              -
              
              
              -
              
              
              -Amortization
                  of unrecognized (gains)/losses
              
              
              33,920
              
              
              43,775
              
              
              101,760
              
              
              131,325Recognition
                  of net loss due to settlement
              
              
              -
              
              
              -
              
              
              -
              
              
              -Net
                  periodic benefit cost
              
              $
              (37,586
              )
              $
              130,630
              
              $
              (112,758
              )
              $
              391,890
 
 **6.
        Stock Option Plans and Other Equity Incentive Plans**
 
 The
        Company follows the disclosure-only provisions of SFAS No. 123, “Accounting for
        Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting for Stock
        Based Compensation - Transition and Disclosure.” SFAS No. 123 allows companies
        to follow existing accounting rules (APB 25) provided that pro forma disclosures
        are made of what net income and earnings per share would have been had the
        company recognized expense for stock-based awards based on their fair value
        at
        date of grant. The fair value disclosure assumes that fair value of option
        grants were calculated at the date of the grant using the Black-Scholes option
        pricing model. No options were granted to employees for the years ended December
        31, 2005 and 2004.
 
 In
        December 2004, the FASB issued SFAS No. 123(R), “Share-Based Payment.”
SFAS 123(R) is a revision of SFAS 123, “Accounting for Stock-Based
        Compensation,” which was originally issued by the FASB in 1995. As originally
        issued, SFAS 123 provided companies with the option to either record
        expense for share-based payments under a fair value model, or to simply disclose
        the impact of the expense. SFAS 123(R) requires companies to measure the
        cost of share-based payments to employees using a fair value model, and to
        recognize that cost over the relevant service period. In addition,
        SFAS 123(R) requires that an estimate of future award forfeitures be made
        at the grant date, while SFAS 123 permitted recognition of forfeitures on
        an as incurred basis. SFAS 123(R) was originally effective July 1, 2005,
        but was
        later deferred by the Securities and Exchange Commission to January 1,
        2006.The adoption of this statement is not expected to have any material
        impact
        on the Company’s consolidated financial statements.
 
 **7.
        Commitments and Contingencies**
 
 Mitte
        Settlement
 
 In
        2002,
        the Company filed a lawsuit against Roy F. Mitte (“Mitte”), The Roy F. and Joann
        Cole Mitte Foundation (the “Foundation”), and Joann Mitte (collectively referred
        to as the “Defendants”). Mitte was the Chairman, President and Chief Executive
        Officer of FIC until he was placed on administrative leave in August, 2002.
        The
        administrative leave, and the subsequent action by the Board of Directors
        in
        October, 2002, to terminate the employment agreement between the Company
        and
        Mitte, resulted from an investigation conducted by the FIC Audit Committee.
        Subsequent to the filing of the lawsuit, Mitte filed a counterclaim against
        the
        Company alleging that the Company breached the employment agreement between
        the
        Company and Mr. Mitte by refusing to pay Mitte the severance benefits and
        compensation provided for under the employment agreement and amendment
        thereto.
 
 On
        May
        15, 2003, the Company entered into a settlement agreement with the Defendants
        and Scott Mitte (a director of the Company and the son of Roy Mitte) (the
“Mitte
        Parties”). Under the terms of the agreement the Mitte Parties released the
        Company from any past, present or future claims which they may have against
        the
        Company, including any claims which Roy Mitte may assert under his employment
        agreement. In addition, the Company agreed to release the Mitte Parties from
        any
        past, present or future claims which the Company may have against the Mitte
        Parties.
  16
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 The
        settlement provides for payments aggregating $3 million by the Company to
        Roy
        Mitte in equal installments of $1 million on June 1, 2003, June 1, 2004 and
        June
        1, 2005, with a provision for acceleration of payments in the event of a
        change
        in control. The settlement agreement also includes provisions whereby, the
        Company agrees (i) to use reasonable efforts to locate purchasers over a
        two-year period for 1,552,206 shares of FIC common stock owned by the Foundation
        at a price of $14.64 per share, (ii) to purchase (or, alternatively, locate
        a
        purchaser) on or before June 1, 2003 for 39,820 shares of FIC common stock
        owned
        by Roy Mitte and 35,502 shares of common stock held in the ESOP account of
        Roy
        Mitte, at a price of $14.64 per share. The agreement also includes provisions
        related to the continuation of health insurance of Roy and Joann Mitte and
        payment for the cancellation of options held by Roy Mitte to purchase 6,600
        shares of FIC common stock. The Company has recognized a charge of $2.9 million
        in 2003 for the discounted amounts to be paid under the settlement agreement,
        which is reflected in the consolidated statement of operations for the six
        months ended June 30, 2003, as litigation settlement.
 
 As
        a
        condition of the obligations of the Company under the settlement agreement,
        the
        Mitte Parties agreed to grant a limited proxy to the persons named as proxies
        by
        FIC in any proxy statement filed by FIC with the SEC. With respect to the
        future
        shareholders meetings, the proxy may be voted “for” all nominees for the Board
        of Directors named on FIC’s proxy statement, “against” any proposal by a person
        other than FIC for the removal of any members of the Board of Directors,
        “withheld” as to nominees for the Board of Directors proposed by any person
        other than FIC and “against” any proposal by any person other than FIC to amend
        the bylaws or articles of FIC. The proxy also extends to certain matters
        which
        may be proposed by FIC at the 2004 annual meeting of shareholders, or any
        later
        annual or special meeting, regarding changes in the ownership percentage
        required in order for a shareholder to call a special meeting of shareholders
        and the elimination of cumulative voting. The granting of the proxy is generally
        conditioned upon the performance of the scheduled purchases of the shares
        of FIC
        common stock owned by the Foundation.
 
 T.
        David Porter v. Financial Industries Corporation
 
 On
        May
        31, 2006, T. David Porter, an FIC shareholder, filed a civil suit in Travis
        County, Texas District Court (the “Court”), against the Company, seeking to
        compel the Company to hold an annual meeting of shareholders. FIC has been
        unable to hold an annual meeting at which its shareholders could be fully
        informed, or which could be attended by a substantial portion of its
        shareholders, because the Company is currently unable to comply with Rule
        14a-3
        of the Securities Exchange Act of 1934, and thus cannot provide an annual
        report
        to shareholders or solicit proxies in connection with an annual meeting.
        Mr.
        Porter sued under Article 2.24(B) of the Texas Business Corporation Act,
        which
        provides that if an annual meeting of shareholders is not held within any
        13-month period and a written consent of shareholders has not been executed
        instead of a meeting, any court of competent jurisdiction in the county in
        which
        the principal office of the corporation is located may, on the application
        of
        any shareholder, summarily order a meeting to be held. On August 7, 2006,
        the
        Company entered into an Agreed Order On Plaintiff’s Motion to Compel Annual
        Shareholders Meeting (the “Order”) and agreed among other things to hold an
        annual shareholders meeting for the election of directors on December 6,
        2006.
        The Company did in fact appear for a meeting of shareholders on December
        6,
        2006, as required by the Agreed Order. In advance of the meeting date, a
        group
        affiliated with Mr. Porter solicited proxies from FIC shareholders in an
        effort
        to replace FIC’s Board of Directors; the Company remained unable to solicit
        proxies. However, on the appointed day for
        the
        shareholder meeting - December 6, 2006 - a quorum
        was not in attendance. On
        December 12, 2006, FIC filed a Motion for Summary Judgment seeking dismissal
        of
        Porter’s suit on the grounds that the Agreed Order did not dispense with the
        requirement of a quorum; the lack of a quorum was a direct and foreseeable
        result of Mr. Porter’s insistence on a one-sided solicitation and election; FIC
        has complied with its obligations under the Agreed Order and Mr. Porter has
        obtained all relief sought by his petition. FIC’s Motion for Summary Judgment
        remains pending and has not been heard. Mr. Porter thereafter applied for
        a
        temporary restraining order and temporary injunction requiring the Company
        to
        convene one or more additional meetings of shareholders, contending that
        in the
        absence of a quorum on December 6, Texas law and the Company’s bylaws entitled a
        majority of the shareholders in attendance to choose a date to which the
        meeting
        would be adjourned. The District Court held a hearing on Porter’s application,
        and on December 22, 2006 entered an order providing among other things that
        FIC
        will hold an annual shareholders meeting for the election of directors on
        January 16, 2007 at 10:00 a.m., but that if a quorum
        is not present on that date, FIC will not be required to hold an annual meeting
        of shareholders at any time before July 17, 2007. In compliance with the
        December 22, 2006 order, FIC has mailed new notices of the January 16, 2007
        meeting to all shareholders of record as of the October 24, 2006 Record Date.
  17
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 Litigation
        with Otter Creek Partnership I, L.P.
  During
        2003, Otter Creek Management Inc., (“Otter Creek Management”), solicited proxies
        for the Company’s 2003 Annual Meeting of Stockholders (the “2003 Annual
        Meeting”) held on July 31, 2003, seeking the election of seven nominees to the
        Board of Directors of the Company in opposition to the ten candidates selected
        by the then incumbent Board of Directors. Otter Creek Management is an
        investment advisory firm that manages three investment funds that are
        shareholders of the Company: Otter Creek Partners I, LP (“Otter Creek
        Partners”), Otter Creek International Ltd. and HHMI XIII, LLC (together with
        Otter Creek Management and Otter Creek Partners, “Otter Creek”).
 
 In
        connection with this solicitation of proxies, on June 13, 2003, Otter Creek
        Partners commenced a lawsuit in the District Court in Travis County, Texas,
        Cause No. GN302872 (the “Litigation”) seeking, among other things, to compel the
        Company to hold the previously delayed 2003 Annual Meeting. Otter Creek also
        sought in the Litigation to neutralize the effect of a proxy obtained by
        the
        Company from the Mitte Family (the “Mitte Proxy”) the preceding month whereby
        the incumbent board was able to vote 1,627,610 shares in favor of its
        nominees.
 
 Following
        the initiation of this litigation and a hearing before the court, the court
        ordered the Company not to amend its bylaws in a manner that would adversely
        affect voting or other matters relating to the Annual Meeting and election
        of
        directors and not to reschedule such Annual Meeting scheduled for July 31,
        2003,
        or the record date of the Annual Meeting.
 
 At
        the
        meeting, six of the seven Otter Creek nominees were elected to the Board:
        R.
        Keith Long, J. Bruce Boisture, Salvador Diaz-Verson Jr., Patrick E. Falconio,
        Richard H. Gudeman and Lonnie L. Steffen. The shares covered by the Mitte
        Proxy
        were all voted in favor of the incumbent nominees at the 2003 Annual Meeting.
        Had Otter Creek been successful in neutralizing the effect of the Mitte Proxy,
        all seven of the Otter Creek nominees would have been elected.
 
 Following
        the 2003 Annual Meeting, Otter Creek and FIC completed a settlement with
        respect
        to the lawsuit in December 2003. Under the settlement agreement, the Company
        reimbursed Otter Creek for $250,000 in proxy expenses in 2003. An additional
        $475,000 of proxy and litigation expenses payable in FIC common stock will
        be
        submitted to the Company’s shareholders for approval at the next Annual Meeting
        of Shareholders. If payment of the additional $475,000 is so approved, the
        amount will be expensed by the Company in the year of approval. The Board
        of
        Directors will recommend that shareholders approve the reimbursement. The
        settlement also included mutual releases between the Company and Otter Creek
        and
        its affiliates. The Chairman of the Board of Directors of the Company, R.
        Keith
        Long, is the President and owner of the General Partner of Otter Creek Partners
        I, L.P.
  Litigation
        with Former Employee of Subsidiary
  In
        October 2003, the Company placed Earl Johnson, the then-president of JNT
        Group,
        Inc. (“JNT”), a subsidiary of FIC that was later sold in December 2003 in the
        sale of the New Era companies, on administrative leave pending an investigation
        of matters related to (1) Johnson’s alleged termination of an employee in
        response to her request for information regarding her workers’ compensation
        rights arising out of an injury and (2) his co-mingled and disorganized
        bookkeeping of JNT’s client accounts with those of a personal business owned by
        Mr. Johnson and run by him at the same office (using the Company’s employees to
        do so). Soon after being interviewed in the course of that investigation,
        Mr.
        Johnson resigned, alleging good reason under his employment agreement with
        a
        subsidiary of FIC, on the ground that the change in the composition of the
        Board
        of Directors of FIC following the 2003 Annual Meeting of Shareholders resulted
        in a “change of control” under the provisions of his employment agreement. The
        employment agreement provided that if Mr. Johnson were to voluntarily terminate
        his employment for good reason, he would receive compensation and benefits
        for
        the remainder of the three-year term of the agreement and would become fully
        vested in 17,899 restricted shares of FIC stock. The Company notified Mr.
        Johnson that his resignation was not for “good reason” pursuant to his
        employment agreement. Under that agreement, termination without good reason
        results in forfeiture of future salary and benefits, as well as forfeiture
        of
        the restricted shares of FIC common stock.
 
 In
        November 2003, Mr. Johnson and his wife, Carol Johnson, filed suit in Harris
        County, Texas District Court against the Company, FIC Financial Services,
        Inc.
        (“FICFS”) and an employee of the Company. The suit, which sought an unspecified
        amount of damages and injunctive relief, alleges that the defendants interfered
        with the non-JNT contract and business relationships of the plaintiffs, made
        slanderous statements regarding the plaintiffs, and accessed computer files
        at
        the JNT offices relating to the non-JNT business relationships of the
        plaintiffs, without the consent of the plaintiffs. The suit also alleged
        conspiracy, conversion, and various other torts, all related to the defendants’
investigation of plaintiff’s business practices at JNT.
  18
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 Subsequently,
        Mr. Johnson filed a demand for arbitration under his employment agreement,
        which
        has a mandatory arbitration clause. In the arbitration, Mr. Johnson sought
        damages for breach of contract and various other benefits relating to the
        termination of his employment contract, totaling $913,133.40. In connection
        with
        the arbitration, FIC submitted a counter-claim, alleging that Mr. Johnson
        committed multiple breaches of his employment agreement, and that he breached
        his fiduciary duty to FIC as a result of his actions in conducting the business
        of JNT, thereby entitling FIC to a dismissal of plaintiff’s claims. Prior to the
        hearing on the arbitration, the Harris County Court ordered that the matters
        raised in that lawsuit by Mr. Johnson (though not Carol Johnson) be combined
        with the arbitration.
  An
        arbitration hearing on Johnson’s contract claims was conducted in April 2005. On
        July 21, 2005, the Arbitrator issued an interim award in which he denied
        all of
        Johnson’s claims for breach of contract, as well as Johnson’s claims with
        respect to the restricted shares of FIC stock. In denying Johnson’s claims, the
        Arbitrator concluded that:
 
 (1)
              Johnson
                  had committed multiple and material breaches of his employment
                  agreement
                  by operating a personal tax and accounting business out of office
                  space
                  and using employees, utilities and other items, all paid for by
                  FICFS; by
                  engaging in a self-dealing transaction involving the payment to
                  himself of
                  $25,000 out of funds held by JNT in a suspense account, an account
                  to
                  which JNT owed fiduciary duties to its customers and clients; and
                  by
                  firing an employee of JNT on the same day that the employee inquired
                  about
                  possible workers compensation benefits in connection with an on-the-job
                  injury,
 
 (2)
              Johnson’s
                  breaches of his employment agreement occurred prior to the time
                  that he
                  was placed on administrative leave, thereby precluding him from
                  maintaining a breach of contract suit against FIC and FICFS, and
 
 (3)
              The
                  change in the majority of the Board of Directors of FIC resulting
                  from the
                  2003 Annual Meeting of FIC’s shareholders did not constitute a “change of
                  control” under Johnson’s employment agreement, thereby denying Johnson’s
                  claim that he was entitled to a “good reason” termination of his
                  employment agreement.
 
 In
        addition, the Arbitrator awarded FICFS $28,000, plus interest at the rate
        of 6%
        per annum from July 21, 2005, to the date of payment, with respect to Johnson’s
        unauthorized conversion of funds held in the JNT suspense account. The order
        confirming the arbitration award was signed on February 27, 2006, by the
        Harris
        County district judge and the Company is currently pursuing collection of
        the
        judgment. No amounts have been recorded in the Company’s financial statements
        for such judgment.
  With
        respect to the matters raised by Mr. Johnson in the Harris County lawsuit,
        which
        were referred by the Court to the arbitration, following his loss in the
        arbitration of the employment agreement, Mr. Johnson notified the Arbitrator
        that he would not pursue arbitration of his other claims. In addition, in
        May
        2006, Mrs. Johnson filed a notice of non-suit with respect to the claims
        made by
        her in the Harris County lawsuit. Accordingly, this matter is now closed.
 
 Litigation
        with Equita Financial and Insurance Services of Texas, Inc. and M&W
        Insurance Services, Inc.
  On
        June
        2, 2005, Equita and M&W Insurance Services, Inc. (“M&W”) filed a civil
        suit in Travis County, Texas District Court against the Company. The suit
        alleges that, in entering into certain agreements with the plaintiffs, the
        Company made certain misrepresentations and omissions as to its business
        and
        financial condition. The agreements referenced in the suit consist of (a)
        an
        option agreement entered into in June 2003 between Equita and the Company,
        granting Equita the right to purchase shares of FIC’s common stock at $16.42 per
        share, if certain sales goals were achieved under an exclusive marketing
        agreement between Equita and a subsidiary of the Company (the “Option
        Agreement”), (b) a stock purchase agreement entered into in June 2003 between
        M&W and the Roy F. and Joann Cole Mitte Foundation, pertaining to the
        purchase of 204,918 shares of FIC’s common stock (the Stock Purchase
        Agreement”), and (c) a registration rights agreement entered into in June 2003
        among the plaintiffs and the Company, whereby the Company agreed to file
        and
        maintain a shelf registration statement which respect to the shares of FIC’s
        common stock purchased by M&W from the Mitte Foundation or which may be
        acquired in the future by Equita under the option agreement (the “Registration
        Rights Agreement,” and, collectively, the “Agreements”).
  19
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 The
        suit
        alleges that the Company breached the provisions of the Option Agreement
        by
        refusing to indemnify the plaintiffs for losses relating to the alleged breach
        of certain representations and warranties included in the Option Agreement.
        The
        plaintiffs also allege that the Company required M&W to purchased 204,918
        shares of FIC common stock from the Mitte Foundation as a condition of Equita’s
        obtaining, in June 2003, an exclusive marketing agreement with a subsidiary
        of
        the Company pertaining to the distribution of insurance products in the “senior
        market” (the “Marketing Agreement”), and that such requirement was motivated by
        the desire of the Company’s management to obtain certain proxy rights obtained
        under a settlement agreement with the Mitte Foundation and the Mitte family.
        The
        plaintiffs further allege that the Company breached the provisions of the
        Registration Rights Agreement by failing to file a shelf registration with
        the
        SEC with respect to the shares of FIC’s common stock purchased by M&W from
        the Mitte Foundation and the shares which may be acquired in the future by
        Equita under the provisions of the Option Agreement. The plaintiffs seek
        rescission of the Agreements; damages in an amount equal to the $3 million
        that
        M&W paid to acquire FIC shares from the Mitte Foundation, together with
        interest and attorney’s fees and unspecified expenses; and an unspecified amount
        of exemplary damages.
 
 Late
        in
        2005, the Company’s two life insurance subsidiaries, Investors Life and Family
        Life, intervened in the lawsuit to assert claims that Equita had breached
        its
        obligations under the Marketing Agreement with respect to the distribution
        of
        insurance products, thereby causing damages to the life insurance subsidiaries.
        Equita moved to dismiss the intervention, but at a hearing on December 20,
        2005,
        the court denied Equita’s motion. As a result, Investors Life and Family Life
        will be permitted to assert their claims against Equita in this
        lawsuit.
 
 Deposition
        discovery with respect to both the case filed by Equita and M&W, and the
        claims in intervention asserted by Family Life and Investors Life, began in
        October 2006.
 
 In
        response to a motion for partial summary judgment, the Company has stipulated
        to
        certain elements of some of the causes of action asserted by Equita and M&W,
        including that certain representations and warranties made in the Option
        Agreement were partially incorrect, and that FIC was unable to comply with
        certain of its obligations under the Option Agreement. FIC did not stipulate,
        and continues to dispute, other elements of certain of the causes of action
        asserted by Equita and M&W, and disputes other causes of action in their
        entirety. FIC intends to vigorously oppose the lawsuit and any effort by
        Equita
        and M&W to recover damages from FIC, and the life insurance subsidiaries
        intend to vigorously prosecute their claims in intervention against Equita.
  Shareholder
        Claim
  The
        Company received a demand letter in April 2004 from a law firm representing
        an
        individual shareholder (Mr. Cook) who owns 530 shares of the Company’s common
        stock, which letter set forth certain allegations and notified the Registrant
        that the shareholder intended to file a shareholder derivative lawsuit (the
        “Demand Letter”).
 
 In
        May
        2004, FIC, by and through its Special Litigation Committee, filed a petition
        in
        the 250th District Court of Travis County, Texas (the “Court”), seeking to have
        the Court appoint a panel of independent and disinterested persons pursuant
        to
        Section H (3) of Article 5.14 of the Texas Business Corporation Act to
        investigate the allegations, and stay any shareholder derivative actions.
        Subsequently, on June 1, 2004, the Court issued an Order appointing Eugene
        Woznicki, Kenneth S. Shifrin, John D. Barnett and F. Gary Valdez as a panel
        of
        independent and disinterested persons (the “Panel”) to make determinations
        contemplated by Section F of Article 5.14 of the Texas Business Corporation
        Act
        in connection with the Demand Letter and staying any shareholder derivative
        actions relating to the letter until the Panel’s review was completed and a
        determination was made by the panel as to what, if any, further action was
        to be
        taken. Messrs. Woznicki, Shifrin and Barnett are independent directors of
        FIC.
        Mr. Valdez is neither a director nor an employee of FIC. Mr. Valdez is the
        founder and president of Focus Strategies, L.L.C. and is active in various
        community and civic organizations in the Austin, Texas area.
 
 Following
        an extensive review of the claims made by the individual shareholder, the
        Panel,
        in January 2005, filed with the court a Petition for Declaratory Judgment
        pursuant to the Texas Declaratory Judgments Act and Article 5.14 of the Texas
        Business Corporations Act (the “Petition”). The Petition describes the process
        used by the Panel and its counsel in considering the matters raised in the
        Demand Letter and the submittal provided by counsel for the shareholder.
        The
        Petition advised the Court that, after consideration of the evidence obtained
        through its inquiry, the Panel had unanimously made a good faith determination
        that the continuation of the Committee’s derivative proceeding and the
        commencement of any further derivative proceedings based on the allegations
        made
        by the individual shareholder was not in the best interests of FIC.
  20
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 On
        October 10, 2005, the 250th District Court of Travis County, Texas, heard
        for
        trial on the merits the matters raised by the Panel in the Petition
        ( Financial
        Industries Corporation v. Tom
        Cook (Cause
        No. GN 401513). After consideration of the pleadings, evidence and authorities
        submitted by counsel for the Company, the Court issued a Final Judgment on
        October 10, 2005, in which it ruled that the determinations made by the Panel,
        as reflected in a report submitted to the Court by a Special Litigation
        Committee appointed by the Registrant’s Board of Directors, were made: (1) in
        good faith, (2) after the Panel conducted a reasonable inquiry, and (3) based
        on
        the factors deemed appropriate under the circumstances by the Panel. The
        Court’s
        ruling otherwise dismissed with prejudice the derivative proceedings involved
        in
        this matter. The Final Judgment was approved as to form and substance by
        counsel
        for the Registrant and by counsel for the defendant.
 
 ***Management
        Conclusion on Legal Proceedings***
 
 In
        the
        opinion of the Company’s management, it is not currently possible to estimate
        the impact, if any, that the ultimate resolution of these foregoing legal
        proceedings will have on the Company’s results of operations, financial
        position, or cash flows.
 
 ***Other
        Litigation***
 
 FIC
        and
        its insurance subsidiaries are regularly involved in litigation, both as
        a
        defendant and as a plaintiff. The litigation naming the insurance subsidiaries
        as defendant ordinarily involves our activities as a provider of insurance
        products. Management does not believe that any of this other litigation,
        either
        individually or in the aggregate, will have a material adverse effect on
        the
        Company’s business or financial condition.
 
 **8.
        Subsequent Events**
 
 Sale
        of Family Life Insurance Company
 
 On
        December 29, 2006, the Company completed the sale of its wholly owned
        subsidiary, Family Life Insurance Company to The Manhattan Life Insurance
        Company ("Manhattan Life").  The cash sales price was $28.0 million,
        subject to certain post closing adjustments as set forth in the definitive
        agreement dated December 8, 2006.
 
 Prior
        to
        the sale, Family Life owned 648,640 shares of FIC common stock. Such shares
        are
        reflected as common treasury stock in the accompanying consolidated financial
        statements. In conjunction with this transaction, the Company acquired from
        Family Life 324,320 of these shares and the remaining 324,320 shares remained
        with Family Life at the time of sale. Also, prior to the closing of the sale,
        the Family Life Pension Plan, along with its assets and liabilities, was
        transferred from Family Life insurance Company to its upstream parent company,
        Family Life Corporation (“FLC”). FLC is wholly owned by FIC and all current and
        future obligations of the Family Life Pension Plan are the responsibility
        of
        FLC.
 
 In
        conjunction with the sale, the Company’s Investors Life subsidiary also entered
        into a coinsurance arrangement with Manhattan Life related to sales of certain
        future insurance products historically marketed by Family Life, such as
        traditional mortgage life insurance.
 
 At
        September 30, 2006, Family Life had assets totaling approximately $121.9
        million
        and capital and surplus totaling approximately $16.3 million, as reported
        on a
        statutory basis of accounting for insurance regulatory purposes. The Company
        has
        not yet completed the preparation of its 2006 consolidated financial statements
        as prepared under GAAP. The estimated GAAP equity basis in Family Life,
        including other adjustments that will affect the determination of loss from
        the
        sale, totals approximately $60 million. Accordingly, management estimates
        that a
        GAAP loss between $30 million and $35 million will result from this sale.
        The
        foregoing amounts are unaudited and could change significantly upon completion
        of 2006 GAAP financial statements and the audits of such financial statements.
  21
 *Index*
  **FINANCIAL
        INDUSTRIES CORPORATION AND SUBSIDIARIES**
 **NOTES
        TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED**
 **(Unaudited)**
 
 Amendment
        of Subordinated Loans
 
 FIC
        and
        FLC have subordinated notes payable to Investors Life with an unpaid balance
        of
        $15.4 million at September 30, 2005 and December 31, 2004. With the approval
        of
        the Texas Department of Insurance, the loans were restructured as of March
        9,
        2006. As amended, the loans provide for a one year moratorium on principal
        payments for the period from March 12, 2006, to December 12, 2006, with
        principal payments to resume on March 12, 2007, with ten equal quarterly
        principal payments until the maturity date of June 12, 2009. These notes
        have
        been eliminated in the consolidated financial statements. The
        Company retired these subordinated notes payable on December 29, 2006 using
        a
        portion of the proceeds from the sale of Family Life Insurance
        Company.
  22
 *Index*
  **ITEM
        2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
        AND RESULTS OF OPERATIONS**
 
 The
        following discussion addresses the financial condition of Financial Industries
        Corporation (“FIC”) as of September 30, 2005, compared with December 31, 2004,
        and its results of operations for the three and nine-month periods ended
        September 30, 2005, compared with the same period last year. This discussion
        should be read in conjunction with Management’s Discussion and Analysis included
        in FIC’s Form 10-K for the year ended December 31, 2004, to which the reader is
        directed for additional information.
 
 **Results
        of Operations - Three Months Ended September 30, 2005 and
        2004**
 
 For
        the
        three month period ended September 30, 2005, the Company reported a net loss
        of
        $2.5 million and basic and diluted loss per common share of $.26 compared
        to a
        net loss of $4.8 million and basic and diluted loss per common share of $0.49
        for the three month period ended September 30, 2004. The three months ended
        September 30, 2005 and 2004 include the impact of certain trends and changes
        in
        the business of the Company which are dominant in the results of the nine
        months
        ended September 30, 2005 and 2004. These items are described in the nine-month
        results of operations below. Of these results, certain significant items
        of
        change between the three months ended September 30, 2005 and 2004 which
        contribute to a decline in net loss of $2.3 million between periods are as
        follows:
 
 ·
              Increase
                  in net investment income of $851,000 primarily due to increased
                  holdings
                  in fixed maturities and cash;
 ·
              Decline
                  in real estate income of $461,000 primarily due to the reduction
                  in rental
                  income following the sale of River Place
                  Pointe;
 ·
              Decline
                  in realized gains of $1.2 million primarily due to a $1 million
                  impairment
                  recorded for an investment in a fixed maturity security in
                  2005;
 ·
              Decline
                  in operating expenses totaling $719,000 due primarily to reductions
                  in
                  unusual expenses noted below in the nine months ended September
                  30,
                  2004;
 ·
              Increase
                  in benefit for federal income taxes of $1.4
                  million.
 
 **Results
        of Operations - Nine Months Ended September 30, 2005 and
        2004**
 
 For
        the
        nine-month period ended September 30, 2005, FIC’s net income was $1.0 million
        (basic and diluted income of $.10 per common share) on revenues of $82.0
        million
        as compared to net loss of $10.9 million (basic and diluted loss of $1.11
        per
        common share) on revenues of $78.4 million in the first nine months of
        2004.
 
 In
        2005,
        FIC’s net loss was affected by the following items:
 
 ·
              Reduction
                  in earned insurance charges of $1.2 million primarily due to the
                  decline
                  in fee income consistent with the trend of run-off of business
                  in
                  2004;
 ·
              Decline
                  in net investment income of $1.0 million, primarily due to the
                  reduced
                  levels of fixed maturity securities during the nine months of 2005
                  compared to the first nine months of 2004;
 ·
              Increase
                  in net realized investment gains of $6.3 million, offset by a reduction
                  in
                  real estate income of $756,000, primarily due to the sale of River
                  Place
                  Pointe;
 ·
              Decline
                  in policyholder benefits and expenses of $4.6 million, resulting
                  from a
                  decline in the amount of death claims and surrenders of policies
                  in the
                  current year;
 ·
              Decline
                  in operating expenses of $3.3 million, predominantly attributed
                  to the
                  reduction in unusual expenses noted
                  below;
 ·
              Increase
                  in provision for federal income tax of $1.4
                  million.
 
 In
        2004,
        FIC’s net loss was affected by the following items:
 
 ·
              Significantly
                  higher policyholder benefits and expenses totaling $36.4 million
                  for the
                  nine months ended September 30, 2004, compared to $34.8 million
                  for the
                  same period in 2003. A substantial portion of this increase was
                  related to
                  higher death benefits.
 ·
              Effective
                  January 1, 2004, the Company adopted Statement of Position (“SOP”) 03-01,
                  “Accounting and Reporting by Insurance Enterprises for Certain
                  Non-traditional Long-Duration Contracts and for Separate Accounts.” This
                  resulted in recognizing additional income totaling $229,000, net
                  of taxes,
                  as a cumulative effect of change in accounting principle in 2004.
                  The
                  implementation of this SOP changed the pattern of recognition of
                  bonus
                  interest credited to contractholders for certain of the Company’s
                  insurance products.
  23
 *Index*
 
 ·
              Significant
                  auditing, actuarial, accounting, consulting, and legal fees were
                  incurred
                  throughout 2004, much of which was associated with the internal
                  review of
                  the Company’s financial accounts and resulting restatement of prior years’
                  financial statements as reported in its 2004 Form 10-K
                  filing.
 ·
              Excess
                  of cost over net assets acquired, or goodwill, totaling $752,000
                  was
                  written off as an operating expense in 2004 as a result of the
                  Company’s
                  annual impairment analysis of such
                  asset.
 
 The
        above
        described items need to be taken into consideration in drawing comparisons
        between the operating results for the nine months ended September 30, 2005
        and
        2004.
 
 *Revenues*
 
 Premium
        revenues reported for traditional life insurance products are recognized
        when
        due. Premium income for the first nine months of 2005, net of reinsurance
        ceded,
        was $17.9 million, as compared to $17.8 million in the first nine months
        of
        2004. This source of revenues is related to the traditional life insurance
        book
        of business of FIC’s insurance subsidiaries for both first year and renewal
        premiums.
 
 In
        accordance with GAAP, deposits received by FIC in connection with annuity
        contracts and premiums received for universal life (“UL”) insurance policies are
        reflected in FIC’s financial statements as increases in liabilities for
        contractholder deposit funds and not as revenues. Earned insurance charges
        assessed against these deposits are reported as revenue. For the nine months
        ended September 30, 2005 and 2004, annuity deposits and UL premiums totaled
        $25.4 million and $31.7 million, respectively.
 
 The
        decline in UL premiums and annuity deposits reflects the net run-off of business
        from the Company’s existing book of business, and declining sales of new UL
        policies. Although the Company is focusing on reversing these trends on an
        overall basis, management has de-emphasized the sale of annuity and UL products
        in periods subsequent to 2003 due primarily to the current interest-rate
        environment and certain design features of FIC’s current annuity
        products.
 
 Earned
        insurance charges totaled $30.3 million for the first nine months of 2005,
        as
        compared to charges of $31.5 million in the same period of 2004. These revenues
        primarily consist of UL cost of insurance charges, but also include policy
        surrender charges, and policy administration charges. The decline in earned
        insurance charges from 2004 to 2005 is primarily due to reduced UL cost of
        insurance charges resulting from the net run-off of business.
 
 Net
        investment income for the first nine months of 2005 was $22.9 million as
        compared to $23.9 million in the same period of 2004. The decrease in net
        investment income from 2004 to 2005 was primarily attributable to 1) a decline
        in the income received from the Company’s interest-bearing investments,
        resulting from decreasing interest rates during 2004 and 2) reduction in
        total
        investments in fixed maturities, equity securities, and short-term investments
        compared to the first nine months of 2004.
 
 Real
        estate income was primarily earned from the leases on the buildings at the
        Company’s River Place Pointe office complex in Austin, Texas. Real estate income
        (revenues from leases less associated operating expenses and depreciation)
        was
        $563,000 for the nine-month period ended September 30, 2005, compared to
        $1.3
        million during the same period in 2004. In June 2005, the Company sold the
        River
        Place Pointe property, and accordingly, the Company will no longer have
        significant real estate-related income subsequent to June 1, 2005 as the
        sales
        proceeds were reinvested primarily in fixed maturity securities.
 
 Net
        realized investment gains were $8.6 million in the first nine months of 2005,
        as
        compared to $2.3 million in the first nine months of 2004. The realized gains
        for 2005 were primarily from the
        sale
        of River Place Pointe. The
        project was sold in June 2005, in a cash transaction, for $103 million. The
        Company realized a gain of $10.6 million on the sale, which included both
        a
        current 2005 realized gain of $8.5 million and a deferred gain of $2.1 million
        to be recognized as a reduction of office lease expenses over the period
        from
        the sale date through March 31, 2008. The realized gains for 2004 were primarily
        from the sales of fixed maturity securities and one of the Company’s real estate
        properties classified as held for sale.
  24
 *Index*
  *Benefits
        and Expenses*
 
 Policyholder
        benefits and expenses, which consist primarily of death benefit claims, were
        $31.9 million in the first nine months of 2005, as compared to $36.4 million
        in
        the first nine months of 2004. The decline in policyholder benefits and expenses
        was primarily attributable to both lower death benefit claims and surrenders
        of
        traditional life insurance policies.
 
 Interest
        expense on contractholder deposit funds represents interest paid or credited
        to
        contractholders on cash values accumulated in their universal life insurance
        and
        annuity accounts.  Interest
        expense totaled $16.6 million in the first nine months of 2005, as compared
        to
        $17.5 million in the same period of the year 2004. The decrease in interest
        expense in 2005 was primarily attributable to declines in liabilities for
        contractholder deposit funds and the continued trend of reductions in interest
        rates credited to policyholders, as the Company managed its interest spread
        in
        response to the low and declining interest rates that characterized 2005
        and
        2004.
 
 With
        the
        decline in market interest rates, there can be effects on the interest spread
        which is the difference in the Company’s investment portfolio rate and the
        interest rates credited on policyholder contracts for universal life insurance
        and annuities. The Company responded to the lower market rates by lowering
        many
        of the credited rates on its policies during 2003 and 2004. However, universal
        life insurance and annuity policies have contractual minimum guaranteed rates
        and credited rates cannot be lower than such minimums. Because many of the
        Company’s policies have minimum guaranteed rates of 4.0%, the market interest
        rate environment in recent years has put pressure on the Company’s interest
        spread.
 
 Amortization
        of deferred policy acquisition costs (DAC) for the first nine months of 2005
        was
        $7.7 million, as compared to $8.7 million in the same period in 2004. These
        expenses represent the amortization of the costs of producing new business,
        which consists primarily of agents’ commissions and certain policy issuance and
        underwriting costs. For traditional life insurance business, DAC is amortized
        over the estimated premium-paying period of the policies in proportion to
        annual
        premium revenue. For interest sensitive products, these costs are amortized
        in
        relation to the estimated annual gross profits of the policies. The level
        of
        policy lapses and surrenders can also have a significant impact on the amount
        of
        amortization in any reporting period.
 
 Present
        value of future profits of acquired business (PVFP) is amortized in a similar
        manner as DAC, as previously described, for traditional and interest sensitive
        business. Amortization of PVFP totaled $2.0 million and $2.5 million for
        the
        nine months ended September 30, 2005 and 2004, respectively. The amortization
        is
        consistent with the run-off of the acquired blocks of business.
 
 Operating
        expenses for the first nine months of 2005 were $21.8 million, as compared
        to
        $25.1 million in the first nine months of 2004. This decrease in the level
        of
        operating expenses is partially the result of several unusual items occurring
        during the first nine months of 2004.
 
 Operating
        expenses in 2004 also include a write off of excess of cost over net assets
        acquired, or goodwill, totaling $752,000 resulting from the Company’s annual
        impairment analysis of such asset. The goodwill was originally recognized
        by
        ILCO in connection with its acquisitions, including Investors Life. The
        impairment of the entire goodwill asset was triggered by the significant
        decline
        in the Company’s stock price from December 31, 2003 to December 31, 2004. The
        Company’s stock price is a significant component in the valuation calculation as
        required in the impairment analysis.
 
 During
        2004, the Company took significant steps to reduce the level of general
        operating expenses. Subsequent to the changes in the Board and management
        in
        late 2003 and early 2004, a comprehensive review of the Company’s staffing and
        operational structure was performed. This review identified numerous
        opportunities in these areas for reductions in the Company’s cost structure,
        given the current levels of sales and business in force. Accordingly,
        significant reductions in staffing levels were achieved in late 2003 and
        during
        2004.
 
 Although
        cost reduction steps were implemented in 2004, with additional steps taken
        in
        2005, these savings were significantly offset by extraordinary auditing,
        actuarial, accounting and other consulting, and legal expenses associated
        with
        the reexamination and restatement of the Company’s 2003 consolidated financial
        statements, compliance with Sarbanes-Oxley, and with its litigation matters
        as
        previously described herein.
 
 Interest
        expense was $829,000 and $624,000 for the nine months ended September 30,
        2005
        and 2004, respectively. The interest expense relates to debt service on $15
        million aggregate principal amount of floating rate Senior Notes due 2033
        (the
“Senior Notes”). The Senior Notes bear interest quarterly at the three-month
        LIBOR rate plus 4.2%.
  25
 *Index*
  *Taxes*
 
 The
        provision for federal income taxes on loss from operations, before cumulative
        effect of change in accounting principles, reflects a tax provision totaling
        $143,000 and a tax benefit totaling $1.3 million for the nine months ended
        September 30, 2005 and 2004, respectively. These tax amounts equate to effective
        tax provision rate of 12.3% and tax benefit rate 10.3% for the nine months
        ended
        September 30, 2005 and 2004, respectively. The primary reason for the deviation
        from the expected statutory tax rate of 34% for the Company is due to increases
        in the valuation allowance for deferred tax assets. Deferred income tax assets
        are subject to ongoing evaluation of whether such assets will be realized.
        Realization of deferred tax assets is dependent upon the Company's generation
        of
        sufficient taxable income in the future to recover tax benefits that cannot
        be
        recovered from taxes paid in prior periods. If future taxable income is not
        expected, the Company establishes a valuation allowance, when based on the
        weight of the available evidence, it is more likely than not that some portion
        of the deferred tax assets will not be realized. The Company’s deferred tax
        assets are primarily comprised of net operating losses of FIC and its non-life
        insurance subsidiaries.
 
 *Change
        in Accounting Principle*
 
 Effective
        January 1, 2004, the Company adopted Statement of Position (“SOP”) 03-01,
“Accounting and Reporting by Insurance Enterprises for Certain Non-traditional
        Long-Duration Contracts and for Separate Accounts.” This resulted in recognizing
        additional income totaling $229,000, net of taxes, as a cumulative effect
        of
        change in accounting principle for the nine months ended September 30, 2004.
        The
        implementation of this SOP resulted in a change in the pattern of recognition
        of
        bonus interest credited to contractholders for certain of the Company’s
        insurance products.
 
 **Liquidity
        and Capital Resources**
 
 Liquidity
        describes the ability of a company to generate sufficient cash flows to meet
        the
        cash requirements of business operations. FIC is an insurance holding company
        whose principal assets consist of its insurance subsidiaries - Family Life
        Insurance Company (“Family Life”) and Investors Life Insurance Company of North
        America (“Investors Life”). As a holding company, FIC’s ability to pay interest
        and principal on its debt, pay its expenses, and pay dividends on its common
        stock depend substantially upon its receipt of dividends or other cash flow
        from
        these subsidiaries.
 
 Liquidity
        management is designed to ensure that adequate funds are available to meet
        all
        current and future financial obligations. The Company meets its liquidity
        requirements primarily by funding cash used in operations with cash flows
        provided by investing activities. Proper liquidity management is crucial
        to
        preserve stable, reliable, and cost-effective sources of cash to meet the
        future
        benefit payments under our various insurance and deposit contracts, pay
        operating expenses (including interest and income taxes), and maintain reserve
        requirements. In this process, we focus on our assets and liabilities, and
        the
        impact of changes in both short-term and long-term interest rates, market
        liquidity and other factors. We believe we have the ability to generate adequate
        cash flows to fund obligations as they come due.
 
 At
        the
        holding company level, FIC’s principal current ongoing liquidity demands relate
        to the payment of principal and interest on its indebtedness. As of September
        30, 2005, Investors Life held $15.4 million of notes receivable from the
        Company
        (the “Affiliated Notes”) with quarterly interest payments at an annual rate of
        5%. Although this intercompany indebtedness is eliminated on FIC’s condensed
        consolidated balance sheets, it creates a debt service requirement at the
        holding company level.
 
 With
        the
        approval of the Texas Department of Insurance, the Affiliated Notes were
        restructured as of March 9, 2006. As amended, the loans provide for a one
        year
        moratorium on principal payments for the period from March 12, 2006, to December
        12, 2006, with principal payments to resume on March 12, 2007, with ten equal
        quarterly principal payments until the maturity date of June 12, 2009. As
        previously described in Note 8 of the accompanying financial statements,
        the
        Company retired the Affiliated Notes on December 29, 2006, using a portion
        of
        the proceeds from the sale of Family Life Insurance Company.
 
 The
        holding company’s other principal liquidity requirement is debt service on the
        $15 million of Senior Notes. These notes require quarterly interest payments
        at
        a variable interest rate of the three-month LIBOR rate plus 4.2%. The principal
        amount of the Senior Notes must be repaid in a single payment in
        2033.
  In
        addition to these debt service requirements, the holding company must pay
        its
        expenses in connection with Board of Directors fees, insurance costs, corporate
        overhead, certain audit and accounting fees, and legal and consulting expenses
        as incurred. The holding company has not paid any dividends to its shareholders
        since early in 2003, and management does not anticipate the payment of such
        dividends in the near future.
  26
 *Index*
  In
        June
        2004, FIC, with the approval of the Texas Department of Insurance, formed
        a
        service company subsidiary and transferred to it many of the administrative
        functions of the insurance companies. The new service company charges each
        insurance company a monthly service fee that is calculated using a formula
        based
        on policies under management, new policies issued, managed assets, and other
        factors. Profits earned by the service company are paid as dividends to the
        holding company, providing an additional source of liquidity at the holding
        company level.
  The
        ability of Family Life and Investors Life to pay dividends to FIC and help
        meet
        these holding-company liquidity demands is subject to restrictions set forth
        in
        the insurance laws and regulations of Texas, its domiciliary state. Texas
        limits
        how and when Family Life and Investors Life can pay such dividends by (a)
        including the “greater of" standard for payment of dividends to shareholders and
        (b) requiring that prior notification of a proposed dividend be given to
        the
        Texas Department of Insurance. Under the “greater of" standard, an insurer may
        pay a dividend in an amount equal to the greater of: (i) 10% of the capital
        and
        surplus or (ii) the insurer's net gain from operations for the previous
        year.
  Liquidity
        considerations at FIC’s insurance subsidiaries are different in nature than for
        the holding company. Sources of cash for FIC’s insurance subsidiaries consist of
        premium payments and deposits from policyholders and annuity holders, charges
        on
        policies and contracts, investment income, and proceeds from the sale of
        investment assets. These funds are applied primarily to provide for the payment
        of claims under insurance and annuity policies, payment of policy withdrawals,
        surrenders and loans, operating expenses, taxes, investments in portfolio
        securities, and shareholder dividends.
 
 A
        primary
        liquidity consideration with respect to life insurance and annuity products
        is
        the risk of early policyholder and contractholder withdrawal. Deposit fund
        liabilities for universal life and annuity products as of September 30, 2005
        were $546.9 million, compared to $572.1 million at December 31, 2004. Individual
        life insurance policies are less susceptible to withdrawal than are annuity
        contracts because life insurance policyholders may incur surrender charges
        and
        undergo a new underwriting process in order to obtain a new insurance policy.
        At
        September 30, 2005, the bulk of the liabilities for contractholder deposit
        funds
        on FIC’s balance sheet, $408.3 million, represented insurance products, as
        compared to $138.6 million of annuity product liabilities.
 
 Since
        each insurance company holds large portfolios of highly liquid publicly traded
        debt securities, raising cash through asset sales is available should other
        sources of liquidity fail to provide cash as needed. In this regard, however,
        the insurance companies must be concerned about such sales at inopportune
        times,
        when adverse movements in interest rates may have depressed the market price
        of
        securities so that sales would result in the realization of significant losses.
        To guard against such an outcome, FIC’s management monitors benefits paid and
        surrenders of insurance products to provide projections of future cash
        requirements. Also as part of this monitoring process, FIC performs cash
        flow
        testing of assets and liabilities at each year-end to evaluate the match
        between
        the planned maturities of the insurance company assets and the likely liquidity
        needs of the companies over time. Such cash-flow testing, prescribed by
        insurance laws and regulations, models the likely performance of assets and
        liabilities over time, using a wide variety of future interest rate scenarios.
 
 There
        can
        be no assurance that future experience regarding benefits and surrenders
        will be
        similar to the historic experience on which such cash-flow testing is based,
        since withdrawal and surrender levels are influenced by such factors as the
        interest-rate environment and general economic conditions as well as the
        claims-paying and financial strength ratings of FIC’s insurance
        subsidiaries.
 
 Cash
        and
        cash equivalents at September 30, 2005 were $87.0 million compared to $52.0
        million at December 31, 2004. The $34.9 million increase in cash and cash
        equivalents at September 30, 2005 from December 31, 2004 was due primarily
        to
        proceeds from the sales of invested real estate, net of reinvestment of much
        of
        the proceeds in fixed maturity securities and short-term investments. This
        was
        partially offset by the net payout of contractholder deposits and use of
        cash by
        operations.
 
 Net
        cash
        used in operating activities was $6.1 million for the nine month period ended
        September 30, 2005, compared to $6.2 million provided by operating activities
        for the same period of 2004. The increase in cash used by operating activities
        of $12.3 million from 2004 to 2005 was primarily attributable the decrease
        in
        other liabilities and net activity from trading securities.
 
 Net
        cash
        provided by investing activities was $68.6 million in the nine month period
        ended September 30, 2005, compared to $52.2 million used in investing activities
        for the same period of 2004. The $120.8 million increase in cash provided
        by
        investing activities in 2005 was due primarily to proceeds received from
        the
        sale of River Place Pointe, offset by reinvestment of these proceeds into
        fixed
        maturity securities available for sale and short-term
        investments.
  27
 *Index*
  Net
        cash
        used in financing activities was $27.6 million in the first nine months of
        2005,
        compared to cash used in financing activities of $22.4 million in the first
        nine
        months of 2004. The most significant components of the Company’s financing
        activities are contractholder fund deposits and withdrawals for annuity and
        universal life insurance policies. For the nine months ended September 30,
        2005
        and 2004, contractholder fund withdrawals exceeded deposits by $27.6 million
        and
        $22.4 million respectively. The change in net withdrawals in 2005 is due
        to a
        decline in deposits in 2005 from 2004 of $6.4 million and a decrease in
        withdrawals of $1.2 million for the same period.
 
 In
        light
        of the information and considerations outlined above, management believes
        at
        this time that the liquidity of FIC and its subsidiaries is sufficient to
        meet
        the needs of its business, including its debt service requirements.
 
 **Financial
        Condition**
 
 During
        the nine months ended September 30, 2005, the equity of the shareholders
        of the
        Company (that is, the excess of the Company’s assets over its liabilities)
        declined by $1.4 million. The primary changes resulting in the net decrease
        to
        shareholders’ equity are detailed as follow:
 
 •
              Net
                  income for the nine months of $1.0
                  million;
 •
              $2.7
                  million increase in accumulated other comprehensive loss from change
                  in
                  net unrealized losses on investments in fixed maturity and equity
                  securities available for sale.
 
 *Assets*
 
 In
        2003,
        following a review of the investment portfolios of the life insurance
        subsidiaries of the Company and the poor performance of recent reinvestments
        by
        the former management, the Investment Committee of the Company's then newly
        elected Board of Directors recommended the engagement of a third-party
        investment manager to provide ongoing, professional management of the
        portfolios. In October 2003, the life insurance subsidiaries entered into
        investment management agreements with Conning. Under these agreements, Conning
        manages the investment security portfolios of the Company’s life insurance
        subsidiaries in accordance with investment policies set by the Company’s Board
        of Directors.
 
 The
        Company, working with Conning, also revised the investment policies of its
        insurance subsidiaries. The new policies reiterate compliance with legal
        requirements of state insurance laws and regulations that are applicable
        to the
        Company’s insurance company subsidiaries. They also emphasize sensitivity to the
        way that FIC’s liabilities are likely to change over time and with changes in
        general interest rate levels. In practical terms, this means that the Company
        now focuses almost all of its investment in investment-grade securities,
        keeping
        the schedule of anticipated asset maturities in line with its projected cash
        needs. It also means that the Company attempts to keep the duration of its
        investment assets (a measure of the sensitivity of their value to changes
        in
        interest rates) in line with the duration of the Company’s
        liabilities.
 
 Since
        the
        engagement of Conning as the Company’s investment manager, the Company has
        realigned its portfolio, decreasing its investment in mortgage-backed securities
        (including asset-backed securities) significantly, from 37.4% at December
        31,
        2004 to 27.0% at September 30, 2005, expressed as a percentage of its total
        investment in fixed maturities. Such securities are sensitive to changes
        in
        prevailing interest rates, since interest rate levels affect the rate at
        which
        the underlying mortgage obligations are repaid. FIC’s insurance subsidiaries
        have reduced the risk of prepayment associated with mortgage-backed securities
        by investing in planned amortization class (“PAC”), target amortization class
        (“TAC”) instruments and scheduled bonds. These investments are designed to
        amortize in a predictable manner by shifting the risk of prepayment of the
        underlying collateral to other investors in other tranches (“support classes”)
        of the CMO.
 
 FIC’s
        equity securities consist primarily of its investment in the investment funds
        underlying the separate accounts business of Investors Life Insurance Company
        of
        North America (“Investors Life”). However, during 2005, the Company increased
        its equity securities holdings by investing $2.1 million in a corporate bond
        mutual fund as part of a strategy to increase diversification and enhance
        overall investment performance. As of September 30, 2005, the market value
        of
        FIC’s equity securities was $10.7 million, compared to $8.5 million at December
        31, 2004.
 
 FIC’s
        real estate investment is primarily related to the River Place Pointe office
        complex (“River Place Pointe”) by Investors Life. At December 31, 2004, FIC’s
        investment totaled $90.1 million in this 600,000 sq. ft., seven-building
        office
        complex on 48 acres in Austin, Texas. The project was sold in June 2005,
        in a
        cash transaction, for $103 million. The Company realized a gain of $10.6
        million
        on the sale, which included both a current realized gain of $8.5 million
        and a
        deferred gain of $2.1 million to be recognized over the period from the sale
        date through March 31, 2008.
  28
 *Index*
  Investors
        Life had $346.8 million of separate account assets as of September 30, 2005
        (not
        including the value of the Company’s own investment in one of the accounts), as
        compared to $359.9 million at the end of 2004. These assets include (a) two
        variable annuity separate accounts that permit contractholders to allocate
        their
        contract values among a selection of third-party mutual funds and (b) assets
        held in custodian accounts in connection with investment annuity contracts.
        The
        investment annuity business is reinsured with Symetra Life Insurance Company
        (formerly Safeco Life Insurance Company), a third-party reinsurer, on a 90%/10%
        coinsurance basis, with Investors Life retaining 10% of such business. Since
        the
        reinsurance treaty is on a coinsurance basis, Investors Life is contingently
        liable to the policyholders in the event that the reinsurer is unable to
        fulfill
        its obligations under the treaty. Investors Life is not marketing new separate
        account annuity contracts.
 
 Effective
        June 1, 2006, Investors Life recaptured the previously reinsured investment
        annuity business with Symetra Life resulting in the retention of 100% of
        this
        business. The Company expects the recapture of this previously reinsured
        business to increase revenues in 2006 and future years. However, as this
        is a
        closed block of business, the revenues are expected to decrease as the policies
        in force decline.
 
 *Liabilities*
 
 The
        Company’s insurance-related liabilities (future policy benefits and
        contractholder deposit funds) were $704.1 million at September 30, 2005,
        compared to $732.3 million at December 31, 2004. The decrease in these
        insurance-related liabilities reflects the business run-off as previously
        described.
  During
          the nine months ended September 30, 2005, deferred income taxes have decreased
          $1.2 million from December 31, 2004. The change is most notably due to
          the tax
          effect of the current year operating results on the net operating loss
          position
          of the Company, the change in unrealized losses on fixed maturities available
          for sale and the change in valuation allowance based on the future realization
          of the deferred tax assets. This valuation allowance decreased primarily
          due to
          the utilization of net operating losses, resulting in more recoverable
          deferred
          tax assets.
 
 *Capital
        Adequacy*
  Financial
        intermediaries such as FIC depend on their equity capital to absorb short-term
        fluctuations in asset and liability values in their financial structures.
        They
        also count on equity capital to support the growth of the business. One typical
        measure of the strength of a financial holding company such as FIC is the
        simple
        ratio of its shareholders’ equity to its total assets. For FIC this ratio was
        7.2% at September 30, 2005, compared to 7.1% at December 31, 2004. If separate
        account assets were not included (which management believes is
        appropriate) this ratio would have been higher by 2.9% at September
        30, 2005 and December 31, 2004. Management believes that its current equity
        capital is sufficient to meet the Company’s current liabilities and to fund
        growth at currently planned levels.
  FIC’s
        insurance subsidiaries are subject to regulation under state law. Among other
        requirements, these state laws and regulations impose capital adequacy
        requirements on insurance companies. Using a calculation that takes into
        account
        the quality, liquidity, maturities, and amounts of its assets and liabilities,
        each insurance company is required to calculate its “risk-based capital” (or
“RBC”). Total adjusted capital must exceed 200% of the authorized control level
        RBC to avoid supervisory activity by the insurance regulators. As of December
        31, 2005, the total adjusted capital of FIC’s insurance subsidiaries, Family
        Life and Investors Life, was approximately 717% and 560% of its authorized
        control level risk-based capital, respectively. The RBC ratio of Investors
        Life
        improved as a result of the June 2005 sale of the River Place Pointe real
        estate
        investment.
 
 State
        regulators also use NAIC IRIS ratios to monitor capital adequacy requirements.
        The NAIC ratios cover 12 categories of financial data with defined “usual”
ranges for each such category. The ratios are intended to provide insurance
        regulators with “early warnings” as to when a company might warrant special
        attention. An insurance company may fall outside of the usual range for one
        or
        more ratios, and such variances may result from specific transactions that
        are,
        by themselves, immaterial or eliminated at the consolidation level. In certain
        states, insurers with more than three IRIS ratios outside of the NAIC usual
        ranges may be subject to increased regulatory oversight. For 2004, each of
        the
        Company’s insurance subsidiaries had six IRIS ratios outside of the usual
        ranges. However, for 2005, Family Life had five ratios and Investors Life
        had
        two ratios which were outside the usual ranges. For Family Life, the ratios
        outside the usual ranges were primarily related to changes in capital and
        surplus, net income, investment income, and non-admitted assets. For Investors
        Life, the ratios outside the usual ranges were primarily related to investment
        income and changes in premium.
  29
 *Index*
  **Critical
        Accounting Policies**
 
 The
        accounting policies below have been identified as critical to the understanding
        of the results of operations and financial position. The application of these
        critical accounting policies in preparing the financial statements requires
        management to use significant judgments and estimates concerning future results
        or other developments, including the likelihood, timing or amount of one
        or more
        future transactions. Actual results may differ from these estimates under
        different assumptions or conditions. On an ongoing basis, estimates, assumptions
        and judgments are evaluated based on historical experience and various other
        information believed to be reasonable under the circumstances. For a detailed
        discussion of other significant accounting policies, see Note 1 - Organization
        and Summary of Significant Accounting Policies in the Notes to Consolidated
        Financial Statements in the Company’s Annual Report on Form 10-K for the year
        ended December 31, 2005.
 
 *Accounting
        for Premiums on Universal Life Policies and for Annuity
        Deposits*
  In
        accordance with accounting principles generally accepted in the United States
        of
        America (“GAAP”), universal life insurance premiums and annuity deposits
        received are reflected in FIC’s consolidated financial statements as increases
        in liabilities for contractholder deposit funds and not as revenues. Instead,
        revenues from such contracts consist of amounts assessed against policyholder
        account balances for mortality, policy administration and surrender charges,
        and
        are recognized in the period in which the benefits and services are provided.
        Similarly, surrender benefits paid relating to universal life insurance policies
        and annuities are reflected as decreases in liabilities for contractholder
        deposit funds and not as expenses.
  *Investments*
  The
        Company’s principal investments are in fixed maturity securities and real
        estate; all of which are exposed to three primary sources of investment risk:
        credit, interest rate and liquidity. The fixed maturity securities, which
        are
        all classified as available for sale, are carried at their fair value in
        the
        Company’s balance sheet, with unrealized gains or losses recorded in accumulated
        other comprehensive income. The investment portfolio is monitored regularly
        to
        ensure that investments which may be other than temporarily impaired are
        identified in a timely fashion and properly valued, and that impairments
        are
        charged against earnings as realized investment losses. The valuation of
        the
        investment portfolio involves a variety of assumptions and estimates, especially
        for investments that are not actively traded. Fair values are obtained from
        a
        variety of external sources. The Company has a policy and process in place
        to
        identify securities that could potentially have an impairment that is
        other-than-temporary. This process involves monitoring market events that
        could
        impact issuers’ credit ratings, business climate, management changes, litigation
        and government actions, and other similar factors. This process also involves
        monitoring late payments, downgrades by rating agencies, key financial ratios,
        financial statements, revenue forecasts and cash flow projections as indicators
        of credit issues. At the end of each quarter, all securities are reviewed
        where
        fair value is less than ninety percent of amortized cost for six months or
        more
        to determine whether impairments should be recorded. The analysis focuses
        on
        each issuer’s ability to service its debts and the length of time the
        security has been trading below cost. This quarterly process includes an
        assessment of the credit quality of each investment in the entire securities
        portfolio. The Company considers relevant facts and circumstances in evaluating
        whether the impairment of a security is other-than-temporary. Relevant facts
        and
        circumstances considered include (1) the length of time the fair value has
        been
        below cost, (2) the financial position of the issuer, including the current
        and
        future impact of any specific events, and (3) the Company’s ability and intent
        to hold the security to maturity or until it recovers in value. To the extent
        the Company determines that a security is deemed to be other than temporarily
        impaired, the difference between amortized cost and fair value is charged
        to
        income as a realized investment loss. There are a number of significant risks
        and uncertainties inherent in the process of monitoring impairments and
        determining if an impairment is other-than-temporary. These risks and
        uncertainties include (1) the risk that the Company’s assessment of an issuer’s
        ability to meet all of its contractual obligations will change based on changes
        in the credit characteristics of that issuer, (2) the risk that the economic
        outlook will be worse than expected or have more of an impact on the issuer
        than
        anticipated, (3) the risk that fraudulent information could be provided to
        the
        Company’s investment professionals who determine the fair value estimates and
        other-than-temporary impairments, and (4) the risk that new information obtained
        by the Company or changes in other facts and circumstances lead the Company
        to
        change its intent to hold the security to maturity or until it recovers in
        value. Any of these situations could result in a charge to income in a future
        period.
  30
 *Index*
  *Real
        Estate*
  The
        Company monitors the performance of its real estate properties on an ongoing
        basis and identifies properties it intends to hold for investment and properties
        it intends to sell. Properties held for investment are classified as investment
        real estate and are stated at cost less accumulated depreciation. Depreciation
        is provided using straight-line methods over estimated useful lives of 5
        to 40
        years, or for leasehold improvements the minimum lease term if shorter. Real
        estate income is reported net of expenses incurred to operate the properties
        and
        depreciation expenses. The Company reviews its investment real estate properties
        on an on-going basis for impairment using a probability-weighted estimation
        of
        the expected net undiscounted future cash flows. If the expected net
        undiscounted future cash flows are less than the net book value of the property,
        the excess of the net book value over the Company’s estimate of fair value of
        the asset is recognized as a realized loss in the consolidated statement
        of
        operations and the new cost basis is depreciated over the property’s remaining
        life.
  Properties
        that are identified for sale and actively marketed by the Company are classified
        as real estate held for sale and are stated at the lower of cost less
        accumulated depreciation or net realizable value. No depreciation is recorded
        while the property is classified as held for sale. Net realizable value is
        determined by the Company based on the estimated selling price less direct
        costs
        of the sale.
  *Deferred
        Policy Acquisition Costs and Present Value of Future Profits of Acquired
        Business*
  The
        costs
        of acquiring new business, including certain costs of issuing policies and
        certain other variable selling expenses (principally commissions), are included
        in deferred policy acquisition costs (“DAC”). DAC is capitalized and then
        amortized to reflect an appropriate expense in relation to the projected
        stream
        of profits (for universal life and annuity products) or to the premium revenue
        stream (for traditional life products). Similarly, when existing blocks of
        business are acquired, an intangible capital asset (termed “present value of
        future profits of acquired business” or “PVFP”) reflecting the costs of
        acquiring the business is created and then amortized relative to the expected
        revenues and profitability of the block.
  Projections
        used to determine the rate of amortization of DAC and PVFP require extensive
        assumptions about, among other things, interest margins, product loads,
        mortality rates, persistency rates, and maintenance expense levels. In setting
        the levels of DAC and PVFP amortization, important assumptions must also
        be made
        about the appropriate level at which blocks of policies will be aggregated
        for
        testing the acceptability of amortization schedules, and views vary widely
        on
        this topic. These
        assumptions involve judgment and are compared to actual experience on an
        ongoing
        basis. Significant changes in these assumptions can impact the carrying balance
        of DAC and PVFP and produce changes that must be reflected in the current
        period’s income as an unlocking adjustment. Loss
        recognition is evaluated periodically on an aggregate basis that combines
        deferred policy acquisition costs with the present value of future profits
        on
        acquired business.
  *Future
        Policy Benefits*
  FIC’s
        liability for future policy benefits accounted for 14.2% of its total
        liabilities at September 30, 2005, or 20.6% after excluding liabilities
        associated with separate accounts. These liabilities for future policy benefits,
        referred to as reserves, are estimated using actuarial methods based on
        assumptions about future receipts of premiums, interest yields, investment
        returns, expenses, mortality, morbidity, and persistency. These assumptions
        consider Company experience and industry standards. The assumptions vary
        by
        plan, age at issue, year of issue, and duration. They include estimates,
        shaped
        by judgment and experience, and have a substantial impact on the reported
        financial condition of the Company. Differences between actual experience
        and
        assumptions used in the pricing of these policies and in the establishment
        of
        liabilities may result in variability of future results in amounts which
        may be
        material.
  *Deferred
        Taxes*
  The
        Company computes deferred income taxes utilizing the asset and liability
        method.
        Under this method, balance sheet amounts for deferred income taxes are computed
        based on the tax effect of the differences between the financial reporting
        and
        federal income tax bases of assets and liabilities using the tax rates which
        are
        expected to be in effect when these differences are anticipated to reverse.
        Deferred income tax assets are subject to ongoing evaluation of whether such
        assets will be realized. Realization of deferred tax assets is dependent
        upon
        the Company's generation of sufficient taxable income in the future to recover
        tax benefits that cannot be recovered from taxes paid in prior periods. The
        Company establishes a valuation allowance, when based on the weight of the
        available evidence, it is more likely than not that some portion of the deferred
        tax assets will not be realized.
  31
 *Index*
  **ITEM
        3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
        RISK**
 
 *General*
 
 FIC’s
        principal assets are financial instruments, which are subject to market risks.
        Market risk is the risk of loss arising from adverse changes in market rates,
        principally interest yields on fixed rate investments. For a discussion of
        the
        Company’s investment portfolio and the management of that portfolio to reflect
        the nature of the underlying insurance obligations of the Company’s insurance
        subsidiaries, please refer to the information set forth in “Management’s
        Discussion and Analysis of Financial Condition and Results of
        Operations.”
 
 The
        following is a discussion of the Company’s primary market-risk-sensitive
        instruments. It should be noted that this discussion has been developed using
        estimates and assumptions. Actual results may differ materially from those
        described below. Further, the following discussion does not take into account
        actions that could be taken by management in response to the assumed changes
        in
        market rates. In addition, the discussion does not take into account other
        types
        of risks that may be involved in the business operations of the Company,
        such as
        the reinsurance recoveries on reinsurance treaties with third party insurers.
 
 The
        primary market risk to the Company’s investment portfolio is interest rate risk.
        The Company does not use derivative financial instruments.
 
 *Interest-Rate
        Risk*
 
 The
        Company manages the interest-rate risk inherent in its fixed maturity assets
        relative to the interest-rate risk inherent in its liabilities. Generally,
        we
        manage interest-rate risk based on the application of a commonly used model.
        The
        model projects the impact of interest rate changes on a range of factors,
        including duration and potential prepayment. For example, assuming an immediate
        increase of 100 basis points in interest rates, the net hypothetical loss
        in
        fair market value related to the financial instruments included in the Company’s
        condensed consolidated balance sheets is estimated to be $31.2 million at
        September 30, 2005 and $28.1 million at December 31, 2004. For purposes of
        the
        foregoing estimate, fixed maturity securities available for sale, and held
        for
        trading, and short-term investments were taken into account. The fair value
        of
        such assets was $586.7 million at September 30, 2005 and $562.7 million at
        December 31, 2004.
 
 The
        fixed
        income investments of the Company include certain mortgage-backed securities
        (excluding asset backed securities). The market value of such securities
        was
        $155.6 million at September 30, 2005 and $179.1 million at December 31, 2004.
        Assuming an immediate increase of 100 basis points in interest rates, the
        net
        hypothetical loss in the fair value related to such mortgage-backed securities
        is estimated to be $11.4 million at September 30, 2005 and $14.1 million
        at
        December 31, 2004.
 
 Separate
        account assets have not been included, since gains and losses on those assets
        generally accrue to the policyholders.
 
 The
        Company generally does not use derivative financial instruments to manage
        its
        exposure to fluctuations in interest rates.
 
 **ITEM
        4. CONTROLS AND PROCEDURES**
 
 The
        Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) or
        15d-15(e) of the Exchange Act, are designed to ensure that information required
        to be disclosed in its reports filed with the SEC is recorded, processed,
        summarized and reported within the time periods specified in the Commission’s
        rules and forms, and that such information is accumulated and communicated
        to
        its management, including its Chief Executive Officer and Chief Financial
        Officer, as appropriate, to allow for timely discussions regarding required
        disclosure. In designing and evaluating the disclosure controls and procedures,
        management recognizes that any controls and procedures, no matter how well
        designed and operated, can provide only reasonable assurance of achieving
        the
        desired control objectives and are subject to certain limitations, including
        the
        exercise of judgment by individuals, the inability to identify unlikely future
        events, and the inability to eliminate misconduct completely. As a result,
        there
        can be no assurance that the Company’s disclosure controls and procedures will
        prevent all errors or fraud or ensure that all material information will
        be made
        known to management in a timely fashion.
  32
 *Index*
  Management
        has completed an evaluation of the effectiveness of the design and operation
        of
        the Company’s disclosure controls and procedures pursuant to Rule 13a-15 under
        the Securities Exchange Act of 1934, as amended. This evaluation has allowed
        management to make conclusions, as set forth below, regarding the state of
        the
        Company’s disclosure controls and procedures as of September 30, 2005. Based on
        its evaluation and the identification of material weakness in internal control
        over financial reporting described below, and because of an inability to
        file
        the Quarterly Report on Form 10-Q within the statutory time period, FIC’s Chief
        Executive Officer and Chief Financial Officer have concluded that, as of
        September 30, 2005, FIC’s disclosure controls and procedures were
        ineffective.
 
 Management
        had assessed our internal control over financial reporting as of December
        31,
        2004, the end of our most recent fiscal year. Management based its assessment
        on
        criteria established in Internal Control—Integrated Framework issued by the
        Committee of Sponsoring Organizations of the Treadway Commission. As disclosed
        in the Company’s Annual Report on Form 10−K for the fiscal year ended December
        31, 2004, in performing its assessment of internal control over financial
        reporting, management determined that material weaknesses existed in the
        Company’s internal controls relating to the following areas: control
        environment, risk assessment, control monitoring, financial close and reporting,
        segregation of duties, reconciliations, use of third-party service providers,
        safeguarding of assets, reinsurance, and policy data integrity.
 
 Following
        its identification of the above-described internal control weaknesses, the
        Company has been actively engaged in the implementation of remediation efforts
        to address the material weaknesses in its internal control over financial
        reporting as of September 30, 2005. There have been no significant changes
        in
        the Company’s internal controls or in other factors that could significantly
        affect internal controls subsequent to the date of the evaluation referred
        to in
        this Item.
 
 
 **PART
        II. OTHER INFORMATION**
 
 **ITEM
        1. LEGAL PROCEEDINGS**
 
 The
        Company and its subsidiaries are defendants in certain legal actions related
        to
        the normal business operations of the Company. Management believes that the
        resolution of such legal actions will not have a material impact on the
        condensed consolidated financial statements.
 
 ***T.
        David Porter v. Financial Industries Corporation***
 
 On
        May
        31, 2006, T. David Porter, an FIC shareholder, filed a civil suit in Travis
        County, Texas District Court (the “Court”), against the Company, seeking to
        compel the Company to hold an annual meeting of shareholders. FIC has been
        unable to hold an annual meeting at which its shareholders could be fully
        informed, or which could be attended by a substantial portion of its
        shareholders, because the Company is currently unable to comply with Rule
        14a-3
        of the Securities Exchange Act of 1934, and thus cannot provide an annual
        report
        to shareholders or solicit proxies in connection with an annual meeting.
        Mr.
        Porter sued under Article 2.24(B) of the Texas Business Corporation Act,
        which
        provides that if an annual meeting of shareholders is not held within any
        13-month period and a written consent of shareholders has not been executed
        instead of a meeting, any court of competent jurisdiction in the county in
        which
        the principal office of the corporation is located may, on the application
        of
        any shareholder, summarily order a meeting to be held. On August 7, 2006,
        the
        Company entered into an Agreed Order On Plaintiff’s Motion to Compel Annual
        Shareholders Meeting (the “Order”) and agreed among other things to hold an
        annual shareholders meeting for the election of directors on December 6,
        2006.
        The Company did in fact appear for a meeting of shareholders on December
        6,
        2006, as required by the Agreed Order. In advance of the meeting date, a
        group
        affiliated with Mr. Porter solicited proxies from FIC shareholders in an
        effort
        to replace FIC’s Board of Directors; the Company remained unable to solicit
        proxies. However, on the appointed day for the shareholder meeting - December
        6,
        2006 - a quorum was not in attendance. On December 12, 2006, FIC filed a
        Motion
        for Summary Judgment seeking dismissal of Porter’s suit on the grounds that the
        Agreed Order did not dispense with the requirement of a quorum; the lack of a
        quorum was a direct and foreseeable result of Mr. Porter’s insistence on a
        one-sided solicitation and election; FIC has complied with its obligations
        under
        the Agreed Order and Mr. Porter has obtained all relief sought by his petition.
        FIC’s Motion for Summary Judgment remains pending and has not been heard. Mr.
        Porter thereafter applied for a temporary restraining order and temporary
        injunction requiring the Company to convene one or more additional meetings
        of
        shareholders, contending that in the absence of a quorum on December 6, Texas
        law and the Company’s bylaws entitled a majority of the shareholders in
        attendance to choose a date to which the meeting would be adjourned. The
        District Court held a hearing on Porter’s application, and on December 22, 2006
        entered an order providing among other things that FIC will hold an annual
        shareholders meeting for the election of directors on January 16, 2007 at
        10:00
        a.m., but that if a quorum is not present on that date, FIC will not be required
        to hold an annual meeting of shareholders at any time before July 17, 2007.
        In
        compliance with the December 22, 2006 order, FIC has mailed new notices of
        the
        January 16, 2007 meeting to all shareholders of record as of the October
        24,
        2006 Record Date.
  33
 *Index*
  ***Litigation
        with Otter Creek Partnership I, L.P.***
 
 During
        2003, Otter Creek Management Inc., (“Otter Creek Management”), solicited proxies
        for the Company’s 2003 Annual Meeting of Stockholders (the “2003 Annual
        Meeting”) held on July 31, 2003, seeking the election of seven nominees to the
        Board of Directors of the Company in opposition to the ten candidates selected
        by the then incumbent Board of Directors. Otter Creek Management is an
        investment advisory firm that manages three investment funds that are
        shareholders of the Company: Otter Creek Partners I, LP (“Otter Creek
        Partners”), Otter Creek International Ltd. and HHMI XIII, LLC (together with
        Otter Creek Management and Otter Creek Partners, “Otter Creek”).
 
 In
        connection with this solicitation of proxies, on June 13, 2003, Otter Creek
        Partners commenced a lawsuit in the District Court in Travis County, Texas,
        Cause No. GN302872 (the “Litigation”) seeking, among other things, to compel the
        Company to hold the previously delayed 2003 Annual Meeting. Otter Creek also
        sought in the Litigation to neutralize the effect of a proxy obtained by
        the
        Company from the Mitte Family (the “Mitte Proxy”) the preceding month whereby
        the incumbent board was able to vote 1,627,610 shares in favor of its
        nominees.
 
 Following
        the initiation of this litigation and a hearing before the court, the court
        ordered the Company not to amend its bylaws in a manner that would adversely
        affect voting or other matters relating to the Annual Meeting and election
        of
        directors and not to reschedule such Annual Meeting scheduled for July 31,
        2003,
        or the record date of the Annual Meeting.
 
 At
        the
        meeting, six of the seven Otter Creek nominees were elected to the Board:
        R.
        Keith Long, J. Bruce Boisture, Salvador Diaz-Verson Jr., Patrick E. Falconio,
        Richard H. Gudeman and Lonnie L. Steffen. The shares covered by the Mitte
        Proxy
        were all voted in favor of the incumbent nominees at the 2003 Annual Meeting.
        Had Otter Creek been successful in neutralizing the effect of the Mitte Proxy,
        all seven of the Otter Creek nominees would have been elected.
 
 Following
        the 2003 Annual Meeting, Otter Creek and FIC completed a settlement with
        respect
        to the lawsuit in December 2003. Under the settlement agreement, the Company
        reimbursed Otter Creek for $250,000 in proxy expenses in 2003. An additional
        $475,000 of proxy and litigation expenses payable in FIC common stock will
        be
        submitted to the Company’s shareholders for approval at the next Annual Meeting
        of Shareholders. If payment of the additional $475,000 is so approved, the
        amount will be expensed by the Company in the year of approval. The Board
        of
        Directors will recommend that shareholders approve the reimbursement. The
        settlement also included mutual releases between the Company and Otter Creek
        and
        its affiliates. The Chairman of the Board of Directors of the Company, R.
        Keith
        Long, is the President and owner of the General Partner of Otter Creek Partners
        I, L.P.
  ***Litigation
        with Former Employee of Subsidiary***
  In
        October 2003, the Company placed Earl Johnson, the then-president of JNT
        Group,
        Inc. (“JNT”), a subsidiary of FIC that was later sold in December 2003 in the
        sale of the New Era companies, on administrative leave pending an investigation
        of matters related to (1) Johnson’s alleged termination of an employee in
        response to her request for information regarding her workers’ compensation
        rights arising out of an injury and (2) his co-mingled and disorganized
        bookkeeping of JNT’s client accounts with those of a personal business owned by
        Mr. Johnson and run by him at the same office (using the Company’s employees to
        do so). Soon after being interviewed in the course of that investigation,
        Mr.
        Johnson resigned, alleging good reason under his employment agreement with
        a
        subsidiary of FIC, on the ground that the change in the composition of the
        Board
        of Directors of FIC following the 2003 Annual Meeting of Shareholders resulted
        in a “change of control” under the provisions of his employment agreement. The
        employment agreement provided that if Mr. Johnson were to voluntarily terminate
        his employment for good reason, he would receive compensation and benefits
        for
        the remainder of the three-year term of the agreement and would become fully
        vested in 17,899 restricted shares of FIC stock. The Company notified Mr.
        Johnson that his resignation was not for “good reason” pursuant to his
        employment agreement. Under that agreement, termination without good reason
        results in forfeiture of future salary and benefits, as well as forfeiture
        of
        the restricted shares of FIC common stock.
 
 In
        November 2003, Mr. Johnson and his wife, Carol Johnson, filed suit in Harris
        County, Texas District Court against the Company, FIC Financial Services,
        Inc.
        (“FICFS”) and an employee of the Company. The suit, which sought an unspecified
        amount of damages and injunctive relief, alleges that the defendants interfered
        with the non-JNT contract and business relationships of the plaintiffs, made
        slanderous statements regarding the plaintiffs, and accessed computer files
        at
        the JNT offices relating to the non-JNT business relationships of the
        plaintiffs, without the consent of the plaintiffs. The suit also alleged
        conspiracy, conversion, and various other torts, all related to the defendants’
investigation of plaintiff’s business practices at JNT.
  34
 *Index*
  Subsequently,
        Mr. Johnson filed a demand for arbitration under his employment agreement,
        which
        has a mandatory arbitration clause. In the arbitration, Mr. Johnson sought
        damages for breach of contract and various other benefits relating to the
        termination of his employment contract, totaling $913,133.40. In connection
        with
        the arbitration, FIC submitted a counter-claim, alleging that Mr. Johnson
        committed multiple breaches of his employment agreement, and that he breached
        his fiduciary duty to FIC as a result of his actions in conducting the business
        of JNT, thereby entitling FIC to a dismissal of plaintiff’s claims. Prior to the
        hearing on the arbitration, the Harris County Court ordered that the matters
        raised in that lawsuit by Mr. Johnson (though not Carol Johnson) be combined
        with the arbitration.
  An
        arbitration hearing on Johnson’s contract claims was conducted in April 2005. On
        July 21, 2005, the Arbitrator issued an interim award in which he denied
        all of
        Johnson’s claims for breach of contract, as well as Johnson’s claims with
        respect to the restricted shares of FIC stock. In denying Johnson’s claims, the
        Arbitrator concluded that:
 
 (1)
              Johnson
                  had committed multiple and material breaches of his employment
                  agreement
                  by operating a personal tax and accounting business out of office
                  space
                  and using employees, utilities and other items, all paid for by
                  FICFS; by
                  engaging in a self-dealing transaction involving the payment to
                  himself of
                  $25,000 out of funds held by JNT in a suspense account, an account
                  to
                  which JNT owed fiduciary duties to its customers and clients; and
                  by
                  firing an employee of JNT on the same day that the employee inquired
                  about
                  possible workers compensation benefits in connection with an on-the-job
                  injury,
 
 (2)
              Johnson’s
                  breaches of his employment agreement occurred prior to the time
                  that he
                  was placed on administrative leave, thereby precluding him from
                  maintaining a breach of contract suit against FIC and FICFS, and
 
 (3)
              The
                  change in the majority of the Board of Directors of FIC resulting
                  from the
                  2003 Annual Meeting of FIC’s shareholders did not constitute a “change of
                  control” under Johnson’s employment agreement, thereby denying Johnson’s
                  claim that he was entitled to a “good reason” termination of his
                  employment agreement.
 
 In
        addition, the Arbitrator awarded FICFS $28,000, plus interest at the rate
        of 6%
        per annum from July 21, 2005, to the date of payment, with respect to Johnson’s
        unauthorized conversion of funds held in the JNT suspense account. The order
        confirming the arbitration award was signed on February 27, 2006, by the
        Harris
        County district judge and the Company is currently pursuing collection of
        the
        judgment. No amounts have been recorded in the Company’s financial statements
        for such judgment.
  With
        respect to the matters raised by Mr. Johnson in the Harris County lawsuit,
        which
        were referred by the Court to the arbitration, following his loss in the
        arbitration of the employment agreement, Mr. Johnson notified the Arbitrator
        that he would not pursue arbitration of his other claims. In addition, in
        May
        2006, Mrs. Johnson filed a notice of non-suit with respect to the claims
        made by
        her in the Harris County lawsuit. Accordingly, this matter is now closed.
 
 ***Litigation
        with Equita Financial and Insurance Services of Texas, Inc. and M&W
        Insurance Services, Inc.***
  On
        June
        2, 2005, Equita and M&W Insurance Services, Inc. (“M&W”) filed a civil
        suit in Travis County, Texas District Court against the Company. The suit
        alleges that, in entering into certain agreements with the plaintiffs, the
        Company made certain misrepresentations and omissions as to its business
        and
        financial condition. The agreements referenced in the suit consist of (a)
        an
        option agreement entered into in June 2003 between Equita and the Company,
        granting Equita the right to purchase shares of FIC’s common stock at $16.42 per
        share, if certain sales goals were achieved under an exclusive marketing
        agreement between Equita and a subsidiary of the Company (the “Option
        Agreement”), (b) a stock purchase agreement entered into in June 2003 between
        M&W and the Roy F. and Joann Cole Mitte Foundation, pertaining to the
        purchase of 204,918 shares of FIC’s common stock (the Stock Purchase
        Agreement”), and (c) a registration rights agreement entered into in June 2003
        among the plaintiffs and the Company, whereby the Company agreed to file
        and
        maintain a shelf registration statement which respect to the shares of FIC’s
        common stock purchased by M&W from the Mitte Foundation or which may be
        acquired in the future by Equita under the option agreement (the “Registration
        Rights Agreement,” and, collectively, the “Agreements”).
 
 The
        suit
        alleges that the Company breached the provisions of the Option Agreement
        by
        refusing to indemnify the plaintiffs for losses relating to the alleged breach
        of certain representations and warranties included in the Option Agreement.
        The
        plaintiffs also allege that the Company required M&W to purchased 204,918
        shares of FIC common stock from the Mitte Foundation as a condition of Equita’s
        obtaining, in June 2003, an exclusive marketing agreement with a subsidiary
        of
        the Company pertaining to the distribution of insurance products in the “senior
        market” (the “Marketing Agreement”), and that such requirement was motivated by
        the desire of the Company’s management to obtain certain proxy rights obtained
        under a settlement agreement with the Mitte Foundation and the Mitte family.
        The
        plaintiffs further allege that the Company breached the provisions of the
        Registration Rights Agreement by failing to file a shelf registration with
        the
        SEC with respect to the shares of FIC’s common stock purchased by M&W from
        the Mitte Foundation and the shares which may be acquired in the future by
        Equita under the provisions of the Option Agreement. The plaintiffs seek
        rescission of the Agreements; damages in an amount equal to the $3 million
        that
        M&W paid to acquire FIC shares from the Mitte Foundation, together with
        interest and attorney’s fees and unspecified expenses; and an unspecified amount
        of exemplary damages.
  35
 *Index*
  Late
        in
        2005, the Company’s two life insurance subsidiaries, Investors Life and Family
        Life, intervened in the lawsuit to assert claims that Equita had breached
        its
        obligations under the Marketing Agreement with respect to the distribution
        of
        insurance products, thereby causing damages to the life insurance subsidiaries.
        Equita moved to dismiss the intervention, but at a hearing on December 20,
        2005,
        the court denied Equita’s motion. As a result, Investors Life and Family Life
        will be permitted to assert their claims against Equita in this lawsuit.
 
 Deposition
        discovery with respect to both the case filed by the Equita and M&W, and the
        claims in intervention asserted by Family Life and Investors Life, began
        in
        October of 2006.
 
 In
        response to a motion for partial summary judgment, the Company has stipulated
        to
        certain elements of some of the causes of action asserted by Equita and M&W,
        including that certain representations and warranties made in the Option
        Agreement were partially incorrect, and that FIC was unable to comply with
        certain of its obligations under the Option Agreement. FIC did not stipulate,
        and continues to dispute other elements of certain of the causes of action
        asserted by Equita and M&W, and disputes other causes of action in their
        entirety. FIC intends to vigorously oppose the lawsuit and any effort by
        Equita
        and M&W to recover damages from FIC, and the life insurance subsidiaries
        intend to vigorously prosecute their claims in intervention against
        Equita.
 
 ***Shareholder
        Claim***
  The
        Company received a demand letter in April 2004 from a law firm representing
        an
        individual shareholder (Mr. Cook) who owns 530 shares of the Company’s common
        stock, which letter set forth certain allegations and notified the Registrant
        that the shareholder intended to file a shareholder derivative lawsuit (the
        “Demand Letter”).
 
 In
        May
        2004, FIC, by and through its Special Litigation Committee, filed a petition
        in
        the 250th District Court of Travis County, Texas (the “Court”), seeking to have
        the Court appoint a panel of independent and disinterested persons pursuant
        to
        Section H (3) of Article 5.14 of the Texas Business Corporation Act to
        investigate the allegations, and stay any shareholder derivative actions.
        Subsequently, on June 1, 2004, the Court issued an Order appointing Eugene
        Woznicki, Kenneth S. Shifrin, John D. Barnett and F. Gary Valdez as a panel
        of
        independent and disinterested persons (the “Panel”) to make determinations
        contemplated by Section F of Article 5.14 of the Texas Business Corporation
        Act
        in connection with the Demand Letter and staying any shareholder derivative
        actions relating to the letter until the Panel’s review was completed and a
        determination was made by the panel as to what, if any, further action was
        to be
        taken. Messrs. Woznicki, Shifrin and Barnett are independent directors of
        FIC.
        Mr. Valdez is neither a director nor an employee of FIC. Mr. Valdez is the
        founder and president of Focus Strategies, L.L.C. and is active in various
        community and civic organizations in the Austin, Texas area.
 
 Following
        an extensive review of the claims made by the individual shareholder, the
        Panel,
        in January 2005, filed with the court a Petition for Declaratory Judgment
        pursuant to the Texas Declaratory Judgments Act and Article 5.14 of the Texas
        Business Corporations Act (the “Petition”). The Petition describes the process
        used by the Panel and its counsel in considering the matters raised in the
        Demand Letter and the submittal provided by counsel for the shareholder.
        The
        Petition advised the Court that, after consideration of the evidence obtained
        through its inquiry, the Panel had unanimously made a good faith determination
        that the continuation of the Committee’s derivative proceeding and the
        commencement of any further derivative proceedings based on the allegations
        made
        by the individual shareholder was not in the best interests of FIC.
 
 On
        October 10, 2005, the 250th District Court of Travis County, Texas, heard
        for
        trial on the merits the matters raised by the Panel in the Petition
        ( Financial
        Industries Corporation v. Tom
        Cook (Cause
        No. GN 401513). After consideration of the pleadings, evidence and authorities
        submitted by counsel for the Company, the Court issued a Final Judgment on
        October 10, 2005, in which it ruled that the determinations made by the Panel,
        as reflected in a report submitted to the Court by a Special Litigation
        Committee appointed by the Registrant’s Board of Directors, were made: (1) in
        good faith, (2) after the Panel conducted a reasonable inquiry, and (3) based
        on
        the factors deemed appropriate under the circumstances by the Panel. The
        Court’s
        ruling otherwise dismissed with prejudice the derivative proceedings involved
        in
        this matter. The Final Judgment was approved as to form and substance by
        counsel
        for the Registrant and by counsel for the defendant.
  36
 *Index*
  ***Other
        Litigation***
 
 FIC
        and
        its insurance subsidiaries are regularly involved in litigation, both as
        a
        defendant and as a plaintiff. The litigation naming the insurance subsidiaries
        as defendant ordinarily involves our activities as a provider of insurance
        products. Management does not believe that any of this other litigation,
        either
        individually or in the aggregate, will have a material adverse effect on
        the
        Company’s business or financial condition.
 
 **ITEM
        2. CHANGES IN SECURITIES AND USE OF
        PROCEEDS**
 
 None
 
 **ITEM
        3. DEFAULTS UPON SENIOR SECURITIES**
 
 None
 
 **ITEM
        4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
        HOLDERS**
 
 There
        were no matters submitted to a vote of security holders during the third
        quarter
        of 2005.
 
 **ITEM
        5. OTHER INFORMATION**
 
 None
 
 **ITEM
        6. EXHIBITS AND REPORTS ON FORM 8-K**
 
 (a)
              Exhibits
 
 31.1
              Certification
                  of Chief Executive Officer of FIC pursuant to Section 302 of the
                  Sarbanes-Oxley Act of 2002
 
 31.2
              Certification
                  of Chief Financial Officer of FIC pursuant to Section 302 of the
                  Sarbanes-Oxley Act of 2002
 
 32.1
              Certification
                  of Chief Executive Officer of FIC pursuant to 18 U.S.C. Section
                  1350.
 32.2
              Certification
                  of Chief Financial Officer of FIC pursuant to 18 U.S.C. Section
                  1350.
 
 (a)
              Reports
                  on Form 8-K
 
 (i) On
        July
        18, 2005 the Registrant filed a Current Report on Form 8-K.  The current
        report disclosed Departure of a Director whereby on July 14, 2005, Salvador
        Diaz-Verson, Jr. submitted his resignation as a director of the Company,
        effective as of that date.
  (ii) On
        August
        2, 2005 the Registrant filed a Current Report on Form 8-K.  The current
        report disclosed Results of Operations and Financial Conditions and a Regulation
        FD Disclosure regarding a press release issued with respect to the Company’s
        financial results for the year ended December 31, 2003.
  (iii) On
        August
        19, 2005 the Registrant filed a Current Report on Form 8-K.  The current
        report disclosed a Temporary Suspension of Trading under Registrant’s Employee
        Benefit Plan, the InterContinental Life Corporation Employees Savings and
        Investment Plan, originally effective June 20, 2005 to August 22, 2005, now
        extended and anticipated to end during the week of September 5,
        2005.
  (iv) On
        September 14, 2005 the Registrant filed a Current Report on Form 8-K.  The
        current report disclosed a Change in Registrant’s Certifying Accountant, whereby
        the Board of the Company approved the appointment of Deloitte & Touche LLP
        as its new independent registered public accounting firm for the year ended
        December 31, 2004.  Also, on September 8, 2005, the Audit Committee
        dismissed PricewaterhouseCoopers LLP as  the Company's independent
        registered public accounting firm, subject to completion of its procedures
        on
        the Financial Statements of the Company's three non-public employee benefit
        plans as of and for the year ended December 31, 2003.
  37
 *Index*
  (v) On
        September 30, 2005 the Registrant filed a Current Report on Form 8-K.  The
        current report disclosed Entry into a Material Definitive Agreement whereby
        the
        Board of the Company approved the Financial Industries Corporation Stock
        Plan
        for Non-Employee Directors. Under the provisions of the Plan, effective as
        of
        September 30, 2005, non-employee directors may elect to receive a portion
        of
        their annual fee for service on the Board of Directors and their annual fee
        for
        service on a committee, or committees, of the Board of Directors in the form
        of
        shares of common stock of the Registrant, in lieu of cash.
  38
 *Index*
  **Signatures**
  Pursuant
        to the requirements 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.
  FINANCIAL
                  INDUSTRIES CORPORATION(Registrant)Date:
                  January 12, 2007
              By:/s/
                  Michael P. HydanusMichael
                  P. HydanusInterim
                  President and Chief Executive OfficerDate:
                  January 12, 2007
              By:/s/
                  Vincent L. KaschVincent
                  L. KaschChief
                  Financial Officer(Principal
                  Accounting and Financial Officer)
   39