**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-K**

** **

**FORANNUAL AND TRANSITIONALREPORTS PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

 

| **(Mark One)** | ** **                                                                                     |
|----------------|------------------------------------------------------------------------------------------------|
| **ý**     | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**     | ** ** |
|           |                                                                                           |   |
| ** **     | **For the fiscal year ended December 31, 2004**                                                | ** ** |
|           |                                                                                           |   |
| ** **     | **OR**                                                                                         | ** ** |
|           |                                                                                           |   |
| **o**          | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** | ** ** |

 

**For the transition period from               to               **

 

**Commission file number:  001-32377**

 

**KMG AMERICA CORPORATION**

(Exact Name of Registrant as Specified in ItsCharter)

 
| **Virginia**                                                    | ** ** | **20-1377270**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization) |       | (I.R.S. Employer  Identification No.) |
| ** **                                                      | ** ** | ** **                            |
| **12600 Whitewater Drive, Suite 150,  Minnetonka, Minnesota**   | ** ** | **55343**                             |
| (Address of Registrant’s Principal  Executive Offices)     |       | (Zip Code)                            |

 

Registrant’s telephone number, including areacode:**  (952)  930-4800**

** **

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

 
| **Title of each class**                     | ** ** | **Name of each exchange on which registered** |
|---------------------------------------------|------------|-----------------------------------------------|
| **Common Stock, par value $0.01 per share** | ** ** | **New York Stock Exchange**                   |

 

Securitiesregistered pursuant to Section 12(g) of the Act:

 

**None**

(Title of class)

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes o  No ý

 

Indicate bycheck mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.  ý

 

Indicate bycheck mark whether the registrant is an accelerated filer (as defined in ExchangeAct Rule 12b-2). Yes o No ý

 

The aggregatemarket value of the voting and nonvoting common equity held by non-affiliatesof the registrant, computed by reference to the price at which common equitywas last sold on December 21, 2004, the date of the closing of the registrant’sinitial public offering of common stock, was approximately $238.4 million.

 

As ofMarch 1, 2005, the number of shares of Common Stock outstanding was22,071,641.

 

Portions ofthe registrant’s definitive Proxy Statement for the annual meeting ofshareholders to be held on May 18, 2005, are incorporated in Part III byreference.  The exhibit index to thisForm 10-K begins on page 117 of this Form 10-K.

 

 

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**KMG AMERICA CORPORATION**TABLE OF CONTENTS

 
| **Item No.**   | ** ** | ** **                                                                                                          | ** ** |
|----------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
|           |       |                                                                                                                |       |
| PART I         |       |                                                                                                                |       |
|           |       |                                                                                                                |       |
| ITEM 1.        |       | BUSINESS                                                                                                            |       |
| ITEM 2.        |       | PROPERTIES                                                                                                          |       |
| ITEM 3.        |       | LEGAL PROCEEDINGS                                                                                                   |       |
| ITEM  4.       |       | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                                |       |
|           |       |                                                                                                                |       |
| PART II        |       |                                                                                                                |       |
|           |       |                                                                                                                |       |
| ITEM  5.       |       | MARKET  FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER  PURCHASES OF EQUITY SECURITIES |       |
| ITEM 6.        |       | SELECTED FINANCIAL  DATA                                                                                            |       |
| ITEM  7.       |       | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS                         |       |
| ITEM  7A.      |       | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                                         |       |
| ITEM  8.       |       | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                                        |       |
| ITEM  9.       |       | CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES                              |       |
| ITEM 9A.       |       | CONTROLS AND  PROCEDURES                                                                                            |       |
| ITEM 9B.       |       | OTHER INFORMATION                                                                                                   |       |
|           |       |                                                                                                                |       |
| PART  III      |       |                                                                                                                |       |
|           |       |                                                                                                                |       |
| ITEM  10.      |       | DIRECTORS  AND EXECUTIVE OFFICERS OF OUR COMPANY                                                                    |       |
| ITEM 11.       |       | EXECUTIVE  COMPENSATION                                                                                             |       |
| ITEM  12.      |       | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER  MATTERS                    |       |
| ITEM  13.      |       | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                                                     |       |
| ITEM  14.      |       | PRINCIPAL  ACCOUNTANT FEES AND SERVICES                                                                             |       |
|           |       |                                                                                                                |       |
| PART  IV       |       |                                                                                                                |       |
|           |       |                                                                                                                |       |
| ITEM  15.      |       | EXHIBITS  AND FINANCIAL STATEMENT SCHEDULES                                                                         |       |
|           |       |
| SIGNATURES     |       |
|           |       |
| EXHIBIT  INDEX |       |

 

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**CAUTIONARY FACTORS THAT MAY AFFECT FUTURE RESULTS**

 

In thisreport, unless the context requires otherwise, references to “we,” “us,” “our,”“KMG America” or the “Company” are intended to mean KMG America Corporation andits consolidated subsidiaries, including, without limitation, Kanawha InsuranceCompany (“Kanawha”).  References to our “predecessor”mean Kanawha prior to it being acquired by KMG America.

 

**Forward-Looking Statements**

** **

In addition tohistorical information, this annual report on Form 10-K containsforward-looking statements that involve risks and uncertainties that couldcause actual results to differ materially from those expressed in ourforward-looking statements. Forward-looking statements include statements regarding our goals,beliefs, plans or current expectations, taking into account the informationcurrently available to our management. Forward-looking statements are not statements of historical fact.  For example, when we use words such as “believe,”“anticipate,” “expect,” “estimate,” “intend,” “should,” “would,” “could,” “may,”“will likely result,” “will continue,” “project,” or other words that conveyuncertainty of future events or outcome, we are making forward-lookingstatements.  Forward-looking statementsinclude, without limitation, statements concerning:

 

**•**                  futureresults of operations;

 

**•**                  liquidity,cash flow and capital expenditures;

 

**•**                  acquisitionactivities and the effect of completed acquisitions, including expectedsynergies and cost savings;

 

**•**                  pendingor anticipated litigation;

 

**•**                  debtlevels and the ability to obtain additional financing or make payments on ourdebt;

 

**•**                  regulatorydevelopments, industry conditions and market conditions; and

 

**•**                  generaleconomic conditions.

 

Factors thatmight cause or contribute to differences between actual results and thoseexpressed in our forward-looking statements include, but are not limited to,those discussed in Item 7 and Exhibit 99.01 of this report, which isincorporated herein by reference.

 

**Industry and Market Data**

** **

We obtainedthe market and competitive position data used throughout this report from ourown research, surveys or studies conducted by third parties, and industry orgeneral publications.  Industrypublications and surveys generally state that they have obtained informationfrom sources believed to be reliable, but do not guarantee the accuracy andcompleteness of such information.  Whilewe believe that each of these studies and publications is reliable, we have notindependently verified such data, and we do not make any representation as tothe accuracy of such information. Similarly, we believe our internal research is reliable, but it has notbeen verified by any independent sources.

 

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# **PART I**

#  

## **ITEM 1.**                             BUSINESS.

##  

#### **Overview**

#### ** **

KMG America isa holding company incorporated under the laws of the Commonwealth of Virginiaon January 21, 2004.  We commenced ouroperations shortly before we completed our initial public offering of commonstock on December 21, 2004, and our shares trade on the New York Stock Exchangeunder the symbol “KMA.”  Concurrentlywith the completion of our initial public offering, we completed ouracquisition of Kanawha and its subsidiaries, which are our primary operatingsubsidiaries and which underwrite and sell life and health insurance productsmarketed primarily in the southeastern United States.  For accounting purposes, Kanawha is treatedas our predecessor entity and is referred to in this report as our “predecessor.”  For financial reporting purposes, we havetreated the acquisition as if it closed on December 31, 2004, rather than theactual closing date of December 21, 2004, as the effects of the acquisition forthe period from December 21, 2004, through December 31, 2004, were not materialto our predecessor’s consolidated statements of operations, cash flows, andchanges in shareholders’ equity for the year ended December 31, 2004.  Accordingly, financial information in thefollowing discussion that relates to our predecessor’s consolidated results ofoperations, cash flows and changes in shareholders’ equity for the year ended2004 are reported on a historical basis without GAAP (generally acceptedaccounting principles in the United States) purchase accounting adjustmentsreflecting the acquisition.  Financialinformation relating to our financial position as of December 31, 2004, hasbeen adjusted for GAAP purchase accounting adjustments reflecting the acquisition.

 

We underwriteand sell life and health insurance products marketed primarily in thesoutheastern United States.  As ofDecember 31, 2004, we had $4.3 billion of life insurance policies inforce.  Our business strategy is tooperate our businesses efficiently while growing some of those businesses.  Our primary growth initiative is to develop aworksite marketing and distribution organization that targets larger employergroups nationwide with an expanded variety of life and health insuranceproducts.  Our executive management teamoversees and coordinates the operations of our businesses and the developmentand implementation of our business strategy. Members of our executive management team have an average of over 20years of experience in the life and health insurance industry, includingexperience in the areas of executive management, underwriting, marketing,distribution, claims processing, actuarial, legal, finance andinvestments.  A significant amount ofthis management experience was in senior management positions at insurance companiestargeting the worksite insurance business.

 

Our operationsconsist of three primary business segments:

 

**•**                  *Worksite insurance business. *Our worksite insurance business isa provider of voluntary life and health insurance products to employers and theiremployees in the southeastern United States. The primary insurance products that this business underwrites includelife insurance, short-term disability insurance, dental insurance, indemnityhealth insurance and critical illness insurance.  Our business strategy is to efficientlyoperate our existing worksite insurance business while developing a newworksite marketing and distribution organization that targets larger employergroups nationwide with an expanded variety of life and health insurance products.  For the year ended December 31, 2004, ourpredecessor’s worksite insurance business produced premiums, commissions andfees, excluding intercompany payments, of $56.3 million, which accounted for48.4% of our predecessor’s premiums, commissions and fees, excludingintercompany payments.

 

**•**                  *Senior market insurance business. *Our senior market insurancebusiness is a provider in the southeastern United States of individualinsurance products tailored to the needs of older individuals.  The primary insurance products it offersinclude long-term care insurance that we underwrite and Medicare supplementinsurance underwritten by another carrier, both of which are marketed directlyto end-customers by independent agents. Growing this business is not a primary objective of our businessstrategy, but we intend to operate this business efficiently and may considerexpanding our geographic target market to select markets throughout thenation.  For the year ended December 31,2004, our predecessor’s senior market insurance business produced premiums, commissionsand fees, excluding

 

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intercompany payments, of $42.1 million,which accounted for 36.2% of our predecessor’s premiums, commissions and fees,excluding intercompany payments.

 

**•**                  *Third-party administration business. *Our third-party administrationbusiness provides a wide range of insurance product administration, claimshandling, eligibility administration, call center and support services.  This business primarily administers theinsurance plans offered by our worksite insurance business and senior marketinsurance business.  Our third-partyadministration business also provides administrative and managed care servicesto third parties, such as employers with self-funded health care plans, otherinsurance carriers, reinsurers and managed care plans.  Our primary business strategy for thisbusiness is to grow this business as it administers the increasing volume of policiesand products that we anticipate will be sold by our worksite insurance businessas we attempt to grow that business.  Inaddition, as our national worksite marketing business develops, we intend toopportunistically market our third-party administration services toself-insured plans, stop loss insurers, pharmacy benefit organizations, managedcare service providers and other insurance carriers and reinsurersnationwide.  For the year ended December31, 2004, our predecessor’s third-party administration business producedcommissions and fees, excluding intercompany payments, of $13.3 million, whichaccounted for 11.4% of our predecessor’s premiums, commissions and fees,excluding intercompany payments.

 

Each of ourthree primary business segments are discussed in greater detail below.

 

In addition tothe three primary business operations noted above, we have two other businesssegments, including the closed block of life and health business reported inour acquired business segment and the investment and marketing activitiesreported in our corporate and other segment. Acquisitions of books of business from other insurance carriers is not aprincipal growth strategy, but we will consider acquisitions on anopportunistic basis if we can complete the acquisitions on favorable financialterms that we expect to be generally accretive to earnings per share and returnon equity while maintaining our financial strength ratings.

 

See theconsolidated financial statements, the notes thereto and Item 7, Management’sDiscussion and Analysis of Financial Condition and Results of Operations, inthis report for information regarding our revenues, profits and losses andtotal assets by business segment.

 

Whether a lifeor health insurance product is referred to as group, voluntary or individualdepends on how the product is marketed to individual beneficiaries.  A voluntary insurance product is anyinsurance product:

 

**•**                  marketedthrough an employer or another organization;

 

**•**                  usuallypaid for by the enrollee (although employers sometimes pay a portion of thepremium); and

 

**•**                  purchasedby eligible individuals at their own discretion.

 

A groupinsurance product is any insurance product:

 

**•**                  sponsoredby an employer;

 

**•**                  inwhich employees can participate, although they have the ability to opt out; and

 

**•**                  forwhich the employer pays a significant portion or all of the premium on behalfof the employees.

 

An individual insurance product is anyinsurance product:

 

**•**                  marketeddirectly to an individual, not through an employer or other organization;

 

**•**                  completelypaid for by the individual; and

 

**•**                  purchasedby the individual at his or her own discretion.

 

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For the twelvemonths ended December 31, 2004, approximately 19.9% of the premiums (paymentsreceived from policyholders or sponsors on insurance policies issued orreinsured by an insurance company) received by our predecessor were premiums onvoluntary life and health insurance products and approximately 4.2% of thepremiums received by it were premiums on group life and health insuranceproducts.  The remaining premiumsreceived by our predecessor were premiums on long-term care insurance products(insurance that protects the insured from specified costs of extended medicalor convalescent care at home or in an outside facility) and other individuallife and health insurance products. Substantially all of our revenues are attributable to customers in theUnited States and substantially all of our assets are located in the UnitedStates.

 

#### **Worksite Insurance Business**

#### ** **

Our worksiteinsurance business is a provider of life and health insurance products toemployers and their employees in the southeastern United States.  This business underwrites primary insuranceproducts including life insurance, disability insurance, dental insurance,indemnity health insurance (which is health insurance coverage under which aninsurance company pays the insured’s health care costs, subject to deductiblesand maximum amount limits, and the insured is not subject to managed carerestrictions such as restrictions on choice of physicians, tests or treatments)and critical illness insurance.  Ourinsurance products are marketed primarily by independent insurance agents toemployers and other groups.  Most of ourworksite insurance products are voluntary products, where the employer orassociation offers the products to its employees or members as part of an arrayof insurance and health benefits from which the employee or member maychoose.  The individual employee ormember elects which products to purchase and the premiums are paid by theemployee or group member.  The employerwill often deduct the premium from the employee’s periodic paycheck and remitthe premium to us.  Some of our worksitemarketing products are group products where the employer or association paysthe premiums for insurance benefiting its employees or members as part of theemployee’s or member’s compensation package.

 

Most of theinsurance products offered by our worksite insurance business are underwrittenby us and the primary underwriting risk under the policies is retained byus.  Some of the insurance productsmarketed by us are underwritten by other insurance companies who retain theunderwriting risk.  We refer to insuranceproducts underwritten by other carriers, but sold by us, as in-sourcedproducts.  Our worksite insurancebusiness is licensed to offer group and individual life and health insuranceproducts in 45 states.  The earningsreported in any period for our worksite insurance business generally depends ongrowth in underwritten business, business mix, persistency of business inforce, benefit payouts and administrative expenses incurred.

 

##### *Worksite Insurance Products*

##### * *

The primary insurance products that weunderwrite include the following:

 

**•**                  *Voluntary life insurance. *Voluntary life insurance insuresthe life of a single individual.  It istypically sold on a renewable term basis or with a cash value component such aswhole life insurance.

 

**•**                  *Group life insurance. *Group life insurance insures the lives of a group ofindividuals and pays benefits upon the death of each member within thegroup.  The group typically is comprisedof an entire employer workforce or other class of covered individuals.

 

**•**                  *Short-term disability insurance. *Disability insurance protectsagainst the loss of wages due to illness or accidental injury.  Short-term disability insurance generallyprovides coverage for up to five years. We do not underwrite long-term disability insurance.

 

**•**                  *Dental insurance. *Dental insurance generally covers all or a portion of thecosts of diagnostic and preventative dental and orthodontics services.  It generally is offered on a voluntary basisand provides benefits on a reimbursement basis.

 

**•**                  *Critical illness insurance. *Critical illness insurance isdesigned to fill financial gaps not covered by health, disability, life andaccident insurance policies when insureds are diagnosed with a criticalillness.

 

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**•**                  *Indemnity health insurance. *Indemnity health insuranceprovides benefits to cover many costs incurred upon the occurrence of anaccidental injury or sickness.

 

In addition tomarketing the individual products discussed above, our worksite insurancebusiness works with each employer or association to assess the unique insurancerequirements of each employer or association and to select a customized,bundled package of insurance products and services designed to meet thoserequirements.  The package may consist ofinsurance products and services offered by our worksite insurance businessand/or in-sourced products underwritten by other insurance carriers.

 

##### *Marketing and Distribution*

##### * *

Most of theproducts sold by our worksite insurance business are sold to individualsthrough their employer or other group of which they are a member, a marketingand distribution effort that we refer to as worksite marketing.  Worksite marketing sales generally have twocomponents:

 

**•**                  groupproducts, where the employer or association pays the premiums for insurancethat covers the employee or member beneficiary as part of the employee ormember beneficiary’s compensation package; and

 

**•**                  voluntaryindividual products, where the employee or member elects to purchasesupplemental coverage and/or additional insurance products not sponsored by theemployer or association, and the employee or member pays the premiums, whichare often deducted from the employee’s or member’s pay and submitted to theinsurance company by the employer or association.

 

Most of ourworksite insurance products are sold as voluntary products, however some aresold as employer pay group products.

 

The majorityof our worksite marketing business is marketed through independent insuranceagents that call on employers, consultants, brokers and other intermediariesthat arrange to present product offerings to sponsoring employers or groupslocated primarily in the southeastern United States.  In general, intermediaries involved inplacing our worksite products with employers or groups receive a brokeragecommission and/or other fee arrangement which is a percentage of gross premiumsgenerated from the placement.  Ourworksite marketing business currently targets mostly small employers and groupsin the southeastern United States generally having fewer than 200 individualemployees or members.

 

##### *Business Strategy for the Worksite MarketingBusiness*

##### * *

Expanding ourworksite insurance business is the primary focus of our business strategy.  Our intent is to grow this business by: (1)developing an internal sales force that will market our products nationwide tolarger employers and groups; (2) enlarging the geographic focus of our smallemployer worksite marketing team to focus on select markets nationwide throughindependent agents; and (3) expanding our product mix by offering additionaltypes of insurance and additional variations of the types of insurance andother services that we currently offer to differentiate us from ourcompetitors.

 

While ourworksite marketing business primarily markets its products through independentagents and consultants that target small employers and groups in thesoutheastern United States generally having fewer than 200 individual employeesor members, our goal is to grow the worksite marketing business by hiring aninternal sales force that will market our products nationwide to largeremployers and groups with 50 to 10,000 employees or members.  Our internal sales force will market ourproducts to potential worksite market employers, and associations, as well asto intermediaries such as employee benefit consultants and other producersspecializing in worksite marketing such as voluntary benefits organizationsthat offer menus of health benefit options through employers to be selected andpaid for by employees, or VBOs, enrollment firms, internal wholesalers,employee benefit consultants and national and regional insurance brokers.  Our senior management team has industryrelationships with many of these types of organizations, and we believe thatthese relationships are instrumental in

 

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developing a nationwideworksite marketing organization and should lead to high levels of salesproductivity per sales force representative and increase profit margins overtime.

 

We intend toexpand our product offerings by offering additional types of worksite life andhealth insurance products as well as additional variations of the types ofinsurance that we currently offer.  Weare considering whether to introduce new varieties of the following productsalready offered by us: individual life insurance; group life insurance;disability insurance; and dental insurance. New products that we may introduce include: medical stop-loss insurancethat provides insurance protection to employers who self-fund a portion or allof employee health benefits; vision insurance that covers all or a portion ofthe costs of diagnostic and preventative eye care services; and accidentaldeath and dismemberment insurance that provides payments to insureds orbeneficiaries upon the occurrence of a fatal accident or accident which resultsin the of loss of limb or eyesight.

 

We intend todifferentiate ourselves from our competitors by offering a broad mix ofvoluntary and group life and health insurance products that, when combined withour third-party administration services, are designed to provide an attractivemix of products and services to employers and their employees.  We believe that few insurance companiescurrently offer a wide range of both voluntary and group life and healthinsurance products through an integrated distribution platform because,historically, voluntary insurance products have been marketed throughindependent insurance agents and group insurance products have been marketedthrough internal sales forces.  Becauseof the potential for conflicts to occur when carriers target worksites throughthese two marketing channels, most established insurance carriers do not pursuea worksite marketing strategy that offers a wide array of both group andvoluntary life and health insurance products as we intend to do.  We plan to avoid these conflicts by havingour independent agents and our internal sales force target different segmentsof the worksite marketplace based on employer size and other criteria.  We are continuing to write life and healthinsurance business through distribution outlets other than the worksite,primarily senior market insurance products offered through independentagents.  In addition, we earn revenuefrom administrative services for third parties such as companies with self-fundedhealth plans and other insurance carriers and reinsurers, as well as fromcommissions for the placement of other insurance carriers’ products through ourdistribution systems.

 

The broad mixof insurance products that we are developing will allow us to market ourproducts to a wide variety of companies. We believe that offering a broad mix of insurance products will enhanceour profitability because persistency (the length of time an insurance policyremains in effect or in force before it expires) should increase as customerspurchase multiple insurance products from us. We believe persistency will increase as we strengthen our relationshipswith multiple product customers and it becomes harder for customers whopurchase multiple products from us to switch to other carriers.  We expect that increasing our persistencywill reduce our per policy marketing and distribution costs, which will enhanceour profitability.

 

A diversifiedbusiness is a key part of our risk management strategy.  We do not expect our results of operations tobe significantly impacted by pricing cycles because we will offer a diverse mixof products that we believe will not all be affected in the same way by lifeand health insurance market conditions or changes in the general economy.  We also believe that our productprofitability will have limited sensitivity to fluctuations in interest ratesbecause we do not intend to offer interest rate sensitive products such asannuities.  Although rising interestrates will adversely affect the value of fixed income securities in ourportfolio and our capital position, we would likely also benefit from risinginterest rates as the aggregate rate of interest earned on our investmentportfolio increases.

 

In addition tovoluntary premiums, annual group life and health premiums generated through theworksite market exceeded $104 billion in 2003, according to the *Life Insurers Fact Book 2004*, published bythe American Council of Life Insurers.

 

Our currenttarget market (workplaces with between 50 and 10,000 employees) included over290,000 businesses in the United States as of August 3, 2003, according toDun & Bradstreet.  We anticipategrowth in the market for voluntary worksite products for the next several yearsas employers increasingly shift benefit costs to employees.

 

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Worksitemarketing is an efficient and convenient way to distribute individual insuranceproducts to employees by deducting premiums from their paychecks and packagingofferings with employer sponsored group coverages.  Some of the marketing and distributionadvantages of the worksite marketing approach include:

 

**•**                  thecredibility of employer sponsored plans;

 

**•**                  theconvenience of payroll deductions;

 

**•**                  theability to market employee and employer coverages together as packagedproducts;

 

**•**                  theopportunity to market to multiple potential insureds (employees) at the sametime;

 

**•**                  asimplified underwriting process because potential insureds are assessed as agroup based on the demographics of their industry or occupation rather than onan individual basis;

 

**•**                  timesaving and enrollment efficiencies; and

 

**•**                  theassistance of the sponsoring employer’s human resources department.

 

Our sales andmarketing personnel are eligible to participate in a broad-based equityincentive plan.  We believe offeringequity incentives that are tied to performance provides us with a significantcompetitive advantage compared to most worksite insurance companies, which,based on LIMRA International, Inc.’s study of 2003 compensation titled “Compensationof Group Insurance/Healthcare Sales and Service Personnel,” generally do notoffer equity incentives to their sales and marketing personnel.

 

##### *Worksite Insurance Competition*

##### * *

We facecompetition from many firms in the life and health insurance industry, but webelieve a limited number of companies participate in the market in the samemanner as we are positioning ourselves to or offer capabilities ascomprehensive as we expect ours ultimately will be.  We view the worksite marketing segment of thelife and health insurance business as being composed of three different typesof companies: (1) companies selling primarily group insurance products,(2) companies selling primarily voluntary insurance products and (3)companies offering both group and voluntary insurance products, but throughseparate distribution channels.  Webelieve that most insurers competing in the worksite market tend to focus oneither the group market or the voluntary market, with very few competitorsfocused on offering both group and voluntary products through the same salesorganization, which is how we intend to operate.  We believe the fastest growth in the worksiteinsurance market in the future will be achieved by those insurers offering bothgroup and voluntary products where cross-selling and product packagingopportunities are significant.

 

Ourcompetitors in the worksite insurance market include AFLAC, Inc., StanCorpFinancial Group, Inc., UnumProvident Corp., Transamerica Corporation,Metropolitan Life Insurance Company, American Fidelity Life Insurance Company,Prudential Financial, Inc., Assurity Life Insurance Company, ING Groep N.V.,Jefferson-Pilot Corporation and Allstate Financial.  Other commercial competitors that offervarious products in the worksite insurance market that do not easily fit intoany one of these categories include various small and medium sized lifeinsurance companies.  In the worksiteinsurance market, competition tends to focus more on the distributionchannel.  Competition in the worksiteinsurance market is based primarily on product mix, service and pricing.

 

We believethat there are a limited number of competitors that offer both group andvoluntary insurance products to the worksite insurance market through the samesales force.  Examples of such carriersinclude John Hancock Financial Services, Inc., Mutual of Omaha and State FarmLife Insurance Company.

 

#### **Senior Market Insurance Business**

#### ** **

Our seniormarket insurance business is a provider in the southeastern United States ofindividual insurance products tailored to the needs of older individuals.  The primary insurance products that this businessoffers include

 

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long-term care insurance thatit underwrites and Medicare supplement insurance underwritten by anothercarrier.  These products are marketeddirectly to end-customers by independent agents.  The senior market of the life and healthinsurance industry focuses on providing insurance and other product offeringsto senior citizens, whose product needs, risk and underwriting propertiesdiffer substantially from the general market. Products offered directly by our senior market insurance business areunderwritten by us and the primary underwriting risk under the policies isretained by us.  Our senior marketinsurance business is licensed to offer senior market insurance products in 45states.

 

##### *Senior Market Insurance Products*

##### * *

The primaryinsurance products sold by our senior market insurance business include thefollowing:

 

**•**                  *Long-term care insurance. *Long-term care insurance protectsthe insured from the costs of long-term care services.  These services include nursing homes,assisted living facilities, adult day care and home health care.  Our long-term care insurance products areunderwritten by us and we bear the underwriting risk.  A portion of this risk is reinsured.

 

**•**                  *Medicare supplement insurance. *Medicare supplement insuranceprovides coverage for Medicare-qualified expenses that are not covered byMedicare because of applicable deductibles or maximum limits.  The Medicare supplement insurance currentlysold by us is underwritten by Mutual of Omaha which bears the underwritingrisk.  Our predecessor ceasedunderwriting its own Medicare supplement insurance in 2003, but Medicaresupplement insurance policies that it underwrote prior to 2003 are still inforce.

 

##### *Marketing and Distribution*

##### * *

Our seniormarket products are marketed primarily by independent agents located primarilyin the southeastern United States.  Theseagents generally target individuals directly rather than employers or groups,as our worksite insurance business does. Our offerings may consist of insurance products and services underwrittenby our senior market insurance business or in-sourced products underwritten byother insurance carriers.  For example,in 2003, our predecessor ceased underwriting new Medicare supplement insurancepolicies, and we now market Medicare supplement insurance underwritten byMutual of Omaha.

 

##### *Business Strategy for Senior Market InsuranceBusiness*

##### * *

Growing oursenior market insurance business is not a primary objective of our businessstrategy, but we intend to operate this business efficiently and may considerexpanding our geographic target market to select markets throughout thenation.  We believe this business willcomplement our worksite insurance business and has growth potential due toseveral demographic trends such as the increase in the proportion of olderindividuals in the United States population and the continued rise in medicaland health care costs.

 

##### *Senior Market Insurance Competition*

##### * *

We facecompetition from a number of competitors in the senior market insuranceindustry.  Our competitors include largenational insurers that offer many of the same products that we offer throughmultiple distribution points. Competition in the senior market is based primarily on product features,pricing and relationships with independent agents.  The level of operating earnings reported inany period for our senior market insurance business generally depends on growthin underwritten business, business mix, risk concentration, the ability toadjust premium rates, persistency of business in force, benefit payouts andadministrative expenses incurred. Revenues are generated primarily from new and renewal premiums.

 

#### **Third-Party Administration Business**

#### ** **

Our third-partyadministration business provides a wide range of insurance productadministration, claims handling, eligibility administration, call center andsupport services.  This businessprimarily administers the

 

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insurance plans offered by ourworksite insurance business and senior market insurance business including ourexisting in force policies.  Our third-partyadministration business also provides administrative and managed care servicesto third parties, such as employers with self-funded health care plans, otherinsurance carriers, reinsurers and managed care plans.  Our third-party benefits administrationbusiness focuses on three primary services: insured products administration;self funded health care plan administration; and managed care services.  As of December 31, 2004, our third-party administrationbusiness employed 309 individuals.  Basedon 2003 revenues, our predecessor ranked in the top 10% of the 386 third-partyplan administrators that are members of the Society of Professional BenefitAdministrators.

 

##### *Insured Products Administration*

##### * *

As of December31, 2004, our third-party administration business administered over 234,000 inforce insurance policies, including a wide variety of voluntary, group andindividual insurance and reinsurance products. The primary responsibility of our third-party administration business isto administer the products underwritten by our worksite insurance business andour senior market insurance business, and most of the products administered bythe third-party administration business are products underwritten by ourinsurance businesses.  In addition, thethird-party administration business administers various insurance productsunderwritten by other insurance companies and reinsurers, includingMetropolitan Life Insurance Company, AXA Financial, Inc., Blue Cross & BlueShield affiliates and several reinsurance companies.  The insurance products that our third-partyadministration business administers include long-term care insurance, group andindividual life and health insurance, accident and health and cancer insuranceand group and individual dental insurance. The insurance administration services we provide include: underwritingand policy issuance; claims management; reinsurance administration; andcustomer service and support.

 

##### *Self-Funded Health Care Plan Administration*

##### * *

As of December31, 2004, our third-party administration business provides plan administrationservices for over 134,000 employees or members of employers or associationsthat self insure their health care benefits. We administer preferred provider organization plans, point-of-serviceplans, health maintenance organization plans, indemnity plans and otherhealthcare plans provided by independent organizations as well as plansprovided by our worksite insurance business and senior market insurancebusiness.  The self-funded health planadministration services provided include: claims administration; eligibilityadministration; call center administration; design and coordination forcustomized plans; administration of Health Reimbursement Accounts, or HRAs,(which are employer-funded accounts provided to employees for reimbursement ofqualifying medical expenses and the reimbursements are excludable from employeegross income); and administration of dental and short-term disability insuranceplans.

 

##### *Managed Care Services*

##### * *

Our third-partyadministration business also provides managed care services through our ownproprietary provider network of over 14,800 providers, with over 30 leasednetworks nationwide and our URAC accredited medical management unit.  The managed care programs and services weprovide include: utilization and case management (a process through which aninsurer assesses, plans, implements, coordinates, monitors and evaluatesoptions and services to meet an individual’s health needs using communicationand available resources to promote quality care and cost effective outcomes)and outpatient review; maternity management; disease management (a system ofcoordinated healthcare intervention and communication for patients withconditions in which the patient typically takes a significant role in their owncare); data aggregation and predictive modeling; and on-site and 24-hour nursetriage.  These programs are administeredby a medical management staff of 15 nurses and a medical director.

 

##### *Business Strategy for Third-PartyAdministration Business*

##### * *

Our primarybusiness strategy is to grow our third-party administration business as itadministers the increasing volume of policies and products that we anticipatewill be sold by our worksite insurance business as we continue to grow thatbusiness.  In addition, as our nationalworksite marketing business develops, we intend to

 

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opportunistically market ourthird-party administration services to self-insured plans, stop loss insurers,pharmacy benefit organizations, managed care service providers, other insurancecarriers and reinsurers nationwide.

 

##### *Third-Party Administrative ServicesCompetition*

##### * *

Thethird-party administrative services business tends to be highly competitive andhighly fragmented.  There are a number ofthird-party administration firms which compete primarily on the basis ofservice, efficiency and cost.  Thesecompetitors range from small local firms to large national firms and include anumber of third-party divisions of insurance companies and generalagencies.  Our administrative servicesbusiness will also compete indirectly in certain services provided by generaloutsourcing firms.  In some cases, third-partyadministration platforms of larger, well-established companies may havesubstantially greater financial, management and marketing resources than ourthird-party administration business. However, we view our third-party administration business as an integralcomplementary component of our worksite marketing product strategy goingforward and also believe that our additional resources resulting from ourinitial public offering in December 2004 will enhance our ability to obtainadditional third-party administrative service business.

 

#### **Acquired Business**

#### ** **

Ourpredecessor obtained over time, through assumption and indemnity reinsurancetransactions, a number of blocks of life and health insurance business in whichit has since elected to discontinue accepting new business.  Revenue from this business reflects renewalpremiums and other considerations on business in force that will continue todecline over time as policies lapse.  Theearnings generated by acquired blocks of business in any period will beaffected by, among other things, historical pricing levels together withapproved premium rate increases (if any), diversification of the underlyinginsurance policies, persistency and loss frequency and severity.

 

#### **Corporate and Other**

#### ** **

The corporateand other segment includes investment income earned on the investment portfoliorelated to capital and surplus not allocated to the insurance segments.  This segment also includes marketingallowances, commissions and related expenses pertaining to product sales forother insurance carriers, which are currently not material.  In addition, this segment includes certainunallocated expenses, primarily deferred compensation and incentivecompensation costs, and other unallocated immaterial items.  The results of this business segment arereflected in discussions of net investment income, realized investment gainsand losses, and general insurance expenses. See Item 7, Management’s Discussion and Analysis of Financial Conditionand Results of Operations.

 

#### **Life and Health Insurance IndustryCompetitive Overview**

#### ** **

##### *Market composition*

##### * *

Life andhealth insurance industry premiums, including annuities, in the United Statesexceeded $504 billion for the year 2003, with approximately $225 billionof statutory equity capital for the year 2003, according to the *Life Insurers Fact Book 2004*.  Industry participants include large nationaland international insurers as well as small and medium-sized insurers withvarying levels of geographic coverage and/or product lines.  Industry participants also include divisionsof multi-line insurance carriers, whose operations may include property andcasualty insurance, financial guaranty insurance and/or other specialtyinsurance lines.  This segment of thelife and health insurance business includes a number of insurers, some of whichtarget only the worksite marketing segment of the industry, and some of whichoffer varying levels of group and individual life, disability, annuity andhealth products to the employer market while also targeting other marketsegments.

 

##### *Operating characteristics of the life andhealth insurance industry as compared to the property and casualty insuranceindustry*

##### * *

In general,the life and health insurance industry has limits on volatility because groupcoverage of most employer groups will cover a significantly diversified numberof employees whose mortality (which is the number of deaths in a specificpopulation over a specific period of time) and morbidity (which is theincidence of disease or

 

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disability in a specificpopulation over a specific period of time) are relatively independent of eachother (exceptions to this general principle include natural and man-madecatastrophes, including terrorist events, in which the covered individualsaffected are often younger and concentrated in close proximity to oneanother).  This is different from theproperty and casualty insurance industry, in which risks are more heterogeneousin nature, policy language is more ambiguous and broad social trends (such asmass tort litigation, jury award trends and judicial and legislative decisionmaking), catastrophes and the emergence of new exposures over time reduce thelevels of independence between the underwritten risks so that large losses mayoccur.  As a result, the life and healthinsurance business has relatively low underwriting risk compared to theproperty and casualty insurance business and is not typically subject tosignificant pricing cycles and major catastrophe and/or mass tort exposureswhere risk has historically not been adequately considered when determiningpremium rates based on experience or where new risks have emerged over time andmay not have been considered at all when determining premium rates.

 

##### *Life and health insurance market environmentand opportunities*

##### * *

We believe weare well positioned to benefit from a number of significant demographic,governmental and market trends that are currently impacting the life and healthinsurance industry, including:

 

**•**                  anaging United States population with growing financial protection needs;

 

**•**                  employersshifting benefit costs to employees;

 

**•**                  continuedrise in medical and health care costs; and

 

**•**                  recentlyenacted Medicare legislation and medical savings account proposals.

 

#### **Recent Trends Affecting the Life and HealthInsurance Industry**

#### ** **

Describedbelow are some of the significant recent events and trends affecting the lifeand health insurance industry and the possible effects they may have on ouroperations in the future.

 

*Recently announced governmental investigations and litigation allegingthe illegal use of bid-rigging schemes and contingent commissions by insurancecompanies and brokers may affect life and health insurance industry regulation,practices and customs in ways that we cannot predict.*

* *

Within thelast twelve months, the New York State Attorney General and other stateagencies have filed lawsuits accusing several large insurance brokers offraudulent behavior, including alleged participation in bid-rigging schemes andacceptance of improper payments from insurers in exchange for agreeing not toshop for competitive quotes for customers of the insurers.  The New York State Attorney General’s officeand other state regulatory agencies are investigating a number of property andcasualty and health and life insurers for alleged participation in theseschemes, as well as arrangements whereby a particular insurer pays an insurancebroker additional or contingent commissions for placing a particular volume ofinsurance or insurance which leads to a certain level of insurerprofitability.  This lawsuit and theseinvestigations have resulted in negative publicity and increased pricevolatility for securities of insurance companies.

 

In addition,the scope of industry participants subject to investigation and enforcementactions is expanding and likely will continue to expand.  While we have not been subpoenaed or named ina lawsuit, we cannot assure you that we will not become involved in aninvestigation or be named as a defendant in an enforcement action or lawsuit.

 

One possibleresult of these investigations and attendant lawsuits is that many insuranceindustry practices and customs may change, including, but not limited to, themanner in which insurance is marketed and distributed through independentbrokers and agents.  Our businessstrategy contemplates that we will rely heavily on both independent brokers andagents and our internal sales force to market and distribute insurance products.  We cannot predict how industry regulation,customs and practices with respect to the use of brokers and agents may change.Such changes, however, may adversely affect our ability to implement ourbusiness strategy, which could materially affect our growth and profitability.  Such changes could also benefit us.  For example, if larger insurance companiescease to offer contingent commissions to brokers, then smaller insurancecompanies that generally do not offer such

 

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commissions, such as us, wouldcease to be at a competitive disadvantage when attempting to market theirinsurance products through these brokers.

 

##### *Shift of health care financing to employees*

##### * *

As employeesare being asked to assume a greater portion of the cost of their health care,they are looking for more efficient products, including major medical andcritical illness insurance policies, where the employee is responsible forcosts related to minor illnesses and injuries, but is covered for the costs ofmajor illnesses and injuries. We believe we will benefit from this trend in thefuture because we will have opportunities to cross-sell our third-partyadministration services to self-insured employers and to expand voluntary salesof insurance products to individual employees that supplement their healthcareand protection needs. We expect to offer a full-service solution to clients andcustomers that is designed to meet the needs of employers as they continue toalter and reevaluate their benefit packages to employees.

 

##### *Aging population and increasing demand forprotection*

##### * *

There is anunprecedented change occurring in the age distribution of the United Statespopulation. The United States population is growing older, and we believe thiswill have substantial ramifications for the insurance products relating toasset protection, income protection, health care and long-term retirementincome over the next thirty years. The aging baby boomer population in theUnited States is one of the most important transforming forces for the life andhealth insurance industry. Approximately 35% of the United States populationwas 45 years old or older in 2002 according to the U.S. Census Bureau. Asan increasing percentage of the United States population reaches retirementage, there will be increased demand for “in-retirement” products rather than “to-retirement”products. Aging baby boomers will require immediate annuities, critical illnessand long-term care products to meet their needs. The anticipated increase indemand for morbidity products represents one of the most importantopportunities in the life and health insurance business. In addition, thetragedy of September 11, 2001, has caused individuals to purchase orincrease coverage on life insurance and disability policies, as many peoplerealized that the threat of terrorism was material. Although this increasedlevel of interest may subside, threats of further attacks or more instances ofnew diseases are likely to keep demand for life and health insurance productshigh. We believe we will be well positioned to take advantage of this growingdemand for mortality and morbidity products given our plans to significantlyexpand our geographic marketing focus and worksite marketing salescapabilities. Our product suite will include long-term care products, for whichwe expect demand to increase as a result of these changing demographics.

 

##### *Historically low interest rates*

##### * *

The currentinterest rate environment poses a problem for most carriers in the life andhealth insurance industry.  Most interest-sensitivelife and annuity policies sold by United States life insurers have guaranteedminimum crediting rates, determined either by regulation or by contract.  Insurers’ profit margins are being negativelyimpacted by the decline in the difference between the crediting rate and whatthey can earn on the underlying assets. As interest rates fall, the decrease in the difference between theamount insurance companies must pay on their fixed rate products and the amountthey can earn on their portfolio assets directly reduces net income.  A rise in interest rates will not necessarilybenefit the life and health insurance industry as a whole in the short termbecause it would cause a decline in the market value of the industry’s bondportfolio (adversely affecting the industry’s capital position) and couldincrease lapse rates in certain product lines as policyholders cash in theirpolicies to take advantage of higher returns elsewhere.  We also believe that our productprofitability will have limited sensitivity to fluctuations in interest ratesbecause we do not intend to offer interest rate sensitive products such asannuities. Although rising interest rates will adversely affect the value offixed income securities in our portfolio and our capital position, we wouldlikely also benefit from rising interest rates as the aggregate rate ofinterest earned on our investment portfolio increases.

 

##### *Volatility in equity markets*

##### * *

The volatilityin the equity markets over the past few years has posed a number of problemsfor some participants in the life and health insurance industry. Many insurersthat relied on returns from equity securities to outperform fixed incomesecurities and add to their overall returns have realized significant capitallosses in recent

 

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years.  Because of the size and duration of thedecline in the equity markets, many companies were forced to write-off theircapital losses as permanent impairments, which are direct reductions in netincome.  Even though the capital marketshave recovered, not all companies have participated evenly in therecovery.  We historically have hadminimal equity exposure in its investment portfolio (less than 1% of totalinvestments as of December 31, 2004) and we plan to continue to manage equityasset allocations conservatively in the future.

 

##### *Corporate bond defaults*

##### * *

Corporatedefaults and credit downgrades, which have resulted in permanent impairment inthe value of many securities, have had a material impact on life and healthinsurers in the past few years.  Moody’sInvestor Service estimates that, as of July 21, 2004, investment portfolios inthe life insurance market had $23 billion of exposure to ten major issuersthat have recently defaulted or have been experiencing credit problems.  Overall corporate credit quality has declinedover the past few years due to recent weakness in the global economy,volatility in the equity markets and the decline of the technology,telecommunication and airline industries, further reducing the value of lifeand health insurers’ debt investments. While Kanawha’s debt investments have not been immune to corporatecredit problems, including problems relating to some of the issuers notedabove, losses from corporate defaults have historically not been material toits financial condition.  We intend tomanage our investment portfolio conservatively in the future to attempt tomitigate our risk of losses from corporate defaults.  We expect our investment portfolio will consistmainly of highly rated and liquid fixed income securities, with diversificationamong asset classes, industries and individual issuers.

 

##### *Capital adequacy*

##### * *

Some life andhealth insurance companies have recently suffered significant reductions incapital and will have to improve their capital adequacy ratios to support theirbusiness.  In the United States, certainlife and health insurance companies have been forced to pay close attention tomanagement of risk-based capital requirements. Risk-based capital requirements are capital requirements for aninsurance company based on an assessment of its aggregate risk exposuredetermined by analyzing each of its individual risk components, such as thenature of the company’s assets, the risk that its losses will be worse thanexpected, its exposure to interest rate fluctuations and other businessrisks.  Risk-based capital requirementsare determined and used by insurance regulators, rating agencies, insurancecompanies and other insurance industry participants.  Fitch IBCA, Inc., estimated in December 2001that life insurance industry losses resulting from the September 11, 2001,tragedy were between $3.0 billion and $5.0 billion, which representsapproximately one to two percent of the life and health industry’s capital forthe year 2002. Although a loss of this size is not devastating to overallindustry capital as a whole, its impact did not fall evenly across the market,hurting some insurers more than others. In addition to the direct impact on thelife and health insurance market, the overall insurance industry, includingproperty and casualty insurance companies, lost between $30 billion and$58 billion in 2001, as estimated by Tillinghast-Towers Perrin.  This catastrophe, in addition to recentsubstantial reserve deficiencies for property and casualty exposures such asasbestos and environmental and other mass torts, has put tremendous pressure onthe capital of some multi-line insurance companies.  We believe this heightened focus on capitalmanagement will have an overall positive effect on us as carriers become moredisciplined with product pricing and/or exit markets or product lines in whichwe will compete.

 

##### *Volatility in reinsurance capacity*

##### * *

Many of theevents and trends affecting the life and health insurance industry have had anequal (or greater) impact on the life and health reinsurance industry.  These events have led to a decline in theavailability of reinsurance.  Consolidationin the life and health reinsurance industry over the last decade has furtherreduced competition and capacity in the market. The combination of increased demand for insurance and the pressure onindustry capital, coupled with the need for companies to become more focused onthe bottom line, has also led to increased demand for reinsurance at a time ofconstrained capacity.  While we currentlycede a limited amount of our primary insurance business to reinsurers and weplan to continue this practice, diminishing reinsurance capacity has led toincreasing reinsurance premium rates and more restrictive terms and conditions,which has negatively impacted our predecessor in the past and may furthernegatively impact our operations in the future. See “-Risk Management and Underwriting” for a discussion of how wemanage our risks, including how we use reinsurance to manage risk.

 

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##### *DAC impairments*

##### * *

The cost ofwriting an insurance policy is significant in comparison to its annual premium.Insurance-specific accounting rules under GAAP allow companies to capitalizesome acquisition expenses and amortize them over the life of the policies tothe extent that there is adequate projected profitability to cover theamortization.  DAC is treated as an asseton the balance sheets of life and health insurers.  As profit margins have declined because oflow interest rates, high defaults and other issues, many companies in recentyears have been forced to write-down their DAC assets.  These write-downs have the same effect oncapital as write-offs of other assets and have had a significant negativeimpact on the earnings and capital position of several life and healthinsurers.  We eliminated all of ourpredecessor’s DAC upon the closing of the Kanawha acquisition as part of theapplication of GAAP purchase accounting requirements.  We began to record DAC prospectively onJanuary 1, 2005.

 

##### *Renewed emphasis on “core business”*

##### * *

The equitymarkets are increasingly focusing on insurers’ ability to deploy their capitaland improve their return on capital.  Webelieve that the current difficult investment environment has led a number ofmulti-line insurance companies in the United States and Europe to reassesstheir business models and divest some or all of their life and health insuranceand/or annuity operations.  We believethis trend and the resulting marketplace disruption presents us withopportunities to capture additional market share in products we will underwriteand market as well as potentially allowing us to grow our business more rapidlythrough selected acquisitions of blocks of business and/or product lines.

 

##### *Consolidation and demutualizations*

##### * *

Some of thelargest life insurance companies in the United States, including PrudentialFinancial, Inc., Metropolitan Life Insurance Company, Mutual of New York, asubsidiary of The MONY Group Inc., and John Hancock Financial Services,Inc.  (The MONY Group Inc. and JohnHancock Financial Services, Inc. were subsequently acquired by othercompanies), recently changed their form of ownership from a mutual structure toa stock company structure through a process called demutualization.  We believe that many of these companies arestill adjusting to being owned by shareholders who may be much more demandingwith respect to returns than policyholders.  There has been some consolidation in the lifeand health insurance industry over the last few years. Further consolidation ispossible as companies try to gain economies of scale.  In many cases, smaller books of business willno longer fit the combined company’s strategy and will be closed or put up forsale.  As a result of these factors, webelieve that we will have opportunities to gain market share as other life andhealth insurers focus on internal issues as well as opportunities to acquiresome lines and/or blocks of business that will augment or complement ourbusiness.

 

#### **Customers**

#### ** **

We have manycustomers that purchase our insurance products, and we are not dependent on anysingle customer, or group of customers in any of our business segments.  No single customer represents more than tenpercent of our total consolidated revenue. Longstanding relationships exist with many customers who purchaseproducts on a continuing basis, and we continually attempt to maintain andimprove these relationships.  The loss ofbusiness from these customers or an increase in business from these customerscould have a significant impact on the results of our operations.

 

#### **Competitive Factors**

#### ** **

We believethat the factors that enable us to compete effectively include:

 

*An experienced management team and an entrepreneurial culture. *We have a talentedand experienced management team both at the holding company level and at eachof our operating businesses.  Ourmanagement team is led by our chairman, president and chief executive officer,Kenneth U. Kuk, who has 17 years of experience in the life insuranceindustry.  Stanley D. Johnson has beenthe chief executive officer of Kanawha since 1986 and is

 

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a member our board of directors.  Members of our executive management team havean average of over 20 years of experience in the life and health insuranceindustry, including experience in the areas of executive management,underwriting, marketing, distribution, claims processing, actuarial, legal,finance and investments.  We believe thisexperience is useful in executing our business strategy to grow our ownnationwide worksite marketing operation and marketing our insurance productsnationwide.  We promote a set ofcorporate values and a common corporate culture that we believe enables us toleverage business ideas, risk management expertise and focus on regulatorycompliance across our businesses.  Weintend to reward and encourage entrepreneurship at each business segment, inpart by implementing performance-based compensation systems.

 

*Strong relationships with key clients, distributors and industrypersonnel. *Ourexecutive managers, senior executives and sales managers have industryrelationships with existing worksite market customers and independent agents inthe southeastern United States and potential worksite market customers andagents nationwide, including employers, VBOs, enrollment firms, internalwholesalers, employee benefit consultants and national and regional insurancebrokers.  We believe that the strength ofthese distribution relationships enable us to market our products and servicesto our existing customers in an effective and efficient manner and will beinstrumental in developing our nationwide worksite marketing efforts.

 

*A broad product mix of both voluntary and group insurance productsoffered through an integrated distribution platform. *We offer a varietyof products that meet the needs of group and voluntary customers throughoutvarious stages of their development and lifecycles.  We have the capability to package insuranceproducts underwritten in-house, insurance products from other carriers andadministrative services options as a “total solutions” product to our clientsand customers, which we do not believe can be duplicated easily by ourcompetitors.  We believe our insuranceoperations combined with products in-sourced from other carriers andadministrative services options provided by our third-party administrationbusiness provide the foundation for significant product cross-selling andproduct extension opportunities.  Webelieve that persistency and profitability are enhanced by offering a widevariety of insurance products to group and voluntary customers.

 

*Strong administrative capabilities in third-party administration. *Our third-partyadministration business provides plan administration services for over 134,000employees or members of employers or associations that self-fund theirhealthcare benefits.  We offer a flexibleand broad suite of administrative services and products that can be highlycustomized to provide tailored solutions to customers.  We intend to significantly expand our strongregional third-party administration business as it administers the increasingvolume of policies and products that we anticipate will be sold by our worksiteinsurance business.

 

*A disciplined approach to underwriting and risk management. *We have implementeda disciplined underwriting and risk management policy.  We focus on generating profitability throughcareful analysis of risks and draw on our experience in core specializedmarkets.  One of the tools we use tomanage our risk is our tele-underwriting program, which enables our trainedunderwriters to interview individual health insurance applicants over thetelephone, which enables our underwriters to ask case-specific questions andgather case-specific information and thus better assess the risks of insuring aspecific potential insured, set appropriate premiums and identify applicantsthat require additional screening.  Inaddition, we closely monitor regulatory and market developments and adapt ourapproach as we deem necessary to achieve our underwriting and risk managementgoals.  For example, we have exitedproducts in which we were not achieving acceptable profitability and intend tointroduce new products in insurance environments that are more favorable.  Our three primary businesses offer a diversemix of products and services throughout the southeastern United States.  These products and businesses generally arenot affected in the same way by economic and operating trends, which we believeallows us to maintain a greater level of financial stability than many of ourcompetitors across business and economic cycles.  We expect our product and geographicdiversity to further increase as we continue to implement our business strategyby expanding our product mix and implementing our nationwide marketingeffort.  We are focused on losscontainment, and we purchase reinsurance as a risk management tool to diversifyour risk and protect against unexpected events, such as catastrophes.  We strive to improve our disciplinedunderwriting and risk management philosophy, which we believe will enable us torealize above average financial returns while focusing on our strategicobjectives.

 

*Excellent financial strength. *Asof December 31, 2004, we had approximately $770 million of total assets andapproximately $188 million of shareholders’ equity.  Kanawha, our insurance subsidiary, hasfinancial strength

 

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ratings of A- (excellent) fromA.M. Best and A- (strong), with a stable outlook, from S&P.  These ratings reflect each rating agency’scurrent opinion of Kanawha’s financial strength, operating performance andability to meet obligations to policyholders and contract holders.  We employ a conservative investment policyand our portfolio primarily consists of high grade, fixed income securities.  As of December 31, 2004, we had approximately$579 million of cash and investments, consisting primarily of investment gradebonds with an average rating of “AA-”. We believe our solid capital base and overall financial strength allowus to distinguish ourselves from our competitors and enable us to attract clientsthat are seeking an insurance company with long-term financial stability.

 

*Strong regional life and health insurance platform. *We are a voluntarylife and health insurance company in the southeastern United States with manyattributes that will aid us as we seek to expand our product selection andimplement a nationwide marketing and distribution focus.  These attributes include:

 

**•**                  ahistory of strong financial strength ratings for many years;

 

**•**                  licensesto provide life and health insurance products in 45 states;

 

**•**                  management,administrative and technology personnel and systems that serve our currentproduct mix and regional marketing efforts that we believe are capable ofexpanding to serve a broader product mix and national marketing efforts whilegenerating cost savings through economies of scale;

 

**•**                  acurrent book of in force insurance that likely will be a key contributor to theprofitability of our insurance businesses;

 

**•**                  acomprehensive set of worksite life and health insurance products;

 

**•**                  dedicatedemployees and knowledgeable insurance professionals;

 

**•**                  aconservatively managed, diversified investment portfolio; and

 

**•**                  anefficient, well regarded worksite marketing business focused on small tomidsize companies in the southeastern United States that we believe can beexpanded to market to larger companies nationwide without significant conflictwith our other marketing and distribution efforts, including our efforts tomarket insurance products tailored to the needs of seniors and to marketinsurance products through independent agents.

 

#### **Business Strategy**

#### ** **

Our objectiveis to achieve superior financial performance by transforming our position as aregional voluntary life and health insurance company into a national life andhealth insurance company with an expanded product mix and nationwide marketingfocus.  We intend to achieve thisobjective by executing the following strategies in pursuit of profitablegrowth:

 

*Expand our experienced management team. *We have begun to and intend to continue to hireadditional senior management personnel with a significant amount of experiencein the life and health insurance industry, particularly with experience inproduct development, underwriting, marketing and sales management within theworksite marketing distribution channel. We believe this experience is useful in executing our business strategyto grow our own nationwide worksite marketing operation and market ourinsurance products nationwide.

 

*Develop a nationwide marketing organization primarily focused onworksite marketing. *Webelieve that one of our critical success factors is to build a national salesand marketing organization that is focused on the worksite market.  We believe the creation of such anorganization, combined with implementation of our product development strategy,is the foundation for our growth plan. To implement our strategy to grow our worksite marketing operation weare taking the following actions:

 

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**•**                  ***Continue to hire employees withworksite marketing sales experience***.  We have begun to and intend to continue torecruit additional insurance executives with experience in marketing worksiteproducts to sponsoring employers and third parties including VBOs, enrollmentfirms, internal wholesalers, employee benefit consultants, brokers and otherparties.  As part of our strategy toexpand our product mix and to expand our geographic coverage of our sales andmarketing efforts, we have hired and intend to continue hiring individuals whohave experience with the new products that we intend to introduce and withcustomer relationships in the new geographic areas that we are targeting.

 

**•**                  ***Target larger employersnationwide. ***Our new andexpanding internal sales force is targeting employers with 50 to 10,000employees.  This target market includesover 290,000 businesses in the United States according to Dun &Bradstreet.  Historically, our predecessorconcentrated on employers having less than 200 individual employees.  We believe that with our enhanced marketingorganization and expanding sales force, we are well equipped and will becomeeven better equipped to serve larger employer sponsor groups.  Targeting larger employers or groups withlarger numbers of employees or members should enable us to sell more insurancepremiums with less sales, marketing, administrative and other overhead costsper premium dollar, which should improve our profit margins on worksiteinsurance products.

 

**•**                  ***Implement performance-based equitycompensation incentives***. We have begun to review options to implement performance-based equitycompensation incentives for our sales and marketing employees that emphasizeprofitability, sales volume, cross-selling our products and services andbundling packages of the products that we market.  These incentives already include equityincentive awards, such as awards of options to purchase our common stock.  Generally, our competitors do not offersimilar broad-based equity incentive awards, which gives us an advantage incontinuing to hire and retain talented sales and marketing personnel.  We believe that implementing performance-basedequity incentives will increase our sales and profitability by aligning theinterests of our marketing employees with our sales and profitabilityobjectives.

 

**•**                  ***Collaborate with key third parties****. *Wehave begun and will continue to seek to hire senior sales managementprofessionals who have experience interacting with the many constituenciesinvolved in our product distribution efforts. We believe that it is important to our success that senior salesmanagement interact with our sales force, sponsoring employers, benefitadvisors and other product intermediaries and independent agents.  We believe relationships between theseparties, as well as with our insurance businesses and our third-partyadministration business, can be expanded to enhance our product packagingcapabilities and cross-selling abilities, including the bundling of insuranceand related products and services from our insurance businesses, our third-partyadministration business and other insurance carriers.

 

**•**                  ***Target small employers nationwide****. *Historically,our predecessor targeted small employers and groups in the southeastern UnitedStates generally having less than 200 individual employees or members through anetwork of independent agents.  We aregrowing our presence in this niche market by expanding the geographic focus ofour independent sales agents to focus on select markets nationwide.

 

*Expand the types and varieties of insuranceproducts and related services that we offer. *In addition to developing a more effectivemarketing organization, we are focusing on our product development and offeringstrategy.  We believe that it is not onlythe individual products that we offer that differentiate us from ourcompetition in the worksite insurance market, but also the breadth of ourproduct mix.  Our objective is to expandour existing product mix and add complementary products that together willprovide a product offering that cannot easily be duplicated by ourcompetitors.  This differentiated productset should allow our sales force the ability to offer our employer sponsors andour distribution partners bundled packages of multiple insurance products andservices that are tailored to meet our customers’ unique needs.  Our strategy for increasing our product mixincludes the following:

 

**•**                  ***Provide additional group andvoluntary insurance products*. **We intend to expand our product offerings by offering additional typesof worksite life and health insurance products as well as additional variationsof the types of insurance that we currently offer.  We may introduce new varieties of thefollowing

 

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products already offered by us: individuallife insurance; group life insurance; disability life insurance; and dentalinsurance.  New products that we mayintroduce include: medical stop-loss insurance that provides insurance protectionto employers who self-fund a portion or all of employee health benefits; visioninsurance that covers all or a portion of the costs of diagnostic andpreventative eye care services; and accidental death and dismembermentinsurance that provides payments to insureds or beneficiaries upon the occurrenceof a fatal accident or accident which results in the of loss of limb oreyesight.

 

**•**                  ***In-sourced product offerings. ***We believe that expanding thevariety of in-sourced products that we market is necessary to accomplish ourgoals of expanding our product mix and marketing customized bundled productpackages tailored to a customer’s needs. As we continue to seek to grow our product mix, bundled solutions andgeographic marketing scope, there will be instances where potential customershave needs that we cannot satisfy with products underwritten by our insurancebusinesses.  Developing a full complementof in-sourced products will be necessary to successfully achieve our growthobjectives.

 

*Develop client-focused strategy. *We believe that long-term success in theworksite market is predicated on a client-driven strategy often missing in themarket today.  We focus on the uniquerequirements of sponsoring employers and worksite intermediaries.  To satisfy our customers’ individualinsurance requirements, we are working to offer more bundled packages ofmultiple insurance products and services that are tailored to meet ourcustomers’ needs.  These bundledsolutions are to be marketed by our internal sales force and independent agentsand will include both group policies as well as voluntary policiestraditionally marketed by independent agents. Many of these bundled solutions will utilize products and servicesprovided by all three of our businesses. For example, we can provide a full insurance solution for an employerthat is self insuring its employees by bundling: (1) administration and claimshandling services relating to the self-insured plan; (2) a medical stop-lossproduct which caps our clients self-insured exposure; (3) group and voluntaryinsurance product offerings underwritten by us as part of an employee benefitpackage; and (4) insurance products from other insurance carriers structured tofulfill group and voluntary insurance product needs that we do not underwriteourselves.

 

*Improve the efficiency of our third-party administration business. *Our businessstrategy is to grow our third-party administration business primarily by havingit administer the increasing volume of policies and products that we anticipatewill be sold by our worksite insurance business.  We believe that our third-partyadministration business has the capacity to administer additional policies andthat as this business administers a higher volume of policies, our per policyadministration costs will decrease and our consolidated net profits willincrease.  While increasing the volume ofinsurance products administered for unrelated third parties will not be aprimary growth initiative for this business, as our national worksite marketingbusiness develops we intend to opportunistically market our third-partyadministration services to other insurance carriers and reinsurers, as well asour traditional end client base, such as self-insured plans, stop lossinsurers, pharmacy benefit organizations and various managed care serviceproviders.

 

*Improve capital management. *Weintend to manage our capital prudently relative to our risk exposure to enhancerisk-adjusted returns on investments and long-term growth in shareholdervalue.  Our capital management strategyis to maintain financial strength through conservative and disciplined riskmanagement practices.  We intend to dothis through product design, strong underwriting and risk selection and prudentclaims management and pricing.  Inaddition, we intend to maintain our conservative investment portfoliomanagement philosophy and properly manage our invested assets in order to matchthe duration of our insurance product liabilities.  We intend to manage our business segments sothat they have the appropriate level of capital required to obtain the ratingsnecessary to operate in their markets and to satisfy various regulatoryrequirements.  We are also evaluating andimplementing cost-cutting measures in each of our business lines.

 

*Maintain a disciplined risk management approach. *We intend tomaintain a disciplined risk management approach through flexible underwritingand pricing strategies, diversification of products, industry, geography andcustomers and the use of reinsurance.  Weare focused on profitable products and markets and a flexible approach toproduct design.  We have implemented acollaborative effort between our marketing and underwriting teams that webelieve will permit us to opportunistically take advantage of salesopportunities and underwrite profitable policies.  We continuously evaluate the profitability ofour products and pursue pricing strategies and adjust our mix of

 

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businesses by geography and byproduct so that we can maintain attractive pricing and margins.  We seek to price our products at levels whichhelp us achieve our target profit objectives.

 

*Pursue acquisitions opportunistically. *While our primary focus is organic growth ofour existing businesses by expanding our product and marketing capabilities, weevaluate opportunities to grow through strategic alliances and acquisitions ofblocks of business and/or companies that are compatible with our corebusinesses.

 

#### **Risk Management and Underwriting**

#### ** **

We manage ourrisks through (1) diversification of products, industry, geography andcustomers, (2) disciplined underwriting and product pricing practices and(3) the use of reinsurance.  Toaccount for and manage our risks, we establish and carry as liabilitiesactuarially determined reserves that we believe will be sufficient to meet ourfuture obligations.

 

##### *Diversification*

##### * *

We diversifyour earnings from premiums by offering a diverse set of voluntary life andhealth, long-term care, indemnity health, critical illness, Medicare supplementinsurance and other coverages.  Theseproducts all have differing price, market and risk characteristics.  The underwriting risk on life insurance isgenerally diversified because covered lives of individuals are typicallyrelatively independent of each other.  Natural and man-made catastrophes, such asterrorist attacks, are the one exception where numerous life insurance claimsmay occur at once.  Geographic diversityof insureds is generally the best protection for such risks.  The recently enacted federal terrorism actthat provides a backstop to the insurance industry excludes life insuranceexposures.  In addition to the increasedrisk due to terrorism, there is significant risk from epidemics such as theSARS or West Nile viruses or other diseases that can spread quickly around theworld given the increasing levels of individual travel, commerce andinterdependency between nations involved in a global economy.  We could be materially impacted by any one ofthese events if they were to strike a significant block of our insureds withina short period of time.  Our worksiteproducts are spread among different employers throughout the southeasternUnited States.  We will continue to monitorthese “macro” issues on an ongoing basis and will evaluate concentrations ofrisk as part of our underwriting process to optimize the diversification ofrisk exposures.  Our product andgeographic diversification should improve as we implement our strategy todevelop a nationwide worksite insurance business with expanded productofferings.

 

##### *Underwriting and Pricing*

##### * *

We manage therisk associated with the insurance policies that we place by implementingdisciplined underwriting and product pricing practices that are tailored byproduct.  Our group product underwritingand pricing is centralized.  We havedeveloped standard rating systems for each product line based on pastexperience and relevant industry experience. We are not obligated to accept any application for a policy or group ofpolicies from any distributor and/or worksite employer.  Our uniform underwriting policies providethat if the coverage exceeds prescribed age and amount limits, we may require aprospective insured to submit to medical examinations.  Product pricing of group insurance productsis based on the expected payment of benefits under the policies that arecalculated using assumptions for mortality, morbidity, interest, expenses andpersistency, depending upon the specific product features.

 

Our individuallife and disability insurance underwriters follow detailed and uniform policiesand procedures to assess and quantify the risk of our individual insuranceproducts.  We may require the applicantto take a variety of underwriting tests, such as medical examinations,electrocardiograms, blood tests, urine tests, chest x-rays and consumerinvestigative reports, depending on the age of the applicant and the amount ofinsurance requested.

 

Consistentwith other carriers offering long-term care insurance in the life and healthinsurance industry, our and our predecessor’s claims have exceeded thoseanticipated when our predecessor first developed long-term care products incertain states.  Most significantly, ourand our predecessor’s cumulative claims experience for long-term care productsin the state of Florida has been 25% higher than expected.  As a result, our predecessor filed

 

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for and obtained rate increasesin the range of 5.0% to 18.5% for seasoned business in the majority ofjurisdictions in which our long-term care insurance is in force; these rateincreases generally take effect on the policyholder’s next anniversarydate.  To date, rates for newly issuedlong-term care insurance have been filed and are currently in effect in 37states, which represent increases of as much as 20% to 35% over our legacylong-term care insurance pricing levels. We intend to continue to monitor our legacy long-term care insurance inforce and make further pricing and other underwriting adjustments whencontractually permitted, if necessary, which will be based on the experience ofour long-term care insurance business going forward.  While we can provide no assurance, we expectthe actions that we have already taken and the pricing discipline we areimplementing in writing new policies will allow us to improve the profitabilityof our long-term care insurance business.

 

##### *Reinsurance*

##### * *

Generally, we purchase reinsurance coveragefor the following major business purposes:

 

**•**                  ***Protection from underwritingrisks. ***As part of ouroverall risk and capacity management strategy, we purchase reinsurance for somerisks underwritten by us, such as excess of loss coverage for individual orgroup claims.

 

**•**                  ***Dispositions of insuredbusiness. ***We usereinsurance to facilitate the sale or exit of product lines and/or blocks ofbusiness.  This is common in theinsurance industry because each insurer offers a distinct set of product lines,which complicates the acquisition and disposition of stand-alone legalentities, and in certain cases, large blocks of insurance business.  In general, a disposition through areinsurance transaction will include a 100% co-insurance agreement under which100% of the policy benefit reserves and related assets of the subject businesswill be transferred to the reinsurer. Also, given the fact that the primary insurer is still legally obligatedunder the policies reinsured, these agreements generally require some degree ofcredit support including bank letters of credit, reinsurer deposits with thereinsured party and trust agreements under which the assets backing theliabilities of the reinsured business are held in a trust along with excesscollateral and the reinsurer is obligated to fund the trust if the value of theassets is deemed insufficient to fund the liabilities.

 

**•**                  ***Capital management. ***We purchase reinsurance as acapital management tool.  State insuranceregulations and accounting regulations permit us to reduce our required capitalwhen underwriting risks are appropriately offset by reinsurance, which allowsus to free up capital to enable us to write additional business.

 

Reinsurance iseither provided on a treaty basis or a facultative basis, and is generallystructured in the proportional form or an excess of loss basis for bothindividual losses and losses in the aggregate. In an indemnity reinsurance transaction offered on a treaty basis, areinsurer agrees to indemnify another insurer for part or all of its liabilityunder a policy or policies it has issued for an agreed upon premium.  These agreements provide for recovery of aportion of losses and associated loss expenses from reinsurers.  These losses and loss expenses refer to theexpenses of settling claims, including legal and other fees and the portion ofgeneral expenses allocated to claim settlement costs plus losses incurred withrespect to claims.  The terms of theseagreements, which are typical for agreements of this type, generally provide,among other things, for the automatic acceptance by the reinsurer of cededrisks in excess of our retention limits (the amount of loss per individual orin the aggregate that we are willing to absorb).  For excess of loss coverage, we pay premiumsto the reinsurers based on rates negotiated and stated in the treaties.  For proportional reinsurance, we pay premiumsto the reinsurers based upon percentages of premiums received by us on thebusiness reinsured and the reinsurer accepts a proportional percentage oflosses on the reinsured business.  Theseagreements are generally terminable as to new risks by us or by the reinsureron appropriate notice; however, termination does not affect risks ceded duringthe term of the agreement, which generally remain with the reinsurer.  The other commonly known form of reinsuranceis referred to as facultative reinsurance in which a specific risk is insured,such as upon the cession of a specific portion of a large insurance policy.

 

In most casesin which we choose to reinsure an underlying exposure, we expect to purchasereinsurance on a treaty basis and either in the form of proportional or excessof loss coverage, dependent on the underlying

 

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properties of the insuranceproducts.  In select cases, we maypurchase reinsurance on a facultative basis in cases in which we have highexposures on specific individual insured risks.

 

Oursignificant reinsurance includes the following:

 

**•**                  ***Individual and group life. ***Our predecessor reinsured itsdirectly written in force individual life insurance policies on an excess ofloss per risk and aggregate basis above identified retention limits.  This reinsurance was with subsidiaries ofG.E.  Employers Re and Scottish Re.  G.E. Employers Re notified our predecessor that, effective February 29,2004, it no longer accepts new business under this treaty.  The treaty, however, remains in effect withrespect to business previously reinsured under the treaty.  Scottish Re replaced G.E.  Employers Re as the reinsurer for all newbusiness.  We also reinsure much of ouracquired individual life insurance policies with Reassure America LifeInsurance Company (a subsidiary of Swiss Re). We reinsure our group life and accidental death and dismembermentinsurance policies with Munich American Reassurance Corporation on an excess ofretention basis.  Individual and groupworksite term life insurance (life insurance written for a specified period andunder which no cash value is generally available on surrender) products arereinsured on a 50% coinsurance basis with Hannover Re, which means thatHannover Re bears the risk for 50% of any claims losses and costs incurred withrespect to these policies.  We intend tocontinue to monitor our risk retention levels on our life insurance policiesand will seek to maintain a reasonable balance between reinsured and retainedrisk.

 

**•**                  ***Fixed annuity block. ***Our predecessor discontinuedunderwriting new fixed annuity products effective December 31, 2003, andwe intend to in-source these products from other life and health insurancecarriers.  All in force annuity productsas of December 31, 2003, were ceded via a 100% coinsurance agreement withMadison National Life Insurance Company, a subsidiary of Independence HoldingCompany.  Madison National assumed all productadministration of this block of business in early 2004.  All risks and profits generated by thereinsured business have been transferred to Madison National; however, we arestill liable on a primary basis for this business should Madison National failto honor its reinsurance obligations.

 

**•**                  ***Long-term care. ***We have reinsured 15% of therisk on the earlier generations of our long-term care insurance with EmployersRe and GenRe on a quota share basis, which means that we are responsible for85% of all losses under these policies. We have reinsured 60% of the risk on our current long-term-care productwith Munich American Re on a quota share basis, which means that we areresponsible for 40% of all losses under these policies.

 

**•**                  ***Medicare supplement block. ***In 2003, our predecessorceased underwriting new Medicare supplement insurance and began offering theproduct to the senior market on an in-source basis through an alliance withMutual of Omaha.  Although we have notmade a final decision on whether to reinsure this block of business, we are currentlysoliciting offers to reinsure this block of business.  We anticipate that any reinsurance agreementthat we enter in the future with respect to this block will be structured via100% coinsurance contracts with all risks and profits generated by thereinsured business being transferred to the identified reinsurer(s).

 

**•**                  ***Group critical illness. ***In 2005, we plan to offer newgroup critical illness products that will be reinsured with Hannover Re.

 

**•**                  ***Other miscellaneous blocks ofbusiness. ***The availabilityof life and health reinsurance has significantly diminished as a result of theevents of September 11, 2001, and other unique circumstances within thelife and health reinsurance industry, as noted elsewhere in this report.  A number of our reinsurance agreementsrelating to major medical, indemnity health, accidental death and dismembermentand other insurance coverages have been recently cancelled by the reinsurersdue to lack of volume of business submitted, and the reinsurers will not acceptnew business pursuant to these agreements. While we would prefer to retain reinsurance coverage for certain ofthese business lines and other older and smaller blocks of business in thefuture assuming acceptable pricing levels, we are comfortable retaining fullexposures in these areas given our view that the current pricing environment

 

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in the life and health reinsurance industryadequately covers the underwriting risk inherent in these products.

 

Under reinsurancetransactions in which we are the ceding insurer, we have retained primaryliability for the underlying policy claims of the insured risks if the assumingcompany fails to meet its obligations. To limit this risk, we have control procedures in place to evaluate thefinancial condition of reinsurers and to monitor the concentration of creditrisk to minimize this exposure.  Theselection of reinsurance companies is based on criteria related to solvency andreliability and, to a lesser degree, diversification.  At December 31, 2004, over 99% of ourreinsurance recoverables were due from reinsurers rated A- or betterby A.M.  Best.  We now seek to purchase reinsurance from onlythose entities rated A- or better by S&P or A.M.  Best and we regularly monitor collectibilityof our reinsurance recoverables, making reserve provisions for amounts weconsider potentially uncollectible and requesting collateral wherenecessary.  We apply the same financialanalysis and approval processes to the selection of reinsurance and otherfinancial protection counterparties as we do to the underwriting of our ownprimary insurance products.

 

Our managementintends to conduct ongoing reviews of the pricing and operationalcharacteristics of each of the products offered by us, our current reinsuranceagreements in force, acceptable risk retentions and reinsurance alternatives,and the availability and cost of reinsurance applicable to our products.

 

##### *Gross Annualized Premium in Force, CededPortion and Net Amount Retained*

##### * *

The followingtable details our gross annualized premium in force segregated by product type,the portion that was ceded to reinsurers and the net amount retained as ofDecember 31, 2004.

 
| ** **                               | ** ** | **As of December 31, 2004** | ** **  |
|------------------------------------------|------------|-----------------------------|-------------|
| ** **                               | ** ** | **Gross**                   | ** **  | **Ceded** | ** ** | **Net** | ** ** | **Percentage  Retained** | ** ** |
| Life insurance and annuities             |       | $                           | 14,595,424  |   | $ | 806,638 |   | $ | 13,788,786 |   | 94.5 |   |
| Group life insurance                     |       | 1,377,152                   |        | 251,914 |   | 1,125,238 |   | 81.7 |   |
| Individual accident and health insurance |       | 107,553,398                 |        | 13,012,657 |   | 94,540,741 |   | 87.9 |   |
| Total consolidated                       |       | $                           | 123,525,974 |   | $ | 14,071,209 |   | $ | 109,454,765 |   | 88.6 |   |

 

##### *Assumed Reinsurance*

##### * *

We have alsoassumed blocks of reinsurance on both an indemnity and assumption basis.  We do not currently intend to acquireadditional blocks of reinsurance, but some of the reinsurance previouslypurchased by us remains in force and will affect our future earnings dependingon the future experience of these blocks of business.  The most significant of these blocks ofbusiness include coverages for waiver of premium benefits associated withcertain life policies underwritten by AXA Financial, Inc., individual healthinsurance business from Metropolitan Life Insurance Company and life insurancebusiness from ING Groep N.V.  Othersmaller life and accident and health insurance blocks of business were alsoassumed during the period 1985 through 1998.

 

##### *Policy Benefit Reserves*

##### * *

We establishand carry as liabilities, actuarially determined reserves that we believe willmeet our future obligations.  Inaccordance with industry and accounting practices and applicable insurance lawsand regulatory requirements, we establish policy benefit reserves to recognizeour future benefit obligations for our in force life, disability and otherrelated policies.  We base the amounts ofthese reserves on actuarially recognized methods using prescribed morbidity andmortality tables in general use in the United States, which we modify toreflect our actual experience when appropriate. Reserves also include claims and claims expenses (the expenses of settlingclaims, including legal and other fees and the portion of general expensesallocated to claim settlement costs) reported but not yet paid, claims incurredbut not reported and claims in the process of settlement.

 

Policy benefitreserves, whether calculated under GAAP or SAP, do not represent an exactcalculation of future policy benefits and expenses but are instead estimatesmade using actuarial and statistical procedures.  We

 

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cannot assure you that any suchreserves will be sufficient to fund our future liabilities in allcircumstances.  Future loss developmentcould require reserves to be increased, which would adversely affect earningsin current and/or future periods. Adjustments to reserve amounts may be required in the event of changesfrom the assumptions regarding future morbidity, the incidence of disabilityclaims and the rate of recovery, taking into account the effects of inflationand other societal and economic factors, persistency, mortality, loss severityand the interest rates used in calculating the reserve amounts.  The reserves reflected in our consolidatedfinancial statements are calculated in accordance with GAAP.

 

We regularlyreview and update policy benefit reserves, using current information.  Any adjustments are reflected in currentresults of operations.  However, becausethe establishment of reserves is an inherently uncertain process, we cannot assureyou that ultimate losses will not exceed existing reserves.

 

#### **Investments**

#### ** **

Investmentreturns are an important part of our overall profitability.  For the year ended December 31, 2004, ourpredecessor’s net investment income was approximately $25.2 million (after aone-time incentive payment of $1.6 million to one of its outside investmentmanagers at the conclusion of the contract period) and our predecessor’s netrealized gains on investments were approximately $9.4 million, whichcollectively accounted for approximately 22.5% of our predecessor’s totalrevenues during this period.  As ofDecember 31, 2004, much of our investment portfolio consisted of fixedmaturity securities, such as corporate and government bonds, United StatesTreasury securities and asset backed debt securities, and less than 1% of ourinvestments were equity securities.  Aportion of our fixed income securities have equity components, which reducetheir current yield.  We intend to sellmany of these securities and reinvest the proceeds in higher yieldinginstruments that do not have equity components, which will likely result inhigher current earnings and reduced capital gains.

 

Significantfluctuations in the fixed income market, such as changes in interest ratescould impair our profitability, financial condition and/or cash flows.  In addition, the natural volatility of claimsmay force us to liquidate securities prior to maturity, which may cause us toincur capital losses.  Of our fixedmaturity securities, as of December 31, 2004, (1) 99.3% were scheduledto mature in more than twelve months and had a weighted-average interest rateof 5.07% and (2) 0.7% were scheduled to mature in less than twelve monthsand had a weighted-average interest rate of 4.83%.  We have attempted to structure our investmentportfolio so that its interest rate and maturity schedule are appropriatelymatched with its expected insurance liabilities to ensure that cash flows areavailable to pay claims as they become due. We intend to expand Kanawha’s pre-acquisition asset/liability matchingstrategy to reduce the adverse effects of interest rate volatility and toengage asset/liability management specialists to implement our asset/liabilitymatching strategy.  However, thesestrategies will not be able to completely eliminate, and may fail tosignificantly reduce, the adverse effects of interest rate volatility, and wecannot precisely predict the timing and magnitude of all claims.  Accordingly, we cannot assure you thatsignificant fluctuations in the level of interest rates and the unforeseentiming and magnitude of claims will not have a material adverse effect on ourbusiness, results of operations and financial condition.

 

We are subjectto credit risk in our investment portfolio, primarily from our investments incorporate bonds and preferred stocks. Defaults by third parties in the payment or performance of theirobligations could reduce our investment income and realized investment gains orresult in investment losses.  Further,the value of any particular fixed maturity security is subject to impairmentbased on the creditworthiness of the issuer. As of December 31, 2004, we held approximately $409.6 million of fixedmaturity securities, or approximately 88.8% of the carrying value of our totalinvested assets at that date.  Our fixedmaturity portfolio also includes below investment grade securities, whichcomprised approximately 2.2% of the carrying value of our total fixed maturitysecurities at December 31, 2004.  Theseinvestments generally provide higher expected returns but present greater riskand can be less liquid than investment grade securities.  A significant increase in defaults andimpairments on our fixed maturity securities portfolio could materiallyadversely affect our results of operations and financial condition.  Our predecessor’s other-than-temporaryimpairment losses on available-for-sale securities were approximately $0.7million for the year ended December 31, 2004.

 

As of December31, 2004, less than 1% of the carrying value of our total investments wasinvested in common stock; however, our predecessor had higher percentages ofcommon stock in its portfolio in the past and we may increase the percentage ofour portfolio that is invested in common stock in the future.  Investments in common

 

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stock generally provide highertotal returns, but present greater risk to preservation of principal than fixedincome investments.

 

We have in thepast invested, and we may in the future invest, in relatively illiquidsecurities including certain infrequently traded public fixed maturitysecurities, privately placed fixed maturity securities, mortgage loans, policyloans, limited partnership interests and real estate investments.  These asset classes represented approximately12.4% of the carrying value of our total cash and invested assets as ofDecember 31, 2004.  If we requiresignificant amounts of cash on short notice in excess of our normal cashrequirements, we may have difficulty selling these investments in a timelymanner, be forced to sell them for less than we otherwise would have been ableto realize, or both.  Our inability toquickly dispose of illiquid investments could have an adverse effect on ourbusiness, results of operations and financial condition.

 

Our investmentcommittee establishes our investment strategy, policies and guidelines forhiring external investment managers.  Ourinvestment committee consists of Kenneth U. Kuk, Scott H. DeLong III, StanleyD. Johnson, Alfred L.  Ferguson, RobertE. Matthews and R.  Dale Vaughan.  Our management, with the assistance ofexternal managers, implements our investment strategy.  The policies and guidelines set by ourinvestment committee will specify minimum criteria on the overall creditquality, liquidity and risk-return characteristics of our investment portfolioand include limitations on the size of particular holdings, as well asrestrictions on investments in different asset classes.  The investment committee monitors our overallinvestment returns, reviews compliance with our investment guidelines andreports overall investment results to our board of directors on a quarterlybasis.

 

Management ofour investment portfolio is a critical part of our business strategy andmaterially affects our profitability. Investment decision making is guided mainly by the nature and timing ofour expected liability payouts, management’s forecast of our cash flows and thepossibility of unexpected cash demands such as unexpected insured losses.  However, to the extent our insuranceliabilities are correlated with an asset class outside our minimum criteria,our investment guidelines allow us to deviate from those minimum criteriaprovided such deviations reduce overall risk. Our fundamental investment philosophy is to manage assets within ourstated risk parameters to generate consistent levels of investment income withcompetitive risk-adjusted returns over the long-term.  In accordance with our investment strategy,we seek to:

 

**•**                  preserveprincipal and maintain liquidity while generating above-average returns on arisk-adjusted basis, through a high quality, diversified portfolio;

 

**•**                  managecredit, interest rate, prepayment and market risks;

 

**•**                  mandatethat our investment portfolio consist mainly of highly rated and liquid fixedincome securities, with adequate diversification among asset classes, industryconcentrations and individual issuers; and

 

**•**                  adhereto all applicable regulatory requirements and laws.

 

Historically,our predecessor did not use financial futures, forwards, options, swaps orother derivative financial instruments. Without the approval of our board of directors, we will not purchasefinancial futures, forwards, options, swaps and other derivatives, except forpurposes of hedging capital market risks or replication transactions, which aredefined as a set of derivative and securities transactions that, when combined,produce the equivalent economic results of an investment meeting our minimumcriteria.

 

#### **Regulation**

#### ** **

*General. *Ourinsurance operations are subject to a wide variety of laws and regulations.South Carolina and other state insurance laws regulate most aspects of ourinsurance businesses.  We are regulatedby the insurance department of South Carolina, the state in which our insurancesubsidiary is domiciled, and by the insurance department of each state in whichwe are licensed.  At the present time, weare licensed to transact business in 45 states. Our insurance products and ourbusinesses also are affected by some United States federal laws.

 

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The purpose ofthe laws and regulations affecting our insurance businesses is primarily toprotect our customers and not our shareholders. Many of the laws and regulations to which we are subject are regularlyre-examined, and existing or future laws and regulations may become morerestrictive or otherwise adversely affect our operations.

 

In addition,insurance and securities regulatory authorities (including state lawenforcement agencies and attorneys general) from time to time may make inquiriesregarding compliance by us and our subsidiaries with insurance and other lawsand regulations regarding the conduct of our insurance businesses.  We will cooperate with such inquiries andtake corrective action when warranted.

 

##### *State Regulation*

##### * *

*General*. We are subject to regulation in the various states and jurisdictions inwhich we transact business.  The extentof regulation varies, but generally derives from statutes that delegateregulatory, supervisory and administrative authority to a department ofinsurance in each state.  The regulation,supervision and administration relate, among other things, to:

 

**•**                  standardsof solvency that must be met and maintained;

 

**•**                  thepayment of dividends;

 

**•**                  changesof control of insurance companies;

 

**•**                  thelicensing of insurers and their agents;

 

**•**                  thetypes of insurance that may be written;

 

**•**                  guarantyfunds;

 

**•**                  privacypractices;

 

**•**                  theability to enter and exit various insurance markets;

 

**•**                  thenature of and limitations on investments, premium rates, or restrictions on thesize of risks that may be insured under a single policy;

 

**•**                  reservesand provisions for unearned premiums, losses and other obligations;

 

**•**                  depositsof securities for the benefit of policyholders;

 

**•**                  paymentof sales compensation to third parties;

 

**•**                  approvalof policy forms; and

 

**•**                  theregulation of market conduct, including underwriting and claims practices.

 

Stateinsurance departments also conduct periodic examinations of the affairs ofinsurance companies and require the filing of annual and other reports,prepared under SAP, relating to the financial condition of companies and othermatters.

 

*Regulation of Health Insurance Products*.  State regulation of health insurance productsvaries from state to state, although all states regulate premium rates, policyforms and underwriting and claims practices to one degree or another.  Most states have special rules for healthinsurance sold to individuals and small groups. For example, a number of states have passed or are considering legislationthat would limit the differentials in rates that insurers could charge forhealth care coverages between new business and renewal business for smallgroups with similar

 

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demographics.  Every state has also adopted legislation thatwould make health insurance available to all small employer groups by requiringcoverage of all employees and their dependents, by limiting the applicabilityof pre-existing conditions exclusions, by requiring insurers to offer a basicplan exempt from certain benefits as well as a standard plan, or byestablishing a mechanism to spread the risk of high risk employees to all smallgroup insurers.  The United StatesCongress and various state legislators have from time to time proposed changesto the health care system that could affect the relationship between healthinsurers and their customers, including external review.  In addition, various states are consideringthe adoption of “play or pay” laws requiring that employers either offer healthinsurance or pay a tax to cover the costs of public health care insurance. Wecannot predict with certainty the effect that any proposals, if adopted, orlegislative developments could have on our insurance businesses and operations.

 

A number ofstates have enacted new health insurance legislation over the past severalyears.  These laws, among other things,mandate benefits with respect to some diseases or medical procedures, requirehealth insurers to offer an independent external review of certain coveragedecisions and establish health insurer liability.  There has also been an increase inlegislation regarding, among other things, prompt payment of claims, privacy ofpersonal health information, health insurer liability and relationships betweenhealth insurers and providers.  We expectthat this trend of increased legislation will continue.  These laws may have the effect of increasingour costs and expenses.

 

*Regulation of Employee Benefits Products*.  State regulation of non-medical groupproducts, including group term life insurance, group disability and groupdental products, also varies from state to state. As with individual insuranceproducts, the regulation of these products generally also includes oversightover premium rates and policy forms, but often to a lesser degree. Theregulatory environment for group term life insurance is relatively established,with few significant changes from year to year.

 

Grouppreferred provider organization (“PPO”) dental insurance policies are generallyregulated in the same manner as non-PPO dental policies, except to the extentthat a small number of states have chosen to restrict the difference inbenefits allowable between in-network and out-of-network services.  Also, some states directly regulate theoperation of the PPO network by requiring separate licensing or registrationfor the organization that contracts with the providers of dental care.  In those states, PPOs also must comply withvarying levels of regulatory oversight concerning the content of PPO contractsand provider practice standards.  Most ofthe states in which prepaid dental plans are written recognize prepaid dentalplans as an activity separate from traditional insurance, because providers arecompensated through capitation arrangements. In most of these states, prepaid dental plans are written by a single-purpose,single-state affiliate that holds a license distinct from the life and healthinsurance license required for group dental insurance policies.  Entities providing prepaid plans arevariously licensed as health maintenance organizations (“HMOs”), prepaid dentalplans, limited service health plans, life and health insurers or risk-bearingPPOs, where such licenses are required. Each state has different rules regarding organization, capitalizationand reporting for the separate entities, with additional variations relating toprovider contracting, oversight, plan management and plan operations.

 

Providers ofgroup disability and dental insurance, like providers of group healthinsurance, are subject to state privacy laws, claims processing rules and “promptpay” requirements in various states.

 

As anextension of past legislative activities in the medical insurance arena,legislative and regulatory consideration, at both the federal and state levels,is being directed toward an effort to mandate what its proponents call “mentalhealth parity” in the policy provisions of group disability insuranceplans.  This would require providers ofgroup disability insurance to extend the same benefits for disabilities relatedto mental illness as are provided for other disabilities.

 

Group benefitplans and the claims thereunder are also largely subject to federal regulationunder ERISA, a complex set of laws and regulations subject to interpretationand enforcement by the Internal Revenue Service, the Department of Labor andother federal agencies.  ERISA regulatescertain aspects of the relationships between us and employers who maintain employeebenefit plans subject to ERISA.  Some ofour administrative services and other activities may also be subject toregulation under ERISA.

 

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*Insurance Holding Company Statutes*.  Although as a holding company, KMG America isnot regulated as an insurance company, it owns all of the capital stock ofKanawha, its insurance subsidiary, and therefore is subject to the stateinsurance holding company statute, as well as certain other laws, of SouthCarolina (the state of domicile of Kanawha). The holding company statute, as well as other laws, require disclosureand, in some instances, prior approval of material transactions between aninsurance company and an affiliate.  Theholding company statute and other laws also require, among other things, priorapproval of an acquisition of control of a domestic insurer, some transactionsbetween affiliates and the payment of extraordinary dividends or distributions.

 

*Insurance Regulation Concerning Dividends*.  The payment of dividends to us by ourinsurance subsidiary in excess of a specified amount (i.e., extraordinarydividends) must be approved by the South Carolina state department ofinsurance.  Extraordinary dividends, forwhich regulatory approval is required, include dividends whose fair marketvalue together with that of other dividends made within the preceding twelvemonths: (a) when paid from other than earned surplus, exceed the lesser of(1) ten percent of the insurer’s surplus as regards policyholders or(2) the net gain from operations, not including net realized capital gainsor losses; or (b) when paid from earned surplus, exceed the greater of (1)ten percent of the insurer’s surplus as regards policyholders or (2) thenet gain from operations, not including net realized capital gains orlosses.  If insurance regulatorsdetermine that payment of an ordinary dividend or any other payments by our insurancesubsidiary to us (such as payments under a tax sharing agreement or paymentsfor employee or other services) would be adverse to policyholders or creditors,the regulators may block such payments that would otherwise be permittedwithout prior approval.

 

*Statutory Accounting Principles*.  SAP is a basis of accounting developed toassist insurance regulators in monitoring and regulating the solvency ofinsurance companies.  It is primarilyconcerned with measuring an insurer’s statutory surplus.  Accordingly, SAP focuses on valuing assetsand liabilities of insurers at financial reporting dates in accordance withappropriate insurance law and regulatory provisions applicable in each insurer’sdomiciliary state.

 

GAAP isconcerned with a company’s solvency, but it is also concerned with other financialmeasurements, such as income and cash flows. GAAP gives more consideration to appropriate matching of revenue andexpenses and accounting for management’s stewardship of assets than doesSAP.  As a direct result, differentassets and liabilities and different amounts of assets and liabilities will bereflected in financial statements prepared in accordance with GAAP as opposedto SAP.

 

SAP, asestablished by the National Association of Insurance Commissioners, or NAIC,and adopted, for the most part, by the various state insurance regulators, isused to determine, among other things, the amount of statutory surplus andstatutory net income our insurance subsidiary has.  Accordingly, SAP is used to determine, in part,the amount of funds our insurance subsidiary will have available to pay asdividends to us.

 

*Assessments for Guaranty Funds*.  Virtually all states require insurerslicensed to do business in their state to bear a portion of the loss sufferedby some insureds as a result of the insolvency of other insurers.  Depending upon state law, insurers can beassessed an amount that is generally equal to between one percent and threepercent of premiums written for the relevant lines of insurance in that stateeach year to pay the claims of an insolvent insurer.  A portion of these payments is recoverablethrough premium rates, premium tax credits or policy surcharges.  Significant increases in assessments couldlimit the ability of our insurance subsidiary to recover such assessmentsthrough tax credits or other means.  Inaddition, there have been some legislative efforts to limit or repeal the taxoffset provisions, which efforts, to date, have been generallyunsuccessful.  These assessments areexpected to increase in the future as a result of recent insolvencies.

 

*Insurance Regulations Concerning Change of Control*.  Many state insurance regulatory laws intendedprimarily for the protection of policyholders contain provisions that requireadvance approval by the state insurance commissioner of any change in controlof an insurance company that is domiciled, or, in some cases, having suchsubstantial business that it is deemed to be commercially domiciled, in thatstate.  Prior to granting such approval,the state insurance commissioner will consider such factors as the financialstrength of the applicant, the integrity of the applicant’s board of directorsand executive officers, the applicant’s plans for the future operations of thedomestic insurer and any anti-competitive results that may arise from theconsummation of the acquisition of control. We own all of the shares of stock of an insurance company domiciled inthe state of South Carolina. Under the applicable South Carolina law, “control”is generally presumed to exist through the ownership of ten percent or

 

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more of the voting securitiesof a domestic insurance company or of any company that controls a domesticinsurance company.  Any purchaser ofshares of common stock representing ten percent or more of the voting power ofour capital stock will be presumed to have acquired control of our insurancesubsidiary unless, following application by that purchaser in South Carolina,the insurance commissioner of South Carolina determines otherwise.

 

In addition tothese filings, the laws of many states contain provisions requiringpre-notification to state agencies prior to any change in control of anon-domestic insurance company admitted to transact business in that state.  While these pre-notification statutes do notauthorize the state agency to disapprove the change of control, they doauthorize issuance of cease and desist orders with respect to the non-domesticinsurer if it is determined that some conditions, such as undue market concentration,would result from the acquisition.

 

Any futuretransactions that would constitute a change in control of our insurancesubsidiary would generally require prior approval by the insurance departmentof the State of South Carolina, in which our insurance subsidiary is domiciled,and any other state where our insurance subsidiary will be consideredcommercially domiciled and may require pre-acquisition notification in thosestates that have adopted pre-acquisition notification provisions and in whichour insurance subsidiary will be admitted to transact business.

 

Theserequirements may deter, delay or prevent transactions affecting the control ofour common stock, including transactions that could be advantageous to ourshareholders.

 

*Insurance Regulatory Information System*.  The NAIC Insurance Regulatory InformationSystem (“IRIS”) was developed to help state regulators identify companies thatmay require special attention.  IRISconsists of a statistical phase and an analytical phase whereby financial examinersreview annual statements and financial ratios. The statistical phase consists of 12 key financial ratios based onyear-end data that are generated from the NAIC database annually; each ratiohas an established “usual range” of results. These ratios assist state insurance departments in executing theirstatutory mandate to oversee the financial condition of insurance companies.

 

A ratio resultfalling outside the usual range of IRIS ratios is not considered a failingresult; rather, unusual values are viewed as part of the regulatory earlymonitoring system. Furthermore, in some years, it may not be unusual forfinancially sound companies to have several ratios that fall outside the usualranges. Generally, an insurance company will become subject to regulatoryscrutiny if it falls outside the usual ranges of four or more of the ratios.

 

*Risk-Based Capital (“RBC”) Requirements*.  In order to enhance the regulation of insurersolvency, the NAIC has adopted formulas and model laws to implement RBC requirementsfor life and health insurers and for health organizations.  These formulas and model laws are designed todetermine minimum capital requirements and to raise the level of protectionthat statutory surplus provides for policyholder obligations.

 

Under lawsadopted by individual states, insurers having less total adjusted capital(generally, as defined by the NAIC) than that required by the relevant RBCformula will be subject to varying degrees of regulatory action, depending onthe level of capital inadequacy.  The RBClaws provide for four levels of regulatory action.  The extent of regulatory intervention andaction increases as the ratio of total adjusted capital to RBC falls.  The first level, the company action level,requires an insurer to submit a plan of corrective actions to the regulator iftotal adjusted capital falls below 200% of the RBC amount (or below 250%, whenthe insurer has a “negative trend” as defined under the RBC laws).  The second level, the regulatory actionlevel, requires an insurer to submit a plan containing corrective actions andrequires the relevant insurance commissioner to perform an examination or otheranalysis and issue a corrective order if total adjusted capital falls below150% of the RBC amount.  The third level,the authorized control level, authorizes the relevant insurance commissioner totake whatever regulatory actions he or she considers necessary to protect thebest interests of the policyholders and creditors of the insurer, which mayinclude causing the insurer to be placed under regulatory control, i.e.,rehabilitation or liquidation, if total adjusted capital falls below 100% ofthe RBC amount.  The fourth action levelis the mandatory control level, which requires the relevant insurancecommissioner to place the insurer under regulatory control if total adjustedcapital falls below 70% of the RBC amount. The formulas have not been designed to differentiate among adequatelycapitalized companies that operate with higher levels of capital.  Therefore, we believe it is inappropriate andineffective to use the formulas to rate or to rank these companies.

 

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##### *Federal Regulation*

##### * *

*General.* In 1945, the United States Congress enacted the McCarran-Ferguson Act whichdeclared the regulation of insurance to be primarily the responsibility of theindividual states.  Although repeal ofMcCarran-Ferguson is debated in the United States Congress from time to time,currently, the federal government generally does not directly regulate theinsurance business.  However, federallegislation and administrative policies in several areas, including healthcare,pension regulation, age and sex discrimination, financial services regulation, securitiesregulation, privacy laws, terrorism and federal taxation, do affect theinsurance business.

 

*The Health Insurance Portability and Accountability Act of 1996 (“HIPAA”)*.  As with other lines of insurance, theregulation of health insurance historically has been within the domain of the states.  However, HIPAA and the implementingregulations promulgated thereunder by the Department of Health and HumanServices impose new obligations for issuers of health and dental insurancecoverage and health and dental benefit plan sponsors.  HIPAA requires certain guaranteed issuanceand renewability of health insurance coverage for individuals and smallemployer groups (generally 50 or fewer employees) and limits exclusions basedon pre-existing conditions.  Most of theinsurance reform provisions of HIPAA became effective for plan years beginningon or after July 1, 1997.

 

HIPAA alsoestablishes new requirements for maintaining the confidentiality and securityof individually identifiable health information and new standards forelectronic health care transactions.  TheDepartment of Health and Human Services promulgated final HIPAA regulations in2002.  The privacy regulations wererequired to be complied with by April 2003, the electronic transactionsregulations by October 2003 and the security regulations by April2005.  Similar to other entities in thehealth care industry, we and our predecessor have incurred substantial costs inmeeting the requirements of these HIPAA regulations and we expect we will continueto incur costs to achieve and to maintain compliance.  We and our predecessor have been workingdiligently to comply with these regulations in the time periods required.  However, we cannot assure you that we willachieve such compliance with all of the required transactions or that other entitieswith which we interact will take appropriate action to meet the compliancedeadlines.  Moreover, as a consequence ofthese new standards for electronic transactions, we may see an increase in thenumber of health care transactions that are submitted to us in paper format,which could increase our costs to process medical claims.

 

HIPAA isfar-reaching and complex, and proper interpretation and practice under the lawcontinue to evolve. Consequently, our efforts to measure, monitor and adjustour business practices to comply with HIPAA will be ongoing. Failure to complycould result in regulatory fines and civil lawsuits. Knowing and intentionalviolations of these rules may also result in federal criminal penalties.

 

*USA PATRIOT Act*.  On October 26, 2001, the InternationalMoney Laundering Abatement and Anti-Terrorist Financing Act of 2001 was enactedinto law as part of the USA PATRIOT Act. Among its many provisions, the law requires that financial institutionsadopt anti-money laundering programs that include policies, procedures andcontrols to detect and prevent money laundering, designate a compliance officerto oversee the program and provide for employee training, and periodic auditsin accordance with regulations proposed by the United States TreasuryDepartment.  Proposed Treasuryregulations governing portions of our life insurance business would require usto develop and implement procedures designed to detect and prevent moneylaundering and terrorist financing.  Wewill be subject to United States regulations that prohibit business dealingswith entities identified as threats to national security.  There are significant criminal and civilpenalties that can be imposed for violation of Treasury regulations.  We believe that the steps we will take tocomply with the current regulations and to prepare for compliance with theproposed regulations should be sufficient to minimize the risks of suchpenalties.

 

*Gramm-Leach-Bliley Act*.  On November 12, 1999, the Gramm-Leach-BlileyAct of 1999 became law, implementing fundamental changes in the regulation ofthe financial services industry in the United States.  The act permits the transformation of thealready converging banking, insurance and securities industries by permittingmergers that combine commercial banks, insurers and securities firms under oneholding company.  Under the act, nationalbanks retain their existing ability to sell insurance products in somecircumstances.  In addition, bank holdingcompanies that qualify and elect to be treated as “financial holding companies”may engage in activities, and acquire companies engaged in activities, that are“financial” in nature or “incidental” or “complementary” to such financialactivities, including acting as principal, agent or broker in selling life,property and casualty and other forms of insurance.  A financial holding company can own any kindof insurance company or insurance broker or

 

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agent, but its bank subsidiarycannot own the insurance company.  Understate law, the financial holding company would need to apply to the insurancecommissioner in the insurer’s state of domicile for prior approval of theacquisition of the insurer, and the act provides that the commissioner, inconsidering the application, may not discriminate against the financial holdingcompany because it is affiliated with a bank. Under the act, no state may prevent or interfere with affiliationsbetween banks and insurers, insurance agents or brokers, or the licensing of abank or affiliate as an insurer or agent or broker.  Privacy provisions of the act became fullyeffective in 2001.  These provisionsestablished consumer protections regarding the security and confidentiality ofnonpublic personal information and require us to make full disclosure of ourprivacy policies to our customers.

 

*ERISA Considerations*.  We provide some products and services toemployee benefit plans that are subject to ERISA or the Internal RevenueCode.  As such, our activities are subjectto the restrictions imposed by ERISA and the Internal Revenue Code, includingthe requirement under ERISA that fiduciaries must perform their duties solelyin the interests of ERISA plan participants and beneficiaries and therequirement under ERISA and the Internal Revenue Code that fiduciaries may notcause a covered plan to engage in certain prohibited transactions with personswho have certain relationships with respect to such plans.  The applicable provisions of ERISA and theInternal Revenue Code are subject to enforcement by the United StatesDepartment of Labor, the IRS and the Pension Benefit Guaranty Corporation.  To the extent ERISA is applicable to aninsurance product, such insurance product is exempt from state regulations thatare inconsistent with ERISA.  However,such exemption is subject to legislative change and to court decisions that maynarrow the scope of the exemption.

 

#### **Employees**

#### ** **

As of December31, 2004, we had approximately 464 employees, a significant number of which arebased in our Lancaster, South Carolina facilities.  We plan to hire additional sales personneland related employees to staff regional and field offices in select locationsthroughout the United States as we continue to develop a nationwide worksitemarketing business.  We expect that wewill continue to hire additional employees as we expand our business.

 

#### **Risks and Uncertainties**

#### ** **

Theinformation presented in Exhibit 99.01 to this report is incorporated herein byreference.  In addition, the informationpresented in Item 7 of this report is incorporated herein by reference.

 

#### **Environmental Compliance**

#### ** **

We haveinvested, and we intend to invest, in real estate and maintain a mortgage loanportfolio.  As of December 31, 2004, 5.1%of our investment assets were mortgage loans and we did not have any realestate investments, although we do own and occupy a group of buildings inLancaster, South Carolina where our primary operations are located and anoffice building in Fort Mill, South Carolina. Liability resulting from environmental problems at properties securingour mortgage loan portfolio and real estate investments or other owned realestate may harm our financial strength and reduce our profitability.  Under the laws of several states,contamination of a property may give rise to a lien on the property to securerecovery of the costs of the cleanup.  Insome states, this kind of lien has priority over the lien of an existingmortgage against the property, which would impair our ability to foreclose onthat property should the related loan be in default.  In addition, under the laws of some statesand under the federal Comprehensive Environmental Response, Compensation andLiability Act of 1980 (“CERCLA”), under certain circumstances, we may be liablefor costs of addressing releases or threatened releases of hazardous substancesthat require remedy at a property securing a mortgage loan held by us.  We also may face this liability afterforeclosing on a property securing a mortgage loan held by us after a loandefault.

 

Under CERCLAand other applicable environmental laws, we will be liable for environmentalconditions, damages and remediation of property owned by us, even if theliability arises from the actions or conduct of previous owners of theproperty, including the actions or conduct of Kanawha prior to our acquisitionof all of its capital stock.  Althoughthe former shareholders and optionholders of Kanawha have agreed to indemnifyus for some environmental losses we incur with respect to the real property thatwe acquired when we acquired Kanawha, this protection is limited, and we willbe exposed to liability for environmental conditions existing on real property

 

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prior to our acquisition ofKanawha to the extent this liability exceeds such indemnification coverage orto the extent that we are not indemnified against this liability.

 

#### **Financial Strength Ratings**

#### ** **

Ratings byindependent agencies are an important factor in establishing the competitiveposition of insurance companies and will continue to be important to ourability to market and sell our products in the future. Rating organizationscontinually review the financial positions of insurers, including Kanawha, ourinsurance subsidiary.  Insurance companiesare assigned financial strength ratings by independent rating agencies basedupon factors relevant to policyholders. Ratings provide both industry participants and insurance consumersmeaningful information on specific insurance companies and are an importantfactor in establishing the competitive position of insurance companies.  Kanawha is currently rated by A.M. Best andStandard & Poor’s. A.M. Best maintains a letter scale rating system ranging from A++ (superior)to F (in liquidation) while S&P maintains a letter scale rating systemranging from AAA (extremely strong) to R (under regulatory supervision).

 

Currently,Kanawha has an A.M. Best financial strength rating of A- (excellent),which is the second highest of ten categories within the A.M. Best ratingsystem and the lowest in the category “excellent.”  S&P’s current financial strength ratingfor Kanawha is A- (strong), with a stable outlook, which is the third highestof nine categories and the lowest within the category based on modifiers (i.e.,A+, A and A- are strong).

 

The objectiveof A.M. Best’s and S&P’s ratings systems is to assist policyholders and toprovide an opinion of an insurer’s financial strength, operating performance,competitive position and ability to meet ongoing obligations to itspolicyholders.  These ratings reflect theopinions of A.M. Best and S&P of our ability to pay policyholder claims andare not a recommendation to buy, sell or hold any security, including ourcommon stock.  These ratings are subjectto periodic review by and may be revised upward, downward or revoked at thesole discretion of A.M. Best and S&P.

 

#### **Administration**

#### ** **

We believe oneof the factors that enables us to compete effectively against other worksiteinsurance providers is our third-party administration business, whichadministers both our underwritten insurance products and products underwrittenby other insurance companies.  Weanticipate that for the foreseeable future, various administrative functions ofours will continue to be performed internally given our expertise inadministrative services and relatively low-cost operating locations in SouthCarolina.  Our predecessor entered intoan agreement in 2003 to outsource a substantial portion of its informationtechnology and document management functions to CGI InformationSystems & Management Consultants, Inc., after giving consideration tothe relative cost implications of retaining these functions internally oroutsourcing them to a third-party.  Theterm of this agreement is 10 years, and it may be terminated by us withoutcause starting November 2006 upon six months’ notice and at any time upon 30days’ notice for cause that remains uncured. We believe the combination of our internal administrative capabilitiesand our outsourced administrative functions will provide us with an optimal mixof flexibility and cost efficiencies.

 

#### **Trademarks and Intellectual Property**

#### ** **

As standardpractice, we and our predecessor have obtained the legal protections believedto be appropriate for our intellectual property.  We do not believe any of our intellectualproperty rights are material to our business. We are not aware of any legal proceedings that have been brought againstus for infringement of intellectual property rights.

 

#### **AVAILABILITY OF REPORTS, CERTAIN COMMITTEECHARTERS AND OTHER INFORMATION**

#### ** **

Our Internetwebsite address is www.kmgamerica.com. We make available free of charge on this website, via a link to the SEC’swebsite, access to our annual report on Form 10-K, quarterly reports on Form10-Q, current reports on Form 8-K and amendments to those reports, as well asother documents that we file with or furnish to the SEC pursuant to Sections13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon asreasonably

 

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practicable after suchdocuments are filed with, or furnished to, the SEC.  The information on our website is not, andshall not be deemed to be, a part of this report or incorporated into any otherfilings we make with the SEC.

 

The chartersfor our Audit, Compensation, and Corporate Governance and NominatingCommittees, as well as our Code of Business Conduct and Ethics and CorporateGovernance Guidelines, are available on our website at www.kmgamerica.com.  We will also provide without charge printedcopies of these materials, including any exhibits thereto, to any shareholder,upon request to KMG America Corporation, 12600 Whitewater Drive, Suite 150,Minnetonka, Minnesota 55343, Attention: Chief Financial Officer.  Ourtelephone number is (952) 930-4800.

** **

## **ITEM 2.**                             PROPERTIES.

##  

We own sixoffice buildings in Lancaster, South Carolina, where most of our operations arelocated.  We also own an office buildingin Fort Mill, South Carolina.  Our ownedproperties had an aggregate book value of approximately $6.8 million as ofDecember 31, 2004.  We lease offices inGreenville, South Carolina, where a processing center of our third-partyadministration business is located; Fort Myers, Florida, where our long-termcare insurance sales office is located; Irvine, California, where a regionalsales office and offices for a senior sales manager are located; Boston,Massachusetts, where a regional sales office and offices for a senior salesmanager are located, and Celina, Ohio and Chester, South Carolina, whereregional sales offices are located.  Wealso lease work space used as regional sales offices in Chicago, Illinois; NewYork, New York; Tampa, Florida; Atlanta, Georgia; Dallas, Texas; and Cleveland,Ohio.

 

We also leaseour principle executive offices in Minnetonka, Minnesota, a suburb ofMinneapolis, where some members of our executive management team, some holdingcompany and underwriting operations and a regional sales office are or will belocated.  As we expand our operations, weintend to execute leases for facilities in select locations throughout theUnited States that will house regional and field offices of our salesorganization.

 

## **ITEM 3.**                             LEGAL PROCEEDINGS.

##  

We are not involved in any material legalproceedings nor, to our knowledge, are any material legal proceedings pendingor threatened against us.  We aretypically subject to routine actions and administrative proceedings, which weexpect to be covered by liability insurance and which, in the aggregate, we donot expect to have a material adverse effect on our business or financialposition, results of operations or cash flows.

 

On February 18, 2005, a complaint was filedby plaintiffs ReliaStar Life Insurance Company and ReliaStar Life InsuranceCompany of New York, both indirect wholly-owned subsidiaries of ING America US,in the Fourth Judicial District Court in Hennepin County, Minnesota, againstKMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and anotherindividual.  Messrs. Kuk, Kraemer and Mooreare officers of KMG America and former employees of the plaintiffs.  The complaint alleges misappropriation oftrade secrets, conversion, tortious interference with business and employmentrelationships, breach of fiduciary duties and breach of contract by KMGAmerica, Kanawha and Messrs. Kuk, Kraemer, and Moore.  The complaint seeks injunctive relief andunspecified monetary damages.  We believethe allegations are without merit and intend to defend the actionvigorously.  While the outcome of legalactions cannot be predicted with certainty, we believe the outcome of thismatter will not have a material adverse effect on our consolidated financialposition or results of operations.

 

## **ITEM 4.**                             SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS.

##  

No matter wassubmitted to a vote of our security holders from December 21, 2004, thecompletion date of our initial public offering, through December 31, 2004, thelast day of our 2004 fourth quarter.

 

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# **PART II**

#  

| **ITEM 5.** | ** ** | **MARKET FOR REGISTRANT’S COMMON  EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY  SECURITIES.** |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------|

 

#### **Market Information**

#### ** **

Our commonshares began trading on the New York Stock Exchange on December 16, 2004, underthe symbol “KMA.”  As of December 31,2004, the last reported closing price per common share on the New York StockExchange was $11.00.  The following tablesets forth the high and low sales price per common share reported on the NewYork Stock Exchange as traded and the dividends paid on the common shares fromDecember 16, 2004, through December 31, 2004.

 
| ** **                                  | ** ** | **Price Range** | ** ** | **Cash Dividend** | ** ** |
|---------------------------------------------|------------|-----------------|------------|-------------------|------------|
| ** **                                  | ** ** | **High**        | ** ** | **Low**           | ** ** | **Per Share** | ** ** |
|                                        |       |            |       |              |       |   |   |
| December 16, 2004 through December 31, 2004 |       | $               | 11.00      |              | $          | 10.41 |   | $ | 0.00 |   |
|                                             |            |                 |            |                   |            |  |  |  |  |  |

 

#### **Shareholder Information**

#### ** **

As of March 1,2005, we had approximately six holders of record of our common shares.  Our registrar and transfer agent is WachoviaBank, National Association.

 

#### **Dividends**

#### ** **

As a holdingcompany whose principal asset is the capital stock of Kanawha and our indirect subsidiaries,we rely primarily on dividends and other statutorily permissible payments fromour subsidiaries to meet our obligations for payment of interest and principalon outstanding debt obligations, dividends to shareholders (including anydividends on our common stock) and corporate expenses.  The ability of Kanawha and our othersubsidiaries to pay dividends and to make such other payments in the futurewill depend on their statutory surplus (which is the excess of assets overliabilities as determined in accordance with statutory accounting principlesset by state insurance regulatory authorities), future statutory earnings(which are earnings as determined in accordance with statutory accountingprinciples) and regulatory restrictions.

 

Kanawha is subjectto state insurance laws and regulations and extensive regulatory oversight,including regulations that limit the amount of dividends and otherdistributions it can pay to KMG America, and consequently, that KMG America canpay to its shareholders.  The payment ofdividends to KMG America by Kanawha in excess of a certain amount (i.e.,extraordinary dividends) must be approved by the State of South Carolinadepartment of insurance.  Extraordinarydividends, for which regulatory approval is required, include dividends whosefair market value together with that of other dividends made within thepreceding twelve months: (1) when paid from other than earned surplus, exceedthe lesser of (a) ten percent of the insurer’s surplus as regards policyholdersor (b) the net gain from operations, not including net realized capitalgains or losses; or (2) when paid from earned surplus, exceed the greater of(a) ten percent of the insurer’s surplus as regards policyholders or(b) the net gain from operations, not including net realized capital gainsor losses.  If insurance regulatorsdetermine that payment of an ordinary dividend or any other payments by ourinsurance subsidiary to us (such as payments under a tax sharing agreement orpayments for employee or other services) would be adverse to policyholders orcreditors, the regulators may block such payments that would otherwise bepermitted without prior approval.  Wecannot assure you that there will not be further regulatory actions restrictingthe ability of our insurance subsidiary to pay dividends.  If the ability of our insurance subsidiary topay dividends or make other payments to us is materially restricted byregulatory requirements, it could adversely affect our ability to pay anydividends on our common stock and/or service our debt and pay our othercorporate expenses.

 

Ournon-insurance subsidiaries generally are not subject to state insurance laws,regulations and oversight.  However,because our non-insurance subsidiaries are owned, directly or indirectly, byKanawha, any dividends or

 

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distributions that Kanawhareceives from them are subject to state insurance regulations that limitdividends and distributions that Kanawha can make to KMG America, andconsequently, that KMG America can pay to its shareholders.

 

We currentlyintend to retain any profits to provide capacity to write insurance andreinsurance and to accumulate reserves and surplus for the payment ofclaims.  As a result, our board of directorscurrently does not intend to declare dividends or make any otherdistributions.  Our board of directorsplans to periodically reevaluate our dividend policy.  Any determination to pay dividends in thefuture will be at the discretion of our board of directors and will depend uponour results of operations, financial condition and other factors deemedrelevant by our board of directors. Consequently, it is uncertain when, if ever, we will declare dividendsto our shareholders.

 

#### **Common Stock Authorized for Issuance UnderOur 2004 Equity Incentive Plan**

#### ** **

Prior to our initial public offering, ourshareholders approved one equity compensation plan, the KMG America Corporation2004 Equity Incentive Plan.  Thefollowing table summarizes information with respect to the plan as of December31, 2004:

 

**Equity Compensation PlanInformation**

 
| **Plan  Category**                                          | ** ** | **Number of securities to be**

** issued  upon exercise of**

**outstanding options,**

**warrants and rights** | ** ** | **Weighted-average  exercise price of  outstanding options,  warrants and rights** | ** ** | **Number  of securities  which remain available  for future issuance  under the equity  compensation plans  (excluding securities  reflected in column (a))** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                  | ** ** | **(a)**                                                                                                               | ** ** | **(b)**                                                                            | ** ** | **(c)**                                                                                                                                                       | ** ** |
| Equity compensation plans approved by  security holders     |       | 1,246,000                                                                                                             |       | $                                                                                  | 9.50       |                                                                                                                                                          | 850,806    |   |
| Equity compensation plans not approved by  security holders |       | —                                                                                                                |       | —                                                                             |       | —                                                                                                                                                        |       |
| Total                                                       |       | 1,246,000                                                                                                             |       | $                                                                                  | 9.50       |                                                                                                                                                          | 850,806    |   |

 

We have noequity compensation plan that has not been approved by our shareholders.

 

#### **Recent Sales of Unregistered Securities**

#### ** **

We were formedon January 21, 2004.  In connection withour formation and capitalization prior to our initial public offering of commonstock, we issued 223,241 shares of our common stock to Kenneth U. Kuk, ourChairman, President & Chief Executive Officer, and 63,006 shares of ourcommon stock to Scott H. DeLong III, our Senior Vice President & ChiefFinancial Officer.  In addition, ourother initial shareholders purchased an aggregate of 50,395 shares of ourcommon stock.  All of these shares werepurchased in April and May 2004 for $0.01 per share and were issued in privateplacements exempt from registration under Section 4(2) of the Securities Act.

 

#### **Uses of Proceeds of Sale of RegisteredSecurities**

#### ** **

In our initialpublic offering, we issued 21,735,000 shares of common stock, par value $0.01per share, pursuant to registration statement no. 333-117911, which wasdeclared effective by the Securities and Exchange Commission on December 14,2004.  Our initial public offeringcommenced on December 15, 2004, and closed on December 21, 2004.  The managing underwriters for the offeringwere Friedman, Billings, Ramsey & Co., Inc., Credit Suisse First Boston,LLC, and SunTrust Capital Markets, Inc. The aggregate offering price of the shares offered was approximately $206.5million, and all of the offered shares were sold for an aggregate amount ofapproximately $206.5 million.

 

From December14, 2004, to December 31, 2004, we incurred approximately $18.5 million inexpenses in connection with the issuance and distribution of the registeredcommon stock, including the payment of a $14.4 million underwriting discount,approximately $0.7 million in other expenses paid to or for the underwriters,and $3.4

 

34

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million in other offering-relatedexpenses.  $0.8 million of these expenseswere paid to our directors or officers or their associates for reimbursement ofexpenses incurred prior to the closing of the offering.

 

The netproceeds from our initial public offering of common stock, after deducting theunderwriting discount and offering expenses payable by us, were approximately$188.0 million.  From December 21, 2004,to December 31, 2004, we did not use any of the net offering proceeds forconstruction of plant, building and facilities, for the purchase andinstallation of machinery and equipment or for the repayment ofindebtedness.  We used $130.0 million ofthe net proceeds to fund the cash portion of the purchase price to acquire all ofthe outstanding common stock of Kanawha. Immediately prior to the acquisition, Stanley D. Johnson, the chiefexecutive officer of Kanawha, and an affiliate of his paid the $6.1 millionexercise price to exercise options to purchase shares of Kanawha commonstock.  As shareholders of Kanawha, Mr.Johnson and his affiliate received a portion of the net proceeds paid for allof the outstanding common stock of Kanawha.

 

The remainingnet proceeds of the initial public offering were deposited into an escrowaccount on December 21, 2004, and were disbursed to us on December 22,2004.  We have broad discretion over themanner in which we and our subsidiaries have applied and will apply theremaining net proceeds, approximately $58.0 million.  We have used and expect to use the remainingnet proceeds as working capital for general corporate purposes, including:

 

•                  topay our fees and expenses incurred in connection with the acquisition ofKanawha, approximately $0.8 million;

 

•                  tofund negative cash flow of approximately $5.0 million to $6.0 million associatedwith initial start-up costs and other expenditures that have been incurred andthat we anticipate will be incurred in 2005, including expenditures to open,improve and relocate our principle offices within the Minneapolis, Minnesotametropolitan area, as well as to open new facilities in New England, southernCalifornia and other selected markets, and to hire and train additional salesand support staff and marketing personnel at these new facilities; and

 

•                  tomaintain the required capital of our insurance subsidiary at the levelnecessary to achieve our desired rating agency financial strength ratings andto comply with applicable regulatory requirements as we grow our insurancebusiness, which, based on a preliminary estimate, we expect will be between$32.2 million and $33.2 million.

 

Pending theseuses, we have invested the remaining proceeds in short-term, investment grade,interest bearing securities, certificates of deposits or guaranteed obligationsof the United States.

 

#### **Company Purchases of Registered Securities ofthe Company**

#### ** **

No purchasesof our registered securities were made by or on behalf of us or any “affiliatedpurchaser” during the period from December 21, 2004, through December 31, 2004.

 

35

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## **ITEM 6.**                             SELECTED FINANCIAL DATA.

##  

The followingtable presents:

 

•                                       Selected historical consolidated financial andother data as of December 31, 2000, 2001, 2002 and 2003, and for each of thefive years ended December 31, 2004, for our predecessor.  The historical consolidated financial data asof December 31, 2003, and for each of the three years ended December 31, 2004,have been derived from, and should be read together with, our predecessor’saudited consolidated financial statements and the related notes included inthis report.  The historical consolidatedfinancial data as of December 31, 2000, 2001 and 2002, and for each of the twoyears ended December 31, 2001 have been derived from our predecessor’s auditedconsolidated financial statements and the related notes not included in thisreport;

 

•                                       Selected historical financial and other datafor the period from January 21, 2004 (KMG America’s date of inception), toDecember 31, 2004, for KMG America.  Forsuch period, KMG America had insignificant operations and cash flows.  See KMG America’s audited financialstatements and the related notes included in this report; and

 

•                                      Selectedhistorical consolidated financial and other data as of December 31, 2004, forKMG America.  The historical consolidatedfinancial data as of December 31, 2004, for KMG America have been derived from,and should be read together with, KMG America’s audited consolidated balancesheet and the related notes included in this report.

 

For GAAPaccounting purposes, Kanawha is treated as our predecessor entity and isreferred to in this table as our “predecessor.”   For financial reportingpurposes, we have treated the Kanawha acquisition as if it closed on December31, 2004, rather than the actual closing date of December 21, 2004, as theeffects of the acquisition for the period from December 21, 2004, throughDecember 31, 2004, were not material to our predecessor’s consolidatedstatements of operations, cash flows, and changes in shareholders’ equity forthe year ended December 31, 2004. Accordingly, selected historical consolidated financial and other dataas of December 31, 2000, 2001, 2002 and 2003, and for each of the five yearsended December 31, 2004, for our predecessor are reported on a historical basiswithout GAAP purchase accounting adjustments reflecting the acquisition.  Financial information relating to KMG America’sconsolidated financial position as of December 31, 2004, has been adjusted forGAAP purchase accounting adjustments reflecting the acquisition.

 

While Kanawhais our predecessor for accounting purposes, we caution you that the financialinformation presented in this report is neither comparable with norrepresentative of the actual results that we expect to achieve in the future.  Many factors may cause our actual results todiffer materially from our predecessor’s historical results including, but notlimited to, the following:

 

•                                      thebusinesses of our predecessor are intended to be only a portion of our businessin the future and are not entirely representative of the principal businessstrategy we plan to pursue;

 

•                                      ouracquisition of Kanawha was subject to GAAP purchase accounting, which caused usto adjust the recorded amounts of our predecessor’s assets and liabilities tofair value following the acquisition; and

 

•                                      thefactors described in Exhibit 99.01 to this report.

 

The financialdata set forth below should be read in conjunction with, and is qualified inits entirety by reference to Item 7, Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, and our predecessor’s and ouraudited financial statements and the related notes included in this report.

 

36

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**KMG AMERICA CORPORATIONAND PREDECESSORSELECTED CONSOLIDATED FINANCIAL DATA**

 
| ** **                                                                         | ** ** | ** **                                | ** ** | **KMG America**                      | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                         | ** ** | **Predecessor**                           | ** ** | **Period from  January 21  through** | ** ** |
| ** **                                                                         | ** ** | **Year Ended December 31,**               | ** ** | **December 31,**                     | ** ** |
| ** **                                                                         | ** ** | **2000**                                  | ** ** | **2001**                             | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** | **2004** | ** ** |
| ** **                                                                         | ** ** | **(in thousands, except per share data)** | ** ** | ** **                           | ** ** |
| **Selected earnings data:**                                                        |       |                                      |       |                                 |       |   |   |   |   |   |   |   |   |
| **Revenue:**                                                                       |       |                                      |       |                                 |       |   |   |   |   |   |   |   |   |
| Insurance premiums                                                                 |       | $                                         | 78,331     |                                 | $          | 86,694 |   | $ | 98,643 |   | $ | 106,416 |   | $ | 102,836 |   | $ | — |   |
| Net investment income(1)                                                           |       | 29,841                                    |       | 29,820                               |       | 27,160 |   | 27,073 |   | 25,202 |   | 18 |   |
| Commission and fee income                                                          |       | 12,410                                    |       | 11,567                               |       | 12,975 |   | 13,018 |   | 13,475 |   | — |   |
| Realized investment gains (losses)                                                 |       | 1,861                                     |       | 4,397                                |       | (3,004 | ) | 7,601 |   | 9,433 |   | — |   |
| Other income                                                                       |       | 2,236                                     |       | 2,697                                |       | 1,869 |   | 2,317 |   | 3,108 |   | — |   |
| Total revenue                                                                      |       | 124,679                                   |       | 135,175                              |       | 137,643 |   | 156,425 |   | 154,054 |   | 18 |   |
| **Benefits and Expenses:**                                                         |       |                                      |       |                                 |       |   |   |   |   |   |   |   |   |
| Policyholder benefits                                                              |       | 66,176                                    |       | 71,072                               |       | 81,285 |   | 89,261 |   | 90,175 |   | — |   |
| Insurance commissions                                                              |       | 6,366                                     |       | 6,479                                |       | 7,351 |   | 9,074 |   | 9,690 |   | — |   |
| General insurance expenses                                                         |       | 25,705                                    |       | 26,646                               |       | 28,407 |   | 29,538 |   | 27,795 |   | 284 |   |
| Insurance taxes, licenses and fees                                                 |       | 3,639                                     |       | 3,589                                |       | 3,927 |   | 4,708 |   | 4,678 |   | 4 |   |
| Depreciation and amortization                                                      |       | 3,057                                     |       | 3,128                                |       | 2,919 |   | 3,005 |   | 2,492 |   | — |   |
| Amortization of deferred policy  acquisitions costs and value of business acquired |       | 10,691                                    |       | 10,336                               |       | 9,515 |   | 9,589 |   | 9,468 |   | — |   |
| Total benefits and expenses                                                        |       | 115,634                                   |       | 121,250                              |       | 133,404 |   | 145,175 |   | 144,298 |   | 288 |   |
| Income before income taxes (benefit)                                               |       | 9,045                                     |       | 13,925                               |       | 4,239 |   | 11,250 |   | 9,756 |   | (270 | ) |
| Provision for income taxes (benefit)                                               |       | (3,148                                    | )          | (4,206                               | )          | (1,157 | ) | (3,499 | ) | (3,566 | ) | 94 |   |
| Net income                                                                         |       | $                                         | 5,897      |                                 | $          | 9,719 |   | $ | 3,082 |   | $ | 7,751 |   | $ | 6,190 |   | $ | (176 | ) |
| **Net income per share:**                                                          |       |                                      |       |                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                              |       | $                                         | 2,257.07   |                                 | $          | 3,720.06 |   | $ | 1,179.36 |   | $ | 2,966.25 |   | $ | 2,369.27 |   | $ | (0.01 | ) |
| Diluted                                                                            |       | $                                         | 2,049.97   |                                 | $          | 3,372.54 |   | $ | 1,066.87 |   | $ | 2,679.87 |   | $ | 2,132.71 |   | $ | (0.01 | ) |
| **Cash dividends paid per share:**                                                 |       |                                      |       |                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                              |       | $                                         | 669.77     |                                 | $          | 669.77 |   | $ | 669.77 |   | $ | 669.77 |   | $ | — |   | $ | — |   |
| Diluted                                                                            |       | $                                         | 608.32     |                                 | $          | 607.20 |   | $ | 605.89 |   | $ | 605.11 |   | $ | — |   | $ | — |   |
| **Weighted-average shares outstanding:**                                           |       |                                      |       |                                 |       |   |   |   |   |   |   |   |   |
| Basic                                                                              |       | 2,612.83                                  |       | 2,612.83                             |       | 2,612.83 |   | 2,612.83 |   | 2,612.83 |   | 22,071,641 |   |
| Diluted                                                                            |       | 2,876.79                                  |       | 2,882.07                             |       | 2,888.30 |   | 2,892.04 |   | 2,902.64 |   | 22,241,550 |   |

 

----

(1)          Net investment incomefor the year ended December 31, 2004, was negatively impacted by a $1.6million incentive payment to one of our predecessor’s outside investmentmanagers at the conclusion of the contract period.  There are no other incentive arrangements ofthis type in effect, and this contract was terminated upon the closing of KMGAmerica’s acquisition of Kanawha.

 

37

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| ** **                                      | ** ** | **Predecessor**                           | ** ** | **KMG America** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|-----------------|------------|
| ** **                                      | ** ** | **As of December 31,**                    | ** ** |
| ** **                                      | ** ** | **2000**                                  | ** ** | **2001**        | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                                      |       | **(in thousands, except per share data)** |       |
| **Balance Sheet Data:**                         |       |                                      |       |            |       |   |   |   |   |   |   |
| Cash and investments                            |       | $                                         | 442,787    |            | $          | 455,365 |   | $ | 486,616 |   | $ | 484,405 |   | $ | 578,541 |   |
| Accrued investment income                       |       | 6,717                                     |       | 6,697           |       | 5,929 |   | 5,387 |   | 4,912 |   |
| Deferred acquisition costs (DAC)                |       | 51,072                                    |       | 60,593          |       | 71,723 |   | 80,657 |   | — |   |
| Value of business acquired (VOBA)               |       | 41,399                                    |       | 36,805          |       | 33,582 |   | 29,605 |   | 74,481 |   |
| Goodwill                                        |       | 1,561                                     |       | 1,258           |       | 1,258 |   | 1,258 |   | — |   |
| Other assets                                    |       | 59,139                                    |       | 58,044          |       | 62,792 |   | 83,858 |   | 112,117 |   |
| Total assets                                    |       | $                                         | 602,675    |            | $          | 618,762 |   | $ | 661,900 |   | $ | 685,170 |   | $ | 770,051 |   |
|                                            |       |                                      |       |            |       |   |   |   |   |   |   |
| Total policy and contract liabilities           |       | $                                         | 414,234    |            | $          | 419,613 |   | $ | 440,824 |   | $ | 462,015 |   | $ | 530,915 |   |
| Deferred income taxes                           |       | 14,427                                    |       | 14,489          |       | 19,792 |   | 22,827 |   | 6,502 |   |
| Other liabilities                               |       | 25,074                                    |       | 28,048          |       | 34,550 |   | 26,851 |   | 44,846 |   |
| Total liabilities                               |       | 453,735                                   |       | 462,150         |       | 495,166 |   | 511,693 |   | 582,263 |   |
| Total shareholders’ equity                 |       | 148,940                                   |       | 156,612         |       | 166,734 |   | 173,477 |   | 187,788 |   |
| Total liabilities and shareholders’ equity |       | $                                         | 602,675    |            | $          | 618,762 |   | $ | 661,900 |   | $ | 685,170 |   | $ | 770,051 |   |

 

## **ITEM 7.**             MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS.

##  

You shouldread the following discussion and analysis of our financial condition andresults of operations in conjunction with our audited financial statements andrelated notes included in this report. This discussion contains forward-looking statements that involve risksand uncertainties.  Our actual resultscould differ materially from those anticipated in these forward-lookingstatements as a result of various factors, including those discussed below andelsewhere in this report, particularly in Item 1 and Exhibit 99.01 attachedhereto.

 

#### **Overview**

#### ** **

KMG America isa holding company incorporated under the laws of the Commonwealth of Virginiaon January 21, 2004.  We commenced ouroperations shortly before we completed our initial public offering of commonstock on December 21, 2004, and our shares trade on the New York Stock Exchangeunder the symbol “KMA.”  Concurrentlywith the completion of our initial public offering, we completed ouracquisition of Kanawha and its subsidiaries, which are our primary operatingsubsidiaries and which underwrite and sell life and health insurance productsmarketed primarily in the southeastern United States.  For GAAP accounting purposes, Kanawha is treatedas KMG America’s predecessor entity and is referred to herein as our “predecessor.”  For financial reporting purposes, we havetreated the acquisition as if it closed on December 31, 2004, rather than theactual closing date of December 21, 2004, as the effects of the acquisition forthe period from December 21, 2004, through December 31, 2004, were not materialto our predecessor’s consolidated statements of operations, cash flows andchanges in shareholders’ equity for the year ended December 31, 2004.  Accordingly, financial information in thefollowing discussion that relates to our predecessor’s consolidated results ofoperations, cash flows and changes in shareholders’ equity for the year ended2004 are reported on a historical basis without GAAP purchase accountingadjustments reflecting the acquisition. Financial information relating to our financial position as of December31, 2004, has been adjusted for GAAP purchase accounting adjustments reflectingthe acquisition.

 

*Worksite insurance business. *Ourworksite insurance business is a provider of voluntary life and healthinsurance products to employers and their employees in the southeastern UnitedStates.  The primary insurance productsthat we underwrite include: life insurance; short-term disability insurance;dental insurance; indemnity health insurance; and critical illnessinsurance.  For the year ended December31, 2004, our predecessor’s worksite insurance business produced premiums,commissions and fees, excluding intercompany payments, of $56.3 million, whichaccounted for 48.4% of our predecessor’s premiums, commissions and fees,excluding intercompany payments in that period. Our business strategy is to operate our existing worksite insurancebusiness efficiently

 

38

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while developing a new worksitemarketing and distribution organization that targets larger employer groupsnationwide with an expanded variety of life and health insurance products whichwill add a new set of employer-paid life insurance, disability and healthproducts to our existing voluntary products. In December 2004, we opened sales offices hosting regional salesmanagers in Boston, Massachusetts and Irvine, California, a Los Angelessuburb.  During 2005, we have openedregional sales offices in Tampa, Florida; Chicago, Illinois; New York, NewYork; Atlanta, Georgia; Dallas, Texas; and Cleveland, Ohio.  We expect to open additional regional salesoffices in 2005 and thereafter.  We havebegun and expect to continue to add and train additional sales and salessupport staff and marketing personnel at these facilities, and will recognizethe costs associated with the these additions before we recognize revenuesresulting from new sales activity. Consequently, we expect negative cash flow and operating losses in theshort term.  This negative cash flow isexpected to be $5.0 million to $6.0 million in 2005 and will be funded from theproceeds of the initial public offering. We expect cash flows from our new sales and marketing organization to bepositive by 2006 but we cannot assure you that this will occur.

 

*Senior market insurance business. *Our senior market insurance business is aprovider in the southeastern United States of individual insurance productstailored to the needs of older individuals. The primary insurance products that this business offers includelong-term care insurance that we underwrite and Medicare supplement insuranceunderwritten by another carrier.  For theyear ended December 31, 2004, our predecessor’s senior market insurancebusiness produced premiums, commissions and fees, excluding intercompanypayments, of $42.1 million, which accounted for 36.2% of our predecessor’spremiums, commissions and fees, excluding intercompany payments, in that period.  While growing this business is not a primarycomponent of our business strategy, we intend to operate this businessefficiently and may consider expanding its geographic target market.

* *

*Third-party administration business. *Our third-party administration businessprovides a wide range of insurance product administration, claims handling,eligibility administration, call center and support services.  This business primarily administers theinsurance plans offered by our worksite insurance business and senior marketinsurance business.  Our third-partyadministration business also provides administrative and managed care servicesto third parties, such as employers with self-funded health care plans, otherinsurance carriers, reinsurers and managed care plans.  For the year ended December 31, 2004, ourpredecessor’s third-party administration business produced commissions andfees, excluding intercompany payments, of $13.3 million, which accounted for11.4% of our predecessor’s premiums, commissions and fees, excludingintercompany payments, in that period. Our primary business strategy for this business is to grow this businessas it administers the increasing volume of policies and products that weanticipate will be sold by the worksite insurance business as we attempt togrow that business.  In addition, as ournational worksite marketing business develops, we intend to opportunisticallymarket our third-party administration services to self-insured plans, stop lossinsurers, pharmacy benefit organizations, managed care service providers, otherinsurance carriers and reinsurers nationwide. It is expected that any incremental costs associated with this expandedmarketing will be modest and will be funded out of the operations of our third-partyadministration business.

 

In addition,we have retained our predecessor’s closed block of life and health businessreported in the acquired business segment and the investment and marketingactivities reported in the corporate and other segment.  While acquisitions of books of business fromother insurance carriers is not one of our principal growth strategies, we willconsider making acquisitions on an opportunistic basis if we can complete theacquisitions on favorable financial terms that we expect to be generallyaccretive to earnings per share and return on equity while maintaining ourfinancial strength ratings.

 

We expect torealize earnings from our investment portfolio. Insurance companies in both the life and health and property andcasualty insurance industries earn profits on the investment float, whichreflects the investment income earned on the premiums paid to the insurerbetween the time of receipt and the time benefits are paid-out under thepolicy.  Volatility in the capitalmarkets, changes in interest rates and changes in economic conditions can allimpact the amount of earnings that we will realize from our investmentportfolio.

 

#### **Marketplace Conditions and Trends**

#### ** **

Describedbelow are some of the significant recent events and trends affecting the lifeand health insurance industry and the possible effects they may have on ouroperations in the future.

 

39

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•                  Thetrend to shift health care costs to employees and rising healthcare costs ingeneral are causing individuals to purchase a wider array of life and healthinsurance products.  We believe thesetrends will result in greater demand for our voluntary worksite insuranceproducts.

 

•                  Wealso believe we will be able to take advantage of the anticipated increases indemand for morbidity products.

 

**•**                  The volatilityin the equity markets over the past few years has posed a number of problemsfor some participants in the life and health insurance industry.  Even though the capital markets haverecovered, not all companies have participated evenly in the recovery.  We and our predecessor have historically hadminimal equity exposure (less than 1% of total invested assets as of December31, 2004) and we plan to continue to manage equity asset allocations conservativelyin the future.

 

**•**                  Corporate bonddefaults and credit downgrades, which have resulted in other than temporaryimpairment in the value of many securities, have had a material impact on lifeand health insurers in the past few years. While our debt investments have not been immune to corporate creditproblems, losses from defaults have historically not been material to ourpredecessor’s financial condition.  Weintend to manage our investment portfolio conservatively in the future toattempt to mitigate the risk of losses from defaults.

 

**•**                  Some life andhealth insurance companies have recently suffered significant reductions incapital and will have to improve their capital adequacy ratios to support theirbusiness or divest a portion of their business. We expect these trends to have a positive impact on our competitiveposition in the industry as carriers become more disciplined with productpricing and/or exit markets or product lines in which we will compete.

 

**•**                  Many of theevents and trends affecting the life and health insurance industry have had anequal (or greater) impact on the life and health reinsurance industry.  These events led to a decline in theavailability of reinsurance.  While wecurrently cede a limited amount of our primary insurance business toreinsurers, and we plan to continue this practice, diminishing reinsurancecapacity has negatively impacted our predecessor in the past and may furthernegatively impact our operations in the future. If we can not obtain affordable reinsurance coverage, either our netexposures will increase or we will have to reduce our underwriting commitments.

 

**•**                  We believerecently enacted Medicare legislation and Medical Savings Accounts proposalsshould benefit life and health insurers in the worksite business.  Medical Savings Accounts (“MSAs”) werecreated by the United States Congress as a trial program in 1996 and allowself-employed individuals, as well as employees of employers with 50 or feweremployees, to set aside funds on a tax-free basis to pay eligible medicalexpenses, so long as such persons are covered under a high-deductible healthinsurance policy.  MSA health insurancepolicies became an important and growing product line for our predecessor.  The MSA legislation expired on December 31,2004.  However, on December 8, 2003,the Medicare Prescription & Modernization Act was signed into law.  This act includes a provision providing forHealth Savings Accounts, or HSAs, which are similar to MSAs but may be utilizedby a much larger class of individuals.

 

**•**                  Recentlyannounced governmental investigations and litigation alleging the illegal useof bid-rigging schemes and contingent commissions by insurance companies andbrokers may adversely affect our industry and us (1) by negatively impactingthe level and volatility of stock prices of companies operating in theinsurance industry, (2) if we become the subject of investigations or relatedlitigation of this type, or (3) if industry regulation, practices and customschange in ways that are detrimental to the success of our business strategy.

 

**•**                  As an increasingpercentage of the United States population reaches retirement age, we believewe will benefit from increased demand for “in-retirement” products rather than “to-retirement”products, as aging baby boomers will require immediate annuities, criticalillness and long-term care products to meet their needs.

 

40

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#### **Critical Factors Affecting Results**

#### ** **

Ourprofitability depends on the adequacy of our product pricing and underwriting,the accuracy of assumptions about future experience used in establishingreserves for future policyholder benefits and claims, returns on investedassets and our ability to manage our costs and expenses.  Factors affecting these items may have amaterial adverse effect on our business, results of operations or financialcondition.  In addition, ourprofitability depends in large part on accurately predicting benefits, claimsand other costs, including medical and dental costs.  It also depends on our ability to managefuture benefit and other costs through product design, underwriting criteria,utilization review or claims management and, in health and dental insurance,negotiation of favorable provider contracts. Changes in market conditions and numerous other factors may alsomaterially adversely affect our ability to manage claim costs.  As a result of one or more of these factorsor other factors, claims could substantially exceed our expectations, whichcould have a material adverse effect on our business, results of operations orfinancial condition.

 

##### *Revenues*

##### * *

We derive ourrevenues primarily from the sale of our insurance policies and, to a lesserextent, fee income from administrative services and commissions on theplacement of third-party insurance products. Sales of insurance policies are recognized in revenue when earned asinsurance premiums, while sales of administrative services and commissionincome are recognized as fee income on our consolidated statements ofoperations when earned.

 

Our premium,fee and commission income is supplemented by income earned from our investmentportfolio.  We recognize revenue frominterest payments, dividends and sales of investments when earned.  Our investment portfolio is currentlyprimarily invested in fixed maturity securities.  Both investment income and realized capitalgains on these investments can be significantly impacted by changes in interestrates.

 

Interest ratevolatility can reduce unrealized gains or create unrealized losses in ourportfolios.  Interest rates are highlysensitive to many factors, including governmental monetary policies, domesticand international economic and political conditions and other factors beyondour control.  Fluctuations in interestrates affect our returns on, and the market value of, fixed maturity andshort-term investments.

 

The fairmarket value of the fixed maturity securities in our portfolio and theinvestment income from these securities fluctuate depending on general economicand market conditions.  The fair marketvalue generally increases or decreases in an inverse relationship withfluctuations in interest rates, while net investment income realized by us fromfuture investments in fixed maturity securities will generally increase ordecrease with interest rates.  Inaddition, actual net investment income and/or cash flows from investments thatcarry prepayment risk, such as mortgage-backed and other asset-backedsecurities, may differ from those anticipated at the time of investment as aresult of interest rate fluctuations.  Inperiods of declining interest rates, mortgage prepayments generally increaseand mortgage-backed securities, mortgage loan obligations and bonds in ourinvestment portfolio are more likely to be prepaid or redeemed as borrowersseek to borrow at lower interest rates, and we may be required to reinvestfunds in lower interest-bearing investments.

 

##### *Expenses*

##### * *

Our expensesprimarily consist of policyholder benefits, insurance commissions, premium taxes,licenses, fees, amortization of deferred acquisition costs, or DAC, and valueof business acquired, or VOBA, interest on the $15.0 million promissory noteissued in connection with the Kanawha acquisition, and general insuranceoperating expenses.

 

##### *Dispositions of Businesses*

##### * *

In December2003, our predecessor sold its fixed annuity block of insurance for contractsstill in the accumulation phase to Madison National Life Insurance Company (“MadisonNational”).  The business was soldpursuant to a 100% coinsurance agreement under which our predecessor ceded toMadison National substantially all assets and liabilities related to its fixedannuity business.  The transactionresulted in a transfer of $15.1 million of reserves and $15.0 million ofrelated assets.  The ceding commission of$0.1 million combined with the write-off of

 

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the remaining DAC asset of $0.1million resulted in no gain or loss being reflected on our predecessor’s GAAPfinancial statements as a result of the transaction.  Total premium considerations of $0, $2.6million, and $1.3 million generated by our predecessor’s fixed annuity businesswere recognized in the years ended December 31, 2004, 2003 and 2002,respectively.

 

#### **Critical Accounting Policies**

#### ** **

We havecompleted a thorough review of our predecessor’s accounting policies and webelieve that our predecessor’s accounting policies are consistent with ouraccounting policies and we do not foresee the need to make any significantchanges in our predecessor’s accounting policies in the foreseeable future.

 

We considerthe following accounting policies to be critical due to the amount of judgmentand uncertainty inherent in the application of these policies.  In calculating financial statement estimates,the use of different assumptions could produce materially differentestimates.  In addition, if factors suchas those described in Exhibit 99.01 attached to this report cause actual eventsto differ from the assumptions used in applying the accounting policies andcalculating financial estimates, our business, results of operations, financialcondition and liquidity could be materially adversely affected.

 

##### *Business Combinations*

##### * *

We recordedthe Kanawha acquisition in a manner consistent with Financial AccountingStandard No. 141, *Business Combinations*(“FAS 141”).  FAS 141 requires that allbusiness combinations be accounted for under the purchase method of accounting,requiring that assets and liabilities be recorded at fair value, and establishesspecific criteria for the recognition of intangible assets separately fromgoodwill.  We have conducted analyses ofhow the purchase price will be allocated among our predecessor’s assets andliabilities, including amounts attributable to VOBA, goodwill and otherintangibles, policy benefit reserves and reinsurance recoverables.  The result of these analyses are reflected inthe pro forma consolidated statements of operations included in Note 4 to theconsolidated financial statements for the years ended December 31, 2004, 2003,and 2002.

 

##### *Reser*ves

##### * *

Policy benefitreserves and other claim reserves are established according to generallyaccepted actuarial principles and are based on a number of factors.  These factors include historical claimpayments experience and actuarial assumptions used to estimate expected futureclaims experience.  These assumptions andother factors include trends in claims severity, frequency and other factorsdiscussed below, the incidence of incurred claims, the extent to which allclaims have been reported and internal claims processing changes.  The methods of making these estimates andestablishing the related reserves are periodically reviewed and updated.

 

Policy benefitand claim reserves do not represent an exact calculation of our ultimateliability, but instead represent our probability-based estimate of what weexpect the ultimate settlement and administration of a claim or group of claimswill cost based on our assessment of facts and circumstances then known.  Policy benefit reserves represent reservesestablished for claims not yet incurred. Claim reserves represent liabilities established for claims that havebeen incurred and have future benefits to be paid as of the balance sheetdate.  The adequacy of reserves will beimpacted by future trends in claims severity, frequency and other factorsincluding:

 

•                  changesin the economic cycle;

 

•                  thelevel of market interest rates and inflation;

 

•                  emergingmedical perceptions regarding physiological or psychological causes ofdisability;

 

•                  emerginghealth issues and new methods of treatment or accommodation;

 

•                  legislativechanges and changes in taxation; and

 

•                  claimshandling procedures.

 

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Many of theseitems are not directly quantifiable, particularly on a prospective basis.  Reserve estimates are refined as experiencedevelops.  Adjustments to reserves, bothpositive and negative, are reflected in the consolidated statements ofoperations of the period in which such estimates are updated.  Because establishment of reserves is aninherently uncertain process involving estimates of future losses, there can beno certainty that ultimate losses will not exceed existing reserves.  Future loss development could require reservesto be increased, which could have a material adverse effect on earnings in theperiods in which such increases are made.

 

##### *Reserving Methodology*

##### * *

Policy benefitreserves for life insurance, long-term care insurance, individual and groupaccident and health insurance, disability insurance and group life and healthinsurance are recorded at the present value of future benefits to be paid topolicyholders and related expenses less the present value of the future netpremiums (this method is called the “net level premium method”).  These amounts are estimated and includeassumptions made when the policy is issued as to the expected investment yield,inflation, mortality, morbidity, claim termination rates, awards for socialsecurity and withdrawal rates, as well as other assumptions that are based onour experience.  These assumptionsreflect anticipated trends and include provisions for possible unfavorabledeviations.  Throughout the life of thepolicy, reserves are based on these original assumptions and cannot be modifiedpursuant to GAAP unless policy reserves prove inadequate.  We also record an unearned premium reservewhich represents the portion of premiums collected or due and unpaid which isintended to pay for insurance coverage in a period after the current accountingperiod.

 

Lossrecognition testing of our policy benefit reserves is performed annually.  This testing involves a comparison of ouractual net liability position (all liabilities less DAC) to the present valueof future liabilities calculated using then-current assumptions.  These assumptions are based on our bestestimate of future experience.  To theextent a premium deficiency exists, it would be recognized immediately by acharge to the statement of operations and a corresponding reduction inDAC.  Any additional deficiency would berecognized as a premium deficiency reserve. Historically, loss recognition testing has not resulted in an adjustmentto DAC or reserves.  These adjustmentswould occur only if economic, mortality and/or morbidity conditionssignificantly deviated from the underlying assumptions.

 

In accordancewith GAAP purchase accounting requirements, our predecessor’s policy andcontract reserves were recorded at fair value upon the closing of the Kanawhaacquisition.  The policy and contractreserves were calculated as the present value of future benefits and expensesless the present value of future premiums. These values were actuarially determined and were based upon assumed futureinterest rates, administrative expenses, mortality, morbidity and policy lapserates as appropriate for the particular benefit on the purchase date.  For long-term care insurance, the assumptionsin the fair value calculation for future policy lapses and future premiums aredifferent than the corresponding assumptions in the reserve calculations in ourpredecessor’s historical GAAP financial statements, with lapses less than andfuture premiums more than in the historical GAAP calculation.  Assumptions for future long term careinsurance premiums in the fair value calculation are consistent with currentand anticipated premium increases, including those approved in the last twelveto eighteen months in certain jurisdictions for policies currently in force.

 

Reserveinterest assumptions (i.e., discount rates) used by us in establishing ourcurrent policy benefit reserves were modified upon the completion of theKanawha acquisition.  The valuationinterest rate is determined by taking into consideration actual and expectedearned rates on our asset portfolio. These liabilities are, for some plans, graded to equal statutory valuesor cash values at or prior to maturity. Benefit reserves for individual life insurance policies include certaindeferred profits on limited payment policies that are being recognized inincome over the policy term.  Policybenefit claims are charged to expense in the period that the claims areincurred.

 

The discountrate is the interest rate at which future benefit cash flows are discounted todetermine the present value of those future cash flows.  If the discount rate chosen is higher thanactual future investment returns, our investment returns will be insufficientto support the interest rate assumed when reserves were established.  In this case, the reserves may eventually beinsufficient to support future benefit payments.  Alternatively, if a discount rate is chosenthat is lower than actual future investment results, the reserves, and, forproducts such as long-term care insurance, the claim cost in the current periodwill be overstated and profits will be accumulated in the reserves rather thanreported as current earnings.  We set ourdiscount rate assumptions in conjunction with the current and expected futureinvestment income rate of the assets supporting the reserves.  If the investment yield at which newinvestments

 

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are purchased is below or abovethe investment yield of the existing investment portfolio, it is likely thatthe discount rate on new claims will be established below or above,respectively, the discount rate on existing claims.

 

EffectiveDecember 31, 2004, as a part of the application of GAAP purchase accountingrequirements, we reestablished our predecessor’s discount rate to providemargin for moderately adverse movements in the future investment portfolioyield rate.

 

In many cases,differences in discount rates and recovery rates can have a significant effecton reserve liabilities.  For example, ifthe discount rate used in the policy reserve calculation was adjusted by 50basis points, the resulting reserve amount calculated would change by about16%.  Similarly, if the discount rateused in the claim reserve calculation varied by 50 basis points, the resultingclaim reserve calculated would vary by about one percent.  If rates of recovery on claim reserves forlong term care insurance claims varied by ten percent from those actuallyassumed, the resulting claim reserve calculation would change by about ninepercent.

 

Wereestablished the valuation interest rate assumptions (generally to make themlower) for all of our products as a part of the application of GAAP purchaseaccounting requirements effective December 31, 2004.  Liabilities were recorded at fair value as ofDecember 31, 2004, using updated interest rate assumptions and other factors.

 

Future policybenefit and expense reserves for fixed annuities (which we no longer offer)consist of policy account balances before applicable surrender charges anddeferred policy initiation fees that are being recognized in income over theterms of the policies.  Policy benefitscharged to expense during the period include amounts paid in excess of policyaccount balances and interest credited to policy account balances.  Interest crediting rates for investmentproducts (i.e., primarily fixed annuity products which we no longer offer)ranged from 3.5% to 5.0% in 2003, and did not change in 2004.  We do not intend to underwrite annuity orother products in which interest is credited to policyholder account balances.

 

Claim reservesrelating to short duration contracts generally are recorded when insured eventsoccur.  The liability is based on theexpected ultimate cost of settling the claims. The claims and benefits payable reserves include: (1) case base reservesfor known but unpaid claims as of the balance sheet date; (2) incurred but notreported (“IBNR”) reserves for claims where the insured event has occurred buthas not been reported as of the balance sheet date; and (3) loss adjustmentexpense reserves for the expected handling costs of settling the claims.  Case base reserves and the IBNR reserves arerecorded at an amount equal to the net present value of the expected futureclaims payments.  Factors considered whensetting IBNR reserves include patterns in elapsed time from claim incidence toclaim reporting, and elapsed time from claim reporting to claim payment.  Claim reserves generally equal our estimate,at the end of the current reporting period, of the present value of theliability for future benefits and expenses to be paid on claims incurred as ofthat date.  A claim reserve for aspecific claim is based on assumptions derived from our actual historicalexperience as to claim duration, as well as the specific characteristics of theclaimant such as benefits available under the policy, the benefit period, andthe age and occupation of the claimant.

 

Claimreserves, unlike policy reserves, are subject to revision as current claimsexperience emerges and projections of future factors affecting claimsexperience change.  In a reportingperiod, actual experience may deviate from the long-term assumptions used todetermine the claim reserves.  We reviewannually emerging experience on investment returns and rates of recovery toattempt to ensure that our claim reserves make adequate and reasonableprovision for future benefits and expenses.

 

We maintainunearned premium reserves for the portion of the premiums on short durationcontracts such as accident and health insurance that is related to theunexpired period of the policy.

 

##### *Deferred Acquisition Costs*

##### * *

The costs ofacquiring new business that vary with and are primarily related to theproduction of new business have been deferred to the extent that these costsare deemed recoverable from future premiums or gross profits and are amortizedinto income as discussed below. Acquisition costs primarily consist of commissions, policy issuanceexpenses and some direct marketing expenses.

 

44

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For mostinsurance products, amortization of DAC is recognized in proportion to theratio of annual premium revenue to the total anticipated premium revenue, whichgives effect to expected terminations. DAC is amortized over the premium-paying period of the relatedpolicies.  Anticipated premium revenue isdetermined using assumptions consistent with those utilized in thedetermination of liabilities for insurance reserves.

 

For fixed andvariable annuities, interest-sensitive life insurance and fixed and variableuniversal life insurance policies (none of which we currently offer), DAC isamortized in proportion to the present value of estimated gross margins orprofits from investment, mortality, expense margins and surrender charges overthe estimated life of the policy or contract. The assumptions used for the estimates are consistent with those used incomputing the policy or contract liabilities.

 

A premiumdeficiency is recognized immediately by a charge to the statement of operationsas a reduction of DAC to the extent that future policy premiums, includinganticipated interest income, are not adequate to recover all DAC and relatedclaims, benefits and expenses.  If thepremium deficiency is greater than unamortized DAC, a liability will be accruedfor the excess deficiency.

 

The interestrate our predecessor used to amortize deferred acquisition costs in 2003 and2004 was 6.58%.

 

We eliminatedall of our predecessor’s DAC upon the closing of the Kanawha acquisition aspart of the application of GAAP purchase accounting requirements.  We began recording DAC prospectively onJanuary 1, 2005.

 

##### *Value of Business Acquired*

##### * *

VOBA is thevalue assigned to the insurance in force of acquired insurance companies orblocks of business at the date of acquisition. The amortization of VOBA is recognized using amortization schedulesestablished at the time of the acquisitions based upon expected patterns ofpremiums, mortality, policy lapses, and morbidity as adjusted to take intoaccount variances between expected and actual costs.  VOBA is amortized over the expected life ofthe underlying business reinsured (or acquired).

 

Ourpredecessor has historically accounted for VOBA in a manner similar toDAC.  The interest rate used to amortizeVOBA in 2003 and 2004 was approximately 7%. Periodically, our predecessor performed tests to determine if VOBAremained recoverable from future premiums on the acquired business.  Our predecessor did not incur any write-offsin 2004, 2003 or 2002 from impairments as a result of these recoverabilitytests.

 

We eliminatedall of our predecessor’s historical VOBA upon the closing of the Kanawhaacquisition as part of our application of GAAP purchase accountingrequirements.  We simultaneouslyre-established VOBA for the value of our predecessor’s in force business.  VOBA interest rate assumptions to amortizethe VOBA were also reset upon the closing of the Kanawha acquisition and therate was approximately 6% at December 31, 2004.

 

Under ourassumptions as of December 31, 2004, we estimate that the amortization of VOBA,for the next five years will be as follows:

 
| **Year  Ended December 31:** | ** ** | **Amortization** | ** ** |
|------------------------------|------------|------------------|------------|
| 2005                         |       | 3.98             | %          |
| 2006                         |       | 4.31             |       |
| 2007                         |       | 4.55             |       |
| 2008                         |       | 4.52             |       |
| 2009                         |       | 4.81             |       |

 

If actuallapse and mortality experience is higher or lower than assumed for the tableabove, then actual amortization will be faster or slower than indicated in thetable.

 

##### *Investments*

##### * *

We regularlymonitor our investment portfolio to ensure that investments that may be otherthan temporarily impaired are identified in a timely fashion and properlyvalued and that any impairment is charged

 

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against earnings in the properperiod.  Our investment portfolio ismanaged by external asset management firms, with the exception of certaininvested assets that are managed internally. Our methodology used to identify potential impairments requires judgmentby us in conjunction with our investment managers.

 

Changes inindividual security values are monitored on a monthly basis in order toidentify potential problem credits.  Inaddition, pursuant to our impairment testing process, each month the portfolioholdings are reviewed with additional screening for securities whose marketprice is equal to 80% or less of their original purchase price.  Management then makes an assessment as towhich of these securities are other than temporarily impaired.  Assessment factors include, but are notlimited to, the financial condition and rating of the issuer, any collateralheld and the length of time the market value of the security has been belowcost.  Each month the watch list isdistributed to our investment committee and the outside investment managers,and discussions are held as needed in order to make any impairmentdecisions.  Each quarter any securitydeemed to have been other than temporarily impaired is written down to its thencurrent market value, with the amount of the write-down reflected in thestatement of operations for that quarter. Previously impaired issues are also monitored monthly, with additionalwrite-downs taken quarterly if necessary.

 

There arerisks and uncertainties involved in making these judgments.  Changes in circumstances and critical factorssuch as a continued weak economy, a pronounced economic downturn or unforeseenevents which affect one or more companies, industry sectors or countries couldresult in additional write-downs in future periods for impairments that aredeemed to be other-than-temporary.

 

EffectiveDecember 31, 2004, under GAAP purchase accounting rules, we recorded ourpredecessor’s investments at fair value and thereby eliminated all unrealizedgains and losses in our predecessor’s portfolio.

 

##### *Reinsurance*

##### * *

As part of ouroverall risk and capacity management strategy, we purchase reinsurance for lossprotection to manage individual and aggregate risk exposure and concentration,to free up capital to allow us to write additional business and, in some cases,effect business dispositions.  We utilizeceded reinsurance for those product lines where there is exposure on a per riskbasis or in the aggregate which exceeds our internal risk retention andconcentration management guidelines.

 

Reinsurance recoverables represent theportion of the policy and contract liabilities that are covered by reinsurance.  These liabilities include reserves for life,annuity, accident and health, policy and contract claims and other policyholderliabilities as shown in the consolidated balance sheets.  The cost of reinsurance is accounted for overthe terms of the underlying reinsured policies using assumptions consistentwith those used to account for the policies reinsured.  Amounts recoverable from reinsurers areestimated in a manner consistent with the methods used to determine theunderlying liabilities reported in our and our predecessor’s consolidatedbalance sheets.

 

Under indemnity reinsurance transactions inwhich we are the ceding insurer, we remain liable for policy claims if theassuming company fails to meet its obligations. In the event one or more assuming companies were to default on itsobligations, it could have an adverse effect on our business, results ofoperations and financial condition.  Tolimit this risk, we have implemented procedures to evaluate the financialcondition of reinsurers and to monitor the concentration of credit risk tominimize this exposure.  In some cases,the reinsurers have placed amounts in trust that would be the equivalent of therecoverable amount and for which we are the beneficiary.  The selection of reinsurance companies isbased on criteria related to solvency and reliability and, to a lesser degree,diversification.  An estimated allowancefor doubtful accounts is recorded on the basis of periodic evaluations ofbalances due from reinsurers, reinsurer solvency, management experience andcurrent economic conditions.  As ofDecember 31, 2004, 2003 and 2002, there was no allowance for doubtful accounts.

 

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#### **Results of Operations**

#### ** **

##### *Consolidated Overview*

##### * *

The followingtable presents:

 

•                  Historicalconsolidated financial information for each of the three years ended December31, 2004, for our predecessor.

 

•                  Historicalfinancial information for the period from January 21, 2004 (KMG America’s dateof inception), to December 31, 2004, for KMG America.

 

For financialreporting purposes, we have treated the Kanawha acquisition as if it closed onDecember 31, 2004, rather than the actual closing date of December 21, 2004, asthe effects of the acquisition for the period from December 21, 2004, throughDecember 31, 2004, were not material to our predecessor’s consolidated resultsof operations, cash flows and changes in shareholders’ equity for the yearended December 31, 2004.  Accordingly,financial information in the table below that relates to our predecessor’sconsolidated statements of operations for the year ended 2004 are reported on ahistorical basis without GAAP purchase accounting adjustments reflecting KMGAmerica’s acquisition of Kanawha.

 
| ** **                        | ** ** | ** **                  | ** ** | **KMG America**                      | ** ** |
|-----------------------------------|------------|-----------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **Predecessor**             | ** ** | **Period from  January 21  through** | ** ** |
| ** **                        | ** ** | **Year Ended December 31,** | ** ** | **December 31,**                     | ** ** |
| ** **                        | ** ** | **2002**                    | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **(dollars in thousands)**  | ** ** | ** **                           | ** ** |
| ** **                        | ** ** | ** **                  | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues:**                     |       |                        |       |                                 |       |   |   |   |   |
| Insurance  premiums               |       | $                           | 98,643.1   |                                 | $          | 106,415.9 |   | $ | 102,835.6 |   | $ | — |   |
| Net investment income(1)          |       | 27,160.2                    |       | 27,072.8                             |       | 25,202.4 |   | 18.4 |   |
| Commission and fees               |       | 12,974.6                    |       | 13,018.0                             |       | 13,475.5 |   | — |   |
| Net realized gains (losses)       |       | (3,003.9                    | )          | 7,600.5                              |       | 9,432.6 |   | — |   |
| Other income                      |       | 1,869.4                     |       | 2,317.3                              |       | 3,108.2 |   | — |   |
|                              |       |                        |       |                                 |       |   |   |   |   |
| Total revenues                    |       | 137,643.4                   |       | 156,424.5                            |       | 154,054.3 |   | 18.4 |   |
|                              |       |                        |       |                                 |       |   |   |   |   |
| **Benefits and expenses:**        |       |                        |       |                                 |       |   |   |   |   |
| Policyholder benefits             |       | 81,284.9                    |       | 89,261.1                             |       | 90,175.0 |   | — |   |
| Commissions                       |       | 7,351.4                     |       | 9,074.2                              |       | 9,690.1 |   | — |   |
| General expenses                  |       | 28,406.8                    |       | 29,538.1                             |       | 27,795.0 |   | 284.4 |   |
| Taxes, licenses and fees          |       | 3,927.0                     |       | 4,708.1                              |       | 4,677.6 |   | 4.1 |   |
| Depreciation and amortization     |       | 2,919.1                     |       | 3,004.8                              |       | 2,491.9 |   | — |   |
| Amortization of DAC               |       | 9,515.5                     |       | 9,588.5                              |       | 9,468.3 |   | — |   |
| Total benefits and expenses       |       | 133,404.7                   |       | 145,174.8                            |       | 144,297.9 |   | 288.5 |   |
|                              |       |                        |       |                                 |       |   |   |   |   |
| **Income before income taxes**    |       | 4,238.7                     |       | 11,249.7                             |       | 9,756.4 |   | (270.1 | ) |
| Income taxes (benefit)            |       | (1,157.3                    | )          | (3,499.4                             | )          | (3,565.9 | ) | 94.5 |   |
|                              |       |                        |       |                                 |       |   |   |   |   |
| **Net income**                    |       | $                           | 3,081.4    |                                 | $          | 7,750.3 |   | $ | 6,190.5 |   | $ | (175.6 | ) |
|                              |       |                        |       |                                 |       |   |   |   |   |
| **Benefits to premiums ratio(2)** |       | 82.4                        | %          | 83.9                                 | %          | 87.7 | % | N/A |   |

 

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(1)          Net investment income for the year endedDecember 31, 2004, was negatively impacted by a $1.6 millionincentive payment to one of our predecessor’s outside investment managers atthe conclusion of the contract period. There are no other incentive arrangements of this type in effect, andthis contract was terminated upon the closing of KMG America’s acquisition ofKanawha.

 

(2)          The benefits to premiums ratio is equal topolicyholder benefits divided by insurance premiums.

 

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#### **Definitions of Insurance Terms**

#### ** **

The followinglist includes definitions of insurance terms used in the discussion of ourpredecessor’s consolidated results of operations.  Terms are listed in the order in which theyappear in our predecessor’s consolidated statements of operations.

 

•                  *Revenues: *Revenuesconsist primarily of premiums, net investment income, commission and feeincome, realized investment gains and losses and other income.

 

•                  *Premiums: *Premiumsare categorized as direct, assumed, ceded, and net.  Each of these categories are furthercategorized as new or renewal.

 

•                  *Direct Premiums: *Direct premiums represent premiums on insurance productswritten and issued by us.

 

•                  *Assumed Premiums:*  Assumed premiums represent premiums writtenand issued by other insurance companies and subsequently reinsured by us.

 

•                  *Ceded Premiums:*  Ceded premiums represent premiums eitherwritten by or assumed by us and subsequently reinsured by other insurancecompanies.

 

•                  *Net premiums:*  Net premiums represent the sum of directpremiums and assumed premiums, less ceded premiums.

 

•                  *New premiums:*  New premiums represent premiums collectedwithin the first twelve months following the initial policy date.

 

•                  *Renewal premiums:*  Renewal premiums represent the premiumsderived from policies greater than twelve months from the original policy date.

 

•                  *Commission and fee income:*  Commission and fee income consists of thecommissions received by our insurance marketing business for the sale by us ofinsurance products underwritten by other insurance companies and fees generatedby our third-party administration business. In addition, both of these businesses provide services to us.  The commission and fee income for servicesthat these businesses provide to us is eliminated from the financial statementamounts referenced in this report.

 

•                  *Other income:*  Other income is comprised primarily ofcommission and expense allowances from reinsurance companies relating toinsurance ceded from us to the reinsurance companies.

 

•                  *Benefits and expenses:*  Benefits and expenses consist primarily ofpolicyholder benefits, insurance commissions, general insurance expenses,insurance taxes, licenses and fees, depreciation and amortization and theamortization of DAC and VOBA.

 

•                  *Policyholder benefits:*  Policyholder benefits consist of the policybenefit claims paid to policyholders and the increase or decrease in benefitreserves.  The primary factors affectingpolicyholder benefits are premium growth, claims experience and reserveassumptions including persistency, morbidity, mortality and interest rates.

 

•                  *Insurance commissions:*  Insurance commissions represent renewalcommissions on products after the first anniversary date as well as first yearcommissions that are not deferred.

 

•                  *General insurance expenses:*  General insurance expenses include primarilyselling, general and administrative expenses incurred by corporate headquarterspersonnel in conducting operations including marketing, policy set-up,administration, adjudication and customer service.

 

•                  *Insurance taxes, licenses and fees:*  Insurance taxes, licenses and fees areprimarily comprised of employment taxes, premium taxes and various filing feesrequired by the jurisdictions in which we do business.

 

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•                  *Depreciation and amortization:*  This item includes depreciation of fixedassets such as information technology hardware and amortization of intangibleassets such as software licenses.  Thisitem is not discussed in detail in this Management’s Discussion and Analysis ofFinancial Condition and Results of Operations because it does not generallyfluctuate significantly from period to period and is not a significant performancestatistic considered by our management.

 

•                  *Amortization of DAC and VOBA:*  DAC relating to most insurance products isamortized over the premium-paying period of related policies in a mannerconsistent with the establishment of benefit reserves.  The amortization of VOBA is comparable to theamortization of DAC and is recognized using amortization schedules establishedat the time of acquisition based upon expected patterns of premiums, mortality,policy lapses and morbidity, and adjustments are made to take into accountcertain variances between expected and actual costs.

 

•                  *Other Operating Measures:*  These are measures that do not appear in theconsolidated statement of operations, but are used by our management toevaluate our operating results.

 

•                  *New sales:* New sales represent annualized premiums on new policies issued.

 

•                  *Benefits to premiums ratio:*  Benefits to premiums ratio equalspolicyholder benefits divided by net premiums. In general, an increase in the ratio indicates a decrease in underwritingmargins of the relevant business segment. Conversely, a decrease in the ratio generally indicates an increase inunderwriting margins for the relevant business segment.  Our management believes that this ratio ismore meaningful in evaluating the changes in underwriting margins on ourproducts from period to period than comparing absolute dollar changes inpremiums and reserves because growth in net premiums produces correspondingincreases in reserves.

 

#### **Discussion of Results by Business Segment**

#### ** **

The followingsection discusses significant factors that impact our revenues and insuranceunderwriting results segregated into the following five business segments:

 

*Worksite insurance business. *Theworksite insurance business provides life and health insurance products toemployers and their employees.  Thisbusiness segment includes worksite business as well as individual insurancebusiness sold directly to the end consumer and not considered part of the seniormarket business.  The primary insuranceproducts sold by this business include life, short-term disability, dental,indemnity health and critical illness. The earnings reported in any period for our worksite insurance businessgenerally depends on growth in underwritten business, business mix, persistencyof business in force, benefit payouts and administrative expensesincurred.  Revenues are generatedprimarily from new and renewal premiums. The worksite insurance business also includes business sold through ourcareer agency distribution channel, which is a group of agents and managersthat are our employees that sell life and health insurance products directly toindividuals and small businesses.

 

*Senior market insurance business. *The senior market insurance business providesindividual insurance products, primarily long-term care insurance, tailored tothe needs of older individuals.  Thelevel of operating earnings reported in any period for our senior marketinsurance business generally depends on growth in underwritten business, businessmix, risk concentration, the ability to adjust premium rates, persistency ofbusiness in force, benefit payouts and administrative expenses incurred.  Revenues are generated primarily from new andrenewal premiums.

 

*Third-party administration business.  *The third-partyadministration business provides administrative services to both the worksiteinsurance business and the senior insurance market business, as well as tothird parties such as employers with self-funded insured health plans, otherinsurance carriers who do not administer the plans they offer, reinsurers andmanaged care plans.  Fees paid by ourinsurance operations to our third-party administrative services subsidiary areeliminated in our consolidated financial statements; fees received from thirdparties for these services are recorded as commissions and fee income in ourconsolidated statements of operations. Costs associated with the operation of this business primarily reflectgeneral overhead expenses and related information technology costs that arereflected in our consolidated statements of operations as general insuranceexpenses.

 

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*Acquired business. *Ourpredecessor obtained over time through assumption and indemnity reinsurance transactions,a number of blocks of life and health insurance business in which it has sinceelected to discontinue accepting new business. Revenue from this business reflects renewal premiums and otherconsiderations on business in force that will continue to decline over time aspolicies lapse.  The earnings generatedby acquired blocks of business in any period will be affected by, among otherthings, historical pricing levels together with approved premium rate increases(if any), diversification of the underlying insurance policies, persistency andloss frequency and severity.

 

*Corporate and other. *Thecorporate and other segment includes investment income earned on the investmentportfolio related to capital and surplus not allocated to the insurance segments.  This segment also includes marketingallowances, commissions and related expenses pertaining to product sales forother insurance carriers, which are currently not material.  In addition, this segment includes certainunallocated expenses, primarily deferred compensation and incentivecompensation costs, and other unallocated immaterial items.  The results of this business segment arereflected in the following discussions of net investment income, realizedinvestment gains and losses, and general insurance expenses.

 

#### **Consolidated Results of Operations**

#### ** **

The followingdiscussion reflects our predecessor’s historical results for the years endedDecember 31, 2004, 2003, and 2002.

 

We wereincorporated on January 21, 2004, and completed our initial public offering ofcommon stock on December 21, 2004.

 

Concurrentlywith the completion of our initial public offering, we completed theacquisition of Kanawha and its subsidiaries. For financial reporting purposes, we have treated the acquisition as ifit closed on December 31, 2004, rather than the actual closing date of December21, 2004, as the effects of the acquisition for the period from December 21,2004, through December 31, 2004, were not material to our predecessor’sconsolidated statements of operations, cash flows and changes in shareholders’equity for the year ended December 31, 2004.

 

Our futureresults may not be consistent with the historical results of ourpredecessor.  The following discussionshould be read in conjunction with our consolidated financial statements andthe related notes included elsewhere in this report.

 

The followingrepresents a summary of our predecessor’s statement of operations and assetcomposition by reportable segment. Except as noted, the financial statement information set forth below isreported on a historical basis without GAAP purchase accounting adjustmentsreflecting the acquisition of the predecessor.

 

**Predecessor:**

 
| ** **                             | ** ** | **For the Year Ended December 31,** | ** **  |
|----------------------------------------|------------|-------------------------------------|-------------|
| ** **                             | ** ** | **2002**                            | ** **  | **2003** | ** ** | **2004** | ** ** |
| **Worksite Insurance Business**        |       |                                |        |   |   |   |   |
| Insurance premiums                     |       | $                                   | 53,173,170  |   | $ | 58,432,771 |   | $ | 56,308,493 |   |
| Net investment income                  |       | 6,266,992                           |        | 5,943,960 |   | 5,028,355 |   |
| Commission and fees                    |       | —                              |        | — |   | — |   |
| Net realized gains                     |       | —                              |        | — |   | — |   |
| Other income                           |       | 197,146                             |        | 386,070 |   | 263,734 |   |
| Total revenues                         |       | 59,637,308                          |        | 64,762,801 |   | 61,600,582 |   |
| Policyholder benefits                  |       | 42,067,226                          |        | 45,129,701 |   | 44,292,442 |   |
| Commissions                            |       | 3,534,254                           |        | 4,027,870 |   | 3,779,844 |   |
| Expenses, taxes, fees and depreciation |       | 11,455,749                          |        | 11,149,951 |   | 9,966,881 |   |
| Amortization of DAC                    |       | 4,122,546                           |        | 5,201,470 |   | 6,208,791 |   |
| Total benefits and expenses            |       | 61,179,775                          |        | 65,508,992 |   | 64,247,958 |   |
| (Loss) before Federal income tax       |       | $                                   | (1,542,467  | ) | $ | (746,191 | ) | $ | (2,647,376 | ) |
|                                   |       |                                |        |   |   |   |   |
| Total assets                           |       | $                                   | 150,694,648 |   | $ | 151,371,669 |   | $ | 169,760,986 | (1) |

 

50

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| ** **                              | ** ** | **For the Year Ended December 31,** | ** **  |
|-----------------------------------------|------------|-------------------------------------|-------------|
| ** **                              | ** ** | **2002**                            | ** **  | **2003** | ** ** | **2004** | ** ** |
| **Senior Market Insurance Business**    |       |                                |        |   |   |   |   |
| Insurance premiums                      |       | $                                   | 37,970,676  |   | $ | 41,546,362 |   | $ | 42,060,326 |   |
| Net investment income                   |       | 1,308,947                           |        | 2,426,903 |   | 3,878,429 |   |
| Commission and fees                     |       | —                              |        | — |   | — |   |
| Net realized gains                      |       | —                              |        | — |   | — |   |
| Other income                            |       | 1,368,706                           |        | 1,563,506 |   | 2,346,577 |   |
| Total revenues                          |       | 40,648,329                          |        | 45,536,771 |   | 48,285,332 |   |
| Policyholder benefits                   |       | 28,785,095                          |        | 33,146,152 |   | 35,829,058 |   |
| Commissions                             |       | 3,307,834                           |        | 4,587,237 |   | 5,481,986 |   |
| Expenses, taxes, fees and depreciation  |       | 2,747,276                           |        | 2,927,784 |   | 3,695,003 |   |
| Amortization of DAC                     |       | 1,621,606                           |        | 825,889 |   | 641,079 |   |
| Total benefits and expenses             |       | 36,461,811                          |        | 41,487,062 |   | 45,647,126 |   |
| Income before Federal income tax        |       | $                                   | 4,186,518   |   | $ | 4,049,709 |   | $ | 2,638,206 |   |
|                                    |       |                                |        |   |   |   |   |   |   |   |
| Total assets                            |       | $                                   | 81,317,287  |   | $ | 115,751,057 |   | $ | 160,381,684 | (1) |
|                                    |       |                                |        |   |   |   |   |   |   |   |
| **Third-Party Administration Business** |       |                                |        |   |   |   |   |
| Insurance premiums                      |       | $                                   | —      |   | $ | — |   | $ | — |   |
| Net investment income                   |       | —                              |        | — |   | — |   |
| Commission and fees                     |       | 12,974,620                          |        | 13,007,733 |   | 13,295,120 |   |
| Net realized gains                      |       | —                              |        | — |   | — |   |
| Other income                            |       | —                              |        | 63,857 |   | 798 |   |
| Total revenues                          |       | 12,974,620                          |        | 13,071,590 |   | 13,295,918 |   |
| Policyholder benefits                   |       | —                              |        | — |   | — |   |
| Commissions                             |       | —                              |        | — |   | — |   |
| Expenses, taxes, fees and depreciation  |       | 12,978,196                          |        | 12,564,353 |   | 12,200,228 |   |
| Amortization of DAC                     |       | —                              |        | — |   | — |   |
| Total benefits and expenses             |       | 12,978,196                          |        | 12,564,353 |   | 12,200,228 |   |
| (Loss) income before Federal income tax |       | $                                   | (3,576      | ) | $ | 507,237 |   | $ | 1,095,690 |   |
|                                    |       |                                |        |   |   |   |   |
| Total assets                            |       | $                                   | 8,737,853   |   | $ | 8,858,946 |   | $ | 8,186,306 | (1) |
|                                    |       |                                |        |   |   |   |   |
| **Acquired Business**                   |       |                                |        |   |   |   |   |
| Insurance premiums                      |       | $                                   | 7,499,276   |   | $ | 6,436,741 |   | $ | 4,466,726 |   |
| Net investment income                   |       | 10,261,228                          |        | 9,230,046 |   | 8,507,129 |   |
| Commissions and fees                    |       | —                              |        | — |   | — |   |
| Net realized gains                      |       | —                              |        | — |   | — |   |
| Other income                            |       | 139,828                             |        | 122,037 |   | 115,613 |   |
| Total revenues                          |       | 17,900,332                          |        | 15,788,824 |   | 13,089,468 |   |
| Policyholder benefits                   |       | 10,432,557                          |        | 10,985,219 |   | 10,053,493 |   |
| Commissions                             |       | 509,277                             |        | 459,135 |   | 428,247 |   |
| Expenses, taxes, fees and depreciation  |       | 3,275,027                           |        | 3,037,122 |   | 2,829,686 |   |
| Amortization of DAC                     |       | 3,771,306                           |        | 3,561,171 |   | 2,618,432 |   |
| Total benefits and expenses             |       | 17,988,167                          |        | 18,042,647 |   | 15,929,858 |   |
| (Loss) before Federal income tax        |       | $                                   | (87,835     | ) | $ | (2,253,823 | ) | $ | (2,840,390 | ) |
|                                    |       |                                |        |   |   |   |   |
| Total assets                            |       | $                                   | 220,934,606 |   | $ | 203,214,521 |   | $ | 215,850,711 | (1) |

 

51

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| ** **                             | ** ** | **For the Year Ended December 31,** | ** **  |
|----------------------------------------|------------|-------------------------------------|-------------|
| ** **                             | ** ** | **2002**                            | ** **  | **2003** | ** ** | **2004** | ** ** |
| **Corporate and Other**                |       |                                |        |   |   |   |   |
| Insurance premiums                     |       | $                                   | —      |   | $ | — |   | $ | — |   |
| Net investment income                  |       | 9,323,064                           |        | 9,471,850 |   | 7,788,499 |   |
| Commissions and fees                   |       | —                              |        | 10,286 |   | 180,402 |   |
| Net realized (losses) gains            |       | (3,003,877                          | )           | 7,600,499 |   | 9,432,585 |   |
| Other income                           |       | 163,734                             |        | 181,850 |   | 381,505 |   |
| Total revenues                         |       | 6,482,921                           |        | 17,264,485 |   | 17,782,991 |   |
| Policyholder benefits                  |       | —                              |        | — |   | — |   |
| Commissions                            |       | —                              |        | — |   | — |   |
| Expenses, taxes, fees and depreciation |       | 4,796,818                           |        | 7,571,779 |   | 6,272,750 |   |
| Amortization of DAC                    |       | —                              |        | — |   | — |   |
| Total benefits and expenses            |       | 4,796,818                           |        | 7,571,779 |   | 6,272,750 |   |
| Income before Federal income tax       |       | $                                   | 1,686,103   |   | $ | 9,692,706 |   | $ | 11,510,241 |   |
|                                   |       |                                |        |   |   |   |   |   |   |   |
| Total assets                           |       | $                                   | 200,215,333 |   | $ | 205,974,072 |   | $ | 157,714,248 | (1) |
|                                   |       |                                |        |   |   |   |   |   |   |   |
| **Total Predecessor:**                 |       |                                |        |   |   |   |   |
| Insurance premiums                     |       | $                                   | 98,643,122  |   | $ | 106,415,874 |   | $ | 102,835,545 |   |
| Net investment income                  |       | 27,160,231                          |        | 27,072,759 |   | 25,202,412 |   |
| Commissions and fees                   |       | 12,974,620                          |        | 13,018,019 |   | 13,475,522 |   |
| Net realized (losses) gains            |       | (3,003,877                          | )           | 7,600,499 |   | 9,432,585 |   |
| Other income                           |       | 1,869,414                           |        | 2,317,320 |   | 3,108,227 |   |
| Total revenues                         |       | 137,643,510                         |        | 156,424,471 |   | 154,054,291 |   |
| Policyholder benefits                  |       | 81,284,878                          |        | 89,261,072 |   | 90,174,993 |   |
| Commissions                            |       | 7,351,365                           |        | 9,074,242 |   | 9,690,077 |   |
| Expenses, taxes, fees and depreciation |       | 35,253,066                          |        | 37,250,989 |   | 34,964,548 |   |
| Amortization of DAC                    |       | 9,515,458                           |        | 9,588,530 |   | 9,468,302 |   |
| Total benefits and expenses            |       | 133,404,767                         |        | 145,174,833 |   | 144,297,920 |   |
| Income before Federal income tax       |       | $                                   | 4,238,743   |   | $ | 11,249,638 |   | $ | 9,756,371 |   |
|                                   |       |                                |        |   |   |   |   |
| Total assets                           |       | $                                   | 661,899,727 |   | $ | 685,170,265 |   | N/A | (2) |

 

----

(1)          KMG America at December 31, 2004, adjustedfor purchase accounting adjustments to reflect the Kanawha acquisition.

 

(2) Aggregate total assets for ourpredecessor as of December 31, 2004, is not reported because our predecessorhad been acquired by KMG America at that date and our predecessor’s assets hadbeen consolidated into the KMG America balance sheet at that date.

 

52

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The followingrepresents a summary of KMG America’s income statement and asset composition asof December 31, 2004.  KMG America’soperations are aggregated into the following reportable segment, as the effectsof its operations were not material to its predecessor’s reportable segments.

 
| ** **                             | ** ** | **For the  Period from  January 21 through  December 31, 2004** | ** **  |
|----------------------------------------|------------|---------------------------------------------------------------------------|-------------|
| **KMG America Corporation:**           |       |                                                                      |        |
| Insurance premiums                     |       | $                                                                         | —      |   |
| Net investment income                  |       | 18,408                                                                    |        |
| Commissions and fees                   |       | —                                                                    |        |
| Net realized gains                     |       | —                                                                    |        |
| Other income                           |       | —                                                                    |        |
| Total revenues                         |       | 18,408                                                                    |        |
| Policyholder benefits                  |       | —                                                                    |        |
| Commissions                            |       | —                                                                    |        |
| Expenses, taxes, fees and depreciation |       | 288,489                                                                   |        |
| Amortization of DAC                    |       | —                                                                    |        |
| Total benefits and expenses            |       | 288,489                                                                   |        |
| (Loss) before Federal income tax       |       | $                                                                         | (270,081    | ) |
| Total assets                           |       | $                                                                         | 770,051,331 |   |
|                                        |            |                                                                           |             |  |  |

 

53

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#### **Year Ended December 31, 2004, Comparedto Year Ended December 31, 2003**

#### ** **

##### *Financial Results Overview*

##### * *

Net income forthe year ended December 31, 2004, decreased $1.6 million, or 20.1%, to $6.2million from net income of $7.8 million in 2003.  The decrease in net income was primarily dueto decreases in premiums and net investment income and an increase inpolicyholder benefits, partially offset by a decrease in general expenses, allof which are described in greater detail below.

 

*Revenues*

* *

Total revenuesfor the year ended December 31, 2004, decreased $2.3 million, or 1.5%, to$154.1 million from total revenues of $156.4 million in 2003.  The primary factors causing the decrease areexplained in the revenue-related discussion below.

 

##### *Premiums*

##### * *

The followingtable presents the distribution of premiums by type and business segment.

 
| ** ** | ** ** | **For the  year ended December 31, 2003** | ** ** | **For the  year ended December 31, 2004** | ** ** | **Increase  (decrease)** | ** ** |
|------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | **Worksite**                                   | ** ** | **Senior**                                     | ** ** | **Acquired**             | ** ** | **Total** | ** ** | **Worksite** | ** ** | **Senior** | ** ** | **Acquired** | ** ** | **Total** | ** ** | **Worksite** | ** ** | **Senior** | ** ** | **Acquired** | ** ** | **Total** | ** ** |
| ** ** | ** ** | **(dollars  in millions)**                     | ** ** |
| Direct     |       |                                           |       |                                           |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | $                                              | 15.9       |                                           | $          | 9.6                      |       | $ | — |   | $ | 25.5 |   | $ | 13.6 |   | $ | 4.4 |   | $ | — |   | $ | 18.0 |   | $ | (2.3 | ) | $ | (5.2 | ) | $ | — |   | $ | (7.5 | ) |
| Renewal    |       | 44.2                                           |       | 42.1                                           |       | —                   |       | 86.3 |   | 44.7 |   | 50.6 |   | — |   | 95.3 |   | 0.5 |   | 8.5 |   | — |   | 9.0 |   |
| Total      |       | 60.1                                           |       | 51.7                                           |       | —                   |       | 111.8 |   | 58.3 |   | 55.0 |   | — |   | 113.3 |   | (1.8 | ) | 3.3 |   | — |   | 1.5 |   |
| Assumed    |       |                                           |       |                                           |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | —                                         |       | —                                         |       | —                   |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Renewal    |       | —                                         |       | —                                         |       | 6.6                      |       | 6.6 |   | — |   | — |   | 4.6 |   | 4.6 |   | — |   | — |   | (2.0 | ) | (2.0 | ) |
| Total      |       | —                                         |       | —                                         |       | 6.6                      |       | 6.6 |   | — |   | — |   | 4.6 |   | 4.6 |   | — |   | — |   | (2.0 | ) | (2.0 | ) |
| Ceded      |       |                                           |       |                                           |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | (0.8                                           | )          | (3.8                                           | )          | —                   |       | (4.6 | ) | (0.9 | ) | (2.8 | ) | 0.0 |   | (3.7 | ) | (0.1 | ) | 1.0 |   | — |   | 0.9 |   |
| Renewal    |       | (0.9                                           | )          | (6.4                                           | )          | (0.1                     | )          | (7.4 | ) | (1.1 | ) | (10.1 | ) | (0.1 | ) | (11.3 | ) | (0.2 | ) | (3.7 | ) | — |   | (3.9 | ) |
| Total      |       | (1.7                                           | )          | (10.2                                          | )          | (0.1                     | )          | (12.0 | ) | (2.0 | ) | (12.9 | ) | (0.1 | ) | (15.0 | ) | (0.3 | ) | (2.7 | ) | — |   | (3.0 | ) |
| Net        |       |                                           |       |                                           |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | 15.1                                           |       | 5.8                                            |       | —                   |       | 20.9 |   | 12.7 |   | 1.6 |   | 0.0 |   | 14.3 |   | (2.4 | ) | (4.2 | ) | — |   | (6.6 | ) |
| Renewal    |       | 43.3                                           |       | 35.7                                           |       | 6.5                      |       | 85.5 |   | 43.6 |   | 40.5 |   | 4.5 |   | 88.6 |   | 0.3 |   | 4.8 |   | (2.0 | ) | 3.1 |   |
| Total      |       | 58.4                                           |       | 41.5                                           |       | 6.5                      |       | 106.4 |   | 56.3 |   | 42.1 |   | 4.5 |   | 102.9 |   | (2.1 | ) | 0.6 |   | (2.0 | ) | (3.5 | ) |
|            |            |                                                |            |                                                |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Worksite netnew premiums decreased $2.4 million, or 15.9%, due to decreased salesvolumes. New sales decreased $1.4 million in total, or 9.5%, to$13.3 million in the year ended December 31, 2004, from$14.7 million in the year ended December 31, 2003.  Our predecessor stopped issuing annuities andMedicare supplement policies in 2003, but both of these products were offeredfor the majority of 2003. Sales of our predecessor’s products through itscareer agency distribution channel declined as a result. New product salesdistributed exclusively through worksite marketing increased $2.3 million, or27.4%, to $10.7 million in the year ended December 31, 2004, from $8.4million in the year ended 2003.   Netrenewal premiums increased $0.3 million, or 0.7%, due to the increasedamount of insurance in force created by prior year sales.

 

Senior marketnet new premiums decreased $4.2 million, or 72.4%, due to the combination of adecrease in direct new premiums and an increase in ceded new premiums.  Direct new premiums decreased $5.2 million,or 54.2%, due to a decline in new sales. New sales decreased $5.1 million, or 61.4%, to $3.2 million in the yearended December 31, 2004, from $8.3 million in the year ended December 31,2003.  A sales decline that began in mid-2003,resulting from the discontinuance of an older product and the introduction of anew product with significantly higher premiums, continued into 2004. Net newpremiums also declined because the new product is reinsured to a greater degreethan the discontinued product, resulting in an increase to ceded premiums. Therisk retained by Kanawha was 85% on the discontinued product compared to 40% onthe new product. Net renewal premiums increased $4.8 million, or 13.4%,due to the increased amount of insurance in force created by prior year sales.This increase is reflected in both the direct renewal premiums and the cededrenewal premiums.

 

Acquiredbusiness premiums decreased $2.0 million, or 30.3%, for the year ended December 31,2004.  We and our predecessor have notacquired any blocks of business since 1999 and the decline is a result ofpolicy lapses

 

54

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and premium refunds that ourpredecessor was required to pay to ceding companies under some of itsreinsurance agreements because its claims experience was better thancontemplated in the agreements. These premium refunds are offset by reductionsin policyholder benefits.

 

##### *Net Investment Income*

##### * *

Net investmentincome declined $1.9 million, or 7.0%, to $25.2 million in the year ended December 31,2004, from $27.1 million in the year ended December 31, 2003. The declinein 2004 was largely the result of an incentive payment of $1.6 million to oneof our predecessor’s outside investment managers at the conclusion of thecontract period as well as a decline in the yield on, and the dollar amount of,invested assets. There are no other incentive arrangements of this type ineffect, and this contract was terminated upon the closing of the Kanawha acquisition.  Net investment income is primarily affectedby changes in levels of invested assets and interest rates.  The decline in investment income in the yearended December 31, 2004, occurred despite an increase in total cash andinvestments of $34.7 million, or 7.2%, to $519.1 million as of December 31,2004, from $484.4 million as of December 31, 2003, excluding the effectsof the Kanawha acquisition. Invested assets declined to $461.1 million as of December 31,2004, from $477.2 million as of December 31, 2003, because assets weresold in the last several months of 2004 and the proceeds of the sale of thoseassets were not reinvested as of December 31, 2004.  This generated a corresponding increase incash.  The increase in cash and investedassets is due to retention of premiums to establish policy reserves for thepayment of future policyholder benefits.

 

The averageyield on invested assets on an amortized cost basis was 5.62% in the year endedDecember 31, 2004, compared to an average yield of 6.02% in the year ended2003.  The continuing decline inprevailing interest rates and the sale of some higher yield investments, bothin 2003 and 2004, contributed to the decline in net investment income in theyear ended December 31, 2004, compared to the year ended December 31,2003.  The $1.6 million incentive paymentpaid to an outside investment manager in 2004, which was recorded as areduction of investment income, was charged directly to the corporate and othersegment, resulting in a significant decline in investment income in thissegment compared to 2003. All other net investment income is allocated to thevarious business segments on a pro rata basis based on the invested assetsattributed to the business segment.

 

Total assetsattributed to the worksite insurance business have not experienced anysignificant fluctuations.  Total assetsattributed to the senior market insurance business have increased significantlydue to the accumulation of long-term care insurance premiums retained toestablish policy reserves for the payment of future policyholder benefits.  Assets attributed to the third-partyadministration business consist primarily of operating cash and receivableswith respect to administrative claims payments awaiting settlement.  These assets are subject to significantvariations due to timing of payments made, and there is no investment incomeattributed to them.  Assets attributed tothe acquired business have declined since 1999 as a result of policy lapses andthe fact that we and our predecessor have not acquired any blocks of businesssince 1999.  Assets attributed to thecorporate and other segment are subject to significant fluctuations becausechanges in unrealized gains are all allocated to the corporate and othersegment. In conjunction with the application of GAAP purchase accountingrequirements, assets attributed to the worksite insurance business, the seniorinsurance business and the acquired business all increased.

 

##### *Commission and Fee Income*

##### * *

Commission andfee income increased $0.5 million, or 3.8%, to $13.5 million for the year endedDecember 31, 2004, from $13.0 million for the year ended December 31,2003.  Most of the commission and feeincome was from administrative fees relating to third-party administration. Theincrease was due to an increase in business in force resulting from increasesin sales of our predecessors administrative services.

 

##### *Realized Investment Gains and Losses*

##### * *

Realizedinvestment gains and losses occur as a result of the sale or impairment ofinvestments.  The net realized investmentgain in the year ended December 31, 2004, increased by $1.8 million to$9.4 million from $7.6 million in the year ended December 31, 2003.  The net gain realized on fixed maturitysecurities in the year ended December 31, 2004, totaled $7.1 millioncompared to a net gain realized on fixed maturity securities of $6.3 million inthe year ended December 31, 2003. In both 2003 and 2004, our predecessor’s investment committee elected totake advantage of favorable market conditions for fixed maturity securities byselling certain fixed maturity securities to recognize gains.  Realized gains on fixed maturity securitiesin 2004 and 2003 were negatively

 

55

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impacted by impairment chargesof $0.5 million and $0.7 million, respectively. The net gain realized on equity securities in the year ended December 31,2004, totaled $2.4 million compared to a net gain realized on equity securitiesof $1.4 million for the year ended December 31, 2003.  These net gains on equity securities were dueto our predecessor’s investment committee’s election to take advantage offavorable market conditions by selling certain common stocks to recognize gainson these sales. Realized gains on equity securities in 2004 and 2003 werenegatively impacted by impairment charges of $0.2 million and $0, respectively.Realized investment gains and losses are allocated entirely to the corporateand other business segment.

 

##### *Other Income*

##### * *

Other incomeincreased $0.8 million, or 34.8%, to $3.1 million in the year ended December 31,2004, from $2.3 million in the year ended December 31, 2003, reflectingthe increased commission and expense allowances from reinsurance companiesgenerated from the increase in ceded premiums described in “—Premiums” above.

 

##### *Benefits and Expenses*

##### * *

Total benefitsand expenses decreased $0.9 million, or 0.6%, to $144.3 million in the yearended December 31, 2004, from $145.2 million in the year ended December 31,2003.  The primary factors causing thisincrease are explained in “—Policyholder Benefits” and “—General InsuranceExpenses” below.

 

##### *Policyholder Benefits*

##### * *

Policyholderbenefits increased $0.9 million, or 1.0%, to $90.2 million in the year ended December 31,2004, from $89.3 million in the year ended December 31, 2003.  This, in combination with the aforementioneddecline in premiums, produced a benefits to premium ratio of 87.7% in 2004compared to 83.9% in 2003.

 

Worksitemarketing policyholder benefits decreased $0.8 million, or 1.8%, to $44.3million for the year ended December 31, 2004, from $45.1 million for theyear ended December 31, 2003.  Thisproduced benefits to premium ratios of 78.7% for the year ended December 31,2004, compared to 77.2% for the year ended December 31, 2003. Whilepolicyholder benefits decreased, a sales decline of $2.6 million resulting fromthe discontinuation of annuities also produced a similar reduction inpolicyholder benefits, as reserve increases associated with this business wereno longer required. The benefits to premium ratio increased primarily as aresult of unfavorable short term disability claims experience at a particularemployer worksite. Actions have been taken to cease any new sales in thatworksite.

 

Senior marketpolicyholder benefits increased $2.7 million, or 8.2%, to $35.8 million for theyear ended December 31, 2004, from $33.1 million for the year ended December 31,2003.  This produced benefits to premiumratios of 85.2% for the year ended December 31, 2004, compared to 79.8%for the year ended December 31, 2003. The primary reason for the ratio increase is an increase in open activeclaims, due to an increase in the number of policies in force and the aging ofour predecessor’s insureds, which resulted in increases in actual claims paidas well as additional claims reserves.

 

Acquiredbusiness policyholder benefits decreased $0.9 million, or 8.2%, to $10.1million for the year ended December 31, 2004, from $11.0 million for theyear ended December 31, 2003.  Thisproduced benefits to premium ratios of 225.1% for the year ended December 31,2004, compared to 170.7% for the year ended December 31, 2003.  These benefits to premium ratios are affectedby large portions of the acquired business that are no longer premium paying,substantial reserves and investment income on reserves that is a primarycomponent of this line of business.  Thedecline in policyholder benefits results from the fact that claims experiencewas better than contemplated under some of the related reinsurance agreements.These better than contemplated policyholder benefits were offset by premiumrefunds that our predecessor was required to pay to the ceding companiesbecause claims experience was favorable. The primary reason for the increasedbenefits to premium ratio was an increase of $0.9 million in policyholderbenefits combined with a decrease of $0.5 million in premiums on a block ofinsurance policies acquired from Metropolitan Life Insurance Company. Theincrease in policyholder benefits on the Metropolitan Life Insurance Companybusiness was due in part to several larger claims, but primarily reflectsincreased claims volume due to the aging of the business. Other than thesebenefit fluctuations, there were no significant changes in acquired businesspolicyholder benefits from 2003 to 2004.

 

56

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##### *Insurance Commissions*

##### * *

Commissionexpenses increased $0.6 million, or 6.6%, to $9.7 million in the year ended December 31,2004, from $9.1 million in the year ended December 31, 2003.  This increase is consistent with the 6.5%increase in net renewal premiums for the non-acquired business.

 

##### *General Insurance Expenses*

##### * *

Generalinsurance expenses decreased $1.7 million, or 5.8%, to $27.8 million in theyear ended December 31, 2004, from $29.5 million in the year ended December 31,2003. General insurance expenses for 2004 and 2003 include approximately $2.2million and $2.8 million, respectively, of costs to develop our predecessor’sworksite marketing business.  In November 2003,our predecessor outsourced the functions of its information technologydepartment to CGI Group, Inc, which had a positive impact on expenses. Inaddition, general expenses (primarily in the third party administrationbusiness) were negatively impacted in 2003 by information technology expensesattributable to administrative system conversions, as well as costs to complywith HIPAA. As a result, the third party administration business experienced adecrease in expenses in 2004 compared to 2003, despite an increase in revenues.Overhead expenses that are not directly associated with a particular businesssegment are allocated to the various business segments on a pro rata basisbased on different factors, such as headcount, policy count, number of policiesissued, premiums and other relevant factors.

 

##### *Insurance Taxes, Licenses and Fees*

##### * *

Insurancetaxes, licenses and fees were unchanged at $4.7 million in the years ended December 31,2004 and 2003.  Premium income, whichdrives premium taxes, was relatively flat between 2003 and 2004.

 

##### *Amortization of DAC and VOBA*

##### * *

Ourpredecessor deferred first year commissions and general insurance expensesassociated with the acquisition of new business.  The total deferrals of policy acquisitioncosts were $13.1 million and $14.5 million in 2004 and 2003, respectively.  The decrease in deferrals was primarily dueto the decrease in net new long-term care premiums in the senior market.

 

Ourpredecessor also assigned a value to the insurance in force of acquiredcompanies or blocks of insurance business at the date of acquisition.  No companies or blocks of business wereacquired in 2004 or 2003.

 

Theamortization of DAC and VOBA decreased $0.1 million, or 1.0%, to $9.5million in the year ended December 31, 2004, from $9.6 million in the yearended December 31, 2003.  In theyear ended December 31, 2004, amortization is composed of DAC amortizationof $6.4 million and VOBA amortization of $3.1 million.  The 2003 amortization is composed of DACamortization of $5.6 million and VOBA amortization of $4.0 million.

 

We eliminatedall of our predecessor’s DAC upon the closing of the Kanawha acquisition aspart of the application of GAAP purchase accounting requirements.  We began recording DAC prospectively on January 1,2005.

 

We eliminatedall of our predecessor’s historical VOBA upon the closing of the Kanawhaacquisition as part of our application of GAAP purchase accountingrequirements.  We simultaneouslyre-established VOBA for the value of our predecessor’s in force business.  VOBA interest rate assumptions to amortizethe VOBA were also reset upon the closing of the acquisition and the rate wasapproximately 6.0% at December 31, 2004.

 

##### *Provision for Income Taxes*

##### * *

Total incometaxes may differ from the amount computed by applying the federal corporate taxrate of 35% due to tax-advantaged investments and a Kanawha subsidiary’s netoperating loss carry forward, and because any losses incurred in thatsubsidiary do not generate tax benefits because of the uncertainty of future operatinggains.  Our predecessor’s effective taxrates for the periods from January 1 through December 31, 2004, and2003 were 36.5% and 31.1%, respectively. In 2003, our predecessor qualified for the small life insurance companydeduction,

 

57

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which had the effect oflowering its overall tax rate. Kanawha did not qualify for the small lifeinsurance company deduction in 2004.

 

#### **Year Ended December 31, 2003, Comparedto Year Ended December 31, 2002**

#### ** **

##### *Financial Results Overview*

##### * *

Net income for2003 increased $4.7 million, or 151.6%, to $7.8 million from net income of $3.1million in 2002.  The increase in netincome was due to an increase in realized investment gains partially offset byan increase in policyholder benefits, all of which are described in greaterdetail below.

 

##### *Revenues*

##### * *

Total revenuesfor 2003 increased $18.8 million, or 13.7%, to $156.4 million from totalrevenues of $137.6 million in 2002.  Theprimary factors causing the increase are explained in the revenue relateddiscussion below.

 

##### *Premiums*

##### * *

The followingtable presents the distribution of premiums by type and business segment.

 
| ** ** | ** ** | **For the  year ended December 31, 2002** | ** ** | **For the  year ended December 31, 2003** | ** ** | **Increase  (decrease)** | ** ** |
|------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | **Worksite**                                   | ** ** | **Senior**                                     | ** ** | **Acquired**             | ** ** | **Total** | ** ** | **Worksite** | ** ** | **Senior** | ** ** | **Acquired** | ** ** | **Total** | ** ** | **Worksite** | ** ** | **Senior** | ** ** | **Acquired** | ** ** | **Total** | ** ** |
| ** ** | ** ** | **(dollars  in millions)**                     | ** ** |
| Direct     |       |                                           |       |                                           |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | $                                              | 12.9       |                                           | $          | 13.8                     |       | $ | — |   | $ | 26.7 |   | $ | 15.9 |   | $ | 9.6 |   | $ | — |   | $ | 25.5 |   | $ | 3.0 |   | $ | (4.2 | ) | $ | — |   | $ | (1.2 | ) |
| Renewal    |       | 42.4                                           |       | 30.7                                           |       | —                   |       | 73.1 |   | 44.2 |   | 42.1 |   | — |   | 86.3 |   | 1.8 |   | 11.4 |   | — |   | 13.2 |   |
| Total      |       | 55.3                                           |       | 44.5                                           |       | —                   |       | 99.8 |   | 60.1 |   | 51.7 |   | — |   | 111.8 |   | 4.8 |   | 7.2 |   | — |   | 12.0 |   |
| Assumed    |       |                                           |       |                                           |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | —                                         |       | —                                         |       | —                   |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Renewal    |       | —                                         |       | —                                         |       | 7.8                      |       | 7.8 |   | — |   | — |   | 6.6 |   | 6.6 |   | — |   | — |   | (1.2 | ) | (1.2 | ) |
| Total      |       | —                                         |       | —                                         |       | 7.8                      |       | 7.8 |   | — |   | — |   | 6.6 |   | 6.6 |   | — |   | — |   | (1.2 | ) | (1.2 | ) |
| Ceded      |       |                                           |       |                                           |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | (0.9                                           | )          | (2.0                                           | )          | —                   |       | (2.9 | ) | (0.8 | ) | (3.8 | ) | — |   | (4.6 | ) | 0.1 |   | (1.8 | ) | — |   | (1.7 | ) |
| Renewal    |       | (1.2                                           | )          | (4.6                                           | )          | (0.3                     | )          | (6.1 | ) | (0.9 | ) | (6.4 | ) | (0.1 | ) | (7.4 | ) | 0.3 |   | (1.8 | ) | 0.2 |   | (1.3 | ) |
| Total      |       | (2.1                                           | )          | (6.6                                           | )          | (0.3                     | )          | (9.0 | ) | (1.7 | ) | (10.2 | ) | (0.1 | ) | (12.0 | ) | 0.4 |   | (3.6 | ) | 0.2 |   | (3.0 | ) |
| Net        |       |                                           |       |                                           |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | 12.0                                           |       | 11.8                                           |       | —                   |       | 23.8 |   | 15.1 |   | 5.8 |   | — |   | 20.9 |   | 3.1 |   | (6.0 | ) | — |   | (2.9 | ) |
| Renewal    |       | 41.2                                           |       | 26.1                                           |       | 7.5                      |       | 74.8 |   | 43.3 |   | 35.7 |   | 6.5 |   | 85.5 |   | 2.1 |   | 9.6 |   | (1.0 | ) | 10.7 |   |
| Total      |       | 53.2                                           |       | 37.9                                           |       | 7.5                      |       | 98.6 |   | 58.4 |   | 41.5 |   | 6.5 |   | 106.4 |   | 5.2 |   | 3.6 |   | (1.0 | ) | 7.8 |   |
|            |            |                                                |            |                                                |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Worksite netnew premiums increased $3.1 million, or 25.8%, due to increased salesvolumes.

 

New salesincreased $3.2 million in total, or 27.8% to $14.7 million in 2003 from$11.5 million in 2002.  New productsales distributed exclusively through worksite marketing increased$2.0 million, or 31.2%, to $8.4 million in 2003 from $6.4 million in2002.  In late 2001, our predecessorhired a new team of marketing executives to grow this business and expendedconsiderable effort and resources to achieve this objective.  As a result, our predecessor’s product salesdistributed exclusively through worksite marketing increased in both 2002 and2003.  Net renewal premiums increased$2.1 million, or 5.1%, due to the increased amount of insurance in forcecreated by prior year sales.

 

Senior marketnet new premiums decreased $6.0 million, or 50.8%, due to the combination of adecrease in direct new premiums and an increase in ceded new premiums.  Direct new premiums decreased $4.2 million,or 30.4%, due to a decline in new sales. New sales decreased $5.1 million, or 38.1%, to $8.3 million in 2003 from$13.4 million in 2002.  Salesdeclined as a result of the discontinuance of an older long-term care productand the introduction of a new long-term care product with significantly higherpremiums.  Ceded new premiums increased$1.8 million, or 90.0%, as a result of the fact that the new product is reinsured to a greater degree than thediscontinued product.  Net renewalpremiums increased $9.6 million, or 36.8%, due to the increased amount ofinsurance in force created by prior year sales. This increase is reflected in both the direct renewal premiums and theceded renewal premiums.

 

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Acquiredbusiness premiums decreased $1.0 million, or 13.3%, in 2003.  Our predecessor and we have not acquired anyblocks of business since 1999 and the decline is a result of policy lapses.

 

##### *Net Investment Income*

##### * *

Net investmentincome declined $0.1 million, or 0.4%, to $27.1 million in 2003 from $27.2million in 2002.  Net investment incomeis primarily affected by changes in levels of invested assets and interestrates.  The decline in investment incomein 2003 occurred despite an increase in total investments of $13.3 million, or2.9%, to $477.2 million as of December 31, 2003, from $463.9 million as ofDecember 31, 2002.  The totalinvestments on an amortized cost basis as of December 31, 2003, totaled$455.9 million compared to $443.5 million as of December 31, 2002.  The increase in invested assets on anamortized cost basis is due to retention of premiums to establish policyreserves for the payment of future policyholder benefits.  The average yield on invested assets on anamortized cost basis was 6.02% in 2003 compared to an average yield of 6.21% in2002.  The continuing decline inprevailing interest rates and our predecessor’s sale of some higher yieldinvestments when it restructured its portfolio in 2002 contributed to thedecline in net investment income in 2003 from 2002.  Net investment income is allocated to thevarious business segments on a pro rata basis based on the invested assetsattributed to the business segment.

 

Total assetsattributed to the worksite insurance business have not experienced anysignificant fluctuations.  Total assetsattributed to the senior market insurance business have increased significantlydue to the accumulation of long-term care insurance premiums retained toestablish policy reserves for the payment of future policyholder benefits.  Assets attributed to the third-partyadministration business consist primarily of operating cash and receivableswith respect to administrative claims payments awaiting settlement.  These assets are subject to significantvariations due to timing of payments made, and there is no investment incomeattributed to them.  Assets attributed tothe acquired business have declined since 1999 as a result of policy lapses andthe fact that our predecessor has not acquired any blocks of business since1999.  Assets attributed to the corporateand other segment are subject to significant fluctuations because the changesin unrealized gains are all allocated to the corporate and other segment.

 

##### *Commission and Fee Income*

##### * *

Commission andfee income for 2003 was $13.0 million, unchanged from 2002.  This amount represented administrative feesfor third-party administrative services.

 

##### *Realized Investment Gains and Losses*

##### * *

Realizedinvestment gains and losses occurred as a result of the sale or impairment ofour predecessor’s investments.  The netrealized investment gain increased by a total of $10.6 million to $7.6 millionin 2003 from a net realized investment loss of $3.0 million in 2002.  The net gain on the sale of fixed maturitysecurities in 2003 totaled $6.3 million compared to a net loss on the sale offixed maturity securities of $3.0 million in 2002.  The $6.3 million net gain in 2003 wasprimarily due to our predecessor’s investment committee’s election to takeadvantage of favorable market conditions for fixed maturity securities byselling fixed maturity securities to recognize gains on these sales.  The $3.0 million net loss in 2002 wasprimarily due to losses on distressed bonds from companies including WorldCom, Inc.and ATT Canada, Inc.  The net gainon the sale of common stock in 2003 totaled $1.4 million due to our predecessor’sinvestment committee’s election to take advantage of favorable marketconditions by selling certain common stock to recognize gains on thesesales.  The sale of common stock in 2002was at a price that approximated the value of the stock on our predecessor’sbalance sheet; therefore, the realized gain was de minimis.  Realized investment gains and losses areallocated entirely to the corporate and other business segment.

 

##### *Other Income*

##### * *

Other incomeincreased $0.4 million, or 21.1%, to $2.3 million in 2003 from $1.9 million in2002, reflecting the increased commission and expense allowances fromreinsurance companies generated from the increase in ceded premiums that isdescribed in the discussion of premiums above.

 

59

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##### *Benefits and Expenses*

##### * *

Total benefitsand expenses increased $11.8 million, or 8.8%, to $145.2 million in 2003, from$133.4 million in 2002.  The primaryfactors causing this increase are explained below in the benefits and expensesrelated discussion below.

 

##### *Policyholder Benefits*

##### * *

Policyholderbenefits increased $8.0 million, or 9.8%, to $89.3 million in 2003 from $81.3million in 2002.  The policyholderbenefits for 2003 include a charge of approximately $0.9 million reflecting areserve deficiency for accident and health insurance that emerged during theyear.  Conversely, policyholder benefitsfor 2002 include a reserve redundancy for accident and health insurance ofapproximately $5.3 million that was released into earnings.

 

Worksitemarketing policyholder benefits increased $3.0 million, or 7.1%, to $45.1million for 2003 from $42.1 million for 2002. This produced benefits to premium ratios of 77.2% for 2003 compared to79.1% for 2002.  This ratio decreasereflects the premium growth over the last two years and the assumption thatclaims will be smaller in the earlier years that policies are in force.

 

Senior marketpolicyholder benefits increased $4.3 million, or 14.9%, to $33.1 million for2003 from $28.8 million for 2002.  Thisproduced benefits to premium ratios of 79.8% for 2003 compared to 75.8% for2002.  The primary reason for the ratioincrease is the increase in actual claims, due to an increase in the number ofpolicies in force and the aging of our predecessor’s insureds, and theassociated claims reserves established.

 

Acquiredbusiness policyholder benefits increased $0.6 million, or 5.8%, to $11.0million for 2003 from $10.4 million for 2002. This produced benefits to premium ratios of 170.7% for 2003 compared to139.1% for 2002.  These benefits topremium ratios reflect the facts that a large portion of the acquired businessis no longer premium paying, this business has substantial reserves and theinvestment income on the reserves is a primary component of this line ofbusiness.  The change in thebenefits-to-premium ratio from 2002 to 2003 was the result of several factorsincluding a $0.2 million leukemia claim in the group accident and health line,an arbitration settlement with John Hancock Financial Services, Inc. for$0.3 million more than the amount reserved and increases of $0.8 million inindividual claims on a block of insurance policies acquired from MetropolitanLife Insurance Company over 2002.  The increasein claims on the Metropolitan Life Insurance Company block of insurancepolicies was due in part to several larger claims, but primarily reflectsincreased claims volume due to the aging of the business.

 

##### *Insurance Commissions*

##### * *

Commissionexpenses increased $1.7 million, or 23.0%, to $9.1 million in 2003 from $7.4million in 2002.  Net renewal premiumsincreased by 14.2%, which generated $1.2 million in increased commissions.  In addition, our predecessor paid $0.6million of first year non-deferred commissions that were related to sales ofgroup cancelable products that were introduced during 2003.

 

##### *General Insurance Expenses*

##### * *

Generalinsurance expenses increased $1.1 million, or 3.9%, to $29.5 million in 2003from $28.4 million in 2002.  General insuranceexpenses were negatively impacted in 2003 and 2002 by information technologyexpenses attributable to administrative system conversions, as well as costs tocomply with HIPAA.  General insuranceexpenses for the years ended December 31, 2003, and 2002 includeapproximately $2.8 million and $2.2 million, respectively, of costs to developour predecessor’s worksite marketing business. Expenses in 2002 (primarily relating to the third party administrationbusiness) were negatively affected by the costs associated with the conversionby our predecessor of a client’s existing information management system to anew HIPAA compliant system.  This projectproduced fees for our predecessor in 2002 and 2003, although the project’sassociated expenses decreased in 2003 compared to 2002.  Overhead expenses that are not directlyassociated with a particular business segment are allocated to the variousbusiness segments on a pro rata basis based on different factors, such asheadcount, policy count, number of policies issued, premiums and other relevantfactors.

 

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##### *Insurance Taxes, Licenses and Fees*

##### * *

Insurancetaxes, licenses and fees increased $0.8 million, or 20.5%, to $4.7 million in2003 from $3.9 million in 2002.  Theincrease exceeded the growth rate in the insurance premiums for the same perioddue primarily to the additional fees of $0.3 million resulting from anexamination performed by the South Carolina Department of Insurance.

 

##### *Amortization of DAC and VOBA*

##### * *

Ourpredecessor deferred first year commissions and general insurance expensesassociated with the acquisition of new business.  The total deferrals of policy acquisitioncosts were $14.5 million and $16.5 million in 2003 and 2002, respectively.  The decrease in deferrals was primarily dueto the decrease in net new long-term care premiums in the senior market.

 

Ourpredecessor also assigned a value to the insurance in force of acquiredcompanies or blocks of insurance business at the date of acquisition.  No companies or blocks of business wereacquired in 2003.  Approximately$1.0 million of costs to acquire an insurance agency were deferred in2002.

 

Theamortization of DAC and VOBA increased $0.1 million, or 1.1%, to$9.6 million in 2003 from $9.5 million in 2002.  The 2003 amortization is composed of DACamortization of $5.6 million and VOBA amortization of$4.0 million.  The 2002 amortizationis composed of DAC amortization of $5.3 million and VOBA amortization of$4.2 million.

 

##### *Provision for Income Taxes*

##### * *

Total incometaxes may differ from the amount computed by applying the federal corporate taxrate of 35% because our predecessor qualified for the small life insurancecompany deduction and due to our predecessor’s tax-advantaged investments.  Our predecessor’s effective tax rates for2003 and 2002 were 31.1% and 27.3%, respectively.  The effective tax rate increased because, asincome increased, the benefit of the small life insurance company deductiondecreased.

 

#### **Investments**

#### ** **

The followingtable shows the carrying value of our and our predecessor’s investments by typeof security as of the dates indicated.

 
| ** **                    | ** ** | **Predecessor**                   | ** ** | **KMG America**                   | ** ** |
|-------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ** **                    | ** ** | **As of December 31,  2003** | ** ** | **As of December 31,  2004** | ** ** |
| ** **                    | ** ** | **(dollars in thousands)**        | ** ** |
| Fixed maturity securities     |       | $                                 | 414,826.0  |                              | 87.0       | % | $ | 409,613.2 |   | 88.8 | % |
| Equity securities             |       | 2,824.9                           |       | 0.6                               |       | 36.0 |   | 0.0 |   |
| Mortgage loans on real estate |       | 31,630.6                          |       | 6.6                               |       | 23,678.7 |   | 5.2 |   |
| Policy loans                  |       | 22,940.3                          |       | 4.8                               |       | 22,620.8 |   | 4.9 |   |
| Other investments             |       | 4,978.2                           |       | 1.0                               |       | 5,192.5 |   | 1.1 |   |
|                          |       |                              |       |                              |       |   |   |   |   |
| Total investments             |       | $                                 | 477,200.0  |                              | 100        | % | $ | 461,141.2 |   | 100 | % |

 

Of the fixedmaturity securities shown above, 77.8% and 80.9% (based on total carryingvalue) were invested in securities rated “A” or better as of December 31,2003, and 2004, respectively.

 

The followingtable provides the cumulative net unrealized gains (pre-tax) on our and ourpredecessor’s fixed maturity securities and equity securities as of the datesindicated.  Effective December 31,2004, our investments were recorded at fair value, thereby eliminating allunrealized gains and losses, as part of the application of GAAP purchaseaccounting requirements.

 

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| ** **                     | ** ** | **Predecessor**                   | ** ** | **KMG America**                   | ** ** |
|--------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ** **                     | ** ** | **As of December 31,  2003** | ** ** | **As of December 31,  2004** | ** ** |
| ** **                     | ** ** | **(dollars  in thousands)**       | ** ** |
| **Fixed maturity securities:** |       |                              |       |                              |       |
| Amortized cost                 |       | $                                 | 396,028.6  |                              | $          | 409,613.2 |   |
| Unrealized gains               |       | 24,992.8                          |       | —                            |       |
| Unrealized losses              |       | (6,195.4                          | )          | —                            |       |
| Carrying value                 |       | $                                 | 414,826.0  |                              | $          | 409,613.2 |   |
|                           |       |                              |       |                              |       |   |   |
| **Equities:**                  |       |                              |       |                              |       |
| Cost                           |       | $                                 | 346.7      |                              | $          | 36.0 |   |
| Unrealized gains               |       | 2,572.9                           |       | —                            |       |
| Unrealized losses              |       | (94.8                             | )          | —                            |       |
| Carrying value                 |       | $                                 | 2,824.8    |                              | $          | 36.0 |   |

 

Net unrealizedgains on fixed maturity securities were $18.8 million as of December 31,2003.

 

Net unrealizedgains on equity securities were $2.5 million as of December 31, 2003.

 

Unrealizedlosses in 2003 were reviewed by our predecessor for other than temporaryimpairment in conjunction with our predecessor’s investment policies during theyear ended December 31, 2003. Impairment charges of $0.7 million weretaken in the year ended 2003 on one bond issue that was determined to be otherthan temporarily impaired due to the length of time that it was in a lossposition.

 

*Loss Impairment. *Allfixed maturity securities are classified as available-for-sale and marked tomarket through other comprehensive income. All securities with gross unrealized losses at the consolidated balancesheet date are subjected to our process for identifying other-than-temporaryimpairments.  Securities deemed to beother-than-temporarily impaired are written down to fair value in the periodthe securities are deemed to be so impaired. The assessment of whether such impairment has occurred is based onmanagement’s case-by-case evaluation of the underlying reasons for the declinein fair value.  Management considers awide range of factors, as described below, about the issuer of the security anduses its best judgment in evaluating the cause of the decline in the estimatedfair value of the security and in assessing its prospects for near termrecovery.  Inherent in management’sevaluation of the security are assumptions and estimates about the operationsof the issuer and its future earnings potential.

 

Considerationsused by management in the impairment evaluation process include, but are notlimited to, the following:

 

•                          lengthof time and the extent to which the market value of the security has been belowamortized cost;

 

•                          whenthe issuer is experiencing significant financial difficulties, a review of allsecurities of the issuer, including its known subsidiaries and affiliates;

 

•                          conditionsof the industry sector or subsector in which the issuer operates;

 

•                          economicconditions in the issuer’s geographic location;

 

•                          catastrophicloss suffered by the issuer or the industry in which the issuer operates; and

 

•                          othersubjective factors, including information obtained from regulators and ratingagencies.

 

The review offixed maturity securities for impairments includes an analysis of the totalgross unrealized losses for three categories of securities: (1) securitieswhere the estimated fair value had declined and remained below amortized costby less than 20%; (2) securities where the estimated fair value haddeclined and remained below amortized cost by 20% or more for less than sixmonths; and (3) securities where the estimated value had declined andremained below amortized cost by 20% or more for six months or greater.  Securities in the first two

 

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categories have generally beenadversely impacted by the downturn in the financial markets, overall economicconditions and certain industry trends. The first category generally includes securities that have declined invalue as a result of fluctuations in interest rates, rather than due todifficulties experienced by the issuer of the securities.  While all of these securities are monitoredfor potential impairment, our and our predecessor’s experience indicates thatsecurities in the first two categories do not present as great a risk ofimpairment, and securities in these categories often recover their fair valueover time as the factors that caused the declines improve.

 

Writedowns arerecorded as investment losses and the cost bases of the securities are adjustedaccordingly.  The revised cost basis isnot changed for subsequent recoveries in value. Writedowns of fixed maturity securities were $0.5 million for the yearended December 31, 2004.  This write-downreflected other than temporary impairments on Delta Airlines and TritonAviation fixed income securities.  Bothof these securities have been impacted by the negative conditions affecting theairline industry generally.  Delta’scredit rating was downgraded twice during 2004 and the value of the Tritonsecurities continued a decline for which an impairment of $0.7 million wasrecognized in 2003.  Writedowns of equitysecurities were $0.2 million for the year ended December 31, 2004,reflecting poor operating results and a market value decline in excess of 75percent on Verso Technologies, Inc.

 

Effective December 31,2004, we recorded all of our predecessor’s assets at fair market value, therebyeliminating all unrealized gains and losses for the year ended December 31,2004, as part of the application of GAAP purchase accounting requirements.

 

#### **Reserves**

#### ** **

The followingtable presents insurance policy benefit and contract-related liabilitiesinformation as of the dates indicated, by reserve type:

 
| ** **                     | ** ** | **Predecessor**                   | ** ** | **KMG America**                   | ** ** |
|--------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ** **                     | ** ** | **As of December 31,  2003** | ** ** | **As of December 31,  2004** | ** ** |
| ** **                     | ** ** | **(dollars  in thousands)**       | ** ** |
| Life and annuity reserves      |       | $                                 | 299,884.2  |                              | $          | 309,940.3 |   |
| Accident and health reserves   |       | 141,209.0                         |       | 200,801.8                         |       |
| Policy and contract claims     |       | 10,460.7                          |       | 9,343.5                           |       |
| Other policyholder liabilities |       | 10,461.1                          |       | 10,829.8                          |       |
| Total policy liabilities       |       | $                                 | 462,015.0  |                              | $          | 530,915.4 |   |

 

Life andannuity reserves increased by $10.0 million, or 3.3%, to $309.9 million as of December 31,2004, from $299.9 million as of December 31, 2003.  The increase in the reserve balance for theyear ended December 31, 2004 includes an increase of $20.2 millionattributed to the application of GAAP purchase accounting requirements.  Excluding the effects of GAAP purchaseaccounting, life and annuity reserves decreased $10.2 million for the yearended December 31, 2004.  A largeportion of the life and annuity reserves relates to acquired blocks of businessthat are lapsing at a steady pace, as expected because no new blocks ofbusiness have been acquired since 1999. These reserves represented $182.1 million as of December 31, 2004,and $180.1 million as of December 31, 2003.  The increase in the acquired life reservebalance for the year ended December 31, 2004, includes an increase of$12.6 million attributed to the application of GAAP purchase accountingrequirements.  Excluding the effects ofGAAP purchase accounting, these blocks represented $10.6 million of thedecrease in reserves for the year ended December 31, 2004, and $10.9million of the decrease in reserves for the year ended December 31,2003.  Accident and health reservesincreased by $59.6 million or 42.2%, to $200.8 million as of December 31,2004, from $141.2 million as of December 31, 2003.  The increase in the reserve balance for theyear ended December 31, 2004, includes an increase of $24.1 millionattributed to the application of GAAP purchase accounting requirements.  The remaining reserve increases of $35.5million are consistent with growth in the underlying business, with the majorityof the reserve growth being accumulated from long-term care premiumsreceived.  Policy and contract claims,which represent liabilities for actual claims reported and payable, decreasedby $1.2 million, or 11.4%, to $9.3 million as of December 31, 2004, from$10.5 million as of December 31, 2003. This decrease represents timing of claims received and processed, andalthough there are always fluctuations in policy and contract claim reservesfrom period to period, there were no significant events or trends during theperiods discussed in this paragraph that would produce any material changes inour claims reserves.

 

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Otherpolicyholder liabilities, which are comprised primarily of dividendaccumulations and advance premiums, increased by $0.3 million, or 2.9%, to$10.8 million as of December 31, 2004, from $10.5 million as of December 31,2003.  The increase in 2004 was primarilydue to an increase in dividend accumulations of $0.2 million and an increase inadvanced premium payments of $0.1 million.

 

#### **Participating Policies**

#### ** **

Participatingpolicies are policies where the policyholder participates in the performance ofthe underlying product profitability. Policyholder dividends on participating insurance products arerecognized over the term of the related policies.  Participating business representedapproximately 30% and 31% of total ordinary life insurance in force at December 31,2004, and 2003, respectively.  Dividendspaid to policyholders were $2.2 million and $2.1 million for the years ended2004 and 2003, respectively, and are recorded as policyholder benefits in theconsolidated statements of operations.

 

#### **Ceded Reinsurance**

#### ** **

As part of ouroverall risk and capacity management strategy, we purchase reinsurance for lossprotection to manage individual and aggregate risk exposure and concentration,to free up capital to allow us to write additional business and, in some cases,effect business dispositions.  We utilizeceded reinsurance for those product lines where there is exposure on a per riskbasis or in the aggregate which exceeds our internal risk retention andconcentration management guidelines.

 

Reinsurancerecoverables represent the portion of the policy and contract liabilities thatare covered by reinsurance.  Theseliabilities include reserves for life, annuity, accident and health, policy andcontract claims and other policyholder liabilities as shown in the consolidatedbalance sheets.  The cost of reinsuranceis accounted for over the terms of the underlying reinsured policies usingassumptions consistent with those used to account for the policiesreinsured.  Amounts recoverable fromreinsurers are estimated in a manner consistent with the methods used todetermine the underlying liabilities reported in the consolidated balancesheets.

 

The followingtable sets forth reinsurance recoverables by category as of the datesindicated:

 
| ** **                                      | ** ** | **Predecessor**                   | ** ** | **KMG America**                   | ** ** |
|-------------------------------------------------|------------|-----------------------------------|------------|-----------------------------------|------------|
| ** **                                      | ** ** | **As of December 31,  2003** | ** ** | **As of December 31,  2004** | ** ** |
| ** **                                      |       | **(dollars  in thousands)**       |       |
| Ceded future policyholder benefits and  expense |       | $                                 | 60,337.7   |                              | $          | 70,584.9 |   |
| Ceded claims and benefits payable               |       | 813.5                             |       | 769.9                             |       |
| Reinsurance recoverables                        |       | $                                 | 61,151.2   |                              | $          | 71,354.8 |   |

 

Reinsurancerecoverables increased by $10.2 million, or 16.7%, to $71.4 million as of December 31,2004, from $61.2 million as of December 31, 2003.  The increase in the recoverable balance forthe year ended December 31, 2004, includes an increase of $3.5 millionattributed to the application of GAAP purchase accounting requirements.  The remaining increase is attributable tounderlying business growth, specifically the growth in long-term care businessreinsured.

 

Recorded cededloss recoveries from reinsurers (recorded as a reduction in policyholderbenefits) were $7.9 million and $5.6 million for the years ended 2004 and 2003,respectively.

 

Underindemnity reinsurance transactions in which we are the ceding insurer, weremain liable for policy claims if the assuming company fails to meet itsobligations.  In the event one or moreassuming companies were to default on its obligations, it could have an adverseeffect on our business, results of operations and financial condition.  To limit this risk, we have implementedprocedures to evaluate the financial condition of reinsurers and to monitor theconcentration of credit risk to minimize this exposure.  In some cases, the reinsurers have placedamounts in trust that would be the equivalent of the recoverable amount and forwhich we are the beneficiary.  Theselection of reinsurance companies is based on criteria related to solvency andreliability and, to a lesser degree, diversification.  An estimated allowance for doubtful accountsis recorded on the basis of periodic evaluations of

 

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balances due from reinsurers, reinsurersolvency, management experience and current economic conditions.  As of December 31, 2004, 2003 and 2002,there was no allowance for doubtful accounts.

 

The followingtable sets forth our individual reinsurance recoverables exposure to specific reinsurersand their corresponding A.M. Best financial strength rating as of December 31,2004:

 
| **Reinsurer**                     | ** ** | **Recoverable Amount**     | ** ** | **A.M. Best Rating** | ** ** |
|-----------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                        | ** ** | **(dollars in thousands)** | ** ** |
| Reassure America                  |       | $                          | 24,001.8   |                 | A+         |   |
| Madison National                  |       | 13,579.9                   |       | A-                   |       |
| GE ERC                            |       | 10,565.7                   |       | A                    |       |
| General & Cologne Re     |       | 9,941.9                    |       | A++                  |       |
| Munich Re                         |       | 10,776.6                   |       | A+                   |       |
| Unum                              |       | 1,560.5                    |       | A-                   |       |
| Swiss Re                          |       | 421.4                      |       | A+                   |       |
| Transamerica                      |       | 112.2                      |       | A+                   |       |
| Scottish Re                       |       | 115.7                      |       | A-                   |       |
| All other                         |       | 279.1                      |       |                 |       |
| Less: Allowance for uncollectible |       | —                     |       |                 |       |
| Total recoverable                 |       | $                          | 71,354.8   |                 |       |   |

 

#### **Liquidity and Capital Resources**

#### ** **

KMG America isa holding company and had minimal operations of its own prior to the completionof its initial public offering and the Kanawha acquisition.  KMG America’s assets consist primarily of thecapital stock of Kanawha and its other non-insurance subsidiaries.  Accordingly, KMG America’s cash flows dependupon the availability of dividends and other statutorily permissible payments,such as payments under tax allocation agreements and under managementagreements, from Kanawha.  Kanawha’sability to pay dividends and to make other payments  is limited primarily by applicable laws andregulations of South Carolina, the state in which Kanawha is domiciled, whichsubjects insurance operations to significant regulatory restrictions.  These laws and regulations require, amongother things, that Kanawha, KMG America’s insurance subsidiary, maintainminimum solvency requirements and limit the amount of dividends it can pay tothe holding company.  Solvencyregulations, capital requirements, types of insurance offered and rating agencystatus are some of the factors used in determining the amount of capitalavailable for dividends.  In general,South Carolina will permit annual dividends from insurance operations equal tothe greater of (1) the most recent calendar year’s statutory net income or(2) 10% of total capital and surplus of the insurance operations at theend of the previous calendar year, *provided*that the dividend payment does not exceed earned surplus, in which case furtherlimitations apply.

 

For 2005, themaximum amount of dividends that Kanawha can pay to KMG America underapplicable laws and regulations without prior regulatory approval is $8.4million.  If KMG America is able to successfullyexecute its business plan and accelerate Kanawha’s earnings growth in itsinsurance operations, KMG America expects that the maximum allowable dividendfrom Kanawha to the holding company will increase at an accelerated rateyear-over-year.  If the ability ofKanawha to pay dividends or make other payments to KMG America is materiallyrestricted by regulatory requirements, it could adversely affect KMG America’sability to pay any dividends on its common stock and/or service its debt andpay its other corporate expenses.

 

The primarysources of funds for KMG America’s subsidiaries consist of insurance premiumsand other considerations, fees and commissions collected, proceeds from thesales and maturity of investments and investment income.  Cash is primarily used to pay insuranceclaims, agent commissions, operating expenses, product surrenders andwithdrawals and taxes.  KMG Americagenerally invests its subsidiaries’ excess funds in order to generateincome.  The primary use of dividends andother distributions from subsidiaries to KMG America will be to pay certainexpenses of the holding company.  Wecurrently have no intention of paying dividends to our shareholders and willreinvest cash flows from operations into our businesses for the foreseeablefuture.

 

KMG Americahas outstanding debt of approximately $15.0 million because a portion of thepurchase price for the Kanawha acquisition was paid in the form of a$15.0 million subordinated promissory note with a five-year term beginningon the closing date of the acquisition. Interest on the promissory note is accruing at 5% per annum

 

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and is added to the principalbalance on December 31 of each year and is payable on the maturitydate.  No cash payments are requiredunder the promissory note until maturity, at which time approximately$19.1 million of principal and accrued interest will be due andpayable.  The terms of the promissorynote limit KMG America’s and Kanawha’s ability to incur additional debt.  KMG America maintains a $2.0 millionline of credit available to meet short-term cash flow needs.  We are seeking to expand our available creditfacilities in order to maximize financial flexibility and are consideringadding leverage to our capital structure.

 

Ourpredecessor’s qualified defined benefit pension plan was under-funded by$2.0 million as of December 31, 2004, with an actuarially determinedprojected benefit obligation of $15.4 million as opposed to plan assets of$13.4 million.  In 2004, ourpredecessor made contributions to the pension fund of $3.1 million.  In accordance with ERISA, there was noexpected minimum funding requirement for this plan for the year ended December 31,2004.  Based on the plan’s currentfunding status and ERISA and IRS guidelines, no required contributions to theplan are anticipated for 2005.

 

We are notcurrently planning to make any other significant capital expenditures oracquisitions in 2005 or subsequent years. However, we plan to significantly expand outlays relating to marketingand sales activities over the next several years including outlays required tobuild a national sales organization, which is a key component of ourstrategy.  These outlays will includeexpenses such as salaries and cash incentive compensation, employee benefits,occupancy and information technology expenses of additional sales personnel,advertising and marketing costs, consulting and recruiting.  The execution of our business plan willrequire additional outlays associated with the development of a nationalinsurance company including home office expenses for executive management andadditional financial, actuarial and underwriting personnel, infrastructuredevelopment and back-office expenses, as well as costs associated with ourbeing a public company.

 

We anticipatethat these costs will be offset over time by increased sales productionresulting from hiring additional sales personnel and increased cross-selling,as well as efficiencies resulting from greater scale.  However, during 2005, we do not expect thatthe anticipated costs described above to implement our business strategy willbe offset by incremental revenues, resulting in a net use of cash ofapproximately $5.0 million to $6.0 million during this period.  This cash outlay will be funded with aportion of the proceeds from the initial public offering.  We expect that net incremental cash flowsresulting from the increased sales production and efficiencies anticipated fromour new business strategy will be positive after 2005 but can provide noassurance that this will occur.

 

##### *Cash Flows*

##### * *

We monitorcash flows at both the consolidated and subsidiary levels.  Cash flow forecasts at the consolidated andsubsidiary levels are provided on a monthly basis, and we use trend andvariance analyses to project future cash needs, making adjustments to theforecasts when needed.

 

The tablebelow shows our predecessor’s recent net cash flows:

 
| ** **                          | ** ** | **For The Year Ended December 31,** | ** ** |
|-------------------------------------|------------|------------------------------------------|------------|
| **Net cash provided by (used in):** | ** ** | **2002**                                 | ** ** | **2003** | ** ** | **2004** | ** ** |
| ** **                          | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Operating activities                |       | $                                        | 27,176.1   |   | $ | (6,890.1 | ) | $ | 19,998.9 |   |
| Investing activities                |       | (18,869.8                                | )          | (6,871.3 | ) | 22,631.2 |   |
| Financing activities                |       | (1,750.0                                 | )          | (1,750.0 | ) | 9,432.9 |   |
| Net change in cash                  |       | $                                        | 6,556.3    |   | $ | (15,511.4 | ) | $ | 52,063.0 |   |

 

*Cash Flows for the Years Ended December 31, 2002, 2003 and2004. *Keyfactors resulting in the net cash inflow of $6.6 million for the yearended December 31, 2002, were higher cash flows from operations,specifically premium income that was placed in reserves, partially offset by$18.9 million in net purchases of investments.  The key factor resulting in net cash outflowof $15.5 million for the year ended December 31, 2003, was theincrease in reinsurance balances recoverable that was generated when ourpredecessor ceded its annuity block of business to Madison National LifeInsurance Company.  The transfer ofassets related to that transaction was $15.0 million.  There were also additional purchases oflong-term investments with excess cash and cash equivalents.  The key factors resulting in net cash inflowof $52.1 million for the year ended December 31, 2004, were cash flowsfrom

 

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operationsrepresenting premium income that was placed in reserves, proceeds from thesales and maturities of invested assets that were not yet reinvested, and thecapital contribution related to the exercise of stock options.  Our predecessor’s significant cash flows forthe year ended 2002, 2003 and 2004, are as follows:

 

Reinsurancerecoverables increased in 2002 as a result of increased reinsurance, primarilyfrom long term care insurance. Reinsurance recoverables increased significantly by $20.2 million in2003.  The key component of the increasewas the result of ceding $15.0 million of reserves associated with theannuity block of business to Madison National Life Insurance Company.  The remaining increase in reinsurancerecoverables in 2003 resulted from increased reinsurance on the long term careinsurance business.  In 2004, reinsurancerecoverables increased by $6.7 million, primarily due to increased reinsuranceon the long term care insurance business.

 

The increasesin policy and contract liabilities result from premiums that are retained toestablish policy reserves.

 

Accountspayable and accrued expenses increased in 2002 as the result of payment for abond trade for $6.1 million that did not settle until 2003.  The payment of this liability largelyaccounts for the decrease in accounts payable and accrued expenses in 2003.  In 2004, accounts payable and accruedexpenses increased by $4.5 million, primarily due to an increase in reinsurancepayables of $6.8 million relating to acquired business, and a decrease inaccrued compensation expense of $1.8 million relating to payments of accruedcompensation that were made in 2004.

 

Other assetsincreased by $3.2 million in 2003 as the result of a reclassification of assetspertaining to an employee deferred compensation plan from “available-for-sale”to “trading,” offset by a decrease in common stock.  In 2004, other assets decreased by $2.2million, primarily due to the timing of payments and receipts between ourpredecessor and its reinsurers.

 

The liabilityfor benefits for employees and agents decreased by $2.3 million in 2003 as theresult of payments for accrued pension plan contributions of $4.4 million.  The remaining increase is attributable toadditional pension plan liability accruals of $1.3 million established to fundfuture payments under the pension plan. The liability for benefits for employees and agents decreased by $2.1million in 2004 as the result of payments for accrued pension plancontributions of $3.1 million.  Theremaining increase is attributable to additional pension plan liabilityaccruals of $1.2 million established to fund future payments under the pensionplan.

 

Realizedlosses occurred in 2002 resulting from the sales of distressedinvestments.  Sales and purchases werehigher in 2002 than 2001 because of a restructuring of the portfolio in 2002.  Realized gains were higher in 2003 due to thedecision made by our predecessor’s investment committee to take advantage offavorable market conditions by selling securities to recognize gains.  These sales activities kept the sales andpurchases of investments at a comparable level with 2002.  In 2004, our predecessor had realized gainsof $9.4 million primarily due to its decision to sell its convertible bondportfolio and the majority of its equity securities. These realized gains werehigher than the gains in 2003, although the activity levels for sales andpurchases was significantly lower than in 2003.

 

As a functionof our third party administration business, insurance funds for clients aremanaged by us.  These funds are held insuspense pending appropriate disposition, and the balances in these funds willvary on a day-to-day basis.  Thevariations in funds held in suspense from year to year are a refection of thisactivity.

 

In connectionwith our acquisition of Kanwha in 2004, outstanding Kanawha stock options wereexercised, resulting in cash receipts of $6.1 million and a tax benefit of $3.3million. The exercise of these outstanding stock options produced both the $9.4million capital contribution and the majority of the $3.8 million increase in federalincome tax recoverable.

 

##### *Commitments and Contingencies*

##### * *

We haveobligations and commitments to third parties as a result of ouroperations.  These obligations andcommitments, as of December 31, 2004, are detailed in the table below:

 

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| ** **                                                              | ** ** | **Total**                  | ** ** | **Less than  one year** | ** ** | **1-3 years** | ** ** | **3-5 years** | ** ** | **After  5 years** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------|------------|-------------------------|------------|---------------|------------|---------------|------------|--------------------|------------|
| ** **                                                              | ** ** | **(dollars in thousands)** | ** ** |
| Contractual obligations:                                                |       |                       |       |                    |       |          |       |          |       |               |       |
| Operating leases                                                        |       | $                          | 478.0      |                    | $          | 166.0         |       | $             | 312.0      |               | $          | — |   | $ | — |   |
| Information technology and document  management outsourcing contract(1) |       | 49,050.0                   |       | 5,450.0                 |       | 10,900.0      |       | 10,900.0      |       | 21,800.0           |       |
| Subordinated promissory note                                            |       | 19,144.2                   |       | —                  |       | —        |       | 19,144.2      |       | —-            |       |
| Policy and contract liabilities(2)                                      |       | 530,915.4                  |       | 13,655.7                |       | 23,463.2      |       | 26,072.6      |       | 467,723.9          |       |
| Total obligations and commitments                                       |       | $                          | 599,587.6  |                    | $          | 19,271.7      |       | $             | 34,675.2   |               | $          | 56,116.8 |   | $ | 489,523.9 |   |

 

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(1)          Theinformation technology and document management outsourcing contract is aten-year contract that began in November 2003.  This contract is subject to cancellation byus at any time starting in November 2006, with the payment of atermination penalty that is based on the number of months remaining in thecontract.

 

(2)           The development of these anticipated paymentsby period entailed the use of actuarial projections of expected future benefitsand expected future net premiums from current in force business.

 

 

#### **New Accounting Standards**

#### ** **

In December 2003,the FASB issued Statement No. 132 (revised 2003), *Employers’ Disclosures about Pensions and OtherPostretirement Benefits* (“Statement 132 (revised 2003)”).  Statement 132 (revised 2003) revisesemployers’ disclosures about pension plans and other postretirement benefitplans.  It does not change themeasurement or recognition provisions of FASB Statements No. 87, *Employers’ Accounting for Pensions*, No. 88,*Employers’ Accounting for Settlements andCurtailments of Defined Benefit Pension Plans and for Termination Benefits*,and No. 106, *Employers’ Accounting forPostretirement Benefits Other Than Pensions*.  Statement 132 (revised 2003) retains thedisclosure requirements contained in FASB Statement No. 132, *Employers’ Disclosures about Pensions and OtherPostretirement Benefits* (“Statement 132”), which itreplaces.  It requires additionaldisclosures about the assets, obligations, cash flows and net periodic benefitcost of defined benefit pension plans and other postretirement benefitplans.  The required information will beprovided separately for pension plans and for other postretirement benefitplans.

 

The provisionsof Statement 132 remain in effect until the provisions of Statement 132(revised 2003) are adopted.  Disclosureof the benefits expected to be paid in each of the next five fiscal years, andin the aggregate for the five fiscal years thereafter is effective for fiscalyears ending after June 15, 2004. The additional disclosure provisions were adopted by our predecessor in2003.

 

In March 2004,the Emerging Issues Task Force (“EITF”) reached a final consensus onEITF 03-1, which is effective for fiscal periods beginning after June 15,2004.  EITF 03-1 requires that whenthe fair value of an investment security is less than its carrying value, animpairment exists for which a determination must be made as to whether theimpairment is other-than-temporary.  Animpairment loss should be recognized equal to the difference between theinvestment’s carrying value and its fair value when an impairment is other-than-temporary.  Subsequent to an other-than-temporaryimpairment loss, a debt security should be accounted for in accordance withStatement of Position No. 03-3, *Accountingfor Loans and Certain Debt Securities Acquired in a Transfer*, whichallows the accretion of the discount between the carrying value and expectedvalue of a security if the amount and timing of the recognition of thatdifference in cash is reasonably estimable. EITF 03-1 also indicates that, although not presumptive, a patternof selling investments prior to the forecasted recovery may call into questionan investor’s intent to hold the security until it recovers its value.

 

The EITF 03-1impairment model applies to all investment securities accounted for underStatement of Financial Accounting Standards (“SFAS”) No. 115, *Accounting for Certain Investment in Debt and EquitySecurities*, and to investment securities accounted for under thecost method to the extent an impairment indicator exists or the reportingentity has estimated the fair value of the investment security in connectionwith SFAS No. 107, *Disclosures aboutFair Value of Financial Instruments.*

 

The finalconsensus on EITF 03-1 included additional disclosure requirementsincremental to those adopted by our predecessor effective December 31,2003, that are effective for fiscal years ending after June 15, 2004.

 

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In October 2004,the FASB delayed the implementation of the accounting requirements included inEITF 03-1 until further study could be completed regarding the impact ofthis guidance, particularly with respect to “available-for-sale”portfolios.  The disclosure requirementsincluded in EITF 03-1 remain in effect.

 

Adoption ofthis standard may:

 

•                          Acceleratethe timing of recognition of certain impairment losses or otherwise result inimpairment losses being recognized when they previously may not have been;

 

•                          Resultin the designation of certain investment securities as trading; and

 

•                          Increasethe volatility of net income due to:

 

•                          Thepotential recognition of unrealized losses in situations where we anticipate afull recovery of certain unrealized losses but do not want to indicate apermanent intent to hold the affected securities, regardless of internal andexternal facts and circumstances, until such time as they fully recover ormature; and

 

•                           Changes in the timing of the recognition of thedifference between carrying value and expected settlement value of debtsecurities for which an other-than-temporary impairment is taken.

 

In July 2003,the Accounting Standards Executive Committee (“AcSEC”) of the AmericanInstitute of Certified Public Accountants (“AICPA”) issued Statement ofPosition 03-01, *Accounting andReporting by Insurance Enterprises for Certain Nontraditional Long-DurationContracts and for Separate Accounts* (the “SOP”).  AcSEC developed the SOP to address theevolution of product designs since the issuance of SFAS No. 60, *Accounting and Reporting by Insurance Enterprises*,and SFAS No. 97, *Accounting andReporting by Insurance Enterprises for Certain Long-Duration Contracts and forRealized Gains and Losses from the Sale of Investments*.  The SOP provides guidance related to thereporting and disclosure of certain insurance contracts and separate accounts,including guidance for computing reserves for products with guaranteedbenefits, such as guaranteed minimum death benefits, and for products withannuitization benefits such as guaranteed minimum income benefits.  In addition, the SOP addresses certain issuesrelated to the presentation and reporting of separate accounts, as well as rules concerningthe capitalization and amortization of sales inducements.  The SOP was effective for financialstatements on January 1, 2004.  Theadoption of the SOP did not have a material impact on our predecessor’sconsolidated financial position and results of operations.

 

In December 2004,the FASB enacted SFAS No. 123 (revised 2004) (“FAS 123 (revised 2004)”), *Share-Based Payment*, which replaces SFAS No. 123(“FAS 123”), *Accounting for Stock-BasedCompensation*, and supersedes APB Opinion No. 25 (“APB 25”), *Accounting for Stock Issued to Employees*.  FAS 123 (revised 2004) requires themeasurement of all employee share-based payments to employees, including grantsof employee stock options, using a fair-value-based method and the recording ofsuch expense in our consolidated statements of operations.  The accounting provisions of FAS 123 (revised2004) are effective for reporting periods beginning after June 15,2005.  We are required to adopt FAS 123(revised 2004) in the second quarter of 2005.

 

The pro formadisclosures previously permitted under FAS 123 no longer will be an alternativeto financial statement recognition. Although we have not yet determined whether the adoption of FAS 123(revised 2004) will result in amounts that are similar to the current pro formadisclosures under FAS 123, we are evaluating the requirements under FAS 123(revised 2004) and expect the adoption to have an impact on our consolidatedstatements of operations and net income per share that is substantially similarto the current pro forma disclosure under FAS 123.

 

### **ITEM 7A.**                     QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

###  

#### **Market Risk Disclosures**

#### ** **

As a providerof insurance products, effective risk management is fundamental to our abilityto protect both our customers’ and shareholders’ interests.  We are exposed to potential loss from variousmarket risks, in particular

 

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interest raterisk and credit risk.  Additionally, weare exposed to inflation risk and, to a small extent, to foreign currency risk.

 

Interest raterisk is the possibility that the fair value of liabilities will change more orless than the market value of investments in response to changes in interestrates, including changes in the slope or shape of the yield curve and changesin spreads due to credit risk and other factors.

 

Equity pricerisk represents the risk associated with investments in equity securities thatexpose us to changes in equity prices.

 

Credit risk isthe possibility that counterparties may not be able to meet payment obligationswhen they become due.  We assumecounterparty credit risk in many forms. A counterparty is any person or entity from which cash or other forms ofconsideration are expected to extinguish a liability or obligation to us.  Primarily, our credit risk exposure isconcentrated in our fixed income investment portfolio and, to a lesser extent,in our reinsurance recoverables.

 

Inflation riskis the possibility that a change in domestic price levels produces an adverseeffect on earnings.  This typicallyhappens when only one of invested assets or liabilities is indexed toinflation.

 

Foreignexchange risk is the possibility that changes in exchange rates produce anadverse effect on earnings and equity when measured in domestic currency.  This risk is most significant when assetsbacking liabilities payable in one currency are invested in financialinstruments of another currency.

 

##### *Interest RateRisk*

##### * *

We investsubstantial funds in interest-sensitive fixed income assets, such as fixedmaturity investments, mortgage-backed and asset-backed securities and mortgageloans, primarily in the United States. We are exposed to two forms of interest rate risk-price risk and reinvestmentrisk.  Price risk occurs when fluctuationsin interest rates have a direct impact on the market valuation of theseinvestments.  As interest rates rise, themarket value of these investments falls, and conversely, as interest ratesfall, the market value of these investments rises.  Reinvestment risk occurs when fluctuations ininterest rates have a direct impact on expected cash flows from mortgage-backedand asset-backed securities.  As interestrates fall, an increase in prepayments on these assets results in earlier thanexpected receipt of cash flows, forcing us to reinvest the proceeds in anunfavorable lower interest rate environment, and conversely as interest ratesrise, a decrease in prepayments on these assets results in later than expectedreceipt of cash flows, forcing us to forgo reinvesting in a favorable higherinterest rate environment.  As of December 31,2004, we held $409.6 million of fixed maturity securities at fair market valueand $23.7 million of mortgage loans for a combined total of 94.0% of totalinvested assets.

 

We are alsoexposed to interest rate risk in establishing our policy benefit reserves.  Life insurance, disability and other policybenefit reserves are discounted at the valuation date using a valuationinterest rate.  The valuation interestrate is determined by taking into consideration actual and expected earnedrates on our asset portfolio, with adjustments for investment expenses andprovisions for adverse deviation.

 

##### *Equity PriceRisk*

##### * *

We manageequity price risk on an integrated basis with other risks through our asset andliability management strategies.  Riskexposures to equity securities are also managed through industry and issuerdiversification and asset allocation.

 

##### *Asset andLiability Management*

##### * *

We evaluateinterest rate risk by periodically projecting our asset and liability cashflows to evaluate the potential sensitivity of our securities investments andliabilities to interest rate movements. Creating these projections involves evaluating the potential gain orloss on most of our in-force business under various increasing and decreasinginterest rate environments.  We manageinterest rate risk and attempt to mitigate against a mismatch greater thanacceptable tolerance levels in the duration of our assets and liabilities byselecting investments with characteristics such as duration, yield, currencyand liquidity that are tailored to allow us to meet the anticipated

 

70

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cash outflowcharacteristics of our insurance and reinsurance liabilities.  We believe that the duration of our investedassets are appropriate for our business given the nature of our liabilities andthe current interest rate environment.  Liabilitydurations cannot be calculated precisely due to the uncertainty of the timingand amount of liability cash flows.  As aresult, there is no generally recognized method of computation of liabilitydurations.

 

For acquiredblocks of business and other products, the average duration of the associatedassets is within or close to the liability duration range.  For long-term care, the liability durationrange is longer than the average duration of the associated assets.  This duration mismatch results inreinvestment risk when assets mature prior to the termination of the associatedliabilities and funds must be reinvested, but does not result in liquidityrisk.  However, we do not believe thatthis reinvestment risk is significant given our belief that future investmentconditions will be at least as favorable as present conditions.

 

As a result ofthe duration profile of our investment portfolio and product liabilities, aswell as our internal cash flow projections, we do not anticipate having todispose of investment securities at inopportune times and/or market prices oraccess credit facilities to obtain required liquidity in the future.

 

The interestrate sensitivity of our fixed maturity security assets is assessed usinghypothetical test scenarios that assume several positive and negative parallelshifts of the underlying yield curve. The individual securities are repriced under each scenario using avaluation model.  For investments such asmortgage-backed and asset-backed securities, a prepayment model was used inconjunction with a valuation model.  Ouractual experience may differ from the results noted below if actual experiencediffers from assumptions utilized or if events occur that were not included inthe assumptions.  The following tablesummarizes the results of this analysis for fixed maturity securities held inour investment portfolio:

 

**InterestRate Movement Analysisof Market Value of Fixed Maturity Securities Investment PortfolioAs of December 31, 2004**

** **
| **Basis Point Change**                       | ** ** | **-100**                  | ** ** | **-50** | ** ** | **0**  | ** ** | **50** | ** ** | **100** | ** ** |
|----------------------------------------------|------------|---------------------------|------------|---------|------------|--------|------------|--------|------------|---------|------------|
| ** **                                   | ** ** | **(dollars in millions)** | ** ** |
| Total market value                           |       | $                         | 434.5      |    | $          | 421.9  |       | $      | 409.6      |    | $          | 397.6 |   | $ | 385.9 |   |
| % Change in market value from base case      |       | 6.1                       | %          | 3.0     | %          | — |       | (2.9   | )%         | (5.8    | )%         |
| $ Change in market value from base case |       | $                         | 24.9       |    | $          | 12.3   |       | $      | —     |    | $          | (12.0 | ) | $ | (23.7 | ) |

 

Asset andliability management is currently the responsibility of our investmentcommittee and chief actuary, which are responsible for setting a broad assetand liability management policy and strategy, reviewing and approving targetportfolios, establishing investment guidelines and limits and providingoversight of the portfolio management process.

 

The portfoliomanagers and asset sector specialists that have been assigned by ourthird-party investment managers and who have responsibility on a day-to-daybasis for risk management of their respective investing activities implementthe goals and objectives established by our investment committee.  The goals of the investment process are tooptimize after-tax, risk-adjusted current investment income and after-tax,risk-adjusted total return while ensuring that the assets and liabilities aremanaged on a cash flow and duration basis. The risk management objectives established by our investment committeestress quality, diversification, asset/liability matching, liquidity and investmentreturn.

 

Ourpredecessor’s risk management strategies prior to the closing of the Kanawhaacquisition did not incorporate the use of various interest rate derivativesthat are used to adjust the overall duration and cash flow profile of itsinvested asset portfolios to better match the duration and cash flow profile ofits liabilities to reduce interest rate risk. We are re-evaluating strategies for risk management, including whetherto utilize derivatives in order to hedge some exposures in the future.  Examples of such instruments includefinancial futures, financial forwards, interest rate and credit default swaps,floors, options, written covered calls and caps.

 

71

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##### *Credit Risk*

##### * *

We are exposedto credit risk primarily as a holder of fixed income securities and as a partyto reinsurance cessions.

 

Our riskmanagement strategy and investment policy is to invest in debt instruments ofissuers with high credit ratings and to limit the amount of credit exposurewith respect to any one issuer.  Weattempt to limit our credit exposure by imposing fixed maturity portfoliolimits on individual issuers based upon credit ratings.  Currently, our portfolio limits are 1.3% forissuers rated AA- and above, 0.9% for issuers rated A- to A+, 0.4% for issuersrated BBB- to BBB+ and 0.3% for issuers rated BB- to BB+.  These portfolio limits are further reducedfor some issuers with whom we have credit exposure on reinsuranceagreements.  We use the lower of Moody’sor Standard & Poor’s ratings to determine an issuer’s rating.

 

The followingtable presents our fixed maturity investment portfolio by ratings of thenationally recognized securities rating organizations as of December 31,2004:

 
| **Rating**  | ** ** | **Carrying Value**         | ** ** | **Percentage of Total** | ** ** |
|-------------|------------|----------------------------|------------|-------------------------|------------|
| ** **  | ** ** | **(dollars in thousands)** | ** ** |
| AAA/AA/A    |       | $                          | 331,539.4  |                    | 80.9       | % |
| BBB         |       | 69,366.5                   |       | 16.9                    |       |
| BB          |       | 6,432.1                    |       | 1.6                     |       |
| B and lower |       | 2,275.2                    |       | 0.6                     |       |
| Total       |       | $                          | 409,613.2  |                    | 100.0      | % |

 

We are alsoexposed to the credit risk of our reinsurers. When we reinsure, we are still liable to our insureds regardless ofwhether we receive reimbursement from our reinsurer.  In the event one or more of our reinsurersdefaults on its obligations, it could adversely affect our financial conditionand the results of our operations.  Aspart of our overall risk and capacity management strategy, we purchasereinsurance for some risks underwritten by our various businesses.

 

Over 50% ofour $71.4 million of reinsurance recoverables at December 31, 2004, areprotected from credit risk because the reinsurer has placed amounts in a trustaccount that is pledged to us.  The trustaccount values are at least equal to the recoverable amounts from theunderlying reinsurance agreements.  Forrecoverables that are not protected by these mechanisms, we depend solely onthe credit of the reinsurer. Substantially all of our reinsurance exposure has been ceded tocompanies rated “A-” or better by A.M. Best.

 

##### *Inflation Risk*

##### * *

We are exposedto inflation risk because we invest substantial funds in nominal assets, whichare not indexed to the level of inflation, but the underlying liabilities areindexed to the level of inflation.  Lifeinsurance policies with reserves of approximately $8.1 million as of December 31,2004 (representing 2.2% of our total reserves), have death benefits that areguaranteed to grow based on inflation linked indices.  Substantially all of these policies aresubject to caps that limit the amount by which the death benefits can grow eachyear.  In times of rapidly risinginflation the credited death benefit growth on these liabilities increasesrelative to the investment income earned on the nominal assets, resulting in anadverse impact on earnings.

 

In addition,we are exposed to inflation risk with respect to some major medical insurancepolicies to the extent that medical costs increase with inflation at a greaterpace than our ability to increase premiums.

 

##### *ForeignExchange Risk*

##### * *

We have noexposure to foreign exchange risk arising from our insurance and other businessoperations.  We also have little foreignexchange exposure in our investment portfolio. Total invested assets from foreign issuers were less than 10% of ourtotal invested assets at December 31, 2004, but all of these foreigninvestments were denominated in dollars.

 

72

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##### *Derivatives*

##### * *

Derivativesare financial instruments whose values are derived from interest rates, foreignexchange rates, financial indices or the prices of securities orcommodities.  Derivative financialinstruments may be exchange-traded or contracted in the over-the-counter marketand include swaps, futures, options and forward contracts.

 

Underinsurance statutes, insurance companies may use derivative financialinstruments to hedge actual or anticipated changes in their assets orliabilities, to replicate cash market instruments or for some income-generatingactivities.  These statutes generallyprohibit the use of derivatives for speculative purposes.

 

Prior to thecompletion of the Kanawha acquisition, our predecessor historically had notused derivative financial instruments. However, we are considering and in the future may elect to utilizederivatives in order to hedge some exposures.

 

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## **ITEM 8.**                             FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

 
| Report of Independent Registered Public  Accounting Firm                                                                                                                                                                                |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                                    |   |
| Consolidated Balance Sheets for KMG America  Corporation as of December 31, 2004, and for Kanawha Insurance Company (the  “Predecessor”), as of December 31, 2003                                                             |   |
|                                                                                                                                                                                                                                    |   |
| Consolidated Statements of Operations for  KMG America Corporation for the period January 21, 2004 (inception) through  December 31, 2004, and for the Predecessor for the years ended December 31,  2002, 2003 and 2004                |   |
|                                                                                                                                                                                                                                    |   |
| Consolidated Statements of Shareholders’  Equity for KMG America Corporation for the period January 21, 2004  (inception) through December 31, 2004, and for the Predecessor for the years  ended December 31, 2002, 2003 and 2004 |   |
|                                                                                                                                                                                                                                    |   |
| Consolidated Statements of Cash Flows for  KMG America Corporation for the period January 21, 2004 (inception) through  December 31, 2004, and for the Predecessor for the years ended December 31,  2002, 2003 and 2004                |   |
|                                                                                                                                                                                                                                    |   |
| Notes to Consolidated Financial Statements                                                                                                                                                                                              |   |
|                                                                                                                                                                                                                                    |   |
| Schedule III – Supplementary Insurance  Information*                                                                                                                                                                               |   |

 

----

* All other required financial statement schedules are omitted becausethe information required is either not applicable or is included in thefinancial statements or the related notes included in this report.

 

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**REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

 

Board of Directors

KMG America Corporation

 

We haveaudited the accompanying consolidated balance sheets of the Predecessor, asdefined in Note 1, as of December 31, 2003 and KMG America Corporation (“theCompany”) as of December 31, 2004, and the Predecessor’s consolidatedstatements of operations, shareholders’ equity and cash flows for the yearsended December 31, 2002, 2003 and 2004 and the Company’s statements ofoperations, shareholders’ equity and cash flows for the period January 21, 2004(inception) through December 31, 2004. Our audits also included the financialstatement schedule listed in the Index at Item 15(2). These financialstatements and schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements andschedule based on our audits.

 

We conductedour audits in accordance with the standards of the Public Company AccountingOversight Board (United States). Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes considerationof internal control over financial reporting as a basis for designing auditprocedures that are appropriate in the circumstances, but not for the purposeof expressing an opinion on the effectiveness of the Company’s internal controlover financial reporting. Accordingly, we express no such opinion. An auditalso includes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management and evaluating the overallfinancial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the consolidated financial position of the Predecessor atDecember 31, 2003 and the Company at December 31, 2004, and the Predecessor’sconsolidated results of operations and cash flows for the years ended December31, 2002, 2003 and 2004 and the Company’s results of operations and cash flowsfor the period January 21, 2004 (inception) through December 31, 2004, inconformity with U.S. generally accepted accounting principles. Also, in ouropinion, the related financial statement schedule, when considered in relationto the basic financial statements taken as a whole, presents fairly in allmaterial respects the information set forth therein.

 
|                       |                 |
|----------------------------|----------------------|
| Greensboro, North Carolina | /s/ Ernst  Young LLP |
| March 25, 2005             |

 

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**KMG AMERICA CORPORATION AND PREDECESSORCONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                      | ** ** | **Predecessor**  | ** **  | **KMG America  Corporation** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|-------------|------------------------------|------------|
| ** **                                                                                                                                      | ** ** | **December 31,** | ** **  |
| ** **                                                                                                                                      | ** ** | **2003**         | ** **  | **2004**                     | ** ** |
| **Assets**                                                                                                                                      |       | ** **       |        |                         |       |
| ** **                                                                                                                                      | ** ** | ** **       | ** **  | ** **                   | ** ** |
| Investments:                                                                                                                                    |       |             |        |                         |       |
| Fixed maturity securities available for  sale, at fair value (amortized cost of $396,028,558 and $409,613,186 for 2003  and 2004, respectively) |       | $                | 414,825,975 |                         | $          | 409,613,186 |   |
| Equity securities available for sale, at  fair value (cost of $346,742 and $36,000 for 2003 and 2004, respectively)                             |       | 2,824,857        |        | 36,000                       |       |
| Mortgage loans                                                                                                                                  |       | 31,630,597       |        | 23,678,639                   |       |
| Policy loans                                                                                                                                    |       | 22,940,322       |        | 22,620,801                   |       |
| Other investments                                                                                                                               |       | 4,978,220        |        | 5,192,525                    |       |
| Total investments                                                                                                                               |       | 477,199,971      |        | 461,141,151                  |       |
|                                                                                                                                            |       |             |        |                         |       |
| Cash and cash equivalents                                                                                                                       |       | 7,204,805        |        | 117,400,156                  |       |
| Reinsurance balances recoverable                                                                                                                |       | 61,151,197       |        | 71,354,798                   |       |
| Accrued investment income                                                                                                                       |       | 5,387,138        |        | 4,912,216                    |       |
| Real estate and equipment (net of  accumulated depreciation of $19,867,031 in 2003)                                                             |       | 10,991,008       |        | 9,701,754                    |       |
| Federal income tax recoverable                                                                                                                  |       | 477,574          |        | 4,239,906                    |       |
| Deferred income tax asset                                                                                                                       |       | —           |        | 236,319                      |       |
| Receivable from affiliates                                                                                                                      |       | 90,166           |        | —                       |       |
| Amounts due from reinsurers                                                                                                                     |       | 1,829,402        |        | 1,940,903                    |       |
| Deferred policy acquisition costs                                                                                                               |       | 80,656,518       |        | —                       |       |
| Value of business acquired                                                                                                                      |       | 29,604,632       |        | 74,481,295                   |       |
| Goodwill                                                                                                                                        |       | 1,257,580        |        | —                       |       |
| Other assets                                                                                                                                    |       | 9,320,274        |        | 24,642,833                   |       |
| Total assets                                                                                                                                    |       | $                | 685,170,265 |                         | $          | 770,051,331 |   |

 

See accompanying notes.

 

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| ** **                                                                                                                                                                                                                           | ** ** | **Predecessor**  | ** **  | **KMG America  Corporation** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|-------------|------------------------------|------------|
| ** **                                                                                                                                                                                                                           | ** ** | **December 31,** | ** **  |
| ** **                                                                                                                                                                                                                           | ** ** | **2003**         | ** **  | **2004**                     | ** ** |
|                                                                                                                                                                                                                                 |       |             |        |                         |       |
| **Liabilities and shareholders’ equity**                                                                                                                                                                                        |       |             |        |                         |       |
|                                                                                                                                                                                                                                 |       |             |        |                         |       |
| Liabilities:                                                                                                                                                                                                                         |       |             |        |                         |       |
| Policy and contract liabilities:                                                                                                                                                                                                     |       |             |        |                         |       |
| Life and annuity reserves                                                                                                                                                                                                            |       | $                | 299,884,170 |                         | $          | 309,940,285 |   |
| Accident and health reserves                                                                                                                                                                                                         |       | 141,209,015      |        | 200,801,846                  |       |
| Policy and contract claims                                                                                                                                                                                                           |       | 10,460,716       |        | 9,343,512                    |       |
| Other policyholder liabilities                                                                                                                                                                                                       |       | 10,461,145       |        | 10,829,794                   |       |
| Total policy and contract liabilities                                                                                                                                                                                                |       | 462,015,046      |        | 530,915,437                  |       |
|                                                                                                                                                                                                                                 |       |             |        |                         |       |
| Accounts payable and accrued expenses                                                                                                                                                                                                |       | 13,080,702       |        | 18,794,922                   |       |
| Taxes, other than federal income taxes                                                                                                                                                                                               |       | 499,635          |        | 528,262                      |       |
| Deferred income taxes                                                                                                                                                                                                                |       | 22,827,314       |        | 6,502,042                    |       |
| Liability for benefits for employees and  agents                                                                                                                                                                                     |       | 6,285,355        |        | 4,158,418                    |       |
| Funds held in suspense                                                                                                                                                                                                               |       | 5,874,285        |        | 4,724,004                    |       |
| Long term notes payable                                                                                                                                                                                                              |       | —           |        | 15,022,603                   |       |
| Other liabilities                                                                                                                                                                                                                    |       | 1,111,399        |        | 1,617,778                    |       |
| Total liabilities                                                                                                                                                                                                                    |       | 511,693,736      |        | 582,263,466                  |       |
|                                                                                                                                                                                                                                 |       |             |        |                         |       |
| Shareholders’ equity:                                                                                                                                                                                                           |       |             |        |                         |       |
| Common Stock: Predecessor common stock, par  value $1,549.4254 per share, 2,612.83487 shares authorized and issued; KMG  America common stock, par value $0.01 per share, 75,000,000 shares authorized  and 22,071,641 shares issued |       | 4,048,393        |        | 220,716                      |       |
| Paid-in capital                                                                                                                                                                                                                      |       | 21,722,289       |        | 187,742,702                  |       |
| Deferred stock option compensation                                                                                                                                                                                                   |       | (207,067         | )           | —                       |       |
| Retained earnings                                                                                                                                                                                                                    |       | 134,114,967      |        | (175,553                     | )          |
| Accumulated other comprehensive income                                                                                                                                                                                               |       | 13,797,947       |        | —                       |       |
| Total shareholders’ equity                                                                                                                                                                                                      |       | 173,476,529      |        | 187,787,865                  |       |
| Total liabilities and shareholders’ equity                                                                                                                                                                                      |       | $                | 685,170,265 |                         | $          | 770,051,331 |   |
|                                                                                                                                                                                                                                      |            |                  |             |                              |            |  |  |  |

 

See accompanying notes.

 

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**KMGAMERICA CORPORATION AND**

**PREDECESSOR**

**CONSOLIDATED STATEMENTS OF OPERATIONS**

 
| ** **                                                                        | ** ** | ** **                  | ** ** | **KMG America  Corporation**         | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------------------|------------|
| ** **                                                                        | ** ** | **Predecessor**             | ** ** | **Period from  January 21  through** | ** ** |
| ** **                                                                        | ** ** | **Year Ended December 31,** | ** ** | **December 31,**                     | ** ** |
| ** **                                                                        | ** ** | **2002**                    | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2004** | ** ** |
| Revenue:                                                                          |       |                        |       |                                 |       |   |   |   |   |
| Insurance premiums                                                                |       | $                           | 98,643,122 |                                 | $          | 106,415,874 |   | $ | 102,835,545 |   | $ | — |   |
| Net investment income                                                             |       | 27,160,231                  |       | 27,072,759                           |       | 25,202,412 |   | 18,408 |   |
| Commission and fee income                                                         |       | 12,974,620                  |       | 13,018,019                           |       | 13,475,522 |   | — |   |
| Realized investment gains (losses)                                                |       | (3,003,877                  | )          | 7,600,499                            |       | 9,432,585 |   | — |   |
| Other income                                                                      |       | 1,869,414                   |       | 2,317,320                            |       | 3,108,227 |   | — |   |
| Total revenues                                                                    |       | 137,643,510                 |       | 156,424,471                          |       | 154,054,291 |   | 18,408 |   |
|                                                                              |       |                        |       |                                 |       |   |   |   |   |
| Benefits and expenses:                                                            |       |                        |       |                                 |       |   |   |   |   |
| Policyholder benefits                                                             |       | 81,284,878                  |       | 89,261,072                           |       | 90,174,993 |   | — |   |
| Insurance commissions, net of deferrals                                           |       | 7,351,365                   |       | 9,074,242                            |       | 9,690,077 |   | — |   |
| General insurance expenses, net of  deferrals                                     |       | 28,406,846                  |       | 29,538,122                           |       | 27,794,989 |   | 284,434 |   |
| Insurance taxes, licenses and fees                                                |       | 3,927,092                   |       | 4,708,052                            |       | 4,677,617 |   | 4,055 |   |
| Depreciation                                                                      |       | 2,919,128                   |       | 3,004,815                            |       | 2,491,942 |   | — |   |
| Amortization of deferred policy acquisition  costs and value of business acquired |       | 9,515,458                   |       | 9,588,530                            |       | 9,468,302 |   | — |   |
| Total benefits and expenses                                                       |       | 133,404,767                 |       | 145,174,833                          |       | 144,297,920 |   | 288,489 |   |
|                                                                              |       |                        |       |                                 |       |   |   |   |   |
| Income (loss) before income taxes                                                 |       | 4,238,743                   |       | 11,249,638                           |       | 9,756,371 |   | (270,081 | ) |
| (Provision) benefit for income taxes                                              |       | (1,157,288                  | )          | (3,499,341                           | )          | (3,565,872 | ) | 94,528 |   |
| Net income (loss)                                                                 |       | $                           | 3,081,455  |                                 | $          | 7,750,297 |   | $ | 6,190,499 |   | $ | (175,553 | ) |
| Net income (loss) per share:                                                      |       |                        |       |                                 |       |   |   |   |   |
| Basic                                                                             |       | $                           | 1,179.36   |                                 | $          | 2,966.25 |   | $ | 2,369.27 |   | $ | (0.01 | ) |
| Diluted                                                                           |       | $                           | 1,066.87   |                                 | $          | 2,679.87 |   | $ | 2,132.71 |   | $ | (0.01 | ) |
| Weighted-average shares outstanding:                                              |       |                        |       |                                 |       |   |   |   |   |
| Basic                                                                             |       | 2,612.83                    |       | 2,612.83                             |       | 2,612.83 |   | 22,071,641 |   |
| Diluted                                                                           |       | 2,888.30                    |       | 2,892.04                             |       | 2,902.64 |   | 22,241,550 |   |

 

See accompanying notes.

 

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**KMGAMERICA CORPORATION AND PREDECESSOR**

**CONSOLIDATED STATEMENTS OF SHAREHOLDERS’EQUITY**

**Predecessorfrom January 1, 2002, through December 31, 2004,and KMG America Corporation from January 21, 2004, through December 31, 2004**

 
| ** **                                                | ** ** | **Common  Stock** | ** ** | **Paid-in  Capital** | ** ** | **Deferred  Stock Option  Compensation** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Total  Shareholders’  Equity** | ** ** |
|-----------------------------------------------------------|------------|-------------------|------------|----------------------|------------|------------------------------------------|------------|------------------------|------------|------------------------------------------------------|------------|---------------------------------------|------------|
| **Predecessor:**                                          |       |              |       |                 |       |                                     |       |                   |       |                                                 |       |                                  |       |
| Balance at January 1, 2002                                |       | $                 | 4,048,393  |                 | $          | 21,722,289                               |       | $                      | (770,527   | )                                                    | $          | 126,783,212                           |       | $ | 4,828,399 |   | $ | 156,611,766 |   |
| Net income                                                |       | —            |       | —               |       | —                                   |       | 3,081,455              |       | —                                               |       | 3,081,455                             |       |
| Change in net unrealized gains                            |       | —            |       | —               |       | —                                   |       | —                 |       | 8,456,720                                            |       | 8,456,720                             |       |
| Comprehensive income                                      |       | —            |       | —               |       | —                                   |       | —                 |       | —                                               |       | 11,538,175                            |       |
| Stock option compensation expense                         |       | —            |       | —               |       | 334,440                                  |       | —                 |       | —                                               |       | 334,440                               |       |
| Dividends to shareholders                                 |       | —            |       | —               |       | —                                   |       | (1,749,998             | )          | —                                               |       | (1,749,998                            | )          |
| Balance at December 31, 2002                              |       | 4,048,393         |       | 21,722,289           |       | (436,087                                 | )          | 128,114,669            |       | 13,285,119                                           |       | 166,734,383                           |       |
| Net income                                                |       | —            |       | —               |       | —                                   |       | 7,750,297              |       | —                                               |       | 7,750,297                             |       |
| Change in net unrealized gains                            |       | —            |       | —               |       | —                                   |       | —                 |       | 543,979                                              |       | 543,979                               |       |
| Minimum pension  liability                                |       | —            |       | —               |       | —                                   |       | —                 |       | (31,151                                              | )          | (31,151                               | )          |
| Comprehensive income                                      |       | —            |       | —               |       | —                                   |       | —                 |       | —                                               |       | 8,263,125                             |       |
| Stock option compensation expense                         |       | —            |       | —               |       | 229,020                                  |       | —                 |       | —                                               |       | 229,020                               |       |
| Dividends to shareholders                                 |       | —            |       | —               |       | —                                   |       | (1,749,999             | )          | —                                               |       | (1,749,999                            | )          |
| Balance at December 31, 2003                              |       | 4,048,393         |       | 21,722,289           |       | (207,067                                 | )          | 134,114,967            |       | 13,797,947                                           |       | 173,476,529                           |       |
| Net income                                                |       | —            |       | —               |       | —                                   |       | 6,190,499              |       | —                                               |       | 6,190,499                             |       |
| Change in net unrealized gains                            |       | —            |       | —               |       | —                                   |       | —                 |       | (1,652,222                                           | )          | (1,652,222                            | )          |
| Minimum pension  liability                                |       | —            |       | —               |       | —                                   |       | —                 |       | 31,151                                               |       | 31,151                                |       |
| Comprehensive income                                      |       |              |       |                 |       |                                     |       |                   |       |                                                 |       | 4,569,428                             |       |
| Stock option compensation expense                         |       | —            |       | —               |       | 207,067                                  |       | —                 |       | —                                               |       | 207,067                               |       |
| Stock options exercised                                   |       | 576,076           |       | 5,571,627            |       | —                                   |       | —                 |       | —                                               |       | 6,147,703                             |       |
| Tax benefit of stock options exercised                    |       | —            |       | 1,512,877            |       | —                                   |       | —                 |       | —                                               |       | 1,512,877                             |       |
| Balance at December 31, 2004                              |       | $                 | 4,624,469  |                 | $          | 28,806,793                               |       | $                      | —     |                                                 | $          | 140,305,466                           |       | $ | 12,176,876 |   | $ | 185,913,604 |   |
|                                                      |       |              |       |                 |       |                                     |       |                   |       |                                                 |       |                                  |       |
| **KMG America Corporation:**                              |       |              |       |                 |       |                                     |       |                   |       |                                                 |       |                                  |       |
| Incorporation and initial public offering  of KMG America |       | $                 | 220,716    |                 | $          | 187,742,702                              |       | $                      | —     |                                                 | $          | —                                |       | $ | — |   | $ | 187,963,418 |   |
| Net income                                                |       | —            |       | —               |       | —                                   |       | (175,553               | )          | —                                               |       | (175,553                              | )          |
| Balance at December 31, 2004                              |       | $                 | 220,716    |                 | $          | 187,742,702                              |       | $                      | —     |                                                 | $          | (175,553                              | )          | $ | — |   | $ | 187,787,865 |   |

 

See accompanying notes.

 

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**KMGAMERICA CORPORATION AND PREDECESSOR**

**CONSOLIDATED STATEMENTS OF CASH FLOW**

 
| ** **                                                                                          | ** ** | ** **                  | ** ** | **KMG America  Corporation**         | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------------------|------------|
| ** **                                                                                          | ** ** | **Predecessor**             | ** ** | **Period from  January 21  through** | ** ** |
| ** **                                                                                          | ** ** | **Year Ended December 31,** | ** ** | **December 31,**                     | ** ** |
| ** **                                                                                          | ** ** | **2002**                    | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2004** | ** ** |
| Net income (loss)                                                                                   |       | $                           | 3,081,455  |                                 | $          | 7,750,297 |   | $ | 6,190,499 |   | $ | (175,553 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |       |                        |       |                                 |       |   |   |   |   |
| Depreciation and amortization                                                                       |       | 3,284,232                   |       | 3,729,188                            |       | 2,904,235 |   | — |   |
| Policy acquisition costs deferred and value  of business acquired                                   |       | (17,421,879                 | )          | (14,544,948                          | )          | (13,124,972 | ) | — |   |
| Amortization of deferred policy acquisition  costs and value of business acquired                   |       | 9,515,458                   |       | 9,588,530                            |       | 9,468,302 |   | — |   |
| Realized investment losses (gains), net                                                             |       | 3,003,877                   |       | (7,600,499                           | )          | (9,432,585 | ) | — |   |
| Deferred income tax expense                                                                         |       | 706,155                     |       | 2,712,583                            |       | 4,355,232 |   | (94,528 | ) |
| Changes in operating assets and  liabilities:                                                       |       |                        |       |                                 |       |   |   |   |   |
| Reinsurance balances recoverable                                                                    |       | (4,977,102                  | )          | (20,175,539                          | )          | (6,675,012 | ) | — |   |
| Accrued investment income                                                                           |       | 768,575                     |       | 541,693                              |       | 477,935 |   | (3,013 | ) |
| Federal income tax recoverable                                                                      |       | 1,093,248                   |       | 145,437                              |       | (3,762,332 | ) | — |   |
| Receivable from affiliates                                                                          |       | 74,901                      |       | 649,658                              |       | 34,055 |   | — |   |
| Other assets                                                                                        |       | 287,694                     |       | (3,244,979                           | )          | 2,165,349 |   | (22,019 | ) |
| Amounts due from reinsurers                                                                         |       | (287,319                    | )          | (132,922                             | )          | (111,501 | ) | — |   |
| Policy and contract liabilities                                                                     |       | 21,211,667                  |       | 21,190,641                           |       | 24,638,984 |   | — |   |
| Accounts payable and accrued expenses                                                               |       | 6,252,057                   |       | (7,766,207                           | )          | 4,531,863 |   | 1,213,508 |   |
| Deferred stock option compensation expense                                                          |       | 334,440                     |       | 229,020                              |       | 207,067 |   | — |   |
| Taxes, other than federal income taxes                                                              |       | 286,793                     |       | (486,253                             | )          | 28,627 |   | — |   |
| Funds held in suspense                                                                              |       | 154,552                     |       | 2,790,524                            |       | (276,281 | ) | — |   |
| Liability for benefits for employees and  agents                                                    |       | 179,645                     |       | (2,293,174                           | )          | (2,126,937 | ) | — |   |
| Other liabilities                                                                                   |       | (372,394                    | )          | 26,805                               |       | 506,378 |   | — |   |
| Net cash provided by (used in) operating  activities                                                |       | 27,176,055                  |       | (6,890,145                           | )          | 19,998,906 |   | 918,395 |   |
| **Investing activities**                                                                            |       |                        |       |                                 |       |   |   |   |   |
| Securities available for sale:                                                                      |       |                        |       |                                 |       |   |   |   |   |
| Sales                                                                                               |       | 175,429,170                 |       | 178,810,507                          |       | 101,856,930 |   | — |   |
| Maturities, calls and redemptions                                                                   |       | 22,880,132                  |       | 5,685,729                            |       | 6,604,630 |   | — |   |
| Purchases                                                                                           |       | (216,091,324                | )          | (214,593,359                         | )          | (94,233,206 | ) | — |   |
| Proceeds from sale of short term  investments                                                       |       | —                      |       | 75,000                               |       | — |   | — |   |
| Repayments of mortgage loans                                                                        |       | 21,090,735                  |       | 24,684,231                           |       | 9,965,210 |   | — |   |
| Mortgage loans originated                                                                           |       | (18,379,229                 | )          | (3,270,300                           | )          | (792,951 | ) | — |   |
| Increase in policy loans, net                                                                       |       | (31,791                     | )          | 3,088,784                            |       | 319,520 |   | — |   |
| Sale of real estate and property and  equipment                                                     |       | —                      |       | 500,000                              |       | — |   | — |   |
| Purchases of real estate, property and  equipment                                                   |       | (3,767,462                  | )          | (1,851,896                           | )          | (1,088,897 | ) | — |   |
| Acquisition of the Predecessor, net of cash  acquired                                               |       | —                      |       | —                               |       | — |   | (71,481,657 | ) |
| Net cash provided by (used in) investing  activities                                                |       | (18,869,769                 | )          | (6,871,304                           | )          | 22,631,236 |   | (71,481,657 | ) |
| **Financing activities**                                                                            |       |                        |       |                                 |       |   |   |   |   |
| Proceeds of initial public offering                                                                 |       | —                      |       | —                               |       | — |   | 187,963,418 |   |
| Capital contributions                                                                               |       | —                      |       | —                               |       | 9,432,845 |   | — |   |
| Cash dividends paid                                                                                 |       | (1,749,998                  | )          | (1,749,999                           | )          | — |   | — |   |
| Net cash provided by (used in) financing activities                                                 |       | (1,749,998                  | )          | (1,749,999                           | )          | 9,432,845 |   | 187,963,418 |   |
| Net increase (decrease) in cash and cash  equivalents                                               |       | 6,556,288                   |       | (15,511,448                          | )          | 52,062,987 |   | 117,400,156 |   |
| Cash and cash equivalents at beginning of  year                                                     |       | 16,159,965                  |       | 22,716,253                           |       | 7,204,805 |   | — |   |
| Cash and cash equivalents at end of year                                                            |       | $                           | 22,716,253 |                                 | $          | 7,204,805 |   | $ | 59,267,792 |   | $ | 117,400,156 |   |
| **Supplemental disclosures of cash flow  information**                                              |       |                        |       |                                 |       |   |   |   |   |
| Federal income taxes paid                                                                           |       | $                           | —     |                                 | $          | 866,816 |   | $ | 600,000 |   | $ | — |   |
|                                                                                                     |            |                             |            |                                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes.

 

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**KMG AMERICACORPORATION AND PREDECESSOR**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

#### **1. Organization,Kanawha Acquisition and Initial Public Offering**

 

KMG AmericaCorporation (“KMG America” or the “Company”) was incorporated onJanuary 21, 2004, as a Virginia corporation. KMG America was formed toacquire Kanawha Insurance Company (“Kanawha” or the “Predecessor”), a life andhealth insurance company.

 

KMG Americacommenced its operations shortly before it completed its initial publicoffering of 21,735,000 shares of common stock on December 21, 2004. The netproceeds from the initial public offering of common stock, after deducting theunderwriting discount and offering expenses payable by KMG America, wereapproximately $188.0 million. KMG America used $130.0 million of the netproceeds to fund the cash portion of the purchase price to acquire all of theoutstanding common stock of the Predecessor on December 21, 2004.

 

The remainingnet proceeds, approximately $58.0 million, have or are expected to be used asworking capital for general corporate purposes, including:

 

**•**                  to pay KMGAmerica’s fees and expenses incurred in connection with the acquisition of thePredecessor, approximately $0.8 million;

 

**•**                  to fund negativecash flow of approximately $5.0 million to $6.0 million associated with initialstart-up costs and other expenditures that have been incurred and that KMGAmerica anticipates will be incurred in 2005, including expenditures to open,improve and relocate KMG America’s principal offices within the Minneapolis,Minnesota metropolitan area, as well as to open new facilities in New England,southern California and other selected markets, and to hire and trainadditional sales and support staff and marketing personnel at these newfacilities; and

 

**•**                  to maintain therequired capital of Kanawha at the level necessary to achieve its desiredrating agency financial strength ratings and to comply with applicableregulatory requirements, which, based on a preliminary estimate, is expected tobe between $32.2 million and $33.2 million.

 

For accountingpurposes, Kanawha is treated as KMG America’s predecessor entity and isreferred to in these Notes as the “Predecessor.” For financial reportingpurposes, management has treated the acquisition of the Predecessor as if itclosed on December 31, 2004, rather than the actual closing date of December21, 2004, as the effects of the acquisition for the period from December 21,2004, through December 31, 2004, were not material to the Predecessor’sconsolidated statements of operations, cash flows, and changes in shareholders’equity for the year ended December 31, 2004. Accordingly, financial informationin the following discussion that relates to the Predecessor’s consolidatedresults of operations, cash flows and changes in shareholders’ equity for theyear ended December 31, 2004 are reported on a historical basis without GAAP(generally accepted accounting principles in the United States) purchaseaccounting adjustments reflecting the acquisition of the Predecessor. Financialinformation relating to the Company’s financial position as of December 31,2004, has been adjusted for GAAP purchase accounting adjustments reflecting thePredecessor’s acquisition.

 

#### **2. Nature ofOperations and Significant Accounting Policies**

 

Kanawha, theprimary operating subsidiary of KMG America, is licensed to issue life andaccident and health insurance. Kanawha is domiciled in South Carolina. Kanawhahas one wholly owned subsidiary, Kanawha HealthCare Solutions, Inc., a third-partyadministrator with operations in Lancaster and Greenville, South Carolina.

 

The Company’sprimary businesses are life and health insurance risk assumption, third-partyadministration and medical management services. Included in risk assumption arethe Company’s product lines of individual life, annuity, supplemental healthand short-term disability, as well as products specifically directed at thesenior market including Medicare supplement, final expense life insurance andlong-term care products. The Company’s

 

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third-party administration andmedical management businesses include a wide array of services with the primaryemphasis in the offering of administrative service-only products.

 

The Company’ssales are primarily in the southeastern United States, predominantly inFlorida, South Carolina and North Carolina, and are marketed through full-timeagents, general agents and brokers. Premium revenues are concentrated in theindividual life and accident and health lines of business.

 

#### **Use ofEstimates and Assumptions**

 

Thepresentation of the accompanying consolidated financial statements requiresmanagement to make estimates and assumptions that affect amounts reported inthe consolidated financial statements and accompanying notes. Such estimatesand assumptions could change in the future as more information becomes known,which could impact the amounts reported and disclosed herein.

 

#### **Basis ofPresentation**

 

Theaccompanying consolidated financial statements for the Predecessor reflecthistorical consolidated financial statements of the Predecessor prior to itsacquisition by the Company and have been prepared in conformity with GAAP. Theaccompanying consolidated financial statements include the accounts of theCompany and the Predecessor after elimination of all significant intercompanybalances and transactions. The Company also submits financial statements toinsurance industry regulatory authorities. Those financial statements areprepared on the basis of statutory accounting practices (“SAP”) and aresignificantly different from financial statements prepared in accordance withGAAP (see Note 11).

 

#### **Cash and CashEquivalents**

 

The Companyincludes with cash and cash equivalents its holdings of highly liquidinvestments with maturities of three months or less of the date of acquisition.

 

#### **Investments**

 

EffectiveDecember 31, 2004, under GAAP purchase accounting rules, the Company recordedthe Predecessor’s investments at fair value.

 

Statement ofFinancial Accounting Standards (“SFAS”) No. 115, *Accounting for Certain Investments in Fixed Maturity and EquitySecurities*, requires that all fixed maturity and equity securitiesbe classified into one of three categories—held to maturity, available-for-sale,or trading. The Company has no securities classified as held to maturity. Managementdetermines the appropriate classification of fixed maturities at the time ofpurchase.

 

Investments are reported on the following basis:

 

Fixedmaturities classified as available-for-sale are stated at fair value withunrealized gains and losses reported directly in shareholders’ equity asaccumulated other comprehensive income. Fair values for fixed maturitysecurities are based on quoted market prices, where available. For fixedmaturity securities that are not actively traded, fair values are estimatedusing values obtained from independent pricing services.

 

Equitysecurities classified as available-for-sale are stated at fair value withunrealized gains and losses reported directly in shareholders’ equity asaccumulated other comprehensive income.

 

Assetssupporting the deferred compensation plan are classified as trading and areincluded in other investments. Trading account assets are held for resale inanticipation of short-term market movements. Trading account assets, consistingof mutual funds, are stated at fair value. Gains and losses, both realized andunrealized, are included in realized gains and losses effective January 1,2003, when these assets were moved to a trading portfolio.

 

Mortgage loanson real estate are stated at unpaid balances, net of allowances forunrecoverable amounts. Valuation allowances for mortgage loans are establishedwhen the Company determines it is probable that it will be unable to collectall amounts (both principal and interest) due according to the contractualterms of the loan

 

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agreement. Such allowances arebased on the present value of expected future cash flows discounted at the loan’seffective interest rate or, if foreclosure is probable, on the estimated fairvalue of the underlying real estate.

 

Policy loans are stated at their unpaidbalances.

 

Interest onloans is generally recorded over the term of the loan based on the unpaidprincipal balance. Accrual of interest is discontinued when either principal orinterest becomes 90 days past due or when, in management’s opinion, collectionof such interest is doubtful. In addition, any previously accrued interest isreversed when the loan becomes 90 days past due.

 

Otherinvestments are stated at fair value, or the lower of cost or fair value, asappropriate.

 

Amortizationof premiums and accrual of discounts on investments in fixed maturity securitiesare reflected in earnings over the contractual terms of the investments in amanner that produces a constant effective yield. Realized gains and losses ondispositions of securities are determined by the specific-identificationmethod.

 

The Companyregularly reviews its investment portfolio to identify securities that may havesuffered impairments in value that will not be recovered, termed potentiallydistressed securities. In identifying potentially distressed securities, theCompany first screens for all securities that have a fair value to cost oramortized cost ratio of less than 80%. Additionally, as part of thisidentification process, the Company utilizes the following information:

 

**•**      Length of time the fair value was below amortized cost;

 

**•**      Industry factors or conditions related to a geographic areanegatively affecting the security;

 

**•**      Downgrades by a rating agency;

 

**•**      Past due interest or principal payments or other violation ofcovenants; and

 

**•**      Deterioration of the overall financial condition of thespecific issuer.

 

In analyzingits potentially distressed securities list for other-than-temporaryimpairments, the Company pays special attention to securities that have been onthe list for a period greater than six months. The Company assumes that, absentreliable contradictory evidence, a security that is potentially distressed fora continuous period greater than twelve months has incurred an other-than-temporaryimpairment. Reliable contradictory evidence might include, among other factors,a liquidation analysis performed by the Company’s investment advisors oroutside consultants, improving financial performance of the issuer, orvaluation of underlying assets specifically pledged to support the credit.

 

Should theCompany conclude that the decline is other-than-temporary, the security iswritten down to fair value through a charge to realized investment gains andlosses. The Company adjusts the amortized cost for securities that haveexperienced other-than-temporary impairments to reflect fair value at the timeof the impairment. The Company considers factors that lead to an other-than-temporaryimpairment of a particular security in order to determine whether theseconditions have impacted other similar securities.

 

#### **Real Estateand Equipment**

 

Company-occupiedreal estate, primarily buildings, are carried at cost less accumulateddepreciation and are depreciated principally by the straight-line method overestimated useful lives generally ranging from 15 to 30 years. Equipment isstated at cost, less accumulated depreciation, and depreciated principally bythe straight-line method over their estimated useful lives, generally 3 to 5years. Effective December 31, 2004, the Company recorded at fair value realestate occupied by the Predecessor and equipment owned by the Predecessor aspart of the application of GAAP purchase accounting requirements.

 

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Expendituresfor improvements are capitalized, and expenditures for maintenance and repairsare charged to operations as incurred. Upon sale or retirement, the cost andrelated accumulated depreciation and amortization are removed from the accountsand the resulting gain or loss, if any, is reflected in operations. For theyears ending December 31, 2002, 2003 and 2004, total depreciation expense wasapproximately $2.9 million, $3.0 million and $2.5 million, respectively.

 

#### **DeferredPolicy Acquisition Costs**

 

Acquisitioncosts incurred by the Predecessor and the Company in the process of acquiringnew business are deferred and amortized into income as discussed below. Costsdeferred consist primarily of commissions and certain policy underwriting,issue and agency expenses that vary with and are primarily related toproduction of new business.

 

For mostinsurance products, the amortization of deferred acquisition costs isrecognized in proportion to the ratio of annual premium revenue to the totalanticipated premium revenue, which gives effect to expected terminations. Deferredacquisition costs are amortized over the premium-paying period of the relatedpolicies. Anticipated premium revenue is determined using assumptionsconsistent with those utilized in the determination of liabilities forinsurance reserves. For interest-sensitive life insurance and investmentproducts such as deferred annuities (no longer sold by the Company) to theextent recoverable from future gross profits, deferred policy acquisition costsare amortized generally in proportion to the present value of expected grossprofits from surrender charges and investment, mortality and expense margins.

 

ThePredecessor’s deferred acquisition costs at December 31, 2004, were eliminatedupon the closing of the acquisition of the Predecessor as part of theapplication of GAAP purchase accounting requirements. The Company beganrecording deferred acquisition costs prospectively on January 1, 2005.

 

#### **Value ofBusiness Acquired**

 

Value ofbusiness acquired is the value assigned to the insurance in force of acquiredinsurance companies or blocks of insurance business at the date of acquisitionand subsequent renewal commissions.

 

Theamortization of value of business acquired is recognized using amortizationschedules established at the time of the acquisitions based upon expectedannual premium. Certain of these amortization schedules include actual toexpected adjustments to reflect actual experience as it emerges. The value ofbusiness acquired is amortized over the premium-paying period of the policies.

 

ThePredecessor’s historical value of business acquired was eliminated upon theclosing of the Kanawha acquisition as part of the application of GAAP purchaseaccounting requirements. Value of business acquired was simultaneouslyre-established, by the Company, for the value of the Predecessor’s in forcebusiness. Interest rate assumptions used to amortize the value of businessacquired were reset upon the closing of the Kanawha acquisition. The interestrate was approximately 6.0% at December 31, 2004.

 

#### **Goodwill**

 

Goodwillreflected in the Predecessor’s consolidated balance sheet resulted from theacquisition of Kanawha HealthCare Solutions, Inc. (formally Kanawha BenefitSolutions, Inc.) in 1990. Accumulated amortization totaled $3.7 million atDecember 31, 2002 and 2001. Effective January 1, 2002, thePredecessor adopted SFAS No. 141, *BusinessCombinations* (“SFAS No. 141”) and SFAS No. 142 *Goodwill and Other Intangible Assets* (“SFASNo. 142”). Under SFAS No. 142, goodwill and intangible assets with indefinitelives are no longer amortized but are reviewed annually for impairment, or morefrequently if impairment indicators arise, with consideration given tofinancial performance and other relevant factors. In addition, certain eventsincluding a significant adverse change in legal factors or the businessclimate, an adverse action or assessment by a regulator, or unanticipatedcompetition, would cause the Company and the Predecessor to review amounts ofgoodwill for impairment. When considered impaired, the carrying amounts arewritten down using a combination of fair value and discount cash flows. Separateintangible assets that are not deemed to have an indefinite life continue to be

 

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amortized overtheir useful lives. For the years ended December 31, 2003, and 2004, thePredecessor and the Company completed impairment analyses and determined thatgoodwill was not impaired. The Predecessor’s goodwill was eliminated upon theCompany’s closing of the Kanawha acquisition as part of the application of GAAPpurchase accounting requirements.

 

No goodwillwas recorded as a result of the Company’s acquisition of the Predecessor,because the purchase price paid by the Company was less than the fair value ofthe net assets acquired by the Company. The difference was recorded as areduction in the value of certain tangible assets on the acquisition date.

 

#### **Impairment ofLong-Lived Assets**

 

Long-livedassets include property and equipment, other intangible assets, systemsdevelopment and other deferred costs and other assets. In accordance with SFASNo. 144, *Accounting for the Impairment orDisposal of Long-Lived Assets* (“SFAS 144”), the Company regularlyevaluates whether events and circumstances have occurred which indicate thatthe carrying amount of long-lived assets may warrant revision or may not berecoverable. When factors indicate that long-lived assets should be evaluatedfor possible impairment, the Company uses an estimate of the futureundiscounted net cash flows of the related business over the remaining life ofthe asset in measuring whether the carrying amount of the related asset isrecoverable. To the extent these projections indicate that future undiscountednet cash flows are not sufficient to recover the carrying amounts of therelated assets, the underlying assets are written down by charges to expense sothat the carrying amount is equal to fair value, primarily determined based onfuture discounted cash flows. In the opinion of management, the Company’slong-lived assets are appropriately valued at December 31, 2004, and thePredecessor’s long-lived assets were appropriately valued at December 31, 2003.

 

#### **BenefitReserves**

 

Insurancereserves for individual life insurance, individual accident and healthinsurance, group life insurance and group accident and health insurance areassociated with earned premiums so as to recognize profits over the premium-payingperiod. This association is accomplished by recognizing the liabilities forinsurance reserves on a net level premium method based on assumptions deemedappropriate at the date of issue as to future investment yield, mortality,morbidity, withdrawals and maintenance expenses, and including margins foradverse deviations. Interest assumptions are based on the Predecessor’sexperience. Mortality, morbidity and withdrawal assumptions are based onrecognized actuarial tables or the Predecessor’s experience, as appropriate. Lifereserves are calculated using mean reserve factors. Accident and healthreserves are calculated using mid-terminal reserve factors. Benefit reservesfor investment products are computed under a retrospective deposit method andrepresent policy account balances before applicable surrender charges. Policybenefits and claims that are charged to expense include benefit claims incurredin the period in excess of related policy account balances.

 

ThePredecessor’s benefit reserves, net of related reinsurance recoverable, atDecember 31, 2004, were adjusted to reflect the closing of the Kanawhaacquisition as part of the application of GAAP purchase accountingrequirements. The valuation interest rate assumptions were generally lowered toreflect the current and expected interest rate environment. This changeresulted in an increase in benefit reserves. Valuation assumptions for mortality,morbidity and withdrawal were selectively changed, which resulted in anincrease in benefit reserves. Finally, the valuation assumptions for futurepremium rates on long term care coverage were increased to account forimplemented and expected rate increases. This change reduced benefit reservesfor this coverage. Taken together, these adjustments to the benefit reservevaluation assumptions had the combined effect of increasing reserves atDecember 31, 2004, by $40.7 million, or 10.5%.

 

Loss recognitiontesting of the Company’s policy benefit reserves is performed annually. Thistesting involves a comparison of the Company’s actual net liability position(all liabilities less DAC) to the present value of future liabilitiescalculated using then-current assumptions. These assumptions are based on theCompany’s best estimate of future experience. To the extent a premiumdeficiency exists, it would be recognized immediately by a charge to thestatement of operations and a corresponding reduction in DAC. Any additionaldeficiency would be recognized as a premium deficiency reserve. Historically,loss recognition testing has not resulted in an adjustment to DAC or reserves. Theseadjustments would occur only if economic, mortality and/or morbidity conditionssignificantly deviated from the underlying assumptions.

 

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#### **Claims andClaim Adjustment Expenses**

 

Claim reservesrelating to short duration contracts generally are recorded when insured eventsoccur. The liability is based on the expected ultimate cost of settling theclaims. The claims and benefits payable reserves include: (1) case basereserves for known but unpaid claims as of the balance sheet date; (2) incurredbut not reported (“IBNR”) reserves for claims where the insured event hasoccurred but has not been reported as of the balance sheet date; and (3) lossadjustment expense reserves for the expected handling costs of settling theclaims. Case base reserves and the IBNR reserves are recorded at an amountequal to the net present value of the expected future claims payments. Factorsconsidered when setting IBNR reserves include patterns in elapsed time fromclaim incidence to claim reporting, and elapsed time from claim reporting toclaim payment. Claim reserves generally equal the Company’s estimate, at theend of the current reporting period, of the present value of the liability forfuture benefits and expenses to be paid on claims incurred as of that date. Aclaim reserve for a specific claim is based on assumptions derived from Kanawha’sactual historical experience as to claim duration, as well as the specificcharacteristics of the claimant such as benefits available under the policy,the benefit period, and the age and occupation of the claimant. Althoughconsiderable variability is inherent in such estimates, management believesthat the reserves for claims and claim adjustment expenses are adequate. Theestimates are continually reviewed and adjusted as necessary as experiencedevelops or new information becomes known; such adjustments are included incurrent operations.

 

#### **Reinsurance**

 

Reinsurancepremiums, benefits and reserves are accounted for on bases consistent withthose used in accounting for the original policies issued and the terms of theinsurance contracts. Benefit reserves and claim liabilities are reported grossof reinsured amounts. An estimated allowance for doubtful accounts is recordedon the basis of periodic evaluations of balance due from reinsurers, reinsurersolvency, Company experience and current economic conditions.

 

#### **Recognition ofRevenue**

 

Premiums onlife insurance products are reported as revenue when due unless received inadvance of the due date. Premiums on accident and health insurance are reportedas earned over the contract period. A reserve is provided for the portion ofpremiums written which relate to unexpired coverage terms.

 

Revenue fromannuity products includes charges for the cost of insurance, for initiation andadministration of the policy and for surrender of the policy. Revenue fromthese products is recognized in the year assessed to the policyholder, exceptthat any portion of an assessment, which relates to services to be provided infuture years, is deferred and recognized over the period during which servicesare provided.

 

Revenue fromcommission and fee income is recognized over the related contract periods.

 

#### **RealizedCapital Gains (Losses)**

 

Realizedcapital gains and losses are reported in the income statement on a pretax basisin the period that the asset giving rise to the gain or loss is sold. Impairmentwritedowns are recorded when there has been a decline in value deemed otherthan temporary, in which case the write down for such impairments is charged toincome.

 

#### **Recognition ofBenefits**

 

Benefitsrelated to traditional life and accident and health insurance products arerecognized when incurred in a manner designed to match them with relatedpremiums and spread income recognition over expected policy lives. For annuityproducts, benefits include interest credited to policyholders’ accounts, whichis recognized as it accrues.

 

86

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#### **Pension Costs**

 

The Companyhas adopted the provisions of SFAS No. 87, *Employers’Accounting for Pensions*, which requires accrual for pension costsfor employees’ pension benefits over the employees’ approximate service period.

 

#### **Stock-BasedCompensation**

 

The Companyhas adopted the disclosure-only requirements of SFAS No. 123, *Accounting for Stock-Based Compensation*,as amended by FASB Statement No. 148, *Accountingfor Stock-Based Compensation-Transition and Disclosure* (SFAS 148). Aspermitted by the provisions of this Statement, the Predecessor accounted forstock-based compensation using the intrinsic value method prescribed byAccounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees, and Related Interpretations*.

 

Accordingly,the Company and the Predecessor recognized no compensation expense for stockoption awards to employees or directors when the option price was not less thanthe market value of the stock at the date of award.

 

SFAS 123requires the presentation of pro forma information as if the Company and thePredecessor had accounted for their employee and director stock options grantedafter December 31, 1994, under the fair value method of that Statement.

 

The followingis a reconciliation of reported net income and pro forma information as if theCompany and the Predecessor had adopted SFAS 123 for its employee and directorstock option awards:

 
| ** **                                                                                                                            | ** ** | **Predecessor**  | ** ** | **KMG America  Corporation** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|------------------|------------|------------------------------|------------|
| ** **                                                                                                                            | ** ** | **December 31,** | ** ** | **December 31,**             | ** ** |
| ** **                                                                                                                            | ** ** | **2002**         | ** ** | **2003**                     | ** ** | **2004** | ** ** | **2004** | ** ** |
| Net income (loss) as reported                                                                                                         |       | $                | 3,081,455  |                         | $          | 7,750,297 |   | $ | 6,190,499 |   | $ | (175,553 | ) |
| Add: Stock-based employee compensation  expense  included in reported net income, net of related tax effects                          |       | 220,730          |       | 151,153                      |       | 134,594 |   | — |   |
| Deduct: Total stock-based employee  compensation determined under fair value based method for all awards, net of  related tax effects |       | (269,071         | )          | (184,257                     | )          | (164,071 | ) | (30,974 | ) |
| Pro forma net income (loss) available to  common stockholders                                                                         |       | $                | 3,033,114  |                         | $          | 7,717,193 |   | $ | 6,161,022 |   | $ | (206,527 | ) |
| Net income (loss) per share-basic:                                                                                                    |       |             |       |                         |       |   |   |   |   |
| As reported                                                                                                                           |       | $                | 1,179.36   |                         | $          | 2,966.25 |   | $ | 2,369.27 |   | $ | (0.01 | ) |
| Pro forma                                                                                                                             |       | $                | 1,160.85   |                         | $          | 2,953.58 |   | $ | 2,357.99 |   | $ | (0.01 | ) |
| Net income  (loss) per share-diluted:                                                                                                 |       |             |       |                         |       |   |   |   |   |
| As reported                                                                                                                           |       | $                | 1,066.87   |                         | $          | 2,679.87 |   | $ | 2,132.71 |   | $ | (0.01 | ) |
| Pro forma                                                                                                                             |       | $                | 1,050.14   |                         | $          | 2,668.42 |   | $ | 2,122.56 |   | $ | (0.01 | ) |
|                                                                                                                                       |            |                  |            |                              |            |  |  |  |  |  |  |  |  |  |  |  |

 

#### **Income Taxes**

 

Income taxesare computed using the liability method required by SFAS No. 109, *Accounting for Income Taxes*. Under thisStatement, deferred tax assets and liabilities are determined based on thedifferences between financial reporting and tax bases of assets and liabilitiesand are measured using the enacted tax rates and laws that will be in effectwhen the differences are expected to reverse. Recorded amounts are adjusted toreflect changes in income tax rates and other tax law provisions as they becomeenacted.

 

#### **ParticipatingPolicies**

 

Policyholderdividends are recognized over the term of the related policies. Participatingbusiness represents approximately 31% and 30%, respectively, of the Predecessor’sand the Company’s total ordinary life

 

87

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insurance inforce at December 31, 2003, and 2004. Dividends paid to policyholders in 2002,2003 and 2004 were approximately $2.2 million, $2.0 million and $2.2 million,respectively. Participating premiums as a percentage of direct life premiumswere 53% in 2002, 52% in 2003 and 51% in 2004.

 

#### **RecentlyIssued Accounting Standards**

 

In December2003, the FASB issued Statement No. 132 (revised 2003), *Employers’ Disclosures about Pensions and OtherPostretirement Benefits* (“Statement 132 (revised 2003)”). Statement 132(revised 2003) revises employers’ disclosures about pension plans and otherpostretirement benefit plans. It does not change the measurement or recognitionprovisions of FASB Statements No. 87, *Employers’Accounting for Pensions*, No. 88, *Employers’Accounting for Settlements and Curtailments of Defined Benefit Pension Plansand for Termination Benefits*, and No. 106, *Employers’ Accounting for Postretirement BenefitsOther Than Pensions*. Statement 132 (revised 2003) retains thedisclosure requirements contained in FASB Statement No. 132, *Employers’ Disclosures about Pensions and OtherPostretirement Benefits* (“Statement 132”), which it replaces. Itrequires additional disclosures about the assets, obligations, cash flows andnet periodic benefit cost of defined benefit pension plans and otherpostretirement benefit plans. The required information is provided separatelyfor pension plans and for other postretirement benefit plans.

 

The provisionsof Statement 132 remain in effect until the provisions of Statement 132(revised 2003) are adopted. Disclosure of the benefits expected to be paid ineach of the next five fiscal years, and in the aggregate for the five fiscalyears thereafter is effective for fiscal years ending after June 15, 2004. Theadditional disclosure provisions were adopted by the Predecessor in 2003.

 

In March 2004,the Emerging Issues Task Force (“EITF”) reached a final consensus onEITF 03-1, which is effective for fiscal periods beginning after June 15,2004. EITF 03-1 requires that when the fair value of an investment security isless than its carrying value, an impairment exists for which a determinationmust be made as to whether the impairment is other-than-temporary. Animpairment loss should be recognized equal to the difference between theinvestment’s carrying value and its fair value when an impairment is other-than-temporary.Subsequent to an other-than-temporary impairment loss, a debt security shouldbe accounted for in accordance with Statement of Position No. 03-3, “Accountingfor Loans and Certain Debt Securities Acquired in a Transfer,” which allows theaccretion of the discount between the carrying value and expected value of asecurity if the amount and timing of the recognition of that difference in cashis reasonably estimable. EITF 03-1 also indicates that, although notpresumptive, a pattern of selling investments prior to the forecasted recoverymay call into question an investor’s intent to hold the security until itrecovers its value.

 

The EITF 03-1 impairmentmodel applies to all investment securities accounted for under Statement ofFinancial Accounting Standards (“SFAS”) No. 115, *Accounting for Certain Investment in Debt and Equity Securities*,and to investment securities accounted for under the cost method to the extentan impairment indicator exists or the reporting entity has estimated the fairvalue of the investment security in connection with SFAS No. 107, *Disclosures about Fair Value of Financial Instruments*.

 

The finalconsensus on EITF 03-1 included additional disclosure requirements incrementalto those adopted by the Predecessor effective December 31, 2003, that areeffective for fiscal years ending after June 15, 2004.

 

In October2004, the FASB delayed the implementation of the accounting requirementsincluded in EITF 03-1 until further study could be completed regarding theimpact of this guidance, particularly with respect to “available-for-sale”portfolios. The disclosure requirements included in EITF 03-1 remain ineffect.

 

Adoption ofthis standard may:

 

**•**                  Accelerate the timing of recognitionof certain impairment losses or otherwise result in impairment losses beingrecognized when they previously may not have been;

 

**•**                  Result in the designation of certaininvestment securities as trading; and

 

88

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**•**                  Increase the volatility of net incomedue to:

 

**•**                  The potential recognition ofunrealized losses in situations where the Company anticipates a full recoveryof certain unrealized losses but does not want to indicate a permanent intentto hold the affected securities, regardless of internal and external facts andcircumstances, until such time as they fully recover or mature; and

 

**•**                  Changes in the timing of therecognition of the difference between carrying value and expected settlementvalue of debt securities for which an other-than-temporary impairment is taken.

 

In July 2003,the Accounting Standards Executive Committee (“AcSEC”) of the AmericanInstitute of Certified Public Accountants (“AICPA”) issued Statement ofPosition 03-01, *Accounting and Reporting byInsurance Enterprises for Certain Nontraditional Long-Duration Contracts andfor Separate Accounts* (the “SOP”). AcSEC developed the SOP toaddress the evolution of product designs since the issuance of SFAS No. 60, *Accounting and Reporting by Insurance Enterprises*,and SFAS No. 97, *Accounting and Reporting byInsurance Enterprises for Certain Long-Duration Contracts and for RealizedGains and Losses from the Sale of Investments*. The SOP providesguidance related to the reporting and disclosure of certain insurance contractsand separate accounts, including guidance for computing reserves for productswith guaranteed benefits, such as guaranteed minimum death benefits, and forproducts with annuitization benefits such as guaranteed minimum incomebenefits. In addition, the SOP addresses certain issues related to thepresentation and reporting of separate accounts, as well as rules concerningthe capitalization and amortization of sales inducements. The SOP was effectivefor financial statements on January 1, 2004. The adoption of the SOP did nothave a material impact on the Predecessor’s consolidated financial position andresults of operations.

 

In December2004, the FASB enacted SFAS No. 123 (revised 2004) (“FAS 123 (revised 2004)”), *Share-Based Payment*, which replaces SFASNo. 123 (“FAS 123”), *Accounting forStock-Based Compensation*, and supersedes APB Opinion No. 25 (“APB 25”),*Accounting for Stock Issued to Employees*.FAS 123 (revised 2004) requires the measurement of all employee share-basedpayments to employees, including grants of employee stock options, using afair-value-based method and the recording of such expense in the Company’sconsolidated statements of operations. The accounting provisions of FAS 123(revised 2004) are effective for reporting periods beginning after June 15,2005. The Company is required to adopt FAS 123 (revised 2004) in the secondquarter of 2005.

 

The pro formadisclosures previously permitted under FAS 123 no longer will be an alternativeto financial statement recognition. Although the Company has not yet determinedwhether the adoption of FAS 123 (revised 2004) will result in amounts that aresimilar to the current pro forma disclosures under FAS 123, the Company isevaluating the requirements under FAS 123 (revised 2004) and expects theadoption to have an impact on its consolidated statements of operations and netincome per share that is substantially similar to the current pro formadisclosure under FAS 123.

 

#### **3. Investments**

 

Aggregateamortized cost, aggregate fair value and gross unrealized gains and losses ofinvestments in fixed maturity and equity securities are summarized in thefollowing table. Effective December 31, 2004, the Company recorded thePredecessor’s investments at fair value and thereby eliminated all unrealizedgains and losses in the Predecessor’s portfolio, as part of the application ofGAAP purchase accounting requirements.

 

89

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| ** **                                                         | ** ** | **Amortized Cost** | ** **  | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------------------------------------|------------|--------------------|-------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| Available for sale securities at December  31, 2003 (Predecessor): |       |               |        |                         |       |                          |       |            |       |
| U.S. treasuries                                                    |       | $                  | 10,666,920  |                         | $          | 573,732                       |       | $               | 139,401    |   | $ | 11,101,251 |   |
| U.S. government agencies                                           |       | 55,189,072         |        | 2,535,941                    |       | 1,508,670                     |       | 56,216,343      |       |
| States and political subdivisions                                  |       | 15,079,528         |        | 460,353                      |       | 447,213                       |       | 15,092,668      |       |
| Foreign bonds                                                      |       | 40,284,839         |        | 3,759,233                    |       | 536,509                       |       | 43,507,563      |       |
| Corporate bonds                                                    |       | 172,286,175        |        | 13,915,219                   |       | 1,936,173                     |       | 184,265,221     |       |
| Mortgage/asset-backed securities                                   |       | 86,235,545         |        | 1,957,685                    |       | 1,521,333                     |       | 86,671,897      |       |
| Preferred stocks—redeemable                                   |       | 16,286,479         |        | 1,790,680                    |       | 106,127                       |       | 17,971,032      |       |
| Subtotal, fixed maturity securities                                |       | 396,028,558        |        | 24,992,843                   |       | 6,195,426                     |       | 414,825,975     |       |
| Equity securities                                                  |       | 346,742            |        | 2,572,865                    |       | 94,750                        |       | 2,824,857       |       |
| Securities available for sale                                      |       | $                  | 396,375,300 |                         | $          | 27,565,708                    |       | $               | 6,290,176  |   | $ | 417,650,832 |   |
| Available for sale securities at December  31, 2004 (KMG America): |       |               |        |                         |       |                          |       |            |       |
| U.S. treasuries                                                    |       | $                  | 12,475,415  |                         | $          | —                        |       | $               | —     |   | $ | 12,475,415 |   |
| U.S. government agencies                                           |       | 43,554,624         |        | —                       |       | —                        |       | 43,554,624      |       |
| States and political subdivisions                                  |       | 13,544,954         |        | —                       |       | —                        |       | 13,544,954      |       |
| Foreign bonds                                                      |       | 42,584,238         |        | —                       |       | —                        |       | 42,584,238      |       |
| Corporate bonds                                                    |       | 149,305,374        |        | —                       |       | —                        |       | 149,305,374     |       |
| Mortgage/asset-backed securities                                   |       | 142,870,750        |        | —                       |       | —                        |       | 142,870,750     |       |
| Preferred stocks—redeemable                                   |       | 5,277,831          |        | —                       |       | —                        |       | 5,277,831       |       |
| Subtotal, fixed maturity securities                                |       | 409,613,186        |        | —                       |       | —                        |       | 409,613,186     |       |
| Equity securities                                                  |       | 36,000             |        | —                       |       | —                        |       | 36,000          |       |
| Securities available for sale                                      |       | $                  | 409,649,186 |                         | $          | —                        |       | $               | —     |   | $ | 409,649,186 |   |

 

Mutual fundsheld for a deferred compensation plan with a cost of $5.0 million and a marketvalue of $4.2 million were transferred from the available-for-sale category tothe trading category effective January 1, 2003.

 

The amortizedcost and fair value of fixed maturity securities at December 31, 2004, bycontractual maturity are shown below. Expected maturities may differ fromcontractual maturities because certain borrowers have the right to call orprepay obligations with or without call or prepayment penalties.

 
| ** **                         | ** ** | **Amortized  Cost** | ** **  | **Fair  Value** | ** ** |
|------------------------------------|------------|---------------------|-------------|-----------------|------------|
| Maturity:                          |       |                |        |            |       |
| One year or less                   |       | $                   | 2,844,418   |            | $          | 2,844,418 |   |
| After year one through five years  |       | 33,730,190          |        | 33,730,190      |       |
| After five years through ten years |       | 62,676,931          |        | 62,676,931      |       |
| After ten years                    |       | 162,213,066         |        | 162,213,066     |       |
| Mortgage/asset-backed securities   |       | 142,870,750         |        | 142,870,750     |       |
| Preferred stocks—redeemable   |       | 5,277,831           |        | 5,277,831       |       |
| Total fixed maturity securities    |       | $                   | 409,613,186 |            | $          | 409,613,186 |   |

 

Proceeds fromthe sales of investments in fixed maturity securities during the years endingDecember 31, 2002, 2003 and 2004, were $175.1 million, $165.7 million and$99.2 million, respectively. Gross gains of $9.2 million and gross losses of$12.2 million were realized in 2002 on those sales. Gross gains of $9.8 millionand gross losses of $3.5 million were realized in 2003 on those sales. Grossgains of $7.9 million and gross losses of $0.7 million were realized in 2004 onthose sales.

 

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Proceeds fromthe sale of investments in common stocks during the years endedDecember 31, 2002, 2003 and 2004, were $0.3 million, $13.1 million and$2.7 million, respectively. Gross gains of approximately $0 and grosslosses of $0 were realized in 2002 on these sales. Gross gains of $1.4 millionand gross losses of approximately $0 were realized in 2003 on those sales. Grossgains of $2.6 million and gross losses of $0 were realized in 2004 on thosesales.

 

At December31, 2004, fixed maturity securities and short-term investments with anamortized cost and fair value of $6.9 million were on deposit with stateinsurance departments to satisfy regulatory requirements. At December 31, 2004,the Company holds bonds with an amortized cost and fair value of $86.2 millionwhich are held in trust accounts for certain reinsurance transactions (seeNote 9).

 

Changes duringthe years ended December 31, 2002, 2003 and 2004, in amounts affecting thePredecessor’s net unrealized gains and losses, reduced by deferred incometaxes, included in the Predecessor’s shareholders’ equity as accumulated othercomprehensive income are as follows:

 
| ** **                                                             | ** ** | **Year Ended December 31, 2002  Net Unrealized Gains** | ** ** |
|------------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                             | ** ** | **Fixed  Maturity  Securities**                             | ** ** | **Equity  Securities** | ** ** | **Total** | ** ** |
| Unrealized gains arising during the period,  before taxes              |       | $                                                           | 9,655,549  |   | $ | 436,202 |   | $ | 10,091,751 |   |
| Income taxes                                                           |       | (3,422,921                                                  | )          | (151,039 | ) | (3,573,960 | ) |
|                                                                   |       | 6,232,628                                                   |       | 285,163 |   | 6,517,791 |   |
| Less reclassification adjustment:                                      |       |                                                        |       |   |   |   |   |
| (Losses) gains realized in net income                                  |       | (3,011,398                                                  | )          | 7,521 |   | (3,003,877 | ) |
| Income taxes                                                           |       | 1,067,550                                                   |       | (2,602 | ) | 1,064,948 |   |
| Reclassification adjustment for (losses)  gains realized in net income |       | (1,943,848                                                  | )          | 4,919 |   | (1,938,929 | ) |
| Other comprehensive income (loss)                                      |       | $                                                           | 8,176,476  |   | $ | 280,244 |   | $ | 8,456,720 |   |

 
| ** **                                                    | ** ** | **Year Ended December 31, 2003  Net Unrealized Gains** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                    | ** ** | **Fixed  Maturity  Securities**                        | ** ** | **Equity  Securities** | ** ** | **Total** | ** ** |
| Unrealized gains arising during the period,  before taxes     |       | $                                                      | 6,622,748  |   | $ | 1,867,944 |   | $ | 8,490,692 |   |
| Income taxes                                                  |       | (2,317,970                                             | )          | (699,709 | ) | (3,017,679 | ) |
|                                                          |       | 4,304,778                                              |       | 1,168,235 |   | 5,473,013 |   |
| Less reclassification adjustment:                             |       |                                                   |       |   |   |   |   |
| Gains realized in net income                                  |       | 6,196,520                                              |       | 1,482,851 |   | 7,679,371 |   |
| Income taxes                                                  |       | (2,168,791                                             | )          | (581,546 | ) | (2,750,337 | ) |
| Reclassification adjustment for gains  realized in net income |       | 4,027,729                                              |       | 901,305 |   | 4,929,034 |   |
| Other comprehensive income                                    |       | $                                                      | 277,049    |   | $ | 266,930 |   | $ | 543,979 |   |

 

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| ** **                                                         | ** ** | **Year Ended December 31, 2004  Net Unrealized Gains** | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **Fixed  Maturity  Securities**                             | ** ** | **Equity  Securities** | ** ** | **Total** | ** ** |
| Unrealized gains (losses) arising during  the period, before taxes |       | $                                                           | 6,687,843  |   | $ | (128,017 | ) | $ | 6,559,826 |   |
| Income taxes                                                       |       | (2,340,745                                                  | )          | 44,806 |   | (2,295,939 | ) |
|                                                               |       | 4,347,098                                                   |       | (83,211 | ) | 4,263,887 |   |
| Less reclassification adjustment:                                  |       |                                                        |       |   |   |   |   |
| Gains realized in net income                                       |       | 6,740,108                                                   |       | 2,361,598 |   | 9,101,706 |   |
| Income taxes                                                       |       | (2,359,038                                                  | )          | (826,559 | ) | (3,185,597 | ) |
| Reclassification adjustment for gains  realized in net income      |       | 4,381,070                                                   |       | 1,535,039 |   | 5,916,109 |   |
| Other comprehensive loss                                           |       | $                                                           | (33,972    | ) | $ | (1,618,250 | ) | $ | (1,652,222 | ) |

 

Majorcategories of the Predecessor’s net investment income for the years endedDecember 31, 2002, 2003 and 2004, are summarized as follows:

 
| ** **                          | ** ** | **Year Ended December 31,** | ** ** |
|-------------------------------------|------------|-----------------------------|------------|
| ** **                          | ** ** | **2002**                    | ** ** | **2003** | ** ** | **2004** | ** ** |
| Income:                             |       |                        |       |   |   |   |   |
| Bonds                               |       | $                           | 20,590,918 |   | $ | 20,870,128 |   | $ | 22,629,014 |   |
| Preferred stocks                    |       | 1,190,089                   |       | 1,191,543 |   | 1,002,311 |   |
| Common stocks, unaffiliated         |       | 197,079                     |       | 676,109 |   | 70,665 |   |
| Mortgage loans                      |       | 4,213,485                   |       | 2,976,465 |   | 1,952,089 |   |
| Policy loans                        |       | 1,437,270                   |       | 1,835,623 |   | 1,420,052 |   |
| Short-term investments and cash     |       | 357,289                     |       | 124,591 |   | 146,091 |   |
| Other                               |       | 184,669                     |       | 387,168 |   | 536,388 |   |
| Total investment income             |       | 28,170,799                  |       | 28,061,627 |   | 27,756,610 |   |
| Expenses:                           |       |                        |       |   |   |   |   |
| Investment expenses                 |       | 1,001,716                   |       | 982,674 |   | 2,548,777 |   |
| Investment taxes, licenses and fees |       | 8,852                       |       | 6,194 |   | 5,421 |   |
| Total investment expenses           |       | 1,010,568                   |       | 988,868 |   | 2,554,198 |   |
| Net investment income               |       | $                           | 27,160,231 |   | $ | 27,072,759 |   | $ | 25,202,412 |   |

 

The minimumand maximum lending rates for mortgage loans originated in 2004 were 7.25% and7.25%, respectively. At the issuance of a loan, the percentage of loan to valueon any one loan does not exceed 75%. All properties covered by mortgage loanshave fire insurance equal to at least the loan excess over the maximum loanthat would be allowed on the land without the building.

 

The Company’smortgage loan portfolio is comprised of conventional real estate mortgagescollateralized primarily by commercial and retail (2.7%), office (2.7%),apartment (3.1%) and residential (91.5%) properties. Mortgage loan underwritingstandards emphasize the credit status of a prospective borrower, quality of theunderlying collateral and conservative loan-to-value ratios. Approximately96.5% of the loans are on properties located in the South Atlantic region. Noother geographic region includes mortgaged property representing 1.8% of theaggregate principal amount of the Company’s mortgage loans as of December 31,2004.

 

Interest isrecognized as revenue when earned according to the terms of the loans and when,in the opinion of management, it is collectible. The accrual of interest on theloans is discontinued at the time the loan is 90 days past due unless thecredit is well secured and in the process of collection. Past due status isbased on the contractual terms of the loan. Loans are placed on non-accrual orcharged off at an earlier date if collection of principal or interest isconsidered doubtful. The Company maintains an allowance for potentiallyuncollectible loans. Additions to the allowance are based on assessments ofcertain factors, including but not limited to historical loan loss

 

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experience ofsimilar types of loans, the Company’s loan loss experience, the amount of pastdue and non-performing loans and current and anticipated economic and interestrate conditions. Evaluation of these factors involves subjective estimates andjudgments that may change. Additions to the allowance are provided through acharge to earnings. There was no balance in the allowance account at December31, 2004. There were no additions to the allowance for the years ended December31, 2002, 2003 and 2004.

 

At December 31,2004, the Company did not hold any residential mortgage loans with interestoverdue more than 90 days.

 

ThePredecessor’s other-than-temporary impairment losses on available-for-salesecurities totaled approximately $0.7 million and $0.7 million for the yearsended December 31, 2003, and 2004, respectively.

 

#### **4. Acquisition**

 

The Companycompleted its acquisition of the Predecessor and its subsidiary on December 21,2004. The acquisition has been recorded as if it were completed on December 31,2004, as the effects of the acquisition for the period from December 21, 2004,through December 31, 2004, were not material.

 

The totalpurchase price paid by the Company in the acquisition was $145.0 million,$130.0 million of which was paid in cash at closing and $15.0 million of whichwas paid pursuant to a five-year subordinated promissory note bearing interestat five percent per annum, added to the principal on December 31 of each yearand payable in full with the principal on the maturity date. The $145.0 millionpurchase price was less than the Company’s estimated fair value of the netassets acquired. Accordingly, the Company’s value of business acquired (“VOBA”),as reflected on the December 31, 2004, balance sheet, was reduced so that thevalue of the net assets acquired, including VOBA, was equal to the purchaseprice.

 

The unauditedpro forma financial information presented below assumes that the Kanawhaacquisition had occurred as of the beginning of each respective period. Accordingly,as part of the application of purchase accounting requirements, all of thePredecessor’s assets and liabilities were recorded at fair value as of thebeginning of each respective period. The unaudited pro forma results have beenprepared for comparative purposes only and do not purport to be indicative ofthe results of operations that would have occurred had the Kanawha acquisitionbeen consummated at the beginning of the respective periods.

 
| ** **                                 | ** ** | **Year Ended December 31,**  | ** ** |
|--------------------------------------------|------------|------------------------------|------------|
| **(In  thousands, except per share data)** | ** ** | **2003**                     | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | **(Pro  forma,  unaudited)** | ** ** | **(Pro  forma,  unaudited)** | ** ** |
| Revenues                                   |       | $                            | 155,369    |   | $ | 152,945 |   |
| Net income                                 |       | $                            | 14,447     |   | $ | 16,301 |   |
| Net income per share:                      |       |                         |       |   |   |
| Basic                                      |       | $                            | 0.65       |   | $ | 0.74 |   |
| Diluted                                    |       | $                            | 0.65       |   | $ | 0.73 |   |

 

#### **5. OtherIntangible Assets**

 

Under FAS No.142, goodwill and intangible assets with indefinite useful lives are notamortized. Effective December 31, 2004, historical goodwill of the Predecessorwas eliminated as a part of the application of GAAP purchase accountingrequirements. The fair value of net assets of the Predecessor purchased wasgreater than the acquisition purchase price, therefore no goodwill wasrecorded, effective December 31, 2004. Certain other intangibles were recordedas a result of the acquisition effective December 31, 2004. The weighted-averageuseful life, gross carrying value, accumulated amortization and net carryingvalue of other intangible assets as of December 31, 2003, and 2004 were asfollows:

 

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| ** **                | ** ** | **Weighted-**            | ** ** | **KMG America  December 31, 2004** | ** ** |
|---------------------------|------------|--------------------------|------------|-----------------------------------------|------------|
| ** **                | ** ** | **Average  Useful Life** | ** ** | **Gross Carrying  Value**               | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Value** | ** ** |
| ** **                | ** ** | ** **               | ** ** | **(in millions)**                       | ** ** | **(in millions)** | ** ** | **(in millions)** | ** ** |
| Customer Relationships    |       | 10  years                |       | $                                       | 4.90       |   | $ | 0 |   | $ | 4.90 |   |
| Trademarks and Trade Name |       | indefinite               |       | 6.11                                    |       | 0 |   | 6.11 |   |
| Product Approvals         |       | 35 years                 |       | 2.83                                    |       | 0 |   | 2.83 |   |
| State Licenses            |       | indefinite               |       | 3.66                                    |       | 0 |   | 3.66 |   |
| Total                     | ** ** |                     |       | $                                       | 17.50      |   | $ | 0 |   | $ | 17.50 |   |

 

Amortizationexpense relating to intangible assets was $0 million in 2004 and$0 million in 2003. Estimated future amortization expense relating tointangible assets for the years ending December 31 are as follows:

 
| **(in millions)**                                                     | ** ** | **2005** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** |
|-----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Estimated future amortization expenses  relating to intangible assets |       | $        | 0.57       |     | $          | 0.57     |       | $        | 0.57       |     | $          | 0.57 |   | $ | 0.57 |   |
|                                                                       |            |          |            |          |            |          |            |          |            |          |            |  |  |  |  |  |

 

**6.  Real Estate and Equipment**

 

Building andequipment consist of the following at December 31:

 
| ** **                    | ** ** | **Predecessor** | ** ** | **KMG America** | ** ** |
|-------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                    | ** ** | **2003**        | ** ** | **2004**        | ** ** |
| Real estate                   |       | $               | 9,399,428  |            | $          | 6,863,407 |   |
| Equipment                     |       | 21,458,611      |       | 2,838,347       |       |
| Total                         |       | 30,858,039      |       | 9,701,754       |       |
| Less accumulated depreciation |       | 19,867,031      |       | —          |       |
|                          |       | $               | 10,991,008 |            | $          | 9,701,754 |   |

 

**7.  Deferred Policy Acquisition Costs and Valueof Business Acquired**

 

The Companyeliminated all of the Predecessor’s deferred acquisition costs upon the closingof the Kanawha acquisition as part of the application of GAAP purchaseaccounting requirements.  The Companywill record deferred acquisition costs prospectively on January 1, 2005.

 

The Companyeliminated all of the Predecessor’s historical value of business acquired  upon the closing of the Kanawha acquisitionas part of the application of GAAP purchase accounting requirements.  The Company simultaneously re-establishedvalue of business acquired for the value of the Predecessor’s in forcebusiness.  Interest rate assumptions usedto amortize the value of business acquired were reset upon the closing of theKanawha acquisition.  The interest ratewas approximately 6.0% at December 31, 2004.

 

94

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Informationabout deferred policy acquisition costs and value of business acquired aresummarized below:

 
| ** **                         | ** ** | **Predecessor**  | ** ** | **KMG America**  | ** ** |
|------------------------------------|------------|------------------|------------|------------------|------------|
| ** **                         | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                         | ** ** | **2002**         | ** ** | **2003**         | ** ** | **2004** | ** ** | **2004** | ** ** |
| Deferred policy acquisition costs: |       |             |       |             |       |   |   |   |   |
| Beginning balance                  |       | $                | 60,592,898 |             | $          | 71,723,015 |   | $ | 80,656,518 |   | $ | — |   |
| Deferral:                          |       |             |       |             |       |   |   | — |   |
| Commissions                        |       | 8,651,677        |       | 6,298,113        |       | 5,374,915 |   | — |   |
| Expenses                           |       | 7,799,596        |       | 8,246,835        |       | 7,750,057 |   | — |   |
| Total deferral                     |       | 16,451,273       |       | 14,544,948       |       | 13,124,972 |   | — |   |
|                               |       |             |       |             |       |   |   |   |   |
| Gross amortization                 |       | 9,296,050        |       | 10,330,819       |       | 11,749,911 |   | — |   |
| Interest accrued                   |       | (3,974,894       | )          | (4,719,374       | )          | (5,307,199 | ) | — |   |
| Net amortization                   |       | 5,321,156        |       | 5,611,445        |       | 6,442,712 |   | — |   |
| Ending balance                     |       | $                | 71,723,015 |             | $          | 80,656,518 |   | $ | 87,338,778 |   | $ | — |   |
|                               |       |             |       |             |       |   |   |   |   |   |   |   |   |
| Value of business acquired:        |       | —           |       |             |       |   |   |   |   |
| Beginning balance                  |       | $                | 36,805,413 |             | $          | 33,581,717 |   | $ | 29,604,632 |   | $ | — |   |
| Deferral:                          |       |             |       |             |       |   |   |   |   |
| Cost of acquisition                |       | 970,606          |       | —           |       | — |   | 74,481,295 |   |
| Total deferral                     |       | 970,606          |       | —           |       | — |   | 74,481,295 |   |
| Gross amortization                 |       | 6,770,681        |       | 6,327,805        |       | 5,097,914 |   | — |   |
| Interest accrued                   |       | (2,576,379       | )          | (2,350,720       | )          | (2,072,324 | ) | — |   |
| Net amortization                   |       | 4,194,302        |       | 3,977,085        |       | 3,025,590 |   | — |   |
| Ending balance                     |       | $                | 33,581,717 |             | $          | 29,604,632 |   | $ | 26,579,042 |   | $ | 74,481,295 |   |

 

The Companyaccounts for value of business acquired in a manner similar to deferredacquisition costs.  The interest ratesused to amortize deferred acquisition costs were 6.56%, 6.58% and 6.58% in2002, 2003 and 2004, respectively.

 

The interestrate used in 2003 and 2004 to amortize value of business acquired wasapproximately 7.0%.  Periodically, theCompany performs tests to determine whether the value of business acquiredremains recoverable from future premiums on the acquired business.  No write-offs were incurred in 2002, 2003 or2004 from impairments as a result of such recoverability tests.  The interest rate assumption used to amortizethe value of business acquired was reset upon the closing of the Kanawhaacquisition and the rate was approximately 6.0% at December 31, 2004.  Under the Company’s assumptions as ofDecember 31, 2004, the Company estimated that the amortization of value ofbusiness acquired for the next five years will be as follows:

 
| **Year ending December 31:** | ** ** | **Amortization** | ** ** |
|------------------------------|------------|------------------|------------|
|                         |       |             |       |
| 2005                         |       | 3.98             | %          |
| 2006                         |       | 4.31             |       |
| 2007                         |       | 4.55             |       |
| 2008                         |       | 4.52             |       |
| 2009                         |       | 4.81             |       |

 

If actuallapse and mortality experience is higher or lower than assumed for the tableabove, then actual amortization will be faster or slower than indicated in the table.

 

#### **8. Benefit Reserves**

#### ** **

Insurancereserves for individual life insurance, individual accident and healthinsurance, group life insurance and group accident and health insurance arecomputed using the net level premium method, including assumptions based on thePredecessor’s experience, modified as necessary to reflect anticipated trendsand to include provisions for possible unfavorable deviations.  Reserve interest assumptions are graded andrange from

 

95

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3.0% to 8.5%.  Such liabilities are, for some plans, gradedto equal statutory values or cash values at or prior to maturity.  The weighted average assumed investment yieldfor all life and accident and health policy reserves was 7.0% in 2002, 6.95% in2003, and 6.84% in 2004.  Benefitreserves for individual life insurance policies include certain deferredprofits on limited-payment policies that are being recognized in income overthe policy term.  Policy benefit claimsare charged to expense in the period that the claims are incurred.

 

Interestcrediting rates for investment products ranged from 4.25% to 4.50% in 2002,3.5% to 5.0% in 2003, and 3.5% to 5.0% in 2004.

 

ThePredecessor’s benefit reserves, net of related reinsurance recoverable, at December31, 2004, were adjusted to reflect the closing of the Kanawha acquisition aspart of the application of GAAP purchase accounting requirements.  The valuation interest rate assumptions weregenerally lowered to reflect the current and expected interest rateenvironment.  This change resulted in anincrease in benefit reserves.  Valuationassumptions for mortality, morbidity and withdrawal were selectively changed,which resulted in an increase in benefit reserves.  Finally, the valuation assumptions for futurepremium rates on long term care coverage were increased to account forimplemented and expected rate increases. This change reduced benefit reserves for this coverage.  Taken together, these adjustments to thebenefit reserve valuation assumptions had the combined effect of increasingreserves at December 31, 2004, by $40.7 million, or 10.5%.

 

#### **9. Reinsurance**

#### ** **

Certainpremiums and benefits are assumed from and ceded to other insurance companiesunder various reinsurance agreements. The assumption agreements provide the Company with increased economiesof scale and the ceded agreements provide the Company with increased capacityto write larger risks and maintain its exposure to loss within its capitalresources and, in some cases, effect business dispositions.  However, if the assuming reinsurer is unableto meet its obligations, the Company remains contingently liable.  The Company evaluates the financial conditionof reinsurers and monitors concentration of credit risk to minimize thisexposure.  In some cases, reinsurers haveplaced amounts in trusts equivalent to the amount recoverable from thereinsurer.

 

96

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  The following represent reinsurance amountsincluded in the accompanying financial statements:

 
| ** **                                                  | ** ** | **Predecessor**  | ** **   | **KMG America**  | ** ** |
|-------------------------------------------------------------|------------|------------------|--------------|------------------|------------|
| ** **                                                  | ** ** | **December 31,** | ** **   | **December 31,** | ** ** |
| ** **                                                  | ** ** | **2002**         | ** **   | **2003**         | ** ** | **2004** | ** ** |
| Balance sheet amounts-assets (liabilities)                  |       |             |         |             |       |   |   |
| Policy and contract liabilities:                            |       |             |         |             |       |   |   |
| Aggregate life, annuity, and accident and  health reserves: |       |             |         |             |       |   |   |
| Direct                                                      |       | $                | (216,439,609 | )                | $          | (249,896,935 | ) | $ | (313,254,449 | ) |
| Assumed (relating to the acquired business  segment)        |       | (204,040,585     | )            | (191,196,250     | )          | (197,487,682 | ) |
| Aggregate life, annuity, and accident and  health reserves  |       | $                | (420,480,194 | )                | $          | (441,093,185 | ) | $ | (510,742,131 | ) |
|                                                        |       |             |         |             |       |   |   |   |   |   |
| Policy and contract claims:                                 |       |             |         |             |       |   |   |
| Direct                                                      |       | $                | (6,655,248   | )                | $          | (8,090,449 | ) | $ | (7,387,538 | ) |
| Assumed                                                     |       | (3,383,374       | )            | (2,370,267       | )          | (1,955,974 | ) |
| Policy and contract claims                                  |       | $                | (10,038,622  | )                | $          | (10,460,716 | ) | $ | (9,343,512 | ) |
|                                                        |       |             |         |             |       |   |   |   |   |   |
| Reinsurance balances recoverable:                           |       |             |         |             |       |   |   |
| Life, annuity, and accident and health  reserves ceded      |       | $                | 40,254,594   |             | $          | 60,337,658 |   | $ | 70,584,942 |   |
| Policy and contract claims ceded                            |       | 721,064          |         | 813,539          |       | 769,856 |   |
| Reinsurance balances recoverable                            |       | $                | 40,975,658   |             | $          | 61,151,197 |   | $ | 71,354,798 |   |
|                                                        |       |             |         |             |       |   |   |   |   |   |
| Experience refunds payable                                  |       | $                | (12,122,137  | )                | $          | (8,322,201 | ) | $ | (15,077,944 | ) |
| Premiums due                                                |       | $                | (745,858     | )                | $          | (551,338 | ) | $ | (1,966,251 | ) |
| Premiums received in advance                                |       | $                | (144,781     | )                | $          | (120,904 | ) | $ | (117,967 | ) |

 
| ** **                                              | ** ** | **Predecessor**  | ** **  |
|---------------------------------------------------------|------------|------------------|-------------|
| ** **                                              | ** ** | **December 31,** | ** **  |
| ** **                                              | ** ** | **2002**         | ** **  | **2003** | ** ** | **2004** | ** ** |
| Statement of operations amounts—(revenue)  expense |       |             |        |   |   |   |   |
| Premiums and benefits paid or provided:                 |       |             |        |   |   |   |   |
| Insurance premiums:                                     |       |             |        |   |   |   |   |
| Direct                                                  |       | $                | (99,821,432 | ) | $ | (111,869,152 | ) | $ | (113,222,042 | ) |
| Assumed                                                 |       | (7,770,579       | )           | (6,568,541 | ) | (4,561,459 | ) |
| Ceded                                                   |       | 8,948,889        |        | 12,021,819 |   | 14,947,956 |   |
| Net insurance premiums                                  |       | $                | (98,643,122 | ) | $ | (106,415,874 | ) | $ | (102,835,545 | ) |
| Policyholder benefits:                                  |       |             |        |   |   |   |   |
| Direct                                                  |       | $                | 79,525,154  |   | $ | 87,269,874 |   | $ | 93,524,974 |   |
| Assumed                                                 |       | 11,795,124       |        | 12,567,420 |   | 11,183,934 |   |
| Ceded                                                   |       | (10,035,400      | )           | (10,576,222 | ) | (14,533,915 | ) |
| Net policyholder benefits                               |       | $                | 81,284,878  |   | $ | 89,261,072 |   | $ | 90,174,993 |   |
|                                                    |       |             |        |   |   |   |   |   |   |   |
| Commissions assumed                                     |       | $                | 509,277     |   | $ | 459,135 |   | $ | 428,247 |   |
| Commission allowance on reinsurance ceded               |       | $                | (3,479,580  | ) | $ | (4,936,291 | ) | $ | (4,825,569 | ) |

 

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#### **10. Federal Income Taxes**

#### ** **

Income taxes as reported in the consolidatedstatements of operations for the years ended December 31, 2002, 2003 and2004, are summarized as follows:

 
| ** **                   | ** ** | **Predecessor** | ** ** | **KMG America** | ** ** |
|------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                   | ** ** | **2002**        | ** ** | **2003**        | ** ** | **2004** | ** ** | **2004** | ** ** |
| Current expense (benefit)    |       | $               | 451,133    |            | $          | 786,758 |   | $ | (789,362 | ) | $ | — |   |
| Deferred expense (benefit)   |       | 706,155         |       | 2,712,583       |       | 4,355,234 |   | (94,528 | ) |
| Income tax expense (benefit) |       | $               | 1,157,288  |            | $          | 3,499,341 |   | $ | 3,565,872 |   | $ | (94,528 | ) |

 

The Companyhas provided for federal income taxes incurred at the statutory income taxrate.

 

ThePredecessor’s provision for federal income taxes incurred is different fromthat which would be obtained by applying the statutory Federal income tax rateto income before income taxes.  Thesignificant items causing this difference are:

 
| ** **                           | ** ** | **For the Year  Ended  December 31,  2002** | ** ** | **Effective  Tax Rate** | ** ** | **For the Year  Ended  December 31,  2003** | ** ** | **Effective  Tax Rate** | ** ** | **For the Year  Ended  December 31,  2004** | ** ** | **Effective  Tax Rate** | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|-------------------------|------------|---------------------------------------------|------------|-------------------------|------------|---------------------------------------------|------------|-------------------------|------------|
| Pre-tax book income                  |       | $                                           | 4,238,743  |                    |       |                                        | $          | 11,249,638              |       |                                        |       | $                       | 9,756,371  |   |   |   |
| Provision computed at statutory rate |       | $                                           | 1,441,173  |                    | 34.00      | %                                           | $          | 3,824,877               |       | 34.00                                       | %          | $                       | 3,317,166  |   | 34.00 | % |
| Small-life deduction                 |       | (576,963                                    | )          | (13.61                  | )%         | (536,862                                    | )          | (4.77                   | )%         | —                                      |       | —                  |       |
| Dividend received deduction          |       | (170,000                                    | )          | (4.01                   | )%         | (170,000                                    | )          | (1.51                   | )%         | (87,500                                     | )          | (0.90                   | )%         |
| Tax exempt investment income         |       | (46,225                                     | )          | (1.09                   | )%         | (88,636                                     | )          | (0.79                   | )%         | (70,000                                     | )          | (0.72                   | )%         |
| Other                                |       | 509,303                                     |       | 12.01                   | %          | 469,962                                     |       | 4.17                    | %          | 406,206                                     |       | 4.17                    | %          |
| Total                                |       | $                                           | 1,157,288  |                    | 27.30      | %                                           | $          | 3,499,341               |       | 31.10                                       | %          | $                       | 3,565,872  |   | 36.55 | % |
|                                      |            |                                             |            |                         |            |                                             |            |                         |            |                                             |            |                         |            |  |  |  |  |  |

 

The taxeffects of temporary differences that result in significant deferred income taxassets and deferred income tax liabilities at December 31 are as follows:

 

98

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| ** **                                        | ** ** | **Predecessor** | ** ** | **KMG  America** | ** ** |
|---------------------------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                        | ** ** | **2003**        | ** ** | **2004**         | ** ** |
| Deferred tax liabilities:                         |       |            |       |             |       |
| Deferred policy acquisition costs                 |       | $               | 23,512,429 |             | $          | — |   |
| Value of business acquired                        |       | 8,702,292       |       | 19,738,531       |       |
| Unrealized investment gains recognized in  equity |       | 7,446,437       |       | 7,010,621        |       |
| Other                                             |       | 453,000         |       | 6,154,097        |       |
| Total deferred tax liabilities                    |       | 40,114,158      |       | 32,903,249       |       |
|                                              |       |            |       |             |       |
| Deferred tax  assets:                             |       |            |       |             |       |
| Policy benefit reserves                           |       | 12,173,979      |       | 24,553,635       |       |
| Deferred compensation and stock options           |       | 3,845,090       |       | 1,387,196        |       |
| Net operating loss carryforward                   |       | 1,663,756       |       | 2,191,378        |       |
| Other                                             |       | 1,175,915       |       | 325,582          |       |
|                                              |       |            |       |             |       |
| Total deferred tax assets                         |       | 18,858,740      |       | 28,457,791       |       |
| Less: valuation allowance                         |       | (1,571,896      | )          | (1,820,265       | )          |
| Deferred tax assets net of valuation  allowance   |       | 17,286,844      |       | 26,637,526       |       |
| Net deferred income tax liabilities               |       | $               | 22,827,314 |             | $          | 6,265,723 |   |
|                                              |       |            |       |             |       |   |   |
| Reconciliation to balance sheet:                  |       |            |       |             |       |
| Deferred income tax liabilities                   |       | 22,827,314      |       | 6,502,042        |       |
| Less: deferred income tax asset                   |       | —          |       | 236,319          |       |
| Net deferred income tax liabilities               |       | $               | 22,827,314 |             | $          | 6,265,723 |   |

 

In connectionwith the Company’s application of GAAP purchase accounting requirements toreflect the Kanawha acquisition, the Company marked to fair value thePredecessor’s assets and liabilities. The revaluation of assets and liabilities to fair value resulted in a$21.6 million reduction in net deferred federal tax liability, which otherwiseincreased by $5.1 million.

 

ThePredecessor’s federal income tax returns for all years through 2000 areclosed.  In the opinion of management,recorded income tax liabilities adequately provide for all remaining openyears.

 

ThePredecessor and its subsidiaries have filed separate federal income tax returnsas required by regulations regarding the consolidation for tax purposes of lifeinsurance and non-life insurance companies. The subsidiaries have incurred net operating losses which will expirebetween 2018 and 2024.  Under SFAS No.109, management must provide a valuation allowance for any deferred tax amountsthat it does not believe will be realized. Management believes that the realization of the subsidiaries’ netoperating losses is uncertain; therefore, a valuation allowance wasestablished.  That valuation allowanceincreased by $0.8 million in 2003 and $0.2 million in 2004.  The Predecessor paid income taxes of $0, $0.9million and $0.6 million, during the years ended December 31, 2002, 2003 and2004, respectively.

 

Prior to 1984,a portion of the Predecessor’s income was not taxed, but was set aside in aspecial tax account designated as “Policyholders’ Surplus.”  Kanawha, the Company’s insurance subsidiary,has approximately $4.3 million of untaxed “Policyholders’ Surplus” on which nopayment of federal income taxes will be required unless it is distributed as adividend, or under other specified conditions. The Company does not believe that any significant portion of the accountwill be taxed in the foreseeable future and no related deferred tax liabilityhas been recognized.  If the entirebalance of the account became taxable under the current federal rate, the taxwould approximate $1.5 million.

 

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#### **11.  StatutoryFinancial Information**

#### ** **

Stateinsurance laws and regulations prescribe accounting practices for determiningstatutory net income and equity for insurance companies.  In addition, state regulators may permitstatutory accounting practices that differ from prescribed practices.  The Company does not have any permittedaccounting practices.

 

Statutoryaccounting practices (“SAP”) prescribed or permitted by regulatory authoritiesfor the Company differ from GAAP. Shareholders’ equity and net loss, as determined in accordance withstatutory accounting practices, for Kanawha are summarized as follows:

 
| Capital and surplus as of December 31, 2002           |   | $ | 67,232,379 |   |
|-------------------------------------------------------|--------|---|------------|--------|
| Net (loss) for the year ended December 31,  2003      |   | $ | (1,372,003 | )      |
| Capital and surplus as of December 31, 2003           |   | $ | 66,807,598 |   |
| Net (loss) for the year ended  December 31, 2004 |   | $ | (1,745,291 | )      |
| Capital and surplus as of December 31, 2004           |   | $ | 83,707,749 |   |

 

Under SouthCarolina insurance regulations, Kanawha is required to maintain minimum capitalof $1.2 million and minimum surplus of $1.2 million.  Additionally, Kanawha is restricted as toamounts that can be transferred in the form of dividends, loans, or advanceswithout the approval of the South Carolina Insurance Commissioner.  Under these restrictions, during 2005,dividends, loans or advances by Kanawha in excess of $8.4 million willrequire the approval of the South Carolina Insurance Commissioner.

 

Risk-BasedCapital (“RBC”) requirements promulgated by the NAIC require life insurers tomaintain minimum capitalization levels that are determined based on formulasincorporating credit risk pertaining to its investments, insurance risk,interest rate risk and general business risk. As of December 31, 2004, the Company’s adjusted SAP capital and surplusexceeded its authorized control level RBC.

 

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#### **12. Unpaid Claims**

#### ** **

The followingtable provides a reconciliation of the beginning and ending balances of unpaidaccident and health claim liabilities, net of reinsurance recoverables, foryears ended December 31:

 
| ** **                                                                            | ** ** | **Predecessor** | ** **  |
|---------------------------------------------------------------------------------------|------------|-----------------|-------------|
| ** **                                                                            | ** ** | **2003**        | ** **  | **2004** | ** ** |
| Unpaid accident and health claims at  beginning of year                               |       | $               | 19,802,468  |   | $ | 22,703,423 |   |
| Less reinsurance recoverables                                                         |       | 3,919,612       |        | 3,896,612 |   |
| Net balance at beginning of year                                                      |       | 15,882,856      |        | 18,806,811 |   |
|                                                                                  |       |            |        |   |   |
| Add provision for claims occurring in:                                                |       |            |        |   |   |
| Current year                                                                          |       | 47,233,641      |        | 50,308,966 |   |
| Prior years                                                                           |       | 900,130         |        | (670,441 | ) |
| Incurred losses during the current year                                               |       | 48,133,771      |        | 49,638,525 |   |
| Deduct payments for claims occurring in:                                              |       |            |        |   |   |
| Current year                                                                          |       | 32,704,150      |        | 35,075,480 |   |
| Prior years                                                                           |       | 12,505,666      |        | 12,464,008 |   |
| Claim payments during the current year                                                |       | 45,209,816      |        | 47,539,488 |   |
| Net balance at end of year  (KMG America at December 31, 2004)                        |       | 18,806,811      |        | 20,905,848 |   |
| Plus reinsurance recoverables  (KMG America at December 31, 2004)                     |       | 3,896,612       |        | 4,474,339 |   |
| Unpaid accident and health claims at end of  year  (KMG America at December 31, 2004) |       | $               | 22,703,423  |   | $ | 25,380,187 |   |
| Unpaid accident and health claims at end of  year  (KMG America at December 31, 2004) |       | $               | 22,703,423  |   | $ | 25,380,187 |   |
| Life policy and contract claims  (KMG America at December 31, 2004)                   |       | 1,849,750       |        | 1,323,144 |   |
| Accident and health policy reserves  (KMG America at December 31, 2004)               |       | $               | 127,116,558 |   | 183,442,027 |   |
|                                                                                  |       | $               | 151,669,731 |   | $ | 210,145,358 |   |
| Accident and health reserves per balance  sheet  (KMG America at December 31, 2004)   |       | $               | 141,209,015 |   | $ | 200,801,846 |   |
| Policy and contract claims per balance  sheet  (KMG America at December 31, 2004)     |       | 10,460,716      |        | 9,343,512 |   |
|                                                                                  |       | $               | 151,669,731 |   | $ | 210,145,358 |   |

 

The foregoingreconciliation reflects a deficiency in the December 31, 2002, reserves of $0.9million, and a redundancy in the December 31, 2003 reserves of $0.7 millionemerged in 2003 and 2004, respectively. The changes in those reserves were primarily the result in changes inestimates as more information became available.

 

#### **13. Employee Benefits**

#### ** **

The Companyadopted the Predecessor’s defined benefit retirement plan, deferredcontribution plan, and deferred compensation plan.  These plans were unchanged by the Kanawhaacquisition and remain in effect.

 

101

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*Defined Benefit Retirement Plan*

 

The Company’sdefined benefit retirement plan complies with three principal standards: theEmployee Retirement Income Security Act of 1974, as amended (“ERISA”), which,in conjunction with the Internal Revenue Code, determines legal minimum andmaximum deductible funding requirements; FAS 87; and Statement of FinancialAccounting Standards No. 132, *Employers’Disclosures About Pensions and Other Postretirement Benefits*, asrevised, which establish rules for financial reporting.  The measurement date for the Company’sdefined benefit plan is December 31.

 

Substantiallyall of the employees and agents of the Company are covered under a definedbenefit pension plan.  Plan benefits arebased on years of service and compensation during the last five years ofservice.  The Company’s funding policy isto make the minimum annual contributions required by applicable regulations,including amortization of unfunded prior service costs over the maximum periodallowed by ERISA.

 

The assets ofthe plan are held in a trust account and are invested primarily in commonstock.  Beneficiaries may elect toreceive benefits in the form of lump-sum distribution, subject to certaindollar limitations, or through one of several annuity options.  Based on the plan’s current funding statusand ERISA guidelines, no required contributions to the plan are anticipated for2005.

 

The netperiodic retirement benefit cost of the plan included the following components:

 
| ** **                               | ** ** | **Predecessor**             | ** ** |
|------------------------------------------|------------|-----------------------------|------------|
| ** **                               | ** ** | **Year Ended December 31,** | ** ** |
| ** **                               | ** ** | **2002**                    | ** ** | **2003** | ** ** | **2004** | ** ** |
| Components of net periodic benefit cost: |       |                        |       |   |   |   |   |
| Service cost                             |       | $                           | 690,136    |   | $ | 825,077 |   | $ | 910,317 |   |
| Interest cost                            |       | 699,226                     |       | 802,054 |   | 912,685 |   |
| Expected return on plan assets           |       | (480,109                    | )          | (526,115 | ) | (829,537 | ) |
| Amortization of transition liability     |       | 17,373                      |       | 17,373 |   | 17,373 |   |
| Recognized net actuarial loss            |       | —                      |       | 207,652 |   | 170,431 |   |
|                                     |       |                        |       |   |   |   |   |
| Net periodic benefit cost                |       | $                           | 926,626    |   | $ | 1,326,041 |   | $ | 1,181,269 |   |

 

Expectedbenefit payments, which reflect expected future service, are as follows for theyears ended December 31:

 
| **2005**   | ** ** | **2006**   | ** ** | **2007**   | ** ** | **2008**   | ** ** | **2009**   | ** ** | **2010-2014** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|---------------|------------|
| ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **    | ** ** |
| $          | 404,832    |       | $          | 451,847    |       | $          | 503,897    |       | $          | 585,895       |       | $ | 693,362 |   | $ | 4,838,305 |   |
|            |            |            |            |            |            |            |            |            |            |               |            |  |  |  |  |  |  |

 

 The defined benefit plan’s change in benefitobligation, change in plan assets, funded status and amounts recognized in thePredecessor’s and the Company’s consolidated balance sheets are as follows:

 
| ** **                                                    | ** ** | **Predecessor** | ** ** |
|---------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                    | ** ** | **2003**        | ** ** | **2004** | ** ** |
| **Change in Benefit Obligation**                              |       |            |       |   |   |
| Obligation at January 1                                       |       | $               | 12,025,408 |   | $ | 13,696,939 |   |
| Service cost                                                  |       | 825,077         |       | 910,317 |   |
| Interest cost                                                 |       | 802,054         |       | 912,685 |   |
| Actuarial loss                                                |       | 376,727         |       | 250,748 |   |
| Benefit payments                                              |       | (332,327        | )          | (382,970 | ) |
| Obligation at December 31 (KMG America at  December 31, 2004) |       | $               | 13,696,939 |   | $ | 15,387,719 |   |

 

102

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| ** **                                                                   | ** ** | **Predecessor** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------|------------|
| ** **                                                                   | ** ** | **2003**        | ** ** | **2004** | ** ** |
| ** **                                                                   | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Reconciliation of Fair Value of Plan  Assets:**                            |       |            |       |   |   |
| Fair value of plan assets at January 1                                       |       | $               | 5,256,242  |   | $ | 10,197,564 |   |
| Actual return on plan assets                                                 |       | 862,908         |       | 458,050 |   |
| Employer contributions                                                       |       | 4,410,741       |       | 3,074,345 |   |
| Benefit payments                                                             |       | (332,327        | )          | (382,970 | ) |
| Fair value of plan assets at December 31 (KMG  America at December 31, 2004) |       | $               | 10,197,564 |   | $ | 13,346,989 |   |
| ** **                                                                   | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Funded Status of the Plan**                                                |       |            |       |   |   |
| Unfunded status at December 31                                               |       | $               | (3,499,375 | ) | $ | (2,040,730 | ) |
| Unrecognized transition obligation                                           |       | 156,364         |       | 138,991 |   |
| Unrecognized net actuarial loss                                              |       | 2,760,410       |       | 3,212,214 |   |
| Accrued benefit cost (KMG America at  December 31, 2004)*                    |       | $               | (582,601   | ) | $ | 1,310,475 |   |

 

----

* Included in liability for employees and agents in the accompanyingconsolidated balance sheets.

 
| ** **                                                             | ** ** | **Predecessor** | ** ** | **KMG  America** | ** ** |
|------------------------------------------------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                             | ** ** | **2003**        | ** ** | **2004**         | ** ** |
| **Amounts recognized in the consolidated  balance sheets consist of:** |       |            |       |             |       |
| Prepaid benefit cost                                                   |       | $               | —     |             | $          | 1,310,475 |   |
| Accrued benefit cost                                                   |       | (799,449        | )          | —           |       |
| Intangible asset                                                       |       | 156,364         |       | —           |       |
| Accumulated other comprehensive income                                 |       | 60,484          |       | —           |       |
| Net amount recognized at end of the year                               |       | $               | (582,601   | )                | $          | 1,310,475 |   |

 

ThePredecessor recorded an additional minimum pension liability of $0.2 millionand $0.0 million, in 2003 and 2004 respectively, for the unfunded portion ofthe accumulated benefit obligation.

 

The projectedbenefit obligation, accumulated benefit obligation, and fair value of planassets for the retirement plans with accumulated benefit obligations in excessof plan assets were as follows:

 
| ** **                     | ** ** | **2003**   | ** ** | **2004**   | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|
| Projected benefit obligation   |       | $          | 13,696,939 |       | $          | 15,387,719 |   |
| Accumulated benefit obligation |       | 10,997,013 |       | 13,140,345 |       |
| Fair value of plan assets      |       | 10,197,564 |       | 13,346,989 |       |
|                                |            |            |            |            |            |  |  |

 

The expectedlong-term rate of return on plan assets is estimated based on input from theCompany’s actuaries and the Company’s investment committee using a variety offactors including long-term historical returns, inflation assumptions, targetedallocation of plan assets (as discussed above) and expectations regardingfuture market returns for both equity and debt securities.

 

The keyassumptions used in the calculation of the accrued benefit obligations aboveare as follows:

 
| ** **                        | ** ** | **2002** | ** ** | **2003** | ** ** | **2004** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Weighted-average assumptions:** |       |     |       |     |       |     |       |
| Discount rate                     |       | 6.75     | %          | 6.75     | %          | 6.25     | %          |
| Expected return on plan assets    |       | 8.75     |       | 8.50     |       | 8.50     |       |
| Expected compensation increase    |       | 5.00     |       | 5.00     |       | 4.00     |       |

 

103

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The actuarialpresent value of accumulated plan benefits does not reflect the actual benefitsthat will be paid on retirement, but rather the liability that would exist ifthe Plan were terminated as of the valuation date.

 

The pensionplan asset allocation at December 31, 2003, and 2004 by asset category is asfollows:

 
| ** **                                 | ** ** | **Percent of Plan Assets  December 31** | ** ** |
|--------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                 | ** ** | **2003**                                     | ** ** | **2004** | ** ** |
| Equity securities (primarily common stock) |       | 71.98                                        | %          | 72.08 | % |
| Debt securities                            |       | —                                       |       | — |   |
| Cash                                       |       | 28.02                                        |       | 27.92 |   |
| Total                                      |       | 100.00                                       | %          | 100.00 | % |

 

The Company’sinvestment strategy for pension plan assets is for approximately one-half ofthe equity investments to be invested in a large capitalization diversifiedequity portfolio.  The portfolio iscurrently managed by Morgan Stanley.  Theinvestment objective is to meet or exceed the S&P 500 index.  At December 31, 2003, and 2004, thePredecessor’s year-end contribution to the Plan was held in cash pendinginvestment in accordance with the Plan.

 

The balance ofthe portfolio is invested in an absolute return hedge fund, theMangan & McColl Offshore Arbitrage Fund.  The performance is measured against the HFRMerger Arbitrage index.

 

*Deferred Contribution Plan*

 

The Companyoffers a 401(k) qualified savings plan for which substantially all employeesand agents are eligible.  Each year, planparticipants may contribute up to 15% of pretax annual compensation, whichincludes overtime, bonuses and commissions. Participants may also contribute amounts representing distributions fromother qualified defined benefit or defined contribution plans.  The Company contributes 25% of the first 6%of base compensation that a participant contributes to the Plan.  The Company may contribute amounts greaterthan 25% at its discretion.  Amountscontributed to the plan by the Company are not significant.

 

*Deferred Compensation Plan*

* *

The Companyhas a non-qualified deferred compensation plan for senior management thatallows the deferment of a portion of their compensation until their serviceswith the Company have terminated.  Theplan includes deferred contributions, which were not elected by employees to betransferred to the 401K plan upon adoption of the 401K plan.  The plan’s investments include money marketfunds and are recorded in investments as held for trading.  The corresponding deferred obligations toparticipants is recorded in other liabilities.

 

*The Predecessor’s Stock Option Plan*

 

ThePredecessor followed Accounting Principles Board Opinion No. 25, *Accounting for Stock Issued to Employees*(APB 25) and related interpretations in accounting for its stock options issuedto senior management.  Under APB 25,for options issued where the exercise price of the issuer’s stock option equalsthe market value of the underlying stock on the date of grant, no compensationexpense is recognized.  Conversely, foroptions issued where the exercise price of the option is less than the marketvalue on the date of grant, the difference between the exercise price and themarket value on the date of the grant is recognized as unearned compensation,included as a component of shareholders’ equity and amortized over the vestingperiod.

 

ThePredecessor granted options for a total of 371.8 shares of the Predecessor’scommon stock.  Stock options for 191shares were granted in 1985 and the exercise price was 100% of the estimatedfair market value of the common stock on the date of the grant, $16,534 per share.  These options were fully vested at theclosing of the Company’s acquisition of the Predecessor.  In 1998, options for the remaining 180.8shares were granted with an exercise price of $16,536 per share, and anestimated fair market value at the grant date of $45,688 per share.  Approximately $5.3 million ofcompensation expense was recorded as unearned upon the issuance of theseoptions.

 

104

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These optionsgenerally vested 30% in 1998 and 10% annually thereafter.  Amortization of deferred stock optioncompensation expense of approximately $0.3 million, $0.2 million and $0.2million was recognized in 2002, 2003 and 2004, respectively.

 

Pro formainformation regarding net income and net income per share, as presented inNote 1, is required by SFAS 123, as amended by SFAS 148, and hasbeen determined as if the Predecessor had accounted for its employee stockoptions under the fair value method of SFAS 123 as of its effective date.  The fair value for these options wasestimated at the date of grant using a Black-Scholes option-pricing model withthe following weighted-average assumptions:

 
| Risk-free Interest Rate |   | 5.71    | %      |
|-------------------------|--------|---------|--------|
| Expected Dividend Yield |   | —  |   |
| Expected Volatility     |   | 35.00   | %      |
| Expected life           |   | 5 years |   |

 

No optionswere issued, exercised or canceled by the Predecessor under its stock optionplan during 2002 and 2003.  In connectionwith the closing of the acquisition of the Predecessor, on December 21,2004, all 371.8 options became 100% vested and were exercised and thePredecessor stock option plan was terminated. No additional stock options can be granted under the Predecessor’s plan.

 

*KMG America 2004 Equity Incentive Plan*

* *

The Companyalso follows APB 25 and related interpretations in accounting for its stockoptions issued to senior management.

 

Through December 31,2004, the Company issued options to purchase a total of 1,246,000 shares ofCompany common stock, all of which were granted on December 15, 2004, atan exercise price of $9.50 per share, which is equal to 100% of the estimatedfair market value of the common stock on the date of the grant.  These options generally vest with respect toone fourth of the shares subject to the option on each of the first, second,third and fourth anniversaries of the date of grant.  Options to purchase****310,000 shares, however, vest one third on each of the first,second and third anniversaries of the date of grant, subject to earlier,immediate vesting upon the termination of the option holder’s employment withthe Company by the Company without cause or by him with good reason, upon achange in control of the Company or upon his receipt of a notice of non-renewalof his employment agreement, or upon his death or disability.

 

Pro formainformation regarding net income and net income per share, as presented inNote 1, is required by SFAS 123, as amended by SFAS 148, and hasbeen determined as if the Company had accounted for its employee stock optionsunder the fair value method of SFAS 123 as of its effective date.  The fair value for these options wasestimated at the date of grant using a Black-Scholes option-pricing model withthe following weighted-average assumptions:

 
| Risk-free Interest Rate |   | 3.63    | %      |
|-------------------------|--------|---------|--------|
| Expected Dividend Yield |   | —  |   |
| Expected Volatility     |   | 20.00   | %      |
| Expected life           |   | 5 years |   |

 

As of December 31,2004, no options to purchase shares of the Company’s common stock wereexercisable.  All options granted underthe plan in 2004 vest in annual increments and are exercisable through December 15,2014, subject to earlier termination of the option holders’ rights to exercisesuch options under the terms of the plan and the option agreements relating tosuch options.

 

*Performance Share Plan*

 

On January 1,2000, the Predecessor established its Performance Share Plan and authorized theissuance of up to 80,000 stock units to attract and retain quality employeesand to allow such employees to participate in the

 

105

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growth of thePredecessor.  Awards could be made toparticipants in the form of stock units. The Performance Share Plan provides for vesting over the 10 yearssubsequent to date of grant (10% per year). Compensation expense was recorded based on the vesting and the change inthe book value of the Predecessor’s common stock from the date of grant to thedate of exercise, adjusted for dividends, stock redemption proceeds and capitalcontributions subsequent to the date of grant. Eligible participants under the Performance Share Plan includedexecutives or key employees of the Predecessor. During 2002, 2003 and 2004, the Predecessor granted 6,500 units, 12,000units and 0 units, respectively, and recognized compensation expense ofapproximately $0.4 million, $0.7 million and $0.0 million, respectively, relatedto these units.  During 2002, 2003 and2004, 1,482 units, 2,918 units and 7,354 units, respectively, were forfeited orredeemed resulting in 65,864 outstanding units at December 20, 2004.  The plan continued in effect through theclosing of the Company’s acquisition of the Predecessor on December 21,2004, when it terminated and all outstanding stock units were redeemed.  No additional stock units may be awardedunder the plan.  The Company does notintend to implement a stand-alone successorperformance share plan, but the Company’s 2004 Equity Incentive Planpermits the Company to award performance shares.

 

#### **14.**       Transaction with Related Parties

#### ** **

Mortgage loansincluded loans to related parties of approximately $6.3 million and $0.0million at December 31, 2003, and 2004, respectively.

 

ThePredecessor utilized the legal, tax and investment services of an entity thatwas previously affiliated with the Predecessor because they were under thecommon control of some of the same shareholders.  The Predecessor paid $0.1 million in each ofthe years 2002, 2003 and 2004 for these services.  Since the Company acquired Kanawha, there isno longer a common control relationship between Kanawha and the legal, tax andinvestment services entity.

 

#### **15.**       Commitments and Contingencies

#### ** **

The Company isoccasionally named as a defendant in various legal actions arising principallyfrom claims made under insurance policies and contracts.  Those actions are considered by the Companyin estimating the policy and contract liabilities and management believesadequate reserves have been established for such cases.  Management believes that the resolution ofthose actions will not have a material effect on the Company’s financialposition or results of operations.

 

On February 18,2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company andReliaStar Life Insurance Company of New York, both indirect wholly-ownedsubsidiaries of ING America US, in the Fourth Judicial District Court inHennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, PaulKraemer, Paul Moore and another individual. Messrs. Kuk, Kraemer and Moore are officers of KMG America andformer employees of the plaintiffs.  Thecomplaint alleges misappropriation of trade secrets, conversion, tortiousinterference with business and employment relationships, breach of fiduciaryduties and breach of contract by KMG America, Kanawha and Messrs. Kuk,Kraemer, and Moore.  The complaint seeksinjunctive relief and unspecified monetary damages.  KMG America believes the allegations arewithout merit, intends to defend the action and believes that the outcome ofthis matter will not have a material adverse effect on its consolidatedfinancial position or results of operations.

 

On December 21,2004, the Company entered into a $15.0 million five-year subordinatedpromissory note to fund a portion of the purchase price for the Kanawhaacquisition.  Interest on the promissorynote accrues at 5% per annum and is added to the principal balance on December 31of each year and is payable on the maturity date.  No cash payments are required under thepromissory note until maturity, at which time approximately $19.1 million ofprincipal and accrued interest will be due and payable.  The terms of the promissory note limit theCompany’s and Kanawha’s ability to incur additional debt.

 

The Companyhad no commitments to fund mortgage loans at December 31, 2004.

 

The Company isassessed amounts by state guaranty funds to cover losses to policyholders ofinsolvent or rehabilitated insurance companies. Those mandatory assessments may be partially recovered through areduction in

 

106

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future premiumtaxes in certain states.  The Companyrecognizes its obligation for guaranty fund assessments and records anestimated accrual for any potential assessment. There were no such accruals as of December 31, 2003, and 2004.

 

The Companyleases office equipment under noncancellable leases.  Total rental expense incurred during 2002 and2003 was not significant and amounted to $0.1 million in 2004.  As of December 31, 2004, future minimumlease payments under noncancellable operating leases with initial or remainingterms in excess of one year are as follows:

 
| 2005   |   | $       | 166,000 |   |
|--------|--------|---------|---------|--------|
| 2006   |   | 159,000 |    |
| 2007   |   | 153,000 |    |
|   |   | $       | 478,000 |   |

 

During February 2005,the Company entered into a lease agreement, pursuant to which it has agreed topay an aggregate of $551,250 to lease its principal executive offices locatedin Minnetonka, Minnesota for the period from April 1, 2005, through June 30,2010.  This lease is not cancelable bythe Company except in connection with specified events that are generallybeyond the Company’s control.

** **

During November 2003,the Predecessor entered into a contract for IT and document management.  Expenses incurred during 2003 and 2004 were$0.5 million and $5.0 million, respectively. This ten-year contract is subject to cancellation by the Company at anytime after 42 months, with the payment of a termination penalty that is subjectto the number of months remaining in the contract.  Future payments under this contract are asfollows:

 
| 2005       |   | $          | 5,450,000  |   |
|------------|--------|------------|------------|--------|
| 2006       |   | 5,450,000  |       |
| 2007       |   | 5,450,000  |       |
| 2008       |   | 5,450,000  |       |
| 2009       |   | 5,450,000  |       |
| Thereafter |   | 21,800,000 |       |
|       |   | $          | 49,050,000 |   |

 

#### **16.**       Concentrations of Credit Risk

#### ** **

At December 31, 2003 and 2004, thePredecessor and the Company, respectively, had no significant exposure tounrated or less-than-investment grade bonds.

 

The Company’s investment in mortgage loansprincipally involves residential and commercial real estate primarily in SouthCarolina and North Carolina.  Suchinvestments consist primarily of first mortgage liens on single-familyresidences; the mortgage outstanding on any individual property does not exceed$1.1 million.

 

#### **17.**       Fair Values of Financial Instruments

#### ** **

The followingmethods and assumptions were used by the Company in estimating the “fair value”disclosures for financial instruments in the accompanying financial statementsand notes thereto:

 

*Cash and Cash Equivalents:*  The carrying amounts reported in theaccompanying balance sheets for these financial instruments approximate theirfair values.

 

*Investment Securities:*  The carrying amount for fixed maturity andequity securities classified as available-for-sale is fair value, which isbased on quoted market prices, where available. For fixed maturity and equity securities that are not actively traded,fair values are estimated using values obtained from independent pricingservices.

 

107

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*Mortgage Loans:*  The fair values for mortgage loans areestimated using discounted cash flow analyses based on interest rates currentlybeing offered for similar loans to borrowers with similar credit ratings.  Loans with similar characteristics areaggregated for purposes of the calculations.

 

*Policy Loans:* The carrying amounts reported in the accompanying balance sheets forthese financial instruments approximate their fair values.

 

*Investment Contracts:*  The fair values of the Company’s liabilitiesunder investment-type insurance contracts are estimated using discounted cashflow calculations, based on interest rates currently being offered for similarcontracts with maturities consistent with those remaining for the contractsbeing valued.

 

The fairvalues of the Company’s insurance contracts other than investment contracts arenot required to be disclosed.  However,the fair values of liabilities under all insurance contracts are taken intoconsideration in the Company’s overall management of interest rate risk, suchthat the Company’s exposure to changing interest rates is minimized through thematching of investment maturities with amounts due under insurance contracts.

 

Additionaldata with respect to fair values of the Company’s investments is disclosed inNote 3.

 

The carryingamounts and fair values of the Company’s and the Predecessor’s cash andinvestments at December 31 are summarized in the following table.  Effective December 31, 2004, as part ofthe application of GAAP purchase accounting requirements, the Company recordedthe Predecessor’s investments at fair value and thereby eliminated allunrealized gains and losses in the Predecessor’s portfolio.

 
| ** **                | ** ** | **Predecessor**      | ** ** | **KMG America** | ** ** |
|---------------------------|------------|----------------------|------------|-----------------|------------|
| ** **                | ** ** | **2003**             | ** ** | **2004**        | ** ** |
| ** **                | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| Cash and cash equivalents |       | $                    | 7,204,805  |            | $          | 7,204,805 |   | $ | 117,400,156 |   | $ | 117,400,156 |   |
| Equity securities         |       | 2,824,857            |       | 2,824,857       |       | 36,000 |   | 36,000 |   |
| Fixed maturity securities |       | 414,825,975          |       | 414,825,975     |       | 409,613,186 |   | 409,613,186 |   |
| Mortgage loans            |       | 31,630,597           |       | 33,149,182      |       | 23,678,639 |   | 23,678,639 |   |
| Policy loans              |       | 22,940,322           |       | 22,940,322      |       | 22,620,801 |   | 22,620,801 |   |
|                           |            |                      |            |                 |            |  |  |  |  |  |  |  |  |

 

The carryingamounts and fair values of the Predecessor’s liabilities for investment-typeinsurance contracts at December 31 are summarized in the followingtable.  Effective December 31, 2004,as part of the application of GAAP purchase accounting requirements as if theacquisition of the Predecessor closed on December 31, 2004, the Companyrecorded the Predecessor’s investment-type insurance contracts at fair valueand thereby eliminated all differences between the carrying value and the fairvalue of the Predecessor’s investment-type insurance contracts.

 
| ** **                               | ** ** | **Predecessor**      | ** ** | **KMG America** | ** ** |
|------------------------------------------|------------|----------------------|------------|-----------------|------------|
| ** **                               | ** ** | **2003**             | ** ** | **2004**        | ** ** |
| ** **                               | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| Individual and group annuities           |       | $                    | 6,500,019  |            | $          | 6,677,416 |   | $ | 7,003,823 |   | $ | 7,003,823 |   |
| Other policyholder funds left on deposit |       | 6,742,794            |       | 6,742,794       |       | 7,007,387 |   | 7,007,387 |   |
| Total                                    |       | $                    | 13,242,813 |            | $          | 13,420,210 |   | $ | 14,011,210 |   | $ | 14,011,210 |   |
|                                          |            |                      |            |                 |            |  |  |  |  |  |  |  |  |  |

 

#### **18.**       Business Segments

#### ** **

The Companyhas five reportable segments that are differentiated by their respectivemethods of distribution and the nature of the related products: worksiteinsurance business, senior market insurance business, third partyadministration business, acquired business and corporate and other.  Management makes decisions

 

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regarding thebusiness based on these segment classifications.  No segments have been aggregated other thanincluding the marketing business in the corporate and other segment.

 

The worksiteinsurance business provides life and health insurance products to employers andtheir employees.  The primary insuranceproducts include life, short-term disability, dental, indemnity health andcritical illness.  This segment includesbusiness sold through the career agency distribution channel, which is a groupof agents and managers that are employees of the Company or its subsidiaries.

 

The seniormarket insurance business provides individual insurance products, primarilylong-term care insurance, tailored to the needs of older individuals.

 

The thirdparty administration business provides fee-based administrative and managed careservices to employers with self funded health care plans, insurance carriers,reinsurance companies and others.

 

The acquiredbusiness represents closed blocks of life and health insurance business thathave been acquired through reinsurance transactions over a period of years.

 

The corporateand other segment includes investment income earned on the investment portfolioallocated to capital and surplus, as well as all realized capital gains andlosses, which are not allocated by line of business.  This segment also includes marketingallowances, commissions and related expenses pertaining to product sales forother insurance carriers, which are currently not material.  In addition, this segment includes certain unallocatedexpenses, primarily deferred compensation and incentive compensation costs, andother non-allocated immaterial items.

 

The followingrepresents a summary of the Predecessor’s statement of operations and assetcomposition by reportable segment. Except as noted, the financial statement information set forth below isreported on a historical basis without GAAP purchase accounting adjustmentsreflecting the Company’s acquisition of the Predecessor.

 
| ** **                             | ** ** | **For the Year Ended December 31,** | ** **  |
|----------------------------------------|------------|------------------------------------------|-------------|
| ** **                             | ** ** | **2002**                                 | ** **  | **2003** | ** ** | **2004** | ** ** |
| **Worksite Insurance Business**        |       |                                     |        |   |   |   |   |
| Insurance premiums                     |       | $                                        | 53,173,170  |   | $ | 58,432,771 |   | $ | 56,308,493 |   |
| Net investment income                  |       | 6,266,992                                |        | 5,943,960 |   | 5,028,355 |   |
| Commission and fees                    |       | —                                   |        | — |   | — |   |
| Net realized gains                     |       | —                                   |        | — |   | — |   |
| Other income                           |       | 197,146                                  |        | 386,070 |   | 263,734 |   |
| Total revenues                         |       | 59,637,308                               |        | 64,762,801 |   | 61,600,582 |   |
| Policyholder benefits                  |       | 42,067,226                               |        | 45,129,701 |   | 44,292,442 |   |
| Commissions                            |       | 3,534,254                                |        | 4,027,870 |   | 3,779,844 |   |
| Expenses, taxes, fees and depreciation |       | 11,455,749                               |        | 11,149,951 |   | 9,966,881 |   |
|                                   |       |                                     |        |   |   |   |   |
| Amortization of DAC                    |       | 4,122,546                                |        | 5,201,470 |   | 6,208,791 |   |
|                                   |       |                                     |        |   |   |   |   |
| Total benefits and expenses            |       | 61,179,775                               |        | 65,508,992 |   | 64,247,958 |   |
| (Loss) before Federal income tax       |       | $                                        | (1,542,467  | ) | $ | (746,191 | ) | $ | (2,647,376 | ) |
| Total assets                           |       | $                                        | 150,694,648 |   | $ | 151,371,669 |   | $ | 169,760,986 | (1) |

 

109

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| ** **                              |   | **For the  Year Ended December 31,** |        |
|-----------------------------------------|--------|-------------------------------------------|-------------|
| ** **                              |   | **2002**                                  | ** **  | **2003** | ** ** | **2004** |   |
| ** **                              |   | ** **                                | ** **  | ** ** | ** ** | ** ** |   |
| **Senior Market Insurance Business**    |   |                                      |        |   |   |   |   |
| Insurance premiums                      |   | $                                         | 37,970,676  |   | $ | 41,546,362 |   | $ | 42,060,326 |   |
| Net investment income                   |   | 1,308,947                                 |        | 2,426,903 |   | 3,878,429 |   |
| Commission and fees                     |   | —                                    |        | — |   | — |   |
| Net realized gains                      |   | —                                    |        | — |   | — |   |
| Other income                            |   | 1,368,706                                 |        | 1,563,506 |   | 2,346,577 |   |
| Total revenues                          |   | 40,648,329                                |        | 45,536,771 |   | 48,285,332 |   |
| Policyholder benefits                   |   | 28,785,095                                |        | 33,146,152 |   | 35,829,058 |   |
| Commissions                             |   | 3,307,834                                 |        | 4,587,237 |   | 5,481,986 |   |
| Expenses, taxes, fees and depreciation  |   | 2,747,276                                 |        | 2,927,784 |   | 3,695,003 |   |
| Amortization of DAC                     |   | 1,621,606                                 |        | 825,889 |   | 641,079 |   |
| Total benefits and expenses             |   | 36,461,811                                |        | 41,487,062 |   | 45,647,126 |   |
| Income before Federal income tax        |   | $                                         | 4,186,518   |   | $ | 4 ,049,709 |   | $ | 2,638,206 |   |
| Total assets                            |   | $                                         | 81,317,287  |   | $ | 115,751,057 |   | $ | 160,381,684 | (1) |
| **Third-Party Administration Business** |   |                                      |        |   |   |   |   |
| Insurance premiums                      |   | $                                         | —      |   | $ | — |   | $ | — |   |
| Net investment income                   |   | —                                    |        | — |   | — |   |
| Commission and fees                     |   | 12,974,620                                |        | 13,007,733 |   | 13,295,120 |   |
| Net realized gains                      |   | —                                    |        | — |   | — |   |
|                                    |   |                                      |        |   |   |   |   |
| Other income                            |   | —                                    |        | 63,857 |   | 798 |   |
| Total revenues                          |   | 12,974,620                                |        | 13,071,590 |   | 13,295,918 |   |
| Policyholder benefits                   |   | —                                    |        | — |   | — |   |
| Commissions                             |   | —                                    |        | — |   | — |   |
| Expenses, taxes, fees and depreciation  |   | 12,978,196                                |        | 12,564,353 |   | 12,200,228 |   |
| Amortization of DAC                     |   | —                                    |        | — |   | — |   |
| Total benefits and expenses             |   | 12,978,196                                |        | 12,564,353 |   | 12,200,228 |   |
| (Loss) income before Federal income tax |   | $                                         | (3,576      | ) | $ | 507,237 |   | $ | 1,095,690 |   |
|                                    |   |                                      |        |   |   |   |   |
| Total assets                            |   | $                                         | 8,737,853   |   | $ | 8,858,946 |   | $ | 8,186,306 | (1) |
|                                    |   |                                      |        |   |   |   |   |
| **Acquired Business**                   |   |                                      |        |   |   |   |   |
| Insurance premiums                      |   | $                                         | 7,499,276   |   | $ | 6,436,741 |   | $ | 4,466,726 |   |
| Net investment income                   |   | 10,261,228                                |        | 9,230,046 |   | 8,507,129 |   |
| Commissions and fees                    |   | —                                    |        | — |   | — |   |
| Net realized gains (losses)             |   | —                                    |        | — |   | — |   |
| Other income                            |   | 139,828                                   |        | 122,037 |   | 115,613 |   |
| Total revenues                          |   | 17,900,332                                |        | 15,788,824 |   | 13,089,468 |   |
| Policyholder benefits                   |   | 10,432,557                                |        | 10,985,219 |   | 10,053,493 |   |
| Commissions                             |   | 509,277                                   |        | 459,135 |   | 428,247 |   |
| Expenses, taxes, fees and depreciation  |   | 3,275,027                                 |        | 3,037,122 |   | 2,829,686 |   |
| Amortization of DAC                     |   | 3,771,306                                 |        | 3,561,171 |   | 2,618,432 |   |
| Total benefits and expenses             |   | 17,988,167                                |        | 18,042,647 |   | 15,929,858 |   |
| (Loss) before Federal income tax        |   | $                                         | (87,835     | ) | $ | (2,253,823 | ) | $ | (2,840,390 | ) |
|                                    |   |                                      |        |   |   |   |   |
| Total assets                            |   | $                                         | 220,934,606 |   | $ | 203,214,521 |   | $ | 215,850,711 | (1) |

 

110

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| ** **                             |   | **For the  Year Ended December 31,** |        |
|----------------------------------------|--------|-------------------------------------------|-------------|
| ** **                             |   | **2002**                                  | ** **  | **2003** | ** ** | **2004** |   |
| ** **                             |   | ** **                                | ** **  | ** ** | ** ** | ** ** |   |
| **Corporate and Other**                |   |                                      |        |   |   |   |   |
| Insurance premiums                     |   | $                                         | —      |   | $ | — |   | $ | — |   |
| Net investment income                  |   | 9,323,064                                 |        | 9,471,850 |   | 7,788,499 |   |
| Commissions and fees                   |   | —                                    |        | 10,286 |   | 180,402 |   |
| Net realized gains (losses)            |   | (3,003,877                                | )           | 7,600,499 |   | 9,432,585 |   |
| Other income                           |   | 163,734                                   |        | 181,850 |   | 381,505 |   |
| Total revenues                         |   | 6,482,921                                 |        | 17,264,485 |   | 17,782,991 |   |
| Policyholder benefits                  |   | —                                    |        | — |   | — |   |
| Commissions                            |   | —                                    |        | — |   | — |   |
| Expenses, taxes, fees and depreciation |   | 4,796,818                                 |        | 7,571,779 |   | 6,272,750 |   |
| Amortization of DAC                    |   | —                                    |        | — |   | — |   |
| Total benefits and expenses            |   | 4,796,818                                 |        | 7,571,779 |   | 6,272,750 |   |
| Income before Federal income tax       |   | $                                         | 1,686,103   |   | $ | 9,692,706 |   | $ | 11,510,241 |   |
|                                   |   |                                      |        |   |   |   |   |
| Total assets                           |   | $                                         | 200,215,333 |   | $ | 205,974,072 |   | $ | 157,714,248 | (1) |
|                                   |   |                                      |        |   |   |   |   |
| **Total Predecessor:**                 |   |                                      |        |   |   |   |   |
| Insurance premiums                     |   | $                                         | 98,643,122  |   | $ | 106,415,874 |   | $ | 102,835,545 |   |
| Net investment income                  |   | 27,160,231                                |        | 27,072,759 |   | 25,202,412 |   |
| Commissions and fees                   |   | 12,974,620                                |        | 13,018,019 |   | 13,475,522 |   |
| Net realized gains (losses)            |   | (3,003,877                                | )           | 7,600,499 |   | 9,432,585 |   |
| Other income                           |   | 1,869,414                                 |        | 2,317,320 |   | 3,108,227 |   |
| Total revenues                         |   | 137,643,510                               |        | 156,424,471 |   | 154,054,291 |   |
| Policyholder benefits                  |   | 81,284,878                                |        | 89,261,072 |   | 90,174,993 |   |
| Commissions                            |   | 7,351,365                                 |        | 9,074,242 |   | 9,690,077 |   |
| Expenses, taxes, fees and depreciation |   | 35,253,066                                |        | 37,250,989 |   | 34,964,548 |   |
| Amortization of DAC                    |   | 9,515,458                                 |        | 9,588,530 |   | 9,468,302 |   |
| Total benefits and expenses            |   | 133,404,767                               |        | 145,174,833 |   | 144,297,920 |   |
| Income before Federal income tax       |   | $                                         | 4,238,743   |   | $ | 11,249,638 |   | $ | 9,756,371 |   |
|                                   |   |                                      |        |   |   |   |   |
| Total assets                           |   | $                                         | 661,899,727 |   | $ | 685,170,265 |   | N/A | (2) |

 

----

(1) KMG America at December 31, 2004, adjusted for purchaseaccounting adjustments to reflect the Kanawha acquisition.

(2) Aggregate total assets for the Predecessor as of December 31,2004, is not reported because the Predecessor had been acquired by KMG Americaat that date and the Predecessor’s assets had been consolidated into the KMGAmerica balance sheet at that date.

 

111

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The followingrepresents a summary of the Company’s income statement and asset composition asof December 31, 2004.  The Company’soperations are aggregated into the following reportable segment, as the effectsof the Company’s operations were not material to the predecessor’s reportablesegments.

 
| ** **                             | ** ** | **For the  Period from  January 21 through  December 31, 2004** | ** **  |
|----------------------------------------|------------|---------------------------------------------------------------------------|-------------|
| **KMG America Corporation:**           |       |                                                                      |        |
| Insurance premiums                     |       | $                                                                         | —      |   |
| Net investment income                  |       | 18,408                                                                    |        |
| Commissions and fees                   |       | —                                                                    |        |
| Net realized gains                     |       | —                                                                    |        |
| Other income                           |       | —                                                                    |        |
| Total revenues                         |       | 18,408                                                                    |        |
| Policyholder benefits                  |       | —                                                                    |        |
| Commissions                            |       | —                                                                    |        |
| Expenses, taxes, fees and depreciation |       | 288,489                                                                   |        |
| Amortization of DAC                    |       | —                                                                    |        |
| Total benefits and expenses            |       | 288,489                                                                   |        |
| (Loss) before Federal income tax       |       | $                                                                         | (270,081    | ) |
|                                   |       |                                                                      |        |
| Total assets                           |       | $                                                                         | 770,051,331 |   |
|                                        |            |                                                                           |             |  |  |

 

#### **19.**       Selected Quarterly Financial Data (Unaudited)

#### ** **

The followingis a summary of the unaudited quarterly results of operations for the yearsended December 31, 2003, and 2004:

 
| ** **                                                  | ** ** | **Predecessor**        | ** ** |
|-------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                  | ** ** | **2003 Quarter Ended** | ** ** |
| ** **                                                  | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| Premiums, fees and other income                             |       | $                      | 29,067,513 |   | $ | 31,104,067 |   | $ | 30,461,106 |   | $ | 31,118,528 |   |
| Net investment income, realized gains and  brokerage income |       | 5,944,053              |       | 13,228,112 |   | 7,173,852 |   | 8,327,241 |   |
| Total revenue                                               |       | 35,011,566             |       | 44,332,179 |   | 37,634,958 |   | 39,445,769 |   |
|                                                        |       |                   |       |   |   |   |   |   |   |
| Benefits and expenses                                       |       | 35,978,290             |       | 38,357,498 |   | 36,419,385 |   | 37,919,002 |   |
| Net income                                                  |       | $                      | (966,724   | ) | $ | 5,974,681 |   | $ | 1,215,573 |   | $ | 1,526,767 |   |
| Basic income per share of common stock                      |       | $                      | (369.99    | ) | $ | 2,286.67 |   | $ | 465.23 |   | $ | 584.33 |   |
| Diluted income per share of common stock                    |       | $                      | (334.73    | ) | $ | 2,066.22 |   | $ | 420.48 |   | $ | 527.92 |   |

 

 
| ** **                                                  | ** ** | **Predecessor**        | ** ** |
|-------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                  | ** ** | **2004 Quarter Ended** | ** ** |
| ** **                                                  | ** ** | **March 31**      | ** ** | **June 30** | ** ** | **September 30** | ** ** | **December 31** | ** ** |
| Premiums, fees and other income                             |       | $                      | 29,437,046 |   | $ | 30,843,485 |   | $ | 29,381,078 |   | $ | 29,757,685 |   |
| Net investment income, realized gains and  brokerage income |       | 5,604,912              |       | 8,443,718 |   | 11,415,501 |   | 9,170,866 |   |
| Total revenue                                               |       | 35,041,958             |       | 39,287,203 |   | 40,796,579 |   | 38,928,551 |   |
| Benefits and expenses                                       |       | 34,951,065             |       | 37,654,312 |   | 37,216,726 |   | 38,041,690 |   |
|                                                        |       |                   |       |   |   |   |   |   |   |
| Net income                                                  |       | $                      | 90,893     |   | $ | 1,632,891 |   | $ | 3,579,853 |   | $ | 886,861 |   |
| Basic income per share of common stock                      |       | $                      | 34.79      |   | $ | 624.95 |   | $ | 1,370.11 |   | $ | 339.43 |   |
| Diluted income per share of common stock                    |       | $                      | 31.39      |   | $ | 565.30 |   | $ | 1,237.06 |   | $ | 305.54 |   |

 

112

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**PREDECESSORAND SUBSIDIARYSCHEDULE III—SUPPLEMENTALINSURANCE INFORMATION**

** **
| **Segment**                           | ** ** | **DAC and  VOBA  Asset** | ** **  | **Policy  Reserves  Liability** | ** ** | **Unearned  Premiums  Liability** | ** ** | **Contract  Claims  and Other  Policy  Liabilities** | ** ** | **Insurance  Premiums** | ** ** | **Net  Investment  Income** | ** ** | **Policyholder  Benefits** | ** **  | **Amortization  of  DAC and  VOBA** | ** ** | **Other  Expenses** | ** ** |
|---------------------------------------|------------|--------------------------|-------------|---------------------------------|------------|-----------------------------------|------------|------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|----------------------------|-------------|-------------------------------------|------------|---------------------|------------|
| *Year-ended  December 31, 2002*  |       |                     |        |                            |       |                              |       |                                                 |       |                    |       |                        |       |                       |        |                                |       |                |       |
| Worksite  insurance                   |       | $                        | 40,717,696  |                            | $          | 135,782,265                       |       | $                                                    | 1,075,711  |                    | $          | 13,836,672                  |       | $                          | 53,173,170  |                                | $          | 6,266,992           |       | $ | 42,067,226 |   | $ | 4,122,546 |   | $ | 14,990,003 |   |
| Senior market  insurance              |       | 36,351,271               |        | 73,210,500                      |       | 6,371,132                         |       | 1,735,655                                            |       | 37,970,676              |       | 1,308,947                   |       | 28,785,095                 |        | 1,621,606                           |       | 6,055,110           |       |
| Third party  administration           |       | —                   |        | —                          |       | —                            |       | —                                               |       | —                  |       | —                      |       | —                     |        | —                              |       | 12,978,196          |       |
| Acquired business                     |       | 28,235,765               |        | 202,887,336                     |       | 1,153,250                         |       | 4,771,883                                            |       | 7,499,276               |       | 10,261,228                  |       | 10,432,557                 |        | 3,771,306                           |       | 3,784,304           |       |
| Corporate and  other                  |       | —                   |        | —                          |       | —                            |       | —                                               |       | —                  |       | 9,323,064                   |       | —                     |        | —                              |       | 4,796,818           |       |
| Total                                 |       | $                        | 105,304,732 |                            | $          | 411,880,101                       |       | $                                                    | 8,600,093  |                    | $          | 20,344,210                  |       | $                          | 98,643,122  |                                | $          | 27,160,231          |       | $ | 81,284,878 |   | $ | 9,515,458 |   | $ | 42,604,431 |   |
|                                  |       |                     |        |                            |       |                              |       |                                                 |       |                    |       |                        |       |                       |        |                                |       |                |       |   |   |   |   |   |   |   |   |   |
| *Year-ended  December 31, 2003*  |       |                     |        |                            |       |                              |       |                                                 |       |                    |       |                        |       |                       |        |                                |       |                |       |
| Worksite  insurance                   |       | $                        | 44,484,787  |                            | $          | 136,921,665                       |       | $                                                    | 1,051,062  |                    | $          | 13,398,942                  |       | $                          | 58,432,771  |                                | $          | 5,943,960           |       | $ | 45,129,701 |   | $ | 5,201,470 |   | $ | 15,177,821 |   |
| Senior market  insurance              |       | 41,101,769               |        | 104,584,187                     |       | 7,340,021                         |       | 3,826,849                                            |       | 41,546,362              |       | 2,426,903                   |       | 33,146,152                 |        | 825,889                             |       | 7,515,021           |       |
| Third party  administration           |       | —                   |        | —                          |       | —                            |       | —                                               |       | —                  |       | —                      |       | —                     |        | —                              |       | 12,564,353          |       |
| Acquired business                     |       | 24,674,594               |        | 190,089,014                     |       | 1,107,236                         |       | 3,696,070                                            |       | 6,436,741               |       | 9,230,046                   |       | 10,985,219                 |        | 3,561,171                           |       | 3,496,257           |       |
| Corporate and  other                  |       | —                   |        | —                          |       | —                            |       | —                                               |       | —                  |       | 9,471,850                   |       | —                     |        | —                              |       | 7,571,779           |       |
| Total                                 |       | $                        | 110,261,150 |                            | $          | 431,594,866                       |       | $                                                    | 9,498,319  |                    | $          | 20,921,861                  |       | $                          | 106,415,874 |                                | $          | 27,072,759          |       | $ | 89,261,072 |   | $ | 9,588,530 |   | $ | 46,325,231 |   |
|                                  |       |                     |        |                            |       |                              |       |                                                 |       |                    |       |                        |       |                       |        |                                |       |                |       |   |   |   |   |   |   |   |   |   |
| *Year  Ended December 31, 2004** |       |                     |        |                            |       |                              |       |                                                 |       |                    |       |                        |       |                       |        |                                |       |                |       |
| Worksite  insurance                   |       | $                        | 14,134,393  |                            | $          | 156,098,046                       |       | $                                                    | 964,052    |                    | $          | 12,698,888                  |       | $                          | 56,308,493  |                                | $          | 5,028,355           |       | $ | 44,292,442 |   | $ | 6,208,791 |   | $ | 13,746,725 |   |
| Senior market  insurance              |       | 40,586,764               |        | 148,442,031                     |       | 7,750,320                         |       | 4,189,333                                            |       | 42,060,326              |       | 3,878,429                   |       | 35,829,058                 |        | 641,079                             |       | 9,176,989           |       |
| Third party  administration           |       | —                   |        | —                          |       | —                            |       | —                                               |       | —                  |       | —                      |       | —                     |        | —                              |       | 12,200,228          |       |
| Acquired business                     |       | 19,760,138               |        | 196,461,950                     |       | 1,025,732                         |       | 3,285,085                                            |       | 4,466,726               |       | 8,507,129                   |       | 10,053,493                 |        | 2,618,432                           |       | 3,257,933           |       |
| Corporate and  other                  |       | —                   |        | —                          |       | —                            |       | —                                               |       | —                  |       | 7,788,499                   |       | —                     |        | —                              |       | 6,272,750           |       |
| Total                                 |       | $                        | 74,481,295  |                            | $          | 501,002,027                       |       | $                                                    | 9,740,104  |                    | $          | 20,921,861                  |       | $                          | 102,835,545 |                                | $          | 25,202,412          |       | $ | 90,174,993 |   | $ | 9,468,302 |   | $ | 44,654,625 |   |
|                                       |            |                          |             |                                 |            |                                   |            |                                                      |            |                         |            |                             |            |                            |             |                                     |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

*Balance sheetamounts at December 31, 2004, are those of KMG America.

 

113

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## **ITEM 9.**        CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ONACCOUNTING AND FINANCIAL DISCLOSURES.

##  

None.

 

### **ITEM 9A.**                        CONTROLS AND PROCEDURES.

###  

We maintaindisclosure controls and procedures that are designed to ensure that informationrequired to be disclosed in the reports that we file or submit under theSecurities Exchange Act of 1934, as amended, is recorded, processed, summarizedand reported within the time periods specified in the rules and forms ofthe SEC, and that such information is accumulated and communicated to ourmanagement timely.  An evaluation wasperformed under the supervision and with the participation of our management,including our Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934) as of December 31,2004.  Based upon that evaluation, ourmanagement, including our Chief Executive Officer and our Chief FinancialOfficer, concluded that our disclosure controls and procedures were effectiveas of December 31, 2004.  There wasno change in our internal control over financial reporting during the fourthquarter of 2004 that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

### **ITEM 9B.**                      OTHERINFORMATION.

###  

Notapplicable.

 

# **PART III**

#  

## **ITEM 10.**                        DIRECTORS AND EXECUTIVE OFFICERS OF OUR COMPANY.

##  

Theinformation presented under the captions “Information Concerning Nominees,” “DirectorsContinuing in Office,” “Section 16(a) Beneficial Ownership ReportingCompliance” and “Executive Officers and Significant Employees” of our definitiveProxy Statement for our Annual Meeting of Shareholders to be held May 18,2005 (the “2005 Proxy Statement”), is incorporated herein by reference.

 

Because ourcommon stock is listed on the NYSE, our Chief Executive Officer is required tomake an annual certification to the NYSE stating that he is not aware of anyviolation by us of the corporate governance listing standards of the NYSE.  Our Chief Executive Officer will make hisannual certification to that effect to the NYSE within 30 days after the firstanniversary of the listing of our common stock on the NYSE as required by theNYSE’s rules.  In addition, we havefiled, as an exhibit to this Annual Report on Form 10-K, thecertification of our principal executive officer and principal financialofficer required under Section 302 of the Sarbanes Oxley Act of 2002 to befiled with the Securities and Exchange Commission regarding the quality of ourpublic disclosure.

 

## **ITEM 11.**                        EXECUTIVE COMPENSATION.

##  

Theinformation presented under the captions “Compensation of Directors” and “ExecutiveCompensation” of our 2005 Proxy Statement (excluding, however, the informationpresented under the subheading “Audit Committee Report”) is incorporated hereinby reference.

 

## **ITEM 12.**      SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS ANDMANAGEMENT AND RELATED STOCKHOLDER MATTERS.

##  

Theinformation presented under the caption “Security Ownership of CertainBeneficial Owners and Management” of our 2005 Proxy Statement is incorporatedherein by reference.

 

Theinformation presented under the caption “Market for the Registrant’s CommonEquity, Related Stockholder Matters and Issuer Purchases of Equity Securities —Common Stock Authorized for Issuance Under Our 2004 Equity Incentive Plan” in Part IIof this Form 10-K is incorporated herein by reference.

 

114

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## **ITEM 13.**                        CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

##  

Theinformation presented under the caption “Certain Relationships and RelatedTransactions” of our 2005 Proxy Statement is incorporated herein by reference.

 

## **ITEM 14.**                        PRINCIPAL ACCOUNTANT FEES AND SERVICES.

##  

Theinformation presented under the captions “Audit Committee Pre-Approval Policy”and “Fees of the Corporation’s Independent Auditors” of our 2005 Proxy Statementis incorporated herein by reference.

 

# **PART IV**

#  

## **ITEM 15.**                      EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.

##  

(1)              Thefollowing documents are filed as part of Item 8 of this report:

 

•                       Report ofIndependent Registered Public Accounting Firm.

 

•                       ConsolidatedBalance Sheets for KMG America Corporation as of  December 31, 2004, and for KanawhaInsurance Company (the “Predecessor”), as of December 31, 2003.

 

•                       ConsolidatedStatements of Operations for KMG America Corporation for the period January 21,2004 (inception) through December 31, 2004, and for the Predecessor forthe years ended December 31, 2002, 2003 and 2004.

 

•                       ConsolidatedStatements of Shareholders’ Equity for KMG America Corporation for the period January 21,2004 (inception) through December 31, 2004, and for the Predecessor forthe years ended December 31, 2002, 2003 and 2004.

 

•                       ConsolidatedStatements of Cash Flows for KMG America Corporation for the period January 21,2004 (inception) through December 31, 2004, and for the Predecessor forthe years ended December 31, 2002, 2003 and 2004.

 

•                       Notes toConsolidated Financial Statements.

 

(2)                                 The followingfinancial statement schedules are filed as part of Item 8 of this report:

 

•                       Schedule III- Supplementary Insurance Information.*

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*  All other required financial statementschedules are omitted because the information required is either not applicableor is included in the financial statements or the related notes included inthis report.

 

(3)  Exhibits.

 

The exhibitsthat are required to be filed or incorporated by reference herein are listed inthe Exhibit Index beginning on page 117 hereof.  Exhibits 10.01 - 10.10 hereto constitutemanagement contracts or compensatory plans or arrangements required to be filedas exhibits hereto.

 

115

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**SIGNATURES**

 

Pursuant tothe requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized, in the city ofMinneapolis, state of Minnesota on March 31, 2005.

 

 
| ** ** | * * | **KMG AMERICA CORPORATION** |
|------------|----------|-----------------------------|
| ** ** | * * | *(Registrant)*              |
| ** ** | * * | * *                    |
|       |     | By:                         | /s/ Kenneth U. Kuk |   |
|       |     |                        | Name: Kenneth U. Kuk |
|       |     |                        | Title: Chairman, President & Chief  Executive Officer |

 

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature** | ** **              | **Title** |
|---------------|-------------------------|-----------|
|          |                    |      |
| By:           | /s/ Kenneth U. Kuk      |      |   | Director and Chairman, President &  Chief Executive Officer |
|          | Kenneth U. Kuk          |      | *(Principal Executive Officer)* |
|          |                    | * *  |
| By:           | /s/ Scott H. DeLong III |      |   | Director and Senior Vice  President & Chief Financial Officer |
|          | Scott H. DeLong III     |      | *(Principal Financial Officer)* |
|          |                    | * *  |
| By:           | /s/ John H. Flittie     |      |   | Director |
|          | John H. Flittie         |      |   |
|          |                    |      |
| By:           | /s/ Stanley D. Johnson  |      |   | Director and Chairman & Chief Executive Officer of Kanawha |
|          | Stanley D. Johnson      |      |   |
|          |                    |      |
| By:           | /s/ Robert L. Laszewski |      |   | Director |
|          | Robert L. Laszewski     |      |   |
|          |                    |      |
| By:           | /s/ Dennis M. Mathisen  |      |   | Director |
|          | Dennis M. Mathisen      |      |   |
|          |                    |      |
| By:           | /s/ James J. Ritchie    |      |   | Director |
|          | James J. Ritchie        |      |   |
|          |                    |      |
| By:           | /s/ Robert E. Matthews  |      | * * | Executive Vice President, Chief Financial Officer &  Treasurer |
|          | Robert E. Matthews      | * *  | of Kanawha *(Principal Accounting  Officer)* |

 

Each of the above signatures is affixed as of March 31, 2005.

 

116

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**EXHIBIT INDEX**

 
| **Exhibit  Number** | ** ** | **Exhibit Title**                                                                                                                                                                                                                                                                                                                                                                                                                            |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **          | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                        |
| 2.01                |       | Amended and Restated Stock Purchase  Agreement by and among the shareholders and optionholders of Kanawha  Insurance Company identified on Schedule A and KMG America Corporation  (incorporated by reference from Exhibit 2.01 attached to KMG America  Corporation’s Registration Statement on Form S-1 (Registration  No. 333-117911)).                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 2.02                |       | Amendment No. 1 to Amended and  Restated Stock Purchase Agreement by and among the shareholders and  optionholders of Kanawha Insurance Company identified on Schedule A to  the Amended and Restated Stock Purchase Agreement and KMG America Corporation  (incorporated by reference from Exhibit 2.02 attached to KMG America  Corporation’s Registration Statement on Form S-1 (Registration  No. 333-117911)). |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 2.03                |       | Amendment No. 2 to Amended and Restated Stock Purchase Agreement  by and among the shareholders and optionholders of Kanawha Insurance Company  identified on Schedule A to the Amended and Restated Stock Purchase  Agreement and KMG America Corporation (incorporated by reference from  Exhibit 2.03 attached to KMG America Corporation’s Registration Statement  on Form S-1 (Registration No. 333-117911)).  |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3.01                |       | Amended and Restated Articles of  Incorporation (incorporated by reference from Exhibit 3.01 attached to  KMG America Corporation’s Registration Statement on Form S-1  (Registration No. 333-117911)).                                                                                                                                                                                                                       |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 3.02                |       | Bylaws (incorporated by reference from  Exhibit 3.02 attached to KMG America Corporation’s Registration  Statement on Form S-1 (Registration No. 333-117911)).                                                                                                                                                                                                                                                                |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.01                |       | Form of Common Stock Share Certificate  (incorporated by reference from Exhibit 4.01 attached to KMG America  Corporation’s Registration Statement on Form S-1 (Registration  No. 333-117911)).                                                                                                                                                                                                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 4.02                |       | Form of $15,000,000 Subordinated  Promissory Note made by KMG America Corporation payable to The Springs  Company in its capacity as representative of the shareholders and  optionholders of Kanawha Insurance Company (incorporated by reference from  Exhibit 4.02 attached to KMG America Corporation’s Registration  Statement on Form S-1 (Registration No. 333-117911)).                                          |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.01               |       | Form of 2004 Equity Incentive Plan  (incorporated by reference from Exhibit 10.01 attached to KMG America  Corporation’s Registration Statement on Form S-1 (Registration  No. 333-117911)).                                                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.02               |       | Form of Employment Agreement between  KMG America Corporation and Kenneth U. Kuk (incorporated by reference from  Exhibit 10.02 attached to KMG America Corporation’s Registration  Statement on Form S-1 (Registration  No. 333-117911)).                                                                                                                                                                               |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.03               |       | Form of Employment Agreement between  KMG America Corporation and Scott H. DeLong III (incorporated by  reference from Exhibit 10.03 attached to KMG America Corporation’s  Registration Statement on Form S-1 (Registration  No. 333-117911)).                                                                                                                                                                     |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| 10.04               |       | Form of Employment Agreement among KMG  America Corporation, Kanawha Insurance Company and Stanley D. Johnson  (incorporated by reference from Exhibit 10.04 attached to KMG America  Corporation’s Registration Statement on Form S-1 (Registration  No. 333-117911)).                                                                                                                                                  |

 

117

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| 10.05  |   | Form of Employment Agreement among KMG  America Corporation, Kanawha Insurance Company and R. Dale Vaughan  (incorporated by reference from Exhibit 10.06 attached to KMG America  Corporation’s Registration Statement on Form S-1 (Registration  No. 333-117911)).                                                                                                  |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.06  |   | Employment Agreement, dated December 21,  2004, among KMG America Corporation, Kanawha Insurance Company and Paul F.  Kraemer.                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.07  |   | Employment Agreement, dated December 21,  2004, among KMG America Corporation, Kanawha Insurance Company and Robert E.  Matthews.                                                                                                                                                                                                                                                              |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.08  |   | Employment Agreement, dated December 21,  2004, among KMG America Corporation, Kanawha Insurance Company and Paul P.  Moore                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.9   |   | Employment Agreement, dated December 21,  2004, among KMG America Corporation, Kanawha Insurance Company and Thomas D.  Sass                                                                                                                                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.10  |   | KMG America Corporation Supplemental  Retirement and Deferred Compensation Plan, Restated and Amended.                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.11  |   | Outsourcing Services Agreement, dated  November 11, 2003, between CGI Information Systems & Management  Consultants, Inc. and Kanawha HealthCare Solutions, Inc (incorporated by  reference from Exhibit 10.07 attached to KMG America Corporation’s  Registration Statement on Form S-1 (Registration No. 333-117911)).                                |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.12  |   | Amendment No. 1 to the Outsourcing  Services Agreement, dated April 1, 2004, between CGI Information  Systems & Management Consultants, Inc. and Kanawha HealthCare  Solutions, Inc. (incorporated by reference from Exhibit 10.08  attached to KMG America Corporation’s Registration Statement on Form S-1  (Registration No. 333-117911)). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 10.13  |   | Lease Agreement, dated February 2,  2005, between KMG America Corporation and Metropolitan Life Insurance Company  in respect of KMG America Corporation’s principal executive offices located  in Minnetonka, Minnesota.                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 14.01  |   | Code of Business Conduct and Ethics  (incorporated by reference from Exhibit 14 attached to KMG America  Corporation’s Current Report on Form 8-K filed with the Securities  and Exchange Commission on March 29, 2005).                                                                                                                                                   |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 21.01  |   | List of Subsidiaries of the Registrant.                                                                                                                                                                                                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 23.01  |   | Consent of Ernst & Young LLP.                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 31.01  |   | Rule 13a-14(a) / 15d-14(a) Certifications  of Chairman, President & Chief Executive Officer.                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 31.02  |   | Rule 13a-14(a) / 15d-14(a) Certifications  of Senior Vice President & Chief Financial Officer.                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 32.01  |   | Section 1350 Certification of  Chairman, President & Chief Executive Officer.                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 32.02  |   | Section 1350 Certification of Senior  Vice President & Chief Financial Officer.                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                           |
| 99.01  |   | Risk Factors.                                                                                                                                                                                                                                                                                                                                                                                  |

 

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