Table of Contents





UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549

| |  | 
| |  | 
| |  | 

FORM 10-Q

|                                                           |                                                                                          
|---------------------------------------------------------- | -----------------------------------------------------------------------------------------
|(Mark One)                                                
|                                                          
|x                                                          | QUARTERLY
 REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|                                                           |                                                                                          
|For the quarterly period ended September
 30, 2007        
|                                                          
|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 Its Charter)

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

Registrants telephone number, including area
code: (952) 930-4800

Former name, former address and former fiscal
year, if changed since last report:

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

Indicate by
check mark whether the registrant is a large accelerated filer, an accelerated
filer, or a non-accelerated filer. See definition of accelerated filer and
large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

|                          |                     |                        
|------------------------- | ------------------- | -----------------------
|Large accelerated filer o | Accelerated filer x | Non-accelerated filer o

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

As of November 2, 2007, the number of shares
of Common Stock outstanding was 22,215,912.





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TABLE OF CONTENTS

|                              |                                                                                                |                                                                                                                                                              |          |  
|----------------------------- | ---------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------ | -------- | -
|ITEM NO.                      |                                                                                                |                                                                                                                                                              | PAGE NO.
|                              |                                                                                                |                                                                                                                                                              |          |  
|PART I. FINANCIAL INFORMATION |                                                                                                | 1                                                                                                                                                           
|                              |                                                                                                |                                                                                                                                                             
|                              | ITEM 1. FINANCIAL STATEMENTS                                                                   |                                                                                                                                                              | 1       
|                              |                                                                                                |                                                                                                                                                              |         
|                              |                                                                                                | CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2007 (UNAUDITED)
 AND DECEMBER 31, 2006                                                                      |          | 1
|                              |                                                                                                |                                                                                                                                                              |          |  
|                              |                                                                                                | CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE
 MONTHS ENDED SEPTEMBER 30, 2007 AND 2006 AND THE NINE MONTHS ENDED SEPTEMBER
 30, 2007 AND 2006 |          | 3
|                              |                                                                                                |                                                                                                                                                              |          |  
|                              |                                                                                                | CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED) FOR THE NINE
 MONTHS ENDED SEPTEMBER 30, 2007 AND 2006                                                      |          | 4
|                              |                                                                                                |                                                                                                                                                              |          |  
|                              |                                                                                                | NOTES TO CONSOLIDATED FINANCIAL STATEMENTS                                                                                                                   |          | 5
|                              |                                                                                                |                                                                                                                                                              |          |  
|                              | ITEM 2. MANAGEMENTS
 DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |                                                                                                                                                              | 22      
|                              |                                                                                                |                                                                                                                                                              |         
|                              | ITEM 3. QUANTITATIVE AND
 QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |                                                                                                                                                              | 47      
|                              |                                                                                                |                                                                                                                                                              |         
|                              | ITEM 4. CONTROLS AND
 PROCEDURES                                                               |                                                                                                                                                              | 47      
|                              |                                                                                                |                                                                                                                                                              |         
|PART II. OTHER INFORMATION    |                                                                                                | 48                                                                                                                                                          
|                              |                                                                                                |                                                                                                                                                             
|                              | ITEM 1. LEGAL PROCEEDINGS                                                                      |                                                                                                                                                              | 48      
|                              |                                                                                                |                                                                                                                                                              |         
|                              | ITEM 1A. RISK FACTORS                                                                          |                                                                                                                                                              | 48      
|                              |                                                                                                |                                                                                                                                                              |         
|                              | ITEM 6. EXHIBITS                                                                               |                                                                                                                                                              | 50      
|                              |                                                                                                |                                                                                                                                                              |         
|SIGNATURES                    |                                                                                                | 51                                                                                                                                                          

i

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Table of Contents

PART IFINANCIAL
INFORMATION

|        |                     
|------- | --------------------
|ITEM 1. | FINANCIAL STATEMENTS

KMG AMERICA CORPORATIONCONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                             |  |                |             |               |   |             | 
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ----------- | ------------- | - | ----------- | 
|                                                                                                                                                                             |  | September
 30, |             | December
 31, |  
|                                                                                                                                                                             |  | 2007           |             | 2006          |  
|                                                                                                                                                                             |  |                |             |               |  
|                                                                                                                                                                             |  | (unaudited)    |             |               |   |            
|Assets                                                                                                                                                                       |  |                |             |               |   |            
|Investments:                                                                                                                                                                 |  |                |             |               |   |             | 
|Fixed maturity securities available for
 sale, at fair value (amortized cost of $579,285,170 and $531,477,537 as of
 September 30, 2007 and December 31, 2006, respectively) |  | $              | 558,748,577 |               | $ | 520,624,942 | 
|Equity securities available for sale, at
 fair value (cost of $10,000 and $101,945 as of September 30, 2007 and
 December 31, 2006, respectively)                            |  |                | 6,700       |               |   | 103,545     | 
|Mortgage loans                                                                                                                                                               |  |                | 11,991,418  |               |   | 13,921,019  | 
|Policy loans                                                                                                                                                                 |  |                | 17,435,734  |               |   | 18,163,223  | 
|Other investments                                                                                                                                                            |  |                | 5,942,669   |               |   | 5,523,232   | 
|                                                                                                                                                                             |  |                |             |               |   |             | 
|Total investments                                                                                                                                                            |  |                | 594,125,098 |               |   | 558,335,961 | 
|                                                                                                                                                                             |  |                |             |               |   |             | 
|Cash and cash equivalents                                                                                                                                                    |  |                | 21,595,623  |               |   | 21,744,137  | 
|Investment in subsidiary                                                                                                                                                     |  |                | 1,083,000   |               |   |            | 
|Reinsurance balances recoverable                                                                                                                                             |  |                | 92,590,426  |               |   | 89,091,232  | 
|Accrued investment income                                                                                                                                                    |  |                | 7,112,084   |               |   | 6,502,801   | 
|Real estate and equipment (net of
 accumulated depreciation of $5,401,797 and $3,652,073 as of September 30,
 2007 and December 31, 2006, respectively)                      |  |                | 16,591,975  |               |   | 15,068,506  | 
|Federal income tax recoverable                                                                                                                                               |  |                | 4,690,803   |               |   | 5,111,539   | 
|Deferred income tax asset                                                                                                                                                    |  |                | 254,927     |               |   | 6,578,604   | 
|Amounts due from reinsurers                                                                                                                                                  |  |                | 4,256,449   |               |   | 2,906,176   | 
|Deferred policy acquisition costs                                                                                                                                            |  |                | 39,138,888  |               |   | 28,453,929  | 
|Value of business acquired                                                                                                                                                   |  |                | 68,674,019  |               |   | 70,766,211  | 
|Other assets                                                                                                                                                                 |  |                | 27,643,171  |               |   | 27,154,750  | 
|                                                                                                                                                                             |  |                |             |               |   |             | 
|Total assets                                                                                                                                                                 |  | $              | 877,756,463 |               | $ | 831,713,846 | 
|                                                                                                                                                                             |  |                |             |               |   |             | 

1

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Table of Contents

KMG AMERICA CORPORATION
CONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                                                 |  |                |             |               |   |             |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------- | ----------- | ------------- | - | ----------- | -
|                                                                                                                                                                                                 |  | September
 30, |             | December
 31, |  
|                                                                                                                                                                                                 |  | 2007           |             | 2006          |  
|                                                                                                                                                                                                 |  |                |             |               |  
|                                                                                                                                                                                                 |  | (unaudited)    |             |               |   |            
|Liabilities and shareholders equity                                                                                                                                                             |  |                |             |               |   |             |  
|Liabilities:                                                                                                                                                                                     |  |                |             |               |   |             |  
|Policy and contract liabilities:                                                                                                                                                                 |  |                |             |               |   |             |  
|Life and annuity reserves                                                                                                                                                                        |  | $              | 246,257,909 |               | $ | 252,658,190 |  
|Accident and health reserves                                                                                                                                                                     |  |                | 320,495,627 |               |   | 294,581,002 |  
|Policy and contract claims                                                                                                                                                                       |  |                | 22,077,067  |               |   | 14,530,782  |  
|Other policyholder liabilities                                                                                                                                                                   |  |                | 10,673,533  |               |   | 10,594,225  |  
|                                                                                                                                                                                                 |  |                |             |               |   |             |  
|Total policy and contract liabilities                                                                                                                                                            |  |                | 599,504,136 |               |   | 572,364,199 |  
|                                                                                                                                                                                                 |  |                |             |               |   |             |  
|Accounts payable and accrued expenses                                                                                                                                                            |  |                | 29,745,593  |               |   | 24,497,525  |  
|Taxes, other than federal income taxes                                                                                                                                                           |  |                | 1,088,269   |               |   | 1,037,508   |  
|Federal income taxes accrued                                                                                                                                                                     |  |                | 191,087     |               |   | 523,889     |  
|Deferred income taxes                                                                                                                                                                            |  |                | 10,536,857  |               |   | 14,735,262  |  
|Liability for benefits for employees and
 agents                                                                                                                                                 |  |                | 6,353,669   |               |   | 5,847,970   |  
|Funds held in suspense                                                                                                                                                                           |  |                | 3,238,450   |               |   | 4,832,579   |  
|Notes payable                                                                                                                                                                                    |  |                | 14,000,000  |               |   | 14,000,000  |  
|Interest payable on note                                                                                                                                                                         |  |                | 26,289      |               |   | 50,350      |  
|Subordinated debt securities                                                                                                                                                                     |  |                | 36,083,000  |               |   |            |  
|Interest payable on subordinated debt                                                                                                                                                            |  |                | 120,577     |               |   |            |  
|Other liabilities                                                                                                                                                                                |  |                | 1,609,730   |               |   | 1,773,077   |  
|                                                                                                                                                                                                 |  |                |             |               |   |             |  
|Total liabilities                                                                                                                                                                                |  |                | 702,497,657 |               |   | 639,662,359 |  
|                                                                                                                                                                                                 |  |                |             |               |   |             |  
|Shareholders equity:                                                                                                                                                                            |  |                |             |               |   |             |  
|Common Stock, par value $0.01 per share,
 75,000,000 shares authorized and 22,215,949 and 22,211,589 shares issued and
 outstanding as of September 30, 2007 and December 31, 2006, respectively |  |                | 222,159     |               |   | 222,116     |  
|Paid-in capital                                                                                                                                                                                  |  |                | 188,714,187 |               |   | 189,150,959 |  
|Retained earnings                                                                                                                                                                                |  |                | 1,644,760   |               |   | 11,702,929  |  
|Accumulated other comprehensive loss                                                                                                                                                             |  |                | (15,322,300 | )             |   | (9,024,517  | )
|                                                                                                                                                                                                 |  |                |             |               |   |             |  
|Total shareholders equity                                                                                                                                                                       |  |                | 175,258,806 |               |   | 192,051,487 |  
|                                                                                                                                                                                                 |  |                |             |               |   |             |  
|Total liabilities and shareholders equity                                                                                                                                                       |  | $              | 877,756,463 |               | $ | 831,713,846 |  
|                                                                                                                                                                                                 |  |                |             |               |   |             |  

See accompanying notes.

2

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Table of Contents

KMG AMERICA CORPORATIONCONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|--------------------------------------------------------------------------------- |  | ------------------------------------------ | ---------- | ----------------------------------------- | - | ---------- | - | ---- | ----------- | - | - | ----------- | -
|                                                                                  |  | For the
 Three Months Ended
 September 30, |            | For the
 Nine Months Ended
 September 30, |  
|                                                                                  |  | 2007                                       |            | 2006                                      |   | 2007       |   | 2006 |            
|                                                                                  |  |                                            |            |                                           |   |            |   |      |            
|Revenue:                                                                          |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Insurance premiums                                                                |  | $                                          | 40,145,423 |                                           | $ | 34,235,437 |   | $    | 121,748,545 |   | $ | 94,708,120  |  
|Net investment income                                                             |  |                                            | 8,728,985  |                                           |   | 7,452,344  |   |      | 24,982,269  |   |   | 22,277,524  |  
|Commission and fee income                                                         |  |                                            | 3,604,773  |                                           |   | 4,017,003  |   |      | 11,844,396  |   |   | 12,353,612  |  
|Realized investment gains                                                         |  |                                            | 422,915    |                                           |   | 6,789      |   |      | 613,739     |   |   | 102,853     |  
|Other income                                                                      |  |                                            | 1,072,863  |                                           |   | 1,274,941  |   |      | 3,325,496   |   |   | 3,183,821   |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Total revenues                                                                    |  |                                            | 53,974,959 |                                           |   | 46,986,514 |   |      | 162,514,445 |   |   | 132,625,930 |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Benefits and expenses:                                                            |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Policyholder benefits                                                             |  |                                            | 35,875,050 |                                           |   | 26,185,612 |   |      | 108,472,280 |   |   | 73,912,980  |  
|Insurance commissions, net of deferrals                                           |  |                                            | 3,928,903  |                                           |   | 3,246,059  |   |      | 12,102,549  |   |   | 9,151,335   |  
|General insurance expenses, net of
deferrals                                      |  |                                            | 10,399,741 |                                           |   | 10,836,365 |   |      | 33,739,077  |   |   | 33,019,337  |  
|Insurance taxes, licenses and fees                                                |  |                                            | 1,265,939  |                                           |   | 1,288,532  |   |      | 4,741,486   |   |   | 4,095,905   |  
|Depreciation and amortization                                                     |  |                                            | 755,461    |                                           |   | 633,920    |   |      | 2,224,748   |   |   | 1,905,279   |  
|Amortization of deferred policy acquisition costs
and value of
 business acquired |  |                                            | 1,974,534  |                                           |   | 1,681,208  |   |      | 5,163,787   |   |   | 4,014,551   |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Total benefits and expenses                                                       |  |                                            | 54,199,628 |                                           |   | 43,871,696 |   |      | 166,443,927 |   |   | 126,099,387 |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Income (loss) before income taxes                                                 |  |                                            | (224,669   | )                                         |   | 3,114,818  |   |      | (3,929,482  | ) |   | 6,526,543   |  
|Provision for income taxes                                                        |  |                                            | (129,355   | )                                         |   | (1,089,138 | ) |      | (6,128,687  | ) |   | (2,247,633  | )
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Net income (loss)                                                                 |  | $                                          | (354,024   | )                                         | $ | 2,025,680  |   | $    | (10,058,169 | ) | $ | 4,278,910   |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Net income (loss) per share:                                                      |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Basic                                                                             |  | $                                          | (0.02      | )                                         | $ | 0.09       |   | $    | (0.45       | ) | $ | 0.19        |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Diluted                                                                           |  | $                                          | (0.02      | )                                         | $ | 0.09       |   | $    | (0.45       | ) | $ | 0.19        |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Weighted-average shares outstanding:                                              |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Basic                                                                             |  |                                            | 22,216,290 |                                           |   | 22,206,893 |   |      | 22,214,005  |   |   | 22,180,730  |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  
|Diluted                                                                           |  |                                            | 22,216,290 |                                           |   | 22,207,981 |   |      | 22,214,005  |   |   | 22,198,708  |  
|                                                                                  |  |                                            |            |                                           |   |            |   |      |             |   |   |             |  

See accompanying notes.

3

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Table of Contents

KMG AMERICA CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)

|                                                                                                    |  |                                       |             |                                       |   |             |  
|--------------------------------------------------------------------------------------------------- |  | ------------------------------------- | ----------- | ------------------------------------- | - | ----------- | -
|                                                                                                    |  | Nine
 Months Ended September 30, 2007 |             | Nine
 Months Ended September 30, 2006 |  
|                                                                                                    |  |                                       |             |                                       |  
|Operating
 Expenses                                                                                 |  |                                       |             |                                       |   |             |  
|Net (loss) income                                                                                   |  | $                                     | (10,058,169 | )                                     | $ | 4,278,910   |  
|Adjustments to reconcile net income (loss) to net
cash provided by
 (used in) operating activities: |  |                                       |             |                                       |   |             |  
|Depreciation and amortization                                                                       |  |                                       | 3,609,276   |                                       |   | 3,442,627   |  
|Policy acquisition costs deferred                                                                   |  |                                       | (13,756,554 | )                                     |   | (12,685,925 | )
|Amortization of deferred policy acquisition
costs and value of business acquired                    |  |                                       | 5,163,787   |                                       |   | 4,014,550   |  
|Realized investment losses (gains), net                                                             |  |                                       | (613,739    | )                                     |   | (102,853    | )
|Deferred income tax expense                                                                         |  |                                       | 5,516,387   |                                       |   | 2,204,053   |  
|Changes in operating assets and
liabilities:                                                        |  |                                       |             |                                       |   |             |  
|Investment in subsidiary                                                                            |  |                                       | (1,083,000  | )                                     |   |            |  
|Reinsurance balances recoverable                                                                    |  |                                       | (3,499,194  | )                                     |   | (9,743,720  | )
|Accrued investment income                                                                           |  |                                       | (609,283    | )                                     |   | (504,574    | )
|Federal income tax recoverable                                                                      |  |                                       | 420,736     |                                       |   |            |  
|Other assets                                                                                        |  |                                       | (488,421    | )                                     |   | (2,308,758  | )
|Amounts due from reinsurers                                                                         |  |                                       | (1,350,273  | )                                     |   | (140,837    | )
|Policy and contract liabilities                                                                     |  |                                       | 27,139,937  |                                       |   | 19,968,159  |  
|Accounts payable and accrued expenses                                                               |  |                                       | 5,248,068   |                                       |   | 2,246,567   |  
|Notes payable                                                                                       |  |                                       |            |                                       |   | (1,479,833  | )
|Interest payable                                                                                    |  |                                       | 96,516      |                                       |   | 569,661     |  
|Stock-based compensation expense                                                                    |  |                                       | (436,729    | )                                     |   | 999,868     |  
|Taxes, other than federal income taxes                                                              |  |                                       | 50,761      |                                       |   | 102,494     |  
|Federal income taxes accrued                                                                        |  |                                       | (332,802    | )                                     |   |            |  
|Funds held in suspense                                                                              |  |                                       | (1,594,129  | )                                     |   | (673,578    | )
|Liability for benefits for employees and
agents                                                     |  |                                       | 505,699     |                                       |   | (144,643    | )
|Other liabilities                                                                                   |  |                                       | (163,347    | )                                     |   | 132,074     |  
|                                                                                                    |  |                                       |             |                                       |   |             |  
|Net cash provided by (used
 in) operating activities                                                |  |                                       | 13,765,527  |                                       |   | 10,174,242  |  
|Investing
 activities                                                                               |  |                                       |             |                                       |   |             |  
|Securities available for
 sale:                                                                     |  |                                       |             |                                       |   |             |  
|Sales                                                                                               |  |                                       | 15,940,725  |                                       |   | 21,265,460  |  
|Maturities, calls and redemptions                                                                   |  |                                       | 21,625,299  |                                       |   | 25,181,535  |  
|Purchases                                                                                           |  |                                       | (86,946,962 | )                                     |   | (79,884,792 | )
|Repayments of mortgage
 loans                                                                       |  |                                       | 1,929,601   |                                       |   | 3,186,698   |  
|Decrease in policy loans,
 net                                                                      |  |                                       | 727,489     |                                       |   | 2,699,934   |  
|Purchases of real estate,
 property and equipment                                                   |  |                                       | (3,273,193  | )                                     |   | (3,935,325  | )
|                                                                                                    |  |                                       |             |                                       |   |             |  
|Net cash (used in)
 investing activities                                                            |  |                                       | (49,997,041 | )                                     |   | (31,486,490 | )
|                                                                                                    |  |                                       |             |                                       |   |             |  
|Financing
 activities                                                                               |  |                                       |             |                                       |   |             |  
|Issuance of subordinated
 debt securities                                                           |  |                                       | 36,083,000  |                                       |   |            |  
|                                                                                                    |  |                                       |             |                                       |   |             |  
|Net cash provided by (used
 in) financing activities                                                |  |                                       | 36,083,000  |                                       |   |            |  
|                                                                                                    |  |                                       |             |                                       |   |             |  
|Net increase (decrease) in
 cash and cash equivalents                                               |  |                                       | (148,514    | )                                     |   | (21,312,248 | )
|Cash and cash equivalents
 at beginning of period                                                   |  |                                       | 21,744,137  |                                       |   | 32,582,964  |  
|                                                                                                    |  |                                       |             |                                       |   |             |  
|Cash and cash equivalents
 at end of period                                                         |  | $                                     | 21,595,623  |                                       | $ | 11,270,716  |  
|                                                                                                    |  |                                       |             |                                       |   |             |  
|Supplemental
 disclosures of cash flow information                                                  |  |                                       |             |                                       |   |             |  
|Federal income taxes paid                                                                           |  | $                                     | 524,367     |                                       | $ |            |  
|                                                                                                    |  |                                       |             |                                       |   |             |  

See accompanying notes.

4

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Table of Contents

KMG AMERICA
CORPORATIONNOTES TO CONSOLIDATED FNANCIAL STATEMENTS

|   |                                      
|-- | -------------------------------------
|1. | Organization and Nature of Operations

Unless
the context requires otherwise, references to we, us, our, KMG America
or the Company are intended to mean KMG America Corporation and its
consolidated subsidiaries, including, without limitation, Kanawha Insurance
Company (Kanawha). References to our predecessor mean Kanawha prior to it
being acquired by KMG America.

KMG
America is a holding company incorporated under the laws of the Commonwealth of
Virginia on January 21, 2004. KMG America commenced operations shortly before
it completed its initial public offering of common stock on December 21, 2004,
and its shares trade on the New York Stock Exchange under the symbol KMA.
Concurrently with the completion of its initial public offering, KMG America
completed its acquisition of Kanawha and its subsidiaries, which are KMG
Americas primary operating subsidiaries and which underwrite and sell life and
health insurance products.

Kanawha,
the primary operating subsidiary of KMG America, is licensed to issue life and
accident and health insurance. Kanawha is domiciled in South Carolina. Kanawha
has one wholly owned subsidiary, Kanawha HealthCare Solutions, Inc., a
third-party administrator with operations in Lancaster and Greenville, South
Carolina.

The
primary insurance products that the Company underwrites include: group and
individual life insurance; group long term disability insurance; group and
individual short term disability insurance; group and individual dental
insurance; group and individual indemnity health insurance; group critical
illness insurance and employer group excess risk insurance. The Company
ceased actively underwriting new long-term care insurance policies after
December 31, 2005. The Company intends to retain and actively manage the
Companys existing block of in force long-term care policies. The Companys
third-party administration and medical management businesses include a wide
array of services with the primary emphasis on the offering of administrative
service-only products.

The
Companys sales historically have been primarily in the southeastern United
States, predominantly in Florida, South Carolina and North Carolina, but are
now expanding nationwide. Sales are made through an internal sales force,
full-time agents, general agents and brokers. Under the Companys current
business strategy, the Company expects group lines of business to account for
an increasing percentage of the Companys premium revenues.

On
September 7, 2007, the Company and Humana Inc. (Humana) entered into an
Agreement and Plan of Merger, dated September 7, 2007 (the Merger Agreement),
by and among the Company, Humana and Hum VM, Inc., a wholly-owned subsidiary of
Humana (the Merger Sub). Under the Merger Agreement, the Merger Sub will
merge with and into the Company (the Merger), with the Company continuing
after the Merger as the surviving corporation and a wholly-owned subsidiary of
Humana. At the effective time of the Merger (the Effective Time), each
outstanding share of Company common stock will be converted into the right to
receive $6.20 in cash, without interest.

To
induce Humana to execute the Merger Agreement, the Company entered into
employment letter agreements (the New Employment Agreements) with Kenneth U.
Kuk, the Companys Chairman, President and Chief Executive Officer, Paul F.
Kraemer, the Companys Senior Vice President of Sales, Paul P. Moore, the
Companys Senior Vice President of Sales and three other executive officers.
Such executives current employment agreements with the Company will remain in
full force and effect until the Effective Time of the Merger. At the Effective
Time of the Merger, the executives current employment agreements will
terminate and the New Employment Agreements will govern the executives
employment with the Company from and after the Effective Time.

Each
outstanding option to purchase shares of Company common stock has an exercise
price per share that is greater than $6.20, and will be canceled without
consideration at the Effective Time of the Merger. Each outstanding restricted
share of Company common stock will be vested immediately prior to the Effective
Time of the Merger and will be eligible to receive the $6.20 per share merger
consideration. To limit the Companys compensation expense in its third quarter 2007 financial statements, on
September 30, 2007, the Company and certain of its executive officers agreed to
cancel 1,389,925 options held by such executives for no consideration.

5

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

There
is no agreement between the option holders and the Company to reissue such
options if the Merger is not completed.

The
Merger was unanimously approved by the boards of directors of the Company and
Humana. The Merger is subject to customary closing conditions, including the
approval by the Companys shareholders and the receipt of governmental and
regulatory approvals, including the approval of the South Carolina Department
of Insurance. On October 5, 2007, the Federal Trade Commission and the
Antitrust Division of the U.S. Department of Justice granted early termination
of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of
1976, as amended, in connection with the Merger. The Company has scheduled
November 16, 2007, as the date of the special meeting of shareholders to vote
on the Merger, and the close of business on October 12, 2007, has been set as
the record date for the meeting. Shareholders of record as of the close of
business on the record date will be entitled to vote at the meeting. The
closing of the Merger is expected to occur late in the fourth quarter of 2007,
possibly as early as November 30, 2007. There can be no assurance that the
Merger Agreement and the Merger will be approved by the Companys shareholders,
and there can be no assurance that the other conditions to the completion of the
proposed merger will be satisfied. If the proposed merger is not completed,
there can be no assurance that a comparable transaction could be achieved.

|   |                                
|-- | -------------------------------
|2. | Significant Accounting Policies

Basis
of Presentation

The
accompanying unaudited consolidated financial statements have been prepared in
accordance with generally accepted accounting principles (GAAP) for interim
financial information. Accordingly, they do not include all of the information
and footnotes required by GAAP for complete financial statements. In the
opinion of management, all adjustments considered necessary for a fair
presentation have been included. All significant intercompany accounts and
transactions have been eliminated in consolidation. Operating results for the
quarter ended September 30, 2007, are not necessarily indicative of the results
that may be expected for the year ended December 31, 2007.

The
Company also submits financial statements to insurance industry regulatory
authorities. Those financial statements are prepared on the basis of statutory
accounting practices (SAP) and are significantly different from financial
statements prepared in accordance with GAAP (see Note 4).

Use of Estimates and Assumptions

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

Cash
and Cash Equivalents

The
Company includes with cash and cash equivalents its holdings of highly liquid
investments with maturities of three months or less from the date of
acquisition.

Investments

Statement
of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain
Investments in Fixed Maturity and Equity Securities, requires that all fixed maturity
and equity securities be classified into one of three categoriesheld to
maturity, available-for-sale, or trading. The Company has no securities
classified as held to maturity. Management determines the appropriate
classification of fixed maturities at the time of purchase.
Investments are reported on the following basis:

Fixed
maturities classified as available-for-sale are stated at fair value with
unrealized gains and losses reported directly in shareholders equity as
accumulated other comprehensive income. Fair values for fixed maturity

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KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

securities are
based on quoted market prices, where available. For fixed maturity securities
that are not actively traded, fair values are estimated using values obtained
from independent pricing services.

Equity
securities classified as available-for-sale are stated at fair value with
unrealized gains and losses reported directly in shareholders equity as
accumulated other comprehensive income.

Assets
supporting the deferred compensation plan are classified as trading and are
included in other investments. Trading account assets are held for resale in
anticipation of short-term market movements. Trading account assets, consisting
of mutual funds, are stated at fair value. Gains and losses, both realized and
unrealized, are included in realized gains and losses.

Mortgage
loans on real estate are stated at unpaid balances, net of allowances for
unrecoverable amounts. Valuation allowances for mortgage loans are established
when the Company determines it is probable that it will be unable to collect
all amounts (both principal and interest) due according to the contractual
terms of the loan agreement. Such allowances are based on the present value of
expected future cash flows discounted at the loans effective interest rate or,
if foreclosure is probable, on the estimated fair value of the underlying real
estate.

Policy
loans are stated at their unpaid balances.

Interest
on loans is generally recorded over the term of the loan based on the unpaid
principal balance. Accrual of interest is discontinued when either principal or
interest becomes 90 days past due or when, in managements opinion, collection
of such interest is doubtful. In addition, any previously accrued interest is
reversed when the loan becomes 90 days past due.

Other
investments are stated at fair value, or the lower of cost or fair value, as
appropriate.

Amortization
of premiums and accrual of discounts on investments in fixed maturity
securities is reflected in earnings over the contractual terms of the
investments in a manner that produces a constant effective yield. Realized
gains and losses on dispositions of securities are determined by the
specific-identification method.

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

|  |                                                                                                 
|- | ------------------------------------------------------------------------------------------------
| | length of
 time the fair value was below amortized cost;                                        
|  |                                                                                                 
| | industry
 factors or conditions related to a geographic area negatively affecting the
 security;
|  |                                                                                                 
| | downgrades
 by a rating agency;                                                                 
|  |                                                                                                 
| | past due
 interest or principal payments or other violation of covenants; and                   
|  |                                                                                                 
| | deterioration
 of the overall financial condition of the specific issuer.                       

In
analyzing its potentially distressed securities list for other-than-temporary
impairments, the Company pays special attention to securities that have been on
the list for a period greater than six months. The Company assumes that, absent
reliable contradictory evidence, a security that is potentially distressed for
a continuous period greater than twelve months has incurred an
other-than-temporary impairment. Reliable contradictory evidence might include,
among other factors, a liquidation analysis performed by the Companys
investment advisors or outside consultants, improving financial performance of
the issuer, or valuation of underlying assets specifically pledged to support
the credit.

Should
the Company conclude that the decline is other-than-temporary, the security is
written down to fair value through a charge to realized investment gains and losses.
The Company adjusts the amortized cost for securities that have experienced
other-than-temporary impairments to reflect fair value at the time of the
impairment. The Company considers factors that lead to an other-than-temporary
impairment of a particular security in order to determine whether these
conditions have impacted other similar securities.

7

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KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

Real Estate and Equipment

Company-occupied
real estate, primarily buildings, is carried at cost less accumulated
depreciation and is depreciated principally by the straight-line method over
estimated useful lives generally ranging from 15 to 30 years. Equipment is
stated at cost, less accumulated depreciation, and depreciated principally by
the straight-line method over their estimated useful lives, generally 3 to 5
years.

Expenditures
for improvements are capitalized, and expenditures for maintenance and repairs
are charged to operations as incurred. Upon sale or retirement, the cost and
related accumulated depreciation and amortization are removed from the accounts
and the resulting gain or loss, if any, is reflected in operations.

Deferred Policy Acquisition Costs

Acquisition
costs incurred by the Company in the process of acquiring new business are
deferred and amortized into income as discussed below. Costs deferred consist
primarily of commissions and certain policy underwriting, issue and agency
expenses that vary with and are primarily related to production of new
business.

For
most insurance products, the amortization of deferred acquisition costs is
recognized in proportion to the ratio of annual premium revenue to the total
anticipated premium revenue, which gives effect to expected terminations.
Deferred acquisition costs are amortized over the premium-paying period of the
related policies. Anticipated premium revenue is determined using assumptions
consistent with those utilized in the determination of liabilities for insurance
reserves.

Value of Business Acquired

Value
of business acquired is the value assigned to the insurance in force of
acquired insurance companies or blocks of insurance business at the date of
acquisition.

The
amortization of value of business acquired is generally recognized using
amortization schedules established at the time of the acquisitions based upon
expected revenue. The amortization is further impacted by actual-to-expected
persistency adjustments which reflect our actual experience as it emerges over
time relative to what we expected in the development of the amortization
schedules.

Impairment of Long-Lived Assets

Long-lived
assets include property and equipment, other intangible assets, systems
development and other deferred costs and other assets. In accordance with SFAS
No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS
144), the Company regularly evaluates whether events and circumstances have
occurred which indicate that the carrying amount of long-lived assets may
warrant revision or may not be recoverable. When factors indicate that
long-lived assets should be evaluated for possible impairment, the Company uses
an estimate of the future undiscounted net cash flows of the related business
over the remaining life of the asset in measuring whether the carrying amount
of the related asset is recoverable. To the extent these projections indicate
that future undiscounted net cash flows are not sufficient to recover the
carrying amounts of the related assets, the underlying assets are written down
by charges to expense so that the carrying amount is equal to fair value,
primarily determined based on future discounted cash flows. In the opinion of
management, the Companys long-lived assets are appropriately valued at
September 30, 2007 and December 31, 2006.

Benefit Reserves

Insurance
reserves for individual life insurance, individual accident and health
insurance, group life insurance and group accident and health insurance are
associated with earned premiums so as to recognize profits over the
premium-paying period. This association is accomplished by recognizing the
liabilities for insurance reserves on a net level premium method based on assumptions
deemed appropriate at the date of issue as to future investment yield,
mortality, morbidity, withdrawals and maintenance expenses, and including
margins for adverse deviations. Interest assumptions are based on the Companys
experience. Mortality, morbidity and withdrawal

8

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

assumptions
are based on recognized actuarial tables or the Companys experience, as
appropriate. Life reserves are calculated using mean reserve factors. Accident
and health reserves are calculated using mid-terminal reserve factors. Benefit
reserves for investment products are computed under a retrospective deposit
method and represent policy account balances before applicable surrender
charges. Policy benefits and claims that are charged to expense include benefit
claims incurred in the period in excess of related policy account balances.

Benefit
reserves as reported are shown on a GAAP basis with
appropriate purchase accounting adjustments to reflect the fair value of the policy liabilities at the
time of the acquisition. This means that the experience assumptions (e.g.,
premium rates and projected rate increases, interest rates, mortality,
morbidity, persistency, administrative expenses, etc.) underlying the
derivation of such benefit reserves were determined as of the date of the
acquisition of Kanawha. Prior to June 30, 2006, the approach was based on
aggregate projection models that were used to calculate reserves. An aggregate
projection modeling approach is commonly used following an acquisition to
establish reserve balances for insurance companies prior to developing policy
by policy (seriatim) calculations. This type of refinement is contemplated by
SFAS 141. Effective June 30, 2006, a refinement in the process was implemented whereby the reserves are
now being developed on a policy by policy (seriatim) basis. The
refinement of the approach to use seriatim developed reserves
had no material impact on total company income but had an impact on the balance sheet on a segment by
segment basis.

Using
the aggregated projection model, the reserve valuation method and experience
assumptions were applied to aggregate projected data (a simplified but
representative model was used to simulate the entire range of ages at issue,
policy duration, amounts of insurance, etc.) for various insurance product
types (similar product types were grouped into one representative product).
Using the seriatim model, the same underlying reserve valuation method and experience
assumptions were applied to actual data for each policy such as the type of
plan, age of insured and amount of insurance. This consistency in reserve
valuation methods and experience assumptions is required by SFAS 60. The effect
on total benefit reserves of the various experience assumptions can only be
approximated in the aggregate model. It is only in the detailed policy by
policy calculations that the actual effect over time of the experience
assumptions is known. The analysis involved in deriving the seriatim reserve
factors provided information not previously available as to how the actual
reserves would emerge over time when all such assumptions are taken into
account. This new information results in a better allocation of the total fair
value of the benefit reserves.

This
seriatim approach was not implemented in prior quarters because it took a
considerable amount of time to complete the substantial volume of calculations
that were required to produce reserve factors that varied by, among other
things, plan, gender, issue age, duration, and smoker status. The benefit
reserve factors that were developed were for long term, level premium products
subject to SFAS 60. As such, complete sets of factors for all products were
needed. The significant staffing and financial constraints faced as a small
start-up company also contributed to the amount of time it took to complete
that effort.

Because
the detailed data in the seriatim valuation was not informative or useful until
the model was completed, it became new information when such calculations were
completed. Accordingly, using the refined seriatim valuation to produce such
new information constituted a change in accounting estimate under SFAS 154 and
was properly accounted for in the period of the change. Under this accounting
principle a restatement of prior periods was not permitted.

Loss
recognition testing of the Companys policy benefit reserves is performed
annually. This testing involves a comparison of the Companys actual net
liability position (all liabilities less deferred acquisition costs (DAC) and
value of business acquired (VOBA)) to the present value of future liabilities
calculated using then-current assumptions. These assumptions are based on the Companys
best estimate of future experience. To the extent a premium deficiency exists,
it would be recognized immediately by a charge to the statement of operations
and a corresponding reduction in DAC or VOBA. Any additional deficiency would
be recognized as a premium deficiency reserve. Historically, loss recognition
testing has not resulted in an adjustment to DAC, VOBA or reserves. These
adjustments would occur only if economic, mortality and/or morbidity conditions
deviated in a significantly adverse fashion from the underlying assumptions.

9

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

Claims and Claim Adjustment Expenses

Claim
reserves relating to short duration contracts generally are recorded when
insured events occur. The liability is based on the expected ultimate cost of
settling the claims. The claims and benefits payable reserves include: (1) case
base reserves for known but unpaid claims as of the balance sheet date; (2)
incurred but not reported (IBNR) reserves for claims where the insured event
has occurred but has not been reported as of the balance sheet date; and (3)
loss adjustment expense reserves for the expected handling costs of settling
the claims. Case base reserves and the IBNR reserves are recorded at an amount
equal to the net present value of the expected future claims payments. Factors
considered when setting IBNR reserves include patterns in elapsed time from
claim incidence to claim reporting, and elapsed time from claim reporting to
claim payment. Claim reserves generally equal the Companys estimate, at the
end of the current reporting period, of the present value of the liability for
future benefits and expenses to be paid on claims incurred as of that date. A
claim reserve for a specific claim is based on assumptions derived from
historical experience as to claim duration, as well as the specific
characteristics of the claimant such as benefits available under the policy,
the benefit period, and the age and occupation of the claimant. Although
considerable variability is inherent in such estimates, management believes
that the reserves for claims and claim adjustment expenses are adequate. The
estimates are continually reviewed and adjusted as necessary as experience
develops or new information becomes known; such adjustments are included in
current operations.

Reinsurance

Reinsurance
premiums, benefits and reserves are accounted for on bases consistent with
those used in accounting for the original policies issued and the terms of the
insurance contracts. Benefit reserves and claim liabilities are reported gross
of reinsured amounts. An estimated allowance for doubtful accounts is recorded
on the basis of periodic evaluations of balance due from reinsurers, reinsurer
solvency, Company experience and current economic conditions.

During
the nine months ended September 30, 2007, we recorded accruals totaling $0.66
million for estimated refunds due to one of our reinsurance carriers to correct
for calculation errors in settled billings relating to prior periods. Of this
accrual, $0.36 million was recorded in the three months ended September 30,
2007. We have determined that, in accordance with APB 28, Interim Financial
Reporting paragraph 29, this out of period correction is not material to either
the current or prior years balance sheets or statements of income.

Recognition of Revenue

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

Revenue
from annuity and interest sensitive products including universal life products
includes charges for the cost of insurance, for initiation and administration
of the policy and for surrender of the policy. Revenue from these products is
recognized in the year assessed to the policyholder, except that any portion of
an assessment, which relates to services to be provided in future years, is
deferred and recognized over the period during which services are provided.

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

Realized Capital Gains (Losses)

Realized
capital gains and losses are reported in the income statement on a pretax basis
in the period that the asset giving rise to the gain or loss is sold.
Impairment write downs are recorded when there has been a decline in value
deemed other than temporary, in which case the write down for such impairments
is charged to income.

10

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

Recognition of Benefits

Benefits
related to traditional life and accident and health insurance products are
recognized when incurred in a manner designed to match them with related
premiums and spread income recognition over expected policy lives. For annuity and
interest sensitive products including universal life products, benefits include
interest credited to policyholders accounts, which is recognized as it
accrues.

Share-Based Compensation

On
January 1, 2006, the Company adopted Statement of Financial Accounting
Standards No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)) which
requires the measurement and recognition of compensation expense for all
share-based payment awards made to employees and directors including stock
options and restricted common stock based on estimated fair values. SFAS 123(R)
supersedes the Companys previous accounting for periods beginning in 2006.

The
Company had adopted the disclosure-only requirements of SFAS No. 123, Accounting for Stock-Based Compensation(SFAS
123), as amended by FASB Statement No. 148, Accounting
for Stock-Based Compensation-Transition and Disclosure (SFAS 148)
through December 31, 2005. As permitted by the provisions of this Statement,
the Predecessor accounted for stock-based compensation using the intrinsic
value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and Related
Interpretations(APB No.
25). Accordingly, the Company recognized no compensation expense for stock
option awards to employees or directors when the option exercise price was not
less than the market value of the stock at the date of award.

The
Company adopted SFAS 123(R) using the modified prospective transition method,
which requires the application of the accounting standard as of January 1,
2006, the first day of the Companys fiscal year 2006. The Companys
Consolidated Financial Statements as of December 31, 2006 reflect the impact of
SFAS 123(R). In accordance with the modified prospective transition method, the
Companys Consolidated Financial Statements for prior periods have not been
restated to reflect, and do not include, the impact of SFAS 123(R).

SFAS
123(R) requires companies to estimate the fair value of share-based payment
awards on the date of grant using an option-pricing model. The Company has used
a Black-Scholes option-pricing model. The value of the portion of the award
that is ultimately expected to vest is recognized as expense over the requisite
service periods in the Companys Consolidated Statement of Income.

On
November 10, 2005, the Financial Accounting Standards Board (FASB) issued
FASB Staff Position No. FAS 123(R)-3 Transition Election Related to Accounting
for Tax Effects of Share-Based Payment Awards. The Company has elected to
adopt the alternative transition method provided in the FASB Staff Position for
calculating the tax effects of stock-based compensation pursuant to SFAS
123(R). The alternative transition method includes simplified methods to
establish the beginning balance.

Defined Benefit Retirement Plan

In
September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined
Benefit Pension and Other Postretirement Plans  An Amendment of FASB Statements
No. 87, 88, 106, and 132R (SFAS No. 158). SFAS No. 158 requires companies to
(1) recognize as an asset or liability, the overfunded or underfunded status of
defined pension and other postretirement benefit plans; (2) recognize changes
in the funded status through other comprehensive income in the year in which
the changes occur; (3) measure the funded status of defined pension and other
postretirement benefit plans as of the date of the companys fiscal year-end;
and (4) provide enhanced disclosures. The provisions of SFAS No. 158 are
effective for the Companys year-ending December 31, 2006. The Company adopted
SFAS No. 158 at December 31, 2006.

11

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

Income Taxes

Income
taxes are computed using the liability method required by SFAS No. 109,
Accounting for Income Taxes. Under this Statement, deferred tax assets and
liabilities are determined based on the differences between financial reporting
and tax bases of assets and liabilities and are measured using the enacted tax
rates and laws that will be in effect when the differences are expected to
reverse. Recorded amounts are adjusted to reflect changes in income tax rates
and other tax law provisions as they become enacted.

Recently
Issued Accounting Standards

In
February 2007, the Financial
Accounting Standards Board (FASB) issued FASB Statement No. 159, The Fair Value Option for Financial
Assets and Financial Liabilities (FAS No. 159), which allows a company to
make an irrevocable election, on specific election dates, to measure eligible
items at fair value with unrealized gains and losses recognized in earnings at
each subsequent reporting date. The election to measure an item at fair value
may be determined on an instrument by instrument basis, with certain
exceptions. If the fair value option is elected, any upfront costs and fees
related to the item will be recognized in earnings as incurred. Items eligible
for the fair value option include: certain recognized financial assets and
liabilities; rights and obligations under certain insurance contracts that are
not financial instruments; host financial instruments resulting from the
separation of an embedded non financial derivative instrument from a non
financial hybrid instrument; and certain commitments. FAS No. 159 is generally
effective for fiscal years beginning after November 15, 2007.As of the
effective date, the fair value option may be elected for certain eligible items
that exist on that date. The effect of the first measurement to fair value
shall be reported as a cumulative effect adjustment to the opening balance of
retained earnings. The Company is currently evaluating the items to which the
fair value option may be applied.

In
September 2006, the FASB issued FASB Statement No. 157, Fair Value
Measurements (FAS No. 157). FAS No. 157 provides guidance for using fair
value to measure assets and liabilities whenever other standards require (or
permit) assets or liabilities to be measured at fair value. FAS No. 157 does
not expand the use of fair value to any new circumstances. Under FAS No. 157,
the FASB clarifies the principle that fair value should be based on the
assumptions market participants would use when pricing the asset or liability.
In support of this principle, FAS No. 157 establishes a fair value hierarchy
that prioritizes the information used to develop such assumptions. The fair
value hierarchy gives the highest priority to quoted prices in active markets and
the lowest priority to unobservable data. FAS No. 157 also requires separate
disclosure of fair value measurements by level within the hierarchy and
expanded disclosure of the effect on earnings for items measured using
unobservable data. The provisions of FAS No. 157 are effective for financial
statements issued for fiscal years beginning after November 15, 2007. The
Company is in the process of determining the impact of adoption of FAS No. 157.

In June
2006, the FASB issued Interpretation (FIN) No. 48, Accounting for
Uncertainty in Income Taxes  an interpretation of FASB Statement 109. FIN 48
prescribes a recognition threshold and measurement attribute for the financial
statement recognition and measurement of a tax position taken or expected to be
taken in a tax return, and provides guidance on derecognition, classification,
interest and penalties, accounting in interim periods, disclosure and
transition. FIN 48 is effective for fiscal years beginning after December 15,
2006. The Company adopted FIN 48 effective January 1, 2007 and has determined
that there is no material impact on its financial statements upon adoption.

In
September 2005, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants (AcSEC) issued Statement of Position
05 -1 (SOP 05 -1), Accounting by Insurance Enterprises for Deferred Acquisition
Costs in Connection with Modifications or Exchanges of Insurance Contracts. SOP
05 -1 provides guidance on accounting by insurance enterprises for deferred
acquisition costs on internal replacements of insurance and investment
contracts other than those specifically described in Statement of Financial
Accounting Standards (SFAS) No. 97, Accounting and Reporting by Insurance Enterprises
for Certain Long-Duration Contracts and for Realized Gains and Losses from Sale
of Investments. SOP 05 -1 defines an internal replacement as a modification in
product benefits, features, rights, or coverages that occur by the exchange of
a contract for a new contract, or by amendment, endorsement, or rider to a
contract, or by the election of a feature or coverage within a contract. SOP 05
-1 is effective for internal replacements occurring in fiscal years beginning
after December 15, 2006 with earlier adoption encouraged. Retrospective
application of SOP 05 -1 to previously issued financial

12

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

statements is
not permitted. The Company adopted SOP 05-1 effective January 1, 2007 and determined
that there was no material financial impact on its financial statements upon
adoption.

|   |            
|-- | -----------
|3. | Investments

Aggregate
amortized cost, aggregate fair value and gross unrealized gains and losses of
investments in fixed maturity and equity securities are summarized in the
following table.

|                                                      |  |                |             |                          |   |                           |  |             |            |  |   |             | 
|----------------------------------------------------- |  | -------------- | ----------- | ------------------------ | - | ------------------------- |  | ----------- | ---------- |  | - | ----------- | 
|                                                      |  | Amortized Cost |             | Gross
 Unrealized
 Gains |   | Gross
 Unrealized
 Losses |  | Fair
 Value |           
|                                                      |  |                |             |                          |   |                           |  |             |           
|Available for sale securities at September
 30, 2007: |  |                |             |                          |   |                           |  |             |            |  |   |             | 
|Fixed maturity securities                             |  | $              | 579,285,170 |                          | $ | 1,315,437                 |  | $           | 21,852,030 |  | $ | 558,748,577 | 
|Equity securities                                     |  |                | 10,000      |                          |   |                          |  |             | 3,300      |  |   | 6,700       | 
|                                                      |  |                |             |                          |   |                           |  |             |            |  |   |             | 
|Securities available for sale                         |  | $              | 579,295,170 |                          | $ | 1,315,437                 |  | $           | 21,855,330 |  | $ | 558,755,277 | 
|                                                      |  |                |             |                          |   |                           |  |             |            |  |   |             | 

|   |                                
|-- | -------------------------------
|4. | Statutory Financial Information

State
insurance laws and regulations prescribe accounting practices for determining
statutory net income and equity for insurance companies. In addition, state
regulators may permit statutory accounting practices that differ from
prescribed practices. The Company does not have any accounting practices that
differ from prescribed statutory accounting practices.

Under
South Carolina insurance regulations, Kanawha is required to maintain minimum
capital of $1.2 million and minimum surplus of $1.2 million. Additionally,
Kanawha is restricted as to amounts that can be transferred in the form of
dividends, loans, or advances. While the South Carolina Insurance Department
acknowledges distinctions between ordinary and extraordinary dividends, their
approval is required before any dividend payments can be made.

|   |                  
|-- | -----------------
|5. | Employee Benefits

Defined Benefit Retirement Plan

As
of the dates indicated, the net periodic retirement benefit cost of the Companys
defined benefit pension plan for the quarters presented included the following
components:

|                                         |  |                                   |          |                                  |   |          |   |      |            |   |   |          |  
|---------------------------------------- |  | --------------------------------- | -------- | -------------------------------- | - | -------- | - | ---- | ---------- | - | - | -------- | -
|                                         |  | Three Months Ended
 September 30, |          | Nine Months Ended
 September 30, |  
|                                         |  |                                   |          |                                  |  
|                                         |  | 2007                              |          | 2006                             |   | 2007     |   | 2006 |           
|                                         |  |                                   |          |                                  |   |          |   |      |           
|Components of net periodic benefit cost: |  |                                   |          |                                  |   |          |   |      |            |   |   |          |  
|Service cost                             |  | $                                 |         |                                  | $ | 47,778   |   | $    |           |   | $ | 143,334  |  
|Interest cost                            |  |                                   | 240,000  |                                  |   | 232,510  |   |      | 720,000    |   |   | 697,530  |  
|Expected return on plan assets           |  |                                   | (360,000 | )                                |   | (309,641 | ) |      | (1,080,000 | ) |   | (928,923 | )
|Amortization of transition liability     |  |                                   |         |                                  |   | 362      |   |      |           |   |   | 1,086    |  
|Recognized net actuarial loss            |  |                                   | 50,000   |                                  |   | 52,646   |   |      | 150,000    |   |   | 157,938  |  
|                                         |  |                                   |          |                                  |   |          |   |      |            |   |   |          |  
|Net periodic benefit cost                |  | $                                 | (70,000  | )                                | $ | 23,655   |   | $    | (210,000   | ) | $ | 70,965   |  
|                                         |  |                                   |          |                                  |   |          |   |      |            |   |   |          |  
|Curtailment Expense                      |  | $                                 |         |                                  |   |         |   | $    |           |   |   | 120,170  |  
|                                         |  |                                   |          |                                  |   |          |   |      |            |   |   |          |  

13

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

On
January 31, 2006, the Company adopted two amendments to the defined benefit
retirement plan that froze participation in the plan and froze accrual of any
additional benefits under the plan. As of June 30, 2006, no new participants
were allowed to enter the plan. Effective as of September 30, 2006, no
additional benefits accrue under the plan with respect to service after that
date. As a result, final average earnings will be determined as of September
30, 2006, for all future benefit payments, and will not be adjusted for future
changes in employee compensation.

The
curtailment expense recognized as a result of the plan freeze was $120,170 for
the nine months ended September 30, 2006.

Defined Contribution Plan

The
Company offers a 401(k) qualified savings plan for which substantially all
employees and agents are eligible. Plan participants may contribute up to 15%
of pretax annual compensation, which includes overtime, bonuses and
commissions. Participants may also contribute amounts representing
distributions from other qualified defined benefit or defined contribution
plans. Until October 1, 2006, the Company contributed 25% of the first 6% of
base compensation that a participant contributed to the Plan. The Company also
could make an additional contribution up to 25% at its discretion.

Effective
as of October 1, 2006, the Company matches 100% of the first 3% of salary
deferral contributions that a participant contributes to the plan and 50% of
the next 2% of salary deferral contributions a participant contributes to the
plan. Effective January 1, 2007, participants will be 100% vested in all
matching contributions made by the Company to the plan on and after that
date.

Effective
January 1, 2007, the Company began additional annual employer contributions to
the 401(k) plan accounts of associates who: have at least five years of service
(were hired before January 1, 2002); are at least age 45 on January 1, 2007;
and have at least 1,000 hours of service in the calendar year for which the
contribution is being made, and are actively employed on December 31 of that
year. The contribution will be equal to the amount of the eligible associates
earned salary and bonus in the calendar year for which the contribution is
being made, multiplied by the percentage in the table below corresponding to
that associates age as of January 1, 2007:

|          |      
|--------- | -----
|Age 45-49 | 1.5% 
|Age 50-54 | 2.75%
|Age 55+   | 4.0% 

The
initial contribution will be made in January 2008, and annually thereafter. The
contribution vests immediately after being made.

Deferred Compensation Plan

The
Company has a non-qualified deferred compensation plan for senior management
that allows the deferment of a portion of their compensation until their
services with the Company have terminated. The plan includes deferred
contributions, which were not elected by employees to be transferred to the 401(k)
plan upon adoption of the 401(k) plan. The plans investments include mutual
funds and are recorded in investments as held for trading. The corresponding
deferred obligations to participants are recorded in other liabilities.

KMG America 2004 Equity Incentive Plan

The
KMG America 2004 Equity Incentive Plan was established in 2004 and amended in
2006 with 2,827,500 shares of KMG America common stock reserved for issuance
under the Plan. Through September 30, 2007, net of forfeitures, 144,308 shares
of Company common stock have been granted which generally vest with respect to
one-fourth of the shares granted on each of the first, second, third, and
fourth anniversaries of the date of grant. To date, 61,274 shares of Company
common stock granted are fully vested. Also, through September 30, 2007, net of
forfeitures, options to purchase 431,000 shares of Company common stock have
been issued which generally vest with respect to one-fourth of the shares
subject to the option on each of the first, second, third and fourth
anniversaries of the date of grant.

14

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KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

Each
outstanding option to purchase shares of Company common stock has an exercise
price per share that is greater than $6.20, and will be canceled without
consideration at the Effective Time of the Merger. Each outstanding restricted
share of Company common stock will be vested immediately prior to the Effective
Time of the Merger and will be eligible to receive the $6.20 per share merger
consideration. To limit the Companys compensation expense in its third quarter
2007 financial statements, on September 30, 2007, the Company and certain of
its executive officers agreed to cancel 1,389,925 options held by such
executives for no consideration. These cancellations created stock option
compensation expense credits of $1.2 million for the three months ended
September 30, 2007 and $0.7 million for the nine months ended September 30,
2007. There is no agreement between the option holders and the Company to
reissue such options if the Merger is not completed.

The
Company adopted SFAS 123(R) as of January 1, 2006. Below is the presentation of
our employee and director stock options and common stock grants under the fair
value method.

Common Stock Grants

The
activity related to the common stock grants is set forth below:

|                                      |  |                                  |         |                                                                                           |  |           |  |        |      |  |  |      | 
|------------------------------------- |  | -------------------------------- | ------- | ----------------------------------------------------------------------------------------- |  | --------- |  | ------ | ---- |  |  | ---- | 
|                                      |  | Common Stock Grants
 Outstanding |         | Weighted Average Grant Date 
 Fair Value Per Share of 
 Common Stock Grants 
 Outstanding | 
|                                      |  |                                  |         |                                                                                           | 
|                                      |  | Nonvested                        |         | Vested                                                                                    |  | Nonvested |  | Vested |     
|                                      |  |                                  |         |                                                                                           |  |           |  |        |     
|Outstanding
 as of December 31, 2006  |  |                                  | 114,042 |                                                                                           |  | 25,906    |  |        | 8.29 |  |  | 8.45 | 
|Granted                               |  |                                  |        |                                                                                           |  | 6,669     |  |        |     |  |  | 6.56 | 
|Vested                                |  |                                  | (28,699 | )                                                                                         |  | 28,699    |  |        | 8.26 |  |  | 8.26 | 
|Forfeited                             |  |                                  | (2,309  | )                                                                                         |  |          |  |        | 8.44 |  |  |     | 
|                                      |  |                                  |         |                                                                                           |  |           |  |        |      |  |  |      | 
|Outstanding
 as of September 30, 2007 |  |                                  | 83,034  |                                                                                           |  | 61,274    |  |        | 8.30 |  |  | 8.16 | 
|                                      |  |                                  |         |                                                                                           |  |           |  |        |      |  |  |      | 

Stock Options

Black-Scholes
option-pricing model assumptions used:

|                                 |  |  |      |  
|-------------------------------- |  |  | ---- | -
|Average
 Risk-free Interest Rate |  |  | 4.54 | %
|Expected
 Dividend Yield         |  |  |     |  
|Expected
 Volatility             |  |  | 20.0 | %
|Expected
 Life (years)           |  |  | 5    |  

The
activity related to the stock options is set forth below:

|                                      |  |                      |            |                                    |  |                               |  |                                                  |           |  |  |      | 
|------------------------------------- |  | -------------------- | ---------- | ---------------------------------- |  | ----------------------------- |  | ------------------------------------------------ | --------- |  |  | ---- | 
|                                      |  | Options
 Outstanding |            | Weighted
 Average 
 Exercise Price |  | Aggregate 
 Intrinsic 
 Value |  | Weighted 
 Average 
 Remaining 
 Life (in years) |          
|                                      |  |                      |            |                                    |  |                               |  |                                                  |          
|Outstanding as of December
 31, 2006  |  |                      | 1,913,425  |                                    |  | 9.16                          |  |                                                  |           |  |  |      | 
|Granted                               |  |                      | 10,000     |                                    |  | 8.74                          |  |                                                  |           |  |  |      | 
|Exercised                             |  |                      |           |                                    |  |                              |  |                                                  |           |  |  |      | 
|Forfeited                             |  |                      | (1,492,425 | )                                  |  | 9.28                          |  |                                                  |           |  |  |      | 
|                                      |  |                      |            |                                    |  |                               |  |                                                  |           |  |  |      | 
|Outstanding as of
 September 30, 2007 |  |                      | 431,000    |                                    |  | 8.76                          |  |                                                  | 1,046,387 |  |  | 8.34 | 
|                                      |  |                      |            |                                    |  |                               |  |                                                  |           |  |  |      | 
|Exercisable as of
 September 30, 2007 |  |                      | 135,500    |                                    |  | 8.90                          |  |                                                  | 327,959   |  |  | 7.94 | 
|                                      |  |                      |            |                                    |  |                               |  |                                                  |           |  |  |      | 

15

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

The
following table sets forth share-based compensation and the related tax benefit:

|                                                            |  |                                       |          |  
|----------------------------------------------------------- |  | ------------------------------------- | -------- | -
|                                                            |  | Nine Months Ended
 September 30, 2007 |         
|                                                            |  |                                       |         
|Total
 Share-Based Compensation                             |  |                                       |          |  
|Included in
 loss before income taxes                       |  | $                                     | (436,729 | )
|Included in
 net loss, net of tax effects                   |  | $                                     | (283,874 | )
|Excess tax
 benefits related to options exercised           |  | $                                     |         |  
|Excess tax
 benefits related to share-based compensation(1) |  | $                                     |         |  

| |                                                                                                        | 
| | ------------------------------------------------------------------------------------------------------ | 
| |                                                                                                        | 
| | (1) Represents the tax benefit, recognized in
 additional paid-in-capital for stock options exercised.

As
of September 30, 2007, there was $1,178,519 of total unrecognized compensation
cost related to nonvested share-based compensation arrangements.

|   |                            
|-- | ---------------------------
|6. | Comprehensive Income (Loss)

Total
comprehensive income (loss) for the nine months ended September 30, 2007 and
2006 was ($16,355,952) and $1,483,867, respectively. The difference between
comprehensive income and net income for these periods was unrealized investment
gains (losses) of $(6,297,783) and $(2,795,043), respectively.

Total
comprehensive income (loss) for the three months ended September 30, 2007 and
2006 was $1,406,970 and $13,243,352, respectively. The difference between
comprehensive income and net income for these periods was unrealized investment
gains (losses) of $1,760,994 and $11,217,672, respectively.

On
December 31, 2006, we adopted Financial Accounting Standards Board
(FASB) Statement of Financial Accounting Standards (SFAS) No. 158, Employers Accounting for Defined Benefit Pension and
Other Postretirement Plans.Upon adoption, we recorded a $1,971,370
reduction in comprehensive income on our consolidated balance sheet as of
December 31, 2006. However, the cumulative effect of change in accounting,
net of tax, should have been recorded as a separate component of accumulated
other comprehensive income. As of December 31, 2006, we reported total
comprehensive income of $3,189,482. With this revised presentation, total
comprehensive income would have been $5,160,852 as of December 31, 2006.
This revised presentation will be reflected in our Annual Report on Form 10-K
as of December 31, 2007.

|   |                              
|-- | -----------------------------
|7. | Commitments and Contingencies

The
Company is occasionally named as a defendant in various legal actions arising
principally from claims made under insurance policies and contracts. Those
actions are considered by the Company in estimating the policy and contract
liabilities and management believes adequate reserves have been established for
such cases. Management believes that the resolution of those actions will not
have a material effect on the Companys financial position or results of
operations.

As
previously disclosed by the Company, on May 4, 2007, the Company entered into a
settlement agreement with ReliaStar Life Insurance Company and ReliaStar Life
Insurance Company of New York (ReliaStar) to settle litigation ReliaStar
brought against the Company, Kanawha, and the following officers of the
Company: Kenneth U. Kuk; Paul F. Kraemer; Paul P. Moore; Thomas J. Gibb; Scott
H. DeLong III; and Thomas D. Sass. The complaint and amended complaint filed by
ReliaStar alleged claims of misappropriation of trade secrets, conversion,
tortious interference with business and employment relationships, breach of
fiduciary duties, breach of contract, unfair competition, interference with
contractual relationships, civil conspiracy, fraudulent misrepresentation and
civil theft. Pursuant to the settlement agreement, the Company made a cash
payment of $825,000 to ReliaStar in settlement of all claims, ending the
litigation. The insurance carrier for the Companys primary directors and
officers insurance policy previously informed the Company that it was willing
to provide reimbursement for a portion of the amount paid by the Company in
settlement of the litigation. The Company views the amount offered by the
insurance carrier to be insufficient. Moreover, during the course of the
litigation, the insurance carrier made various deductions from its
reimbursements to the Company for the legal fees expended by

16

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

the Company. The Company
will make a good faith effort to reach an agreement with the insurance carrier
relating to the insurance carriers contribution to the settlement and the
insurance carriers payments for the legal fees incurred by the Company
throughout the duration of the litigation. At the present time, it is unclear
whether the Company will be able to reach a satisfactory arrangement with its
primary directors and officers liability carrier. If it is not able to do so,
the Company intends to pursue additional reimbursement from the insurance
carrier under the insurance policy. The Company has not recorded a gain
contingency relating to this transaction.

|   |                           
|-- | --------------------------
|8. | Debt and Other Obligations

Wachovia
Credit Agreement.

On
December 21, 2006, the Company entered into a credit agreement with Wachovia,
which provides a $15.0 million unsecured revolving credit facility from which
we borrowed $14.0 million to repay the five-year subordinated promissory note
that was issued to fund a portion of the purchase price for the Kanawha
acquisition. The remaining $1.0 million available under the credit facility may
be used to finance the Companys working capital, liquidity needs and general
working requirements and those of its subsidiaries. Amounts outstanding under
the credit agreement will bear interest at a rate calculated according to, at
the Companys option, a base rate or the LIBOR rate plus an applicable
percentage. The applicable percentage is based on the A.M. Best financial
strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans
and from 1.25% to 1.35% for LIBOR rate loans. In the case of LIBOR rate loans,
interest on amounts outstanding is payable at the end of the interest period,
which can be one, two, three or six months, as selected by the Company in its
notice of borrowing. Wachovias obligation to fund the credit agreement
terminates, and all principal outstanding under the credit agreement is due and
payable, no later than December 31, 2007. As of September 30, 2007, the $14.0
million outstanding under the credit agreement was a LIBOR rate plus applicable
percentage loan with an interest rate of 6.76%.

The
credit agreement requires the Company to comply with certain covenants,
including, among others, maintaining a maximum ratio of consolidated
indebtedness to total capitalization, a minimum available dividend amount for
Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha.
The Company must also comply with limitations on certain payments, additional
debt obligations, dispositions of assets and its lines of business. The credit
agreement also restricts the Company from creating or allowing certain liens on
its assets and from making certain investments.

Subordinated
Debt Securities.

On
March 22, 2007, KMG America completed the issuance and sale in a private
placement of $35,000,000 in aggregate principal amount of trust preferred
securities (the Trust Preferred Securities) issued by the Companys
newly-formed subsidiary, KMG Capital Statutory Trust I, a Delaware statutory
trust (the Trust). The Trust Preferred Securities will mature on March 15,
2037, may be called at par by the Company any time after March 15, 2012, and
require quarterly distributions of interest by the Trust to the holder of the
Trust Preferred Securities. Distributions are payable quarterly at a fixed
interest rate equal to 8.02% per annum through March 15, 2012, and then will be
payable at a floating interest rate equal to the 3-month London Interbank
Offered Rate (LIBOR) plus 310 basis points per annum. The Trust
simultaneously issued one of the Trusts common securities (the Common
Securities) to the Company for a purchase price of $1,083,000, which
constitutes all of the issued and outstanding common securities of the Trust.

The
Trust used the proceeds from the sale of the Trust Preferred Securities together
with the proceeds from the sale of the Common Securities to purchase
$36,083,000 in aggregate principal amount of unsecured junior subordinated
deferrable interest debt securities due March 15, 2037, issued by the Company
(the Junior Subordinated Debt). The net proceeds to the Company from the sale
of the Junior Subordinated Debt to the Trust will be used by the Company for
general corporate purposes.

The
Junior Subordinated Debt was issued pursuant to an Indenture, dated March 22,
2007 (the Indenture), between the Company, as issuer, Wilmington Trust
Company, as trustee, and the administrators named therein. The terms of the
Junior Subordinated Debt are substantially the same as the terms of the Trust
Preferred Securities. The interest payments on the Junior Subordinated Debt
paid by the Company will be used by the Trust to pay the quarterly
distributions to the holders of the Trust Preferred Securities. The Indenture
permits the Company

17

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

to redeem the
Junior Subordinated Debt (and thus a like amount of the Trust Preferred
Securities) on or after March 15, 2012. If the Company redeems any amount of
the Junior Subordinated Debt, the Trust must redeem a like amount of the Trust
Preferred Securities.

The
Trust was not consolidated based on the guidance issued by the FASB in
Interpretation (FIN) No. 46(R), Consolidation of Variable Interest Entities,
but rather is treated like an equity-method investment. Thus, the Companys
$1.1 million investment in the Trust is recorded as an Investment in
subsidiary.

|   |                     
|-- | --------------------
|9. | Federal Income Taxes

The
actual effective rate for the nine months ended September 30, 2007 varies from
the expected statutory rate of approximately 35% primarily as a result of the
establishment of a $7.6 million valuation allowance to offset the portion of
the deferred tax asset relating to the holding company. The decision by A.M.
Best to change the outlook of our rating from stable to negative, and the
resulting strategic options being considered, has created uncertainty about our
ability and timing to generate taxable income at the holding company. Because
of this uncertainty, the Company has deemed it appropriate to establish the
valuation allowance. The Company intends to continue to evaluate tax planning
strategies to utilize the operating losses prior to their expiration.

The
Company had no interest and penalties for the nine months ended September 30,
2007 and no amounts were accrued. To the extent the Company incurred interest
and penalties, such amounts would be recognized in provision for income taxes.
For KMG Americas subsidiaries, tax years 2002 through 2006 are subject to
examination by the Internal Revenue Service. There are no income tax
examinations currently in process. The Company has no unrecognized tax
positions at September 30, 2007 and expects no material change in its
unrecognized tax positions within the next 12 months.

|    |                  
|--- | -----------------
|10. | Business Segments

The
Company has five reportable segments that are differentiated by their
respective methods of distribution and the nature of the related products:
worksite insurance business, senior market insurance business, third party
administration business, acquired business and corporate and other. Management
makes decisions regarding the Companys business based on these segment
classifications. No segments have been aggregated other than including the
marketing business in the corporate and other segment.

The
worksite insurance business provides life and health insurance products to
employers and employees. The primary insurance products that the Company
underwrites include: group and individual life insurance; group long term
disability insurance; group and individual short term disability insurance;
group and individual dental insurance; group and individual indemnity health
insurance; group critical illness insurance and employer group excess risk
insurance. This segment also includes business sold through the career
agency distribution channel, which is a group of agents and managers that are
employees of the Company or its subsidiaries.

The
senior market insurance business consists primarily of the Companys in-force
block of long-term care insurance policies that the Company actively manages,
including the right to receive renewal premiums and liability for future
claims. Effective January 1, 2006, the Company ceased actively underwriting
long-term care insurance policies.

The
third party administration business provides fee-based administrative and
managed care services to employers with self funded health care plans,
insurance carriers, reinsurance companies and others.

The
acquired business represents closed blocks of life and health insurance
business that have been acquired through reinsurance transactions over a period
of years.

The
corporate and other segment includes investment income earned on the investment
portfolio allocated to capital and surplus, as well as all realized capital
gains and losses, which are not allocated by line of business. This segment
also includes marketing allowances, commissions and related expenses pertaining
to product sales for other insurance carriers, which are currently not material.
In addition, this segment includes certain unallocated

18

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Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

expenses,
primarily costs associated with being a public company, deferred compensation,
incentive compensation and stock based compensation, and other non-allocated
items such as the costs associated with the litigation with ReliaStar.

Benefit
reserves as reported are shown on a GAAP basis with appropriate purchase
accounting adjustments to reflect the fair value of the policy liabilities at
the time of the acquisition. This means that the experience assumptions (e.g.,
premium rates and projected rate increases, interest rates, mortality,
morbidity, persistency, administrative expenses, etc.) underlying the derivation
of such benefit reserves were determined as of the date of the acquisition of
Kanawha. Prior to June 30, 2006, the approach was based on aggregate projection
models that were used to calculate reserves. An aggregate projection modeling
approach is commonly used following an acquisition to establish reserve
balances for insurance companies prior to developing policy by policy
(seriatim) calculations. This type of refinement is contemplated by SFAS 141.
Effective June 30, 2006, a refinement in the process was implemented whereby
the reserves are now being developed on a policy by policy (seriatim) basis.
The refinement of the approach to use seriatim developed reserves had no
material impact on total company income but had an impact on the balance sheet
on a segment by segment basis.

Using
the aggregated projection model, the reserve valuation method and experience
assumptions were applied to aggregate projected data (a simplified but
representative model was used to simulate the entire range of ages at issue,
policy duration, amounts of insurance, etc.) for various insurance product
types (similar product types were grouped into one representative product).
Using the seriatim model, the same underlying reserve valuation method and
experience assumptions were applied to actual data for each policy such as the
type of plan, age of insured and amount of insurance. This consistency in
reserve valuation methods and experience assumptions is required by SFAS 60.
The effect on total benefit reserves of the various experience assumptions can
only be approximated in the aggregate model. It is only in the detailed policy
by policy calculations that the actual effect over time of the experience
assumptions is known. The analysis involved in deriving the seriatim reserve
factors provided information not previously available as to how the actual
reserves would emerge over time when all such assumptions are taken into
account. This new information results in a better allocation of the total fair
value of the benefit reserves.

This
seriatim approach was not implemented in prior quarters because it took a
considerable amount of time to complete the substantial volume of calculations
that were required to produce reserve factors that varied by, among other things,
plan, gender, issue age, duration, and smoker status. The benefit reserve
factors that were developed were for long term, level premium products subject
to SFAS 60. As such, complete sets of factors for all products were needed. The
significant staffing and financial constraints faced as a small start-up
company also contributed to the amount of time it took to complete that effort.
Further, while an acquiring company typically has substantial actuarial
resources that would contribute to the process, this was not the case in this
situation, where Kanawhas operations became KMG Americas primary operations.

Because
the detailed data in the seriatim valuation was not informative or useful until
the model was completed, it became new information when such calculations were
completed. Accordingly, using the refined seriatim valuation to produce such
new information constituted a change in accounting estimate under SFAS 154 and
was properly accounted for in the period of the change. Under this accounting
principle a restatement of prior periods was not permitted.

The
result of the reallocation of reserves between business segments was to
strengthen reserves by $ 37.5 million in the senior market insurance business
segment. This was offset by a reduction in reserves of $ 31.2 million in the
acquired business segment and $ 6.3 million in the worksite segment. No
material effect to overall policy reserves or to earnings resulted from the
reallocation, but this reallocation of reserves between the business segments
does impact the comparability of the quarter and year to date reported
policyholder benefits and the resulting reported benefit ratios by segment.

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Table of Contents

KMG AMERICA CORPORATION 
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

The
following represents a summary of the Companys statements of income and asset
composition by reportable segment.

|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|--------------------------------------- |  | ---------------------------------- | ----------- | --------------------------------- | - | ----------- |  | ---- | ----------- | - | - | ----------- | -
|                                        |  | Three
 Months Ended
 September 30, |             | Nine
 Months Ended
 September 30, |  
|                                        |  | 2007                               |             | 2006                              |   | 2007        |  | 2006 |            
|                                        |  |                                    |             |                                   |   |             |  |      |            
|Worksite Insurance Business             |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  | 30,131,268  |                                   | $ | 23,703,164  |  | $    | 90,032,214  |   | $ | 61,535,883  |  
|Net investment income                   |  |                                    | 2,258,249   |                                   |   | 1,868,419   |  |      | 6,483,375   |   |   | 5,226,959   |  
|Commissions and fees                    |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Net realized gains                      |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Other income                            |  |                                    | 179,138     |                                   |   | 41,139      |  |      | 533,725     |   |   | 137,363     |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total revenues                          |  |                                    | 32,568,655  |                                   |   | 25,612,722  |  |      | 97,049,314  |   |   | 66,900,205  |  
|Policyholder benefits                   |  |                                    | 25,061,426  |                                   |   | 17,043,732  |  |      | 77,068,908  |   |   | 38,043,879  |  
|Commissions                             |  |                                    | 2,555,464   |                                   |   | 1,902,554   |  |      | 7,796,933   |   |   | 4,986,597   |  
|Expenses, taxes, fees and depreciation  |  |                                    | 4,452,893   |                                   |   | 4,281,888   |  |      | 14,023,173  |   |   | 12,965,899  |  
|Amortization of DAC and VOBA            |  |                                    | 1,949,114   |                                   |   | 1,138,631   |  |      | 4,646,859   |   |   | 2,442,814   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 34,018,897  |                                   |   | 24,366,805  |  |      | 103,535,873 |   |   | 58,439,189  |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                                  | (1,450,242  | )                                 | $ | 1,245,917   |  | $    | (6,486,559  | ) | $ | 8,461,016   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total assets                            |  | $                                  | 187,499,283 |                                   | $ | 167,949,426 |  | $    | 187,499,283 |   | $ | 167,949,426 |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Senior Market Insurance Business        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  | 10,255,276  |                                   | $ | 9,901,357   |  | $    | 32,116,386  |   | $ | 31,281,477  |  
|Net investment income                   |  |                                    | 2,949,849   |                                   |   | 2,367,286   |  |      | 8,480,744   |   |   | 5,344,533   |  
|Commissions and fees                    |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Net realized gains                      |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Other income                            |  |                                    | 779,068     |                                   |   | 825,885     |  |      | 2,339,444   |   |   | 2,394,890   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total revenues                          |  |                                    | 13,984,193  |                                   |   | 13,094,528  |  |      | 42,936,574  |   |   | 39,020,900  |  
|Policyholder benefits                   |  |                                    | 10,020,277  |                                   |   | 7,432,374   |  |      | 26,509,357  |   |   | 62,729,941  |  
|Commissions                             |  |                                    | 1,288,537   |                                   |   | 1,252,339   |  |      | 4,044,317   |   |   | 3,888,795   |  
|Expenses, taxes, fees and depreciation  |  |                                    | 674,273     |                                   |   | 714,831     |  |      | 2,220,905   |   |   | 2,213,905   |  
|Amortization of DAC and VOBA            |  |                                    | 273,700     |                                   |   | 648,242     |  |      | 873,651     |   |   | 1,624,352   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 12,256,787  |                                   |   | 10,047,786  |  |      | 33,648,230  |   |   | 70,456,993  |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                                  | 1,727,406   |                                   | $ | 3,046,742   |  | $    | 9,288,344   |   | $ | (31,436,093 | )
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total assets                            |  | $                                  | 279,395,752 |                                   | $ | 255,012,640 |  | $    | 279,395,752 |   | $ | 255,012,640 |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Third Party Administration Business     |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  |            |                                   | $ |            |  | $    |            |   |   |            |  
|Net investment income                   |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Commissions and fees                    |  |                                    | 3,542,093   |                                   |   | 3,923,545   |  |      | 11,572,867  |   |   | 12,082,886  |  
|Net realized gains                      |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Other income                            |  |                                    |            |                                   |   | 504         |  |      |            |   |   | 504         |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total revenues                          |  |                                    | 3,542,093   |                                   |   | 3,924,049   |  |      | 11,572,867  |   |   | 12,083,390  |  
|Policyholder benefits                   |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Commissions                             |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Expenses, taxes, fees and depreciation  |  |                                    | 3,300,260   |                                   |   | 3,529,628   |  |      | 10,184,080  |   |   | 10,480,937  |  
|Amortization of DAC and VOBA            |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 3,300,260   |                                   |   | 3,529,628   |  |      | 10,184,080  |   |   | 10,480,937  |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Income (loss) before Federal income tax |  |                                    | 241,833     |                                   | $ | 394,421     |  | $    | 1,388,787   |   | $ | 1,602,453   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total assets                            |  | $                                  | 9,218,299   |                                   | $ | 6,689,366   |  | $    | 9,218,299   |   | $ | 6,689,366   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  

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KMG AMERICA CORPORATION 
NOTES TO CONSOLIDATED FNANCIAL STATEMENTS

|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|--------------------------------------- |  | ---------------------------------- | ----------- | --------------------------------- | - | ----------- | - | ---- | ----------- | - | - | ----------- | -
|                                        |  | Three
 Months Ended
 September 30, |             | Nine
 Months Ended
 September 30, |  
|                                        |  | 2007                               |             | 2006                              |   | 2007        |   | 2006 |            
|                                        |  |                                    |             |                                   |   |             |   |      |            
|Acquired Business                       |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  | (241,120    | )                                 | $ | 630,916     |   | $    | (400,055    | ) | $ | 1,890,761   |  
|Net investment income                   |  |                                    | 1,947,144   |                                   |   | 1,979,339   |   |      | 5,932,464   |   |   | 6,066,100   |  
|Commissions and fees                    |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|Net realized gains                      |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|Other income                            |  |                                    | 18,287      |                                   |   | 15,836      |   |      | 56,199      |   |   | 54,858      |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                    | 1,724,311   |                                   |   | 2,626,091   |   |      | 5,588,608   |   |   | 8,011,719   |  
|Policyholder benefits                   |  |                                    | 793,348     |                                   |   | 1,709,506   |   |      | 4,894,015   |   |   | (26,860,840 | )
|Commissions                             |  |                                    | 84,903      |                                   |   | 91,166      |   |      | 261,299     |   |   | 275,943     |  
|Expenses, taxes, fees and depreciation  |  |                                    | 691,870     |                                   |   | 594,523     |   |      | 1,880,301   |   |   | 1,795,998   |  
|Amortization of DAC and VOBA            |  |                                    | (248,280    | )                                 |   | (105,665    | ) |      | (356,723    | ) |   | (52,615     | )
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 1,321,841   |                                   |   | 2,289,530   |   |      | 6,678,892   |   |   | (24,841,514 | )
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                                  | 402,470     |                                   | $ | 336,561     |   | $    | (1,090,284  | ) | $ | 32,853,233  |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                                  | 155,524,604 |                                   | $ | 163,274,384 |   | $    | 155,524,604 |   | $ | 163,274,384 |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Corporate and Other                     |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  |            |                                   | $ |            |   | $    |            |   | $ |            |  
|Net investment income                   |  |                                    | 1,573,743   |                                   |   | 1,237,299   |   |      | 4,085,686   |   |   | 5,639,931   |  
|Commissions and fees                    |  |                                    | 62,680      |                                   |   | 93,458      |   |      | 271,529     |   |   | 270,726     |  
|Net realized gains                      |  |                                    | 422,915     |                                   |   | 6,791       |   |      | 613,739     |   |   | 102,853     |  
|Other income                            |  |                                    | 96,370      |                                   |   | 391,575     |   |      | 396,128     |   |   | 596,205     |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                    | 2,155,708   |                                   |   | 1,729,123   |   |      | 5,367,082   |   |   | 6,609,715   |  
|Policyholder benefits                   |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|Commissions                             |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|Expenses, taxes, fees and depreciation  |  |                                    | 3,301,844   |                                   |   | 3,637,946   |   |      | 12,396,852  |   |   | 11,563,780  |  
|Amortization of DAC and VOBA            |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 3,301,844   |                                   |   | 3,637,946   |   |      | 12,396,852  |   |   | 11,563,780  |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                                  | (1,146,136  | )                                 | $ | (1,908,823  | ) | $    | (7,029,770  | ) | $ | (4,954,065  | )
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                                  | 246,118,525 |                                   | $ | 228,986,920 |   | $    | 246,118,525 |   | $ | 228,986,920 |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total Company                           |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  | 40,145,423  |                                   | $ | 34,235,437  |   | $    | 121,748,545 |   |   | 94,708,120  |  
|Net investment income                   |  |                                    | 8,728,985   |                                   |   | 7,452,344   |   |      | 24,982,269  |   |   | 22,277,524  |  
|Commissions and fees                    |  |                                    | 3,604,773   |                                   |   | 4,017,003   |   |      | 11,844,396  |   |   | 12,353,612  |  
|Net realized gains                      |  |                                    | 422,915     |                                   |   | 6,789       |   |      | 613,739     |   |   | 102,853     |  
|Other income                            |  |                                    | 1,072,863   |                                   |   | 1,274,941   |   |      | 3,325,496   |   |   | 3,183,821   |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                    | 53,974,959  |                                   |   | 46,986,514  |   |      | 162,514,445 |   |   | 132,625,930 |  
|Policyholder benefits                   |  |                                    | 35,875,050  |                                   |   | 26,185,612  |   |      | 108,472,280 |   |   | 73,912,980  |  
|Commissions                             |  |                                    | 3,928,903   |                                   |   | 3,246,059   |   |      | 12,102,549  |   |   | 9,151,335   |  
|Expenses, taxes, fees and depreciation  |  |                                    | 12,421,141  |                                   |   | 12,758,817  |   |      | 40,705,311  |   |   | 39,020,521  |  
|Amortization of DAC and VOBA            |  |                                    | 1,974,534   |                                   |   | 1,681,208   |   |      | 5,163,787   |   |   | 4,014,551   |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 54,199,628  |                                   |   | 43,871,696  |   |      | 166,443,927 |   |   | 126,099,387 |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  |                                    | (224,669    | )                                 | $ | 3,114,818   |   | $    | (3,929,482  | ) | $ | 6,526,543   |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                                  | 877,756,463 |                                   | $ | 821,912,736 |   | $    | 877,756,463 |   | $ | 821,912,736 |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  

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|        |                                                                                       
|------- | --------------------------------------------------------------------------------------
|ITEM 2. | MANAGEMENTS DISCUSSION AND
 ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

KMG
America is a holding company incorporated under the laws of the Commonwealth of
Virginia on January 21, 2004. We commenced our operations shortly before we
completed our initial public offering of common stock on December 21, 2004, and
our shares trade on the New York Stock Exchange under the symbol KMA.
Concurrently with the completion of our initial public offering, we completed
our acquisition of Kanawha and its subsidiaries, which are our primary
operating subsidiaries and which underwrite and sell life and health insurance
products.

For
GAAP accounting purposes, Kanawha is treated as KMG Americas predecessor
entity and is referred to herein as our predecessor. For financial reporting
purposes, we have treated the acquisition as if it closed on December 31, 2004,
rather than the actual closing date of December 21, 2004, as the effects of the
acquisition for the period from December 21, 2004, through December 31, 2004,
were not material. Accordingly, in the following discussion any financial
information as of any date prior to, or for any period ending on or prior to,
December 31, 2004, is reported on a historical basis without GAAP purchase
accounting adjustments reflecting the acquisition, and any financial
information as of any date on or after, or for any period ending after,
December 31, 2004, reflects GAAP purchase accounting adjustments made as of December
31, 2004, reflecting the acquisition.

Proposed
merger.On September 7, 2007, the Company and Humana
entered into the Merger Agreement, by and among the Company, Humana and Merger
Sub, a wholly-owned subsidiary of Humana. Under the Merger Agreement, Merger
Sub will merge with and into the Company, with the Company continuing after the
Merger as the surviving corporation and a wholly-owned subsidiary of Humana. At
the Effective Time, each outstanding share of Company common stock will be converted
into the right to receive $6.20 in cash, without interest.

To
induce Humana to execute the Merger Agreement, the Company entered into
employment letter agreements (the New Employment Agreements) with Kenneth U.
Kuk, the Companys Chairman, President and Chief Executive Officer, Paul F.
Kraemer, the Companys Senior Vice President of Sales, Paul P. Moore, the
Companys Senior Vice President of Sales and three other executive officers.
Such executives current employment agreements with the Company will remain in
full force and effect until the Effective Time of the Merger. At the Effective
Time of the Merger, the executives current employment agreements will
terminate and the New Employment Agreements will govern the executives employment
with the Company from and after the Effective Time.

Each
outstanding option to purchase shares of Company common stock has an exercise
price per share that is greater than $6.20, and will be canceled without
consideration at the Effective Time of the Merger. Each outstanding restricted
share of Company common stock will be vested immediately prior to the Effective
Time of the Merger and will be eligible to receive the $6.20 per share merger
consideration. To limit the Companys compensation expense in its third quarter
2007 financial statements, on September 30, 2007, the Company and certain of
its executive officers agreed to cancel 1,389,925 options held by such
executives for no consideration. There is no agreement between the option
holders and the Company to reissue such options if the Merger is not completed.

The
Merger was unanimously approved by the boards of directors of the Company and
Humana. The Merger is subject to customary closing conditions, including the
approval by the Companys shareholders and the receipt of governmental and
regulatory approvals, including the approval of the South Carolina Department
of Insurance. On October 5, 2007, the Federal Trade Commission and the
Antitrust Division of the U.S. Department of Justice granted early termination
of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of
1976, as amended, in connection with the Merger. The Company has scheduled
November 16, 2007, as the date of the special meeting of shareholders to vote
on the Merger, and the close of business on October 12, 2007, has been set as
the record date for the meeting. Shareholders of record as of the close of
business on the record date will be entitled to vote at the meeting. The
closing of the Merger is expected to occur late in the fourth quarter of 2007,
possibly as early as November 30, 2007. There can be no assurance that the
Merger Agreement and the Merger will be approved by the Companys shareholders,
and there can be no assurance that the other conditions to the

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completion of
the proposed merger will be satisfied. If the proposed merger is not completed,
there can be no assurance that a comparable transaction could be achieved.

Worksite
insurance business. Our worksite insurance business is
a provider of life and health insurance products to employers and their
employees. Our predecessors marketing and sales efforts were primarily in the
southeastern United States, predominately in Florida, South Carolina and North
Carolina. Since acquiring our predecessor, we have begun to implement our
business strategy to market our products nationwide. The primary insurance
products that we underwrite include: group and individual life insurance; group
long term disability insurance; group and individual short term disability
insurance; group and individual dental insurance; group and individual
indemnity health insurance; group critical illness insurance and employer group
excess risk insurance. For the nine months ended September 30, 2007, our
worksite insurance business produced premiums, commissions and fees, excluding
intercompany payments, of $90.0 million, which accounted for 67.4% of our
premiums, commissions and fees, excluding intercompany payments in that period.
Our business strategy is to operate our existing worksite insurance business
efficiently while developing a new worksite marketing and distribution
organization that targets larger employer groups nationwide with an expanded
variety of life and health insurance products which have added a new set of
employer-paid life insurance, disability and health products to our existing
voluntary products. Since December 2004, we have opened sales offices hosting
regional sales managers in Boston, Massachusetts and Irvine, California, a Los
Angeles suburb and we have opened regional sales offices in Tampa, Florida;
Chicago, Illinois; Morristown, New Jersey; Atlanta, Georgia; Dallas, Texas;
Kansas City, Missouri; Cleveland, Ohio; Philadelphia, Pennsylvania; New
Orleans, Louisiana; San Diego and San Francisco, California; Phoenix, Arizona;
Denver, Colorado; and Minneapolis, Minnesota. We will base future expansion of
our sales organization on developing market trends and our profit margins. The
costs associated with any expansion of our sales organization will be
recognized before we recognize revenues resulting from new sales activity.
Consequently, we expect negative cash flow and operating losses in the short
term.

Senior
market insurance business. Our senior market insurance
business has been a provider in the southeastern United States of individual
insurance products tailored to the needs of older individuals. The primary
insurance product included in this business is long-term care insurance that we
underwrote. For the nine months ended September 30, 2007, our senior market
insurance business produced premiums, commissions and fees, excluding
intercompany payments, of $32.1 million, which accounted for 24.0% of our
premiums, commissions and fees, excluding intercompany payments, in that
period.

Effective
January 1, 2006, we ceased actively underwriting long-term care insurance
policies. Significant factors that contributed to our decision to cease
actively underwriting long-term care insurance policies include, among others:
(1) sales for this business were significantly lower than originally projected;
and (2) the lack of strategic fit between the underwriting and distribution of
long-term care products and our current strategy of focusing on worksite
marketing of life and health insurance products. We intend to retain and
actively manage the existing block of in-force long-term care insurance
policies (including the right to receive future premiums and the liability for
future claims).

Third-party
administration business. Our third-party
administration business provides a wide range of insurance product
administration, claims handling, eligibility administration, call center and
support services. This business primarily administers the insurance plans offered
by our worksite insurance business and senior market insurance business. Our
third-party administration business also provides administrative and managed
care services to third parties, such as employers with self-funded health care
plans, other insurance carriers, reinsurers and managed care plans. For the
nine months ended September 30, 2007, our third-party administration business
produced commissions and fees, excluding intercompany payments, of $11.6
million, which accounted for 8.7% of our premiums, commissions and fees,
excluding intercompany payments, in that period. Our strategy is to grow this
business as it administers the increasing volume of policies and products that
we anticipate will be sold by the worksite insurance business as we attempt to
grow that business. In addition, as our national worksite marketing business
develops, we intend to opportunistically market our third-party administration
services to self-insured plans, stop loss insurers, pharmacy benefit
organizations, managed care service providers, other insurance carriers and
reinsurers nationwide. It is expected that any incremental costs associated
with this expanded marketing will be modest and will be funded out of the
operations of our third-party administration business.

In
addition, we have retained our predecessors closed block of life and health
insurance business reported in the acquired business segment and the investment
and marketing activities reported in the corporate and other segment. While
acquisitions of books of business from other insurance carriers is not one of
our principal growth

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strategies, we
will consider making acquisitions on an opportunistic basis if we can complete
the acquisitions on favorable financial terms that we expect to be generally
accretive to earnings per share and return on equity while maintaining our
financial strength ratings.

We
expect to realize earnings from our investment portfolio. Insurance companies
in both the life and health and property and casualty insurance industries earn
profits on the investment float, which reflects the investment income earned on
the premiums paid to the insurer between the time of receipt and the time
benefits are paid-out under the policy. Volatility in the capital markets,
changes in interest rates and changes in economic conditions can all impact the
amount of earnings that we will realize from our investment portfolio.

Financial Strength Ratings Outlook

Kanawha
has an A.M. Best financial strength rating of A- (excellent). Recently, A.M.
Best changed its outlook for Kanawhas rating from stable to negative. A.M.
Best reviews their ratings periodically and Kanawhas current rating may not be
maintained in the future.

A.M.
Best has announced that, if the Merger is not completed, it will reduce
Kanawhas financial strength rating. If Kanawhas rating is reduced, the
Company would likely be precluded from participating in certain markets that
are key to its growth plans and financial prospects under its current business
strategy, its competitive position in the insurance industry would likely
suffer, it would likely lose customers, its cost of borrowing would likely
increase, its sales and earnings would likely decrease and its results of
operations and financial condition would likely be materially adversely
affected. To address these risks, the Company would likely need to materially
change its business strategy, and there can be no assurances that acceptable
alternatives exist or could be implemented.

Kanawha
also has a financial strength rating of BBB (good), with a positive ratings
outlook from S&P. The Company has informed S&P of its intention to
discontinue this rating in the future.

Current Year Developments

After
a comprehensive review of its stop loss book of business, the Company
recognized a $6 million charge in the first quarter of 2007 for increased
claims and reserves that reflected recent experience on stop loss cases. The
Company began writing annually renewable stop loss insurance in mid-2005, and
initially relied on pricing assumptions, a common industry practice relative to
new books of stop loss business, to establish expected loss ratios due to a
lack of credible actual claim experience. As a contrast, companies with mature
books of stop loss business typically establish claim reserves as a function of
experience studies of its business. Because actual claims on stop loss cases
typically are not fully reported until after the end of the policy period, it
is a common practice to increase or decrease claims reserves once the actual
claims experience becomes known.

As
experience emerged, the Company recognized additional claims and reserves
reflecting the recent adverse claims experience. The Company also decided to
increase claims assumptions on business prospectively, reflecting a more
conservative estimate of future claims on this business. The Companys
experience has been that it takes four quarters after a case has been written
before a clear picture becomes apparent regarding claims for that case. While
some of the unfavorable claims data began to emerge late in the fourth quarter
of 2006 and guided our reserving at year-end, new more meaningful data came to
the Companys attention late in the first quarter of this year after the
year-end books were closed and earnings reported. As a result of the new data
that became available in the first quarter of 2007, the Company concluded that
it was prudent to increase the estimated loss ratios on newer cases for claims
before credible claims experience developed on this business. As a result of
these first quarter 2007 actions, the Company believes its current claim
reserves on stop loss business adequately reflect both the development of
recent experience and the Companys more conservative outlook on loss
experience related to current premiums.

In
order to address the imbalance in its overall new sales mix, which has a
disproportionate concentration of stop loss business, the Company has
restructured the sales incentive compensation plan for its sales organization
with increased incentives for sales of core group life/disability and voluntary
benefit products. Additionally, the Company is limiting new sales of stop loss
by means of pricing new business at a higher expected profit margin and a
requirement that sales of stop loss be packaged with other products.

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The
Company has also established a $7.6 million valuation allowance as a non-cash
charge to offset the portion of the deferred tax asset that was generated by
net operating losses at the holding company. The decision by A.M. Best to
change the outlook of our rating from stable to negative, and the resulting
strategic options being considered, has created uncertainty about our ability and
timing to generate taxable income at the holding company. Because of this
uncertainty, the Company deemed it appropriate to establish the valuation
allowance. The Company intends to continue to evaluate tax planning strategies
to utilize the operating losses prior to their expiration.

Strategic Alternatives

On
May 7, 2007, the Company publicly announced that it had retained Keefe,
Bruyette & Woods, Inc., an investment banking firm, to advise management
and the Board of Directors regarding strategic alternatives, including the
possible sale or merger of the Company. At the conclusion of that process, on
September 7, 2007, in a joint press release with Humana Inc., the Company
announced that it had entered into the Merger Agreement with Humana and Merger
Sub pursuant to which the Company would become a wholly owned subsidiary of
Humana and the Companys shareholders would receive $6.20 in cash as
consideration for each outstanding share of Company common stock

To
induce Humana to execute the Merger Agreement, the Company entered into
employment letter agreements (the New Employment Agreements) with Kenneth U.
Kuk, the Companys Chairman, President and Chief Executive Officer, Paul F.
Kraemer, the Companys Senior Vice President of Sales, Paul P. Moore, the
Companys Senior Vice President of Sales and three other executive officers.
Such executives current employment agreements with the Company will remain in
full force and effect until the Effective Time of the Merger. At the Effective
Time of the Merger, the executives current employment agreements will
terminate and the New Employment Agreements will govern the executives
employment with the Company from and after the Effective Time.

Each
outstanding option to purchase shares of Company common stock has an exercise
price per share that is greater than $6.20, and will be canceled without
consideration at the Effective Time of the Merger. Each outstanding restricted
share of Company common stock will be vested immediately prior to the Effective
Time of the Merger and will be eligible to receive the $6.20 per share merger
consideration. To limit the Companys compensation expense in its third quarter
2007 financial statements, on September 30, 2007, the Company and certain of
its executive officers agreed to cancel 1,389,925 options held by such
executives for no consideration. There is no agreement between the option
holders and the Company to reissue such options if the Merger is not completed.

The
Merger Agreement has been unanimously approved by the Companys and Humanas
respective boards of directors. The completion of the Merger is subject to
certain customary closing conditions, including the approval of the Companys
shareholders and the receipt of government and regulatory approvals, such as
the approval of the South Carolina Department of Insurance. On October 5, 2007,
the Federal Trade Commission and the Antitrust Division of the U.S. Department
of Justice granted early termination of the waiting period under the
Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, in connection
with the proposed Merger. The Company has scheduled November 16, 2007, as the
date of the special meeting of shareholders to vote on the proposed Merger, and
the close of business on October 12, 2007, has been set as the record date for
the meeting. Shareholders of record as of the close of business on the record
date will be entitled to vote at the meeting. The closing of the Merger is
expected to occur late in the fourth quarter of 2007, possibly as early as
November 30, 2007. There can be no assurance that the Merger Agreement and the
Merger will be approved by the Companys shareholders, and there can be no
assurance that the other conditions to the completion of the proposed merger
will be satisfied. If the proposed merger is not completed, there can be no
assurance that a comparable transaction could be achieved.

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Results of Operations

Consolidated Overview

The
following table presents consolidated financial information for the quarters
ended September 30, 2007 and September 30, 2006 for KMG America.

|                              |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|----------------------------- |  | -------------------------------- | ------ | ------------------------------- | - | ------ | - | ---- | ------- | - | - | ------- | -
|                              |  | Three Months Ended September 30, |        | Nine Months Ended September 30, |  
|                              |  |                                  |        |                                 |  
|                              |  | 2007                             |        | 2006                            |   | 2007   |   | 2006 |        
|                              |  |                                  |        |                                 |   |        |   |      |        
|                              |  | (000s omitted)                  |       
|Revenues:                     |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|Insurance premiums            |  | $                                | 40,145 |                                 | $ | 34,236 |   | $    | 121,749 |   | $ | 94,708  |  
|Net investment income         |  |                                  | 8,729  |                                 |   | 7,452  |   |      | 24,982  |   |   | 22,277  |  
|Commission and fees           |  |                                  | 3,605  |                                 |   | 4,017  |   |      | 11,844  |   |   | 12,354  |  
|Net realized gains (losses)   |  |                                  | 423    |                                 |   | 7      |   |      | 614     |   |   | 103     |  
|Other income                  |  |                                  | 1,073  |                                 |   | 1,275  |   |      | 3,326   |   |   | 3,184   |  
|                              |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|Total revenues                |  |                                  | 53,975 |                                 |   | 46,987 |   |      | 162,515 |   |   | 132,626 |  
|                              |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|Benefits and expenses:        |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|Policyholder benefits         |  |                                  | 35,875 |                                 |   | 26,186 |   |      | 108,472 |   |   | 73,913  |  
|Commissions                   |  |                                  | 3,929  |                                 |   | 3,246  |   |      | 12,103  |   |   | 9,151   |  
|General expenses              |  |                                  | 10,400 |                                 |   | 10,836 |   |      | 33,739  |   |   | 33,019  |  
|Taxes, licenses and fees      |  |                                  | 1,266  |                                 |   | 1,289  |   |      | 4,741   |   |   | 4,096   |  
|Depreciation and amortization |  |                                  | 755    |                                 |   | 634    |   |      | 2,225   |   |   | 1,905   |  
|Amortization of DAC and VOBA  |  |                                  | 1,975  |                                 |   | 1,681  |   |      | 5,164   |   |   | 4,015   |  
|                              |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|Total benefits and expenses   |  |                                  | 54,200 |                                 |   | 43,872 |   |      | 166,444 |   |   | 126,099 |  
|                              |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|Income before income taxes    |  |                                  | (225   | )                               |   | 3115   |   |      | (3,929  | ) |   | 6,527   |  
|Provision for income taxes    |  |                                  | (129   | )                               |   | (1,089 | ) |      | (6,129  | ) |   | (2,248  | )
|                              |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|Net income                    |  | $                                | (354   | )                               | $ | 2,026  |   | $    | (10,058 | ) | $ | 4,279   |  
|                              |  |                                  |        |                                 |   |        |   |      |         |   |   |         |  
|Benefits to premiums
ratio(1) |  |                                  | 89.4   | %                               |   | 76.5   | % |      | 89.1    | % |   | 78.0    | %

|    |                                                                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(1) | The benefits
 to premiums ratio is equal to policyholder benefits (equal to incurred claims
 plus increases in policyholder active life reserves) divided by insurance
 premiums.

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Consolidated Results of Operations by Business Segment

The
following represents a summary of the Companys statements of income and asset
composition by reportable segment.

|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|--------------------------------------- |  | ---------------------------------- | ----------- | --------------------------------- | - | ----------- |  | ---- | ----------- | - | - | ----------- | -
|                                        |  | Three
 Months Ended
 September 30, |             | Nine
 Months Ended
 September 30, |  
|                                        |  | 2007                               |             | 2006                              |   | 2007        |  | 2006 |            
|                                        |  |                                    |             |                                   |   |             |  |      |            
|Worksite Insurance Business             |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  | 30,131,268  |                                   | $ | 23,703,164  |  | $    | 90,032,214  |   | $ | 61,535,883  |  
|Net investment income                   |  |                                    | 2,258,249   |                                   |   | 1,868,419   |  |      | 6,483,375   |   |   | 5,226,959   |  
|Commissions and fees                    |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Net realized gains                      |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Other income                            |  |                                    | 179,138     |                                   |   | 41,139      |  |      | 533,725     |   |   | 137,363     |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total revenues                          |  |                                    | 32,568,655  |                                   |   | 25,612,722  |  |      | 97,049,314  |   |   | 66,900,205  |  
|Policyholder benefits                   |  |                                    | 25,061,426  |                                   |   | 17,043,732  |  |      | 77,068,908  |   |   | 38,043,879  |  
|Commissions                             |  |                                    | 2,555,464   |                                   |   | 1,902,554   |  |      | 7,796,933   |   |   | 4,986,597   |  
|Expenses, taxes, fees and depreciation  |  |                                    | 4,452,893   |                                   |   | 4,281,888   |  |      | 14,023,173  |   |   | 12,965,899  |  
|Amortization of DAC and VOBA            |  |                                    | 1,949,114   |                                   |   | 1,138,631   |  |      | 4,646,859   |   |   | 2,442,814   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 34,018,897  |                                   |   | 24,366,805  |  |      | 103,535,873 |   |   | 58,439,189  |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                                  | (1,450,242  | )                                 | $ | 1,245,917   |  | $    | (6,486,559  | ) | $ | 8,461,016   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total assets                            |  | $                                  | 187,499,283 |                                   | $ | 167,949,426 |  | $    | 187,499,283 |   | $ | 167,949,426 |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Senior Market Insurance Business        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  | 10,255,276  |                                   | $ | 9,901,357   |  | $    | 32,116,386  |   | $ | 31,281,477  |  
|Net investment income                   |  |                                    | 2,949,849   |                                   |   | 2,367,286   |  |      | 8,480,744   |   |   | 5,344,533   |  
|Commissions and fees                    |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Net realized gains                      |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Other income                            |  |                                    | 779,068     |                                   |   | 825,885     |  |      | 2,339,444   |   |   | 2,394,890   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total revenues                          |  |                                    | 13,984,193  |                                   |   | 13,094,528  |  |      | 42,936,574  |   |   | 39,020,900  |  
|Policyholder benefits                   |  |                                    | 10,020,277  |                                   |   | 7,432,374   |  |      | 26,509,357  |   |   | 62,729,941  |  
|Commissions                             |  |                                    | 1,288,537   |                                   |   | 1,252,339   |  |      | 4,044,317   |   |   | 3,888,795   |  
|Expenses, taxes, fees and depreciation  |  |                                    | 674,273     |                                   |   | 714,831     |  |      | 2,220,905   |   |   | 2,213,905   |  
|Amortization of DAC and VOBA            |  |                                    | 273,700     |                                   |   | 648,242     |  |      | 873,651     |   |   | 1,624,352   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 12,256,787  |                                   |   | 10,047,786  |  |      | 33,648,230  |   |   | 70,456,993  |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                                  | 1,727,406   |                                   | $ | 3,046,742   |  | $    | 9,288,344   |   | $ | (31,436,093 | )
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total assets                            |  | $                                  | 279,395,752 |                                   | $ | 255,012,640 |  | $    | 279,395,752 |   | $ | 255,012,640 |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Third Party Administration Business     |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  |            |                                   | $ |            |  | $    |            |   |   |            |  
|Net investment income                   |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Commissions and fees                    |  |                                    | 3,542,093   |                                   |   | 3,923,545   |  |      | 11,572,867  |   |   | 12,082,886  |  
|Net realized gains                      |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Other income                            |  |                                    |            |                                   |   | 504         |  |      |            |   |   | 504         |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total revenues                          |  |                                    | 3,542,093   |                                   |   | 3,924,049   |  |      | 11,572,867  |   |   | 12,083,390  |  
|Policyholder benefits                   |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Commissions                             |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|Expenses, taxes, fees and depreciation  |  |                                    | 3,300,260   |                                   |   | 3,529,628   |  |      | 10,184,080  |   |   | 10,480,937  |  
|Amortization of DAC and VOBA            |  |                                    |            |                                   |   |            |  |      |            |   |   |            |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 3,300,260   |                                   |   | 3,529,628   |  |      | 10,184,080  |   |   | 10,480,937  |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Income (loss) before Federal income tax |  |                                    | 241,833     |                                   | $ | 394,421     |  | $    | 1,388,787   |   | $ | 1,602,453   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  
|Total assets                            |  | $                                  | 9,218,299   |                                   | $ | 6,689,366   |  | $    | 9,218,299   |   | $ | 6,689,366   |  
|                                        |  |                                    |             |                                   |   |             |  |      |             |   |   |             |  

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Table of Contents

|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|--------------------------------------- |  | ---------------------------------- | ----------- | --------------------------------- | - | ----------- | - | ---- | ----------- | - | - | ----------- | -
|                                        |  | Three
 Months Ended
 September 30, |             | Nine
 Months Ended
 September 30, |  
|                                        |  | 2007                               |             | 2006                              |   | 2007        |   | 2006 |            
|                                        |  |                                    |             |                                   |   |             |   |      |            
|Acquired Business                       |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  | (241,120    | )                                 | $ | 630,916     |   | $    | (400,055    | ) | $ | 1,890,761   |  
|Net investment income                   |  |                                    | 1,947,144   |                                   |   | 1,979,339   |   |      | 5,932,464   |   |   | 6,066,100   |  
|Commissions and fees                    |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|Net realized gains                      |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|Other income                            |  |                                    | 18,287      |                                   |   | 15,836      |   |      | 56,199      |   |   | 54,858      |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                    | 1,724,311   |                                   |   | 2,626,091   |   |      | 5,588,608   |   |   | 8,011,719   |  
|Policyholder benefits                   |  |                                    | 793,348     |                                   |   | 1,709,506   |   |      | 4,894,015   |   |   | (26,860,840 | )
|Commissions                             |  |                                    | 84,903      |                                   |   | 91,166      |   |      | 261,299     |   |   | 275,943     |  
|Expenses, taxes, fees and depreciation  |  |                                    | 691,870     |                                   |   | 594,523     |   |      | 1,880,301   |   |   | 1,795,998   |  
|Amortization of DAC and VOBA            |  |                                    | (248,280    | )                                 |   | (105,665    | ) |      | (356,723    | ) |   | (52,615     | )
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 1,321,841   |                                   |   | 2,289,530   |   |      | 6,678,892   |   |   | (24,841,514 | )
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                                  | 402,470     |                                   | $ | 336,561     |   | $    | (1,090,284  | ) | $ | 32,853,233  |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                                  | 155,524,604 |                                   | $ | 163,274,384 |   | $    | 155,524,604 |   | $ | 163,274,384 |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Corporate and Other                     |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  |            |                                   | $ |            |   | $    |            |   | $ |            |  
|Net investment income                   |  |                                    | 1,573,743   |                                   |   | 1,237,299   |   |      | 4,085,686   |   |   | 5,639,931   |  
|Commissions and fees                    |  |                                    | 62,680      |                                   |   | 93,458      |   |      | 271,529     |   |   | 270,726     |  
|Net realized gains                      |  |                                    | 422,915     |                                   |   | 6,791       |   |      | 613,739     |   |   | 102,853     |  
|Other income                            |  |                                    | 96,370      |                                   |   | 391,575     |   |      | 396,128     |   |   | 596,205     |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                    | 2,155,708   |                                   |   | 1,729,123   |   |      | 5,367,082   |   |   | 6,609,715   |  
|Policyholder benefits                   |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|Commissions                             |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|Expenses, taxes, fees and depreciation  |  |                                    | 3,301,844   |                                   |   | 3,637,946   |   |      | 12,396,852  |   |   | 11,563,780  |  
|Amortization of DAC and VOBA            |  |                                    |            |                                   |   |            |   |      |            |   |   |            |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 3,301,844   |                                   |   | 3,637,946   |   |      | 12,396,852  |   |   | 11,563,780  |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                                  | (1,146,136  | )                                 | $ | (1,908,823  | ) | $    | (7,029,770  | ) | $ | (4,954,065  | )
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                                  | 246,118,525 |                                   | $ | 228,986,920 |   | $    | 246,118,525 |   | $ | 228,986,920 |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total Company                           |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                                  | 40,145,423  |                                   | $ | 34,235,437  |   | $    | 121,748,545 |   |   | 94,708,120  |  
|Net investment income                   |  |                                    | 8,728,985   |                                   |   | 7,452,344   |   |      | 24,982,269  |   |   | 22,277,524  |  
|Commissions and fees                    |  |                                    | 3,604,773   |                                   |   | 4,017,003   |   |      | 11,844,396  |   |   | 12,353,612  |  
|Net realized gains                      |  |                                    | 422,915     |                                   |   | 6,789       |   |      | 613,739     |   |   | 102,853     |  
|Other income                            |  |                                    | 1,072,863   |                                   |   | 1,274,941   |   |      | 3,325,496   |   |   | 3,183,821   |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                    | 53,974,959  |                                   |   | 46,986,514  |   |      | 162,514,445 |   |   | 132,625,930 |  
|Policyholder benefits                   |  |                                    | 35,875,050  |                                   |   | 26,185,612  |   |      | 108,472,280 |   |   | 73,912,980  |  
|Commissions                             |  |                                    | 3,928,903   |                                   |   | 3,246,059   |   |      | 12,102,549  |   |   | 9,151,335   |  
|Expenses, taxes, fees and depreciation  |  |                                    | 12,421,141  |                                   |   | 12,758,817  |   |      | 40,705,311  |   |   | 39,020,521  |  
|Amortization of DAC and VOBA            |  |                                    | 1,974,534   |                                   |   | 1,681,208   |   |      | 5,163,787   |   |   | 4,014,551   |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                    | 54,199,628  |                                   |   | 43,871,696  |   |      | 166,443,927 |   |   | 126,099,387 |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  |                                    | (224,669    | )                                 | $ | 3,114,818   |   | $    | (3,929,482  | ) | $ | 6,526,543   |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                                  | 877,756,463 |                                   | $ | 821,912,736 |   | $    | 877,756,463 |   | $ | 821,912,736 |  
|                                        |  |                                    |             |                                   |   |             |   |      |             |   |   |             |  

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Nine Months Ended September 30, 2007,
Compared to Nine Months Ended September 30, 2006

Financial Results
Overview

Net
income for the nine months ended September 30, 2007, decreased $14.4 million,
or 334.9%, to a $10.1 million net loss compared to net income of $4.3 million
for the nine months ended September 30, 2006. The decrease in net income was
primarily due to $6 million of reserve strengthening in the stop loss book of
business which will be discussed in the policyholder benefits analysis below as
well as the establishment of a deferred tax valuation allowance of $7.6 million
which will be discussed in the provision for income taxes analysis below. Other
factors include increases in premiums and net investment income, offset by
increases in policyholder benefits, commissions and general expenses, all of
which are described in greater detail below.

Revenues

Total
revenues for the nine months ended September 30, 2007, increased $29.9 million,
or 22.5%, to $162.5 million from total revenues of $132.6 million for the nine
months ended September 30, 2006. The primary factors causing the increase are
explained below under the captions Premiums, Net Investment Income,
Commission and Fee Income, Realized Investment Gains and Losses and
Other Income.

Premiums

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

|        |  |                                             |      |                                             |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|------- |  | ------------------------------------------- | ---- | ------------------------------------------- | - | ------------------- | - | ----- | ---- | -------- | - | ------ | - | -------- | ---- | ----- | - | -------- | - | ------ | --- | -------- | - | ----- | - | - | ---- | - | - | ---- | - | - | ---- | - | - | ---- | -
|        |  | For the nine months endedSeptember 30, 2007 |      | For the nine months endedSeptember 30, 2006 |   | Increase (decrease) |  
|        |  |                                             |      |                                             |   |                     |  
|        |  | Worksite                                    |      | Senior                                      |   | Acquired            |   | Total |      | Worksite |   | Senior |   | Acquired |      | Total |   | Worksite |   | Senior |     | Acquired |   | Total |  
|        |  |                                             |      |                                             |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |  
|        |  |                                             |      |                                             |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |  
|Direct  |  |                                             |      |                                             |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  | $                                           | 60.9 |                                             | $ | 0.2                 |   | $     |     |          | $ | 61.1   |   | $        | 31.6 |       | $ | 0.6      |   | $      |    |          | $ | 32.2  |   | $ | 29.3 |   | $ | (0.4 | ) | $ |     |   | $ | 28.9 |  
|Renewal |  |                                             | 35.6 |                                             |   | 42.5                |   |       |     |          |   | 78.1   |   |          | 34.3 |       |   | 41.5     |   |        |    |          |   | 75.8  |   |   | 1.3  |   |   | 1.0  |   |   |     |   |   | 2.3  |  
|Total   |  |                                             | 96.5 |                                             |   | 42.7                |   |       |     |          |   | 139.2  |   |          | 65.9 |       |   | 42.1     |   |        |    |          |   | 108.0 |   |   | 30.6 |   |   | 0.6  |   |   |     |   |   | 31.2 |  
|Assumed |  |                                             |      |                                             |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                             | 0.1  |                                             |   |                    |   |       |     |          |   | 0.1    |   |          | 2.9  |       |   |         |   |        |    |          |   | 2.9   |   |   | (2.8 | ) |   |     |   |   |     |   |   | (2.8 | )
|Renewal |  |                                             | 1.5  |                                             |   |                    |   |       | 0.3  |          |   | 1.8    |   |          |     |       |   |         |   |        | 1.9 |          |   | 1.9   |   |   | 1.5  |   |   |     |   |   | (1.6 | ) |   | (0.1 | )
|Total   |  |                                             | 1.6  |                                             |   |                    |   |       | 0.3  |          |   | 1.9    |   |          | 2.9  |       |   |         |   |        | 1.9 |          |   | 4.8   |   |   | (1.3 | ) |   |     |   |   | (1.6 | ) |   | (2.9 | )
|Ceded   |  |                                             |      |                                             |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                             | (7.0 | )                                           |   |                    |   |       |     |          |   | (7.0   | ) |          | (6.4 | )     |   | (0.4     | ) |        |    |          |   | (6.8  | ) |   | (0.6 | ) |   | 0.4  |   |   |     |   |   | (0.2 | )
|Renewal |  |                                             | (1.1 | )                                           |   | (10.6               | ) |       | (0.7 | )        |   | (12.4  | ) |          | (0.9 | )     |   | (10.4    | ) |        |    |          |   | (11.3 | ) |   | (0.2 | ) |   | (0.2 | ) |   | (0.7 | ) |   | (1.1 | )
|Total   |  |                                             | (8.1 | )                                           |   | (10.6               | ) |       | (0.7 | )        |   | (19.4  | ) |          | (7.3 | )     |   | (10.8    | ) |        |    |          |   | (18.1 | ) |   | (0.8 | ) |   | 0.2  |   |   | (0.7 | ) |   | (1.3 | )
|Net     |  |                                             |      |                                             |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                             | 54.0 |                                             |   | 0.2                 |   |       |     |          |   | 54.2   |   |          | 28.1 |       |   | 0.2      |   |        |    |          |   | 28.3  |   |   | 25.9 |   |   |     |   |   |     |   |   | 25.9 |  
|Renewal |  |                                             | 36.0 |                                             |   | 31.9                |   |       | (0.4 | )        |   | 67.5   |   |          | 33.4 |       |   | 31.1     |   |        | 1.9 |          |   | 66.4  |   |   | 2.6  |   |   | 0.8  |   |   | (2.3 | ) |   | 1.1  |  
|Total   |  | $                                           | 90.0 |                                             | $ | 32.1                |   | $     | (0.4 | )        | $ | 121.7  |   | $        | 61.5 |       | $ | 31.3     |   | $      | 1.9 |          | $ | 94.7  |   | $ | 28.5 |   | $ | 0.8  |   | $ | (2.3 | ) | $ | 27.0 |  

Worksite
net new premiums increased $25.9 million, or 92.2%, to $54.0 million for the
nine months ended September 30, 2007, from $28.1 million for the nine months
ended September 30, 2006, due to increased sales volumes. The primary driver of
this increase was new stop loss premium generated by the new KMG America sales
force, which represents $42.1 million of direct new premiums, offset by $5.0
million of ceded new premiums. In order to address the imbalance in its
overall new sales mix, which has a disproportionate concentration of stop loss
business, the Company has restructured the sales incentive compensation plan
for its sales organization with increased incentives for sales of core group
life/disability and voluntary benefit products. Additionally, the Company is
limiting new sales of stop loss by means of pricing new business at a higher
expected profit margin and a requirement that sales of stop loss be packaged
with other products. Net renewal premiums increased $2.6 million, or
7.8%, for the nine months ended September 30, 2007, compared to the nine months
ended September 30, 2006, as a result of the assumption of a block of voluntary
term life insurance and universal life insurance policies from Columbian Life
Insurance Company and Columbian Mutual Life Insurance Company.

Senior
market net new premiums, composed of long term care policies, remained constant
at $0.2 million for the nine months ended September 30, 2007 compared to the
nine months ended September 30, 2006. The Company ceased actively underwriting
new long term care policies after December 31, 2005.Net renewal premiums

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increased 2.6%
to $31.9 million for the nine months ended September 30, 2007, compared to the
nine months ended September 30, 2006, representing premiums from the insurance
in force created by prior year sales.

Acquired
business premiums decreased $2.3 million, or 121.1%, to $(0.4) million for the
nine months ended September 30, 2007, from $1.9 million for the nine months
ended September 30, 2006. We have not acquired any blocks of business since
1999 and a significant portion of the decline is a result of policy lapses. In
2007, an estimated refund due to our reinsurance carrier of $0.7 million was
accrued in relation to possible adjustments needed for previously settled
billings. In addition, experience refunds are generated on certain reinsurance
treaties that reduce both premiums and policyholder benefits equally. The
experience refunds increased to $7.3 million for the nine months ended
September 30, 2007, from $6.4 million for the nine months ended September 30,
2006.

Net Investment Income

Net
investment income increased $2.7 million, or 12.1%, to $25.0 million for the
nine months ended September 30, 2007, from $22.3 million for the nine months
ended September 30, 2006. Net investment income is primarily affected by
changes in levels of invested assets and interest rates. The increase in
investment income for the nine months ended September 30, 2007, occurred
primarily as a result of an additional $35.0 million of cash and invested
assets generated through the issuance of junior subordinated debt, as described
in Note 8. Generally, an increase in invested assets is due to retention of
premiums to establish policy reserves for the payment of future policyholder
benefits.

Net
investment income is allocated to our various business segments on a pro rata
basis based on the invested assets attributed to the business segment. Assets
attributed to the senior market insurance segment continue to increase as a
result of policy reserve increases in this segment, while assets attributed to
the acquired segment continue to decline as this business lapses. There were no
other significant asset shifts in the business segments.

Commission and Fee Income

Commission
and fee income decreased $0.5 million, or 4.0%, to $11.9 million for the nine
months ended September 30, 2007, from $12.4 million for the nine months ended
September 30, 2006. Most of the commission and fee income was from
administrative fees relating to third-party administration, and the volume of
business in force has declined slightly compared to 2006 levels.

Realized Investment Gains and Losses

Realized
investment gains and losses occur as a result of the sale or impairment of
investments. The net realized investment gain for the nine months ended
September 30, 2007 increased by $0.5 million to $0.6 million, from $0.1 million
for the nine months ended September 30, 2006. The Company realized a $0.3
million gain in 2007 related to the sale of a minority interest in an LLC, and
the remaining increase is due primarily to marking to market investments held
in the Companys trading account. These investments represent the assets
purchased to support the deferred compensation liability of the Company, and
realized gains and/or losses are directly offset with increases and/or
decreases in compensation expenses. Realized investment gains and losses are
allocated entirely to the corporate and other business segment.

Other Income

Other
income increased $0.1 million, or 3.1%, to $3.3 million for the nine months
ended September 30, 2007, from $3.2 million for the nine months ended September
30, 2006, reflecting a $0.1 million payment received as part of WorldComs
settlement with former bond holders.

Benefits and Expenses

Total
benefits and expenses increased $40.3 million, or 32.0%, to $166.4 million for
the nine months ended September 30, 2007, from $126.1 million for the nine
months ended September 30, 2006. The primary factors causing this increase are
explained below under the captions Policyholder Benefits, Insurance

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Commissions,
General Insurance Expenses, Insurance Taxes, Licenses and Fees, and
Amortization of DAC and VOBA.

Policyholder Benefits

Policyholder
benefits increased $34.6 million, or 46.8%, to $108.5 million for the nine
months ended September 30, 2007, from $73.9 million for the nine months ended
September 30, 2006. This produced a benefits to premium ratio of 89.1% for the
nine months ended September 30, 2007, compared to 78.0% for the nine months
ended September 30, 2006.

Worksite
marketing policyholder benefits increased $39.1 million, or 102.9%, to $77.1
million for the nine months ended September 30, 2007, from $38.0 million for
the nine months ended September 30, 2006. This produced benefits to premium
ratios of 85.7% for the nine months ended September 30, 2007, compared to 61.8%
for the nine months ended September 30, 2006. The ratio in 2006 was deflated
due to the conversion to Purchase GAAP seriatim reserve factors from the
aggregate method, which resulted in decreased benefits of $6.3 million. The
nine months ended September 30, 2006 benefits to premium ratio adjusted would
be 72.0% without the reserve conversion impact.

In the first quarter of 2007, after a comprehensive review of its stop
loss book of business, the Company recognized a $6 million charge for increased
claims and reserves that reflected recent experience on stop loss cases. The
Company began writing annually renewable stop loss in mid-2005, and initially
relied on pricing assumptions, a common industry practice relative to new books
of stop loss business, to establish expected loss ratios due to lack of
credible actual claim experience. As a contrast, companies with mature books of
stop loss business typically establish claim reserves as a function of
experience studies of its business. Because actual claims on stop loss cases
typically are not fully reported until after the end of the policy period, it
is a common practice to increase or decrease claims reserves once the actual
claims experience becomes known. As experience emerged, the Company recognized
additional claims and reserves reflecting the recent adverse claims experience.
The Company also decided to increase claims assumptions on business
prospectively, reflecting a more conservative estimate of future claims on this
business. The Companys experience has been that it takes four quarters after a
case has been written before a clear picture becomes apparent regarding claims
for that case. As a result of the new data that became available in the first
quarter of 2007, the Company concluded that it would be prudent to increase the
estimated loss ratios on newer cases for claims before credible claims
experience has developed on this business. As a result of these first quarter
2007 actions, the Company believes its current claim reserves on stop loss
business adequately reflect both the development of recent experience and the
Companys more conservative outlook on loss experience related to current
premiums.

Senior
market policyholder benefits decreased $36.2 million, or 57.7%, to $26.5
million for the nine months ended September 30, 2007, from $62.7 million for
the nine months ended September 30, 2006. This produced benefits to premium
ratios of 82.6% for the nine months ended September 30, 2007, compared to
200.3% for the nine months ended September 30, 2006. The benefits to premium
ratio decreased primarily as a result of the 2006 conversion to Purchase GAAP
seriatim reserve factors from the aggregate method, which resulted in increased
benefits of $37.5 million. The nine months ended September 30, 2006 benefits to
premium ratio adjusted would be 80.5% without the reserve conversion impact.
The benefits to premium ratio increased due to a modest increase in open active
claims during the nine months ended September 30, 2007 compared to the nine
months ended September 30, 2006.

Acquired
business policyholder benefits increased $31.8 million, to $4.9 million for the
nine months ended September 30, 2007, from $(26.9) million for the nine months
ended September 30, 2006. Benefits to premium ratios do not provide meaningful
information in this segment without first adjusting for certain routine items
that have no impact on net income but have significant impact on the benefit
ratios Experience refunds are generated on certain reinsurance treaties that
reduce both premiums and policyholder benefits equally. The experience refunds
increased to $7.3 million for the nine months ended September 30, 2007, from
$6.4 million for the nine months ended September 30, 2006. In addition, the
2006 conversion to Purchase GAAP seriatim reserve factors from the aggregate
method resulted in decreased benefits of $31.2 million. Also, in 2007, an estimated
refund due to our reinsurance carrier of $0.7 million was accrued in relation
to possible adjustments needed for previously settled billings. Excluding the
effects of these items, the comparable benefit ratios are 161.5% for the nine
months ended

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September 30,
2007 and 158.7% for the nine months ended September 30, 2006. These benefits to
premium ratios are affected by large portions of the acquired business that are
no longer premium paying with substantial reserves and investment income on reserves.
In the nine months ended September 30, 2007, paid claims were up $0.8 million,
premiums were down $0.5 million, there was an increase of $0.6 million in
accident and health reserve increases, and there was a release of redundant
life reserves of $1.7 million, when compared to the nine months ended September
30, 2006.

Insurance Commissions

Commission
expenses increased $2.9 million, or 31.5%, to $12.1 million for the nine months
ended September 30, 2007, from $9.2 million for the nine months ended September
30, 2006. This increase consists of normal increases related to increased
renewal premiums, in addition to an increase in first year commissions that
were not deferred, a large portion of which relates to the increased sales of
stop loss products.

General Insurance Expenses

General
insurance expenses increased $0.7 million, or 2.1%, to $33.7 million for the
nine months ended September 30, 2007, from $33.0 million for the nine months
ended September 30, 2006. The increased expenses for the nine months ended
September 30, 2007 include some unusual items, including a $0.8 million
litigation settlement expense and $1.2 million of costs associated with our
pending merger transaction. These are partially offset by a $1.4 million reduction
in stock based compensation expense created by the voluntary surrender of stock
options held by the Companys executive officers in September 2007. The $1.4
million reduction is represented by a credit of $0.7 million in the nine months
ended September 30, 2007 compared to an expense of $0.7 million in the nine
months ended September 30, 2006.

Overhead
expenses that are not directly associated with a particular business segment
are allocated to the various business segments on a pro rata basis based on
different factors, such as headcount, policy count, number of policies issued,
premiums and other relevant factors.

Insurance Taxes, Licenses and Fees

Insurance
taxes, licenses and fees increased $0.6 million, or 14.6%, to $4.7 million for
the nine months ended September 30, 2007, from $4.1 million for the nine months
ended September 30, 2006. Employment taxes related to additional staffing
represents approximately half of the increase, and additional premium taxes due
to increased premiums represents the other half of the increase.

Amortization of DAC and VOBA

First
year commissions and general insurance expenses associated with the acquisition
of new business are deferred and amortized over the premium-paying period of the
related policies. The total deferrals of policy acquisition costs were $13.8
million and $12.7 million for the nine months ended September 30, 2007 and
2006, respectively. The increase in deferrals was primarily due to the increase
in net new premiums and the associated increase in commissions and expenses in
the worksite segment.

The
amortization of DAC and VOBA increased $1.2 million, or 30.0%, to $5.2 million
for the nine months ended September 30, 2007, from $4.0 million for the nine
months ended September 30, 2006, reflecting the increased deferrals described
above. The DAC balance at September 30, 2007 increased by $14.6 million from
the balance at September 30, 2006, which accounted for a large part of the
increase in amortization expense.

Provision for Income Taxes

Total
income taxes may differ from the amount computed by applying the federal
corporate tax rate of 35% due to tax-advantaged investments and net operating
loss carry forwards available. The effective income tax rates for the nine
months ended September 30, 2007 and 2006 were (156.0) % and 34.4%,
respectively. The variation in these rates is due to a valuation allowance of
$7.6 million that was established in 2007.

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Under
SFAS No. 109, management must provide a valuation allowance for any deferred
tax amounts that it believes are uncertain to be realized. The decision by A.M.
Best to change the outlook of our rating from stable to negative, and the
resulting strategic options being considered, has created uncertainty about our
ability and timing to generate taxable income at the holding company. Because
of this uncertainty, the Company deemed it appropriate to establish a valuation
allowance of $7.6 million which represents the portion of the deferred tax asset
that was generated by net operating losses at the holding company.

Three Months Ended September 30, 2007,
Compared to Three Months Ended September 30, 2006

Financial Results
Overview

Net
income for the three months ended September 30, 2007, decreased $2.4 million,
or 120.0%, to a loss of $0.4 million compared to net income of $2.0 million for
the three months ended September 30, 2006. The decrease in net income was
primarily due to increases in premiums and net investment income, which were more
than offset by increases in policyholder benefits, all of which are described
in greater detail below.

Revenues

Total
revenues for the three months ended September 30, 2007, increased $7.0 million,
or 14.9%, to $54.0 million from total revenues of $47.0 million for the three
months ended September 30, 2006. The primary factors causing the increase are
explained below under the captions Premiums, Net Investment Income,
Commission and Fee Income, Realized Investment Gains and Losses and
Other Income.

Premiums

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

|        |  |                                              |      |                                              |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |     |  |   |      |   |   |      |  
|------- |  | -------------------------------------------- | ---- | -------------------------------------------- | - | ------------------- | - | ----- | ---- | -------- | - | ------ | - | -------- | ---- | ----- | - | -------- | - | ------ | --- | -------- | - | ----- | - | - | ---- | - | - | --- |  | - | ---- | - | - | ---- | -
|        |  | For the three months endedSeptember 30, 2007 |      | For the three months endedSeptember 30, 2006 |   | Increase (decrease) |  
|        |  |                                              |      |                                              |   |                     |  
|        |  | Worksite                                     |      | Senior                                       |   | Acquired            |   | Total |      | Worksite |   | Senior |   | Acquired |      | Total |   | Worksite |   | Senior |     | Acquired |   | Total |  
|        |  |                                              |      |                                              |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |  
|        |  |                                              |      |                                              |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |     |  |   |      |   |   |      |  
|Direct  |  |                                              |      |                                              |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |     |  |   |      |   |   |      |  
|New     |  | $                                            | 20.1 |                                              | $ | 0.1                 |   | $     |     |          | $ | 20.2   |   | $        | 11.7 |       | $ | 0.1      |   | $      |    |          | $ | 11.8  |   | $ | 8.4  |   | $ |    |  | $ |     |   | $ | 8.4  |  
|Renewal |  |                                              | 12.1 |                                              |   | 13.7                |   |       |     |          |   | 25.8   |   |          | 11.7 |       |   | 13.5     |   |        |    |          |   | 25.2  |   |   | 0.4  |   |   | 0.2 |  |   |     |   |   | 0.6  |  
|Total   |  |                                              | 32.2 |                                              |   | 13.8                |   |       |     |          |   | 46.0   |   |          | 23.4 |       |   | 13.6     |   |        |    |          |   | 37.0  |   |   | 8.8  |   |   | 0.2 |  |   |     |   |   | 9.0  |  
|Assumed |  |                                              |      |                                              |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |     |  |   |      |   |   |      |  
|New     |  |                                              | 0.1  |                                              |   |                    |   |       |     |          |   | 0.1    |   |          | 2.9  |       |   |         |   |        |    |          |   | 2.9   |   |   | (2.8 | ) |   |    |  |   |     |   |   | (2.8 | )
|Renewal |  |                                              | 0.5  |                                              |   |                    |   |       | 0.1  |          |   | 0.6    |   |          |     |       |   |         |   |        | 0.6 |          |   | 0.6   |   |   | 0.5  |   |   |    |  |   | (0.5 | ) |   |     |  
|Total   |  |                                              | 0.6  |                                              |   |                    |   |       | 0.1  |          |   | 0.7    |   |          | 2.9  |       |   |         |   |        | 0.6 |          |   | 3.5   |   |   | (2.3 | ) |   |    |  |   | (0.5 | ) |   | (2.8 | )
|Ceded   |  |                                              |      |                                              |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |     |  |   |      |   |   |      |  
|New     |  |                                              | (2.3 | )                                            |   |                    |   |       |     |          |   | (2.3   | ) |          | (2.3 | )     |   | (0.1     | ) |        |    |          |   | (2.4  | ) |   |     |   |   | 0.1 |  |   |     |   |   | 0.1  |  
|Renewal |  |                                              | (0.4 | )                                            |   | (3.5                | ) |       | (0.3 | )        |   | (4.2   | ) |          | (0.3 | )     |   | (3.6     | ) |        |    |          |   | (3.9  | ) |   | (0.1 | ) |   | 0.1 |  |   | (0.3 | ) |   | (0.3 | )
|Total   |  |                                              | (2.7 | )                                            |   | (3.5                | ) |       | (0.3 | )        |   | (6.5   | ) |          | (2.6 | )     |   | (3.7     | ) |        |    |          |   | (6.3  | ) |   | (0.1 | ) |   | 0.2 |  |   | (0.3 | ) |   | (0.2 | )
|Net     |  |                                              |      |                                              |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |     |  |   |      |   |   |      |  
|New     |  |                                              | 17.9 |                                              |   | 0.1                 |   |       |     |          |   | 18.0   |   |          | 12.3 |       |   |         |   |        |    |          |   | 12.3  |   |   | 5.6  |   |   | 0.1 |  |   |     |   |   | 5.7  |  
|Renewal |  |                                              | 12.2 |                                              |   | 10.2                |   |       | (0.2 | )        |   | 22.2   |   |          | 11.4 |       |   | 9.9      |   |        | 0.6 |          |   | 21.9  |   |   | 0.8  |   |   | 0.3 |  |   | (0.8 | ) |   | 0.3  |  
|Total   |  | $                                            | 30.1 |                                              | $ | 10.3                |   | $     | (0.2 | )        | $ | 40.2   |   | $        | 23.7 |       | $ | 9.9      |   | $      | 0.6 |          | $ | 34.2  |   | $ | 6.4  |   | $ | 0.4 |  | $ | (0.8 | ) | $ | 6.0  |  

Worksite
net new premiums increased $5.6 million, or 45.5%, to $17.9 million for the
three months ended September 30, 2007, from $12.3 million for the three months
ended September 30, 2006, due to increased sales volumes. The primary driver of
this increase was new stop loss premium generated by the new KMG America sales
force, which represents $13.6 million of direct new premiums, offset by $1.5
million of ceded new premiums. In order to address the imbalance in its
overall new sales mix, which has a disproportionate concentration of stop loss
business, the Company has restructured the sales incentive compensation plan
for its sales organization with increased incentives for sales of core group
life/disability and voluntary benefit products. Additionally, the Company is
limiting new sales of stop loss by means of pricing new business at a higher
expected profit margin and a requirement that sales of stop loss be packaged
with other products. Net renewal premiums increased $0.8 million or
7.0%, for the three months ended September 30, 2007, compared to the three
months ended September 30, 2006, as a result of the assumption of a block of
voluntary term life insurance and universal life insurance policies from
Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.

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Senior
market net new premiums, composed of long term care policies, increased to $0.1
million for the three months ended September 30, 2007, compared to $0.0 million
for the three months ended September 30, 2006. The Company ceased actively
underwriting new long term care policies after December 31, 2005.Net renewal premiums increased 3.0% to
$10.2 million, for the three months ended September 30, 2007, compared to the
three months ended September 30, 2006, representing premiums from the insurance
in force created by prior year sales.

Acquired
business premiums decreased $0.8 million, or 133.3%, to $(0.2) million for the
three months ended September 30, 2007, from $0.6 million for the three months
ended September 30, 2006. We have not acquired any blocks of business since
1999 and a significant portion of the decline is a result of policy lapses. In
the current quarter, an estimated refund due to our reinsurance carrier of $0.4
million was accrued in relation to possible adjustments needed for previously
settled billings. In addition, experience refunds are generated on certain
reinsurance treaties that reduce both premiums and policyholder benefits
equally. The experience refunds increased to $2.3 million for the three months
ended September 30, 2007, from $2.1 million for the three months ended
September 30, 2006.

Net Investment Income

Net
investment income increased $1.2 million, or 16.0%, to $8.7 million for the
three months ended September 30, 2007, from $7.5 million for the three months
ended September 30, 2006. Net investment income is primarily affected by
changes in levels of invested assets and interest rates. The increase in
investment income for the three months ended September 30, 2007, occurred
primarily as a result of an additional $35.0 million of cash and invested
assets generated through the issuance of junior subordinated debt, as described
in Note 8. Generally, an increase in invested assets is due to retention of
premiums to establish policy reserves for the payment of future policyholder
benefits.

Net
investment income is allocated to our various business segments on a pro rata
basis based on the invested assets attributed to the business segment. Assets
attributed to the senior market insurance segment continue to increase as a
result of policy reserve increases in this segment, while assets attributed to
the acquired segment continue to decline as this business lapses. There were no
other significant asset shifts in the business segments.

Commission and Fee Income

Commission
and fee income decreased $0.4 million, or 10.0%, to $3.6 million for the three
months ended September 30, 2007, from $4.0 million for the three months ended
September 30, 2006. Most of the commission and fee income was from
administrative fees relating to third-party administration, and the volume of
business in force has declined slightly compared to 2006 levels.

Realized Investment Gains and Losses

Realized
investment gains and losses occur as a result of the sale or impairment of
investments. The net realized investment gain for the three months ended
September 30, 2007 increased by $0.4 million to $0.4 million, from $0.0 million
for the three months ended September 30, 2006. The Company realized a $0.3
million gain in the third quarter of 2007 related to the sale of a minority interest
in an LLC, and the remaining increase is due primarily to marking to market
investments held in the Companys trading account. These investments represent
the assets purchased to support the deferred compensation liability of the
Company, and realized gains and/or losses are directly offset with increases
and/or decreases in compensation expenses. Realized investment gains and losses
are allocated entirely to the corporate and other business segment.

Other Income

Other
income decreased $0.2 million, or 15.4%, to $1.1 million for the three months
ended September 30, 2007, from $1.3 million for the three months ended
September 30, 2006, reflecting normal quarterly fluctuations.

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Benefits and Expenses

Total
benefits and expenses increased $10.3 million, or 23.5%, to $54.2 million for
the three months ended September 30, 2007, from $43.9 million for the three
months ended September 30, 2006. The primary factors causing this increase are
explained below under the captions Policyholder Benefits, Insurance
Commissions, General Insurance Expenses, Insurance Taxes, Licenses and
Fees, and Amortization of DAC and VOBA.

Policyholder Benefits

Policyholder
benefits increased $9.7 million, or 37.0%, to $35.9 million for the three
months ended September 30, 2007, from $26.2 million for the three months ended
September 30, 2006. This produced a benefits to premium ratio of 89.4% for the
three months ended September 30, 2007, compared to 76.5% for the three months
ended September 30, 2006.

Worksite
marketing policyholder benefits increased $8.1 million, or 47.6%, to $25.1
million for the three months ended September 30, 2007, from $17.0 million for
the three months ended September 30, 2006. This produced benefits to premium
ratios of 83.2% for the three months ended September 30, 2007, compared to
71.7% for the three months ended September 30, 2006.

The
Company began writing annually renewable stop loss business in mid-2005, and
initially relied on pricing assumptions, a common industry practice relative to
new books of stop loss business, to establish expected loss ratios due to lack
of credible actual claim experience. As a contrast, companies with mature books
of stop loss business typically establish claim reserves as a function of
experience studies of its business. Because actual claims on stop loss cases
typically are not fully reported until after the end of the policy period, it
is a common practice to increase or decrease claims reserves once the actual
claims experience becomes known. In the first quarter of 2007, as experience
emerged, the Company recognized additional claims and reserves reflecting the
adverse claims experience. The Company also decided to increase claims
assumptions on business prospectively, reflecting a more conservative estimate
of future claims on this business. The Companys experience has been that it
takes four quarters after a case has been written before a clear picture
becomes apparent regarding claims for that case. As a result of the new data
that became available in the first quarter of 2007, the Company concluded that
it would be prudent to increase the estimated loss ratios on newer cases for
claims before credible claims experience has developed on this business. As a
result of these first quarter 2007 actions, the Company believes its current
claim reserves on stop loss business adequately reflect both the development of
recent experience and the Companys more conservative outlook on loss
experience related to current premiums.

Senior
market policyholder benefits increased $2.6 million, or 35.1%, to $10.0 million
for the three months ended September 30, 2007, from $7.4 million for the three
months ended September 30, 2006. This produced benefits to premium ratios of
97.0% for the three months ended September 30, 2007, compared to 74.7% for the
three months ended September 30, 2006. The benefits to premium ratio increased
due to a larger than normal increase in open active claims during the current
quarter, which resulted in increases in actual claims paid and additional
claims reserves. Claims reserves must be established for the remaining future
benefits for open claims, and therefore are highly volatile from quarter to
quarter as new open claims are established and existing claims are closed.
Although the year to date increase in open claims has been modest, the increase
for the three months ending September 30, 2007 was fairly substantial when
compared to the three months ended September 30, 2006.

Acquired
business policyholder benefits decreased $0.9 million, to $0.8 million for the
three months ended September 30, 2007, from $1.7 million for the three months
ended September 30, 2006. Benefits to premium ratios do not provide meaningful
information in this segment without first adjusting for certain routine items
that have no impact on net income but have significant impact on the benefit
ratios. Experience refunds are generated on certain reinsurance treaties that
reduce both premiums and policyholder benefits equally. The experience refunds
increased to $2.3 million for the three months ended September 30, 2007, from
$2.1 million for the three months ended September 30, 2006. Also, in the third
quarter of 2007, an estimated refund due to our reinsurance carrier of $0.4
million was accrued in relation to possible adjustments needed for previously
settled billings. Excluding the effects of these items, the comparable benefit
ratios are 127.2% for the three months ended September 30, 2007 and 139.9% for
the three months ended September 30, 2006. These benefits to premium ratios are
affected by large portions of

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the acquired
business that are no longer premium paying with substantial reserves and
investment income on reserves. In the three months ended September 30, 2007,
paid claims were up $0.6 million, premiums were down $0.1 million, there was an
increase of $0.5 million in accident and health reserve increases, and there
was a release of redundant life reserves of $1.7 million, when compared to the
three months ended September 30, 2006.

Insurance Commissions

Commission
expenses increased $0.7 million, or 21.9%, to $3.9 million for the three months
ended September 30, 2007, from $3.2 million for the three months ended
September 30, 2006. This increase consists of normal increases related to
increased renewal premiums, in addition to an increase in first year
commissions that were not deferred, a large portion of which relates to the
increased sales of stop loss products.

General Insurance Expenses

General
insurance expenses decreased $0.4 million, or 3.7%, to $10.4 million for the
three months ended September 30, 2007, from $10.8 million for the three months
ended September 30, 2006. The decreased expenses for the three months ended
September 30, 2007 include some unusual items, primarily $1.1 million of costs
associated with our pending merger transaction that is offset by a $1.5 million
reduction in stock based compensation expense created by the voluntary
surrender of stock options held by the Companys executive officers in
September 2007. The $1.5 million reduction is represented by a credit of $1.2
million in the three months ended September 30, 2007 compared to an expense of
$0.3 million in the three months ended September 30, 2006.

Overhead
expenses that are not directly associated with a particular business segment
are allocated to the various business segments on a pro rata basis based on
different factors, such as headcount, policy count, number of policies issued,
premiums and other relevant factors.

Insurance Taxes, Licenses and Fees

Insurance
taxes, licenses and fees were flat at $1.3 million for the three months ended
September 30, 2007 and 2006, respectively.

Amortization of DAC and VOBA

First
year commissions and general insurance expenses associated with the acquisition
of new business are deferred and amortized over the premium-paying period of
the related policies. The total deferrals of policy acquisition costs were $4.6
million and $5.0 million for the three months ended September 30, 2007 and
2006, respectively. Deferrals can fluctuate on a quarterly basis, but will
generally increase over a period of time in a rising sales environment.

The
amortization of DAC and VOBA increased $0.3 million, or 17.6%, to $2.0 million
for the three months ended September 30, 2007, from $1.7 million for the three
months ended September 30, 2006. The DAC balance at September 30, 2007
increased by $14.6 million over the balance at September 30, 2006, which
accounted for a large part of the increase in amortization expense.

Provision for Income Taxes

Total
income taxes may differ from the amount computed by applying the federal
corporate tax rate of 35% due to tax-advantaged investments and net operating
loss carry forwards available. The effective income tax rates for the three
months ended September 30, 2007 and 2006 were (57.6) % and 35.0%, respectively.
The variation in these rates is due to a valuation allowance of $0.4 million
that was established during the current quarter.

Under SFAS No.
109, management must provide a valuation allowance for any deferred tax amounts
that it believes are uncertain to be realized. The decision by A.M. Best to
change the outlook of our rating from stable to negative, and the resulting
strategic options being considered, has created uncertainty about our ability
and timing to generate taxable income at the holding company. Because of this
uncertainty, the Company deemed it appropriate to establish

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a valuation
allowance of $0.4 million which represents the portion of the deferred tax
asset that was generated by net operating losses at the holding company during
the current quarter.

Liquidity and Capital Resources

KMG
America is a holding company and had minimal operations of its own prior to the
completion of its initial public offering and the Kanawha acquisition. KMG
Americas assets consist primarily of the capital stock of Kanawha and its
non-insurance subsidiary. Accordingly, KMG Americas cash flows depend upon the
availability of dividends and other statutorily permissible payments, such as
payments under tax allocation agreements and under management agreements, from
Kanawha. Kanawhas ability to pay dividends and to make other payments is
limited primarily by applicable laws and regulations of South Carolina, the
state in which Kanawha is domiciled, which subjects insurance operations to
significant regulatory restrictions. These laws and regulations require, among
other things, that Kanawha, KMG Americas insurance subsidiary, maintain
minimum solvency requirements and limit the amount of dividends it can pay to
the holding company. Solvency regulations, capital requirements, types of
insurance offered and rating agency status are some of the factors used in
determining the amount of capital available for dividends. In general, South
Carolina will permit annual dividends from insurance operations equal to the
greater of (1) the most recent calendar years statutory net income or (2) 10%
of total capital and surplus of the insurance operations at the end of the
previous calendar year, provided that the dividend payment does not exceed
earned surplus, in which case further limitations apply. While the South Carolina
Insurance Department acknowledges distinctions between ordinary and
extraordinary dividends, their approval is required before any dividend
payments can be made.

If
KMG America is able to successfully execute its business plan and accelerate Kanawhas
earnings growth in its insurance operations, KMG America expects that the
maximum allowable dividend from Kanawha to the holding company will increase at
an accelerated rate year-over-year. If the ability of Kanawha to pay dividends
or make other payments to KMG America is materially restricted by regulatory
requirements, it could adversely affect KMG Americas ability to pay any
dividends on its common stock and/or service its debt and pay its other
corporate expenses.

The
primary sources of funds for KMG Americas subsidiaries consist of insurance
premiums and other considerations, fees and commissions collected, proceeds
from the sales and maturity of investments and investment income. Cash is
primarily used to pay insurance claims, agent commissions, operating expenses,
product surrenders and withdrawals and taxes. KMG America generally invests its
subsidiaries excess funds in order to generate income. The primary use of
dividends and other distributions from subsidiaries to KMG America will be to
pay certain expenses of the holding company. We currently have no intention of
paying dividends to our shareholders and will reinvest cash flows from
operations into our businesses for the foreseeable future.

On
March 22, 2007, KMG America completed the issuance and sale in a private
placement of $35,000,000 in aggregate principal amount of trust preferred
securities (the Trust Preferred Securities) issued by the Companys
newly-formed subsidiary, KMG Capital Statutory Trust I, a Delaware statutory
trust (the Trust). The Trust Preferred Securities will mature on March 15,
2037, may be called at par by the Company any time after March 15, 2012, and
require quarterly distributions of interest by the Trust to the holder of the
Trust Preferred Securities. Distributions are payable quarterly at a fixed
interest rate equal to 8.02% per annum through March 15, 2012, and then will be
payable at a floating interest rate equal to the 3-month London Interbank
Offered Rate (LIBOR) plus 310 basis points per annum. The Trust
simultaneously issued one of the Trusts common securities (the Common
Securities) to the Company for a purchase price of $1,083,000, which
constitutes all of the issued and outstanding common securities of the Trust.

The
Trust used the proceeds from the sale of the Trust Preferred Securities
together with the proceeds from the sale of the Common Securities to purchase
$36,083,000 in aggregate principal amount of unsecured junior subordinated
deferrable interest debt securities due March 15, 2037, issued by the Company
(the Junior Subordinated Debt). The net proceeds to the Company from the sale
of the Junior Subordinated Debt to the Trust will be used by the Company for
general corporate purposes.

The
Junior Subordinated Debt was issued pursuant to an Indenture, dated March 22,
2007 (the Indenture), between the Company, as issuer, Wilmington Trust
Company, as trustee, and the administrators named

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therein. The
terms of the Junior Subordinated Debt are substantially the same as the terms
of the Trust Preferred Securities. The interest payments on the Junior
Subordinated Debt paid by the Company will be used by the Trust to pay the
quarterly distributions to the holders of the Trust Preferred Securities. The
Indenture permits the Company to redeem the Junior Subordinated Debt (and thus
a like amount of the Trust Preferred Securities) on or after March 15, 2012. If
the Company redeems any amount of the Junior Subordinated Debt, the Trust must
redeem a like amount of the Trust Preferred Securities.

On
December 21, 2006, the Company entered into a credit agreement with Wachovia,
which provides a $15.0 million unsecured revolving credit facility from which
we borrowed $14.0 million to repay the five-year subordinated promissory note
that was issued to fund a portion of the purchase price for the Kanawha
acquisition. The remaining $1.0 million available under the credit facility may
be used to finance the Companys working capital, liquidity needs and general
working requirements and those of its subsidiaries. Amounts outstanding under
the credit agreement will bear interest at a rate calculated according to, at
the Companys option, a base rate or the LIBOR rate plus an applicable
percentage. The applicable percentage is based on the A.M. Best financial
strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans
and from 1.25% to 1.35% for LIBOR rate loans. In the case of LIBOR rate loans,
interest on amounts outstanding is payable at the end of the interest period,
which can be one, two, three or six months, as selected by the Company in its
notice of borrowing. Wachovias obligation to fund the credit agreement
terminates, and all principal outstanding under the credit agreement is due and
payable, no later than December 31, 2007. As of September 30, 2007, the $14.0
million outstanding under the credit agreement was a LIBOR rate plus applicable
percentage loan with an interest rate of 6.76%. Pursuant to the terms of the
Merger Agreement, the Company agreed that, between September 7, 2007, and the
Effective Time of the Merger, subject to certain exceptions or unless otherwise
agreed to by Humana, it would not repay or retire any indebtedness for borrowed
money except as required by the terms of such indebtedness. The Company also
agreed not to incur or assume any indebtedness for borrowed money not currently
outstanding (except to maintain the A.M. Best capital adequacy ratio of Kanawha
at 130%) or to assume or otherwise become liable or responsible for the
obligations of any person or to create, assume or incur any material lien or
otherwise encumber any capital stock or other equity securities of the Company
or its subsidiaries, except with the prior written consent of Humana.

The
credit agreement requires the Company to comply with certain covenants,
including, among others, maintaining a maximum ratio of consolidated
indebtedness to total capitalization, a minimum available dividend amount for
Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha.
The Company must also comply with limitations on certain payments, additional
debt obligations, dispositions of assets and its lines of business. The credit
agreement also restricts the Company from creating or allowing certain liens on
its assets and from making certain investments.

If
the Company is unable to complete the Merger, the Company will need to either
extend the credit agreement with Wachovia or seek other forms of additional
financing. While we expect to be able to extend the credit facility with
Wachovia, there can be no assurance that we will be able to do so or to obtain
financing from any other source on terms acceptable to the Company. If we are
unable to extend the Wachovia credit agreement or obtain financing from other
sources, this could have a material adverse effect on our liquidity, operating
performance and financial condition.

While
our primary focus is organic growth of our existing businesses by expanding our
product and marketing capabilities, we do evaluate opportunities to grow
through strategic alliances and acquisitions of blocks of business and/or
companies that are compatible with our core businesses. If such opportunities
arise we may make significant capital expenditures or acquisitions in 2007 or
subsequent years. However, our primary focus is on significantly expanding
outlays relating to marketing and sales activities over the next several years
including outlays required to continue to build a national sales organization,
which is a key component of our strategy. These outlays will include expenses
such as salaries and cash incentive compensation, employee benefits, occupancy
and information technology expenses of additional sales personnel, advertising
and marketing costs, consulting and recruiting. The execution of our business
plan will require additional outlays associated with the development of a
national insurance company including home office expenses for executive
management and additional financial, actuarial and underwriting personnel,
infrastructure development and back-office expenses, as well as costs
associated with our being a public company.

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We
anticipate that these costs will be offset over time by increased sales
production resulting from hiring additional sales personnel and increased
cross-selling, as well as efficiencies resulting from greater scale.

On
September 7, 2007, the Company and Humana entered into the Merger Agreement, by
and among the Company, Humana and Merger Sub, a wholly-owned subsidiary of
Humana. Under the Merger Agreement, Merger Sub will merge with and into the
Company, with the Company continuing after the Merger as the surviving
corporation and a wholly-owned subsidiary of Humana. At the effective time of
the Merger, each outstanding share of Company common stock will be converted
into the right to receive $6.20 in cash, without interest.

The
Merger was unanimously approved by the boards of directors of the Company and
Humana. The Merger is subject to customary closing conditions, including the
approval by the Companys shareholders and the receipt of governmental and
regulatory approvals, including the approval of the South Carolina Department
of Insurance. On October 5, 2007, the Federal Trade Commission and the
Antitrust Division of the U.S. Department of Justice granted early termination
of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of
1976, as amended, in connection with the Merger. The Company has scheduled
November 16, 2007, as the date of the special meeting of shareholders to vote
on the Merger, and the close of business on October 12, 2007, has been set as
the record date for the meeting. Shareholders of record as of the close of
business on the record date will be entitled to vote at the meeting. The
closing of the Merger is expected to occur late in the fourth quarter of 2007,
possibly as early as November 30, 2007. There can be no assurance that the
Merger Agreement and the Merger will be approved by the Companys shareholders,
and there can be no assurance that the other conditions to the completion of
the proposed merger will be satisfied. If the proposed merger is not completed,
there can be no assurance that a comparable transaction could be achieved.

Analysis
of Change in Financial Condition and Cash Flows

The
nature of the life insurance business is that premiums are collected and
invested and will be used for the payment of claims when they arise, and policy
reserve liabilities are established in anticipation of these future claims. As
a result, the change in financial condition directly corresponds to the cash
flows and they are discussed here in tandem.

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

The table
below shows the Companys net cash flows in the indicated periods:

|                               |  |                                        |                         |                                        |   |           |  
|------------------------------ |  | -------------------------------------- | ----------------------- | -------------------------------------- | - | --------- | -
|Net cash provided by (used in) |  | Nine Months
 Ended
 September 30, 2007 |                         | Nine Months
 Ended
 September 30, 2006 |  
|                               |  |                                        |                         |                                        |  
|                               |  |                                        | (dollars
 in thousands) |                                       
|Operating
 activities          |  | $                                      | 13,765.5                |                                        | $ | 10,174.2  |  
|Investing
 activities          |  |                                        | (49,997.0               | )                                      |   | (31,486.4 | )
|Financing
 activities          |  |                                        | 36,083.0                |                                        |   |          |  
|                               |  |                                        |                         |                                        |   |           |  
|Net change
 in cash            |  | $                                      | (148.5                  | )                                      | $ | (21,312.2 | )
|                               |  |                                        |                         |                                        |   |           |  

Cash
Flows for the Nine Months Ended September 30, 2007 and 2006.In
the table shown above, increases in net cash provided by operating activities
generally result from collected premiums while decreases in net cash flow
provided by investing activities generally are a result of the investment of
collected premiums. Policy and contract liabilities increase when premiums
collected are retained to establish policy reserves. The portions of these
liabilities that are reinsured by reinsurance companies are reflected in
reinsurance balances recoverable.

As
a function of our third party administration business, we manage insurance
funds for our clients. These funds are held in suspense accounts pending
appropriate disposition, and the balances held in suspense vary on a day-to-day
basis as insurance funds are received and applied by us.

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Other
changes in cash flows for the nine months ended September 30, 2007 and
September 30, 2006, are as follows:

We
held approximately $21.7 million in cash and cash equivalents at December 31,
2006, primarily consisting of investments in short term commercial paper. We
also had $36.1 million net cash provided from financing activities as the
result of the issuance of subordinated debt securities discussed previously in
the Liquidity and Capital Resources section. We invested a significant portion
of these funds in longer term securities, resulting in the net cash outflow
from investing activities of $50.0 million for the nine months ended September
30, 2007. This produced a corresponding increase in invested assets.

Other
assets increased by $0.5 million in the nine months ended September 30, 2007
compared to an increase of $2.3 million in the nine months ended September 30,
2006. These variances occurred primarily as a result of fluctuations in claims
reimbursements due from self funded Administrative Services Only (ASO)
clients. These claims are not actually disbursed until receipt of these funds,
so there is nothing at risk with these assets, and fluctuations from day to day
are typical. In addition, there was a receivable for securities awaiting
settlement of $0.7 million at September 30, 2007.

Accounts
payable and accrued expenses increased $5.2 million in the nine months ended
September 30, 2007, compared to an increase of $2.2 million in the nine months
ended September 30, 2006. The increase in 2006 and $2.4 million of the increase
in 2007 is due to fluctuations in our reinsurance settlements payable. In
addition, there was a payable for securities awaiting settlement of $2.0
million at September 30, 2007.

Federal
income tax recoverable decreased by $0.4 million from the December 31, 2006
balance, while the deferred tax asset decreased by $6.3 million, the federal
income taxes payable decreased by $0.3 million, and the deferred tax liability
decreased by $4.2 million. The combination of these items resulted in a net
decrease in tax assets of $2.2 million, inclusive of an increase of $3.4
million related to the change in fair market value of invested assets.
Exclusive of the change relating to the increase in fair market value, the net
deferred tax asset decreased by $5.6 million, which consists of tax payments
made in the current year and tax credits on current year losses offset by the
$7.6 valuation allowance discussed in the provision for income taxes section of
this document.

Investments

The
following table summarizes the unrealized gains and losses in our investment
portfolio as of September 30, 2007.

|                                                      |  |                 |             |                          |   |                           |  |             |            |  |   |             | 
|----------------------------------------------------- |  | --------------- | ----------- | ------------------------ | - | ------------------------- |  | ----------- | ---------- |  | - | ----------- | 
|                                                      |  | Amortized
 Cost |             | Gross
 Unrealized
 Gains |   | Gross
 Unrealized
 Losses |  | Fair
 Value |           
|                                                      |  |                 |             |                          |   |                           |  |             |           
|Available for sale securities at September
 30, 2007: |  |                 |             |                          |   |                           |  |             |            |  |   |             | 
|U.S. Treasuries                                       |  | $               | 7,573,501   |                          | $ | 10,285                    |  | $           | 54,117     |  | $ | 7,529,669   | 
|U.S. Government Agencies                              |  |                 | 19,392,517  |                          |   | 63,937                    |  |             | 110,550    |  |   | 19,345,904  | 
|States and Political Subdivisions                     |  |                 | 15,162,172  |                          |   | 77,602                    |  |             | 332,212    |  |   | 14,907,562  | 
|Foreign Bonds                                         |  |                 | 40,354,195  |                          |   | 194,199                   |  |             | 1,566,908  |  |   | 38,981,486  | 
|Corporate Bonds                                       |  |                 | 244,817,107 |                          |   | 581,675                   |  |             | 12,495,531 |  |   | 232,903,251 | 
|Mortgage/Asset-Backed Securities                      |  |                 | 222,626,280 |                          |   | 373,337                   |  |             | 5,584,116  |  |   | 217,415,501 | 
|Preferred StocksRedeemable                           |  |                 | 29,359,398  |                          |   | 14,402                    |  |             | 1,708,596  |  |   | 27,665,204  | 
|                                                      |  |                 |             |                          |   |                           |  |             |            |  |   |             | 
|Subtotal, Fixed Maturity Securities                   |  | $               | 579,285,170 |                          | $ | 1,315,437                 |  | $           | 21,852,030 |  | $ | 558,748,577 | 
|Equity Securities                                     |  |                 | 10,000      |                          |   |                          |  |             | 3,300      |  |   | 6,700       | 
|                                                      |  |                 |             |                          |   |                           |  |             |            |  |   |             | 
|Securities Available For Sale                         |  | $               | 579,295,170 |                          | $ | 1,315,437                 |  | $           | 21,855,330 |  | $ | 558,755,277 | 
|                                                      |  |                 |             |                          |   |                           |  |             |            |  |   |             | 

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We
regularly monitor our investment portfolio to ensure that investments that may
be other than temporarily impaired are identified in a timely fashion and
properly valued and that any impairment is charged against earnings in the
proper period. Our investment portfolio is managed by external asset management
firms, with the exception of certain invested assets that are managed
internally. Our methodology used to identify potential impairments requires
judgment by us in conjunction with our investment managers.

Changes
in individual security values are monitored on a monthly basis in order to
identify potential problem credits. In addition, pursuant to our impairment
testing process, each month the portfolio holdings are reviewed with additional
screening for securities whose market price is equal to 80% or less of their
original purchase price. Management then makes an assessment as to which, if
any, of these securities is other than temporarily impaired. Assessment factors
include, but are not limited to, the financial condition and rating of the
issuer, any collateral held and the length of time the market value of the
security has been below cost. Each month the watch list is distributed to our
investment committee and the outside investment managers, and discussions are
held as needed in order to make any impairment decisions. Each quarter any
security deemed to have been other than temporarily impaired is written down to
its then current market value, with the amount of the write-down reflected in the
statement of income for that quarter. Previously impaired issues are also
monitored monthly, with additional write-downs taken quarterly if necessary.

The
substantial majority of our unrealized losses at September 30, 2007, can be
attributed to increases in interest rates that caused the value of the fixed
income securities in our investment portfolio to decrease.

|                                              |  |                        |     |                              |   |                                |  |   |           | 
|--------------------------------------------- |  | ---------------------- | --- | ---------------------------- | - | ------------------------------ |  | - | --------- | 
|                                              |  | Number of
 Issues      |     | Aggregate
 Unrealized 
 Loss |   | Aggregate Estimated Fair Value | 
|                                              |  |                        |     |                              |  
|                                              |  | (dollars in thousands) |    
|Securities
 at a loss for 12 months or less   |  |                        | 205 |                              | $ | 9,560.5                        |  | $ | 210,344.8 | 
|Securities
 at a loss for more than 12 months |  |                        | 323 |                              | $ | 12,294.8                       |  | $ | 265,078.1 | 

Management
has reviewed these securities which either have been in an unrealized loss
position for more than twelve months or have significant unrealized loss
relative to cost and have concluded that these securities have not experienced
any other than temporary impairment. Factors considered in making this
evaluation included issue specific drivers of the decrease in price, near term
prospects of the issuer, the length of time and degree of volatility of the
depressed value, and the financial condition of the industry. Based on this
review, no unrealized losses were considered to be other than temporary during
the nine months ended September 30, 2007.

As
a result of purchase accounting adjustments as required in connection with our
acquisition of Kanawha as of December 31, 2004, the mark to market adjustments
to the investment portfolio occurred at a time when very low market interest
rates prevailed. Therefore, as interest rates rise, we would expect substantial
unrealized investment losses. Due to the long range nature of our liabilities,
the majority of these interest related unrealized losses are not expected to
materialize into realized losses, and therefore should not have an adverse
effect on our operations.

As
of September 30, 2007, the Company held investments in mortgage-backed
securities collateralized by subprime mortgages with a carrying value of $4.5
million, representing approximately 0.7% of the Companys cash and invested
assets. These securities have an average S&P rating of AA.

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Reserves

The
following table presents insurance policy benefit and contract-related
liabilities information as of the dates indicated, by reserve type:

|                                |  |                           |           |                          |   |           | 
|------------------------------- |  | ------------------------- | --------- | ------------------------ | - | --------- | 
|                                |  | As of
 September 30, 2007 |           | As of
 December 31, 2006 |  
|                                |  |                           |           |                          |  
|                                |  | (dollars in thousands)    |          
|Life and
 annuity reserves      |  | $                         | 246,257.9 |                          | $ | 252,658.2 | 
|Accident and
 health reserves   |  |                           | 320,495.6 |                          |   | 294,581.0 | 
|Policy and
 contract claims     |  |                           | 22,077.1  |                          |   | 14,530.8  | 
|Other
 policyholder liabilities |  |                           | 10,673.5  |                          |   | 10,594.2  | 
|                                |  |                           |           |                          |   |           | 
|Total policy
 liabilities       |  | $                         | 599,504.1 |                          | $ | 572,364.2 | 
|                                |  |                           |           |                          |   |           | 

Life
and annuity reserves decreased by $6.4 million, or 2.5%, to $246.3 million as
of September 30, 2007, from $252.7 million as of December 31, 2006. A large
portion of the life and annuity reserves relates to acquired blocks of business
that are lapsing at a steady pace because no new blocks of business have been
acquired since 1999, and therefore represents a significant portion of the
decrease in reserves for the nine months ended September 30, 2007. Accident and
health reserves increased by $25.9 million, or 8.8%, to $320.5 million as of
September 30, 2007 from $294.6 million as of December 31, 2006. These reserve
increases are consistent with growth in the underlying business, with the
majority of the reserve growth being accumulated from long-term care renewal
premiums received. Policy and contract claims, which represent liabilities for
actual claims incurred, increased by $7.6 million, or 52.4%, to $22.1 million
as of September 30, 2007 from $14.5 million as of December 31, 2006. This
primarily represents the significant increase in new premiums in the stop loss
book of business, combined with higher anticipated claims described below.

After
a comprehensive review of its stop loss book of business, the Company
recognized a $6 million charge in the first quarter of 2007 for increased
claims and reserves that reflects recent experience on stop loss cases. The
Company began writing annually renewable stop loss insurance in mid-2005, and
initially relied on pricing assumptions, a common industry practice relative to
new books of stop loss business, to establish expected loss ratios due to a
lack of credible actual claim experience. As a contrast, companies with mature
books of stop loss business typically establish claim reserves as a function of
experience studies of its business. Because actual claims on stop loss cases
typically are not fully reported until after the end of the policy period, it
is a common practice to increase or decrease claims reserves once the actual
claims experience becomes known.

As
experience emerged, the Company recognized additional claims and reserves
reflecting the recent adverse claims experience. The Company also decided to
increase claims assumptions on business prospectively, reflecting a more
conservative estimate of future claims on this business. The Companys
experience has been that it takes four quarters after a case has been written
before a clear picture becomes apparent regarding claims for that case. While
some of the unfavorable claims data began to emerge late in the fourth quarter
of 2006 and guided our reserving at year-end, new more meaningful data came to
the Companys attention late in the first quarter of this year after the
year-end books were closed and earnings reported. As a result of the new data that
became available in the first quarter of 2007, the Company concluded that it
would be prudent to increase the estimated loss ratios on newer cases for
claims before credible claims experience has developed on this business. As a
result of these first quarter 2007 actions, the Company believes its current
claim reserves on stop loss business adequately reflect both the development of
recent experience and the Companys more conservative outlook on loss
experience related to current premiums.

Other
policyholder liabilities, which are comprised primarily of dividend
accumulations and advance premiums, increased by $0.1 million, or 0.9%, to
$10.7 million as of September 30, 2007 from $10.6 million as of December 31,
2006.

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The
following table sets forth reinsurance recoverables by category as of the dated
indicated:

|                                                |  |                           |          |                          |   |          | 
|----------------------------------------------- |  | ------------------------- | -------- | ------------------------ | - | -------- | 
|                                                |  | As of
 September 30, 2007 |          | As of
 December 31, 2006 |  
|                                                |  |                           |          |                          |  
|                                                |  | (dollars in thousands)    |         
|Ceded future
 policyholder benefits and expense |  | $                         | 89,713.0 |                          | $ | 86,296.1 | 
|Ceded claims
 and benefits payable              |  |                           | 2,877.4  |                          |   | 2,795.1  | 
|                                                |  |                           |          |                          |   |          | 
|Reinsurance
 recoverables                       |  | $                         | 92,590.4 |                          | $ | 89,091.2 | 
|                                                |  |                           |          |                          |   |          | 

Reinsurance
recoverables increased by $3.5 million, or 3.9%, to $92.6 million as of
September 30, 2007, from $89.1 million as of December 31, 2006. The increase in
the recoverable balance is attributable to underlying business growth,
specifically the growth in long-term care and excess risk business reinsured.

Critical Accounting Policies and
Estimates

Our
consolidated financial statements and certain disclosures made in this report
have been prepared in accordance with GAAP and require us to make estimates and
assumptions that affect reporting amounts of assets and liabilities and
contingent assets and contingent liabilities at the dates of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. The estimates most susceptible to material changes due to
significant judgment (identified as the critical accounting policies) are
those used in determining investment impairments, the reserves for future
policy benefits and claims, deferred acquisition costs and value of business
acquired, and the provision for income taxes. The results of these estimates are
critical because they affect our profitability and may affect key indicators
used to measure our performance. These estimates have a material effect on our
results of operations and financial condition.

We
consider the following accounting policies to be critical due to the amount of
judgment and uncertainty inherent in the application of these policies. In
calculating financial statement estimates, the use of different assumptions
could produce materially different estimates. In addition, if factors such as
those described in Item 1A of this report cause actual events to differ from
the assumptions used in applying the accounting policies and calculating
financial estimates, our business, results of operations, financial condition
and liquidity could be materially adversely affected.

Reserves.
Policy benefit reserves and other claim reserves are established according to
generally accepted actuarial principles and are based on a number of factors.
Policy benefit reserves are estimated and include assumptions made when the
policy is issued as to the expected investment yield, inflation, mortality,
morbidity, claim termination rates, awards for social security and withdrawal
rates, as well as other assumptions that are based on our experience. These
assumptions reflect anticipated trends and include provisions for possible
unfavorable deviations. Throughout the life of the policy, reserves are based
on these original assumptions and cannot be modified pursuant to GAAP unless
policy reserves prove inadequate. Claim reserves are based on factors that
include historical claim payments experience and actuarial assumptions used to
estimate expected future claims experience. These assumptions and other factors
include trends in claims severity, frequency and other factors discussed below,
the incidence of incurred claims, the extent to which all claims have been
reported and internal claims processing changes. The methods of making these
estimates and establishing the related reserves are periodically reviewed and
updated. Since claim reserve estimates are refined as experience develops, they
are subject to some variability of assumptions. Relative to policy benefit
reserves, claim reserves represent a small part of the Companys overall
reserve liabilities. Claim reserves were 2.5% of the total reserve liability at
December 31, 2006.

Policy
benefit and claim reserves do not represent an exact calculation of our
ultimate liability, but instead represent our probability-based estimate of what
we expect the ultimate settlement and administration of a claim or group of
claims will cost based on our assessment of facts and circumstances then known.
Policy benefit reserves represent reserves established for claims not yet
incurred. Claim reserves represent liabilities established for claims that have
been incurred and have future benefits to be paid as of the balance sheet date.
The adequacy of reserves will be impacted by future trends in claims severity,
frequency and other factors including:

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| |   |                                                                                                        
| | - | -------------------------------------------------------------------------------------------------------
| |  | changes in
 the economic cycle;                                                                        
| |   |                                                                                                        
| |  | the level of
 market interest rates and inflation;                                                     
| |   |                                                                                                        
| |  | emerging
 medical perceptions regarding physiological or psychological causes of
 disability;          
| |   |                                                                                                        
| |  | emerging
 health issues and new methods of treatment or accommodation;                                 
| |   |                                                                                                        
| |  | legislative
 changes and changes in taxation;                                                          
| |   |                                                                                                        
| |  | inherent
 claims volatility in a new book of business, such as our employer excess risk
 insurance; and
| |   |                                                                                                        
| |  | claims
 handling procedures.                                                                           

Many
of these items are not directly quantifiable, particularly on a prospective
basis. Claims reserve estimates are refined as experience develops. Adjustments
to reserves, both positive and negative, are reflected in the consolidated
statements of operations of the period in which such estimates are updated.
Because establishment of reserves is an inherently uncertain process involving
estimates of future losses, there can be no certainty that ultimate losses will
not exceed existing reserves. Future loss development could require reserves to
be increased, which could have a material adverse effect on earnings in the
periods in which such increases are made.

Particularly
with respect to new lines of business, there is some inherent uncertainty as to
how claims experience will emerge so, initially before actual claim experience
develops, we must rely more heavily on estimates in setting the claim reserves.
The line of business which is exposed to the greatest degree of uncertainty
relative to those estimates is the annually renewable stop loss business which
we began issuing in mid-2005. Claim reserves for this line of business
represent a short-term liability but are subject to greater variability than
other lines of business. Initially, we relied on pricing assumptions, a
common industry practice relative to new books of stop loss business, to
establish expected loss ratios on which our claim reserves were based.

The
Company uses actual claims data as it emerges, to re-evaluate the expected loss
ratios used to determine future claim liabilities relative to in force business
and, if necessary, would modify the estimated loss ratios on new cases as well.
To the extent that emerging experience varies from the loss ratio assumptions,
the claim reserves could be increased or decreased which could have a material
effect on earnings in the periods in which such increases or decreases are
made.

Reserving
Methodology. Policy benefit reserves for life insurance, long-term care
insurance, individual and group accident and health insurance, disability
insurance and group life and health insurance are recorded at the present value
of future benefits to be paid to policyholders less the present value of the
future net premiums (this method is called the net level premium method).
These amounts are estimated and include assumptions made when the policy is
issued as to the expected investment yield, inflation, mortality, morbidity,
claim termination rates, awards for social security and withdrawal rates, as
well as other assumptions that are based on our experience. These assumptions
reflect anticipated trends and include provisions for possible unfavorable
deviations. Throughout the life of the policy, reserves are based on these
original assumptions and cannot be modified pursuant to GAAP unless policy
reserves prove inadequate. We also record an unearned premium reserve which
represents the portion of premiums collected or due and unpaid which is
intended to pay for insurance coverage in a period after the current accounting
period.

Loss
recognition testing of our policy benefit reserves is performed annually. This
testing involves a comparison of our actual net liability position (all
liabilities less DAC and VOBA) to the present value of future net cash flows
calculated using then-current assumptions. These assumptions are based on our
best estimate of future experience. To the extent a premium deficiency exists,
it would be recognized immediately by a charge to the statement of operations
and a corresponding reduction in DAC or VOBA. Any additional deficiency would
be recognized as a premium deficiency reserve. Historically, loss recognition
testing has not resulted in an adjustment to DAC or reserves. These adjustments
would occur only if economic, mortality and/or morbidity conditions
significantly deviated from the underlying assumptions.

In
accordance with GAAP purchase accounting requirements, our predecessors policy
and contract reserves were recorded at fair value upon the closing of the Kanawha
acquisition. The policy and contract reserves were calculated as the present
value of future benefits and expenses less the present value of future net
premiums. These values were actuarially determined and were based upon assumed
future interest rates, administrative

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expenses,
mortality, morbidity and policy lapse rates as appropriate for the particular
benefit on the purchase date. For long-term care insurance, assumptions for the
present value of net premiums in the fair value calculation are consistent with
current and anticipated premium increases, including those approved in the last
twelve to eighteen months in certain jurisdictions for policies currently in
force. These assumptions now serve as the original assumptions described in the
first paragraph above under the caption Reserving Methodology.

Reserve
interest assumptions (i.e., discount rates) used by us in establishing our
current policy benefit reserves were modified on the purchase date. The
valuation interest rate is determined by taking into consideration actual and
expected earned rates on our asset portfolio. Benefit reserves for limited
payment policies take into account, where necessary, any deferred profits to be
recognized in income over the policy term. Policy benefit claims are charged to
expense in the period that the claims are incurred.

The
discount rate is the interest rate at which future net cash flows are
discounted to determine the present value of such cash flows. If the discount
rate chosen is higher than actual future investment returns, our investment
returns will be insufficient to support the interest rate assumed when reserves
were established. In this case, the reserves may eventually be insufficient to
support future benefit payments. Alternatively, if a discount rate is chosen
that is lower than actual future investment results, the reserves, and, for
products such as long-term care insurance, the claims incurred in the current
period will be overstated and profits will be accumulated in the reserves
rather than reported as current earnings. We set our discount rate assumptions
in conjunction with the current and expected future investment income rate of
the assets supporting the reserves. If the investment yield at which new
investments are purchased is below or above the investment yield of the
existing investment portfolio, it is likely that the discount rate chosen at
future financial reporting dates will vary accordingly.

Deferred
Acquisition Costs. The costs of acquiring new business that vary with and are
primarily related to the production of new business have been deferred to the
extent that these costs are deemed recoverable from future premiums or gross
profits and are amortized into income as discussed below. Acquisition costs
primarily consist of commissions, policy issuance expenses and some direct
marketing expenses.

For
most insurance products, amortization of DAC is recognized in proportion to the
ratio of annual premium revenue to the total anticipated premium revenue, which
gives effect to expected terminations. DAC is amortized over the premium-paying
period of the related policies. Anticipated premium revenue is determined using
assumptions consistent with those utilized in the determination of liabilities
for insurance reserves, and as such can not be subsequently modified once
established. Absent a premium deficiency, as described in the following
paragraph, variability in amortization after policy issuance is caused only by
variability in persistency (which is the annual rate at which policies remain
in effect or in force). If actual persistency is higher than assumed, then
actual amortization will be slower. In this event, premiums, claims and policy
reserves would also be higher, which when netted together would generally
increase operating profits. Conversely, if actual persistency is lower than
assumed, then actual amortization will be faster. In this event, premiums,
claims and policy reserves would also be lower, which when netted together would
generally decrease operating profits. The Company is unable to predict the
movement or impact of these offsetting items over time.

A
premium deficiency is recognized immediately by a charge to the statement of
operations as a reduction of DAC to the extent that future policy premiums,
including anticipated interest income, are not adequate to recover all DAC and
related claims, benefits and expenses. If the premium deficiency is greater
than unamortized DAC, a liability will be accrued for the excess deficiency.
The Company has never had a premium deficiency.

We
eliminated all of our predecessors DAC upon the closing of the Kanawha
acquisition as part of the application of GAAP purchase accounting
requirements. We began recording DAC prospectively on January 1, 2005.

Value
of Business Acquired. VOBA is the value assigned to the insurance in force of
acquired insurance companies or blocks of business at the date of acquisition.
The amortization of VOBA is recognized using amortization schedules established
at the time of the acquisitions based upon expected patterns of premiums,
mortality, policy lapses, and morbidity as adjusted to take into account
variances between expected and actual costs. VOBA is amortized over the expected
life of the underlying business reinsured (or acquired).

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We
eliminated all of our predecessors historical VOBA upon the closing of the
Kanawha acquisition as part of our application of GAAP purchase accounting
requirements. We simultaneously re-established VOBA for the value of our
predecessors in force business. VOBA interest rate assumptions to amortize the
VOBA were also reset upon the closing of the Kanawha acquisition and the rate
was approximately 6.0% on both December 31, 2005 and December 31, 2006.

Under
our assumptions as of December 31, 2006, we estimate that the amortization of
VOBA, for the next five years will be as follows:

|                        |  |              |   | 
|----------------------- |  | ------------ | - | 
|Year Ended December 31: |  | Amortization |  
|2007                    |  | 4.96         | % | 
|2008                    |  | 4.93         |   | 
|2009                    |  | 5.24         |   | 
|2010                    |  | 5.23         |   | 
|2011                    |  | 5.14         |   | 

Absent
a premium deficiency, variability in amortization after policy acquisition is
caused only by variability in persistency. If actual persistency is higher than
assumed, then actual amortization will be slower. In this event, premiums,
claims and policy reserves would also be higher, which when netted together
would generally increase operating profits. Conversely, if actual persistency
is lower than assumed, then actual amortization will be faster. In this event,
premiums, claims and policy reserves would also be lower, which when netted
together would generally decrease operating profits. The Company is unable to
predict the movement or impact of these offsetting items over time.

A
premium deficiency is recognized immediately by a charge to the statement of
operations as a reduction of VOBA to the extent that future policy premiums,
including anticipated interest income, are not adequate to recover all VOBA and
related claims, benefits and expenses. If the premium deficiency is greater
than unamortized VOBA, a liability will be accrued for the excess deficiency.
The Company has never had a premium deficiency.

Investments.
We regularly monitor our investment portfolio to ensure that investments that may
be other than temporarily impaired are identified in a timely fashion and
properly valued and that any impairment is charged against earnings in the
proper period. Our investment portfolio is managed by an external asset
management firm, with the exception of certain invested assets that are managed
internally. Our methodology used to identify potential impairments requires
judgment by us in conjunction with our investment managers.

Changes
in individual security values are monitored on a monthly basis in order to
identify potential problem credits. In addition, pursuant to our impairment
testing process, each month the portfolio holdings are reviewed with additional
screening for securities whose market price is equal to 80% or less of their original
purchase price. Management then makes an assessment as to which of these
securities are other than temporarily impaired. Assessment factors include, but
are not limited to, the financial condition and rating of the issuer, any
collateral held and the length of time the market value of the security has
been below cost. Each month the watch list is distributed to our investment
committee and the outside investment managers, and discussions are held as
needed in order to make any impairment decisions. Each quarter any security
deemed to have been other than temporarily impaired is written down to its then
current market value, with the amount of the write-down reflected in the
statement of operations for that quarter. Previously impaired issues are also
monitored monthly, with additional write-downs taken quarterly if necessary.

There
are risks and uncertainties involved in making these judgments. Changes in
circumstances and critical factors such as a continued weak economy, a
pronounced economic downturn or unforeseen events which affect one or more
companies, industry sectors or countries could result in additional write-downs
in future periods for impairments that are deemed to be other-than-temporary.

Effective
December 31, 2004, our investments were recorded at fair value, thereby
eliminating all unrealized gains and losses, as part of the application of GAAP
purchase accounting requirements. Since that time, the Company has recognized
impairment charges of $0.0 million and $0.2 million in 2006 and 2005,
respectively.

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

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

Under
indemnity reinsurance transactions in which we are the ceding insurer, we
remain liable for policy claims if the assuming company fails to meet its
obligations. In the event one or more assuming companies were to default on its
obligations, it could have an adverse effect on our business, results of
operations and financial condition. To limit this risk, we have implemented
procedures to evaluate the financial condition of reinsurers and to monitor the
concentration of credit risk to minimize this exposure. In some cases, the
reinsurers have placed amounts in trust that would be the equivalent of the
recoverable amount and for which we are the beneficiary. The selection of
reinsurance companies is based on criteria related to solvency and reliability
and, to a lesser degree, diversification. An estimated allowance for doubtful
accounts is recorded on the basis of periodic evaluations of balances due from
reinsurers, reinsurer solvency, management experience and current economic
conditions. As of December 31, 2006, 2005 and 2004, there were no allowances
for doubtful accounts. The Company has never written off any amounts due to
unrecoverable reinsurance.

Forward-Looking
Statements

Forward-looking
statements in the foregoing Managements Discussion and Analysis of Financial
Condition and Results of Operations include statements that are identified by
the use of words or phrases including, but not limited to, the following: will
likely result, expected to, will continue, is anticipated, estimated,
project, believe, expect and words or phrases of similar import. Changes
in the following important factors, among others, could cause our actual
results to differ materially from those expressed in any such forward-looking
statements: competitive products and pricing; fluctuations in demand; possible
recessionary trends in the United States economy; governmental policies and
regulations; interest rates; our shareholders may not approve and adopt the
proposed Merger agreement with Humana; the parties to the Merger may be unable
to obtain governmental and regulatory approvals required for the Merger;
required governmental or regulatory approvals may delay the Merger or result in
the imposition of conditions that could cause the parties to abandon the
Merger; the parties may be unable to complete the Merger because, among other
reasons, conditions to the closing of the Merger may not be satisfied or
waived; risks disclosed in Part I Item 1A to Annual Report of Form 10-K for the
year ended December 31, 2006 and in Part II, Item IA of this report and our
Quarterly Report on Form 10Q for the quarter ended March 31, 2007; and other
risks that are detailed from time to time in reports we file with the
Securities and Exchange Commission. We undertake no obligation to update any
forward-looking statements, whether as a result of new information, future
events or otherwise.

|        |                                                            
|------- | -----------------------------------------------------------
|ITEM 3. | QUANTITATIVE AND QUALITATIVE
 DISCLOSURES ABOUT MARKET RISK

There
are no material changes to the disclosure on this matter made in our Annual
Report on Form 10-K for the year ended December 31, 2006.

|        |                        
|------- | -----------------------
|ITEM 4. | CONTROLS AND PROCEDURES

We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in the reports that we file or submit
under the Securities Exchange Act of 1934, as amended, is recorded, processed,
summarized and reported within the time periods specified in the rules and
forms of the SEC, and that such information is accumulated and communicated to
our management, including our Chief Executive Officer and

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Chief
Financial Officer, to allow timely decisions regarding required disclosure. An
evaluation was performed under the supervision and with the participation of
our management, including our Chief Executive Officer and our Chief Financial
Officer, of the effectiveness of our disclosure controls and procedures (as
defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of
1934) as of September 30, 2007. Based upon that evaluation, our management,
including our Chief Executive Officer and our Chief Financial Officer,
concluded that our disclosure controls and procedures were effective as of
September 30, 2007. There was no change in our internal control over financial
reporting during the quarter ended September 30, 2007, that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting.

PART II
OTHER INFORMATION

|        |                  
|------- | -----------------
|ITEM 1. | LEGAL PROCEEDINGS

The
disclosure made in Note 7, Commitments and Contingencies, of the Notes to
Consolidated Financial Statements included in this report, which discusses
certain legal proceedings in which we are involved, is incorporated herein by
reference.

|         |             
|-------- | ------------
|ITEM 1A. | RISK FACTORS

In
addition to the risk factors previously disclosed in Part I, Item 1A of the
Companys Annual Report on Form 10-K for the fiscal year ended December 31,
2006, and the changes to the risk factors set forth in Part II, Item 1A of the
Companys Quarterly Report on Form 10-Q for the quarter ended March 31, 2007,
the Company has identified the following new risk factor:

If the proposed Merger with Humana is not completed,
the Companys business, results of operations and financial condition, and the
price per share of Company common stock, would likely be materially affected.On
September 7, 2007, the Company and Humana entered into the Merger Agreement by
and among the Company, Humana and Merger Sub, a wholly-owned subsidiary of
Humana. Under the Merger Agreement, Merger Sub will merge with and into the
Company, with the Company continuing after the Merger as the surviving
corporation and a wholly-owned subsidiary of Humana. At the Effective Time of
the Merger, each outstanding share of Company common stock will be converted
into the right to receive $6.20 in cash, without interest.

The
Merger is subject to customary closing conditions, including the approval by
the Companys shareholders and the receipt of governmental and regulatory
approvals, including the approval of the South Carolina Department of
Insurance. On October 5, 2007, the Federal Trade Commission and the Antitrust
Division of the U.S. Department of Justice granted early termination of the
waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as
amended, in connection with the Merger. The Company has scheduled November 16,
2007, as the date of the special meeting of shareholders to vote on the Merger,
and the close of business on October 12, 2007, has been set as the record date
for the meeting. Shareholders of record as of the close of business on the
record date will be entitled to vote at the meeting. The closing of the Merger
is expected to occur late in the fourth quarter of 2007, possibly as early as
November 30, 2007.

There
can be no assurance that the Merger Agreement and the Merger will be approved
by the Companys shareholders, and there can be no assurance that the other
conditions to the completion of the proposed merger will be satisfied. In
connection with the proposed merger, the Company will be subject to several
risks, including the following:

|  |                                                                                                                                                           
|- | ----------------------------------------------------------------------------------------------------------------------------------------------------------
| | the
 occurrence of any effect, event, development or change that could give rise
 to the termination of the Merger Agreement;                             
|  |                                                                                                                                                           
| | the outcome
 of any legal proceedings that may be instituted against the Company and
 others following announcement of entering into the Merger Agreement;

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|  |                                                                                                                                                                                                                                           
|- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | the
 inability to complete the Merger due to the failure to obtain shareholder
 approval or the failure to satisfy other conditions to completion of the
 Merger, including the receipt of certain governmental and regulatory
 approvals;
|  |                                                                                                                                                                                                                                           
| | risks that
 the proposed transactions disrupt current plans and operations as well as
 potential difficulties in employee retention;                                                                                                      
|  |                                                                                                                                                                                                                                           
| | risks that
 the proposed transactions cause the Companys brokers, producers, policy
 holders, customers, vendors or service providers to terminate or reduce their
 relationship with the Company; and                                   
|  |                                                                                                                                                                                                                                           
| | the amount
 of the costs, fees, expenses and charges incurred that relate to the proposed
 Merger.                                                                                                                                        

If
the Merger is not completed for any reason, the Companys shareholders will not
receive the $6.20 per share merger consideration. Instead, the Company will
remain a public company and shares of the Company common stock will continue to
be listed on the New York Stock Exchange. If the Merger is not completed, the
Company does not expect to be able to continue to conduct its business in a
manner similar to the manner in which it is presently conducted. A.M. Best has
announced that, if the Merger is not completed, it will reduce Kanawhas
financial strength rating. If Kanawhas rating is reduced, the Company would
likely be precluded from participating in certain markets that are key to its
growth plans and financial prospects under its current business strategy, its
competitive position in the insurance industry would likely suffer, it would
likely lose customers, its cost of borrowing would likely increase, its sales
and earnings would likely decrease and its results of operations and financial
condition would likely be materially adversely affected. To address these
risks, we would likely need to materially change our business strategy, and
there can be no assurances that acceptable alternatives exist or could be
implemented. In such event, the value of shares of Company common stock would
continue to be subject to risks and opportunities, including the various
factors described in our past filings with the SEC, in particular the risks
with A.M. Bests financial strength rating of Kanawha, the condition of the
insurance industry and prevailing economic and market conditions. If the Merger
is not completed, the Company common stock may trade at or below levels at
which it traded prior to the announcement of the merger due to adverse market
reaction. If the Merger is not completed, there can be no assurance that any
other transaction similar to the Merger would be available to the Company. Even
if such a transaction were available, there can be no assurance that such a
transaction would be acceptable to the Companys board of directors and would
offer the Companys shareholders the opportunity to receive a cash payment for
their shares of Company common stock at a premium over the market prices at
which Company common stock traded before the public announcement of any such
transaction.

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|        |         
|------- | --------
|ITEM 6. | EXHIBITS

| |       |                                                                                                                                                                                                                                                                                      
| | ----- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (a)   | Exhibits:                                                                                                                                                                                                                                                                            
| |       |                                                                                                                                                                                                                                                                                      
| | 2.01  | Agreement
 and Plan of Merger, dated September 7, 2007, by and among KMG America
 Corporation, Humana Inc. and Hum VM, Inc. (incorporated by reference from
 Exhibit 2.1 attached to KMG America Corporations Current Report on Form 8-K
 filed with the SEC on September 13, 2007).
| |       |                                                                                                                                                                                                                                                                                      
| | 10.1  | Employment
 Letter Agreement, dated September 7, 2007, by and between KMG America
 Corporation and Kenneth U. Kuk (incorporated by reference from Exhibit 10.1
 attached to KMG America Corporations Current Report on Form 8-K filed with
 the SEC on September 13, 2007).         
| |       |                                                                                                                                                                                                                                                                                      
| | 10.2  | Employment
 Letter Agreement, dated September 7, 2007, by and between KMG America
 Corporation and Paul F. Kraemer (incorporated by reference from Exhibit 10.2
 attached to KMG America Corporations Current Report on Form 8-K filed with
 the SEC on September 13, 2007).        
| |       |                                                                                                                                                                                                                                                                                      
| | 10.3  | Employment
 Letter Agreement, dated September 7, 2007, by and between KMG America
 Corporation and Paul P. Moore (incorporated by reference from Exhibit 10.3
 attached to KMG America Corporations Current Report on Form 8-K filed with
 the SEC on September 13, 2007).          
| |       |                                                                                                                                                                                                                                                                                      
| | 31.01 | Certification
 of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act
 of 2002.                                                                                                                                                                                
| |       |                                                                                                                                                                                                                                                                                      
| | 31.02 | Certification
 of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act
 of 2002.                                                                                                                                                                                
| |       |                                                                                                                                                                                                                                                                                      
| | 32.01 | Certification
 of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act
 of 2002.                                                                                                                                                                                
| |       |                                                                                                                                                                                                                                                                                      
| | 32.02 | Certification
 of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act
 of 2002.                                                                                                                                                                                

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SIGNATURES

Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.

|                        |                         |  |                                                                                                     
|----------------------- | ----------------------- |  | ----------------------------------------------------------------------------------------------------
|                        | KMG AMERICA CORPORATION
|                        | (Registrant)           
|                        |                         |  |                                                                                                     
|Date:
 November 8, 2007 | By:                     |  | /s/
 Scott H. DeLong III                                                                            
|                        |                         |  |                                                                                                     
|                        |                         |  | Name:
 Scott H. DeLong III                                                                          
|                        |                         |  | Title:
 Senior Vice President & Chief Financial Officer                                             
|                        |                         |  | (Principal
 Financial Officer)                                                                      
|                        |                         |  |                                                                                                     
|Date:
 November 8, 2007 | By:                     |  | /s/
 Robert E. Matthews                                                                             
|                        |                         |  |                                                                                                     
|                        |                         |  | Name:
 Robert E. Matthews                                                                           
|                        |                         |  | Title:
 Executive Vice
 President, Chief Financial Officer & Treasurer of Kanawha Insurance
 Company
|                        |                         |  | (Principal
 Accounting Officer)                                                                     

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