Table of Contents





UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, 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 June 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                                                        |  | 20-1377270                           
|(State or Other Jurisdiction of
 Incorporation or Organization) |  | (I.R.S. Employer
 Identification No.)

|                                                          |  |           
|--------------------------------------------------------- |  | ----------
|12600 Whitewater Drive, Suite 150,
 Minnetonka, Minnesota |  | 55343     
|(Address of Registrants
 Principal Executive Offices)    |  | (Zip Code)

Registrants telephone number, including 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 August 3, 2007, the number of shares of Common Stock outstanding was 22,216,319.





---

TABLE OF CONTENTS

|                              |                                                                                                |                                                                                                                                                   |          |  
|----------------------------- | ---------------------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------- | -------- | -
|ITEM NO.                      |                                                                                                |                                                                                                                                                   | PAGE NO.
|                              |                                                                                                |                                                                                                                                                   |          |  
|PART I. FINANCIAL INFORMATION |                                                                                                | 1                                                                                                                                                
|                              |                                                                                                |                                                                                                                                                  
|                              | ITEM 1. FINANCIAL STATEMENTS                                                                   |                                                                                                                                                   | 1       
|                              |                                                                                                |                                                                                                                                                   |         
|                              |                                                                                                | CONSOLIDATED BALANCE SHEETS AS OF JUNE 30, 2007 (UNAUDITED) AND
 DECEMBER 31, 2006                                                                |          | 1
|                              |                                                                                                |                                                                                                                                                   |          |  
|                              |                                                                                                | CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE
 MONTHS ENDED JUNE 30, 2007 AND 2006 AND THE SIX MONTHS ENDED JUNE 30, 2007
 AND 2006 |          | 3
|                              |                                                                                                |                                                                                                                                                   |          |  
|                              |                                                                                                | CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED) FOR THE SIX
 MONTHS ENDED JUNE 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 |                                                                                                                                                   | 20      
|                              |                                                                                                |                                                                                                                                                   |         
|                              | ITEM 3. QUANTITATIVE AND
 QUALITATIVE DISCLOSURES ABOUT MARKET RISK                            |                                                                                                                                                   | 40      
|                              |                                                                                                |                                                                                                                                                   |         
|                              | ITEM 4. CONTROLS AND PROCEDURES                                                                |                                                                                                                                                   | 40      
|                              |                                                                                                |                                                                                                                                                   |         
|PART II. OTHER INFORMATION    |                                                                                                | 40                                                                                                                                               
|                              |                                                                                                |                                                                                                                                                  
|                              | ITEM 1. LEGAL PROCEEDINGS                                                                      |                                                                                                                                                   | 40      
|                              |                                                                                                |                                                                                                                                                   |         
|                              | ITEM 1A. RISK FACTORS                                                                          |                                                                                                                                                   | 40      
|                              |                                                                                                |                                                                                                                                                   |         
|                              | ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                    |                                                                                                                                                   | 40      
|                              |                                                                                                |                                                                                                                                                   |         
|                              | ITEM 6. EXHIBITS                                                                               |                                                                                                                                                   | 41      
|                              |                                                                                                |                                                                                                                                                   |         
|SIGNATURES                    |                                                                                                | 42                                                                                                                                               

i

---

Table of Contents

PART IFINANCIAL INFORMATION

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

KMG AMERICA CORPORATION
CONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                        |  |                |             |                   |   |             | 
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ----------- | ----------------- | - | ----------- | 
|                                                                                                                                                                        |  | June 30,
 2007 |             | December 31, 2006 |  
|                                                                                                                                                                        |  |                |             |                   |  
|                                                                                                                                                                        |  | (unaudited)    |             |                   |   |            
|Assets                                                                                                                                                                  |  |                |             |                   |   |             | 
|Investments:                                                                                                                                                            |  |                |             |                   |   |             | 
|Fixed maturity securities available for
 sale, at fair value (amortized cost of $573,883,218 and $531,477,537 as of
 June 30, 2007 and December 31, 2006, respectively) |  | $              | 550,635,804 |                   | $ | 520,624,942 | 
|Equity securities available for sale, at
 fair value (cost of $156,840 and $101,945 as of June 30, 2007 and December
 31, 2006, respectively)                           |  |                | 155,140     |                   |   | 103,545     | 
|Mortgage loans                                                                                                                                                          |  |                | 12,590,408  |                   |   | 13,921,019  | 
|Policy loans                                                                                                                                                            |  |                | 17,847,931  |                   |   | 18,163,223  | 
|Other investments                                                                                                                                                       |  |                | 5,798,598   |                   |   | 5,523,232   | 
|                                                                                                                                                                        |  |                |             |                   |   |             | 
|Total investments                                                                                                                                                       |  |                | 587,027,881 |                   |   | 558,335,961 | 
|                                                                                                                                                                        |  |                |             |                   |   |             | 
|Cash and cash equivalents                                                                                                                                               |  |                | 26,796,650  |                   |   | 21,744,137  | 
|Investment in subsidiary                                                                                                                                                |  |                | 1,083,000   |                   |   |            | 
|Reinsurance balances recoverable                                                                                                                                        |  |                | 92,136,868  |                   |   | 89,091,232  | 
|Accrued investment income                                                                                                                                               |  |                | 6,788,960   |                   |   | 6,502,801   | 
|Real estate and equipment (net of
 accumulated depreciation of $4,788,866 and $3,652,073 as of June 30, 2007 and
 December 31, 2006, respectively)                      |  |                | 16,208,206  |                   |   | 15,068,506  | 
|Federal income tax recoverable                                                                                                                                          |  |                | 5,111,539   |                   |   | 5,111,539   | 
|Deferred income tax asset                                                                                                                                               |  |                | 295,483     |                   |   | 6,578,604   | 
|Amounts due from reinsurers                                                                                                                                             |  |                | 2,770,885   |                   |   | 2,906,176   | 
|Deferred policy acquisition costs                                                                                                                                       |  |                | 36,044,022  |                   |   | 28,453,929  | 
|Value of business acquired                                                                                                                                              |  |                | 69,143,463  |                   |   | 70,766,211  | 
|Other assets                                                                                                                                                            |  |                | 26,876,967  |                   |   | 27,154,750  | 
|                                                                                                                                                                        |  |                |             |                   |   |             | 
|Total assets                                                                                                                                                            |  | $              | 870,283,924 |                   | $ | 831,713,846 | 
|                                                                                                                                                                        |  |                |             |                   |   |             | 

1

---

Table of Contents

KMG AMERICA CORPORATIONCONSOLIDATED BALANCE SHEETS

|                                                                                                                                                                                            |  |                |             |                     |   |             |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ----------- | ------------------- | - | ----------- | -
|                                                                                                                                                                                            |  | June 30,
 2007 |             | December
 31,
 2006 |  
|                                                                                                                                                                                            |  |                |             |                     |  
|                                                                                                                                                                                            |  | (unaudited)    |             |                     |   |            
|Liabilities and shareholders equity                                                                                                                                                        |  |                |             |                     |   |             |  
|Liabilities:                                                                                                                                                                                |  |                |             |                     |   |             |  
|Policy and contract liabilities:                                                                                                                                                            |  |                |             |                     |   |             |  
|Life and annuity reserves                                                                                                                                                                   |  | $              | 248,957,703 |                     | $ | 252,658,190 |  
|Accident and health reserves                                                                                                                                                                |  |                | 309,500,346 |                     |   | 294,581,002 |  
|Policy and contract claims                                                                                                                                                                  |  |                | 27,198,420  |                     |   | 14,530,782  |  
|Other policyholder liabilities                                                                                                                                                              |  |                | 10,815,834  |                     |   | 10,594,225  |  
|                                                                                                                                                                                            |  |                |             |                     |   |             |  
|Total policy and contract liabilities                                                                                                                                                       |  |                | 596,472,303 |                     |   | 572,364,199 |  
|                                                                                                                                                                                            |  |                |             |                     |   |             |  
|Accounts payable and accrued expenses                                                                                                                                                       |  |                | 26,173,654  |                     |   | 24,497,525  |  
|Taxes, other than federal income taxes                                                                                                                                                      |  |                | 718,724     |                     |   | 1,037,508   |  
|Federal income taxes accrued                                                                                                                                                                |  |                | 188,160     |                     |   | 523,889     |  
|Deferred income taxes                                                                                                                                                                       |  |                | 9,939,861   |                     |   | 14,735,262  |  
|Liability for benefits for employees and
 agents                                                                                                                                            |  |                | 6,178,598   |                     |   | 5,847,970   |  
|Funds held in suspense                                                                                                                                                                      |  |                | 3,752,378   |                     |   | 4,832,579   |  
|Notes payable                                                                                                                                                                               |  |                | 14,000,000  |                     |   | 14,000,000  |  
|Interest payable on note                                                                                                                                                                    |  |                | 25,550      |                     |   | 50,350      |  
|Subordinated debt securities                                                                                                                                                                |  |                | 36,083,000  |                     |   |            |  
|Interest payable on subordinated debt                                                                                                                                                       |  |                | 120,577     |                     |   |            |  
|Other liabilities                                                                                                                                                                           |  |                | 1,593,946   |                     |   | 1,773,077   |  
|                                                                                                                                                                                            |  |                |             |                     |   |             |  
|Total liabilities                                                                                                                                                                           |  |                | 695,246,751 |                     |   | 639,662,359 |  
|                                                                                                                                                                                            |  |                |             |                     |   |             |  
|Shareholders equity:                                                                                                                                                                       |  |                |             |                     |   |             |  
|Common Stock, par value $0.01 per share,
 75,000,000 shares authorized and 22,216,319 and 22,211,589 shares issued and
 outstanding as of June 30, 2007 and December 31, 2006, respectively |  |                | 222,163     |                     |   | 222,116     |  
|Paid-in capital                                                                                                                                                                             |  |                | 189,899,520 |                     |   | 189,150,959 |  
|Retained earnings                                                                                                                                                                           |  |                | 1,998,784   |                     |   | 11,702,929  |  
|Accumulated other comprehensive loss                                                                                                                                                        |  |                | (17,083,294 | )                   |   | (9,024,517  | )
|                                                                                                                                                                                            |  |                |             |                     |   |             |  
|Total shareholders equity                                                                                                                                                                  |  |                | 175,037,173 |                     |   | 192,051,487 |  
|                                                                                                                                                                                            |  |                |             |                     |   |             |  
|Total liabilities and shareholders equity                                                                                                                                                  |  | $              | 870,283,924 |                     | $ | 831,713,846 |  
|                                                                                                                                                                                            |  |                |             |                     |   |             |  

See accompanying notes.

2

---

Table of Contents

KMG AMERICA CORPORATIONCONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)

|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|--------------------------------------------------------------------------------- |  | ------------------------------------- | ---------- | ----------------------------------- | - | ---------- | - | ---- | ----------- | - | - | ---------- | -
|                                                                                  |  | For the Three Months Ended 
 June 30, |            | For the Six Months Ended 
 June 30, |  
|                                                                                  |  | 2007                                  |            | 2006                                |   | 2007       |   | 2006 |            
|                                                                                  |  |                                       |            |                                     |   |            |   |      |            
|Revenue:                                                                          |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Insurance premiums                                                                |  | $                                     | 41,687,214 |                                     | $ | 30,662,058 |   | $    | 81,603,122  |   | $ | 60,472,683 |  
|Net investment income                                                             |  |                                       | 8,377,617  |                                     |   | 7,619,113  |   |      | 16,253,284  |   |   | 14,825,180 |  
|Commission and fee income                                                         |  |                                       | 4,071,473  |                                     |   | 4,117,494  |   |      | 8,239,623   |   |   | 8,336,609  |  
|Realized investment gains (losses)                                                |  |                                       | 243,732    |                                     |   | (115,044   | ) |      | 190,824     |   |   | 96,064     |  
|Other income                                                                      |  |                                       | 1,193,565  |                                     |   | 922,347    |   |      | 2,252,633   |   |   | 1,908,880  |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Total
 revenues                                                                   |  |                                       | 55,573,601 |                                     |   | 43,205,968 |   |      | 108,539,486 |   |   | 85,639,416 |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Benefits and expenses:                                                            |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Policyholder benefits                                                             |  |                                       | 35,054,608 |                                     |   | 24,373,653 |   |      | 72,597,230  |   |   | 47,727,367 |  
|Insurance commissions, net of deferrals                                           |  |                                       | 4,021,202  |                                     |   | 2,923,991  |   |      | 8,173,646   |   |   | 5,905,276  |  
|General insurance expenses, net of
deferrals                                      |  |                                       | 11,169,219 |                                     |   | 11,289,622 |   |      | 23,339,336  |   |   | 22,182,973 |  
|Insurance taxes, licenses and fees                                                |  |                                       | 1,860,532  |                                     |   | 1,292,320  |   |      | 3,475,548   |   |   | 2,807,372  |  
|Depreciation and amortization                                                     |  |                                       | 764,139    |                                     |   | 630,494    |   |      | 1,469,286   |   |   | 1,271,359  |  
|Amortization of deferred policy acquisition costs
and value of
 business acquired |  |                                       | 1,108,572  |                                     |   | 1,155,242  |   |      | 3,189,253   |   |   | 2,333,343  |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Total benefits and expenses                                                       |  |                                       | 53,978,272 |                                     |   | 41,665,322 |   |      | 112,244,299 |   |   | 82,227,690 |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Income (loss) before income taxes                                                 |  |                                       | 1,595,329  |                                     |   | 1,540,646  |   |      | (3,704,813  | ) |   | 3,411,726  |  
|Provision for income taxes                                                        |  |                                       | (1,036,261 | )                                   |   | (523,612   | ) |      | (5,999,332  | ) |   | (1,158,495 | )
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Net income (loss)                                                                 |  | $                                     | 559,068    |                                     | $ | 1,017,034  |   | $    | (9,704,145  | ) | $ | 2,253,231  |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Net income per share:                                                             |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Basic                                                                             |  | $                                     | 0.03       |                                     | $ | 0.05       |   | $    | (0.44       | ) | $ | .10        |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Diluted                                                                           |  | $                                     | 0.03       |                                     | $ | 0.05       |   | $    | (0.44       | ) | $ | .10        |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Weighted-average shares outstanding:                                              |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Basic                                                                             |  |                                       | 22,213,894 |                                     |   | 22,201,305 |   |      | 22,212,845  |   |   | 22,167,545 |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  
|Diluted                                                                           |  |                                       | 22,213,894 |                                     |   | 22,217,635 |   |      | 22,212,845  |   |   | 22,197,249 |  
|                                                                                  |  |                                       |            |                                     |   |            |   |      |             |   |   |            |  

See accompanying notes.

3

---

Table of Contents

KMG AMERICA CORPORATIONCONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)

|                                                                                                     |  |                                 |             |                               |   |             |  
|---------------------------------------------------------------------------------------------------- |  | ------------------------------- | ----------- | ----------------------------- | - | ----------- | -
|                                                                                                     |  | Six Months Ended
 June 30, 2007 |             | Six Months EndedJune 30, 2006 |  
|                                                                                                     |  |                                 |             |                               |  
|Operating Expenses                                                                                   |  |                                 |             |                               |   |             |  
|Net (loss) income                                                                                    |  | $                               | (9,704,145  | )                             | $ | 2,253,231   |  
|Adjustments
 to reconcile net (loss) income to net cash provided by (used in) operating
 activities: |  |                                 |             |                               |   |             |  
|Depreciation and amortization                                                                        |  |                                 | 2.376,117   |                               |   | 2,271,834   |  
|Policy acquisition costs deferred                                                                    |  |                                 | (9,156,598  | )                             |   | (7,671,963  | )
|Amortization of deferred policy acquisition costs
and value of
 business acquired                    |  |                                 | 3,189,253   |                               |   | 2,333,343   |  
|Realized investment losses (gains), net                                                              |  |                                 | (190,824    | )                             |   | (96,064     | )
|Deferred income tax expense                                                                          |  |                                 | 5,827,061   |                               |   | 1,158,495   |  
|Changes in operating assets and
liabilities:                                                         |  |                                 |             |                               |   |             |  
|Investment in subsidiary                                                                             |  |                                 | (1,083,000  | )                             |   |            |  
|Reinsurance balances recoverable                                                                     |  |                                 | (3,045,636  | )                             |   | (8,368,881  | )
|Accrued investment income                                                                            |  |                                 | (286,159    | )                             |   | (133,907    | )
|Other assets                                                                                         |  |                                 | 277,783     |                               |   | (5,218,721  | )
|Amounts due from reinsurers                                                                          |  |                                 | 135,291     |                               |   | (2,024,758  | )
|Policy and contract liabilities                                                                      |  |                                 | 24,108,104  |                               |   | 12,675,064  |  
|Accounts payable and accrued expenses                                                                |  |                                 | 1,676,129   |                               |   | 2,396,528   |  
|Interest payable                                                                                     |  |                                 | 95,777      |                               |   | 393,750     |  
|Stock-based compensation expense                                                                     |  |                                 | 748,609     |                               |   | 628,013     |  
|Taxes, other than federal income taxes                                                               |  |                                 | (318,784    | )                             |   | (247,359    | )
|Federal income taxes accrued                                                                         |  |                                 | (335,729    | )                             |   |            |  
|Funds held in suspense                                                                               |  |                                 | (1,080,201  | )                             |   | (430,410    | )
|Liability for benefits for employees and
agents                                                      |  |                                 | 330,628     |                               |   | (427,691    | )
|Other liabilities                                                                                    |  |                                 | (179,131    | )                             |   | (450        | )
|                                                                                                     |  |                                 |             |                               |   |             |  
|Net cash provided by (used in) operating activities                                                  |  |                                 | 13,384,545  |                               |   | (509,946    | )
|Investing activities                                                                                 |  |                                 |             |                               |   |             |  
|Securities available for sale:                                                                       |  |                                 |             |                               |   |             |  
|Sales                                                                                                |  |                                 | 11,806,084  |                               |   | 7,797,608   |  
|Maturities, calls and redemptions                                                                    |  |                                 | 13,889,921  |                               |   | 18,739,103  |  
|Purchases                                                                                            |  |                                 | (69,480,446 | )                             |   | (53,795,616 | )
|Repayments of mortgage loans                                                                         |  |                                 | 1,330,611   |                               |   | 2,196,666   |  
|Decrease in policy loans, net                                                                        |  |                                 | 315,292     |                               |   | 2,670,782   |  
|Purchases of real estate, property and equipment                                                     |  |                                 | (2,276,494  | )                             |   | (2,735,270  | )
|                                                                                                     |  |                                 |             |                               |   |             |  
|Net cash (used in) investing activities                                                              |  |                                 | (44,415,032 | )                             |   | (25,126,727 | )
|                                                                                                     |  |                                 |             |                               |   |             |  
|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                                                 |  |                                 | 5,052,513   |                               |   | (25,636,673 | )
|Cash and cash equivalents at beginning of period                                                     |  |                                 | 21,744,137  |                               |   | 32,582,964  |  
|                                                                                                     |  |                                 |             |                               |   |             |  
|Cash and cash equivalents at end of period                                                           |  | $                               | 26,796,650  |                               | $ | 6,946,291   |  
|                                                                                                     |  |                                 |             |                               |   |             |  
|Supplemental disclosures of cash flow information                                                    |  |                                 |             |                               |   |             |  
|Federal income taxes paid                                                                            |  | $                               | 508,000     |                               | $ |            |  
|                                                                                                     |  |                                 |             |                               |   |             |  

See accompanying notes.

4

---

Table of Contents

KMG AMERICA CORPORATIONNOTES TO CONSOLIDATED FINANCIAL 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
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. The process is underway and advanced
negotiations are occurring. There can be no assurance that this process will
result in a sale or merger of the Company, or if a sale or merger is
undertaken, the potential terms or timing of the transaction. The Company does
not intend to publicly disclose updates or developments in its strategic
alternatives process until such time as the Company enters into a definitive
agreement with a third party in connection with a transaction or terminates the
strategic alternatives process.

|   |                                
|-- | -------------------------------
|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 June 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).

5

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Use of Estimates and Assumptions

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

Cash and Cash Equivalents

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

Investments

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

Fixed
maturities classified as available-for-sale are stated at fair value with
unrealized gains and losses reported directly in shareholders equity as accumulated
other comprehensive income. Fair values for fixed maturity securities are based
on quoted market prices, where available. For fixed maturity securities that
are not actively traded, fair values are estimated using values obtained from
independent pricing services.

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

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

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

Policy
loans are stated at their unpaid balances.

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

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

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:

6

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

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

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

Real Estate and Equipment

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

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

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.

7

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

Benefit
reserves as reported are shown on a GAAP purchase accounting basis (PGAAP).
Prior to the quarter ending June 30, 2006, this conversion was based on an
adjustment to benefit reserves developed on a historical GAAP basis. Effective
June 30, 2006, a refinement in methodology was implemented whereby the benefit
reserves are now being developed directly on a PGAAP basis. This seriatim
factor approach was not implemented in prior quarters because of the
significant amount of time it has taken to develop the complete set of reserve
factors that was needed. The refinement of the methodology to use seriatim
developed reserves had no material impact on income but did have an impact on
the balance sheet on a segment by segment basis as of June 30, 2006.

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.

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

8

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

based on
assumptions derived from historical experience as to claim duration, as well as
the specific characteristics of the claimant such as benefits available under
the policy, the benefit period, and the age and occupation of the claimant. Although
considerable variability is inherent in such estimates, management believes
that the reserves for claims and claim adjustment expenses are adequate. The
estimates are continually reviewed and adjusted as necessary as experience
develops or new information becomes known; such adjustments are included in
current operations.

Reinsurance

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

Recognition of Revenue

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

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

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

Realized Capital Gains (Losses)

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

Recognition
of Benefits

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

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.

9

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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.

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

10

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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, 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
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.

|                                                  |  |               |             |                            |   |                             |  |           |            |  |   |             | 
|------------------------------------------------- |  | ------------- | ----------- | -------------------------- | - | --------------------------- |  | --------- | ---------- |  | - | ----------- | 
|                                                  |  | AmortizedCost |             | Gross
  Unrealized
  Gains |   | Gross
  Unrealized
  Losses |  | FairValue |           
|                                                  |  |               |             |                            |   |                             |  |           |           
|Available for sale securities at June 30,
  2007: |  |               |             |                            |   |                             |  |           |            |  |   |             | 
|Fixed maturity securities                         |  | $             | 573,883,218 |                            | $ | 562,346                     |  | $         | 23,809,760 |  | $ | 550,635,804 | 
|Equity securities                                 |  |               | 156,840     |                            |   |                            |  |           | 1,700      |  |   | 155,140     | 
|                                                  |  |               |             |                            |   |                             |  |           |            |  |   |             | 
|Securities available for sale                     |  | $             | 574,040,058 |                            | $ | 562,346                     |  | $         | 23,811,460 |  | $ | 550,790,944 | 
|                                                  |  |               |             |                            |   |                             |  |           |            |  |   |             | 

|   |                                
|-- | -------------------------------
|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.

11

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|   |                                
|-- | -------------------------------
|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
  June 30, |          | Six Months Ended
  June 30, |  
|                                           |  |                               |          |                             |  
|                                           |  | 2007                          |          | 2006                        |   | 2007     |   | 2006 |         
|                                           |  |                               |          |                             |   |          |   |      |         
|Components
  of net periodic benefit cost: |  |                               |          |                             |   |          |   |      |          |   |   |          |  
|Service cost                               |  | $                             |         |                             | $ | 47,778   |   | $    |         |   | $ | 95,556   |  
|Interest cost                              |  |                               | 240,000  |                             |   | 232,510  |   |      | 480,000  |   |   | 465,020  |  
|Expected
  return on plan assets           |  |                               | (360,000 | )                           |   | (309,641 | ) |      | (720,000 | ) |   | (619,282 | )
|Amortization
  of transition liability     |  |                               |         |                             |   | 362      |   |      |         |   |   | 724      |  
|Recognized
  net actuarial loss            |  |                               | 50,000   |                             |   | 52,646   |   |      | 100,000  |   |   | 105,292  |  
|                                           |  |                               |          |                             |   |          |   |      |          |   |   |          |  
|Net periodic
  benefit cost                |  | $                             | (70,000  | )                           | $ | 23,655   |   | $    | (140,000 | ) | $ | 47,310   |  
|                                           |  |                               |          |                             |   |          |   |      |          |   |   |          |  
|Curtailment Expense                        |  | $                             |         |                             |   |         |   | $    |         |   |   | 120,170  |  
|                                           |  |                               |          |                             |   |          |   |      |          |   |   |          |  

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 six months ended June 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% 

12

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 June 30, 2007, net of forfeitures, 144,678 shares of
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, 52,742 shares of Common Stock
granted are fully vested. Also, through June 30, 2007, net of forfeitures,
options to purchase 1,860,925 shares of 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. With respect to options issued to one optionholder, they vest one-third
on each of the first, second and third anniversaries of the date of grant,
subject to earlier immediate vesting upon the termination of the optionholders
employment with the Company, by the Company without cause, by him with good
reason, upon a change in control of the Company and upon his receipt of a
notice of non-renewal of his employment agreement, or upon his death or
disability.

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                               |  |                                  | (20,167 | )                                                                                       |  | 20,167    |  |        | 8.02 |  |  | 8.02 | 
|Forfeited                            |  |                                  | (1,939  | )                                                                                       |  |          |  |        | 8.36 |  |  |     | 
|                                     |  |                                  |         |                                                                                         |  |           |  |        |      |  |  |      | 
|Outstanding
 as of June 30, 2007     |  |                                  | 91,936  |                                                                                         |  | 52,742    |  |        | 8.35 |  |  | 8.05 | 
|                                     |  |                                  |         |                                                                                         |  |           |  |        |      |  |  |      | 

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    |  

13

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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                            |  |                       | (62,500   | )                                 |  | 8.99                        |  |                                               |           |  |  |      | 
|                                     |  |                       |           |                                   |  |                             |  |                                               |           |  |  |      | 
|Outstanding as of June 30,
 2007     |  |                       | 1,860,925 |                                   |  | 9.17                        |  |                                               | 4,554,565 |  |  | 7.99 | 
|                                     |  |                       |           |                                   |  |                             |  |                                               |           |  |  |      | 
|Exercisable as of June 30,
 2007     |  |                       | 807,852   |                                   |  | 9.35                        |  |                                               | 1,982,425 |  |  | 7.70 | 
|                                     |  |                       |           |                                   |  |                             |  |                                               |           |  |  |      | 

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

|                                                            |  |                                |         | 
|----------------------------------------------------------- |  | ------------------------------ | ------- | 
|                                                            |  | Six Months Ended June 30, 2007 |        
|                                                            |  |                                |        
|Total
 Share-Based Compensation                             |  |                                |         | 
|Included in
 loss before income taxes                       |  | $                              | 748,609 | 
|Included in
 net loss, net of tax effects                   |  | $                              | 486,596 | 
|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 June 30, 2007, there was $2,702,976 of total unrecognized compensation cost
related to nonvested share-based compensation arrangements.

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

Total
comprehensive income (loss) for the six months ended June 30, 2007 and 2006 was
($17,762,922) and $(11,759,484), respectively. The difference between
comprehensive income and net income for these periods was unrealized investment
gains (losses) of $(8,058,777) and $(14,012,715), respectively.

Total
comprehensive income (loss) for the three months ended June 30, 2007 and 2006
was $(7,987,949) and $(5,055,412), respectively. The difference between
comprehensive income and net income for these periods was unrealized investment
gains (losses) of $(8,547,017) and $(6,072,446), respectively.

On December 31, 2006,
we adopted Financial 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 the 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.

14

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|   |                              
|-- | -----------------------------
|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
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.

|   |                           
|-- | --------------------------
|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 June 30, 2007, the $14.0
million outstanding under the credit agreement was a LIBOR rate plus applicable
percentage loan with an interest rate of 6.57%.

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.

15

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 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 six months ended June 30, 2007 varies from the expected
statutory rate of approximately 35% primarily as a result of the establishment
of a $7.2 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 will continue to evaluate tax planning strategies to utilize the
operating losses prior to their expiration.

The
Company had no interest and penalties for the six months ended June 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 June 30, 2007 and expects no material change in its unrecognized
tax positions within the next 12 months.

16

---

Table of Contents

KMG AMERICA CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

During
the quarter ended June 30, 2006, the Company finalized the calculation of
seriatim PGAAP reserve factors and implemented the use of such factors. While
the implementation of seriatim PGAAP factors did not change total reserves of
the Company, it did result in a reallocation of reserves among the worksite
insurance, senior market insurance and acquired business segments. This
reallocation was reflected in the second quarter results of the affected
segments.

The
result of the reallocation of reserves between business segments was to
strengthen reserves by $ 37.5 million in the senior market insurance business
segment in the second quarter of 2006. 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 in the second quarter of 2006. 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.

17

---

Table of Contents

KMG AMERICA
CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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

|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|--------------------------------------- |  | ----------------------------- | ----------- | --------------------------- | - | ----------- | - | ---- | ----------- | - | - | ----------- | -
|                                        |  | Three
 Months Ended
 June 30, |             | Six
 Months Ended
 June 30, |  
|                                        |  | 2007                          |             | 2006                        |   | 2007        |   | 2006 |            
|                                        |  |                               |             |                             |   |             |   |      |            
|Worksite Insurance Business             |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                             | 30,706,642  |                             | $ | 19,326,163  |   | $    | 59,900,946  |   | $ | 37,832,719  |  
|Net investment income                   |  |                               | 2,174,360   |                             |   | 1,763,532   |   |      | 4,225,126   |   |   | 3,358,540   |  
|Commissions and fees                    |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Net realized gains                      |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Other income                            |  |                               | 193,747     |                             |   | 49,941      |   |      | 354,587     |   |   | 96,224      |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                               | 33,074,749  |                             |   | 21,139,636  |   |      | 64,480,659  |   |   | 41,287,483  |  
|Policyholder benefits                   |  |                               | 24,494,203  |                             |   | 7,405,312   |   |      | 52,007,482  |   |   | 21,000,147  |  
|Commissions                             |  |                               | 2,558,078   |                             |   | 1,563,226   |   |      | 5,241,470   |   |   | 3,084,044   |  
|Expenses, taxes, fees and depreciation  |  |                               | 4,769,710   |                             |   | 4,460,388   |   |      | 9,570,279   |   |   | 8,684,010   |  
|Amortization of DAC and VOBA            |  |                               | 1,083,159   |                             |   | 525,981     |   |      | 2,697,746   |   |   | 1,304,183   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                               | 32,905,150  |                             |   | 13,954,907  |   |      | 69,516,977  |   |   | 34,072,384  |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                             | 169,599     |                             | $ | 7,184,729   |   | $    | (5,036,318  | ) | $ | 7,215,099   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                             | 187,638,359 |                             | $ | 163,926,424 |   | $    | 187,638,359 |   | $ | 163,926,424 |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Senior Market Insurance Business        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                             | 11,082,822  |                             | $ | 10,705,500  |   | $    | 21,861,110  |   | $ | 21,380,120  |  
|Net investment income                   |  |                               | 2,826,936   |                             |   | 1,565,634   |   |      | 5,530,895   |   |   | 2,977,247   |  
|Commissions and fees                    |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Net realized gains                      |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Other income                            |  |                               | 780,063     |                             |   | 759,930     |   |      | 1,560,376   |   |   | 1,569,005   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                               | 14,689,821  |                             |   | 13,031,064  |   |      | 28,952,381  |   |   | 25,926,372  |  
|Policyholder benefits                   |  |                               | 8,736,603   |                             |   | 46,762,345  |   |      | 16,489,080  |   |   | 55,297,567  |  
|Commissions                             |  |                               | 1,375,851   |                             |   | 1,269,647   |   |      | 2,755,780   |   |   | 2,636,456   |  
|Expenses, taxes, fees and depreciation  |  |                               | 814,877     |                             |   | 733,915     |   |      | 1,546,631   |   |   | 1,499,074   |  
|Amortization of DAC and VOBA            |  |                               | 273,294     |                             |   | 503,996     |   |      | 599,951     |   |   | 976,110     |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                               | 11,200,625  |                             |   | 49,269,903  |   |      | 21,391,442  |   |   | 60,409,207  |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                             | 3,489,196   |                             | $ | (36,238,839 | ) | $    | 7,560,939   |   | $ | (34,482,835 | )
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                             | 272,716,346 |                             | $ | 249,677,460 |   | $    | 272,716,346 |   | $ | 249,677,460 |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Third Party Administration Business     |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                             |            |                             | $ |            |   | $    |            |   |   |            |  
|Net investment income                   |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Commissions and fees                    |  |                               | 3,911,330   |                             |   | 4,025,624   |   |      | 8,030,774   |   |   | 8,159,341   |  
|Net realized gains                      |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Other income                            |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                               | 3,911,330   |                             |   | 4,025,624   |   |      | 8,030,774   |   |   | 8,159,341   |  
|Policyholder benefits                   |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Commissions                             |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Expenses, taxes, fees and depreciation  |  |                               | 3,260,921   |                             |   | 3,448,153   |   |      | 6,883,821   |   |   | 6,951,309   |  
|Amortization of DAC and VOBA            |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                               | 3,260,921   |                             |   | 3,448,153   |   |      | 6,883,821   |   |   | 6,951,309   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Income before Federal income tax        |  |                               | 650,409     |                             | $ | 577,471     |   | $    | 1,146,953   |   | $ | 1,208,032   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                             | 9,514,510   |                             | $ | 10,141,646  |   | $    | 9,514,510   |   | $ | 10,141,646  |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  

18

---

Table of Contents

KMG AMERICA
CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|--------------------------------------- |  | ----------------------------- | ----------- | --------------------------- | - | ----------- | - | ---- | ----------- | - | - | ----------- | -
|                                        |  | Three
 Months Ended
 June 30, |             | Six
 Months Ended
 June 30, |  
|                                        |  | 2007                          |             | 2006                        |   | 2007        |   | 2006 |            
|                                        |  |                               |             |                             |   |             |   |      |            
|Acquired Business                       |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                             | (102,249    | )                           | $ | 630,395     |   | $    | (158,935    | ) | $ | 1,259,845   |  
|Net investment income                   |  |                               | 1,975,864   |                             |   | 2,106,105   |   |      | 3,985,320   |   |   | 4,086,761   |  
|Commissions and fees                    |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Net realized gains                      |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Other income                            |  |                               | 21,689      |                             |   | 23,221      |   |      | 37,911      |   |   | 39,022      |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                               | 1,895,304   |                             |   | 2,759,721   |   |      | 3,864,296   |   |   | 5,385,628   |  
|Policyholder benefits                   |  |                               | 1,823,802   |                             |   | (29,794,003 | ) |      | 4,100,667   |   |   | (28,570,346 | )
|Commissions                             |  |                               | 87,273      |                             |   | 91,118      |   |      | 176,396     |   |   | 184,776     |  
|Expenses, taxes, fees and depreciation  |  |                               | 592,088     |                             |   | 593,502     |   |      | 1,188,431   |   |   | 1,201,476   |  
|Amortization of DAC and VOBA            |  |                               | (247,881    | )                           |   | 125,265     |   |      | (108,443    | ) |   | 53,050      |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                               | 2,255,282   |                             |   | (28,984,118 | ) |      | 5,357,051   |   |   | (27,131,044 | )
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|(Loss) income before Federal income tax |  | $                             | (359,978    | )                           | $ | 31,743,839  |   | $    | (1,492,755  | ) | $ | 32,516,672  |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                             | 158,195,046 |                             | $ | 164,916,856 |   | $    | 158,195,046 |   | $ | 164,916,856 |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Corporate and Other                     |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                             |            |                             | $ |            |   | $    |            |   | $ |            |  
|Net investment income                   |  |                               | 1,400,456   |                             |   | 2,183,841   |   |      | 2,511,943   |   |   | 4,402,631   |  
|Commissions and fees                    |  |                               | 160,144     |                             |   | 91,871      |   |      | 208,849     |   |   | 177,268     |  
|Net realized gains                      |  |                               | 243,732     |                             |   | (115,044    | ) |      | 190,824     |   |   | 96,064      |  
|Other income                            |  |                               | 198,066     |                             |   | 89,255      |   |      | 299,759     |   |   | 204,629     |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                               | 2,002,398   |                             |   | 2,249,923   |   |      | 3,211,375   |   |   | 4,880,592   |  
|Policyholder benefits                   |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Commissions                             |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|Expenses, taxes, fees and depreciation  |  |                               | 4,356,295   |                             |   | 3,976,478   |   |      | 9,095,007   |   |   | 7,925,835   |  
|Amortization of DAC and VOBA            |  |                               |            |                             |   |            |   |      |            |   |   |            |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                               | 4,356,295   |                             |   | 3,976,478   |   |      | 9,095,007   |   |   | 7,925,835   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|(Loss) before Federal income tax        |  | $                             | (2,353,897  | )                           | $ | (1,726,555  | ) | $    | (5,883,632  | ) | $ | (3,045,243  | )
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                             | 242,219,663 |                             | $ | 206,034,361 |   | $    | 242,219,663 |   | $ | 206,034,361 |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total Company                           |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                             | 41,687,214  |                             | $ | 30,662,058  |   | $    | 81,603,122  |   |   | 60,472,683  |  
|Net investment income                   |  |                               | 8,377,617   |                             |   | 7,619,113   |   |      | 16,253,284  |   |   | 14,825,180  |  
|Commissions and fees                    |  |                               | 4,071,473   |                             |   | 4,117,494   |   |      | 8,239,623   |   |   | 8,336,609   |  
|Net realized gains                      |  |                               | 243,732     |                             |   | (115,044    | ) |      | 190,824     |   |   | 96,064      |  
|Other income                            |  |                               | 1,193,565   |                             |   | 922,347     |   |      | 2,252,633   |   |   | 1,908,880   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                               | 55,573,601  |                             |   | 43,205,968  |   |      | 108,539,486 |   |   | 85,639,416  |  
|Policyholder benefits                   |  |                               | 35,054,608  |                             |   | 24,373,653  |   |      | 72,597,230  |   |   | 47,727,367  |  
|Commissions                             |  |                               | 4,021,202   |                             |   | 2,923,991   |   |      | 8,173,646   |   |   | 5,905,276   |  
|Expenses, taxes, fees and depreciation  |  |                               | 13,793,890  |                             |   | 13,212,436  |   |      | 28,284,170  |   |   | 26,261,704  |  
|Amortization of DAC and VOBA            |  |                               | 1,108,572   |                             |   | 1,155,242   |   |      | 3,189,253   |   |   | 2,333,343   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                               | 53,978,272  |                             |   | 41,665,322  |   |      | 112,244,299 |   |   | 82,227,690  |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  |                               | 1,595,329   |                             | $ | 1,540,646   |   | $    | (3,704,813  | ) | $ | 3,411,726   |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                             | 870,283,924 |                             | $ | 794,696,747 |   | $    | 870,283,924 |   | $ | 764,696,747 |  
|                                        |  |                               |             |                             |   |             |   |      |             |   |   |             |  

19

---

Table of Contents

|        |                                                                                       
|------- | --------------------------------------------------------------------------------------
|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.

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 six
months ended June 30, 2007, our worksite insurance business produced premiums,
commissions and fees, excluding intercompany payments, of $59.9 million, which
accounted for 66.5% 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 six months ended June 30, 2007, our senior market insurance
business produced premiums, commissions and fees, excluding intercompany
payments, of $21.9 million, which accounted for 24.3% 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

20

---

Table of Contents

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 six months ended June 30, 2007, our third-party administration business
produced commissions and fees, excluding intercompany payments, of $8.0
million, which accounted for 8.9% 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 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. Also,
S&P recently lowered the financial strength rating for Kanawha to BBB
(good), with a positive ratings outlook. Rating agencies review their ratings
periodically and Kanawhas current ratings may not be maintained in the future.

If
Kanawhas ratings are reduced from their current levels by A.M. Best or
S&P, or as recently occurred with A.M. Best, are placed under surveillance
or review with possible negative implications, Kanawhas competitive position
in the insurance industry would likely suffer and it would likely lose
customers. Since A.M. Best changed Kanawhas rating outlook from stable to
negative, we have not been precluded from bidding on group cases, although we
have lost some cases we expected to be awarded. If Kanawhas financial strength
ratings are reduced, the negative impact may be more pronounced. Our cost of
borrowing would likely increase, our sales and earnings would likely decrease
and our results of operations and financial condition would likely be
materially adversely affected. For example, a minimum A.M. Best rating of A-
is generally required to participate in the group life and disability and
excess risk insurance markets. If Kanawhas A.M. Best rating of A- is reduced,
we likely will be precluded from participating in those markets, which are key
to our growth and financial strength.

Potential
stop loss claims volatility and the adverse effect it may have on our results
of operations could induce A.M. Best or S&P to downgrade Kanawhas
financial strength rating.

See
Item 1A. Risk Factors  The financial strength of Kanawha, our insurance
subsidiary, is rated by A.M. Best and S&P, and a decline in these ratings
would likely negatively affect our standing in the insurance industry, cause
our sales and earnings to decrease and our results of operations and financial
condition would likely be materially adversely affected.

21

---

Table of Contents

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 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
the Company has 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 actions, the Company believes
its June 30, 2007 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.

The
Company has also established a $7.2 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. The process is underway and advanced
negotiations are occurring. There can be no assurance that this process will
result in a sale or merger of the Company, or if a sale or merger is
undertaken, the potential terms or timing of the transaction. The Company does
not intend to publicly disclose updates or developments in its strategic
alternatives process until such time as the Company enters into a definitive
agreement with a third party in connection with a transaction or terminates the
strategic alternatives process.

22

---

Table of Contents

Results of Operations

Consolidated Overview

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

|                              |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|----------------------------- |  | --------------------------- | ------ | ------------------------- | - | ------ | - | ---- | ------- | - | - | ------ | -
|                              |  | Three Months Ended June 30, |        | Six Months Ended June 30, |  
|                              |  |                             |        |                           |  
|                              |  | 2007                        |        | 2006                      |   | 2007   |   | 2006 |        
|                              |  | (000s omitted)             |       
|Revenues:                     |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|Insurance premiums            |  | $                           | 41,687 |                           | $ | 30,662 |   | $    | 81,603  |   | $ | 60,473 |  
|Net investment income         |  |                             | 8,378  |                           |   | 7,619  |   |      | 16,253  |   |   | 14,825 |  
|Commission and fees           |  |                             | 4,071  |                           |   | 4,118  |   |      | 8,240   |   |   | 8,336  |  
|Net realized gains (losses)   |  |                             | 244    |                           |   | (115   | ) |      | 191     |   |   | 96     |  
|Other income                  |  |                             | 1,194  |                           |   | 922    |   |      | 2,252   |   |   | 1,909  |  
|                              |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|Total revenues                |  |                             | 55,574 |                           |   | 43,206 |   |      | 108,539 |   |   | 85,639 |  
|                              |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|Benefits and expenses:        |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|Policyholder benefits         |  |                             | 35,055 |                           |   | 24,374 |   |      | 72,597  |   |   | 47,728 |  
|Commissions                   |  |                             | 4,021  |                           |   | 2,924  |   |      | 8,174   |   |   | 5,905  |  
|General expenses              |  |                             | 11,169 |                           |   | 11,290 |   |      | 23,339  |   |   | 22,183 |  
|Taxes, licenses and fees      |  |                             | 1,861  |                           |   | 1,292  |   |      | 3,476   |   |   | 2,807  |  
|Depreciation and amortization |  |                             | 764    |                           |   | 630    |   |      | 1,469   |   |   | 1,271  |  
|Amortization of DAC and VOBA  |  |                             | 1,109  |                           |   | 1,155  |   |      | 3,189   |   |   | 2,333  |  
|                              |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|Total benefits and expenses   |  |                             | 53,979 |                           |   | 41,665 |   |      | 112,244 |   |   | 82,227 |  
|                              |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|Income before income taxes    |  |                             | 1,595  |                           |   | 1,541  |   |      | (3,705  | ) |   | 3,412  |  
|Provision for income taxes    |  |                             | (1,036 | )                         |   | (524   | ) |      | (5,999  | ) |   | (1,159 | )
|                              |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|Net income                    |  | $                           | 559    |                           | $ | 1,017  |   | $    | (9,704  | ) | $ | 2,253  |  
|                              |  |                             |        |                           |   |        |   |      |         |   |   |        |  
|Benefits to premiums
ratio(1) |  |                             | 84.1   | %                         |   | 79.5   | % |      | 89.0    | % |   | 78.9   | %

|    |                                                                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|(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.

23

---

Table of Contents

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 
 June 30, |             | Six Months
 Ended 
 June 30, |  
|                                        |  | 2007                           |             | 2006                         |   | 2007        |   | 2006 |            
|                                        |  |                                |             |                              |   |             |   |      |            
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Worksite Insurance Business             |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                              | 30,706,642  |                              | $ | 19,326,163  |   | $    | 59,900,946  |   | $ | 37,832,719  |  
|Net investment income                   |  |                                | 2,174,360   |                              |   | 1,763,532   |   |      | 4,225,126   |   |   | 3,358,540   |  
|Commissions and fees                    |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Net realized gains                      |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Other income                            |  |                                | 193,747     |                              |   | 49,941      |   |      | 354,587     |   |   | 96,224      |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                | 33,074,749  |                              |   | 21,139,636  |   |      | 64,480,659  |   |   | 41,287,483  |  
|Policyholder benefits                   |  |                                | 24,494,203  |                              |   | 7,405,312   |   |      | 52,007,482  |   |   | 21,000,147  |  
|Commissions                             |  |                                | 2,558,078   |                              |   | 1,563,226   |   |      | 5,241,470   |   |   | 3,084,044   |  
|Expenses, taxes, fees and depreciation  |  |                                | 4,769,710   |                              |   | 4,460,388   |   |      | 9,570,279   |   |   | 8,684,010   |  
|Amortization of DAC and VOBA            |  |                                | 1,083,159   |                              |   | 525,981     |   |      | 2,697,746   |   |   | 1,304,183   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                | 32,905,150  |                              |   | 13,954,907  |   |      | 69,516,977  |   |   | 34,072,384  |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                              | 169,599     |                              | $ | 7,184,729   |   | $    | (5,036,318  | ) | $ | 7,215,099   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                              | 187,638,359 |                              | $ | 163,926,424 |   | $    | 187,638,359 |   | $ | 163,926,424 |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Senior Market Insurance Business        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                              | 11,082,822  |                              | $ | 10,705,500  |   | $    | 21,861,110  |   | $ | 21,380,120  |  
|Net investment income                   |  |                                | 2,826,936   |                              |   | 1,565,634   |   |      | 5,530,895   |   |   | 2,977,247   |  
|Commissions and fees                    |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Net realized gains                      |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Other income                            |  |                                | 780,063     |                              |   | 759,930     |   |      | 1,560,376   |   |   | 1,569,005   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                | 14,689,821  |                              |   | 13,031,064  |   |      | 28,952,381  |   |   | 25,926,372  |  
|Policyholder benefits                   |  |                                | 8,736,603   |                              |   | 46,762,345  |   |      | 16,489,080  |   |   | 55,297,567  |  
|Commissions                             |  |                                | 1,375,851   |                              |   | 1,269,647   |   |      | 2,755,780   |   |   | 2,636,456   |  
|Expenses, taxes, fees and depreciation  |  |                                | 814,877     |                              |   | 733,915     |   |      | 1,546,631   |   |   | 1,499,074   |  
|Amortization of DAC and VOBA            |  |                                | 273,294     |                              |   | 503,996     |   |      | 599,951     |   |   | 976,110     |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                | 11,200,625  |                              |   | 49,269,903  |   |      | 21,391,442  |   |   | 60,409,207  |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  | $                              | 3,489,196   |                              | $ | (36,238,839 | ) | $    | 7,560,939   |   | $ | (34,482,835 | )
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                              | 272,716,346 |                              | $ | 249,677,460 |   | $    | 272,716,346 |   | $ | 249,677,460 |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Third Party Administration Business     |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                              |            |                              | $ |            |   | $    |            |   |   |            |  
|Net investment income                   |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Commissions and fees                    |  |                                | 3,911,330   |                              |   | 4,025,624   |   |      | 8,030,774   |   |   | 8,159,341   |  
|Net realized gains                      |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Other income                            |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                | 3,911,330   |                              |   | 4,025,624   |   |      | 8,030,774   |   |   | 8,159,341   |  
|Policyholder benefits                   |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Commissions                             |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Expenses, taxes, fees and depreciation  |  |                                | 3,260,921   |                              |   | 3,448,153   |   |      | 6,883,821   |   |   | 6,951,309   |  
|Amortization of DAC and VOBA            |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                | 3,260,921   |                              |   | 3,448,153   |   |      | 6,883,821   |   |   | 6,951,309   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Income before Federal income tax        |  |                                | 650,409     |                              | $ | 577,471     |   | $    | 1,146,953   |   | $ | 1,208,032   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                              | 9,514,510   |                              | $ | 10,141,646  |   | $    | 9,514,510   |   | $ | 10,141,646  |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  

24

---

Table of Contents

|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|--------------------------------------- |  | ------------------------------ | ----------- | ---------------------------- | - | ----------- | - | ---- | ----------- | - | - | ----------- | -
|                                        |  | Three
 Months Ended 
 June 30, |             | Six Months
 Ended 
 June 30, |  
|                                        |  | 2007                           |             | 2006                         |   | 2007        |   | 2006 |            
|                                        |  |                                |             |                              |   |             |   |      |            
|Acquired Business                       |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                              | (102,249    | )                            | $ | 630,395     |   | $    | (158,935    | ) | $ | 1,259,845   |  
|Net investment income                   |  |                                | 1,975,864   |                              |   | 2,106,105   |   |      | 3,985,320   |   |   | 4,086,761   |  
|Commissions and fees                    |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Net realized gains                      |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Other income                            |  |                                | 21,689      |                              |   | 23,221      |   |      | 37,911      |   |   | 39,022      |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                | 1,895,304   |                              |   | 2,759,721   |   |      | 3,864,296   |   |   | 5,385,628   |  
|Policyholder benefits                   |  |                                | 1,823,802   |                              |   | (29,794,003 | ) |      | 4,100,667   |   |   | (28,570,346 | )
|Commissions                             |  |                                | 87,273      |                              |   | 91,118      |   |      | 176,396     |   |   | 184,776     |  
|Expenses, taxes, fees and depreciation  |  |                                | 592,088     |                              |   | 593,502     |   |      | 1,188,431   |   |   | 1,201,476   |  
|Amortization of DAC and VOBA            |  |                                | (247,881    | )                            |   | 125,265     |   |      | (108,443    | ) |   | 53,050      |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                | 2,255,282   |                              |   | (28,984,118 | ) |      | 5,357,051   |   |   | (27,131,044 | )
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|(Loss) income before Federal income tax |  | $                              | (359,978    | )                            | $ | 31,743,839  |   | $    | (1,492,755  | ) | $ | 32,516,672  |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                              | 158,195,046 |                              | $ | 164,916,856 |   | $    | 158,195,046 |   | $ | 164,916,856 |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Corporate and Other                     |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                              |            |                              | $ |            |   | $    |            |   | $ |            |  
|Net investment income                   |  |                                | 1,400,456   |                              |   | 2,183,841   |   |      | 2,511,943   |   |   | 4,402,631   |  
|Commissions and fees                    |  |                                | 160,144     |                              |   | 91,871      |   |      | 208,849     |   |   | 177,268     |  
|Net realized gains                      |  |                                | 243,732     |                              |   | (115,044    | ) |      | 190,824     |   |   | 96,064      |  
|Other income                            |  |                                | 198,066     |                              |   | 89,255      |   |      | 299,759     |   |   | 204,629     |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                | 2,002,398   |                              |   | 2,249,923   |   |      | 3,211,375   |   |   | 4,880,592   |  
|Policyholder benefits                   |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Commissions                             |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|Expenses, taxes, fees and depreciation  |  |                                | 4,356,295   |                              |   | 3,976,478   |   |      | 9,095,007   |   |   | 7,925,835   |  
|Amortization of DAC and VOBA            |  |                                |            |                              |   |            |   |      |            |   |   |            |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                | 4,356,295   |                              |   | 3,976,478   |   |      | 9,095,007   |   |   | 7,925,835   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|(Loss) before Federal income tax        |  | $                              | (2,353,897  | )                            | $ | (1,726,555  | ) | $    | (5,883,632  | ) | $ | (3,045,243  | )
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                              | 242,219,663 |                              | $ | 206,034,361 |   | $    | 242,219,663 |   | $ | 206,034,361 |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total Company                           |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Insurance premiums                      |  | $                              | 41,687,214  |                              | $ | 30,662,058  |   | $    | 81,603,122  |   |   | 60,472,683  |  
|Net investment income                   |  |                                | 8,377,617   |                              |   | 7,619,113   |   |      | 16,253,284  |   |   | 14,825,180  |  
|Commissions and fees                    |  |                                | 4,071,473   |                              |   | 4,117,494   |   |      | 8,239,623   |   |   | 8,336,609   |  
|Net realized gains                      |  |                                | 243,732     |                              |   | (115,044    | ) |      | 190,824     |   |   | 96,064      |  
|Other income                            |  |                                | 1,193,565   |                              |   | 922,347     |   |      | 2,252,633   |   |   | 1,908,880   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total revenues                          |  |                                | 55,573,601  |                              |   | 43,205,968  |   |      | 108,539,486 |   |   | 85,639,416  |  
|Policyholder benefits                   |  |                                | 35,054,608  |                              |   | 24,373,653  |   |      | 72,597,230  |   |   | 47,727,367  |  
|Commissions                             |  |                                | 4,021,202   |                              |   | 2,923,991   |   |      | 8,173,646   |   |   | 5,905,276   |  
|Expenses, taxes, fees and depreciation  |  |                                | 13,793,890  |                              |   | 13,212,436  |   |      | 28,284,170  |   |   | 26,261,704  |  
|Amortization of DAC and VOBA            |  |                                | 1,108,572   |                              |   | 1,155,242   |   |      | 3,189,253   |   |   | 2,333,343   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total benefits and expenses             |  |                                | 53,978,272  |                              |   | 41,665,322  |   |      | 112,244,299 |   |   | 82,227,690  |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Income (loss) before Federal income tax |  |                                | 1,595,329   |                              | $ | 1,540,646   |   | $    | (3,704,813  | ) | $ | 3,411,726   |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  
|Total assets                            |  | $                              | 870,283,924 |                              | $ | 794,696,747 |   | $    | 870,283,924 |   | $ | 764,696,747 |  
|                                        |  |                                |             |                              |   |             |   |      |             |   |   |             |  

25

---

Table of Contents

Six Months Ended June 30, 2007 Compared to
Six Months Ended June 30, 2006

Financial Results
Overview

Net
income for the six months ended June 30, 2007, decreased $12.0 million, or
521.7%, to a $9.7 million net loss compared to net income of $2.3 million for
the six months ended June 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 $7.2 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 six months ended June 30, 2007, increased $22.9 million, or
26.8%, to $108.5 million from total revenues of $85.6 million for the six
months ended June 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
(dollars in millions).

|        |  |                                        |      |                                        |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|------- |  | -------------------------------------- | ---- | -------------------------------------- | - | ------------------- | - | ----- | ---- | -------- | - | ------ | - | -------- | ---- | ----- | - | -------- | - | ------ | --- | -------- | - | ----- | - | - | ---- | - | - | ---- | - | - | ---- | - | - | ---- | -
|        |  | For the six months ended June 30, 2007 |      | For the six months ended June 30, 2006 |   | Increase (decrease) |  
|        |  |                                        |      |                                        |   |                     |  
|        |  | Worksite                               |      | Senior                                 |   | Acquired            |   | Total |      | Worksite |   | Senior |   | Acquired |      | Total |   | Worksite |   | Senior |     | Acquired |   | Total |  
|        |  |                                        |      |                                        |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |  
|        |  |                                        |      |                                        |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |  
|Direct  |  |                                        |      |                                        |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  | $                                      | 40.8 |                                        | $ | 0.1                 |   | $     |     |          | $ | 40.9   |   | $        | 19.9 |       | $ | 0.5      |   | $      |    |          | $ | 20.4  |   | $ | 20.9 |   | $ | (0.4 | ) | $ |     |   | $ | 20.5 |  
|Renewal |  |                                        | 23.5 |                                        |   | 28.8                |   |       |     |          |   | 52.3   |   |          | 22.6 |       |   | 28.0     |   |        |    |          |   | 50.6  |   |   | 0.9  |   |   | 0.8  |   |   |     |   |   | 1.7  |  
|Total   |  |                                        | 64.3 |                                        |   | 28.9                |   |       |     |          |   | 93.2   |   |          | 42.5 |       |   | 28.5     |   |        |    |          |   | 71.0  |   |   | 21.8 |   |   | 0.4  |   |   |     |   |   | 22.2 |  
|Assumed |  |                                        |      |                                        |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                        |     |                                        |   |                    |   |       |     |          |   |       |   |          |     |       |   |         |   |        |    |          |   |      |   |   |     |   |   |     |   |   |     |   |   |     |  
|Renewal |  |                                        | 1.0  |                                        |   |                    |   |       | 0.1  |          |   | 1.1    |   |          |     |       |   |         |   |        | 1.3 |          |   | 1.3   |   |   | 1.0  |   |   |     |   |   | (1.2 | ) |   | (0.2 | )
|Total   |  |                                        | 1.0  |                                        |   |                    |   |       | 0.1  |          |   | 1.1    |   |          |     |       |   |         |   |        | 1.3 |          |   | 1.3   |   |   | 1.0  |   |   |     |   |   | (1.2 | ) |   | (0.2 | )
|Ceded   |  |                                        |      |                                        |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                        | (4.7 | )                                      |   |                    |   |       |     |          |   | (4.7   | ) |          | (4.1 | )     |   | (0.3     | ) |        |    |          |   | (4.4  | ) |   | (0.6 | ) |   | 0.3  |   |   |     |   |   | (0.3 | )
|Renewal |  |                                        | (0.7 | )                                      |   | (7.0                | ) |       | (0.3 | )        |   | (8.0   | ) |          | (0.6 | )     |   | (6.8     | ) |        |    |          |   | (7.4  | ) |   | (0.1 | ) |   | (0.2 | ) |   | (0.3 | ) |   | (0.6 | )
|Total   |  |                                        | (5.4 | )                                      |   | (7.0                | ) |       | (0.3 | )        |   | (12.7  | ) |          | (4.7 | )     |   | (7.1     | ) |        |    |          |   | (11.8 | ) |   | (0.7 | ) |   | 0.1  |   |   | (0.3 | ) |   | (0.9 | )
|Net     |  |                                        |      |                                        |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |     |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                        | 36.1 |                                        |   | 0.1                 |   |       |     |          |   | 36.2   |   |          | 15.8 |       |   | 0.2      |   |        |    |          |   | 16.0  |   |   | 20.3 |   |   | (0.1 | ) |   |     |   |   | 20.2 |  
|Renewal |  |                                        | 23.8 |                                        |   | 21.8                |   |       | (0.2 | )        |   | 45.4   |   |          | 22.0 |       |   | 21.2     |   |        | 1.3 |          |   | 44.5  |   |   | 1.8  |   |   | 0.6  |   |   | (1.5 | ) |   | 0.9  |  
|Total   |  | $                                      | 59.9 |                                        | $ | 21.9                |   | $     | (0.2 | )        | $ | 81.6   |   | $        | 37.8 |       | $ | 21.4     |   | $      | 1.3 |          | $ | 60.5  |   | $ | 22.1 |   | $ | 0.5  |   | $ | (1.5 | ) | $ | 21.1 |  

Worksite
net new premiums increased $20.3 million, or 128.5%, to $36.1 million for the
six months ended June 30, 2007, from $15.8 million for the six months ended
June 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 $28.5 million of direct new premiums, offset by $3.5
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 $1.8 million or 8.2%
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, decreased $0.1
million, or 50.0%, to $0.1 million for the six months ended June 30, 2007, from
$0.2 million for the six months ended June 30, 2006 due to decreased sales
volumes as the Company ceased actively underwriting new long term care policies
after December 31, 2005.Net renewal
premiums increased 2.8% to $21.8 million, representing premiums from the
insurance in force created by prior year sales.

26

---

Table of Contents

Acquired
business premiums decreased $1.5 million, or 115.4%, to $(0.2) million for the
six months ended June 30, 2007, from $1.3 million for the six months ended June
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 second quarter of
2007, an estimated refund due to a reinsurance carrier of $0.3 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 $4.9 million for the six months ended June 30,
2007, from $4.3 million for the six months ended June 30, 2006.

Net Investment Income

Net
investment income increased $1.5 million, or 10.1%, to $16.3 million for the
six months ended June 30, 2007, from $14.8 million for the six months ended
June 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 six months ended June 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 $0.1 million, or 1.2%, to $8.2 million for the six
months ended June 30, 2007, from $8.3 million for the six months ended June 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 is
relatively flat 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 six months ended June 30,
2007, increased by $0.1 million to $0.2 million, from $0.1 million for the six
months ended June 30, 2006, 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 $0.4 million, or 21.1%, to $2.3 million for the six months
ended June 30, 2007, from $1.9 million for the six months ended June 30, 2006,
reflecting increased administrative fees for the issuance of universal life
products, increased commission and expense allowances from reinsurance
companies generated from an increase in renewal ceded premiums, and a payment
received as part of WorldComs settlement with former bond holders.

Benefits and Expenses

Total
benefits and expenses increased $30.0 million, or 36.5%, to $112.2 million for
the six months ended June 30, 2007, from $82.2 million for the six months ended
June 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.

27

---

Table of Contents

Policyholder Benefits

Benefit
reserves as reported are shown after conversion to a GAAP purchase accounting
basis. Prior to the quarter ending June 30, 2006, this conversion was based on
an adjustment to benefit reserves developed on a historical GAAP basis.
Effective June 30, 2006, a change in methodology was implemented whereby the
benefit reserves began to be developed directly on a purchase GAAP basis. The
change to seriatim developed reserves had no material impact on income but does
have an impact on the balance sheet on a segment by segment basis. This balance
sheet impact is further discussed in Note 10 (Business Segments).

Policyholder
benefits increased $24.9 million, or 52.2%, to $72.6 million for the six months
ended June 30, 2007, from $47.7 million for the six months ended June 30, 2006.
This produced a benefits to premium ratio of 89.0% for the six months ended
June 30, 2007, compared to 78.9% for the six months ended June 30, 2006.

Worksite
marketing policyholder benefits increased $31.0 million, or 147.6%, to $52.0
million for the six months ended June 30, 2007, from $21.0 million for the six
months ended June 30, 2006. This produced benefits to premium ratios of 86.8%
for the six months ended June 30, 2007, compared to 55.5% for the six months
ended June 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 six months ended June 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 reflects 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 has emerged, the Company has
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 the Company has 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 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 more conservative pricing and a requirement that sales of stop loss
be packaged with other products.

Senior
market policyholder benefits decreased $38.8 million, or 70.2%, to $16.5
million for the six months ended June 30, 2007, from $55.3 million for the six
months ended June 30, 2006. This produced benefits to premium ratios of 75.3%
for the six months ended June 30, 2007, compared to 258.6% for the six months
ended June 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 six months ended June 30, 2006 benefits to premium ratio adjusted would be
83.3% without the reserve conversion impact. The first six months of 2006 had
some large increases in open claims that have not been repeated in the first
six months of 2007, which accounts for the improved benefits ratio.

Acquired
business policyholder benefits increased $32.7 million, to $4.1 million for the
six months ended June 30, 2007, from $(28.6) million for the six months ended
June 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

28

---

Table of Contents

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 $4.9 million
for the six months ended June 30, 2007, from $4.3 million for the six months
ended June 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 the second quarter of 2007, an estimated refund due to
our reinsurance carrier of $0.3 million was accrued in relation to possible
adjustments needed for previously settled billings. Excluding the effects of
these items, the comparable benefit ratios are 177.8% for the six months ended
June 30, 2007 and 167.8% for the six months ended June 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.

Insurance Commissions

Commission
expenses increased $2.3 million, or 39.0%, to $8.2 million for the six months
ended June 30, 2007, from $5.9 million for the six months ended June 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 $1.1 million, or 4.9%, to $23.3 million for the
six months ended June 30, 2007, from $22.2 million for the six months ended
June 30, 2006. The increased expenses for the six months ended June 30, 2007
are primarily attributable to a $0.8 million litigation settlement expenses and
interest on the junior subordinated debt of $0.8, offset somewhat by a $0.6
million decrease in legal expenses related to the litigation.

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 $0.7 million, or 25.0%, to $3.5 million for
the six months ended June 30, 2007, from $2.8 million for the six months ended
June 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 $9.2
million and $7.7 million for the six months ended June 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 deferred acquisition costs (DAC) and the value of business
acquired (VOBA) increased $0.9 million, or 39.1%, to $3.2 million for the six
months ended June 30, 2007, from $2.3 million for the six months ended June 30,
2006, reflecting the increased deferrals described above. The DAC balance at
June 30, 2007 has increased $14.8 million over the balance at June 30, 2006,
which accounts for a large part of the increase in amortization expense.

29

---

Table of Contents

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 six
months ended June 30, 2007 and 2006 were 161.9 % and 33.9%, respectively. The
variation in these rates is due to a valuation allowance of $7.2 million that
has been established.

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 $7.2 million which represents the portion of the deferred tax
asset that was generated by net operating losses at the holding company.

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

Financial Results Overview

Net
income for the three months ended June 30, 2007, decreased $0.4 million, or
40.0%, to $0.6 million from net income of $1.0 million for the three months
ended June 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, general expenses and federal income taxes, all of
which are described in greater detail below.

Revenues

Total
revenues for the three months ended June 30, 2007, increased $12.4 million, or
28.7%, to $55.6 million from total revenues of $43.2 million for the three
months ended June 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
(dollars in millions).

|        |  |                                          |      |                                          |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |      |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|------- |  | ---------------------------------------- | ---- | ---------------------------------------- | - | ------------------- | - | ----- | ---- | -------- | - | ------ | - | -------- | ---- | ----- | - | -------- | - | ------ | ---- | -------- | - | ----- | - | - | ---- | - | - | ---- | - | - | ---- | - | - | ---- | -
|        |  | For the three months ended June 30, 2007 |      | For the three months ended June 30, 2006 |   | Increase (decrease) |  
|        |  |                                          |      |                                          |   |                     |  
|        |  | Worksite                                 |      | Senior                                   |   | Acquired            |   | Total |      | Worksite |   | Senior |   | Acquired |      | Total |   | Worksite |   | Senior |      | Acquired |   | Total |  
|        |  |                                          |      |                                          |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |      |          |   |       |  
|        |  |                                          |      |                                          |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |      |          |   |       |  
|Direct  |  |                                          |      |                                          |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |      |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  | $                                        | 21.1 |                                          | $ | 0.1                 |   | $     |     |          | $ | 21.2   |   | $        | 10.5 |       | $ | 0.2      |   | $      |     |          | $ | 10.7  |   | $ | 10.6 |   | $ | (0.1 | ) | $ |     |   | $ | 10.5 |  
|Renewal |  |                                          | 11.8 |                                          |   | 14.5                |   |       |     |          |   | 26.3   |   |          | 11.3 |       |   | 14.1     |   |        |     |          |   | 25.4  |   |   | 0.5  |   |   | 0.4  |   |   |     |   |   | 0.9  |  
|Total   |  |                                          | 32.9 |                                          |   | 14.6                |   |       |     |          |   | 47.5   |   |          | 21.8 |       |   | 14.3     |   |        |     |          |   | 36.1  |   |   | 11.1 |   |   | 0.3  |   |   |     |   |   | 11.4 |  
|Assumed |  |                                          |      |                                          |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |      |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                          | 0.1  |                                          |   |                    |   |       |     |          |   | 0.1    |   |          |     |       |   |         |   |        |     |          |   |      |   |   | 0.1  |   |   |     |   |   |     |   |   | 0.1  |  
|Renewal |  |                                          | 0.6  |                                          |   |                    |   |       | 0.2  |          |   | 0.8    |   |          |     |       |   |         |   |        | 0.7  |          |   | 0.7   |   |   | 0.6  |   |   |     |   |   | (0.5 | ) |   | 0.1  |  
|Total   |  |                                          | 0.7  |                                          |   |                    |   |       | 0.2  |          |   | 0.9    |   |          |     |       |   |         |   |        | 0.7  |          |   | 0.7   |   |   | 0.7  |   |   |     |   |   | (0.5 | ) |   | 0.2  |  
|Ceded   |  |                                          |      |                                          |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |      |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                          | (2.5 | )                                        |   |                    |   |       |     |          |   | (2.5   | ) |          | (2.2 | )     |   | (0.1     | ) |        |     |          |   | (2.3  | ) |   | (0.3 | ) |   | 0.1  |   |   |     |   |   | (0.2 | )
|Renewal |  |                                          | (0.4 | )                                        |   | (3.5                | ) |       | (0.3 | )        |   | (4.2   | ) |          | (0.3 | )     |   | (3.5     | ) |        | (0.1 | )        |   | (3.9  | ) |   | (0.1 | ) |   |     |   |   | (0.2 | ) |   | (0.3 | )
|Total   |  |                                          | (2.9 | )                                        |   | (3.5                | ) |       | (0.3 | )        |   | (6.7   | ) |          | (2.5 | )     |   | (3.6     | ) |        | (0.1 | )        |   | (6.2  | ) |   | (0.4 | ) |   | 0.1  |   |   | (0.2 | ) |   | (0.5 | )
|Net     |  |                                          |      |                                          |   |                     |   |       |      |          |   |        |   |          |      |       |   |          |   |        |      |          |   |       |   |   |      |   |   |      |   |   |      |   |   |      |  
|New     |  |                                          | 18.7 |                                          |   | 0.1                 |   |       |     |          |   | 18.8   |   |          | 8.3  |       |   | 0.1      |   |        |     |          |   | 8.4   |   |   | 10.4 |   |   |     |   |   |     |   |   | 10.4 |  
|Renewal |  |                                          | 12.0 |                                          |   | 11.0                |   |       | (0.1 | )        |   | 22.9   |   |          | 11.0 |       |   | 10.6     |   |        | 0.6  |          |   | 22.2  |   |   | 1.0  |   |   | 0.4  |   |   | (0.7 | ) |   | 0.7  |  
|Total   |  | $                                        | 30.7 |                                          | $ | 11.1                |   | $     | (0.1 | )        | $ | 41.7   |   | $        | 19.3 |       | $ | 10.7     |   | $      | 0.6  |          | $ | 30.6  |   | $ | 11.4 |   | $ | 0.4  |   | $ | (0.7 | ) | $ | 11.1 |  

Worksite
net new premiums increased $10.4 million, or 125.3%, to $18.7 million for the
three months ended June 30, 2007, from $8.3 million for the three months ended
June 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 $14.6 million of direct new premiums, offset by $1.7
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,

30

---

Table of Contents

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 $1.0 million or 9.1% 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
unchanged at $0.1 million for the three months ended June 30, 2007, and 2006,
respectively. The Company ceased actively underwriting new long term care
policies after December 31, 2005.Net
renewal premiums increased 3.8% to $11.0 million, representing premiums from
the insurance in force created by prior year sales.

Acquired
business premiums decreased $0.7 million, or 116.7%, to $(0.1) million for the
three months ended June 30, 2007, from $0.6 million for the three months ended
June 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 a reinsurance carrier of $0.3 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 June
30, 2007, from $2.0 million for the three months ended June 30, 2006.

Net Investment Income

Net
investment income increased $0.8 million, or 10.5%, to $8.4 million for the
three months ended June 30, 2007, from $7.6 million for the three months ended
June 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 June 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 remained constant at $4.1 million for the three months ended
June 30, 2007 and 2006, respectively. Most of the commission and fee income was
from administrative fees relating to third-party administration, and the volume
of business in force is relatively flat 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 June
30, 2007, increased by $0.3 million to $0.2 million, from $(0.1) million for
the three months ended June 30, 2006, 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 $0.3 million, or 33.3%, to $1.2 million for the three months
ended June 30, 2007, from $0.9 million for the three months ended June 30,
2006, reflecting increased administrative fees for the issuance

31

---

Table of Contents

of universal
life products, increased commission and expense allowances from reinsurance
companies generated from an increase in renewal ceded premiums, and a payment
received as part of WorldComs settlement with former bond holders.

Benefits and Expenses

Total
benefits and expenses increased $12.3 million, or 29.5%, to $54.0 million for
the three months ended June 30, 2007, from $41.7 million for the three months
ended June 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

Benefit
reserves as reported are shown after conversion to a GAAP purchase accounting
basis. Prior to the quarter ending June 30, 2006, this conversion was based on
an adjustment to benefit reserves developed on a historical GAAP basis.
Effective June 30, 2006, a change in methodology was implemented whereby the
benefit reserves began to be developed directly on a purchase GAAP basis. The
change to seriatim developed reserves had no material impact on income but does
have an impact on the balance sheet on a segment by segment basis. This balance
sheet impact is further discussed in Note 10 (Business Segments).

Policyholder
benefits increased $10.7 million, or 43.9%, to $35.1 million for the three
months ended June 30, 2007, from $24.4 million for the three months ended June
30, 2006. This produced a benefits to premium ratio of 84.1% for the three
months ended June 30, 2007, compared to 79.5% for the three months ended June
30, 2006.

Worksite
marketing policyholder benefits increased $17.1 million, or 231.1%, to $24.5
million for the three months ended June 30, 2007, from $7.4 million for the
three months ended June 30, 2006. This produced benefits to premium ratios of
79.8% for the three months ended June 30, 2007, compared to 38.3% for the three
months ended June 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 three months ended
June 30, 2006 benefits to premium ratio adjusted would be 70.7% without the
reserve conversion impact.

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. As experience has emerged, the Company has
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 the Company has 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 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 more conservative pricing and a requirement that sales of stop loss
be packaged with other products.

Senior
market policyholder benefits decreased $38.1 million, or 81.4%, to $8.7 million
for the three months ended June 30, 2007, from $46.8 million for the three
months ended June 30, 2006. This produced benefits to

32

---

Table of Contents

premium ratios
of 78.8% for the three months ended June 30, 2007, compared to 436.8% for the
three months ended June 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 three months ended June 30, 2006 benefits to premium ratio
adjusted would be 86.6% without the reserve conversion impact. The second quarter
of 2006 had some large increases in open claims that have not been repeated in
the second quarter of 2007, which accounts for the improved benefits ratio.

Acquired
business policyholder benefits increased $31.6 million, to $1.8 million for the
three months ended June 30, 2007, from $(29.8) million for the three months
ended June 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 June 30, 2007, from $2.0
million for the three months ended June 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 the second quarter of
2007, an estimated refund due to our reinsurance carrier of $0.3 million was
accrued in relation to possible adjustments needed for previously settled
billings. Excluding the effects of these items, the comparable benefit ratios
are 186.8% for the three months ended June 30, 2007 and 174.9% for the three
months ended June 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.

Insurance Commissions

Commission
expenses increased $1.1 million, or 37.9%, to $4.0 million for the three months
ended June 30, 2007, from $2.9 million for the three months ended June 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 $0.1 million, or 1.0%, to $11.2 million for the
three months ended June 30, 2007, from $11.3 million for the three months ended
June 30, 2006. Increases were created by interest on the junior subordinated
debt of $0.7, offset somewhat by a $0.4 million decrease in legal expenses
related to litigation.

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 46.2%, to $1.9 million for
the three months ended June 30, 2007, from $1.3 million for the three months
ended June 30, 2006. Employment taxes and additional premium taxes due to
increased premiums account for 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 $4.9
million and $3.9 million for the three months ended June 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 deferred acquisition costs (DAC) and the value of business
acquired (VOBA) remained constant at $1.1 million for the three months ended
June 30, 2007 and 2006, respectively.

33

---

Table of Contents

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 June 30, 2007 and 2006 were 65.0 % and 34.0%, respectively. The
variation in these rates is due to a valuation allowance of $0.4 million that
has been 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 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

34

---

Table of Contents

(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 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 June 30, 2007, the $14.0 million
outstanding under the credit agreement was a LIBOR rate plus applicable
percentage loan with an interest rate of 6.57%.

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.

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.

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.

35

---

Table of Contents

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. The process is underway and advanced
negotiations are occurring. There can be no assurance that this process will
result in a sale or merger of the Company, or if a sale or merger is
undertaken, the potential terms or timing of the transaction. The Company does
not intend to publicly disclose updates or developments in its strategic
alternatives process until such time as the Company enters into a definitive
agreement with a third party in connection with a transaction or terminates the
strategic alternatives process.

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 (dollars in
thousands):

|                               |  |                                  |           |                                  |   |           |  
|------------------------------ |  | -------------------------------- | --------- | -------------------------------- | - | --------- | -
|Net cash provided by (used in) |  | Six Months
 Ended
 June 30, 2007 |           | Six Months
 Ended
 June 30, 2006 |  
|                               |  |                                  |           |                                  |  
|Operating activities           |  | $                                | 13,384.5  |                                  | $ | (509.9    | )
|Investing activities           |  |                                  | (44,415.0 | )                                |   | (25,126.7 | )
|                               |  |                                  |           |                                  |   |           |  
|Financing activities           |  |                                  | 36,083.0  |                                  |   |          |  
|                               |  |                                  |           |                                  |   |           |  
|Net change in cash             |  | $                                | 5,052.5   |                                  | $ | (25,636.6 | )
|                               |  |                                  |           |                                  |   |           |  

Cash
Flows for the Six Months Ended June 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.

Other
changes in cash flows for the six months ended June 30, 2007 and June 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 $44.4 million for the six months ended June 30,
2007. This produced a corresponding increase in invested assets.

Other
assets decreased by $0.3 million in the six months ended June 30, 2007
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.

36

---

Table of Contents

Accounts
payable and accrued expenses increased $1.7 million in the six months ended
June 30, 2007, compared to a decrease of $2.4 million in the six months ended
June 30, 2006 due to fluctuations in our reinsurance settlements payable.

Federal
income tax recoverable remained constant from the December 31, 2006 balance.
The deferred tax asset decreased by $6.3 million and the deferred tax liability
decreased by $4.8 million. The combination of these items resulted in a net
decrease in tax assets of $1.5 million, inclusive of an increase of $4.3
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 $5.9 million, which consists of tax credits on
current year losses offset by the $7.2 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 June 30, 2007.

|                                                 |  |                 |             |                          |   |                           |  |             |            |  |   |             | 
|------------------------------------------------ |  | --------------- | ----------- | ------------------------ | - | ------------------------- |  | ----------- | ---------- |  | - | ----------- | 
|                                                 |  | Amortized
 Cost |             | Gross
 Unrealized
 Gains |   | Gross
 Unrealized
 Losses |  | Fair
 Value |           
|                                                 |  |                 |             |                          |   |                           |  |             |           
|Available for sale securities at June 30,
 2007: |  |                 |             |                          |   |                           |  |             |            |  |   |             | 
|U.S. Treasuries                                  |  | $               | 7,799,687   |                          | $ |                          |  | $           | 260,686    |  | $ | 7,539,001   | 
|U.S. Government Agencies                         |  |                 | 19,472,446  |                          |   |                          |  |             | 577,154    |  |   | 18,895,292  | 
|States and Political Subdivisions                |  |                 | 13,384,428  |                          |   | 28,397                    |  |             | 510,012    |  |   | 12,902,813  | 
|Foreign Bonds                                    |  |                 | 38,383,380  |                          |   | 47,014                    |  |             | 1,983,500  |  |   | 36,446,894  | 
|Corporate Bonds                                  |  |                 | 240,776,982 |                          |   | 374,188                   |  |             | 11,888,471 |  |   | 229,262,699 | 
|Mortgage/Asset-Backed Securities                 |  |                 | 224,655,208 |                          |   | 102,120                   |  |             | 7,398,159  |  |   | 217,359,169 | 
|Preferred StocksRedeemable                      |  |                 | 29,411,087  |                          |   | 10,627                    |  |             | 1,191,778  |  |   | 28,229,936  | 
|                                                 |  |                 |             |                          |   |                           |  |             |            |  |   |             | 
|Subtotal, Fixed Maturity Securities              |  | $               | 573,883,218 |                          | $ | 562,346                   |  | $           | 23,809,760 |  | $ | 550,635,804 | 
|Equity Securities                                |  |                 | 156,840     |                          |   |                          |  |             | 1,700      |  |   | 155,140     | 
|                                                 |  |                 |             |                          |   |                           |  |             |            |  |   |             | 
|Securities Available For Sale                    |  | $               | 574,040,058 |                          | $ | 562,346                   |  | $           | 23,811,460 |  | $ | 550,790,944 | 
|                                                 |  |                 |             |                          |   |                           |  |             |            |  |   |             | 

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 June 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.

37

---

Table of Contents

|                                              |  |                   |     |                               |                |                                    |  |  |           | 
|--------------------------------------------- |  | ----------------- | --- | ----------------------------- | -------------- | ---------------------------------- |  |  | --------- | 
|                                              |  | Number of
 Issues |     | Aggregate 
 Unrealized 
 Loss |                | Aggregate 
 Estimated 
 Fair Value | 
|                                              |  |                   |     |                               |                |                                    | 
|                                              |  |                   |     |                               | (in thousands) |                                    |  |  |          
|Securities at a loss for 12 months or less    |  |                   | 226 |                               | $              | 9,006.1                            |  |  | 234,269.5 | 
|Securities at a loss for more than 12
 months |  |                   | 327 |                               | $              | 14,805.4                           |  |  | 266,724.9 | 

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 six
months ended June 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.

Reserves

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

|                               |  |                        |           |                          |   |           | 
|------------------------------ |  | ---------------------- | --------- | ------------------------ | - | --------- | 
|                               |  | As of
 June 30, 2007   |           | As of
 December 31, 2006 |  
|                               |  |                        |           |                          |  
|                               |  | (dollars in thousands) |          
|Life and annuity reserves      |  | $                      | 248,957.7 |                          | $ | 252,658.2 | 
|Accident and health reserves   |  |                        | 309,500.4 |                          |   | 294,581.0 | 
|Policy and contract claims     |  |                        | 27,198.4  |                          |   | 14,530.8  | 
|Other policyholder liabilities |  |                        | 10,815.8  |                          |   | 10,594.2  | 
|                               |  |                        |           |                          |   |           | 
|Total policy liabilities       |  | $                      | 596,472.3 |                          | $ | 572,364.2 | 
|                               |  |                        |           |                          |   |           | 

Life
and annuity reserves decreased by $3.7 million, or 1.5%, to $249.0 million as
of June 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 six months ended June 30, 2007. Accident and
health reserves increased by $14.9 million, or 5.1%, to $309.5 million as of
June 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 $12.7 million, or 87.6%, to $27.2 million
as of June 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

38

---

Table of Contents

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 the
Company has 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 actions, the Company believes
its June 30, 2007 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 $0.2 million, or 1.9%, to
$10.8 million as of June 30, 2007 from $10.6 million as of December 31, 2006.

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

|                                                |  |                         |          |                          |   |          | 
|----------------------------------------------- |  | ----------------------- | -------- | ------------------------ | - | -------- | 
|                                                |  | As of
 June 30, 2007    |          | As of
 December 31, 2006 |  
|                                                |  |                         |          |                          |  
|                                                |  | (dollars
 in thousands) |         
|Ceded future
 policyholder benefits and expense |  | $                       | 88,485.0 |                          | $ | 86,296.1 | 
|Ceded claims
 and benefits payable              |  |                         | 3,651.9  |                          |   | 2,795.1  | 
|                                                |  |                         |          |                          |   |          | 
|Reinsurance
 recoverables                       |  | $                       | 92,136.9 |                          | $ | 89,091.2 | 
|                                                |  |                         |          |                          |   |          | 

Reinsurance
recoverables increased by $3.0 million, or 3.4%, to $92.1 million as of June
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. For more information about our critical
accounting policies, please refer to our discussion of critical accounting
policies in our Annual Report on Form 10-K for the year ended December 31,
2006.

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:
the results of the strategic alternatives review process that the Company is
presently conducting; competitive products and pricing; fluctuations in demand;
possible recessionary trends in the United States

39

---

Table of Contents

economy;
governmental policies and regulations; interest rates; 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 1A to our Quarterly Report on From 10-Q 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 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 June 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 June
30, 2007. There was no change in our internal control over financial reporting
during the quarter ended June 30, 2007, that has materially affected, or is
reasonably likely to materially affect, our internal control over financial
reporting.

PART IIOTHER 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

As of June
30, 2007, there have been no material changes in the risk factors of the
Company as previously disclosed in the Companys Annual Report on Form 10-K for
the fiscal year ended December 31, 2006, and subsequently updated in the
Companys Quarterly Report on Form 10-Q for the quarter ended March 31, 2007.

|        |                                                     
|------- | ----------------------------------------------------
|ITEM 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

At the
annual meeting of the shareholders on May 3, 2007, the shareholders voted upon
nominees for election to the Board of Directors as Class III directors to serve
three year terms expiring at the 2010 annual meeting of shareholders. Each of
the two nominees was elected. The following is a summary of the votes cast:

|                |  |                       |  |                           | 
|--------------- |  | --------------------- |  | ------------------------- | 
|                |  | Number of Shares
 For |  | Number ofShares
 Withheld | 
|                |  |                       |  |                           | 
|                |  |                       |  |                           | 
|Kenneth U. Kuk  |  | 19,730,179            |  | 1,370,792                 | 
|John H. Flittie |  | 19,108,427            |  | 1,992,544                 | 

There
were no abstentions or broker non-votes.

40

---

Table of Contents

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

| |       |                                                                                                      
| | ----- | -----------------------------------------------------------------------------------------------------
| | (a)   | Exhibits:                                                                                            
|
| | 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.

41

---

Table of Contents

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:
 August 9, 2007 | By:                     |  | /s/
 Scott H. DeLong III                                                                            
|                      |                         |  |                                                                                                     
|                      |                         |  | Name:
 Scott H. DeLong III                                                                          
|                      |                         |  | Title:
 Senior Vice President & Chief Financial Officer                                             
|                      |                         |  | (Principal
 Financial Officer)                                                                      
|                      |                         |  |                                                                                                     
|Date:
 August 9, 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)                                                                      

42

---