UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549   FORM 10-Q  (Mark One)  xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  For the quarterly period ended September 30, 2006 OR o  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  For the transition period fromto  Commission file number:001-32377  KMG AMERICA CORPORATION (Exact Name of Registrant as Specified in Its Charter)  Virginia
(State or Other Jurisdiction of
Incorporation or Organization)

12600 Whitewater Drive, Suite 150, Minnetonka, Minnesota
(Address of Registrants Principal Executive Offices)
        20-1377270
(I.R.S. Employer
Identification No.)

55343
(Zip Code)
  Registrants telephone number, including area code:(952) 930-4800  Former name, former address and former fiscal year, if changed since last report:  Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.xYes  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 oAccelerated filerxNon-accelerated filer o Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o Yes [ X] No  As of November 3, 2006, the number of shares of Common Stock outstanding was 22,208,943.  KMG AMERICA CORPORATION  FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006  TABLE OF CONTENTS  ITEM NO.
        PAGE NO.PART 1. FINANCIAL INFORMATION
        1ITEM 1. FINANCIAL STATEMENTS
        1CONSOLIDATED BALANCE SHEETS AS OF SEPTEMBER 30, 2006 (UNAUDITED) and DECEMBER 31, 2005
        1CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005 AND THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
        3CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2006 AND 2005
        4NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
        5ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
        19ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
        33ITEM 4. CONTROLS AND PROCEDURES
        33PART II. OTHER INFORMATION
        34ITEM 1. LEGAL PROCEEDINGS
        34ITEM 1A. RISK FACTORS
        34ITEM 6. EXHIBITS
        34SIGNATURES
        35
    i  PART 1 FINANCIAL INFORMATION  ITEM 1.
        FINANCIAL STATEMENTS
  KMG AMERICA CORPORATION CONSOLIDATED BALANCE SHEETS   September 30,
        
        December 31,2006
        
        2005Assets
        
        
        (unaudited)Investments:Fixed maturity securities available for sale, at fair value (amortized cost of $537,620,068 and
$505,848,751 as of September 30, 2006 and December 31, 2005, respectively)
        
        $
        525,636,212
        
        $
        498,157,355Equity securities available for sale, at fair value (cost of $246,560 and $286,809 as of September 30, 2006 and December 31, 2005, respectively)
        
        
        245,659
        
        
        286,809Mortgage loans
        
        
        14,420,048
        
        
        17,606,746Policy loans
        
        
        19,103,496
        
        
        21,803,430Other investments
        
        
        5,225,779
        
        
        5,452,198Total investments
        
        
        564,631,194
        
        
        543,306,538Cash and cash equivalents
        
        
        11,270,716
        
        
        32,582,964Reinsurance balances recoverable
        
        
        88,039,777
        
        
        78,296,057Accrued investment income
        
        
        6,421,710
        
        
        5,917,136Real estate and equipment (net of accumulated depreciation of  $3,161,850 and $ 1,748,519 as of September 30, 2006 and December 31, 2005, respectively)
        
        
        14,245,863
        
        
        11,723,869Federal income tax recoverable
        
        
        5,111,539
        
        
        5,111,539Deferred income tax asset
        
        
        6,659,463
        
        
        6,015,462Amounts due from reinsurers
        
        
        2,425,180
        
        
        2,284,343Deferred policy acquisition costs
        
        
        24,547,849
        
        
        14,031,875Value of business acquired
        
        
        70,794,368
        
        
        72,638,967Other assets
        
        
        27,765,077
        
        
        25,456,319Total assets
        
        $
        821,912,736
        
        $
        797,365,069
   1  KMG AMERICA CORPORATION CONSOLIDATED BALANCE SHEETS  September 30,
        
        December 31,2006
        
        2005(unaudited)Liabilities and shareholders equityLiabilities:Policy and contract liabilities:Life and annuity reserves
        
        $
        254,290,117
        
        $
        299,454,172Accident and health reserves
        
        
        290,671,925
        
        
        227,705,619Policy and contract claims
        
        
        12,150,224
        
        
        10,008,352Other policyholder liabilities
        
        
        10,750,224
        
        
        10,726,188Total policy and contract liabilities
        
        
        567,862,490
        
        
        547,894,331Accounts payable and accrued expenses
        
        
        22,351,953
        
        
        20,105,386Taxes, other than federal income taxes
        
        
        1,029,270
        
        
        926,776Deferred income taxes
        
        
        14,404,166
        
        
        13,061,136Liability for benefits for employees and agents
        
        
        5,522,654
        
        
        5,667,297Funds held in suspense
        
        
        3,997,810
        
        
        4,671,388Long term notes payable
        
        
        13,520,167
        
        
        15,000,000Interest payable on long term notes
        
        
        1,343,394
        
        
        773,733Other liabilities
        
        
        1,913,973
        
        
        1,781,899Total liabilities
        
        
        631,945,877
        
        
        609,881,946Shareholders equity:Common Stock, par value $0.01 per share, 75,000,000 shares authorized and 22,209,093 and   22,125,998                shares issued and outstanding as of September 30, 2006 and December 31, 2005, respectively
        
        
        222,091
        
        
        221,260Paid-in capital
        
        
        189,632,103
        
        
        188,223,636Deferred stock based compensation
        
        
        (860,132
        )
        
        (450,703
        )Retained earnings
        
        
        8,762,889
        
        
        4,483,979Accumulated other comprehensive (loss)
        
        
        (7,790,092
        )
        
        (4,995,049
        )Total shareholders equity
        
        
        189,966,859
        
        
        187,483,123Total liabilities and shareholders equity
        
        $
        821,912,736
        
        $
        797,365,069
  See accompanying notes. 2  KMG AMERICA CORPORATION CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)   For the Three Months EndedSeptember 30,
        
        For the Nine Months EndedSeptember 30,2006
        
        2005
        
        2006
        
        2005Revenue:Insurance premiums
        
        $
        34,235,437
        
        $
        26,422,849
        
        $
        94,708,120
        
        $
        79,437,198Net investment income
        
        
        7,452,344
        
        
        7,088,996
        
        
        22,277,524
        
        
        20,542,548Commission and fee income
        
        
        4,017,003
        
        
        3,773,422
        
        
        12,353,612
        
        
        11,012,161Realized investment gains
        
        
        6,789
        
        
        278,153
        
        
        102,853
        
        
        324,115Other income
        
        
        1,274,941
        
        
        1,199,521
        
        
        3,183,821
        
        
        2,969,498Total revenues
        
        
        46,986,514
        
        
        38,762,941
        
        
        132,625,930
        
        
        114,285,520Benefits and expenses:Policyholder benefits
        
        
        26,185,612
        
        
        21,890,367
        
        
        73,912,980
        
        
        62,966,111Insurance commissions, net of deferrals
        
        
        3,246,059
        
        
        2,239,283
        
        
        9,151,335
        
        
        7,281,608General insurance expenses, net of deferrals
        
        
        10,836,365
        
        
        10,258,446
        
        
        33,019,337
        
        
        30,963,785Insurance taxes, licenses and fees
        
        
        1,288,532
        
        
        1,193,176
        
        
        4,095,905
        
        
        3,643,402Depreciation and amortization
        
        
        633,920
        
        
        746,506
        
        
        1,905,279
        
        
        2,170,790Amortization of deferred policy acquisition costs and value of business acquired
        
        
        1,681,208
        
        
        462,539
        
        
        4,014,551
        
        
        2,762,043Total benefits and expenses
        
        
        43,871,696
        
        
        36,790,317
        
        
        126,099,387
        
        
        109,787,739Income before income taxes
        
        
        3,114,818
        
        
        1,972,624
        
        
        6,526,543
        
        
        4,497,781Provision for income taxes
        
        
        (1,089,138
        )
        
        (634,178
        )
        
        (2,247,633
        )
        
        (1,426,126
        )Net income
        
        $
        2,025,680
        
        $
        1,338,446
        
        $
        4,278,910
        
        $
        3,071,655Net income per share:Basic
        
        $
        0.09
        
        $
        0.06
        
        $
        0.19
        
        $
        0.14Diluted
        
        $
        0.09
        
        $
        0.06
        
        $
        0.19
        
        $
        0.14Weighted-average shares outstanding:Basic
        
        
        22,206,893
        
        
        22,090,273
        
        
        22,180,730
        
        
        22,077,950Diluted
        
        
        22,207,981
        
        
        22,093,854
        
        
        22,198,708
        
        
        22,083,674
  See accompanying notes.  3  KMG AMERICA CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)   Nine Months Ended
September 30, 2006
        
        Nine Months EndedSeptember 30, 2005Operating activitiesNet income
        
        $
        4,278,910
        
        $
        3,071,655Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization
        
        
        3,442,627
        
        
        2,882,842Policy acquisition costs deferred and value of business acquired
        
        
        (12,685,925
        )
        
        (11,225,417
        )Amortization of deferred policy acquisition costs and value of business acquired
        
        
        4,014,550
        
        
        2,762,043Realized investment (gains), net
        
        
        (102,853
        )
        
        (324,115
        )Deferred income tax expense
        
        
        2,204,053
        
        
        2,664,603Changes in operating assets and liabilities:Reinsurance balances recoverable
        
        
        (9,743,720
        )
        
        (4,619,475
        )Accrued investment income
        
        
        (504,574
        )
        
        (350,249
        )Federal income tax recoverable
        
        
        
        
        
        (1,238,477
        )Other assets
        
        
        (2,308,758
        )
        
        3,507,470Amounts due from reinsurers
        
        
        (140,837
        )
        
        (293,742
        )Policy and contract liabilities
        
        
        19,968,159
        
        
        12,153,946Accounts payable and accrued expenses
        
        
        2,246,567
        
        
        14,094,252Long term notes payable
        
        
        (1,479,833
        )
        
        Interest payable on long term notes
        
        
        569,661
        
        
        562,500Stock-based compensation expense
        
        
        999,868
        
        
        10,375Taxes, other than federal income taxes
        
        
        102,494
        
        
        78,760Funds held in suspense
        
        
        (673,578
        )
        
        (1,462,977
        )Liability for benefits for employees and agents
        
        
        (144,643
        )
        
        780,915Other liabilities
        
        
        132,074
        
        
        124,116Net cash provided by operating activities
        
        
        10,174,242
        
        
        23,179,025Investing activitiesSecurities available for sale:Sales
        
        
        21,265,460
        
        
        46,310,947Maturities, calls and redemptions
        
        
        25,181,535
        
        
        266,272,077Purchases
        
        
        (79,884,792
        )
        
        (438,788,713
        )Repayments of mortgage loans
        
        
        3,186,698
        
        
        5,323,355Decrease in policy loans, net
        
        
        2,699,934
        
        
        726,592Sale of real estate and property and equipment
        
        
        
        
        
        85,564Purchases of real estate, property and equipment
        
        
        (3,935,325
        )
        
        (2,725,113
        )Acquisition of the Predecessor, net of cash acquired
        
        
        
        
        
        (160,000
        )Net cash (used in) investing activities
        
        
        (31,486,490
        )
        
        (122,955,291
        )Net (decrease) in cash and cash equivalents
        
        
        (21,312,248
        )
        
        (99,776,266
        )Cash and cash equivalents at beginning of period
        
        
        32,582,964
        
        
        117,400,156Cash and cash equivalents at end of period
        
        $
        11,270,716
        
        $
        17,623,890Supplemental disclosures of cash flow informationFederal income taxes paid
        
        $
        43,582
        
        $
        
   See accompanying notes. 4  KMG AMERICA CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS  1. Organization, Kanawha Acquisition, Initial Public Offering, 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, and one wholly owned indirect subsidiary, Kanawha Marketing Group, Inc.  The primary insurance products that the Company underwrites include: group and individual life insurance; group long term disability; group and individual short term disability; 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. Over time, the Company expects group lines of business to account for an increasing percentage of the Company's premium revenues.  Effective September 1, 2006, KMG Americas subsidiaries Kanawha and Kanawha Healthcare Solutions entered into a reinsurance and administrative arrangement with Columbian Life Insurance Company (CLIC) and Columbian Mutual Life Insurance Company (CMLIC).  CLIC and CMLIC are affiliates of each other.  Under the arrangement, which is subject to state approvals, Kanawha reinsures 100% of the risk of a block of voluntary term life insurance policies and universal life insurance policies from CLIC and CMLIC.  Kanawha HealthCare Solutions, Inc. will assume responsibility for the administration of these policies. As part of the transaction, CLIC and CMLIC also assigned key trademarks to Kanawha for these insurance policies and their marketing brand, UNIQ Benefit Solutions.  This transaction is expected to enhance KMG Americas presence in the voluntary term life market, create access to additional distribution and is expected to favorably impact the financial results. 2. Significant Accounting Policies Basis of Presentation The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All significant intercompany accounts and transactions have been eliminated in consolidation. Operating results for the quarter ended September 30, 2006, are not necessarily indicative of the results that may be expected for the year ended December 31, 2006.  5  The Company also submits financial statements to insurance industry regulatory authorities. Those financial statements are prepared on the basis of statutory accounting practices (SAP) and are significantly different from financial statements prepared in accordance with GAAP (see Note 4). Use of Estimates and Assumptions The presentation of the accompanying consolidated financial statements requires management to make estimates and assumptions that affect amounts reported in the consolidated financial statements and accompanying notes. Such estimates and assumptions could change in the future as more information becomes known, which could impact the amounts reported and disclosed herein. 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 maturity and equity securities at the time of purchase. Investments are reported on the following basis: 
        Fixed maturity 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. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities 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. 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 on deferred compensation investments.
 
        Mortgage loans on real estate are typically 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 market, or the lower of cost or market, as appropriate.
 
        Amortization of premiums and accrual of discounts on investments in fixed maturity securities are 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.
  6  The Company regularly reviews its investment portfolio to identify securities that may have suffered impairments in value that will not be recovered, termed potentially distressed securities. In identifying potentially distressed securities, the Company first screens for all securities that have a fair value to cost or amortized cost ratio of less than 80%. Additionally, as part of this identification process, the Company utilizes the following information:  
        Length of time the fair value was below amortized cost;
 
        Industry factors or conditions related to a geographic area negatively affecting the security;
 
        Downgrades by a rating agency;
 
        Past due interest or principal payments or other violation of covenants; and
 
        Deterioration of the overall financial condition of the specific issuer.
  In analyzing its potentially distressed securities list for other-than-temporary impairments, the Company pays special attention to securities that have been on the list for a period greater than six months. The Company assumes that, absent reliable contradictory evidence, a security that is potentially distressed for a continuous period greater than twelve months has 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 in value 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. 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 individual 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. The Company does not currently defer acquisition costs on group insurance products sold to employers. 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 recognized using amortization schedules established at the time of the acquisitions based upon expected annual premium, and, in some cases, expected future earnings. Certain of these amortization results include actual to expected adjustments to reflect policy or premium persistency as it emerges. The value of business acquired for premium paying policies is amortized in proportion to future expected premiums. The value of business acquired for policies paid up as of the acquisition date is amortized in proportion to expected future earnings. 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  7  investment yield, mortality, morbidity, withdrawals and maintenance expenses, and including margins for adverse deviations. Interest assumptions are based on interest rate levels and expectations at the time policies are sold. Mortality, morbidity and withdrawal assumptions are based on recognized actuarial tables or the Company or its Predecessor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 (not material in the current mix of business in force) 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 continue to be shown after conversion to 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 purchase GAAP 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 does have an impact on the balance sheet on a segment by segment basis. This balance sheet impact is further discussed in Note 8 (Business Segments).  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, or DAC) 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 income and a corresponding reduction in DAC. Any additional deficiency would be recognized as a premium deficiency reserve. Historically, loss recognition testing has not resulted in an adjustment to DAC or reserves. These adjustments would occur only if economic, mortality and/or morbidity conditions significantly deviated from the underlying assumptions. 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. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (SAB 107) relating to SFAS 123(R). The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R).  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 and for the nine months ended September 30, 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). Share-based compensation expense recognized under SFAS 123(R) for the nine months ended September 30, 2006 was $999,868, which consisted of share-based compensation expense related to director and employee stock options and common stock grants.  8  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.  Stock-based compensation expense recognized during the period is based on the value of the portion of share-based payment awards that is ultimately expected to vest during the period. Stock-based compensation expense recognized in the Companys Consolidated Statement of Income for the nine months of 2006 included compensation expense for share-based payment awards granted prior to, but not yet vested as of December 31, 2005 based on the grant date fair value estimated in accordance with the pro forma provisions of SFAS 123 and compensation expense for the share-based payment awards granted subsequent to January 1, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123(R). As stock-based compensation expense recognized in the Consolidated Statement of Income for the nine months of fiscal 2006 is based on awards ultimately expected to vest, it has
been reduced for estimated forfeitures. SFAS 123(R) requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Companys pro forma information required under SFAS 123 for the period prior to fiscal 2006, the Company accounted for forfeitures as they occurred.  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 of the additional paid-in capital pool (APIC pool) related to the tax effects of employee stock-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123(R).  Recently Issued Accounting Standards 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 is still in the process of evaluating the impact that SFAS No. 158 will have on the
Companys financial statements. In June 2006, the Financial Accounting Standards Board (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 is currently assessing the impact of FIN 48 on its financial statements. In November 2005, the Financial Accounting Standards Board (FASB), issued FSP (FASB Staff Position) FAS 115 -1 and 124 -1  The Meaning of Other  Than- Temporary Impairment and its Application to Certain Investments. The FSP addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. The FSP also addresses accounting considerations subsequent to the recognition of an other than temporary impairment and requires certain disclosures about unrealized losses. FSP FAS 115 -1 replaces the impairment evaluation guidance of EITF 03 -1. EITF 03 -1s disclosure requirements stay in effect. The guidance was effective for reporting periods beginning after December 15, 2005. At December 31, 2005 the Company followed the current guidance in place (EITF 03 -1) when
assessing its portfolio for Other-Than-Temporary Impairments. The Company and its Investment Committee recognize the changes as a result of FSP FAS 115 -1 and have ensured adherence to the guidelines. The adoption of FSP FAS 115-1 did not have a material impact on the Companys operations or financial position.  9  In December 2004, the Financial Accounting Standards Board (FASB) enacted SFAS No. 123 (revised 2004) (FAS 123 (revised 2004)), Share-Based Payment, which replaces SFAS No. 123 (FAS 123), Accounting for Stock-Based Compensation, and supersedes APB Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees. FAS 123 (revised 2004) requires the measurement of all employee share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in the Companys consolidated statements of operations. The accounting provisions of FAS 123 (revised 2004) are effective for reporting periods beginning December 31, 2005. The Company adopted FAS 123 (revised 2004) in the first quarter of 2006.  In November 2005, the Financial Accounting Standards Board (FASB) issued FSP (FASB Staff Position) FAS 123(R)  Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards. FSP FAS 123(R) requires the calculation of excess tax benefits available to absorb tax deficiencies (termed an additional paid-in-capital or APIC pool) recognized subsequent to the adoption of SFAS 123(R). Because most companies did not adopt the recognition provisions in SFAS 123 as is the case with the Company, and instead opted for the disclosure-only approach, many companies concluded they do not have the information to comply with the transition requirements in SFAS 123R. Accordingly, the FASB adopted an elective short- cut approach when a company transitions to SFAS 123R. An entity that adopts SFAS 123(R) using either the modified retrospective method or modified
prospective method may make a one time election to adopt the transition method described in FSP 123(R). The entity must follow the guidance for calculating the pool of excess tax benefits and the guidance related to reporting the cash flows. An entity is free to choose either approach to the calculation of excess tax benefits without having to justify the preferability of the election. The Company has evaluated the requirements under FAS 123(R) in tandem with FSP SFAS 123(R) and adopted the pronouncements as of January 1, 2006.  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 will evaluate whether adoption of this pronouncement impacts the Companys consolidated financial condition and results of operations in 2006.  In June 2005, the Financial Accounting Standards Board (FASB) issued SFAS No. 154 (SFAS 154), Accounting Changes and Error Corrections, a replacement of APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. SFAS 154 requires retrospective application to prior periods financial statements for all voluntary changes in accounting principle, unless impracticable.  SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 31, 2005. SFAS 154 had no immediate impact on the Companys consolidated financial statements, though it will impact our presentation of future voluntary accounting changes, should such changes occur.  10  3. Investments Aggregate amortized cost, aggregate fair value and gross unrealized gains and losses of investments in fixed maturity and equity securities are summarized in the following table. Amortized Cost
        
        GrossUnrealizedGains
        
        GrossUnrealizedLosses
        
        FairValueAvailable for sale securities at September 30, 2006:Fixed maturity securities
        
        $
        537,620,068
        
        $
        1,624,824
        
        $
        13,608,680
        
        $
        525,636,212Equity securities
        
        
        246,560
        
        
        
        
        
        901
        
        
        245,659Securities available for sale
        
        $
        537,866,628
        
        $
        1,624,824
        
        $
        13,609,581
        
        $
        525,881,871
 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 without the approval of the South Carolina Insurance Commissioner. Under these restrictions, during 2006, dividends, loans or advances by Kanawha in excess of $8.5 million will require the approval of the South Carolina Insurance Commissioner. 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 EndedSeptember 30,
        
        Nine Months EndedSeptember 30,2006
        
        2005
        
        2006
        
        2005Components of net periodic benefit cost:Service cost
        
        $
        47,778
        
        $
        227,579
        
        $
        143,334
        
        $
        682,737Interest cost
        
        
        232,510
        
        
        228,171
        
        
        697,530
        
        
        684,513Expected return on plan assets
        
        
        (309,641
        )
        
        (207,384
        )
        
        (928,923
        )
        
        (622,152
        )Amortization of transition liability
        
        
        362
        
        
        4,343
        
        
        1,086
        
        
        13,029Recognized net actuarial loss
        
        
        52,646
        
        
        42,608
        
        
        157,938
        
        
        127,824Net periodic benefit cost
        
        $
        23,655
        
        $
        295,317
        
        $
        70,965
        
        $
        885,951Curtailment Expense
        
        $
        
        
        
        
        
        $
        120,170
 On January 31, 2006, the Company adopted two amendments to the defined benefit retirement plan that freeze participation in the plan and freeze accrual of any additional benefits under the plan.  As of March 31, 2006, no new participants are allowed to enter the plan. Effective as of September 30, 2006, no additional benefits will 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.  11  The curtailment expense recognized during the three months ended March 31, 2006, as a result of the plan freeze was $120,170. Defined Contribution Plan  The Company offers a 401(k) qualified savings plan for which substantially all employees and agents are eligible. Presently, each year, 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. The Company contributes 25% of the first 6% of base compensation that a participant contributes to the Plan. The Company may contribute amounts greater than 25% at its discretion.  The Company approved amendments to the defined contribution plan increasing the Companys match of salary deferral contributions. Effective as of October 1, 2006, the Company will match 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.  Also effective January 1, 2007, the Company will make non-matching contributions to the accounts of plan participants who are actively employed with the Company and meet certain age and service requirements as of January 1, 2007.  The contributions will be equal to the amount of the eligible plan participants earned salary and bonus in the
calendar year for which the contribution is made, multiplied by the percentage in the table below corresponding to that participants age as of January 1, 2007:  Age 45-49:
        1.5%
 Age 50-54:
        2.75%
 Age 55+:
        4.0%
  The initial contributions will be made in January 2008, and annually thereafter.  The contributions vest 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
 SFAS 123 required the presentation of pro forma information as if the Company had accounted for its employee and director stock options granted after December 31, 1994, under the fair value method of that Statement. 12  The following is a reconciliation of reported net income and pro forma information as if the Company had adopted SFAS 123 for its employee and director stock option awards for the quarterly period presented:  Three Months Ended September 30,
        
        Nine Months Ended September 30,2005
        
        2005Net income as reported
        
        $
        1,338,446
        
        $
        3,071,655Add:  Stock-based employee compensation expense included in reported net income, net of related tax effects
        
        
        
        
        
        Deduct:  Total stock-based employee compensation determined under fair value based methods for all awards, net of related tax effects
        
        
        (181,661
        )
        
        (526,745
        )Pro forma net income available to common stockholders
        
        $
        1,156,785
        
        $
        2,544,910Net income per share-basic:As reported
        
        $
        0.06
        
        $
        0.14Pro forma
        
        $
        0.05
        
        $
        0.12Net income per share-diluted:As reported
        
        $
        0.06
        
        $
        0.14Pro forma
        
        $
        0.05
        
        $
        0.12
  The Company adopted SFAS 123(R) as of January 1, 2006. Below is the presentation of the Company's 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 ofCommon Stock Grants OutstandingNonvested
        
        
        
        Vested
        
        
        Nonvested
        
        
        
        VestedOutstanding as of December 31, 2005
        
        54,357
        
        
        
        0
        
        $
        8.86
        
        
        $
        0Granted
        
        76,150
        
        
        
        10,779
        
        
        8.02
        
        
        
        7.86Vested
        
        (8,534
        )
        
        
        8,534
        
        
        8.83
        
        
        
        8.83Forfeited
        
        (3,834
        )
        
        
        0
        
        
        9.06
        
        
        
        0Outstanding as of September 30, 2006
        
        118,139
        
        
        
        19,313
        
        $
        8.30
        
        
        
        8.40
  Stock Options  Black-Scholes option-pricing model assumptions used:  Average Risk-free Interest Rate
        5.05%
 Expected Dividend Yield
        
 Expected Volatility
        20.0%
 Expected Life (years)
        5
  13  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, 2005
        1,413,750
        
        $
        9.47Granted
        385,175
        
        
        8.04Exercised
        0
        
        
        0Forfeited
        (11,750
        )
        
        8.97Outstanding as of September 30, 2006
        1,787,175
        
        
        9.17
        
        $
        4,358,663
        
        8.63Exercisable as of September 30, 2006
        369,521
        
        $
        9.49
        
        $
        909,132
        
        8.30
  The following table sets forth share-based compensation and the related tax benefit:  Quarter EndedSeptember 30, 2006Total Share-Based CompensationIncluded in income before income taxes
        $
        999,868Included in net income, net of tax effects
        $
        649,914Excess tax benefits related to options exercised
        $
        0Excess tax benefits related to share-based compensation(1)
        $
        0
 ________________________ (1)  Represents the tax benefit, recognized in additional paid-in-capital for stock options exercised.  As of September 30, 2006, there was $3,518,624 of total unrecognized compensation cost related to nonvested share-based compensation arrangements. 6. Comprehensive Income (Loss) Total comprehensive income (loss) for the nine months ended September 30, 2006 and 2005 was $1,483,867 and $(24,584), respectively. The difference between comprehensive income and net income for these periods was unrealized investment gains (losses) of $(2,795,043) and $(3,096,239), respectively. Total comprehensive income (loss) for the three months ended September 30, 2006 and 2005 was $13,243,352 and $(6,647,050), respectively. The difference between comprehensive income and net income for these periods was unrealized gains (losses) of $11,217,672 and $(7,985,497), respectively. 7. Commitments and Contingencies On December 21, 2004, the Company entered into a $15.0 million five-year subordinated promissory note to fund a portion of the purchase price for the Kanawha acquisition.  Interest on the promissory note accrues at 5% per annum and is added to the principal balance on December 31 of each year and is payable on the maturity date.  No cash payments are required under the promissory note until maturity, at which time principal and accrued interest will be due and payable.  The terms of the promissory note limit the Company's and Kanawha's ability to incur additional debt.  The Company has the right to offset certain indemnification claims it may have against the former shareholders of Kanawha who hold the note against the amounts it owes under the note.  Pursuant to the terms of the stock purchase agreement the Company entered into with the former shareholders of Kanawha in connection with the Companys purchase of the outstanding capital stock of Kanawha in December 2004, and the terms of the promissory note, the Company asserted five indemnification claims against the former shareholders of Kanawha relating to the period prior to the closing of the Kanawha acquisition.  The five claims made by the Company sought indemnification for: (i) workers compensation premiums owed by Kanawha for the 2003-2004 coverage period; (ii) a sales tax assessment made by the South Carolina Department of Revenue against Kanawha; (iii) an overstatement of Kanawhas invested asset valuation; (iv) unpaid reinsurance premiums owed by Kanawha; and (v) premium refunds paid by Kanawha as a result of a cancelled block of insurance policies.  14  Under the terms of the promissory note, the Company has offset the amount of these claims, totaling $1.5 million, against the amounts it owes under the note.  As a result of this offset, approximately $17.4 million of principal and accrued interest will be due on the note at its maturity.  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.  On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York (ReliaStar), both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore and Gibb are officers of KMG America and former employees of the plaintiffs.  The complaint alleges misappropriation of trade secrets, conversion, tortious interference with business and employment relationships, breach of fiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive relief and unspecified monetary damages. On August 24, 2005, the plaintiffs amended their complaint to add Scott H. DeLong
III and Thomas D. Sass as defendants. Messrs. DeLong and Sass are officers of KMG America and former employees of the plaintiffs. The plaintiffs amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentations and civil theft. On August 9, 2005, a hearing was held before the court to consider plaintiffs motion for a temporary injunction and on August 26, 2005, the court issued a ruling denying plaintiffs motion. Since that date, plaintiffs filed a notice of appeal of the courts ruling with the Minnesota Court of Appeals and oral argument was held on June 13, 2006. On September 5, 2006, the Minnesota Court of Appeals issued a ruling affirming the district courts denial of plaintiffs motion for a temporary injunction. The Company believes the allegations are without merit and intends to defend the action vigorously. While the outcome of legal actions cannot be
predicted with certainty, management believes the outcome of this matter will not have a material adverse effect on the Companys consolidated financial position or results of operations.  The Company has been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will, subject to the terms, conditions and limitations of the insurance policy, reimburse the Company for a significant portion of future defense costs and potential damages, losses and liabilities resulting from this litigation.  The Company also has received partial reimbursement under the insurance policy for defense costs incurred to date.  As a result, the Company expects that the ongoing defense cost reimbursements and reimbursements of any damages, losses or liabilities under the directors and officers insurance policy should reduce the risk that future defense costs and any damages, losses or liabilities may have a material adverse effect on the
Companys future consolidated financial position or results of operations. 8. 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. 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; group and individual short term disability; 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. The Company ceased actively underwriting long-term care insurance policies after December 31, 2005. 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.  15  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 implemented the use of seriatim PGAAP reserve 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 has been 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. This was offset by a reduction in reserves of $31.2 million in the acquired business segment and $6.3 million in the worksite segment. No material effect to overall policy reserves or to earnings resulted from the reallocation. Subsequent reserve adequacy testing of policy reserves by segment indicates that the resulting alignment of reserves is sufficient in each segment.  This reallocation of reserves between the business segments does impact the comparability of the current quarter reported policyholder benefits and the resulting reported benefit ratios by segment.  16  The following represents a summary of the Companys statements of income and asset composition by reportable segment.  Three Months Ended
        
        
        Nine Months EndedSeptember 30,
        
        
        September 30,2006
        
        
        2005
        
        
        2006
        
        
        2005Worksite Insurance BusinessInsurance premiums
        
        $
        23,703,164
        
        $
        15,105,546
        
        $
        61,535,883
        
        $
        44,791,793Net investment income
        
        
        1,868,419
        
        
        1,537,580
        
        
        5,226,959
        
        
        4,922,481Commissions and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        41,139
        
        
        39,898
        
        
        137,363
        
        
        129,619Total revenues
        
        
        25,612,722
        
        
        16,683,024
        
        
        66,900,205
        
        
        49,843,893Policyholder benefits
        
        
        17,043,732
        
        
        11,501,803
        
        
        38,043,879
        
        
        33,052,454Commissions
        
        
        1,902,554
        
        
        847,974
        
        
        4,986,597
        
        
        2,726,454Expenses, taxes, fees and depreciation
        
        
        4,281,888
        
        
        4,043,392
        
        
        12,965,899
        
        
        11,796,341Amortization of DAC and VOBA
        
        
        1,138,631
        
        
        1,112,928
        
        
        2,442,814
        
        
        2,827,308Total benefits and expenses
        
        
        24,366,805
        
        
        17,506,097
        
        
        58,439,189
        
        
        50,402,557(Loss) income before Federal income tax
        
        $
        1,245,917
        
        $
        (823,073
        )
        $
        8,461,016
        
        $
        (558,664
        )Total assets
        
        $
        167,949,426
        
        $
        167,106,744
        
        $
        167,949,426
        
        $
        167,106,744Senior Market Insurance BusinessInsurance premiums
        
        $
        9,901,357
        
        $
        10,376,261
        
        $
        31,281,477
        
        $
        32,104,963Net investment income
        
        
        2,367,286
        
        
        1,195,795
        
        
        5,344,533
        
        
        3,344,360Commissions and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        825,885
        
        
        731,410
        
        
        2,394,890
        
        
        2,187,982Total revenues
        
        
        13,094,528
        
        
        12,303,466
        
        
        39,020,900
        
        
        37,637,305Policyholder benefits
        
        
        7,432,374
        
        
        8,845,120
        
        
        62,729,941
        
        
        26,366,213Commissions
        
        
        1,252,339
        
        
        1,294,005
        
        
        3,888,795
        
        
        4,255,366Expenses, taxes, fees and depreciation
        
        
        714,831
        
        
        1,098,722
        
        
        2,213,905
        
        
        3,225,266Amortization of DAC and VOBA
        
        
        648,242
        
        
        (392,462
        )
        
        1,624,352
        
        
        403,240Total benefits and expenses
        
        
        10,047,786
        
        
        10,845,385
        
        
        70,456,993
        
        
        34,250,085(Loss) before Federal income tax
        
        $
        3,046,742
        
        $
        1,458,081
        
        $
        (31,436,093
        )
        $
        3,387,220Total assets
        
        $
        255,012,640
        
        $
        185,674,997
        
        $
        255,012,640
        
        $
        185,674,997Third Party Administration BusinessInsurance premiums
        
        $
        
        
        $
        
        
        $
        
        
        
        Net investment income
        
        
        
        
        
        
        
        
        
        
        
        Commissions and fees
        
        
        3,923,545
        
        
        3,695,647
        
        
        12,082,886
        
        
        10,761,455Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        504
        
        
        573
        
        
        504
        
        
        1,435Total revenues
        
        
        3,924,049
        
        
        3,696,220
        
        
        12,083,390
        
        
        10,762,890Policyholder benefits
        
        
        
        
        
        
        
        
        
        
        
        Commissions
        
        
        
        
        
        
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        3,529,628
        
        
        3,130,480
        
        
        10,480,937
        
        
        9,597,648Amortization of DAC and VOBA
        
        
        
        
        
        3
        
        
        
        
        
        Total benefits and expenses
        
        
        3,529,628
        
        
        3,130,480
        
        
        10,480,937
        
        
        9,597,648Income before Federal income tax
        
        $
        394,421
        
        $
        565,740
        
        $
        1,602,453
        
        $
        1,165,242Total assets
        
        $
        6,689,366
        
        $
        10,326,878
        
        $
        6,689,366
        
        $
        10,326,878
    17   Three Months Ended
        
        
        Nine Months EndedSeptember 30,
        
        
        September 30,2006
        
        
        2005
        
        
        2006
        
        
        2005Acquired BusinessInsurance premiums
        
        $
        630,916
        
        $
        941,042
        
        $
        1,890,761
        
        $
        2,540,442Net investment income
        
        
        1,979,339
        
        
        1,865,737
        
        
        6,066,100
        
        
        5,844,126Commissions and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        15,836
        
        
        19,655
        
        
        54,858
        
        
        51,367Total revenues
        
        
        2,626,091
        
        
        2,826,434
        
        
        8,011,719
        
        
        8,435,935Policyholder benefits
        
        
        1,709,506
        
        
        1,543,444
        
        
        (26,860,840
        )
        
        3,547,444Commissions
        
        
        91,166
        
        
        97,304
        
        
        275,943
        
        
        299,788Expenses, taxes, fees and depreciation
        
        
        594,523
        
        
        674,650
        
        
        1,795,998
        
        
        2,046,264Amortization of DAC and VOBA
        
        
        (105,665
        )
        
        (257,927
        )
        
        (52,615
        )
        
        (468,505
        )Total benefits and expenses
        
        
        2,289,530
        
        
        2,057,471
        
        
        (24,841,514
        )
        
        5,424,991Income before Federal income tax
        
        $
        336,561
        
        $
        768,963
        
        $
        32,853,233
        
        $
        3,010,944Total assets
        
        $
        163,274,384
        
        $
        207,228,787
        
        $
        163,274,384
        
        $
        207,228,787Corporate and OtherInsurance premiums
        
        $
        
        
        $
        
        
        $
        
        
        $
        Net investment income
        
        
        1,237,299
        
        
        2,489,884
        
        
        5,639,931
        
        
        6,431,581Commissions and fees
        
        
        93,458
        
        
        77,775
        
        
        270,726
        
        
        250,706Net realized gains
        
        
        6,791
        
        
        278,153
        
        
        102,853
        
        
        324,115Other income
        
        
        391,575
        
        
        407,985
        
        
        596,205
        
        
        599,095Total revenues
        
        
        1,729,123
        
        
        3,253,797
        
        
        6,609,715
        
        
        7,605,497Policyholder benefits
        
        
        
        
        
        
        
        
        
        
        
        Commissions
        
        
        
        
        
        
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        3,637,946
        
        
        3,250,884
        
        
        11,563,780
        
        
        10,112,458Amortization of DAC and VOBA
        
        
        
        
        
        
        
        
        
        
        
        Total benefits and expenses
        
        
        3,637,946
        
        
        3,250,884
        
        
        11,563,780
        
        
        10,112,458(Loss) before Federal income tax
        
        $
        (1,908,823
        )
        $
        2,913
        
        $
        (4,954,065
        )
        $
        (2,506,961
        )Total assets
        
        $
        228,986,920
        
        $
        231,785,624
        
        $
        228,986,920
        
        $
        231,785,624Total CompanyInsurance premiums
        
        $
        34,235,437
        
        $
        26,422,849
        
        $
        94,708,120
        
        $
        79,437,198Net investment income
        
        
        7,452,344
        
        
        7,088,996
        
        
        22,277,524
        
        
        20,542,548Commissions and fees
        
        
        4,017,003
        
        
        3,773,422
        
        
        12,353,612
        
        
        11,012,161Net realized gains
        
        
        6,789
        
        
        278,153
        
        
        102,853
        
        
        324,115Other income
        
        
        1,274,941
        
        
        1,199,521
        
        
        3,183,821
        
        
        2,969,498Total revenues
        
        
        46.986,514
        
        
        38,762,941
        
        
        132,625,930
        
        
        114,285,520Policyholder benefits
        
        
        26,185,612
        
        
        21,890,367
        
        
        73,912,980
        
        
        62,966,111Commissions
        
        
        3,246,059
        
        
        2,239,283
        
        
        9,151,335
        
        
        7,281,608Expenses, taxes, fees and depreciation
        
        
        12,758,817
        
        
        12,198,128
        
        
        39,020,521
        
        
        36,777,977Amortization of DAC and VOBA
        
        
        1,681,208
        
        
        462,539
        
        
        4,014,551
        
        
        2,762,043Total benefits and expenses
        
        
        43,871,696
        
        
        36,790,317
        
        
        126,099,387
        
        
        109,787,739Income before Federal income tax
        
        
        3,114,818
        
        $
        1,972,624
        
        $
        6,526,543
        
        $
        4,497,781Total assets
        
        $
        821,912,736
        
        $
        802,123,030
        
        $
        821,912,736
        
        $
        802,123,030
  18  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 which historically have been marketed primarily in the southeastern United States, but are now actively marketed nationwide.  Worksite insurance business. Our worksite insurance business is a provider of voluntary life and health insurance products to employers and their employees which have been historically marketed primarily in the southeastern United States but are now actively marketed nationwide.  The primary insurance products that we underwrite include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. For the nine months ended September 30, 2006, our worksite insurance business produced premiums, commissions and fees, excluding intercompany payments, of $61.5 million, which accounted for 57.5% 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 will add a new set of employer-paid life insurance, disability and health products to our existing voluntary products. Through December 31, 2005, we opened regional sales offices in Boston, Massachusetts; Tampa, Florida; Chicago, Illinois; New York, New York; Atlanta, Georgia; Dallas, Texas; Kansas City, Missouri; Cleveland, Ohio; Philadelphia, Pennsylvania; New Orleans, Louisiana; Irvine (a Los Angeles suburb), San Diego and San Francisco, California; and Minneapolis, Minnesota. Since January 1, 2006, we opened regional sales offices in Cincinnati, Ohio; Denver, Colorado; and Phoenix, Arizona. While we expect to continue to add and train additional sales and sales support staff and
marketing personnel at these facilities and at offices we open in other markets throughout the United States, we have decided for the remainder of 2006 to limit hiring and maintain 21 sales representatives until we see margin improvement in the market.  We will recognize the costs associated with the new worksite distribution organization before we recognize revenues resulting from new sales activity. Consequently, we expect negative cash flow and operating losses in the short term.  Senior market insurance business. Our senior market insurance business has been a provider in the southeastern United States of individual insurance products tailored to the needs of older individuals. The primary insurance product included in this business is long-term care insurance that we underwrote. For the nine months ended September 30, 2006, our senior market insurance business produced premiums, commissions and fees, excluding intercompany payments, of $31.3 million, which accounted for 29.2% of our premiums, commissions and fees, excluding intercompany payments, in that period.  Beginning January 1, 2006, the Company ceased actively underwriting long-term care insurance policies.  We intend to retain and actively manage the existing block of in-force long-term care insurance policies (including the right to receive future premiums and the liability for future claims).  Third-party administration business. Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services. This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business. Our third-party administration business also provides administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, reinsurers and managed care plans. For the nine months ended September 30, 2006, our third-party administration business produced commissions and fees, excluding intercompany payments, of $12.1 million, which accounted for            11.3% of our premiums, commissions and fees, excluding intercompany payments, in that period. Our
primary business strategy for this business 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  19  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 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. Results of Operations Consolidated Overview The following table presents consolidated financial information for the three and nine months ended September 30, 2006 and September 30, 2005 for KMG America. Three Months Ended
September 30,
        
        
        Nine Months Ended
September 30,2006
        
        
        2005
        
        
        2006
        
        
        2005(dollars in thousands)
        
        
        (dollars in thousands)Revenues:Insurance premiums
        
        $
        34,236
        
        $
        26,423
        
        $
        94,708
        
        $
        79,438Net investment income
        
        
        7,452
        
        
        7,089
        
        
        22,277
        
        
        20,542Commission and fees
        
        
        4,017
        
        
        3,773
        
        
        12,354
        
        
        11,012Net realized gains (losses)
        
        
        7
        
        
        278
        
        
        103
        
        
        324Other income
        
        
        1,275
        
        
        1,200
        
        
        3,184
        
        
        2,970Total revenues
        
        
        46,987
        
        
        38,763
        
        
        132,626
        
        
        114,286Benefits and expenses:Policyholder benefits
        
        
        26,186
        
        
        21,890
        
        
        73,913
        
        
        62,966Commissions
        
        
        3,246
        
        
        2,239
        
        
        9,151
        
        
        7,282General expenses
        
        
        10,836
        
        
        10,259
        
        
        33,019
        
        
        30,964Taxes, licenses and fees
        
        
        1,289
        
        
        1,193
        
        
        4,096
        
        
        3,643Depreciation and amortization
        
        
        634
        
        
        747
        
        
        1,905
        
        
        2,171Amortization of DAC and VOBA
        
        
        1,681
        
        
        463
        
        
        4,015
        
        
        2,762Total benefits and expenses
        
        
        43,872
        
        
        36,791
        
        
        126,099
        
        
        109,788Income before income taxes
        
        
        3,115
        
        
        1,972
        
        
        6,527
        
        
        4,498Provision for income taxes
        
        
        (1,089
        )
        
        (634
        )
        
        (2,248
        )
        
        (1,426
        )Net income
        
        $
        2,026
        
        $
        1,338
        
        $
        4,279
        
        $
        3,072Benefits to premiums ratio(1)
        
        
        76.5
        %
        
        82.8
        %
        
        78.0
        %
        
        79.3
        %
  (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.
  20  Consolidated Results of Operations by Business Segment  Note 8, Business Segments, of the Notes to Consolidated Financial Statements included in this report, which includes a summary of our statements of income and asset composition by reportable segment, is incorporated herein by reference.  Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005  Financial Results Overview Net income for the nine months ended September 30, 2006, increased $1.2 million, or 38.7%, to $4.3              million from net income of $3.1 million for the nine months ended September 30, 2005. The increase in net income was primarily due to increases in premiums and net investment income, offset by increases in policyholder benefits and general expenses, all of which are described in greater detail below. Revenues Total revenues for the nine months ended September 30, 2006, increased $18.3 million, or 16.0%, to $132.6 million from total revenues of $114.3 million for the nine months ended September 30, 2005. The primary factors causing the increase are explained below under the captions Premiums, Net Investment Income, Commission and Fee Income, Realized Investment Gains and Losses and Other Income. Premiums The following table presents the distribution of premiums by type and business segment. For the nine months ended September 30, 2006
        
        For the nine months ended September 30, 2005
        
        Increase (decrease)Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        TotalDirectNew
        
        $
        31.6
        
        $
        0.6
        
        $
        
        
        $
        32.2
        
        $
        12.7
        
        $
        1.5
        
        $
        
        
        $
        14.2
        
        $
        18.9
        
        $
        (0.9
        )
        $
        
        
        $
        18.0Renewal
        
        
        34.3
        
        
        41.5
        
        
        
        
        
        75.8
        
        
        34.0
        
        
        40.9
        
        
        
        
        
        74.9
        
        
        0.3
        
        
        0.6
        
        
        
        
        
        0.9Total
        
        
        65.9
        
        
        42.1
        
        
        
        
        
        108.0
        
        
        46.7
        
        
        42.4
        
        
        
        
        
        89.1
        
        
        19.2
        
        
        (0.3
        )
        
        
        
        
        18.9AssumedNew
        
        
        2.9
        
        
        
        
        
        
        
        
        2.9
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        2.9
        
        
        
        
        
        
        
        
        2.9Renewal
        
        
        
        
        
        
        
        
        1.9
        
        
        1.9
        
        
        
        
        
        
        
        
        2.5
        
        
        2.5
        
        
        
        
        
        
        
        
        (0.6
        )
        
        (0.6
        )Total
        
        
        2.9
        
        
        
        
        
        1.9
        
        
        4.8
        
        
        
        
        
        
        
        
        2.5
        
        
        2.5
        
        
        2.9
        
        
        
        
        
        (0.6
        )
        
        2.3CededNew
        
        
        (6.4
        )
        
        (0.4
        )
        
        
        
        
        (6.8
        )
        
        (1.2
        )
        
        (0.8
        )
        
        
        
        
        (2.0
        )
        
        (5.2
        )
        
        0.4
        
        
        
        
        
        (4.8
        )Renewal
        
        
        (0.9
        )
        
        (10.4
        )
        
        
        
        
        (11.3
        )
        
        (0.7
        )
        
        (9.5
        )
        
        
        
        
        (10.2
        )
        
        (0.2
        )
        
        (0.9
        )
        
        
        
        
        (1.1
        )Total
        
        
        (7.3
        )
        
        (10.8
        )
        
        
        
        
        (18.1
        )
        
        (1.9
        )
        
        (10.3
        )
        
        
        
        
        (12.2
        )
        
        (5.40
        )
        
        (0.5
        )
        
        
        
        
        (5.9
        )NetNew
        
        
        28.1
        
        
        0.2
        
        
        
        
        
        28.3
        
        
        11.5
        
        
        0.7
        
        
        
        
        
        12.2
        
        
        16.6
        
        
        (0.5
        )
        
        
        
        
        16.1Renewal
        
        
        33.4
        
        
        31.1
        
        
        1.9
        
        
        66.4
        
        
        33.3
        
        
        31.4
        
        
        2.5
        
        
        67.2
        
        
        0.1
        
        
        (0.3
        )
        
        (0.6
        )
        
        (0.8
        )Total
        
        $
        61.5
        
        $
        31.3
        
        $
        1.9
        
        $
        94.7
        
        $
        44.8
        
        $
        32.1
        
        $
        2.5
        
        $
        79.4
        
        $
        16.7
        
        $
        (0.8
        )
        $
        (0.6
        )
        $
        15.3
  Worksite net new premiums increased $16.6 million, or 144.3%, to $28.1 million for the nine months ended September 30, 2006, from $11.5 million for the nine months ended September 30, 2005, due to increased sales volumes. The primary driver of this increase was new premium generated by the new KMG America sales force, which represents $21.9million of direct new premiums, offset by $5.5 million of ceded new premiums.  In addition, there was $2.9 million of new reinsurance assumed premium for the block acquisition of voluntary term life insurance and universal life insurance policies from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.  Net renewal premiums increased $0.1 million or 0.3%. Senior market net new premiums, composed of long term care policies, decreased $0.5 million, or 71.4%, to $0.2 million for the nine months ended September 30, 2006, from $0.7 million for the nine months ended September 30, 2005 due to decreased sales volumes.  New sales decreased $0.9 million, or 69.2%, to $ 0.4 million for the nine months ended September 30, 2006, from $1.3 million for the nine months ended September 30, 2005. Effective January 1, 2006, the Company ceased actively underwriting new long term care policies. Sales in 2006 result from business submitted prior to December 31, 2005 and issued in 2006, as well as the exercise of guaranteed  21  purchase options on in force policies. Net renewal premiums decreased $ 0.3 million, or 1.0% to $31.1 million for the nine months ended September 30, 2006, from $31.4 million for the nine months ended September 30, 2005. This business represents the insurance in force created by prior year sales. Acquired business premiums decreased $0.6 million, or 24.0%, to $1.9 million for the nine months ended September 30, 2006, from $2.5 million for the nine months ended September 30, 2005. We have not acquired any blocks of business in this segment since 1999 and the decline is a result of policy lapses. Net Investment Income Net investment income increased $1.8 million, or 8.8%, to $22.3 million for the nine months ended September 30, 2006, from $20.5 million for the nine months ended September 30, 2005. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The increase in investment income for the nine months ended September 30, 2006, occurred primarily as a result of investing in longer term securities in combination with higher interest rates in 2006. Cash and invested assets on an amortized cost basis decreased $9.7 million, or 1.6%, to $587.9 million as of September 30, 2006, from $597.6 million as of September 30, 2005. Cash and invested assets were somewhat inflated at September 30, 2005 as the cash settlement of $12.6 million securities payable had not yet occurred. Generally, an increase in invested assets is due to retention of premiums to establish
policy reserves for the payment of future policyholder benefits. The average yield on cash and invested assets on an amortized cost basis was 5.07% for the nine months ended September 30, 2006, compared to an average yield of 4.66% for the nine months ended September 30, 2005. This increase resulted from higher interest rates combined with the significantly lesser amount of assets held in cash during the nine months ended September 30, 2006. 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. In addition, the reallocation of reserves has a corresponding reallocation of attributed assets between business segments. This balance sheet impact is further discussed in Note 8 (Business Segments).  Commission and Fee Income Commission and fee income increased $1.3 million, or 11.8%, to $12.3 million for the nine months ended September 30, 2006, from $11.0 million for the nine months ended September 30, 2005. Most of the commission and fee income was from administrative fees relating to third-party administration, and the increase was due to an increase in business in force relating to increased sales of administrative services. Realized Investment Gains and Losses Realized investment gains and losses occur as a result of the sale or impairment of investments and the change in fair value of securities in the Company's trading portfolio. The net realized investment gain for the nine months ended September 30, 2006, decreased by $0.2 million to $0.1 million, from $0.3 million for the nine months ended September 30, 2005. Capital losses of $0.2 million were recognized in the fixed maturity portfolio in 2006 compared to capital gains of $0.2 million for the same period of 2005. These losses resulted from the sales of assets as is necessary from time to time in order to keep the portfolio properly structured. In addition, capital gains of $0.3 million in 2006 and $0.1 million in 2005 were recognized due 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.  22  Other Income Other income increased $0.2 million, or 6.7%, to $3.2 million for the nine months ended September 30, 2006, from $3.0 million for the nine months ended September 30, 2005, reflecting increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums. Benefits and Expenses Total benefits and expenses increased $16.3 million, or 14.8%, to $126.1 million for the nine months ended September 30, 2006, from $109.8 million for the nine months ended September 30, 2005. 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 continue to be 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 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 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 8 (Business Segments).  Policyholder benefits increased $10.9 million, or 17.3%, to $73.9 million for the nine months ended September 30, 2006, from $63.0 million for the nine months ended September 30, 2005. This produced a benefits to premium ratio of 78.0% for the nine months ended September 30, 2006, compared to 79.3% for the nine months ended September 30, 2005. Worksite marketing policyholder benefits increased $5.0 million, or 15.2%, to $38.0 million for the nine months ended September 30, 2006, from $33.0 million for the nine months ended September 30, 2005. This produced a deflated benefits to premium ratio of 61.8% for the nine months ended September 30, 2006, compared to    73.8% for the nine months ended September 30, 2005.  The reduced ratio is driven by the conversion to PGAAP seriatim reserve factors from the aggregate method, which resulted in decreased benefits of $6.3 million coupled with an increase in new premiums with more favorable benefit ratios.  The nine months ended September 30, 2006 benefits to premium ratio excluding the reserve conversion impact would be 72.0%.  In the nine months ended September 30, 2006 results there is recognition of $0.9 million of stop loss claims relating to specific cases written in 2005, as we
transition from formula reserving to actual claims experience as this block grows and matures.  Volatility, both favorable and unfavorable, is not uncommon in small, growing books of business.  Cases giving rise to these excess claims have since been re-priced or did not renew. Senior market policyholder benefits increased $36.3 million, or 137.5%, to $62.7 million for the nine months ended September 30, 2006, from $26.4 million for the nine months ended September 30, 2005. This produced an inflated benefits to premium ratio of 200.5% for the nine months ended September 30, 2006, compared to 82.1% for the nine months ended September 30, 2005. The benefits to premium ratio increased primarily as a result of the conversion to PGAAP seriatim reserve factors from the aggregate method, which resulted in increased benefits of $37.5 million, coupled with an increase in open active claims due to the aging of our policyholders, which resulted in increases in actual claims paid and additional claim reserves.  The nine months ended September 30, 2006 benefits to premium ratio excluding the reserve conversion impact would be 80.7%. Acquired business policyholder benefits decreased $30.4 million, to $(26.9) million for the nine months ended September 30, 2006, from $3.5 million for the nine months ended September 30, 2005. This produced a skewed benefits to premium ratio of (1420.6)% for the nine months ended September 30, 2006, compared to 139.6% for the nine months ended September 30, 2005.The benefits to premium ratio decreased primarily as the result of the conversion to PGAAP seriatim reserve factors from the aggregate method, which resulted in decreased benefits of  23  $31.2 million coupled with the fact that 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. The nine months ended September 30, 2006 benefits to premium ratio excluding the reserve conversion impact would be 231.4%. Insurance Commissions
 Commission expenses increased $1.9 million, or 26.0%, to $9.2 million for the nine months ended September 30, 2006, from $7.3 million for the nine months ended September 30, 2005. 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 excess risk products. General Insurance Expenses General insurance expenses increased $2.1 million, or 6.8%, to $33.0 million for the nine months ended September 30, 2006, from $30.9 million for the nine months ended September 30, 2005. The increased expenses for the nine months ended September 30, 2006 are primarily attributable to increases in salaries and related benefits due to the additional staff associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel. Also, there was the recognition of employee and director stock option and common stock expense of $1.0 million as a result of the adoption of SFAS123(R) Shared-Based Payment. 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 $0.5 million, or 13.9%, to $4.1 million for the nine months ended September 30, 2006, from $3.6 million for the nine months ended September 30, 2005. 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 $12.7 million and $11.2 million for the nine months ended September 30, 2006 and 2005, 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 $1.2 million, or 42.9% to $4.0 million for the nine months ended September 30, 2006, from $2.8 million for the nine months ended September 30, 2005. The DAC balance at September 30, 2006 has increased by $14.2 million, or 137.9%, over the balance at September 30, 2005. This is due to the fact that our predecessors DAC balance was eliminated at December 31, 2004, when the acquisition was completed. Therefore, as of September 30, 2005, there were only nine months of deferrals compared to 21 months of deferrals as of September 30, 2006. This increase in the DAC balance accounts for the related increase in amortization expense. Provision for Income Taxes Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments, non-deductible expenses and net operating loss carry forwards available. The effective income tax rates for the nine months ended September 30, 2006 and 2005 were 34.4% and 31.7%, respectively. The variations in these rates are due to the fact that portions of our consolidated income for the nine  24  months ended September 30, 2006 and September 30, 2005 resulted from a subsidiary that has net operating loss carryforwards available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the consolidated company. The variation in the overall consolidated rate between periods is driven by the levels of the subsidiary's contribution to total income. Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005  Financial Results Overview Net income for the three months ended September 30, 2006, increased $0.7 million, or 53.8%, to $2.0            million from net income of $1.3 million for the three months ended September 30, 2005. The increase in net income was primarily due to increases in premiums and net investment income, offset by increases in policyholder benefits and general expenses, all of which are described in greater detail below. Revenues Total revenues for the three months ended September 30, 2006, increased $8.2 million, or 21.1%, to $47.0            million from total revenues of $38.8 million for the three months ended September 30, 2005. The primary factors causing the increase are explained below under the captions Premiums, Net Investment Income, Commission and Fee Income, Realized Investment Gains and Losses and Other Income. Premiums The following table presents the distribution of premiums by type and business segment. For the three months ended September 30, 2006
        
        For the three months ended September 30, 2005
        
        Increase (decrease)Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        TotalDirectNew
        
        $
        11.7
        
        $
        0.1
        
        $
        
        
        $
        11.8
        
        $
        4.9
        
        $
        0.5
        
        $
        
        
        $
        5.4
        
        $
        6.8
        
        $
        (0.4
        )
        $
        
        
        $
        6.4Renewal
        
        
        11.7
        
        
        13.5
        
        
        
        
        
        25.2
        
        
        11.2
        
        
        13.3
        
        
        
        
        
        24.5
        
        
        0.5
        
        
        0.2
        
        
        
        
        
        0.7Total
        
        
        23.4
        
        
        13.6
        
        
        
        
        
        37.0
        
        
        16.1
        
        
        13.8
        
        
        
        
        
        29.9
        
        
        7.3
        
        
        (0.2
        )
        
        
        
        
        7.1AssumedNew
        
        
        2.9
        
        
        
        
        
        
        
        
        2.9
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        2.9
        
        
        
        
        
        
        
        
        2.9Renewal
        
        
        
        
        
        
        
        
        0.6
        
        
        0.6
        
        
        
        
        
        
        
        
        0.9
        
        
        0.9
        
        
        
        
        
        
        
        
        (0.3
        )
        
        (0.3
        )Total
        
        
        2.9
        
        
        
        
        
        0.6
        
        
        3.5
        
        
        
        
        
        
        
        
        0.9
        
        
        0.9
        
        
        2.9
        
        
        
        
        
        (0.3
        )
        
        2.6CededNew
        
        
        (2.3
        )
        
        (0.1
        )
        
        
        
        
        (2.4
        )
        
        (0.8
        )
        
        (0.3
        )
        
        
        
        
        (1.1
        )
        
        (1.5
        )
        
        0.2
        
        
        
        
        
        (1.3
        )Renewal
        
        
        (0.3
        )
        
        (3.6
        )
        
        
        
        
        (3.9
        )
        
        (0.2
        )
        
        (3.1
        )
        
        
        
        
        (3.3
        )
        
        (0.1
        )
        
        (0.5
        )
        
        
        
        
        (0.6
        )Total
        
        
        (2.6
        )
        
        (3.7
        )
        
        
        
        
        (6.3
        )
        
        (1.0
        )
        
        (3.4
        )
        
        
        
        
        (4.4
        )
        
        (1.6
        )
        
        (0.3
        )
        
        
        
        
        (1.9
        )NetNew
        
        
        12.3
        
        
        
        
        
        
        
        
        12.3
        
        
        4.1
        
        
        0.2
        
        
        
        
        
        4.3
        
        
        8.2
        
        
        (0.2
        )
        
        
        
        
        8.0Renewal
        
        
        11.4
        
        
        9.9
        
        
        0.6
        
        
        21.9
        
        
        11.0
        
        
        10.2
        
        
        0.9
        
        
        22.1
        
        
        0.4
        
        
        (0.3
        )
        
        (0.3
        )
        
        (0.2
        )Total
        
        $
        23.7
        
        $
        9.9
        
        $
        0.6
        
        $
        34.2
        
        $
        15.1
        
        $
        10.4
        
        $
        0.9
        
        $
        26.4
        
        $
        8.6
        
        $
        (0.5
        )
        $
        (0.3
        )
        $
        7.8
  Worksite net new premiums increased $8.2 million, or 200.0%, to $12.3 million for the three months ended September 30, 2006, from $4.1 million for the three months ended September 30, 2005, due to increased sales volumes. The primary driver of this increase was new premium generated by the new KMG America sales force, which represents $8.6 million of direct new premiums, offset by $2.0 million of ceded new premiums.   In addition, there was $2.9 million of new reinsurance assumed premium from the block acquisition of voluntary term life insurance and universal life insurance policies from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.  Net renewal premiums increased $0.4 million or 3.6%. Senior market net new premiums, composed of long term care policies, decreased $0.2 million, or                                                             100.0%, to $0.0 million for the three months ended September 30, 2006, from $0.2 million for the three months ended September 30, 2005 due to decreased sales volumes. New sales decreased $ 0.4 million, or 100.0%, to $0.0           million for the three months ended September 30, 2006, from $0.4 million for the three months ended September 30, 2005.  Effective January 1, 2006, the Company ceased actively underwriting new long term care policies. Net  25  renewal premiums decreased $ 0.3 million, or 2.9%, to $9.9 million due to quarterly fluctuations of policy anniversary dates. Acquired business premiums decreased $0.3 million, or 33.3%, to $0.6 million for the three months ended September 30, 2006, from $0.9 million for the three months ended September 30, 2005. We have not acquired any blocks of business in this segment since 1999 and the decline is a result of policy lapses. Net Investment Income Net investment income increased $0.4 million, or 5.6 %, to $7.5 million for the three months ended September 30, 2006, from $7.1 million for the three months ended September 30, 2005. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The increase in investment income for the three months ended September 30, 2006, occurred primarily as a result of investing in longer term securities in combination with higher interest rates in 2006. Cash and invested assets on an amortized cost basis decreased $9.7 million, or 1.6%, to $587.9 million as of September 30, 2006, from $597.6 million as of September 30, 2005. Cash and invested assets were somewhat inflated at September 30, 2005 as the cash settlement of $12.6 million securities payable had not yet occurred. Generally, an increase in invested assets is due to retention of premiums to establish
policy reserves for the payment of future policyholder benefits. The average yield on cash and invested assets on an amortized cost basis was 5.11% for the three months ended September 30, 2006, compared to an average yield of 4.81% for the three months ended September 30, 2005. This increase resulted from higher interest rates combined with the significantly lesser amount of assets held in cash during the quarter ended September 30, 2006. 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 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. In addition, the reallocation of reserves has a corresponding reallocation of attributed assets between business segments. This balance sheet impact is further discussed in Note 8 (Business Segments).  Commission and Fee Income Commission and fee income increased $0.2 million, 5.3%, to $4.0 million for the three months ended September 30, 2006, from $3.8 million for the three months ended September 30, 2005. Most of the commission and fee income was from administrative fees relating to third-party administration, and the increase was due to an increase in business in force relating to increased sales of administrative services. Realized Investment Gains and Losses Realized investment gains and losses occur as a result of the sale or impairment of investments and the change in fair value of securities in the Company's trading portfolio. The net realized investment gains for the three months ended September 30, 2006, decreased by $0.3 million to $0.0 million, from $0.3 million for the three months ended September 30, 2005. Capital losses of $0.2 million were recognized in the fixed maturity portfolio in 2006 compared to capital gains of $0.1 million for the same period of 2005. These resulted from the sales of assets as is necessary from time to time in order to keep the portfolio properly structured. In addition, capital gains of $0.2 million in 2006 and $0.1 million in 2005 were recognized due 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.  26  Other Income Other income increased $0.1 million, or 8.3%, to $1.3 million for the three months ended September 30, 2006, from $1.2 million for the three months ended September 30, 2005, reflecting increased commission and expense allowances from reinsurance companies generated from renewal ceded premiums. Benefits and Expenses Total benefits and expenses increased $7.1 million, or 19.3%, to $43.9 million for the three months ended September 30, 2006, from $36.8 million for the three months ended September 30, 2005. 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 continue to be 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 refinement in methodology was implemented whereby the benefit reserves are now being developed directly on a purchase GAAP 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 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 8 (Business Segments).  Policyholder benefits increased $4.3 million, or 19.6%, to $26.2 million for the three months ended September 30, 2006, from $21.9 million for the three months ended September 30, 2005. This produced a benefits to premium ratio of 76.5% for the three months ended September 30, 2006, compared to 82.8% for the three months ended September 30, 2005. Worksite marketing policyholder benefits increased $5.5 million, or 47.8%, to $17.0 million for the three months ended September 30, 2006, from $11.5 million for the three months ended September 30, 2005. This produced benefits to premium ratios of 71.9% for the three months ended September 30, 2006, compared to        76.1% for the three months ended September 30, 2005.  The reduced ratio is driven by an increase in new premiums with more favorable benefit ratios, as well as the recognition of $0.9 million of stop loss claims relating to specific cases written in 2005 as we transition from formula reserving to actual claims experience as this block grows and matures.   Volatility, both favorable and unfavorable, is not uncommon in small, growing books of business.  Cases giving rise to these excess claims have since been re-priced or did not renew. Senior market policyholder benefits decreased $1.4 million, or 15.9%, to $7.4 million for the three months ended September 30, 2006, from $8.8 million for the three months ended September 30, 2005. This produced benefits to premium ratios of 75.1% for the three months ended September 30, 2006, compared to 85.2% for the three months ended September 30, 2005. The benefits to premium ratio decreased primarily as a result of a decrease in open active claims, which resulted in decreases in actual claims paid and less claim reserves. Acquired business policyholder benefits increased $0.2 million, or 13.3%, to $1.7 million for the three months ended September 30, 2006, from $1.5 million for the three months ended September 30, 2005. This produced benefits to premium ratios of 271.0% for the three months ended September 30, 2006, compared to 164.0% for the three months ended September 30, 2005. The benefits to premium ratio is affected by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. The increased ratio for the quarter is more properly attributed to reduced premiums than to increases in claims.  27  Insurance Commissions Commission expenses increased $1.0 million, or 45.5%, to $3.2 million for the three months ended September 30, 2006, from $2.2 million for the three months ended September 30, 2005. 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 core group products. General Insurance Expenses General insurance expenses increased $0.6 million, or 5.8%, to $10.8 million for the three months ended September 30, 2006, from $10.2 million for the three months ended September 30, 2005.  The increased expenses for the three months ended September 30, 2006 are primarily attributable to normal increases in salaries and other expenses. Also, there is now recognition of the employee and director stock option and common stock expense as a result of the adoption of SFAS 123(R) Share- Based payment. 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 $0.1 million, or 8.3%, to $1.3 million for the three months ended September 30, 2006, from $1.2 million for the three months ended September 30, 2005. Employment taxes related to additional staffing and premium taxes related to additional premiums are the primary drivers of this 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 $5.0 million and $4.0 million for the three months ended September 30, 2006 and 2005, 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 $1.2 million, or 240%, to $1.7 million for the three months ended September 30,2006, from $0.5 million  for the three months ended September 30,2005. The DAC balance at September 30, 2006 has increased by $14.2 million, or 137.9%, over the balance at September 30, 2005. This is due to the fact that our predecessors DAC balance was eliminated at December 31, 2004 when the acquisition was completed. Therefore, as of September 30, 2005, there were was only nine months of deferrals compared to 21 months of deferrals as of September 30, 2006. This increase in the DAC balance accounts for the majority of the related increase in amortization expense. In addition, adjustments to amortization are made based on policy persistency. The third quarter of 2005 had a slightly
positive adjustment, while the third quarter of 2006 had a slightly negative adjustment. 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, non-deductible expenses and net operating loss carry forwards available. The effective income tax rates for the three months ended September 30, 2006 and 2005 were 34.9% and 32.1%, respectively. The variations in these rates are due to the fact that a portion of our consolidated income for the three months ended September 30, 2006 and September 30, 2005 resulted from a subsidiary that has net operating loss carry forwards available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the consolidated  28  company. The variation in the overall consolidated rate between periods is driven by the levels of the subsidiary's contribution to total income. 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 other non-insurance subsidiaries. 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, comply with minimum solvency and
capital 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,providedthat the dividend payment does not exceed earned surplus, in which case further limitations apply. For 2006, the maximum amount of dividends that Kanawha can pay to KMG America under applicable laws and regulations without prior regulatory approval is $8.5 million. 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. KMG America has outstanding debt of approximately $14.9 million because a portion of the purchase price for the Kanawha acquisition was paid in the form of a $15.0 million subordinated promissory note with a five-year term beginning on the closing date of the acquisition.   Interest on the promissory note is accruing at 5% per annum and is added to the principal balance on December 31 of each year and is payable on the maturity date. No cash payments are required under the promissory note until maturity, at which time principal and accrued interest will be due and payable. The terms of the promissory note limit KMG Americas and Kanawhas ability to incur additional debt.  The Company has the right to offset certain indemnification claims it may have against the former shareholders of Kanawha who hold the note against the amounts it owes under the note.  The amount KMG
America owes under the note has been reduced by an offset against the note of approximately $1.5 million for certain indemnification claims made by KMG America against the former shareholders of Kanawha.  As a result of this offset, the outstanding amount of principal and interest owed on the note is approximately $14.9 million and approximately $17.4 million of principal and accrued interest will be due on the note at its maturity.  We are seeking to expand our available credit facilities in order to maximize financial flexibility and are considering adding leverage to our capital structure. 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 2006 or subsequent years. However, our primary focus is on  29  significantly expanding outlays relating to marketing and sales activities over the next several years including outlays required 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. 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: For the Nine Months Ended
September 30,2006
        
        2005(dollars in thousands)Net cash provided by (used in)Operating activities
        
        $
        10,174.2
        
        $
        23,179.0Investing activities
        
        
        (31,486.4
        )
        
        (122,955.3
        )Financing activities
        
        
        
        
        
        Net change in cash
        
        $
        (21,312.2
        )
        $
        (99,776.3
        )
  Cash Flows for the Quarters Ended September 30, 2006 and 2005.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. Other changes in cash flows for the nine months ended September 30, 2006 and September 30, 2005, are as follows: We held approximately $32.6 million in cash and cash equivalents at December 31, 2005, primarily consisting of investments in short term commercial paper. We invested a significant portion of this in longer term securities in the first nine months of 2006, resulting in the net cash outflow from investing activities of $31.5              million for the nine months ended September 30, 2006. This produced a corresponding increase in invested assets.  Other assets increased by $2.3 million in the nine months ended September 30, 2006 primarily as a result of 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.  30  Accounts payable and accrued expenses increased $2.2 million in the nine months ended September 30, 2006.  The increase is primarily due to a $1.7 million increase in the reinsurance payable to one of our reinsurance assumed clients.  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.  Federal income tax recoverable remained constant from the December 31, 2005 balance. The deferred tax asset increased by $0.6 million and the deferred tax liability increased by $1.3 million. The combination of these items resulted in a net increase in tax liabilities of $0.7 million, inclusive of a decrease of $1.5 million related to the decrease in fair market value of invested assets. Investments The following table summarizes the unrealized gains and losses in our investment portfolio as of September 30, 2006. Amortized Cost
        
        GrossUnrealizedGains
        
        GrossUnrealizedLosses
        
        FairValueAvailable for sale securities at
September 30, 2006:U.S. Treasury Securities
        
        $
        8,507,339
        
        $
        2,833
        
        $
        193,783
        
        $
        8,316,389U.S. Government Agency Securities
        
        
        26,763,812
        
        
        0
        
        
        465,312
        
        
        26,298,500States and Political Subdivision Securities
        
        
        13,575,332
        
        
        62,775
        
        
        260,335
        
        
        13,377,772Foreign Bonds
        
        
        43,844,066
        
        
        60,849
        
        
        1,457,082
        
        
        42,447,833Corporate Bonds
        
        
        229,868,397
        
        
        823,573
        
        
        7,493,918
        
        
        223,198,052Mortgage/Asset-Backed Securities
        
        
        212,531,451
        
        
        674,794
        
        
        3,588,429
        
        
        209,617,816Preferred StocksRedeemable
        
        
        2,529,671
        
        
        0
        
        
        149,821
        
        
        2,379,850Subtotal, Fixed Maturity Securities
        
        
        537,620,068
        
        
        1,624,824
        
        
        13,608,680
        
        
        525,636,212Equity Securities
        
        
        246,560
        
        
        0
        
        
        901
        
        
        245,659Securities Available For Sale
        
        $
        537,866,628
        
        $
        1,624,824
        
        $
        13,609,581
        
        $
        525,881,871
  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 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.  31  The substantial majority of our unrealized losses at September 30, 2006, can be attributed to increases in interest rates that caused the value of the fixed income securities in our investment portfolio to decrease. Number of Issues
        
        Aggregate Unrealized Loss
        
        Aggregated Estimated Fair Value(in thousands)Securities at a loss for 12 months or less
        
        138
        
        $
        (3,327.3
        )
        $
        145,342.9Securities at a loss for more than 12 months
        
        332
        
        $
        (10,282.2
        )
        $
        277,835.9
  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 first nine months of 2006.  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 ofSeptember 30, 2006
        
        As ofDecember 31, 2005(dollars in thousands)Life and annuity reserves
        
        $
        254,290.1
        
        $
        299,454.2Accident and health reserves
        
        
        290,671.9
        
        
        227,705.6Policy and contract claims
        
        
        12,150.2
        
        
        10,008.3Other policyholder liabilities
        
        
        10,750.2
        
        
        10,726.2Total policy liabilities
        
        $
        567,862.4
        
        $
        547,894.3
  Life and annuity reserves decreased by $45.2 million, or 15.1%, to $254.3 million as of September 30, 2006 from $299.5 million as of December 31, 2005. A large portion of the life and annuity reserves relates to acquired blocks of business that are lapsing at a steady pace because no new blocks of business have been acquired since 1999, and therefore represents a significant portion of the decrease in reserves for the nine months ended September 30, 2006 as well as the conversion to PGAAP seriatim reserves (refer to Note 8  Business Segments, incorporated herein by reference for further explanation). Accident and health reserves increased by $63.0 million, or 27.7%, to $290.7 million as of September 30, 2006 from $227.7 million as of December 31, 2005. 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 as well as the conversion to PGAAP seriatim reserves (refer to Note 8  Business Segments, of the Notes to Consolidated Financial Statements included in this report, which is incorporated herein by reference).  Policy and contract claims, which represent liabilities for actual claims reported and payable, increased by $2.1 million, or 21.0%, to $12.1 million as of September 30, 2006 from $10.0 million as of December 31, 2005. The majority of this increase represents claims reserves established for the new excess risk business sold in the last year. Although there are always fluctuations in policy and contract claim reserves from period to period, there were no  32  other significant events or trends during the periods discussed in this paragraph that would produce any material changes in our claims reserves.  Other policyholder liabilities, which are comprised primarily of dividend accumulations and advance premiums, were flat year over year at $10.7 million.  The following table sets forth reinsurance recoverables by category as of the dated indicated:  As ofSeptember 30, 2006
        
        As ofDecember 31, 2005(dollars in thousands)Ceded future policyholder benefits and expense
        
        $
        84,714.3
        
        $
        77,086.6Ceded claims and benefits payable
        
        
        3,325.5
        
        
        1,209.5Reinsurance recoverables
        
        $
        88,039.8
        
        $
        78,296.1
  Reinsurance recoverables increased by $9.7 million, or 12.4%, to $88.0 million as of September 30, 2006, from $78.3 million as of December 31, 2004. 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/A Amendment No. 1 for the year ended December 31, 2005. Forward-Looking Statements Forward-looking statements in the foregoing Managements Discussion and Analysis of Financial Condition and Results of Operations include statements that are identified by the use of words or phrases including, but not limited to, the following: will likely result, expected to, will continue, is anticipated, estimated, project, believe, expect, and words or phrases of similar import. Changes in the following important factors, among others, could cause our actual results to differ materially from those expressed in any such forward-looking statements: competitive products and pricing; fluctuations in demand; possible recessionary trends in the United States economy; governmental policies and regulations; interest rates; risks disclosed in Part I Item 1A to Annual Report of Form 10-K/A
Amendment No. 1 for the year ended December 31, 2005; 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/A Amendment No. 1 for the year ended December 31, 2005. 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,  33  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 timely. An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of September 30, 2006. Based upon that evaluation, our management, including our Chief Executive Officer and our Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of September 30, 2006. There was no change in our internal control over financial reporting during the quarter ended September 30, 2006, that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting. PART II OTHER INFORMATION  ITEM 1. LEGAL PROCEEDINGS The disclosure made in the third and fourth paragraphs of Note 7, Commitments and Contingencies, of the Notes to Consolidated Financial Statements included in this report, which discuss certain legal proceedings in which we are involved, is incorporated herein by reference. ITEM 1A. RISK FACTORS
 As of September 30, 2006, 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/A Amendment No. 1 for the fiscal year ended December 31, 2005.  34  ITEM 6.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.
  35  SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.  KMG AMERICA CORPORATION
(Registrant)Date:  November 8, 2006
        By:
        /s/ Scott H. DeLong IIIDate:  November 8, 2006
        By:
        Name: Scott H. DeLong III
Title: Senior Vice President & Chief Financial Officer
(Principal Financial Officer)

/s/ Glenn S. SackettName: Glenn S. Sackett
Title: Vice President & Controller
(Principal Accounting Officer)
   36