**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****WASHINGTON, D.C. 20549**

 

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**FORM 10-Q**

 

 

**(Mark One)**

**ý        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the quarterly period endedMarch 31, 2005**

**OR**

** **

** **

**o        TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**                                Forthe transition period from                                                                  to**

** **

** **

**Commission file number:****001-32377**

 

**KMGAMERICA CORPORATION**

(Exact Name of Registrant as Specified in Its Charter)

 

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

 

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

 

Indicate by check mark whether theregistrant:  (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ýNo o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes oNo ý

 

As of May 2, 2005, the number of shares of Common Stock outstanding was22,071,641.

 

 

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**KMG AMERICA CORPORATION**

 

**FORM 10-Q**

 

**FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005**

**TABLE OFCONTENTS**

** **
| **ITEM NO.**                   | ** **                                                                                         | ** **                                                                                  |
|--------------------------------|----------------------------------------------------------------------------------------------------|---------------------------------------------------------------------------------------------|
|                           |                                                                                               |                                                                                        |
| PART I. FINANCIAL  INFORMATION |                                                                                               |                                                                                        |
|                           |                                                                                               |                                                                                        |
|                           | ITEM 1.                                                                                            | FINANCIAL STATEMENTS                                                                        |   |   |
|                           |                                                                                               |                                                                                        |
|                           | CONSOLIDATED BALANCE SHEETS  AS OF DECEMBER 31, 2004, AND MARCH 31, 2005 (UNAUDITED)               |                                                                                        |   |
|                           | CONSOLIDATED  STATEMENTS OF INCOME (UNAUDITED) FOR THE QUARTERS ENDED MARCH 31, 2004, AND  2005    |                                                                                        |   |
|                           | CONSOLIDATED  STATEMENTS OF CASH FLOW (UNAUDITED) FOR THE QUARTERS ENDED MARCH 31, 2004,  AND 2005 |                                                                                        |   |
|                           | NOTES TO  CONSOLIDATED FINANCIAL STATEMENTS                                                        |                                                                                        |   |
|                           |                                                                                               |                                                                                        |   |
|                           | ITEM  2.                                                                                           | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |   |   |
|                           |                                                                                               |                                                                                        |
|                           | ITEM  3.                                                                                           | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 |   |   |
|                           |                                                                                               |                                                                                        |
|                           | ITEM 4.                                                                                            | CONTROLS AND  PROCEDURES                                                                    |   |   |
|                           |                                                                                               |                                                                                        |
| PART II. OTHER INFORMATION     |                                                                                               |                                                                                        |
|                           |                                                                                               |                                                                                        |
|                           | ITEM 1.                                                                                            | LEGAL PROCEEDINGS                                                                           |   |   |
|                           |                                                                                               |                                                                                        |
|                           | ITEM  2.                                                                                           | UNREGISTERED  SALES OF EQUITY SECURITIES AND USE OF PROCEEDS                                |   |   |
|                           |                                                                                               |                                                                                        |
|                           | ITEM 6.                                                                                            | EXHIBITS                                                                                    |   |   |
|                           |                                                                                               |                                                                                        |
| SIGNATURES                     |                                                                                               |                                                                                        |

 

i

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# **PART IFINANCIAL INFORMATION**

 

## **ITEM 1.**                                     FINANCIAL STATEMENTS.

 

**KMGAMERICA CORPORATION AND SUBSIDIARY**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                | ** ** | **December 31,  2004** | ** **  | **March 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|-------------|---------------------|------------|
| ** **                                                                                                                                                                | ** ** | ** **             | ** **  | **(Unaudited)**     | ** ** |
| **Assets**                                                                                                                                                                | ** ** | ** **             | ** **  | ** **          | ** ** |
| ** **                                                                                                                                                                | ** ** | ** **             | ** **  | ** **          | ** ** |
| Investments:                                                                                                                                                              |       |                   |        |                |       |
| Fixed maturity securities available for sale, at fair value  (amortized cost of $409,613,186 and $488,127,072 as of December 31, 2004, and  March 31, 2005, respectively) |       | $                      | 409,613,186 |                | $          | 481,406,851 |   |
| Equity securities available for sale, at fair value (cost of $36,000  and $36,000 as of December 31, 2004, and March 31, 2005, respectively)                              |       | 36,000                 |        | 36,000              |       |
| Mortgage loans                                                                                                                                                            |       | 23,678,639             |        | 21,658,300          |       |
| Policy loans                                                                                                                                                              |       | 22,620,801             |        | 22,492,716          |       |
| Other investments                                                                                                                                                         |       | 5,192,525              |        | 5,075,327           |       |
| Total investments                                                                                                                                                         |       | 461,141,151            |        | 530,669,194         |       |
|                                                                                                                                                                      |       |                   |        |                |       |
| Cash and cash equivalents                                                                                                                                                 |       | 117,400,156            |        | 41,928,551          |       |
| Reinsurance balances recoverable                                                                                                                                          |       | 71,354,798             |        | 71,800,173          |       |
| Accrued investment income                                                                                                                                                 |       | 4,912,216              |        | 5,223,095           |       |
| Real estate and equipment                                                                                                                                                 |       | 9,701,754              |        | 9,619,084           |       |
| Federal income tax recoverable                                                                                                                                            |       | 4,239,906              |        | 4,953,278           |       |
| Deferred income tax asset                                                                                                                                                 |       | 236,319                |        | 1,036,184           |       |
| Amounts due from reinsurers                                                                                                                                               |       | 1,940,903              |        | 2,020,936           |       |
| Deferred policy acquisition costs                                                                                                                                         |       | —                 |        | 3,015,307           |       |
| Value of business acquired                                                                                                                                                |       | 74,481,295             |        | 73,740,420          |       |
| Other assets                                                                                                                                                              |       | 24,642,833             |        | 24,153,596          |       |
| Total assets                                                                                                                                                              |       | $                      | 770,051,331 |                | $          | 768,159,818 |   |

See accompanying notes.

 

1

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**KMGAMERICA CORPORATION AND SUBSIDIARY**

**CONSOLIDATEDBALANCE SHEETS**

**(Continued)**

 
| ** **                                                                                          | ** ** | **December 31,  2004** | ** **  | **March 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|------------------------|-------------|---------------------|------------|
| ** **                                                                                          | ** ** | ** **             | ** **  | **(Unaudited)**     | ** ** |
| **Liabilities and shareholders’ equity**                                                       |       |                   |        |                |       |
|                                                                                                |       |                   |        |                |       |
| Liabilities:                                                                                        |       |                   |        |                |       |
| Policy and contract liabilities:                                                                    |       |                   |        |                |       |
| Life and annuity reserves                                                                           |       | $                      | 309,940,285 |                | $          | 306,331,886 |   |
| Accident and health reserves                                                                        |       | 200,801,846            |        | 206,566,178         |       |
| Policy and contract claims                                                                          |       | 9,343,512              |        | 9,611,984           |       |
| Other policyholder liabilities                                                                      |       | 10,829,794             |        | 11,267,621          |       |
| Total policy and contract liabilities                                                               |       | 530,915,437            |        | 533,777,669         |       |
|                                                                                                |       |                   |        |                |       |
| Accounts payable and accrued expenses                                                               |       | 18,794,922             |        | 18,176,468          |       |
| Taxes, other than federal income taxes                                                              |       | 528,262                |        | 515,851             |       |
| Deferred income taxes                                                                               |       | 6,502,042              |        | 6,224,155           |       |
| Liability for benefits for employees and agents                                                     |       | 4,158,418              |        | 4,258,504           |       |
| Funds held in suspense                                                                              |       | 4,724,004              |        | 3,930,156           |       |
| Long term notes payable                                                                             |       | 15,022,603             |        | 15,210,103          |       |
| Other liabilities                                                                                   |       | 1,617,778              |        | 1,627,193           |       |
| Total liabilities                                                                                   |       | 582,263,466            |        | 583,720,099         |       |
|                                                                                                |       |                   |        |                |       |
| Shareholders’ equity:                                                                          |       |                   |        |                |       |
| Common Stock, par value $0.01 per share, 75,000,000 shares authorized  and 22,071,641 shares issued |       | 220,716                |        | 220,716             |       |
| Paid-in capital                                                                                     |       | 187,742,702            |        | 187,742,702         |       |
| Retained earnings                                                                                   |       | (175,553               | )           | 844,445             |       |
| Accumulated other comprehensive (loss)                                                              |       | —                 |        | (4,368,144          | )          |
| Total shareholders’ equity                                                                     |       | 187,787,865            |        | 184,439,719         |       |
| Total liabilities and shareholders’ equity                                                     |       | $                      | 770,051,331 |                | $          | 768,159,818 |   |

 

See accompanying notes.

 

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**KMG AMERICA CORPORATION ANDPREDECESSOR**

**CONSOLIDATED STATEMENTS OF INCOME(UNAUDITED)**

** **
| ** **                                                                        | ** ** | **Predecessor**                    | ** ** | **KMG America  Corporation**       | ** ** |
|-----------------------------------------------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                                                                        | ** ** | **Quarter Ended  March 31,  2004** | ** ** | **Quarter Ended  March 31,  2005** | ** ** |
| Revenue:                                                                          |       |                               |       |                               |       |
| Insurance premiums                                                                |       | $                                  | 25,337,779 |                               | $          | 26,197,560 |   |
| Net investment income                                                             |       | 5,389,620                          |       | 6,652,785                          |       |
| Commission and fee income                                                         |       | 3,351,974                          |       | 3,568,048                          |       |
| Realized investment gains                                                         |       | 215,292                            |       | 27,580                             |       |
| Other income                                                                      |       | 747,293                            |       | 791,647                            |       |
| Total revenues                                                                    |       | 35,041,958                         |       | 37,237,620                         |       |
|                                                                              |       |                               |       |                               |       |
| Benefits and expenses:                                                            |       |                               |       |                               |       |
| Policyholder benefits                                                             |       | 22,540,589                         |       | 20,429,834                         |       |
| Insurance commissions, net of deferrals                                           |       | 2,344,550                          |       | 2,666,167                          |       |
| General insurance expenses, net of deferrals                                      |       | 6,095,307                          |       | 9,459,535                          |       |
| Insurance taxes, licenses and fees                                                |       | 1,129,514                          |       | 1,319,917                          |       |
| Depreciation                                                                      |       | 703,426                            |       | 696,061                            |       |
| Amortization of deferred policy acquisition costs and value of  business acquired |       | 2,090,855                          |       | 1,085,155                          |       |
| Total benefits and expenses                                                       |       | 34,904,241                         |       | 35,656,669                         |       |
|                                                                              |       |                               |       |                               |       |
| Income before income taxes                                                        |       | 137,717                            |       | 1,580,951                          |       |
| (Provision) for income taxes                                                      |       | (46,824                            | )          | (560,953                           | )          |
| Net income                                                                        |       | $                                  | 90,893     |                               | $          | 1,019,998 |   |
| Net income per share:                                                             |       |                               |       |                               |       |
| Basic                                                                             |       | $                                  | 34.78      |                               | $          | 0.05 |   |
| Diluted                                                                           |       | $                                  | 31.39      |                               | $          | 0.05 |   |
| Weighted-average shares outstanding:                                              |       |                               |       |                               |       |
| Basic                                                                             |       | 2,612.83                           |       | 22,071,641                         |       |
| Diluted                                                                           |       | 2,895.98                           |       | 22,155,739                         |       |

 

See accompanying notes.

 

3

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**KMG AMERICA CORPORATION ANDPREDECESSOR**

**CONSOLIDATED STATEMENTS OF CASHFLOW (UNAUDITED)**

** **
| ** **                                                                         | ** ** | **Predecessor**                    | ** ** | **KMG America  Corporation**       | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                                                                         | ** ** | **Quarter Ended  March 31,  2004** | ** ** | **Quarter Ended  March 31,  2005** | ** ** |
| **Operating activities**                                                           |       |                               |       |                               |       |
| Net income                                                                         |       | $                                  | 90,893     |                               | $          | 1,019,998 |   |
| Adjustments to reconcile net income to net cash provided by operating  activities: |       |                               |       |                               |       |
| Depreciation and amortization                                                      |       | 637,193                            |       | 977,083                            |       |
| Policy acquisition costs deferred                                                  |       | (3,847,600                         | )          | (3,359,587                         | )          |
| Amortization of deferred policy acquisition costs and value of  business acquired  |       | 2,090,855                          |       | 1,085,155                          |       |
| Realized investment (gains), net                                                   |       | (215,292                           | )          | (27,580                            | )          |
| Deferred income tax expense                                                        |       | 948,830                            |       | 1,274,325                          |       |
| Changes in operating assets and liabilities:                                       |       |                               |       |                               |       |
| Reinsurance balances recoverable                                                   |       | (1,478,789                         | )          | (445,375                           | )          |
| Accrued investment income                                                          |       | (31,437                            | )          | (310,879                           | )          |
| Federal income tax recoverable                                                     |       | (593,115                           | )          | (713,372                           | )          |
| Other assets                                                                       |       | (774,318                           | )          | 489,237                            |       |
| Amounts due from reinsurers                                                        |       | (976,536                           | )          | (80,033                            | )          |
| Policy and contract liabilities                                                    |       | 5,941,236                          |       | 2,862,232                          |       |
| Accounts payable and accrued expenses                                              |       | 4,895,632                          |       | (618,454                           | )          |
| Long term notes payable                                                            |       | 3⁄4                             |       | 187,500                            |       |
| Deferred stock option compensation expense                                         |       | 35,295                             |       | 3⁄4                             |       |
| Taxes, other than federal income taxes                                             |       | 64,475                             |       | (12,411                            | )          |
| Funds held in suspense                                                             |       | 294,608                            |       | (793,848                           | )          |
| Liability for benefits for employees and agents                                    |       | 264,018                            |       | 100,086                            |       |
| Other liabilities                                                                  |       | 33,151                             |       | 9,415                              |       |
| Net cash provided by operating activities                                          |       | 7,379,099                          |       | 1,643,492                          |       |
| **Investing activities**                                                           |       |                               |       |                               |       |
| Securities available for sale:                                                     |       |                               |       |                               |       |
| Sales                                                                              |       | 6,348,493                          |       | 14,752,142                         |       |
| Maturities, calls and redemptions                                                  |       | 2,343,827                          |       | 42,279,225                         |       |
| Purchases                                                                          |       | (17,443,525                        | )          | (135,853,363                       | )          |
| Repayments of mortgage loans                                                       |       | 1,801,032                          |       | 2,020,339                          |       |
| Mortgage loans originated                                                          |       | (692,951                           | )          | 3⁄4                             |       |
| Increase in policy loans, net                                                      |       | 57,705                             |       | 128,085                            |       |
| Sale of real estate and property and equipment                                     |       | 3⁄4                             |       | 85,564                             |       |
| Purchases of real estate, property and equipment                                   |       | (138,167                           | )          | (527,089                           | )          |
| Net cash (used in) investing activities                                            |       | (7,723,586                         | )          | (77,115,097                        | )          |
|                                                                               |       |                               |       |                               |       |
| Net (decrease) in cash and cash equivalents                                        |       | (344,487                           | )          | (75,471,605                        | )          |
| Cash and cash equivalents at beginning of period                                   |       | 7,204,805                          |       | 117,400,156                        |       |
| Cash and cash equivalents at end of period                                         |       | $                                  | 6,860,318  |                               | $          | 41,928,551 |   |
| **Supplemental disclosures of cash flow  information**                             |       |                               |       |                               |       |
| Federal income taxes paid                                                          |       | $                                  | 600,000    |                               | $          | — |   |

See accompanying notes.

 

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**KMG AMERICA CORPORATION AND PREDECESSOR**

 

#### **NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

KMG America Corporation (“KMG America” or the “Company”) is a holdingcompany incorporated under the laws of the Commonwealth of Virginia on January21, 2004.  KMG America commencedoperations shortly before it completed its initial public offering of commonstock on December 21, 2004, and its shares trade on the New York Stock Exchangeunder the symbol “KMA.”  Concurrentlywith the completion of its initial public offering, KMG America completed itsacquisition of Kanawha Insurance Company (“Kanawha” or the “Predecessor”) andits subsidiaries, which are KMG America’s primary operating subsidiaries andwhich underwrite and sell life and health insurance products marketed primarilyin the southeastern United States.

 

Kanawha, the primary operating subsidiary of KMG America, is licensedto 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 withoperations in Lancaster and Greenville, South Carolina, and one wholly ownedindirect subsidiary, Kanawha Marketing Group, Inc.

 

The Company’s primary businesses are life and health insurance riskassumption, third-party administration and medical managementservices.  Included in risk assumptionare the Company’s product lines of individual life, annuity, supplementalhealth and short-term disability, as well as products specifically directed atthe senior market including Medicare supplement, final expense life insuranceand long-term care products.  The Company’sthird-party administration and medical management businesses include awide array of services with the primary emphasis in the offering ofadministrative service-only products.

 

The Company’s sales are primarily in the southeastern UnitedStates, predominantly in Florida, South Carolina and North Carolina, and aremarketed by an internal sales force, as well as independent agents andbrokers.  Premium revenues areconcentrated in the individual life and accident and health lines of business.

 

#### **2.  Significant Accounting Policies**

 

#### **Basisof Presentation**

 

For accountingpurposes, Kanawha is treated as KMG America’s predecessor entity and isreferred to in these Notes as the “Predecessor.”  Financial information in the followingdiscussion that relates to the Predecessor’s consolidated results ofoperations, cash flows and changes in shareholders’ equity for the quarterended March 31, 2004, are reported on a historical basis without GAAP(generally accepted accounting principles in the United States) purchaseaccounting adjustments reflecting the acquisition of the Predecessor.  Financial information relating to the Company’sconsolidated results of operations, cash flows and changes in shareholders’equity for the quarter ended March 31, 2005, and the Company’s financialposition as of December 31, 2004, and March 31, 2005, has been adjusted forGAAP purchase accounting adjustments reflecting the Predecessor’s acquisition.

 

The accompanyingunaudited consolidated financial statements have been prepared in accordancewith GAAP for interim financial information. Accordingly, they do not include all of the information and footnotesrequired by GAAP for complete financial statements.  In the opinion of management, all adjustmentsconsidered necessary for a fair presentation have been included.  All significant intercompany accounts andtransactions have been eliminated in consolidation.  Operating results for the quarter ended March31, 2005, are not necessarily indicative of the results that may be expectedfor the year ended December 31, 2005. Certain prior year amounts have been reclassified to conform with thecurrent year presentation.

 

The Company also submits financial statements to insurance industryregulatory authorities.  Those financialstatements are prepared on the basis of statutory accounting practices (“SAP”)and are significantly different from financial statements prepared inaccordance with GAAP (see Note 4).

 

5

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**KMG AMERICA CORPORATION AND PREDECESSOR**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

#### **Useof Estimates and Assumptions**

 

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

 

#### **Investments**

 

Effective December 31, 2004, under GAAP purchase accounting rules, theCompany recorded the Predecessor’s investments at fair value.

 

Statement of Financial Accounting Standards (“SFAS”) No. 115, *Accounting for Certain Investments in Fixed Maturityand Equity Securities*, requires that all fixed maturity and equitysecurities 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 appropriateclassification of fixed maturities at the time of purchase.

 

Investments are reported on the following basis:

 

•                    Fixed maturity securitiesclassified as available-for-sale are stated at fair value with unrealized gainsand losses reported directly in shareholders’ equity as accumulated othercomprehensive income.  Fair values forfixed maturity securities are based on quoted market prices, whereavailable.  For fixed maturity securitiesnot actively traded, fair values are estimated using values obtained fromindependent pricing services.

 

•                    Equity securities classifiedas available-for-sale are stated at fair value with unrealized gains and lossesreported directly in shareholders’ equity as accumulated other comprehensiveincome.

 

•                    Assets supporting thedeferred compensation plan are classified as trading.  Trading account assets are held for resale inanticipation of short-term market movements. Trading account assets, consisting of mutual funds, are stated at fairvalue.  Gains and losses, both realizedand unrealized, are included in realized gains and losses on deferredcompensation investments.

 

•                    Mortgage loans on realestate are typically stated at unpaid balances, net of allowances for unrecoverableamounts.  However, due to the Company’sacquisition of the Predecessor, effective December 31, 2004, under GAAPpurchase accounting rules, mortgage loans were recorded at fair value.  Valuation allowances for mortgage loans areestablished when the Company determines it is probable that it will be unableto collect all amounts (both principal and interest) due according to thecontractual terms of the loan agreement. Such allowances are based on the present value of expected future cashflows discounted at the loan’s effective interest rate or, if foreclosure isprobable, on the estimated fair value of the underlying real estate.

 

•                    Policy loans are stated attheir unpaid balances.

 

•                    Interest on loans isgenerally recorded over the term of the loan based on the unpaid principalbalance.  Accrual of interest isdiscontinued when either principal or interest becomes 90 days past due orwhen, in management’s opinion, collection of such interest is doubtful.  In addition, any previously accrued interestis reversed when the loan becomes 90 days past due.

 

•                    Other investments are statedat market, or the lower of cost or market, as appropriate.

 

•                    Amortization of premiums andaccrual of discounts on investments in fixed maturity securities are reflectedin earnings over the contractual terms of the investments in a manner thatproduces a constant effective yield. Realized gains and losses on dispositions of securities are determinedby the specific-identification method.

 

6

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#### **DeferredPolicy Acquisition Costs**

 

Acquisition costs incurred by the Predecessor and the Company in theprocess of acquiring new business are deferred and amortized into income asdiscussed below.  Costs deferred consistprimarily of commissions and certain policy underwriting, issue and agencyexpenses that vary with and are primarily related to production of newbusiness.

 

For most insurance products, the amortization of deferred acquisitioncosts is recognized in proportion to the ratio of annual premium revenue to thetotal anticipated premium revenue, which gives effect to expectedterminations.  Deferred acquisition costsare amortized over the premium-paying period of the relatedpolicies.  Anticipated premium revenue isdetermined using assumptions consistent with those utilized in thedetermination of liabilities for insurance reserves.  For interest-sensitive life insurance andinvestment products such as deferred annuities (no longer sold by the Company)to the extent recoverable from future gross profits, deferred policyacquisition costs are amortized generally in proportion to the present value ofexpected gross profits from surrender charges and investment, mortality andexpense margins.

 

The Predecessor’s deferred acquisition costs at December 31, 2004, wereeliminated upon the closing of the acquisition of the Predecessor as part ofthe application of GAAP purchase accounting requirements.  The Company began recording deferred acquisitioncosts prospectively on January 1, 2005.

 

#### **Valueof Business Acquired**

 

Value of business acquired is the value assigned to the insurance inforce of acquired insurance companies or blocks of insurance business at thedate of acquisition.

 

The amortization of value of business acquired is recognized usingamortization schedules established at the time of the acquisitions based uponexpected annual premium.  Certain ofthese amortization schedules include actual to expected adjustments to reflectactual experience as it emerges.  Thevalue of business acquired for premium paying policies is amortized inproportion to future expected premiums. The value of business acquired for policies paid up as of theacquisition date is amortized in proportion to expected future earnings.

 

The Predecessor’s historical value of business acquired was eliminatedupon the closing of the Kanawha acquisition as part of the application of GAAPpurchase accounting requirements.  Valueof business acquired was simultaneously re-established, by the Company, for thevalue of the Predecessor’s in force business. Interest rate assumptions used to amortize the value of businessacquired were reset upon the closing of the Kanawha acquisition.

 

#### **BenefitReserves**

 

Insurance reserves for individual life insurance, individual accidentand health insurance, group life insurance and group accident and healthinsurance are associated with earned premiums so as to recognize profits overthe premium-paying period.  Thisassociation is accomplished by recognizing the liabilities for insurancereserves on a net level premium method based on assumptions deemed appropriateat the date of issue as to future investment yield, mortality, morbidity,withdrawals and maintenance expenses, and including margins for adversedeviations.  Interest assumptions arebased on interest rate levels and expectations at the time policies aresold.  Mortality, morbidity andwithdrawal assumptions are based on recognized actuarial tables or thePredecessor’s experience, as appropriate. Life reserves are calculated using mean reserve factors.  Accident and health reserves are calculatedusing mid-terminal reserve factors. Benefit reserves for investment products are computed under aretrospective deposit method and represent policy account balances before applicablesurrender charges.  Policy benefits andclaims that are charged to expense include benefit claims incurred in theperiod in excess of related policy account balances.

 

The Predecessor’s benefit reserves, net of related reinsurancerecoverable, at December 31, 2004, were adjusted to reflect the closing of theKanawha acquisition as part of the application of GAAP purchase accountingrequirements.  The valuation interestrate assumptions were generally lowered to reflect the current and expectedinterest rate environment at the time the acquisition closed.  This change resulted in an increase inbenefit reserves.  Valuation assumptionsfor mortality, morbidity and withdrawal were changed to reflect currentexpectations, which resulted in an increase in benefit reserves.  Finally, the valuation assumptions for futurepremium rates on long term

 

7

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care coverage were increased to account forimplemented and expected rate increases. These changes reduced benefit reserves for this coverage.

 

Loss recognition testing of the Company’s policy benefit reserves isperformed annually.  This testinginvolves a comparison of the Company’s actual net liability position (allliabilities less deferred acquisition costs, or DAC) to the present value offuture liabilities calculated using then-current assumptions.  These assumptions are based on the Company’sbest estimate of future experience.  Tothe extent a premium deficiency exists, it would be recognized immediately by acharge to the statement of income and a corresponding reduction in DAC.  Any additional deficiency would be recognizedas a premium deficiency reserve. Historically, loss recognition testing has not resulted in an adjustmentto DAC or reserves.  These adjustmentswould occur only if economic, mortality and/or morbidity conditionssignificantly deviated from the underlying assumptions.

 

#### **Stock-BasedCompensation**

 

The Company has 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-BasedCompensation-Transition and Disclosure* (“SFAS 148”).  As permitted by the provisions of thisStatement, the Predecessor accounted for stock-based compensation usingthe intrinsic value method prescribed by Accounting Principles Board OpinionNo. 25, *Accounting for Stock Issued toEmployees, and Related Interpretations*.

 

Accordingly, the Company and the Predecessor recognized no compensationexpense for stock option awards to employees or directors when the option pricewas not less than the market value of the stock at the date of award.

 

SFAS 123 requires the presentation of pro forma information as if theCompany and the Predecessor had accounted for their employee and director stockoptions granted after December 31, 1994, under the fair value method of thatStatement.

 

The following is a reconciliation of reported net income and pro formainformation as if the Company and the Predecessor had adopted SFAS 123 for itsemployee and director stock option awards for the quarterly periods presented:

 

| ** **                                                                                                                           | ** ** | **Predecessor**                    | ** ** | **KMG America  Corporation**       | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                                                                                                                           | ** ** | **Quarter Ended  March 31,  2004** | ** ** | **Quarter Ended  March 31,  2005** | ** ** |
| Net income as reported                                                                                                               |       | $                                  | 90,893     |                               | $          | 1,019,998 |   |
| Add: Stock-based employee compensation expense included in reported  net income, net of related tax effects                          |       | 23,295                             |       | —                             |       |
| Deduct: Total stock-based employee compensation determined  under fair value based method for all awards, net of related tax effects |       | (28,397                            | )          | (165,610                           | )          |
| Pro forma net income available to common stockholders                                                                                |       | $                                  | 85,791     |                               | $          | 854,388 |   |
| Net income per share-basic:                                                                                                          |       |                               |       |                               |       |
| As reported                                                                                                                          |       | $                                  | 34.78      |                               | $          | 0.05 |   |
| Pro forma                                                                                                                            |       | $                                  | 32.83      |                               | $          | 0.04 |   |
| Net income per share-diluted:                                                                                                        |       |                               |       |                               |       |
| As reported                                                                                                                          |       | $                                  | 31.39      |                               | $          | 0.05 |   |
| Pro forma                                                                                                                            |       | $                                  | 29.62      |                               | $          | 0.04 |   |

 

**RecentlyIssued Accounting Standards**

 

In March 2004, the Emerging Issues Task Force (“EITF”) reached a finalconsensus on EITF 03-1, which is effective for fiscal periodsbeginning after June 15, 2004.  EITF 03-1requires that when the fair value of an investment security is less than itscarrying value, an impairment exists for which a determination must be made asto whether the impairment is other-than-temporary.  An impairment loss should be recognized equalto the

 

8

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difference between the investment’s carryingvalue and its fair value when an impairment is other-than-temporary.  Subsequent to an other-than-temporaryimpairment loss, a debt security should be accounted for in accordance withStatement of Position No. 03-3, *Accountingfor Loans and Certain Debt Securities Acquired in a Transfer*, whichallows the accretion of the discount between the carrying value and expectedvalue of a security if the amount and timing of the recognition of thatdifference in cash is reasonably estimable. EITF 03-1 also indicates that, although not presumptive, a patternof selling investments prior to the forecasted recovery may call into questionan investor’s intent to hold the security until it recovers its value.

 

The final consensus on EITF 03-1 included additional disclosurerequirements incremental to those adopted by the Predecessor effective December31, 2003, that are effective for fiscal years ending after June 15, 2004.

 

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

 

In December 2004, the FASB enacted SFAS No. 123 (revised 2004) (“SFAS123 (revised 2004)”), *Share-Based Payment*,which replaces SFAS No. 123 (“SFAS 123”), *Accountingfor Stock-Based Compensation*, and supersedes APB Opinion No. 25, *Accounting for Stock Issued to Employees*.  SFAS 123 (revised 2004) requires themeasurement of all employee share-based payments to employees, including grantsof employee stock options, using a fair-value-based method and the recording ofsuch expense in the Company’s consolidated statements of income.  The accounting provisions of SFAS 123(revised 2004) are effective for reporting periods beginning after January 1,2006.  The Company is required to adoptSFAS 123 (revised 2004) in the first quarter of 2006.

 

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

 

#### **3.  Investments**

 

Aggregate amortized cost, aggregate fair value and gross unrealizedgains and losses of investments in fixed maturity and equity securities aresummarized in the following table. Effective December 31, 2004, the Company recorded the Predecessor’sinvestments at fair value and thereby eliminated all unrealized gains andlosses in the Predecessor’s portfolio, as part of the application of GAAPpurchase accounting requirements.

 
| ** **                                       | ** ** | **Amortized Cost** | ** **  | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|--------------------------------------------------|------------|--------------------|-------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| Available for sale securities at March 31, 2005: |       |               |        |                         |       |                          |       |            |       |
| Fixed maturity securities                        |       | $                  | 488,127,072 |                         | $          | 669,869                       |       | $               | 7,390,090  |   | $ | 481,406,851 |   |
| Equity securities                                |       | 36,000             |        | —                       |       | —                        |       | 36,000          |       |
| Securities available for sale                    |       | $                  | 488,163,072 |                         | $          | 669,869                       |       | $               | 7,390,090  |   | $ | 481,442,851 |   |

 

#### **4.  Statutory Financial Information**

 

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

 

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

 

9

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#### **5.  Employee Benefits**

 

As of the datesindicated, the net periodic retirement benefit cost of the Company’s definedbenefit pension plan for the quarters presented included the followingcomponents:

 
| ** **                               | ** ** | **Predecessor**                    | ** ** | **KMG  America**                   | ** ** |
|------------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                               | ** ** | **Quarter Ended  March 31,  2004** | ** ** | **Quarter Ended  March 31,  2005** | ** ** |
| Components of net periodic benefit cost: |       |                               |       |                               |       |
| Service cost                             |       | $                                  | 206,269    |                               | $          | 227,579 |   |
| Interest cost                            |       | 200,513                            |       | 228,171                            |       |
| Expected return on plan assets           |       | (131,529                           | )          | (207,384                           | )          |
| Amortization of transition liability     |       | 4,343                              |       | 4,343                              |       |
| Recognized net actuarial loss            |       | 51,913                             |       | 42,608                             |       |
|                                     |       |                               |       |                               |       |
| Net periodic benefit cost                |       | $                                  | 331,509    |                               | $          | 295,317 |   |

 

The Company expects that its aggregate contributions to its definedbenefit pension plan will be between $0 and $850,000 in 2005.  No contributions were made during the quarterended March 31, 2005.

 

In the quarter ended March 31, 2005, the Company granted options topurchase an aggregate of 82,250 shares of its common stock.  The options vest in four equal annualinstallments beginning on the first anniversary of the date of grant.  Subject to certain conditions set forth inthe option agreements, options are exercisable upon vesting until the tenthanniversary of the date of grant.

 

#### **6.  Comprehensive Income (Loss)**

 

Total comprehensive income (loss) for the quarters ended March 31, 2004and 2005 was $7,666,992 and $(3,348,146), respectively.  The difference between comprehensive incomeand net income for these periods was unrealized gains (losses) of $7,576,099and $(4,368,144), respectively.

 

#### **7.  Commitments and Contingencies**

 

The Company is occasionally named as a defendant in various legalactions arising principally from claims made under insurance policies andcontracts.  Those actions are consideredby the Company in estimating the policy and contract liabilities and managementbelieves adequate reserves have been established for such cases.  Management believes that the resolution ofthose actions will not have a material effect on the Company’s financialposition or results of operations.

 

On February 18, 2005, a complaint was filed by plaintiffs ReliaStarLife Insurance Company and ReliaStar Life Insurance Company of New York, bothindirect wholly-owned subsidiaries of ING America US, in the Fourth JudicialDistrict Court in Hennepin County, Minnesota, against KMG America, Kanawha,Kenneth U. Kuk, Paul Kraemer, Paul Moore and another individual.  Messrs. Kuk, Kraemer and Moore are officers ofKMG America and former employees of the plaintiffs.  The complaint alleges misappropriation oftrade secrets, conversion, tortious interference with business and employmentrelationships, breach of fiduciary duties and breach of contract by KMGAmerica, Kanawha and Messrs. Kuk, Kraemer, and Moore.  The complaint seeks injunctive relief andunspecified monetary damages.  KMGAmerica believes the allegations are without merit, intends to defend theaction and believes that the outcome of this matter will not have a materialadverse effect on its consolidated financial position or results of operations.

 

On December 21, 2004, the Company entered into a $15.0 millionfive-year subordinated promissory note to fund a portion of the purchase pricefor the Kanawha acquisition.  Interest onthe promissory note accrues at 5% per annum and is added to the principalbalance on December 31 of each year and is payable on the maturity date.  No cash payments are required under thepromissory note until maturity, at which time approximately $19.1 million

 

10

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of principal and accrued interest will be dueand payable.  The terms of the promissorynote limit the Company’s and Kanawha’s ability to incur additional debt.

 

#### **8.  Business Segments**

 

The Company has five reportable segments that are differentiated bytheir respective methods of distribution and the nature of the relatedproducts: worksite insurance business, senior market insurance business, thirdparty administration business, acquired business and corporate and other.  Management makes decisions regarding theCompany’s business based on these segment classifications.  No segments have been aggregated other thanincluding the marketing business in the corporate and other segment.

 

The worksite insurance business provides life and health insuranceproducts to employers and their employees. The primary insurance products include life, short-term disability,dental, indemnity health and critical illness. This segment includes business sold through the career agencydistribution channel, which is a group of agents and managers that areemployees of the Company or its subsidiaries.

 

The senior market insurance business provides individual insuranceproducts, primarily long-term care insurance, tailored to the needs ofolder individuals.

 

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

 

The acquired business represents closed blocks of life and healthinsurance business that have been acquired through reinsurance transactionsover a period of years.

 

The corporate and other segment includes investment income earned onthe investment portfolio allocated to capital and surplus, as well as allrealized capital gains and losses, which are not allocated by line ofbusiness.  This segment also includesmarketing allowances, commissions and related expenses pertaining to productsales for other insurance carriers, which are currently not material.  In addition, this segment includes certainunallocated expenses, primarily deferred compensation and incentivecompensation costs, and other non-allocated immaterial items.

 

The following represents a summary of the Company’s and the Predecessor’sstatements of income and asset composition by reportable segment.  The financial statement information of thePredecessor for the quarter ended March 31, 2004, is reported on a historicalbasis without GAAP purchase accounting adjustments reflecting the acquisitionof the Predecessor, while the Company’s financial statement information for thequarter ended March 31, 2005, has been adjusted for GAAP purchase accountingadjustments reflecting the acquisition.

 
| ** **                              | ** ** | **Predecessor**                     | ** **  | **KMG America  Corporation**       | ** ** |
|-----------------------------------------|------------|-------------------------------------|-------------|------------------------------------|------------|
| ** **                              | ** ** | **Quarter Ended   March 31,  2004** | ** **  | **Quarter Ended  March 31,  2005** | ** ** |
| **Worksite Insurance Business**         |       |                                |        |                               |       |
| Insurance premiums                      |       | $                                   | 14,024,664  |                               | $          | 14,658,027 |   |
| Net investment income                   |       | 1,404,387                           |        | 1,781,787                          |       |
| Commissions and fees                    |       | —                              |        | —                             |       |
| Net realized gains                      |       | —                              |        | —                             |       |
| Other income                            |       | 130,195                             |        | 49,437                             |       |
| Total revenues                          |       | 15,559,246                          |        | 16,489,251                         |       |
| Policyholder benefits                   |       | 11,530,192                          |        | 10,890,125                         |       |
| Commissions                             |       | 872,747                             |        | 1,077,650                          |       |
| Expenses, taxes, fees and depreciation  |       | 2,297,522                           |        | 3,555,616                          |       |
| Amortization of DAC                     |       | 1,221,886                           |        | 820,006                            |       |
| Total benefits and expenses             |       | 15,922,347                          |        | 16,343,397                         |       |
| (Loss) income before Federal income tax |       | $                                   | (363,101    | )                                  | $          | 145,854 |   |
|                                    |       |                                |        |                               |       |
| Total assets                            |       | $                                   | 152,155,353 |                               | $          | 168,714,162 |   |

 

11

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| ** **                              | ** ** | **Predecessor**                     | ** **  | **KMG America  Corporation**       | ** ** |
|-----------------------------------------|------------|-------------------------------------|-------------|------------------------------------|------------|
| ** **                              | ** ** | **Quarter Ended   March 31,  2004** | ** **  | **Quarter Ended  March 31,  2005** | ** ** |
| ** **                              |       |                                |        |                               |       |
| **Senior Market Insurance Business**    |       |                                |        |                               |       |
| Insurance premiums                      |       | $                                   | 10,323,112  |                               | $          | 10,601,060 |   |
| Net investment income                   |       | 781,628                             |        | 1,011,456                          |       |
| Commissions and fees                    |       | —                              |        | —                             |       |
| Net realized gains                      |       | —                              |        | —                             |       |
| Other income                            |       | 495,612                             |        | 657,362                            |       |
| Total revenues                          |       | 11,600,352                          |        | 12,269,878                         |       |
| Policyholder benefits                   |       | 8,924,411                           |        | 8,344,925                          |       |
| Commissions                             |       | 1,364,714                           |        | 1,489,165                          |       |
| Expenses, taxes, fees and depreciation  |       | 544,374                             |        | 1,139,320                          |       |
| Amortization of DAC                     |       | 179,571                             |        | 370,438                            |       |
| Total benefits and expenses             |       | 11,013,070                          |        | 11,343,848                         |       |
| Income before Federal income tax        |       | $                                   | 587,282     |                               | $          | 926,030 |   |
|                                    |       |                                |        |                               |       |
| Total assets                            |       | $                                   | 125,540,938 |                               | $          | 168,485,632 |   |
| ** **                              |       |                                |        |                               |       |
| **Third-Party Administration Business** |       |                                |        |                               |       |
| Insurance premiums                      |       | $                                   | —      |                               | $          | — |   |
| Net investment income                   |       | —                              |        | —                             |       |
| Commissions and fees                    |       | 3,346,267                           |        | 3,483,387                          |       |
| Net realized gains                      |       | —                              |        | —                             |       |
| Other income                            |       | 626                                 |        | 862                                |       |
| Total revenues                          |       | 3,346,893                           |        | 3,484,249                          |       |
| Policyholder benefits                   |       | —                              |        | —                             |       |
| Commissions                             |       | —                              |        | —                             |       |
| Expenses, taxes, fees and depreciation  |       | 2,934,886                           |        | 3,206,326                          |       |
| Amortization of DAC                     |       | —                              |        | —                             |       |
| Total benefits and expenses             |       | 2,934,886                           |        | 3,206,326                          |       |
| Income before Federal income tax        |       | $                                   | 412,007     |                               | $          | 277,923 |   |
|                                    |       |                                |        |                               |       |
| Total assets                            |       | $                                   | 7,170,994   |                               | $          | 8,406,380 |   |
| ** **                              |       |                                |        |                               |       |
| **Acquired Business**                   |       |                                |        |                               |       |
| Insurance premiums                      |       | $                                   | 990,003     |                               | $          | 938,473 |   |
| Net investment income                   |       | 2,212,046                           |        | 2,062,616                          |       |
| Commissions and fees                    |       | —                              |        | —                             |       |
| Net realized gains                      |       | —                              |        | —                             |       |
| Other income                            |       | 25,354                              |        | 13,381                             |       |
| Total revenues                          |       | 3,227,403                           |        | 3,014,470                          |       |
| Policyholder benefits                   |       | 2,085,986                           |        | 1,194,784                          |       |
| Commissions                             |       | 107,089                             |        | 99,352                             |       |
| Expenses, taxes, fees and depreciation  |       | 686,250                             |        | 704,629                            |       |
| Amortization of DAC                     |       | 689,398                             |        | (105,289                           | )          |
| Total benefits and expenses             |       | 3,568,723                           |        | 1,893,476                          |       |
| (Loss) income before Federal income tax |       | $                                   | (341,320    | )                                  | $          | 1,120,994 |   |
| Total assets                            |       | $                                   | 201,032,795 |                               | $          | 212,187,641 |   |

 

12

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| ** **                             | ** ** | **Predecessor**                     | ** **  | **KMG America  Corporation**       | ** ** |
|----------------------------------------|------------|-------------------------------------|-------------|------------------------------------|------------|
| ** **                             | ** ** | **Quarter Ended   March 31,  2004** | ** **  | **Quarter Ended  March 31,  2005** | ** ** |
| ** **                             |       |                                |        |                               |       |
| **Corporate and Other**                |       |                                |        |                               |       |
| Insurance premiums                     |       | $                                   | —      |                               | $          | — |   |
| Net investment income                  |       | 991,559                             |        | 1,796,926                          |       |
| Commissions and fees                   |       | 5,707                               |        | 84,661                             |       |
| Net realized gains                     |       | 215,292                             |        | 27,580                             |       |
| Other income                           |       | 95,506                              |        | 70,605                             |       |
| Total revenues                         |       | 1,308,064                           |        | 1,979,772                          |       |
| Policyholder benefits                  |       | —                              |        | —                             |       |
| Commissions                            |       | —                              |        | —                             |       |
| Expenses, taxes, fees and depreciation |       | 1,465,215                           |        | 2,869,622                          |       |
| Amortization of DAC                    |       | —                              |        | —                             |       |
| Total benefits and expenses            |       | 1,465,215                           |        | 2,869,622                          |       |
| (Loss) before Federal income tax       |       | $                                   | (157,151    | )                                  | $          | (889,850 | ) |
|                                   |       |                                |        |                               |       |
| Total assets                           |       | $                                   | 223,488,791 |                               | $          | 210,366,003 |   |
|                                   |       |                                |        |                               |       |
| **Total Company**                      |       |                                |        |                               |       |
| Insurance premiums                     |       | $                                   | 25,337,779  |                               | $          | 26,197,560 |   |
| Net investment income                  |       | 5,389,620                           |        | 6,652,785                          |       |
| Commissions and fees                   |       | 3,351,974                           |        | 3,568,048                          |       |
| Net realized gains                     |       | 215,292                             |        | 27,580                             |       |
| Other income                           |       | 747,293                             |        | 791,647                            |       |
| Total revenues                         |       | 35,041,958                          |        | 37,237,620                         |       |
| Policyholder benefits                  |       | 22,540,589                          |        | 20,429,834                         |       |
| Commissions                            |       | 2,344,550                           |        | 2,666,167                          |       |
| Expenses, taxes, fees and depreciation |       | 7,928,247                           |        | 11,475,513                         |       |
| Amortization of DAC                    |       | 2,090,855                           |        | 1,085,155                          |       |
| Total benefits and expenses            |       | 34,904,241                          |        | 35,656,669                         |       |
| Income before Federal income tax       |       | $                                   | 137,717     |                               | $          | 1,580,951 |   |
|                                   |       |                                |        |                               |       |
| Total assets                           |       | $                                   | 709,388,871 |                               | $          | 768,159,818 |   |

 

13

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## **ITEM 2.**                             MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

**BusinessOverview**

 

KMG America is a holding company incorporated under the laws of theCommonwealth of Virginia on January 21, 2004. We commenced our operations shortly before we completed our initialpublic offering of common stock on December 21, 2004, and our shares trade onthe New York Stock Exchange under the symbol “KMA.”  Concurrently with the completion of ourinitial public offering, we completed our acquisition of Kanawha InsuranceCompany (“Kanawha”) and its subsidiaries, which are our primary operatingsubsidiaries and which underwrite and sell life and health insurance productsmarketed primarily in the southeastern United States.  For GAAP accounting purposes, Kanawha istreated as KMG America’s predecessor entity and is referred to herein as our “predecessor.”  Financial information in the followingdiscussion that relates to our predecessor’s consolidated results ofoperations, cash flows and changes in shareholders’ equity for the quarterended March 31, 2004, are reported on a historical basis without GAAP purchaseaccounting adjustments reflecting the acquisition.  Financial information relating to ourconsolidated results of operations, cash flows and changes in shareholders’equity for the quarter ended March 31, 2005, and our financial position as ofDecember 31, 2004, and March 31, 2005, has been adjusted for GAAP purchaseaccounting adjustments reflecting the acquisition.  Our operations are conducted in the fivefollowing business segments.

 

*Worksite insurance business*.  Our worksite insurance business is a providerof voluntary life and health insurance products to employers and theiremployees in the southeastern United States. The primary insurance products that we underwrite include: lifeinsurance; short-term disability insurance; dental insurance; indemnity healthinsurance; and critical illness insurance. For the quarter ended March 31, 2005, our worksite insurance businessreported premiums, commissions and fees, excluding intercompany payments, of$14.7 million, which accounted for 49.3% of our premiums, commissions and fees,excluding intercompany payments in that period. Our business strategy is to operate our existing worksite insurancebusiness efficiently while developing a new worksite marketing and distributionorganization that targets larger employer groups nationwide with an expandedvariety of life and health insurance products which will add a new set ofemployer-paid life insurance, disability and health products to our existingvoluntary products.  In December 2004, weopened sales offices hosting regional sales managers in Boston, Massachusettsand Irvine, California, a Los Angeles suburb. During 2005, we have opened regional sales offices in Tampa, Florida;Chicago, Illinois; New York, New York; Atlanta, Georgia; Dallas, Texas; andCleveland, Ohio.  We expect to openadditional regional sales offices later in 2005 and thereafter.  We have begun and expect to continue to addand train additional sales and support staff and marketing personnel at thesefacilities, and will recognize the costs associated with these additions beforewe recognize revenues resulting from new sales activity.  Consequently, we expect negative cash flowand operating losses in the short term. We expect cash flows from our new sales and marketing organization to bepositive by 2006 but we cannot assure you that this will occur.

 

*Senior market insurance business*.  Our senior market insurance business is aprovider in the southeastern United States of individual insurance productstailored to the needs of older individuals. The primary insurance products that this business offers includelong-term care insurance that we underwrite and Medicare supplement insuranceunderwritten by another carrier.  For thequarter ended March 31, 2005, our senior market insurance business reportedpremiums, commissions and fees, excluding intercompany payments, of $10.6million, which accounted for 35.6% of our premiums, commissions and fees,excluding intercompany payments, in that period.  While growing this business is not a primarycomponent of our business strategy, we intend to operate this businessefficiently and may consider expanding its geographic target market.

 

*Third-party administration business*.  Our third-party administration businessprovides a wide range of insurance product administration, claims handling,eligibility administration, call center and support services.  This business primarily administers theinsurance plans offered by our worksite insurance business and senior marketinsurance business.  Our third-partyadministration business also provides administrative and managed care servicesto third parties, such as employers with self-funded health care plans, otherinsurance carriers, reinsurers and managed care plans.  For the quarter ended March 31, 2005, ourthird-party administration business reported commissions and fees, excludingintercompany payments, of $3.5 million, which accounted for 11.7% of ourpremiums, commissions and fees, excluding intercompany payments, in thatperiod.  Our primary business strategyfor this business is to grow this business as it administers the increasingvolume of policies and products that we anticipate will be sold by the worksiteinsurance business as we attempt to grow that business.  In addition, as our

 

14

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national worksite marketing businessdevelops, we intend to opportunistically market our third-party administrationservices to self-insured plans, stop loss insurers, pharmacy benefitorganizations, managed care service providers, other insurance carriers andreinsurers nationwide.  It is expectedthat any incremental costs associated with this expanded marketing will bemodest and will be funded out of the operations of our third-partyadministration business.

 

*Acquired business*.  In addition, we have retained our predecessor’sclosed block of life and health business reported in the acquired businesssegment.  While acquisitions of books ofbusiness from other insurance carriers is not one of our principal growthstrategies, we will consider making acquisitions on an opportunistic basis ifwe can complete the acquisitions on favorable financial terms that we expect tobe generally accretive to earnings per share and return on equity whilemaintaining our financial strength ratings.

 

*Corporate and other*.  We have also retained our predecessor’sinvestment and marketing activities reported in the corporate and othersegment.  We expect to realize earningsfrom our investment portfolio.  Insurancecompanies in both the life and health and property and casualty insuranceindustries earn profits on the investment float, which reflects the investmentincome earned on the premiums paid to the insurer between the time of receiptand the time benefits are paid-out under the policy.  Volatility in the capital markets, changes ininterest rates and changes in economic conditions can all impact the amount ofearnings that we will realize from our investment portfolio.

 

#### **Resultsof Operations**

 

##### *Consolidated Overview*

 

The following table presents historical consolidated financialinformation for the quarter ended March 31, 2004, for our predecessor, andconsolidated financial information for thequarter ended March 31, 2005, for KMG America.

 

| ** **                            | ** ** | **Predecessor**                    | ** ** | **KMG America**                    | ** ** |
|---------------------------------------|------------|------------------------------------|------------|------------------------------------|------------|
| ** **                            | ** ** | **Quarter Ended  March 31,  2004** | ** ** | **Quarter Ended  March 31,  2005** | ** ** |
| ** **                            | ** ** | **(dollars in thousands)**         | ** ** |
| **Revenues:**                         |       |                               |       |                               |       |
| Insurance premiums                    |       | $                                  | 25,337.8   |                               | $          | 26,197.6 |   |
| Net investment income(1)              |       | 5,389.6                            |       | 6,652.8                            |       |
| Commission and fees                   |       | 3,352.0                            |       | 3,568.0                            |       |
| Net realized gains                    |       | 215.3                              |       | 27.6                               |       |
| Other income                          |       | 747.3                              |       | 791.6                              |       |
| Total revenues                        |       | 35,042.0                           |       | 37,237.6                           |       |
|                                  |       |                               |       |                               |       |
| **Benefits and expenses:**            |       |                               |       |                               |       |
| Policyholder benefits                 |       | 22,540.6                           |       | 20,429.8                           |       |
| Commissions                           |       | 2,344.6                            |       | 2,666.2                            |       |
| General expenses                      |       | 6,095.3                            |       | 9,459.5                            |       |
| Taxes, licenses and fees              |       | 1,129.5                            |       | 1,319.9                            |       |
| Depreciation and amortization         |       | 703.4                              |       | 696.1                              |       |
| Amortization of DAC                   |       | 2,090.9                            |       | 1,085.1                            |       |
| Total benefits and expenses           |       | 34,904.3                           |       | 35,656.6                           |       |
|                                  |       |                               |       |                               |       |
| **Income before income taxes**        |       | 137.7                              |       | 1,581.0                            |       |
| Provision for income taxes            |       | (46.8                              | )          | (561.0                             | )          |
|                                  |       |                               |       |                               |       |
| **Net income**                        |       | $                                  | 90.9       |                               | $          | 1,020.0 |   |
|                                  |       |                               |       |                               |       |
| **Benefits to p****remiums ratio(2)** |       | 89.0                               | %          | 78.0                               | %          |

----

(1)                                 Netinvestment income for the three months ended March 31, 2004, was negativelyimpacted by a $1.6 million incentive payment to one of Kanawha’s outside investmentmanagers at the conclusion of the contract period.  There are no other incentive arrangements ofthis type in force, and this contract was terminated upon the closing of ouracquisition of Kanawha.

 

(2)                                 Thebenefits to premiums ratio is equal to policyholder benefits (equal to incurredclaims plus increases in policyholder active life reserves) divided byinsurance premiums.

 

15

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#### **ConsolidatedResults of Operations by Business Segment**

 

Note 8., Business Segments, of the Notes to Consolidated FinancialStatements included in this report, which includes a summary of our and ourpredecessor’s statements of income and asset composition by reportable segment,is incorporated herein by reference.

 

**QuarterEnded March 31, 2005, Compared to Quarter Ended March 31, 2004**

 

##### *Financial Results Overview*

 

Net income for the quarter ended March 31, 2005, increased $0.9million, or 900.0%, to $1.0 million from net income of $0.1 million for thequarter ended March 31, 2004.  Theincrease in net income was primarily due to increases in premiums and netinvestment income combined with decreases in policyholder benefits, partiallyoffset by an increase in general expenses, all of which are described ingreater detail below.

 

##### *Revenues*

 

Total revenues for the quarter ended March 31, 2005, increased $2.2million, or 6.3%, to $37.2 million from total revenues of $35.0 million for thequarter ended March 31, 2004.  Theprimary factors causing the increase are explained below under the captions “—Premiums,”“—Net Investment Income,” “—Commission and Fee Income,” “—Realized InvestmentGains and Losses” and “—Other Income.”

 

##### *Premiums*

 

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

 
| ** ** | ** ** | **For the quarter ended March 31, 2004** | ** ** | **For the quarter ended March 31, 2005** | ** ** | **Increase (decrease)** | ** ** |
|------------|------------|------------------------------------------|------------|------------------------------------------|------------|-------------------------|------------|
| ** ** | ** ** | **Worksite**                             | ** ** | **Senior**                               | ** ** | **Acquired**            | ** ** | **Total** | ** ** | **Worksite** | ** ** | **Senior** | ** ** | **Acquired** | ** ** | **Total** | ** ** | **Worksite** | ** ** | **Senior** | ** ** | **Acquired** | ** ** | **Total** | ** ** |
| ** ** | ** ** | **(dollars in millions)**                | ** ** |
| Direct     |       |                                     |       |                                     |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | $                                        | 3.2        |                                     | $          | 1.5                     |       | $ | — |   | $ | 4.7 |   | $ | 3.8 |   | $ | 0.5 |   | $ | — |   | $ | 4.3 |   | $ | 0.6 |   | $ | (1.0 | ) | $ | — |   | $ | (0.4 | ) |
| Renewal    |       | 11.2                                     |       | 12.2                                     |       | —                  |       | 23.4 |   | 11.4 |   | 13.5 |   | — |   | 24.9 |   | 0.2 |   | 1.3 |   | — |   | 1.5 |   |
| Total      |       | 14.4                                     |       | 13.7                                     |       | —                  |       | 28.1 |   | 15.2 |   | 14.0 |   | — |   | 29.2 |   | 0.8 |   | 0.3 |   | — |   | 1.1 |   |
| Assumed    |       |                                     |       |                                     |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | —                                   |       | —                                   |       | —                  |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Renewal    |       | —                                   |       | —                                   |       | 1.0                     |       | 1.0 |   | — |   | — |   | 0.9 |   | 0.9 |   | — |   | — |   | (0.1 | ) | (0.1 | ) |
| Total      |       | —                                   |       | —                                   |       | 1.0                     |       | 1.0 |   | — |   | — |   | 0.9 |   | 0.9 |   | — |   | — |   | (0.1 | ) | (0.1 | ) |
| Ceded      |       |                                     |       |                                     |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | (0.2                                     | )          | (0.9                                     | )          | —                  |       | (1.1 | ) | (0.3 | ) | (0.3 | ) | — |   | (0.6 | ) | (0.1 | ) | 0.6 |   | — |   | 0.5 |   |
| Renewal    |       | (0.2                                     | )          | (2.5                                     | )          | —                  |       | (2.7 | ) | (0.2 | ) | (3.1 | ) | — |   | (3.3 | ) | — |   | (0.6 | ) | — |   | (0.6 | ) |
| Total      |       | (0.4                                     | )          | (3.4                                     | )          | —                  |       | (3.8 | ) | (0.5 | ) | (3.4 | ) | — |   | (3.9 | ) | (0.1 | ) | — |   | — |   | (0.1 | ) |
| Net        |       |                                     |       |                                     |       |                    |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | 3.0                                      |       | 0.6                                      |       | —                  |       | 3.6 |   | 3.5 |   | 0.2 |   | — |   | 3.7 |   | 0.5 |   | (0.4 | ) | — |   | 0.1 |   |
| Renewal    |       | 11.0                                     |       | 9.7                                      |       | 1.0                     |       | 21.7 |   | 11.2 |   | 10.4 |   | 0.9 |   | 22.5 |   | 0.2 |   | 0.7 |   | (0.1 | ) | 0.8 |   |
| Total      |       | 14.0                                     |       | 10.3                                     |       | 1.0                     |       | 25.3 |   | 14.7 |   | 10.6 |   | 0.9 |   | 26.2 |   | 0.7 |   | 0.3 |   | (0.1 | ) | 0.9 |   |
|            |            |                                          |            |                                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Worksite net new premiums increased $0.5million, or 16.7%, to $3.5 million for the quarter ended March 31, 2005, from$3.0 million for the quarter ended March 31, 2004, due to increased sales volumes.New sales increased $0.9 million, or 40.9%, to $3.1 million for the quarterended March 31, 2005, from $2.2 million for the quarter ended March 31,2004.  Net renewal premiums increased$0.2 million, or 1.8%, due to the increased amount of insurance in forcecreated by prior year sales.

 

Senior market net new premiums, composed oflong term care policies, decreased $0.4 million, or 66.7%, to $0.2 million forthe quarter ended March 31, 2005, from $0.6 million for the quarter ended March31, 2004 due to decreased sales volumes. New sales decreased $0.9 million, or 69.2%, to $0.4 million for thequarter ended March

 

16

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31, 2005, from $1.3 million for the quarterended March 31, 2004.  A sales decline that began in mid-2003, resultingfrom the discontinuance of an older product and the introduction of a newproduct with significantly higher premiums, continued into 2005.  Net renewal premiums increased $0.7million, or 7.2%, due to the increased amount of insurance in force created byprior year sales.  This increase isreflected in both the direct renewal premiums and the ceded renewal premiums.

 

Acquired business premiums decreased $0.1million, or 10.0%, to $0.9 million for the quarter ended March 31, 2005, from$1.0 million for the quarter ended March 31, 2004.  We and our predecessor have not acquired anyblocks of business since 1999 and the decline is a result of policy lapses.

 

##### *Net Investment Income*

 

Net investment income increased $1.3 million, or 24.1%, to $6.7 millionfor the quarter ended March 31, 2005, from $5.4 million for the quarter endedMarch 31, 2004.  Net investment incomefor the quarter ended March 31, 2004, was negatively impacted by a non-recurring$1.6 million incentive payment to one of Kanawha’s outside investment managersat the conclusion of the contract period. Excluding this item, net investment income for the quarter ended March31, 2005, decreased by $0.3 million from the quarter ended March 31, 2004.  Net investment income is primarily affectedby changes in levels of invested assets and interest rates.  The decline in investment income for thequarter ended March 31, 2005, occurred despite an increase in total cash andinvestments of $69.3 million, or 13.8%, to $572.6 million as of March 31, 2005,from $503.3 million as of March 31, 2004. Invested assets increased by $69.6 million or 15.1%, to $530.7 millionas of March 31, 2005, from $461.1 million as of December 31, 2004, reflecting theinvestment of cash generated by 2004 asset sales and our initial publicoffering.  Generally, the increase incash and invested assets was due to retention of premiums to establish policyreserves for the payment of future policyholder benefits.

 

The average yield on cash and invested assets on an amortized costbasis was 4.60% for the quarter ended March 31, 2005, compared to an averageyield of 5.95% for the quarter ended March 31, 2004, excluding the effects ofthe non-recurring $1.6 million incentive payment to one of Kanawha’s outside investmentmanagers.  This decline resulted fromlower interest rates combined with the significantly larger amount of assetsheld in cash during the quarter ended March 31, 2005.  The incentive payment made in 2004 wascharged directly to the corporate and other segment, while all other netinvestment income is allocated to our various business segments on a pro ratabasis based on the invested assets attributed to the business segment.

 

In conjunction with the application of GAAP purchase accounting requirements,assets attributed to the worksite insurance business, the senior insurancebusiness and the acquired business all increased significantly, as evidenced bya comparison of segment assets in the segment tables shown in Note 8., BusinessSegments, from March 31, 2004, to March 31, 2005.

 

##### *Commission and Fee Income*

 

Commission and fee income increased $0.2 million, or 5.9%, to $3.6million for the quarter ended March 31, 2005, from $3.4 million for the quarterended March 31, 2004.  Most of thecommission and fee income was from administrative fees relating to third-partyadministration, and the increase was due to an increase in business in forcerelating to increased sales of administrative services.

 

##### *Realized Investment Gainsand Losses*

 

Realized investment gains and losses occur as a result of the sale orimpairment of investments.  The netrealized investment gain for the quarter ended March 31, 2005, decreased by$0.2 million to $0.0 million, from $0.2 million for the quarter ended March 31,2004.  The net gain realized on fixedmaturity securities for the quarter ended March 31, 2005, totaled $0.0 millioncompared to a net gain realized on fixed maturity securities of $0.2 millionfor the quarter ended March 31, 2004. There were no net gains realized on equity securities for the quartersended March 31, 2004, and March 31, 2005. Realized investment gains and losses are allocated entirely to thecorporate and other business segment.

 

17

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##### *Other Income*

 

Other income increased $0.1 million, or 14.3%, to $0.8 million for thequarter ended March 31, 2005, from $0.7 million for the quarter ended March 31,2004, reflecting increased commission and expense allowances from reinsurancecompanies generated from an increase in renewal ceded premiums.

 

##### *Benefits and Expenses*

 

Total benefits and expenses increased $0.8 million, or 2.3%, to $35.7million for the quarter ended March 31, 2005, from $34.9 million for thequarter ended March 31, 2004.  Theprimary factors causing this increase are explained below under the captions “—PolicyholderBenefits,” “—Insurance Commissions,” “—General Insurance Expenses,” “—InsuranceTaxes, Licenses and Fees,” and “—Amortization of DAC and VOBA.”

 

##### *Policyholder Benefits*

 

Policyholder benefits decreased $2.1 million, or 9.3%, to $20.4 millionfor the quarter ended March 31, 2005, from $22.5 million for the quarter endedMarch 31, 2004.  This produced a benefitsto premium ratio of 78.0% for the quarter ended March 31, 2005, compared to 89.0%for the quarter ended March 31, 2004. The benefits to premium ratio declined primarily as a result of the GAAPpurchase accounting adjustments described in the next three paragraphs.

 

Worksite marketing policyholder benefits decreased $0.6 million, or5.2%, to $10.9 million for the quarter ended March 31, 2005, from $11.5 millionfor the quarter ended March 31, 2004. This produced benefits to premium ratios of 74.3% for the quarter endedMarch 31, 2005, compared to 82.2% for the quarter ended March 31, 2004.  In accordance with GAAP purchase accountingrequirements, policy and contract reserves were recorded at fair value onDecember 31, 2004.  This adjustmentproduced increased reserve balances, which should result in smaller reserveincreases in the future.  The benefits topremium ratio decreased primarily as a result of this reduction in the increasein policy and contract reserves.

 

Senior market policyholder benefits decreased $0.6 million, or 6.7%, to$8.3 million for the quarter ended March 31, 2005, from $8.9 million for thequarter ended March 31, 2004.  Thisproduced benefits to premium ratios of 78.7% for the quarter ended March 31,2005, compared to 86.5% for the quarter ended March 31, 2004.  In accordance with GAAP purchase accountingrequirements, policy and contract reserves were recorded at fair value onDecember 31, 2004.  This adjustmentproduced increased reserve balances, which should result in smaller reserveincreases in the future.  The benefits topremium ratio decreased primarily as a result of this reduction in the increasein policy and contract reserves, partially offset by an increase in open activeclaims due to an increase in the number of policies in force and the aging ofour policyholders, which resulted in increases in actual claims paid andadditional claims reserves.

 

Acquired business policyholder benefits decreased $0.9 million, or42.9%, to $1.2 million for the quarter ended March 31, 2005, from $2.1 millionfor the quarter ended March 31, 2004. This produced benefits to premium ratios of 127.3% for the quarter endedMarch 31, 2005, compared to 210.7% for the quarter ended March 31, 2004.  These benefits to premium ratios are affectedby large portions of the acquired business that are no longer premium payingwith substantial reserves and investment income on reserves.  In accordance with GAAP purchase accountingrequirements, policy and contract reserves were recorded at fair value onDecember 31, 2004.  This adjustmentproduced increased reserve balances, which should result in smaller reserveincreases going forward.  The benefits topremium ratio decreased as a result of this reduction in the increase in policyand contract reserves as well as a reduction in benefits incurred during thequarter on a block of insurance policies acquired from Metropolitan LifeInsurance Company.

 

##### *Insurance Commissions*

 

Commission expenses increased $0.4 million, or 17.4%, to $2.7 millionfor the quarter ended March 31, 2005, from $2.3 million for the quarter endedMarch 31, 2004.  This increase consistsof normal increases related to increased renewal premiums, in addition to anincrease in first year commissions that were not deferred.

 

18

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##### *General Insurance Expenses*

 

General insurance expenses increased $3.4 million, or 55.7%, to $9.5million for the quarter ended March 31, 2005, from $6.1 million for the quarterended March 31, 2004.  General insuranceexpenses for the quarter ended March 31, 2005, include approximately $2.5million of incremental costs associated with our continuing expansion to anational insurance company, including the addition of management and marketingpersonnel, occupancy costs, infrastructure development, back-office expenses,director and officer and related types of insurance coverage, and costsassociated with being a public company. Additionally, expenses for the quarters ended March 31, 2005 and 2004,include approximately $0.6 million and $0.2 million, respectively, of costs todevelop our worksite marketing business. Overhead expenses that are not directly associated with a particularbusiness segment are allocated to the various business segments on a pro ratabasis based on different factors, such as headcount, policy count, number ofpolicies issued, premiums and other relevant factors.

 

##### *Insurance Taxes, Licensesand Fees*

 

Insurance taxes, licenses and fees increased $0.2 million, or 18.2%, to$1.3 million for the quarter ended March 31, 2005, from $1.1 million for thequarter ended March 31, 2004.  Employmenttaxes related to additional staffing are the primary driver of this increase.

 

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

 

First year commissions and general insurance expenses associated withthe acquisition of new business are deferred and amortized over thepremium-paying period of the related policies. The total deferrals of policy acquisition costs were $3.4 million and$3.8 million for the quarters ended March 31, 2005 and 2004, respectively.  The decrease in deferrals was primarily dueto the decrease in net new long-term care premiums in the senior market.

 

Our predecessor assigned a value to the insurance in force of acquiredcompanies or blocks of insurance business at the date of acquisition.  No companies or blocks of business wereacquired in the quarters ended March 31, 2005 or 2004.

 

The amortization of deferred acquisition costs (“DAC”) and the value ofbusiness acquired (“VOBA”) decreased $1.0 million, or 47.6%, to $1.1 millionfor the quarter ended March 31, 2005, from $2.1 million for the quarter endedMarch 31, 2004.  In accordance with GAAPpurchase accounting requirements, our predecessor’s DAC and VOBA wereeliminated, and a new VOBA was established for the value of the in-forcebusiness as of December 31, 2004.  Thisadjustment resulted in decreased DAC and VOBA balances, which cause smalleramortization charges going forward, as evidenced by the $1.0 millionamortization decrease in the quarter ended March 31, 2005 compared to thequarter ended March 31, 2004.

 

#### **Liquidityand Capital Resources**

 

KMG America is aholding company and had minimal operations of its own prior to the completionof its initial public offering and the Kanawha acquisition.  KMG America’s assets consist primarily of thecapital stock of Kanawha and its other non-insurance subsidiaries.  Accordingly, KMG America’s cash flows dependupon the availability of dividends and other statutorily permissible payments,such as payments under tax allocation agreements and under managementagreements, from Kanawha.  Kanawha’sability to pay dividends and to make other payments is limited primarily byapplicable laws and regulations of South Carolina, the state in which Kanawhais domiciled, which subjects insurance operations to significant regulatoryrestrictions.  These laws and regulationsrequire, among other things, that Kanawha, KMG America’s insurance subsidiary,comply with minimum solvency and capital requirements and limit the amount ofdividends it can pay to the holding company. Solvency regulations, capital requirements, types of insurance offeredand rating agency status are some of the factors used in determining the amountof capital available for dividends.  Ingeneral, South Carolina will permit annual dividends from insurance operationsequal to the greater of (1) the most recent calendar year’s statutory netincome or (2) 10% of total capital and surplus of the insurance operations atthe end of the previous calendar year, *provided*that the dividend payment does not exceed earned surplus, in which case furtherlimitations apply.

 

19

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

 

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

 

KMG America hasoutstanding debt of approximately $15.0 million because a portion of thepurchase price for the Kanawha acquisition was paid in the form of a$15.0 million subordinated promissory note with a five-year termbeginning on the closing date of the acquisition.  Interest on the promissory note is accruingat 5% per annum and is added to the principal balance on December 31 ofeach year and is payable on the maturity date. No cash payments are required under the promissory note until maturity,at which time approximately $19.1 million of principal and accruedinterest will be due and payable.  Theterms of the promissory note limit KMG America’s and Kanawha’s ability to incuradditional debt.  KMG America maintains a$2.0 million line of credit available to meet short-term cash flowneeds.  We are seeking to expand ouravailable credit facilities in order to maximize financial flexibility and areconsidering adding leverage to our capital structure.

 

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

 

We anticipate thatthese costs will be offset over time by increased sales production resultingfrom hiring additional sales personnel and increased cross-selling, aswell as efficiencies resulting from greater scale.  However, during 2005, we do not expect thatthe anticipated costs described above to implement our business strategy willbe offset by incremental revenues, resulting in an aggregate net use of cash in2005.  As of March 31, 2005, we haddisbursed approximately $2.3 million of those costs, net of investment income.  We expect that net incremental cash flowsresulting from the increased sales production and efficiencies anticipated fromour new business strategy will be positive after 2005 but can provide noassurance that this will occur.

 

##### *CashFlows*

 

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

 

The table below shows our predecessor’s and our net cash flows in theindicated periods:

 

20

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| ** **                          | ** ** | **Predecessor**                     | ** ** | **KMG America** | ** ** |
|-------------------------------------|------------|-------------------------------------|------------|-----------------|------------|
| ** **                          | ** ** | **For The Quarter Ended March 31,** | ** ** |
| **Net cash provided by (used in):** | ** ** | **2004**                            | ** ** | **2005**        | ** ** |
| ** **                          | ** ** | **(dollars in thousands)**          | ** ** |
| Operating activities                |       | $                                   | 7,379.1    |            | $          | 1,643.5 |   |
| Investing activities                |       | (7,723.6                            | )          | (77,115.1       | )          |
| Financing activities                |       | 0.0                                 |       | 0.0             |       |
| Net change in cash                  |       | $                                   | (344.5     | )               | $          | (75,471.6 | ) |

 

*CashFlows for the Quarters Ended March 31, 2004 and 2005. *In the table shown above, increases in net cashprovided by operating activities generally result from collected premiums whiledecreases in net cash flow provided by investing activities generally are aresult of the investment of collected premiums. Policy and contract liabilities increase when premiums collected areretained to establish policy reserves. The portions of these liabilities that are reinsured by reinsurancecompanies are reflected in reinsurance balances recoverable.

 

Other changes incash flows for the quarters ended March 31, 2004 and March 31, 2005, are asfollows:

 

We heldapproximately $117.4 million in cash at December 31, 2004, primarily consistingof cash proceeds from sales and maturities of our invested assets and from ourinitial public offering of common stock. We invested a significant portion of this cash in the first quarter of2005, resulting in the net cash outflow from investing activities of $77.1million for the quarter ended March 31, 2005.

 

Other assetsincreased by $0.7 million in the quarter ended March 31, 2004, primarily as aresult of third party administration receivables that were not collected untilthe second quarter of 2004.  Other assetsdecreased by $0.5 million in the quarter ended March 31, 2005, primarily as aresult of the receipt of $1.5 million of securities trade receivables as ofDecember 31, 2004, partially offset by the prepayment of $0.9 million ofexpenses related to annual insurance premiums.

 

Accounts payableand accrued expenses increased by $4.9 million in the quarter ended March 31,2004, primarily due to increases in reinsurance settlements due related to theacquired business.  These balancesdecreased by $0.6 million in the quarter ended March 31, 2005, representingnormal fluctuations.

 

As a function ofour third party administration business, we manage insurance funds for ourclients.  These funds are held insuspense accounts pending appropriate disposition, and the balances held insuspense vary on a day-to-day basis as insurance funds are received and appliedby us.

 

##### ***Investments***

 

The following tablesummarizes the unrealized gains and losses in our investment portfolio as ofMarch 31, 2005.

 
| ** **                                       | ** ** | **Amortized Cost** | ** **  | **Gross Unrealized Gains** | ** ** | **Gross Unrealized Losses** | ** ** | **Fair Value** | ** ** |
|--------------------------------------------------|------------|--------------------|-------------|----------------------------|------------|-----------------------------|------------|----------------|------------|
| Available for sale securities at March 31, 2005: |       |               |        |                       |       |                        |       |           |       |
| U.S. treasury securities                         |       | $                  | 12,506,352  |                       | $          | 16,046                      |       | $              | 161,088    |   | $ | 12,361,310 |   |
| U.S. government agency securities                |       | 41,474,005         |        | 41,730                     |       | 602,317                     |       | 40,913,418     |       |
| States and political subdivision securities      |       | 14,656,007         |        | 4,945                      |       | 160,800                     |       | 14,500,152     |       |
| Foreign bonds                                    |       | 81,322,239         |        | 128,383                    |       | 828,557                     |       | 80,622,065     |       |
| Corporate bonds                                  |       | 170,117,829        |        | 316,901                    |       | 3,558,842                   |       | 166,875,888    |       |
| Mortgage/asset-backed securities                 |       | 163,591,809        |        | 161,564                    |       | 2,014,695                   |       | 161,738,678    |       |
| Preferred stocks—redeemable                 |       | 4,458,831          |        | 300                        |       | 63,791                      |       | 4,395,340      |       |
| Subtotal, fixed maturity securities              |       | 488,127,072        |        | 669,869                    |       | 7,390,090                   |       | 481,406,851    |       |
| Equity securities                                |       | 36,000             |        | —                     |       | —                      |       | 36,000         |       |
| Securities available for sale                    |       | $                  | 488,163,072 |                       | $          | 669,869                     |       | $              | 7,390,090  |   | $ | 481,442,851 |   |

 

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

 

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

 

The substantial majority of our unrealized losses at March 31, 2005,can be attributed to increases in interest rates that caused the value of thefixed income securities in our investment portfolio to decrease.  At March 31, 2005, all securities in anunrealized loss position had been in a continuous loss position for less thansix months.

 

#### **CriticalAccounting Policies and Estimates**

 

Our consolidated financial statements and certain disclosures made inthis report have been prepared in accordance with GAAP and require us to makeestimates and assumptions that affect reporting amounts of assets andliabilities and contingent assets and contingent liabilities at the dates ofthe financial statements and the reported amounts of revenues and expensesduring the reporting periods.  Theestimates most susceptible to material changes due to significant judgment(identified as the “critical accounting policies”) are those used indetermining investment impairments, the reserves for future policy benefits andclaims, deferred acquisition costs and value of business acquired, and theprovision for income taxes.  The resultsof these estimates are critical because they affect our profitability and mayaffect key indicators used to measure our performance.  These estimates have a material effect on ourresults of operations and financial condition. For more information about our critical accounting policies, pleaserefer to our discussion of critical accounting policies in our Annual Report onForm 10-K for the year ended December 31, 2004.

 

#### **Forward-LookingStatements**

 

Forward-looking statements in the foregoing Management’s Discussion andAnalysis of Financial Condition and Results of Operations include statementsthat are identified by the use of words or phrases including, but not limitedto, the following: “will likely result,” “expected to,” “will continue,” “isanticipated,” “estimated,” “project,” “believe,” “expect,” and words or phrasesof similar import.  Changes in thefollowing important factors, among others, could cause our actual results todiffer materially from those expressed in any such forward-looking statements:competitive products and pricing; fluctuations in demand; possible recessionarytrends in the United States economy; governmental policies and regulations;interest rates; risks disclosed in Exhibit 99.01 to our Annual Report of Form10-K for the year ended December 31, 2004; and other risks that are detailedfrom time to time in reports we file with the Securities and ExchangeCommission.

 

## **ITEM 3.**                             QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

 

There are no material changes to the disclosure on this matter made inour Annual Report on Form 10-K for the year ended December 31, 2004.

 

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## **ITEM 4.**                             CONTROLSAND PROCEDURES.

 

We maintain disclosurecontrols and procedures that are designed to ensure that information requiredto be disclosed in the reports that we file or submit under the SecuritiesExchange Act of 1934, as amended, is recorded, processed, summarized andreported within the time periods specified in the rules and forms of the SEC,and that such information is accumulated and communicated to our managementtimely.  An evaluation was performedunder the supervision and with the participation of our management, includingour Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures (as defined in Rules13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of March31, 2005.  Based upon that evaluation,our management, including our Chief Executive Officer and our Chief FinancialOfficer, concluded that our disclosure controls and procedures were effectiveas of March 31, 2005.  There was nochange in our internal control over financial reporting during the quarterended March 31, 2005, that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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# **PART IIOTHER INFORMATION**

 

## **ITEM 1.**                             LEGALPROCEEDINGS.

 

The disclosure made in the first two paragraphs of Note 7., Commitmentsand Contingencies, of the Notes to Consolidated Financial Statements includedin this report, which discuss certain legal proceedings in which we areinvolved, is incorporated herein by reference.

 

**ITEM 2.          UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**

 

In our initial public offering, we issued 21,735,000 shares of commonstock, par value $0.01 per share, pursuant to registration statement no.333-117911, which was declared effective by the Securities and ExchangeCommission on December 14, 2004.  The netproceeds from the initial public offering, after deducting the underwritingdiscount and offering expenses payable by us, were approximately $188.0million.  From December 14, 2004, throughand including March 31, 2005, we applied the net proceeds of the offering asfollows:

 

•                  $130.0 million of the net proceedswas used to fund the cash portion of the purchase price to acquire all of theoutstanding common stock of Kanawha, and approximately $0.8 million of the netproceeds was used to pay our fees andexpenses incurred in connection with the Kanawha acquisition.

 

•                  Approximately$2.3 million of the net proceeds was used tofund negative cash flow associated with initial start-up costs and otherexpenditures, including expenditures to open our principle executive offices inMinneapolis, Minnesota and regional sales offices in selected locationsthroughout the United States and to hire and train additional sales andsupport staff and marketing personnel at these new facilities.

 

•                  Theremaining net proceeds, approximately $54.9 million, was invested in short- andlong-term, fixed maturity, interest bearing investments to be used for workingcapital needs and other general corporate purposes, including, among otherthings, (i) to fund additional start-up costs and other expenditures, includingopening additional facilities in selectedlocations throughout the United States and to hire and train additionalsales and support staff and marketing personnel at these new facilities and(ii) to maintain the required capital ofKanawha, our insurance subsidiary, at the level necessary to achieve ourdesired rating agency financial strength ratings and to comply with applicableregulatory requirements as we grow our insurance business.

 

**ITEM 6.****                              EXHIBITS.**

 

**(a)****                                ****Exhibits:**

 

10.01                   Lease Agreement,dated February 2, 2005, between KMG America Corporation and Metropolitan LifeInsurance Company in respect of KMG America Corporation’s principal executiveoffices located in Minnetonka, Minnesota (incorporated by reference from Exhibit 10.12 attachedto KMG America Corporation’s Annual Report on Form 10-K (File No. 001-32377)).

 

10.02**                 **Employment Agreement,dated as of March 21, 2005, between KMG America Corporation and James E.Nelson.

 

31.01                   Certification of Chief Executive Officerpursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

31.02                   Certification of Chief Financial Officerpursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

 

32.01                   Certification of Chief Executive Officerpursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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32.02                   Certification of Chief Financial Officerpursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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**SIGNATURES**

 

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

 
| ** **              | **KMG AMERICA CORPORATION**  |                                                                  |
|-------------------------|-----------------------------------|-----------------------------------------------------------------------|
| ** **              | *(Registrant)*                    |                                                                  |
| ** **              | * *                          |                                                                  |   |
| Date: May 16, 2005 | By:                | /s/ Scott H. DeLong III                                               |   |
|                    |                              | Name: Scott H. DeLong III                                        |   |
|                    |                              | Title: Senior Vice President & Chief Financial  Officer           |   |
|                    |                              |   (Principal Financial Officer)                        |   |
|                    |                              |                                                                  |   |
| Date: May 16, 2005 | By:                | /s/ Robert E. Matthews                                                |   |
|                    |                              | Name: Robert E. Matthews                                         |   |
|                    |                              | Title: Executive Vice President, Chief Financial  Officer &  |   |
|                    |                              |   Treasurer of Kanawha Insurance Company               |   |
|                    |                              |   (Principal Accounting Officer)                            |   |

 

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