**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 

**(Mark One)**
| **ý**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                   |       |                                                                                                    |
| **For the  quarterly period ended June 30, 2005** |
| ** **                                             |
| **OR**                                                 |
| ** **                                             |
| **o**                                                  | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from                         to**

 

**Commissionfile number: 001-32377**

 

**KMG AMERICA CORPORATION**

(Exact Name of Registrant asSpecified 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**

 

**N/A**

(Former Name, Former Addressand Former Fiscal Year, If Changed Since Last Report)

 

Indicate by check mark whether theregistrant:  (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ý No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the ExchangeAct).  Yes o No ý

 

As of June 30,2005, the number of shares of Common Stock outstanding was 22,071,641.

 

 

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**KMGAMERICA CORPORATION**

** **

**FORM 10-Q**

** **

**FOR THEQUARTERLY PERIOD ENDED JUNE 30, 2005**

**TABLE OF CONTENTS**

 
| **Item No.**                        |     |                                                                                                                                                         |
|-------------------------------------|----------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                |     |                                                                                                                                                         |   |
| PART I.  FINANCIAL INFORMATION |     |
|                                |     |                                                                                                                                                         |   |
|                                | ITEM 1.  | FINANCIAL STATEMENTS                                                                                                                                         |   |
|                                |     |                                                                                                                                                         |   |
|                                |     | CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2004, AND  JUNE 30, 2005 (UNAUDITED)                                                                |   |
|                                |     | CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE MONTHS  ENDED JUNE 30, 2004, AND 2005 AND THE SIX MONTHS ENDED JUNE 30,  2004 AND 2005 |   |
|                                |     | CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED) FOR THE SIX  MONTHS ENDED JUNE 30, 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 4.  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS                                                                                                         |   |
|                                |     |                                                                                                                                                         |   |
|                                | ITEM  6. | EXHIBITS                                                                                                                                                     |   |
|                                |     |                                                                                                                                                         |   |
| SIGNATURES                          |     |                                                                                                                                                         |

 

i

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# **PART I**

# **FINANCIAL INFORMATION**

##  

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

** **

**KMGAMERICA CORPORATION**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                         | ** ** | **December 31,  2004** | ** **  | **June 30,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|-------------------------|------------|
| ** **                                                                                                                                                                         | ** ** | ** **                  | ** **  | **(Unaudited)**         | ** ** |
| **Assets**                                                                                                                                                                         | ** ** | ** **                  | ** **  | ** **              | ** ** |
| ** **                                                                                                                                                                         | ** ** | ** **                  | ** **  | ** **              | ** ** |
| Investments:                                                                                                                                                                       |       |                        |        |                    |       |
| Fixed maturity securities available for  sale, at fair value (amortized cost of $409,613,186 and $520,494,998 as of  December 31, 2004, and June 30, 2005, respectively) |       | $                           | 409,613,186 |                    | $          | 528,039,933 |   |
| Equity securities available for sale, at  fair value (cost of $36,000 and $36,000 as of December 31, 2004, and  June 30, 2005, respectively)                             |       | 36,000                      |        | 13,000                  |       |
| Mortgage loans                                                                                                                                                                     |       | 23,678,639                  |        | 19,016,908              |       |
| Policy loans                                                                                                                                                                       |       | 22,620,801                  |        | 22,002,765              |       |
| Other investments                                                                                                                                                                  |       | 5,192,525                   |        | 5,163,333               |       |
| Total investments                                                                                                                                                                  |       | 461,141,151                 |        | 574,235,939             |       |
|                                                                                                                                                                               |       |                        |        |                    |       |
| Cash and cash equivalents                                                                                                                                                          |       | 117,400,156                 |        | 15,092,487              |       |
| Reinsurance balances recoverable                                                                                                                                                   |       | 71,354,798                  |        | 73,468,891              |       |
| Accrued investment income                                                                                                                                                          |       | 4,912,216                   |        | 5,804,708               |       |
| Real estate and equipment                                                                                                                                                          |       | 9,701,754                   |        | 9,837,105               |       |
| Federal income tax recoverable                                                                                                                                                     |       | 4,239,906                   |        | 5,505,704               |       |
| Deferred income tax asset                                                                                                                                                          |       | 236,319                     |        | 1,329,982               |       |
| Amounts due from reinsurers                                                                                                                                                        |       | 1,940,903                   |        | 1,513,618               |       |
| Deferred policy acquisition costs                                                                                                                                                  |       | —                      |        | 6,357,325               |       |
| Value of business acquired                                                                                                                                                         |       | 74,481,295                  |        | 73,101,475              |       |
| Other assets                                                                                                                                                                       |       | 24,642,833                  |        | 23,282,519              |       |
| Total assets                                                                                                                                                                       |       | $                           | 770,051,331 |                    | $          | 789,529,753 |   |

 

See accompanying notes.

 

1

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**KMGAMERICA CORPORATION**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                          | ** ** | **December 31,  2004** | ** **  | **June 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|-------------------------|------------|
| ** **                                                                                          | ** ** | ** **                  | ** **  | **(Unaudited)**         | ** ** |
| **Liabilities and shareholders’ equity**                                                       |       |                        |        |                    |       |
|                                                                                                |       |                        |        |                    |       |
| Liabilities:                                                                                        |       |                        |        |                    |       |
| Policy and contract liabilities:                                                                    |       |                        |        |                    |       |
| Life and annuity reserves                                                                           |       | $                           | 309,940,285 |                    | $          | 303,479,751 |   |
| Accident and health reserves                                                                        |       | 200,801,846                 |        | 213,644,376             |       |
| Policy and contract claims                                                                          |       | 9,343,512                   |        | 9,376,996               |       |
| Other policyholder liabilities                                                                      |       | 10,829,794                  |        | 11,092,367              |       |
| Total policy and contract liabilities                                                               |       | 530,915,437                 |        | 537,593,490             |       |
|                                                                                                |       |                        |        |                    |       |
| Accounts payable and accrued expenses                                                               |       | 18,794,922                  |        | 19,266,164              |       |
| Taxes, other than federal income taxes                                                              |       | 528,262                     |        | 417,074                 |       |
| Deferred income taxes                                                                               |       | 6,502,042                   |        | 12,230,129              |       |
| Liability for benefits for employees and  agents                                                    |       | 4,158,418                   |        | 4,627,493               |       |
| Funds held in suspense                                                                              |       | 4,724,004                   |        | 3,675,264               |       |
| Long term notes payable                                                                             |       | 15,000,000                  |        | 15,000,000              |       |
| Interest payable on long term notes                                                                 |       | 22,603                      |        | 397,603                 |       |
| Other liabilities                                                                                   |       | 1,617,778                   |        | 1,912,204               |       |
| Total liabilities                                                                                   |       | 582,263,466                 |        | 595,119,421             |       |
|                                                                                                |       |                        |        |                    |       |
| 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                    | )           | 1,557,656               |       |
| Accumulated other comprehensive (gain)                                                              |       | —                      |        | 4,889,258               |       |
| Total shareholders’ equity                                                                     |       | 187,787,865                 |        | 194,410,332             |       |
| Total liabilities and shareholders’ equity                                                     |       | $                           | 770,051,331 |                    | $          | 789,529,753 |   |

 

See accompanying notes.

 

2

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**KMGAMERICA CORPORATION AND PREDECESSOR**

**CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)**

** **
| ** **                                                                        | ** ** | **Predecessor**                                  | ** ** | **KMG America  Corporation**               | ** ** | **Predecessor** | ** ** | **KMG America  Corporation** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------|------------|-----------------|------------|------------------------------|------------|
| ** **                                                                        | ** ** | **For the Three Months Ended June 30****,** | ** ** | **For the Six Months Ended June 30,** | ** ** |
| ** **                                                                        | ** ** | **2004**                                         | ** ** | **2005**                                   | ** ** | **2004**        | ** ** | **2005**                     | ** ** |
| Revenue:                                                                          |       |                                             |       |                                       |       |            |       |                         |       |
| Insurance premiums                                                                |       | $                                                | 26,649,086 |                                       | $          | 26,816,789      |       | $                            | 51,986,865 |   | $ | 53,014,349 |   |
| Net investment income                                                             |       | 6,930,907                                        |       | 6,800,767                                  |       | 12,320,527      |       | 13,453,552                   |       |
| Commission and fee income                                                         |       | 3,484,216                                        |       | 3,670,691                                  |       | 6,836,190       |       | 7,238,739                    |       |
| Realized investment gains                                                         |       | 1,512,811                                        |       | 18,382                                     |       | 1,728,103       |       | 45,962                       |       |
| Other income                                                                      |       | 710,183                                          |       | 978,330                                    |       | 1,457,476       |       | 1,769,977                    |       |
| Total revenues                                                                    |       | 39,287,203                                       |       | 38,284,959                                 |       | 74,329,161      |       | 75,522,579                   |       |
|                                                                              |       |                                             |       |                                       |       |            |       |                         |       |
| Benefits and expenses:                                                            |       |                                             |       |                                       |       |            |       |                         |       |
| Policyholder benefits                                                             |       | 24,006,648                                       |       | 20,645,910                                 |       | 46,547,237      |       | 41,075,744                   |       |
| Insurance commissions, net of deferrals                                           |       | 2,434,619                                        |       | 2,376,158                                  |       | 4,779,169       |       | 5,042,325                    |       |
| General insurance expenses, net of  deferrals                                     |       | 6,334,907                                        |       | 11,245,804                                 |       | 12,430,214      |       | 20,705,339                   |       |
| Insurance taxes, licenses and fees                                                |       | 1,179,113                                        |       | 1,130,309                                  |       | 2,308,627       |       | 2,450,226                    |       |
| Depreciation                                                                      |       | 714,904                                          |       | 728,223                                    |       | 1,418,330       |       | 1,424,284                    |       |
| Amortization of deferred policy acquisition  costs and value of business acquired |       | 2,264,904                                        |       | 1,214,349                                  |       | 4,355,759       |       | 2,299,504                    |       |
| Total benefits and expenses                                                       |       | 36,935,095                                       |       | 37,340,753                                 |       | 71,839,336      |       | 72,997,422                   |       |
|                                                                              |       |                                             |       |                                       |       |            |       |                         |       |
| Income before income taxes                                                        |       | 2,352,108                                        |       | 944,206                                    |       | 2,489,825       |       | 2,525,157                    |       |
| Provision for income taxes                                                        |       | (719,217                                         | )          | (230,995                                   | )          | (766,041        | )          | (791,948                     | )          |
| Net income                                                                        |       | $                                                | 1,632,891  |                                       | $          | 713,211         |       | $                            | 1,723,784  |   | $ | 1,733,209 |   |
| Net income per share:                                                             |       |                                             |       |                                       |       |            |       |                         |       |
| Basic                                                                             |       | $                                                | 624.95     |                                       | $          | 0.03            |       | $                            | 659.74     |   | $ | 0.08 |   |
| Diluted                                                                           |       | $                                                | 565.30     |                                       | $          | 0.03            |       | $                            | 596.77     |   | $ | 0.08 |   |
| Weighted-average shares outstanding:                                              |       |                                             |       |                                       |       |            |       |                         |       |
| Basic                                                                             |       | 2,612.83                                         |       | 22,071,641                                 |       | 2,612.83        |       | 22,071,641                   |       |
| Diluted                                                                           |       | 2,888.53                                         |       | 22,071,641                                 |       | 2,888.53        |       | 22,106,419                   |       |

 

See accompanying notes.

 

3

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**KMGAMERICA CORPORATION AND PREDECESSOR**

**CONSOLIDATED STATEMENTS OF CASH FLOW(UNAUDITED)**

** **
| ** **                                                                         | ** ** | **Predecessor**                             | ** ** | **KMG America  Corporation**               | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                         | ** ** | **Six Months Ended  June 30,****2004** | ** ** | **Six Months Ended   June 30,  2005** | ** ** |
| ** **                                                                         | ** ** | ** **                                  | ** ** | ** **                                 | ** ** |
| **Operating activities**                                                           |       |                                        |       |                                       |       |
| Net income                                                                         |       | $                                           | 1,723,784  |                                       | $          | 1,733,209 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                                        |       |                                       |       |
| Depreciation and amortization                                                      |       | 1,480,420                                   |       | 1,560,133                                  |       |
| Policy acquisition costs deferred                                                  |       | (6,591,781                                  | )          | (7,173,009                                 | )          |
| Amortization of deferred policy acquisition  costs and value of business acquired  |       | 4,355,759                                   |       | 2,299,504                                  |       |
| Realized investment (gains), net                                                   |       | (1,728,103                                  | )          | (45,962                                    | )          |
| Deferred income tax expense                                                        |       | 1,237,892                                   |       | 2,057,747                                  |       |
| Changes in operating assets and  liabilities:                                      |       |                                        |       |                                       |       |
| Reinsurance balances recoverable                                                   |       | (1,926,746                                  | )          | (2,114,093                                 | )          |
| Accrued investment income                                                          |       | (206,463                                    | )          | (892,492                                   | )          |
| Federal income tax recoverable                                                     |       | (100,571                                    | )          | (1,265,798                                 | )          |
| Other assets                                                                       |       | 398,376                                     |       | 1,360,314                                  |       |
| Amounts due from reinsurers                                                        |       | 277,089                                     |       | 427,285                                    |       |
| Policy and contract liabilities                                                    |       | 11,864,342                                  |       | 6,678,053                                  |       |
| Accounts payable and accrued expenses                                              |       | 3,117,563                                   |       | 471,242                                    |       |
| Interest payable on long term notes                                                |       | —                                      |       | 375,000                                    |       |
| Deferred stock option compensation expense                                         |       | 70,590                                      |       | —                                     |       |
| Taxes, other than federal income taxes                                             |       | (159,758                                    | )          | (111,188                                   | )          |
| Funds held in suspense                                                             |       | (625,444                                    | )          | (1,048,740                                 | )          |
| Liability for benefits for employees and agents                                    |       | 407,453                                     |       | 469,075                                    |       |
| Other liabilities                                                                  |       | 142,670                                     |       | 294,426                                    |       |
| Net cash provided by operating activities                                          |       | 13,737,072                                  |       | 5,074,706                                  |       |
| **Investing activities**                                                           |       |                                        |       |                                       |       |
| Securities available for sale:                                                     |       |                                        |       |                                       |       |
| Sales                                                                              |       | 23,644,932                                  |       | 17,650,873                                 |       |
| Maturities, calls and redemptions                                                  |       | 3,881,357                                   |       | 132,245,521                                |       |
| Purchases                                                                          |       | (42,047,333                                 | )          | (261,738,990                               | )          |
| Repayments of mortgage loans                                                       |       | 5,292,142                                   |       | 4,661,731                                  |       |
| Mortgage loans originated                                                          |       | (792,951                                    | )          | —                                     |       |
| (Increase) decrease in policy loans, net                                           |       | (95,827                                     | )          | 618,036                                    |       |
| Sale of real estate and property and  equipment                                    |       | —                                      |       | 85,564                                     |       |
| Purchases of real estate, property and  equipment                                  |       | (675,083                                    | )          | (745,110                                   | )          |
| Acquisition of the Predecessor, net of cash  acquired                              |       | —                                      |       | (160,000                                   | )          |
| Net cash (used in) investing activities                                            |       | (10,792,763                                 | )          | (107,382,375                               | )          |
|                                                                               |       |                                        |       |                                       |       |
| Net increase (decrease) in cash and cash  equivalents                              |       | 2,944,309                                   |       | (102,307,669                               | )          |
| Cash and cash equivalents at beginning of  period                                  |       | 7,204,805                                   |       | 117,400,156                                |       |
| Cash and cash equivalents at end of period                                         |       | $                                           | 10,149,114 |                                       | $          | 15,092,487 |   |
| **Supplemental disclosures of cash flow  information**                             |       |                                        |       |                                       |       |
| Federal income taxes paid                                                          |       | $                                           | 600,000    |                                       | $          | — |   |

 

See accompanying notes.

 

4

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**KMGAMERICA CORPORATION AND PREDECESSOR**

 

#### *NOTES TOCONSOLIDATED FINANCIAL STATEMENTS*

#### * *

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

#### * *

KMG AmericaCorporation (“KMG America” or the “Company”) is a holding company incorporatedunder the laws of the Commonwealth of Virginia on January 21, 2004.  KMG America commenced operations shortlybefore it completed its initial public offering of common stock on December 21,2004, and its shares trade on the New York Stock Exchange under the symbol “KMA.”  Concurrently with the completion of itsinitial public offering, KMG America completed its acquisition of KanawhaInsurance Company (“Kanawha” or the “Predecessor”) and its subsidiaries, whichare KMG America’s primary operating subsidiaries and which underwrite and selllife and health insurance products marketed primarily in the southeasternUnited States.

 

Kanawha, theprimary operating subsidiary of KMG America, is licensed to issue life andaccident and health insurance.  Kanawhais domiciled in South Carolina.  Kanawhahas one wholly owned subsidiary, Kanawha HealthCare Solutions, Inc., athird-party administrator with operations in Lancaster and Greenville, SouthCarolina, and one wholly owned indirect subsidiary, Kanawha Marketing Group, Inc.

 

The Company’sprimary businesses are life and health insurance risk assumption, third-partyadministration and medical management services. Included in risk assumption are the Company’s product lines ofindividual life, annuity, supplemental health and short-term disability.  The Company announced on June 3, 2005,that it has decided to sell or otherwise dispose of its in-house agency thatdistributes senior market insurance products by the end of 2005 and it expectsat some point not long after the sale or other disposition of the agency to ceaseunderwriting new long-term care insurance. The Company will retain and actively manage its existing block of inforce long-term care policies.  TheCompany’s third-party administration and medical management businesses includea wide array of services with the primary emphasis in the offering ofadministrative service-only products.

 

ThePredecessor’s marketing efforts and sales were primarily in the southeasternUnited States, predominantly in Florida, South Carolina and NorthCarolina.  Since acquiring the Predecessor,the Company has begun to implement its business strategy to market its productsnationwide.  While most of the Company’ssales in the first six months of 2005 were primarily in the southeastern UnitedStates, the Company expects its nationwide marketing effort to generatesignificant nationwide sales in the future.

 

#### *2.  Significant AccountingPolicies*

#### * *

#### *Basis of Presentation*

#### * *

For accountingpurposes, Kanawha is treated as KMG America’s predecessor entity and isreferred to in these Notes as the “Predecessor.”  For financial reporting purposes, managementhas treated the acquisition of the Predecessor as if it closed on December 31,2004, rather than the actual closing date of December 21, 2004, as theeffects of the acquisition for the period from December 21, 2004, to December 31,2004, were not material to the Predecessor’s consolidated statements ofoperations, cash flows, and changes in shareholders’ equity for the year ended December 31,2004.  Accordingly, financial informationin the following discussion that relates to the Predecessor’s consolidatedresults of operations for the six months ended June 30, 2004 and the threemonths ended June 30, 2004, and cash flows and changes in shareholders’equity for the six months ended June 30, 2004, are reported on ahistorical basis without GAAP (generally accepted accounting principles in theUnited States) purchase accounting adjustments reflecting the acquisition ofthe Predecessor.  Financial informationrelating to the Company’s consolidated results of operations for the six monthsended June 30, 2005 and three months ended June 30, 2005, and cashflows and changes in shareholders’ equity for the six months ended June 30,2005, and the Company’s financial position as of December 31, 2004, and June 30,2005, has been adjusted for GAAP purchase accounting adjustments reflecting thePredecessor’s acquisition.

 

Theaccompanying unaudited consolidated financial statements (other than the December 31,2004, balance sheet data, which has been derived from audited financialstatements) have been prepared in accordance with GAAP for interim financialinformation.  Accordingly, they do notinclude all of the information and footnotes required by GAAP for completefinancial statements.  In the opinion ofmanagement, the unaudited consolidated financial

 

5

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statements included hereinreflect all adjustments consisting only of normal recurring accruals which arenecessary for the fair presentation of the financial condition and results ofoperations for the interim periods presented. All significant intercompany accounts and transactions have beeneliminated in consolidation.  Operatingresults for the three and six month periods ended June 30, 2005, are notnecessarily indicative of the results that may be expected for the year ended December 31,2005.  Certain prior year amounts havebeen reclassified to conform with the current year presentation.

 

The Companyalso submits financial statements to insurance industry regulatoryauthorities.  Those financial statementsare prepared on the basis of statutory accounting principles (“SAP”) and aresignificantly different from financial statements prepared in accordance withGAAP (see Note 4).

 

#### *Use of Estimates and Assumptions*

#### * *

The presentationof the accompanying consolidated financial statements requires management tomake estimates and assumptions that affect amounts reported in the consolidatedfinancial statements and accompanying notes. Such estimates and assumptions could change in the future as moreinformation becomes known, which could impact the amounts reported anddisclosed herein.

 

#### *Investments*

#### * *

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

 

Statement ofFinancial 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.  TheCompany has no securities classified as held to maturity.  Management determines the appropriateclassification of fixed maturities at the time of purchase.

 

Investmentsare reported on the following basis:

 

•                    Fixedmaturity securities classified as available-for-sale are stated at fair valuewith unrealized gains and losses reported directly in shareholders’ equity asaccumulated other comprehensive income. Fair values for fixed maturity securities are based on quoted marketprices, where available.  For fixedmaturity securities not actively traded, fair values are estimated using valuesobtained from independent pricing services.

 

•                    Equitysecurities classified as available-for-sale are stated at fair value with unrealizedgains and losses reported directly in shareholders’ equity as accumulated othercomprehensive income.

 

•                    Assetssupporting the deferred 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.

 

•                    Mortgageloans on real estate are typically stated at unpaid balances, net of allowancesfor unrecoverable amounts.  However, dueto the Company’s acquisition of the Predecessor, effective December 31,2004, under GAAP purchase accounting rules, mortgage loans were recorded atfair value.  Valuation allowances formortgage loans are established when the Company determines it is probable thatit will be unable to collect all amounts (both principal and interest) dueaccording to the contractual terms of the loan agreement.  Such allowances are based on the presentvalue of expected future cash flows discounted at the loan’s effective interestrate or, if foreclosure is probable, on the estimated fair value of theunderlying real estate.

 

•                    Policyloans are stated at their unpaid balances.

 

•                    Intereston loans is generally recorded over the term of the loan based on the unpaidprincipal balance.  Accrual of interestis discontinued when either principal or interest becomes 90 days past due orwhen,

 

6

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in management’s opinion, collection of suchinterest is doubtful.  In addition, anypreviously accrued interest is reversed when the loan becomes 90 days past due.

 

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

 

•                    Amortizationof premiums and accrual of discounts on investments in fixed maturitysecurities are reflected in earnings over the contractual terms of theinvestments in a manner that produces a constant effective yield.  Realized gains and losses on dispositions ofsecurities are determined by the specific-identification method.

 

#### *Deferred Policy Acquisition Costs*

#### * *

Acquisitioncosts incurred by the Predecessor and the Company in the process of acquiringnew business are deferred and amortized into income as discussed below.  Costs deferred consist primarily ofcommissions and certain policy underwriting, issue and agency expenses thatvary with and are primarily related to production of new business.

 

For mostinsurance products, the amortization of deferred acquisition costs isrecognized in proportion to the ratio of annual premium revenue to the totalanticipated premium revenue, which gives effect to expected terminations.  Deferred acquisition costs are amortized overthe premium-paying period of the related policies.  Anticipated premium revenue is determinedusing assumptions consistent with those utilized in the determination ofliabilities for insurance reserves.  Forinterest-sensitive life insurance and investment products such as deferredannuities (no longer sold by the Company) to the extent recoverable from futuregross profits, deferred policy acquisition costs are amortized generally inproportion to the present value of expected gross profits from surrender chargesand investment, mortality and expense margins.

 

ThePredecessor’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 deferredacquisition costs prospectively on January 1, 2005.

 

#### *Value of Business Acquired*

#### * *

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

 

Theamortization of value of business acquired is recognized using amortizationschedules established at the time of the acquisitions based upon expectedannual premium.  Certain of theseamortization schedules include actual to expected adjustments to reflect actualexperience as it emerges.  The value ofbusiness acquired for premium paying policies is amortized in proportion tofuture expected premiums.  The value ofbusiness acquired for policies paid up as of the acquisition date is amortizedin proportion to expected future earnings.

 

ThePredecessor’s historical value of business acquired was eliminated upon theclosing of the Kanawha acquisition as part of the application of GAAP purchaseaccounting requirements.  Value ofbusiness 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.

 

#### *Benefit Reserves*

#### * *

Insurancereserves for individual life insurance, individual accident and healthinsurance, group life insurance and group accident and health insurance areassociated with earned premiums so as to recognize profits over the premium-payingperiod.  This association is accomplishedby recognizing the liabilities for insurance reserves on a net level premiummethod based on assumptions deemed appropriate at the date of issue as tofuture investment yield, mortality, morbidity, withdrawals and maintenanceexpenses, and including margins for adverse deviations.  Interest assumptions are based on interestrate levels and expectations at the time policies are sold.  Mortality, morbidity and withdrawalassumptions are based on recognized actuarial tables or the Company’s and 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

 

7

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computed under a retrospectivedeposit 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.

 

ThePredecessor’s benefit reserves, net of related reinsurance recoverable, at December 31,2004, were adjusted to reflect the closing of the Kanawha acquisition as partof the application of GAAP purchase accounting requirements.  The valuation interest rate assumptions weregenerally lowered to reflect the current and expected interest rate environmentat the time the acquisition closed.  Thischange resulted in an increase in benefit reserves.  Valuation assumptions for mortality,morbidity and withdrawal were changed to reflect current expectations, whichresulted in an increase in benefit reserves. Finally, the valuation assumptions for future premium rates on long termcare coverage were increased to account for implemented and expected rateincreases.  While the assumptionchange for future premium rates taken alone would reduce benefit reserves forthe long term care coverage, the overall impact of the changes to valuation assumptionstaken together resulted in an increase in reserves for this coverage.

 

Lossrecognition testing of the Company’s policy benefit reserves is performedannually.  This testing involves acomparison of the Company’s actual net liability position (all liabilities lessdeferred acquisition costs, or DAC) to the present value of future liabilitiescalculated using then-current assumptions. These assumptions are based on the Company’s best estimate of futureexperience.  To the extent a premiumdeficiency exists, it would be recognized immediately by a charge to thestatement 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-Based Compensation*

#### * *

The Companyhas adopted the disclosure-only requirements of SFAS No. 123, *Accounting for Stock-Based Compensation*(“SFAS123”), as amended by FASB Statement No. 148, *Accounting for Stock-Based Compensation-Transition and Disclosure*(“SFAS 148”).  As permitted by theprovisions of this Statement, the Predecessor accounted for stock-basedcompensation using the intrinsic value method prescribed by AccountingPrinciples Board Opinion No. 25, *Accountingfor Stock Issued to Employees, and Related Interpretations*.

 

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

 

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

 

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

 

8

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| ** **                                                                                                                            | ** ** | **Predecessor**                            | ** ** | **KMG America  Corporation**                | ** ** | **Predecessor**                           | ** ** | **KMG America  Corporation**              | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                            | ** ** | **Three Months  Ended June 30  2004** | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2004** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
| Net income as reported                                                                                                                |       | $                                          | 1,632,891  |                                        | $          | 713,211                                   |       | $                                         | 1,723,784  |   | $ | 1,733,209 |   |
| Add: Stock-based employee compensation  expense included in reported net income, net of related tax effects                           |       | 23,294                                     |       | —                                      |       | 46,589                                    |       | —                                    |       |
| Deduct: Total stock-based employee  compensation determined under fair value based method for all awards, net of  related tax effects |       | (28,395                                    | )          | (179,474                                    | )          | (56,792                                   | )          | (345,084                                  | )          |
| Pro forma net income available to common  stockholders                                                                                |       | $                                          | 1,627,790  |                                        | $          | 533,737                                   |       | $                                         | 1,713,581  |   | $ | 1,388,125 |   |
| Net income per share-basic:                                                                                                           |       |                                       |       |                                        |       |                                      |       |                                      |       |
| As reported                                                                                                                           |       | $                                          | 624.95     |                                        | $          | 0.03                                      |       | $                                         | 659.74     |   | $ | 0.08 |   |
| Pro forma                                                                                                                             |       | $                                          | 623.00     |                                        | $          | 0.02                                      |       | $                                         | 655.83     |   | $ | 0.06 |   |
| Net income per share-diluted:                                                                                                         |       |                                       |       |                                        |       |                                      |       |                                      |       |
| As reported                                                                                                                           |       | $                                          | 565.30     |                                        | $          | 0.03                                      |       | $                                         | 596.77     |   | $ | 0.08 |   |
| Pro forma                                                                                                                             |       | $                                          | 563.62     |                                        | $          | 0.02                                      |       | $                                         | 593.24     |   | $ | 0.06 |   |

 

**Recently Issued Accounting Standards**

 

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

 

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

 

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

 

In December 2004,the FASB enacted SFAS No. 123 (revised 2004) (“SFAS 123 (revised 2004)”), *Share-Based Payment*, which replaces SFAS No. 123(“SFAS 123”), *Accounting for Stock-BasedCompensation*, 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 formadisclosures previously permitted under SFAS 123 no longer will be analternative to financial statement recognition. Although the Company has not yet determined whether the adoption of SFAS123 (revised 2004) will result in amounts that are similar to the current proforma disclosures under SFAS 123, the Company is evaluating the requirementsunder SFAS 123 (revised 2004) and expects the adoption to have an impact on itsconsolidated statements of income and net income per share that issubstantially similar to the current pro forma disclosure under SFAS 123.

 

9

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#### *3.  Investments*

#### * *

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

 
| ** **                                            | ** ** | **Amortized Cost** | ** **  | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|-------------------------------------------------------|------------|--------------------|-------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| Available for sale securities at  June 30, 2005: |       |               |        |                         |       |                          |       |            |       |
| Fixed maturity securities                             |       | $                  | 520,494,998 |                         | $          | 9,620,316                     |       | $               | 2,075,381  |   | $ | 528,039,933 |   |
| Equity securities                                     |       | 36,000             |        | —                       |       | 23,000                        |       | 13,000          |       |
| Securities available for sale                         |       | $                  | 520,530,998 |                         | $          | 9,620,316                     |       | $               | 2,098,381  |   | $ | 528,052,933 |   |

#### * *

#### *4.  Statutory FinancialInformation*

#### * *

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

 

#### *5.  Employee Benefits*

#### * *

The netperiodic retirement benefit cost of the Company’s defined benefit pension planfor the three and six month periods presented included the followingcomponents:

 
| ** **                               | ** ** | **Predecessor**                            | ** ** | **KMG America  Corporation**               | ** ** | **Predecessor**                          | ** ** | **KMG America  Corporation**             | ** ** |
|------------------------------------------|------------|--------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| ** **                               | ** ** | **Three Months Ended  June 30, 2004** | ** ** | **Three Months Ended  June 30, 2005** | ** ** | **Six Months Ended  June 30, 2004** | ** ** | **Six Months Ended  June 30, 2005** | ** ** |
| ** **                               | ** ** | ** **                                 | ** ** | ** **                                 | ** ** | ** **                               | ** ** | ** **                               | ** ** |
| Components of net periodic benefit cost: |       |                                       |       |                                       |       |                                     |       |                                     |       |
| Service cost                             |       | $                                          | 206,269    |                                       | $          | 227,579                                  |       | $                                        | 412,538    |   | $ | 455,158 |   |
| Interest cost                            |       | 200,514                                    |       | 228,171                                    |       | 401,027                                  |       | 456,342                                  |       |
| Expected return on plan assets           |       | (131,528                                   | )          | (207,384                                   | )          | (263,057                                 | )          | (414,768                                 | )          |
| Amortization of transition liability     |       | 4,343                                      |       | 4,343                                      |       | 8,686                                    |       | 8,686                                    |       |
| Recognized net actuarial loss            |       | 51,913                                     |       | 42,608                                     |       | 103,826                                  |       | 85,216                                   |       |
| Net periodic benefit cost                |       | $                                          | 331,511    |                                       | $          | 295,317                                  |       | $                                        | 663,020    |   | $ | 590,634 |   |

 

The Companyexpects that its aggregate contributions to its defined benefit pension planwill be between $0 and $850,000 in 2005. No contributions were made during the six months ended June 30, 2005.

 

In the threemonths and six months ended June 30, 2005, the Company granted options topurchase an aggregate of 74,500 and 156,750 shares of its common stock,respectively.  The options vest in fourequal annual installments beginning on the first anniversary of the date ofgrant.  Subject to certain conditions setforth in the option agreements, options are exercisable upon vesting until thetenth anniversary of the date of grant.

 

10

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

#### * *

Totalcomprehensive income (loss) for the six month periods ended June 30, 2004and 2005 was $(6.4) million and $6.6 million, respectively.  The difference between comprehensive incomeand net income for these periods was unrealized gains (losses) of $(8.1)million and $4.9 million, respectively.

 

Totalcomprehensive income (loss) for the three month periods ended June 30,2004 and 2005 was $(14.1) million and $10.0 million, respectively.  The difference between comprehensive incomeand net income for these periods was unrealized gains (losses) of $(15.7)million and $9.3 million, respectively.

 

#### *7.  Commitments and Contingencies*

#### * *

The Company isoccasionally named as a defendant in various legal actions arising principallyfrom claims made under insurance policies and contracts.  Those actions are considered by the Companyin estimating the policy and contract liabilities and management believesadequate reserves have been established for such cases.  Management believes that the resolution of thoseactions will not have a material effect on the Company’s financial position orresults of operations.

 

On February 18,2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company andReliaStar Life Insurance Company of New York, both indirect wholly-ownedsubsidiaries of ING America US, in the Fourth Judicial District Court inHennepin County, Minnesota (the “Court”), against KMG America, Kanawha, KennethU. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb (the “ReliaStar Litigation”).  Messrs. Kuk, Kraemer and Moore areofficers of KMG America and former employees of the plaintiffs.  Mr. Gibb is an employee of KMG Americaand a former employee of the plaintiffs. The complaint alleges misappropriation of trade secrets, conversion,tortious interference with business and employment relationships, breach offiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk,Kraemer, and Moore.  The complaint seeksinjunctive relief and unspecified monetary damages.   On July 26, 2005, the plaintiffs filed amotion in the Court to amend their complaint to add Scott H. DeLong III andThomas D. Sass as defendants.  Messrs. DeLongand Sass are officers of KMG America and former employees of theplaintiffs.  The plaintiffs’ motion to amendtheir complaint also seeks to add claims alleging unfair competition,interference with contractual relationships, civil conspiracy, fraudulentmisrepresentation and civil theft.   KMG America believes the allegations arewithout merit, intends to defend the action and believes that the outcome ofthis matter will not have a material adverse effect on its financial positionor results of operations; however, defense costs may have a material adverseeffect on its consolidated financial position or results of operations.

 

On December 21,2004, the Company entered into a $15.0 million five-year subordinatedpromissory note to fund a portion of the purchase price for the Kanawhaacquisition.  Interest on the promissorynote accrues at 5% per annum and is added to the principal balance on December 31of each year and is payable on the maturity date.  No cash payments are required under thepromissory note until maturity, at which time approximately $19.1 million ofprincipal and accrued interest will be due and payable.  The terms of the promissory note limit theCompany’s and Kanawha’s ability to incur additional debt.

 

#### *8.  Business Segments*

#### * *

The Companyhas five reportable segments that are differentiated by their operations andfunctions, including their respective methods of distributing insuranceproducts and services and the nature of the insurance products and servicesthey provide: worksite insurance business, senior market insurance business,third party administration business, acquired business and corporate andother.  Management makes decisionsregarding the Company’s business based on these segment classifications.  No segments have been aggregated other thanincluding the marketing business in the corporate and other segment.

 

The worksiteinsurance business provides life and health insurance products to employers andtheir employees.  The primary insuranceproducts include life, short-term disability, dental, indemnity health andcritical illness.  This segment includesbusiness sold through the career agency distribution channel, which is a groupof agents and managers that are employees of the Company or its subsidiaries.

 

11

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The seniormarket insurance business provides individual insurance products, primarilylong-term care insurance, tailored to the needs of older individuals.  In June 2005, the Company decided toexit the senior market insurance business by (1) selling its in-houseagency that distributes senior market insurance products, (2) ceasing toactively underwrite long-term care insurance and (3) allowing its existingblock of in force long-term care insurance policies to runoff, which isexpected to occur gradually.

 

The thirdparty administration business provides fee-based administrative and managedcare services to employers with self funded health care plans, insurancecarriers, reinsurance companies and others.

 

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

 

The corporateand other segment includes investment income earned on the investment portfolioallocated to capital and surplus, as well as all realized capital gains andlosses, which are not allocated by line of business.  This segment also includes marketingallowances, commissions and related expenses pertaining to product sales forother insurance carriers, which are currently not material.  In addition, this segment includes certainunallocated expenses, primarily deferred compensation and incentivecompensation costs, and other non-allocated immaterial items.

 

The followingrepresents a summary of the Company’s and the Predecessor’s statements ofincome and asset composition by reportable segment.  The financial statement information of thePredecessor for the six months ended June 30, 2004, and the three monthsended June 30, 2004, is reported on a historical basis without GAAPpurchase accounting adjustments reflecting the acquisition of the Predecessor, whilethe Company’s financial statement information for the six months ended June 30,2005 and the three months ended June 30, 2005, has been adjusted for GAAPpurchase accounting adjustments reflecting the acquisition.

 
| ** **                              | ** ** | **Predecessor**                              | ** **  | **KMG America  Corporation**                | ** ** | **Predecessor**                           | ** ** | **KMG America  Corporation**              | ** **  |
|-----------------------------------------|------------|----------------------------------------------|-------------|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|-------------|
| ** **                              | ** ** | **Three Months Ended   June 30,  2004** | ** **  | **Three Months Ended  June 30,  2005** | ** ** | **Six Months Ended  June 30,  2004** | ** ** | **Six Months Ended  June 30,  2005** | ** **  |
| ** **                              | ** ** | ** **                                   | ** **  | ** **                                  | ** ** | ** **                                | ** ** | ** **                                | ** **  |
| **Worksite Insurance Business**         |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Insurance premiums                      |       | $                                            | 14,173,108  |                                        | $          | 15,028,220                                |       | $                                         | 28,197,772  |   | $ | 29,686,247 |   |
| Net investment income                   |       | 1,293,549                                    |        | 1,603,114                                   |       | 2,697,936                                 |       | 3,384,901                                 |        |
| Commissions and fees                    |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Net realized gains                      |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Other income                            |       | 34,043                                       |        | 40,284                                      |       | 164,238                                   |       | 89,721                                    |        |
| Total revenues                          |       | 15,500,700                                   |        | 16,671,618                                  |       | 31,059,946                                |       | 33,160,869                                |        |
| Policyholder benefits                   |       | 11,604,209                                   |        | 10,660,526                                  |       | 23,134,401                                |       | 21,550,651                                |        |
| Commissions                             |       | 945,529                                      |        | 800,830                                     |       | 1,818,276                                 |       | 1,878,480                                 |        |
| Expenses, taxes, fees and depreciation  |       | 2,331,493                                    |        | 4,197,333                                   |       | 4,629,015                                 |       | 7,752,949                                 |        |
| Amortization of DAC                     |       | 1,653,005                                    |        | 894,374                                     |       | 2,874,891                                 |       | 1,714,380                                 |        |
| Total benefits and expenses             |       | 16,534,236                                   |        | 16,553,063                                  |       | 32,456,583                                |       | 32,896,460                                |        |
| (Loss) income before Federal income tax |       | $                                            | (1,033,536  | )                                           | $          | 118,555                                   |       | $                                         | (1,396,637  | ) | $ | 264,409 |   |
|                                    |       |                                         |        |                                        |       |                                      |       |                                      |        |   |   |   |   |
| Total assets                            |       | $                                            | 151,757,275 |                                        | $          | 167,166,152                               |       | $                                         | 151,757,275 |   | $ | 167,166,152 |   |

 

12

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| ** **                              | ** ** | **Predecessor**                              | ** **  | **KMG America  Corporation**                | ** ** | **Predecessor**                           | ** ** | **KMG America  Corporation**              | ** **  |
|-----------------------------------------|------------|----------------------------------------------|-------------|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|-------------|
| ** **                              | ** ** | **Three Months Ended   June 30,  2004** | ** **  | **Three Months Ended  June 30,  2005** | ** ** | **Six Months Ended  June 30,  2004** | ** ** | **Six Months Ended  June 30,  2005** | ** **  |
| ** **                              |       |                                         |        |                                        |       |                                      |       |                                      |        |
| **Senior Market Insurance Business**    |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Insurance premiums                      |       | $                                            | 11,350,538  |                                        | $          | 11,127,642                                |       | $                                         | 21,673,650  |   | $ | 21,728,702 |   |
| Net investment income                   |       | 1,092,060                                    |        | 1,137,109                                   |       | 1,873,688                                 |       | 2,148,565                                 |        |
| Commissions and fees                    |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Net realized gains                      |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Other income                            |       | 555,784                                      |        | 799,210                                     |       | 1,051,396                                 |       | 1,456,572                                 |        |
| Total revenues                          |       | 12,998,382                                   |        | 13,063,961                                  |       | 24,598,734                                |       | 25,333,839                                |        |
| Policyholder benefits                   |       | 9,795,104                                    |        | 9,176,168                                   |       | 18,719,515                                |       | 17,521,093                                |        |
| Commissions                             |       | 1,378,439                                    |        | 1,472,196                                   |       | 2,743,153                                 |       | 2,961,361                                 |        |
| Expenses, taxes, fees and depreciation  |       | 1,053,408                                    |        | 987,224                                     |       | 1,597,782                                 |       | 2,126,544                                 |        |
| Amortization of DAC                     |       | (33,593                                      | )           | 425,264                                     |       | 145,978                                   |       | 795,702                                   |        |
| Total benefits and expenses             |       | 12,193,358                                   |        | 12,060,852                                  |       | 23,206,428                                |       | 23,404,700                                |        |
| Income before Federal income tax        |       | $                                            | 805,024     |                                        | $          | 1,003,109                                 |       | $                                         | 1,392,306   |   | $ | 1,929,139 |   |
|                                    |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Total assets                            |       | $                                            | 134,309,795 |                                        | $          | 177,146,500                               |       | $                                         | 134,309,795 |   | $ | 177,146,500 |   |
|                                    |       |                                         |        |                                        |       |                                      |       |                                      |        |   |   |   |   |
| **Third-Party Administration Business** |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Insurance premiums                      |       | $                                            | —      |                                        | $          | —                                    |       | $                                         | —      |   | $ | — |   |
| Net investment income                   |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Commissions and fees                    |       | 3,453,263                                    |        | 3,582,421                                   |       | 6,799,530                                 |       | 7,065,808                                 |        |
| Net realized gains                      |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Other income                            |       | —                                       |        | —                                      |       | 626                                       |       | 862                                       |        |
| Total revenues                          |       | 3,453,263                                    |        | 3,582,421                                   |       | 6,800,156                                 |       | 7,066,670                                 |        |
| Policyholder benefits                   |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Commissions                             |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Expenses, taxes, fees and depreciation  |       | 3,084,677                                    |        | 3,260,842                                   |       | 6,019,563                                 |       | 6,467,168                                 |        |
| Amortization of DAC                     |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Total benefits and expenses             |       | 3,084,677                                    |        | 3,260,842                                   |       | 6,019,563                                 |       | 6,467,168                                 |        |
| Income before Federal income tax        |       | $                                            | 368,586     |                                        | $          | 321,579                                   |       | $                                         | 780,593     |   | $ | 599,502 |   |
|                                    |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Total assets                            |       | $                                            | 7,231,988   |                                        | $          | 8,303,823                                 |       | $                                         | 7,231,988   |   | $ | 8,303,823 |   |
|                                    |       |                                         |        |                                        |       |                                      |       |                                      |        |   |   |   |   |
| **Acquired Business**                   |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Insurance premiums                      |       | $                                            | 1,125,440   |                                        | $          | 660,927                                   |       | $                                         | 2,115,443   |   | $ | 1,599,400 |   |
| Net investment income                   |       | 2,315,726                                    |        | 1,915,773                                   |       | 4,527,772                                 |       | 3,978,389                                 |        |
| Commissions and fees                    |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Net realized gains                      |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Other income                            |       | 24,852                                       |        | 18,331                                      |       | 50,206                                    |       | 31,712                                    |        |
| Total revenues                          |       | 3,466,018                                    |        | 2,595,031                                   |       | 6,693,421                                 |       | 5,609,501                                 |        |
| Policyholder benefits                   |       | 2,607,335                                    |        | 809,216                                     |       | 4,693,321                                 |       | 2,004,000                                 |        |
| Commissions                             |       | 110,651                                      |        | 103,132                                     |       | 217,740                                   |       | 202,484                                   |        |
| Expenses, taxes, fees and depreciation  |       | 674,249                                      |        | 666,985                                     |       | 1,360,499                                 |       | 1,371,614                                 |        |
| Amortization of DAC                     |       | 645,492                                      |        | (105,289                                    | )          | 1,334,890                                 |       | (210,578                                  | )           |
| Total benefits and expenses             |       | 4,037,727                                    |        | 1,474,044                                   |       | 7,606,450                                 |       | 3,367,520                                 |        |
| (Loss) income before Federal income tax |       | $                                            | (571,709    | )                                           | $          | 1,120,987                                 |       | $                                         | (913,029    | ) | $ | 2,241,981 |   |
| Total assets                            |       | $                                            | 201,197,904 |                                        | $          | 209,619,560                               |       | $                                         | 201,197,904 |   | $ | 209,619,560 |   |

 

13

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| ** **                             | ** ** | **Predecessor**                              | ** **  | **KMG America  Corporation**                | ** ** | **Predecessor**                           | ** ** | **KMG America  Corporation**              | ** **  |
|----------------------------------------|------------|----------------------------------------------|-------------|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|-------------|
| ** **                             | ** ** | **Three Months Ended   June 30,  2004** | ** **  | **Three Months Ended  June 30,  2005** | ** ** | **Six Months Ended  June 30,  2004** | ** ** | **Six Months Ended  June 30,  2005** | ** **  |
|                                   |       |                                         |        |                                        |       |                                      |       |                                      |        |
| **Corporate and Other**                |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Insurance premiums                     |       | $                                            | —      |                                        | $          | —                                    |       | $                                         | —      |   | $ | — |   |
| Net investment income                  |       | 2,229,572                                    |        | 2,144,771                                   |       | 3,221,131                                 |       | 3,941,697                                 |        |
| Commissions and fees                   |       | 30,953                                       |        | 88,270                                      |       | 36,660                                    |       | 172,931                                   |        |
| Net realized gains                     |       | 1,512,811                                    |        | 18,382                                      |       | 1,728,103                                 |       | 45,962                                    |        |
| Other income                           |       | 95,504                                       |        | 120,505                                     |       | 191,010                                   |       | 191,110                                   |        |
| Total revenues                         |       | 3,868,840                                    |        | 2,371,928                                   |       | 5,176,904                                 |       | 4,351,700                                 |        |
| Policyholder benefits                  |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Commissions                            |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Expenses, taxes, fees and depreciation |       | 1,085,097                                    |        | 3,991,952                                   |       | 2,550,312                                 |       | 6,861,574                                 |        |
| Amortization of DAC                    |       | —                                       |        | —                                      |       | —                                    |       | —                                    |        |
| Total benefits and expenses            |       | 1,085,097                                    |        | 3,991,952                                   |       | 2,550,312                                 |       | 6,861,574                                 |        |
| (Loss) before Federal income tax       |       | $                                            | 2,783,743   |                                        | $          | (1,620,024                                | )          | $                                         | 2,626,592   |   | $ | (2,509,874 | ) |
|                                   |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Total assets                           |       | $                                            | 195,952,789 |                                        | $          | 227,293,718                               |       | $                                         | 195,952,789 |   | $ | 227,293,718 |   |
|                                   |       |                                         |        |                                        |       |                                      |       |                                      |        |
| **Total Company**                      |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Insurance premiums                     |       | $                                            | 26,649,086  |                                        | $          | 26,816,789                                |       | $                                         | 51,986,865  |   | $ | 53,014,349 |   |
| Net investment income                  |       | 6,930,907                                    |        | 6,800,767                                   |       | 12,320,527                                |       | 13,453,552                                |        |
| Commissions and fees                   |       | 3,484,216                                    |        | 3,670,691                                   |       | 6,836,190                                 |       | 7,238,739                                 |        |
| Net realized gains                     |       | 1,512,811                                    |        | 18,382                                      |       | 1,728,103                                 |       | 45,962                                    |        |
| Other income                           |       | 710,183                                      |        | 978,330                                     |       | 1,457,476                                 |       | 1,769,977                                 |        |
| Total revenues                         |       | 39,287,203                                   |        | 38,284,959                                  |       | 74,329,161                                |       | 75,522,579                                |        |
| Policyholder benefits                  |       | 24,006,648                                   |        | 20,645,910                                  |       | 46,547,237                                |       | 41,075,744                                |        |
| Commissions                            |       | 2,434,619                                    |        | 2,376,158                                   |       | 4,779,169                                 |       | 5,042,325                                 |        |
| Expenses, taxes, fees and depreciation |       | 8,228,924                                    |        | 13,104,336                                  |       | 16,157,171                                |       | 24,579,849                                |        |
| Amortization of DAC                    |       | 2,264,904                                    |        | 1,214,349                                   |       | 4,355,759                                 |       | 2,299,504                                 |        |
| Total benefits and expenses            |       | 36,935,095                                   |        | 37,340,753                                  |       | 71,839,336                                |       | 72,997,422                                |        |
| Income before Federal income tax       |       | $                                            | 2,352,108   |                                        | $          | 944,206                                   |       | $                                         | 2,489,825   |   | $ | 2,525,157 |   |
|                                   |       |                                         |        |                                        |       |                                      |       |                                      |        |
| Total assets                           |       | $                                            | 690,449,751 |                                        | $          | 789,529,753                               |       | $                                         | 690,449,751 |   | $ | 789,529,753 |   |

 

14

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

 

**Business Overview**

 

KMG America isa holding company incorporated under the laws of the Commonwealth of Virginiaon January 21, 2004.  We commencedour operations shortly before we completed our initial public offering ofcommon stock on December 21, 2004, and our shares trade on the New YorkStock Exchange under the symbol “KMA.” Concurrently with the completion of our initial public offering, wecompleted our acquisition of Kanawha Insurance Company (“Kanawha”) and itssubsidiaries, which are our primary operating subsidiaries and which underwriteand sell life and health insurance products. For GAAP accounting purposes, Kanawha is treated as KMG America’spredecessor entity and is referred to herein as our “predecessor.”  Financial information in the following discussionthat relates to our predecessor’s consolidated results of operations for thethree and six month periods ended June 30, 2004, and cash flows andchanges in shareholders’ equity for the six months ended June 30, 2004,are reported on a historical basis without GAAP purchase accounting adjustmentsreflecting the acquisition.  Financialinformation relating to our consolidated results of operations for the threeand six month periods ended on June 30, 2005, and cash flows and changesin shareholders’ equity for the six months ended June 30, 2005, and ourfinancial position as of December 31, 2004, and June 30, 2005, hasbeen adjusted for GAAP purchase accounting adjustments reflecting theacquisition.  Our operations areconducted in the five following business segments.

 

*Worksite insurance business*.  Our worksite insurance business is a providerof voluntary life and health insurance products to employers and theiremployees.  The primary insuranceproducts that we underwrite include: life insurance; short-term disabilityinsurance; dental insurance; indemnity health insurance; and critical illnessinsurance.  For the six months ended June 30,2005, our worksite insurance business reported premiums, commissions and fees,excluding intercompany payments, of $29.7 million, which accounted for 49.3% ofour premiums, commissions and fees, excluding intercompany payments in thatperiod.  Our Predecessor’s marketingefforts and sales were primarily in the southeastern United States,predominantly in Florida, South Carolina and North Carolina.  Since acquiring our predecessor, we havebegun to implement our business strategy to operate our existing worksiteinsurance business efficiently while developing a new worksite marketing anddistribution organization that targets larger employer groups nationwide withan expanded variety of life and health insurance products which will add a newset of employer-paid life insurance, disability and health products to ourexisting voluntary products.  While mostof our sales in the first six months of 2005 were primarily in the southeasternUnited States, we expect our nationwide marketing effort to generatesignificant nationwide sales in the future. In December 2004, we opened sales offices hosting regional salesmanagers in Boston, Massachusetts and Irvine, California, a Los Angelessuburb.  During 2005, we have openedregional sales offices in Tampa, Florida; Chicago, Illinois; New York, NewYork; Atlanta, Georgia; Dallas, Texas; and Cleveland, Ohio.  We expect to open additional regional salesoffices later in 2005 and thereafter.  Wehave begun and expect to continue to add and train additional sales and supportstaff and marketing personnel at these facilities, and will recognize the costsassociated with these additions before we recognize revenues resulting from newsales activity.  Consequently, we expectnegative cash flow and operating losses in the short term.  We expect cash flows from our new sales andmarketing organization to be positive by 2006 but we cannot assure you thatthis 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 thesix months ended June 30, 2005, our senior market insurance businessreported premiums, commissions and fees, excluding intercompany payments, of$21.7 million, which accounted for 36.0% of our premiums, commissions and fees,excluding intercompany payments, in that period.

 

In June 2005,after completing an internal review of our operations and business strategies,we have decided to sell or otherwise dispose of our in-house agency thatdistributes senior market insurance products. The agency consists of 16 marketing employees and has its primaryoperations located in Fort Myers, Florida. We anticipate the sale or other disposition of the agency to becompleted by the end of 2005.  We expectto cease underwriting long-term care insurance at some point not long after thesale or other disposition of the agency. We expect to retain and actively manage the existing block of in-forcelong-term care insurance policies (including the right to receive futurepremiums and the liability of future claims).

 

15

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Significantfactors that contributed to the foregoing decisions include, among others:  (1) year-to-date sales for this businessare significantly lower than originally projected; and (2) the lack of strategicfit between the underwriting and distribution of long-term care products andour current strategy of focusing on worksite marketing of life and healthinsurance products.

 

The impact of thisdecision is not expected to have a material effect on the financial performanceor condition of the Company in the short- or long-term.  In the short-term, the expected level of newsales of long-term care products was minimal compared to the expected sales ofworksite products.  In the long-term, asthe existing block of long-term care insurance policies runoff, the reducedpremium revenue from long-term care products is expected to be more than offsetby increased revenues from the Company’s core worksite marketing business.

 

*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 six months ended June 30, 2005,our third-party administration business reported commissions and fees,excluding intercompany payments, of $7.1million, which accounted for 11.8% ofour premiums, 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 national worksitemarketing business develops, we intend to opportunistically market ourthird-party administration services to self-insured plans, stop loss insurers,pharmacy benefit organizations, managed care service providers, other insurancecarriers and reinsurers nationwide.  Itis expected that any incremental costs associated with this expanded marketingwill be modest 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 the life and health insurance industry earn profits on theinvestment float, which reflects the investment income earned on the premiumspaid to the insurer between the time of receipt and the time benefits arepaid-out under the policy.  Volatility inthe capital markets, changes in interest rates and changes in economicconditions can all impact the amount of earnings that we will realize from ourinvestment portfolio.  Defense costsrelated to the ReliaStar Litigation are reported in the corporate and othersegment.  We believe the outcome of thismatter will not have a material adverse effect on our financial position orresults of operations; however, defense costs may have a material adverseeffect on our consolidated financial position or results of operations.

 

#### *Results of Operations*

#### * *

##### *Consolidated Overview*

##### * *

The followingtable presents historical consolidated financial information for the three and sixmonth periods ended June 30, 2004, for our predecessor, and consolidatedfinancial information for the three and six months periods ended June 30,2005, for KMG America.

 

16

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| ** **                        | ** ** | **Predecessor**                             | ** ** | **KMG America  Corporation**                | ** ** | **Predecessor**                           | ** ** | **KMG America**                           | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|-------------------------------------------|------------|
| ** **                        | ** ** | **Three Months  Ended June 30,  2004** | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2004** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
| ** **                        | ** ** | ** **                                  | ** ** | ** **                                  | ** ** | **(dollars in thousands)**                | ** ** |
| **Revenues:**                     | ** ** | ** **                                  | ** ** | ** **                                  | ** ** | ** **                                | ** ** | ** **                                | ** ** |
| Insurance  premiums               |       | $                                           | 26,649     |                                        | $          | 26,817                                    |       | $                                         | 51,987     |   | $ | 53,014 |   |
| Net investment income(1)          |       | 6,931                                       |       | 6,801                                       |       | 12,321                                    |       | 13,454                                    |       |
| Commission and fees               |       | 3,484                                       |       | 3,671                                       |       | 6,836                                     |       | 7,239                                     |       |
| Net realized gains                |       | 1,513                                       |       | 18                                          |       | 1,728                                     |       | 46                                        |       |
| Other income                      |       | 710                                         |       | 978                                         |       | 1,457                                     |       | 1,770                                     |       |
| Total revenues                    |       | 39,287                                      |       | 38,285                                      |       | 74,329                                    |       | 75,523                                    |       |
|                              |       |                                        |       |                                        |       |                                      |       |                                      |       |
| **Benefits and expenses:**        |       |                                        |       |                                        |       |                                      |       |                                      |       |
| Policyholder benefits             |       | 24,007                                      |       | 20,646                                      |       | 46,547                                    |       | 41,076                                    |       |
| Commissions                       |       | 2,434                                       |       | 2,376                                       |       | 4,779                                     |       | 5,042                                     |       |
|                              |       |                                        |       |                                        |       |                                      |       |                                      |       |
| General expenses                  |       | 6,335                                       |       | 11,246                                      |       | 12,430                                    |       | 20,706                                    |       |
| Taxes, licenses and fees          |       | 1,179                                       |       | 1,130                                       |       | 2,309                                     |       | 2,450                                     |       |
| Depreciation and amortization     |       | 715                                         |       | 728                                         |       | 1,418                                     |       | 1,424                                     |       |
| Amortization of DAC               |       | 2,265                                       |       | 1,215                                       |       | 4,356                                     |       | 2,300                                     |       |
| Total benefits and expenses       |       | 36,935                                      |       | 37,341                                      |       | 71,839                                    |       | 72,998                                    |       |
|                              |       |                                        |       |                                        |       |                                      |       |                                      |       |
| **Income before income taxes**    |       | 2,352                                       |       | 944                                         |       | 2,490                                     |       | 2,525                                     |       |
| Provision for income taxes        |       | (719                                        | )          | (231                                        | )          | (766                                      | )          | (792                                      | )          |
|                              |       |                                        |       |                                        |       |                                      |       |                                      |       |
| **Net income**                    |       | $                                           | 1,633      |                                        | $          | 713                                       |       | $                                         | 1,724      |   | $ | 1,733 |   |
|                              |       |                                        |       |                                        |       |                                      |       |                                      |       |
| **Benefits to premiums ratio(2)** |       | 90.1                                        | %          | 77.0                                        | %          | 89.5                                      | %          | 77.5                                      | %          |

 

----

(1)                                 Netinvestment income for the six months ended June 30, 2004, was negativelyimpacted by a $1.6 million incentive payment in the first quarter of 2004 toone of Kanawha’s outside investment managers at the conclusion of the contractperiod.  There are no other incentivearrangements of this type in force, and this contract was terminated upon theclosing of our acquisition 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.

#### * *

#### *Consolidated Results of Operations by Business Segment*

 

Note 8.,Business Segments, of the Notes to Consolidated Financial Statements includedin this report, which includes a summary of our and our predecessor’sstatements of income and asset composition by reportable segment, isincorporated herein by reference.

 

*Three and Six Months Ended June 30, 2005, Compared to Three andSix Months Ended June 30, 2004*

 

Due to thelong term nature of insurance products, variations that relate to the sixmonths periods will typically correspond to variations for the three monthsperiods.  The following discussions focusprimarily on the comparisons of the six months periods, with additionalcomments concerning the three months periods where appropriate.

 

##### *Financial Results Overview*

##### * *

Net income forthe six months ended June 30, 2005 of $1.7 million was unchanged from netincome of $1.7 million for the six months ended June 30, 2004.  Contributing factors were increases inpremiums and net investment income combined with decreases in policyholderbenefits, partially offset by an increase in general expenses and a decrease inrealized investment gains, all of which are described in greater detail below.

 

Net income forthe three months ended June 30, 2005, decreased $0.9 million, or 56.3%, to$0.7 million from $1.6 million for the three months ended June 30,2004.  A decrease in pre-tax realizedinvestment gains of $1.5 million was a primary contributing factor.

 

17

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##### *Revenues*

##### * *

Total revenuesfor the six months ended June 30, 2005, increased $1.2 million, or 1.6%,to $75.5 million from total revenues of $74.3 million for the six months ended June 30,2004.  Total revenues for the threemonths ended June 30, 2005, decreased $1.0 million, or 2.5% to $38.3million from total revenues of $39.3 million for the three months ended June 30,2004.  The primary factors causing theincrease are explained below under the captions “—Premiums,” “—Net InvestmentIncome,” “—Commission and Fee Income,” “—Realized Investment Gains and Losses”and “—Other Income.”

 

*Premiums*

 

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

 
| ** ** | ** ** | **For the  Six Months Ended June 30, 2004** | ** ** | **For the  Six Months Ended June 30, 2005** | ** ** | **Increase  (decrease)** | ** ** |
|------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|--------------------------|------------|
| ** ** | ** ** | **Worksite**                                     | ** ** | **Senior**                                       | ** ** | **Acquired**             | ** ** | **Total** | ** ** | **Worksite** | ** ** | **Senior** | ** ** | **Acquired** | ** ** | **Total** | ** ** | **Worksite** | ** ** | **Senior** | ** ** | **Acquired** | ** ** | **Total** | ** ** |
| ** ** | ** ** | **(dollars  in millions)**                       | ** ** |
| Direct     |       |                                             |       |                                             |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | $                                                | 6.4        |                                             | $          | 2.9                      |       | $ | — |   | $ | 9.3 |   | $ | 7.8 |   | $ | 1.0 |   | $ | — |   | $ | 8.8 |   | $ | 1.4 |   | $ | (1.9 | ) | $ | — |   | $ | (0.5 | ) |
| Renewal    |       | 22.7                                             |       | 25.0                                             |       | —                   |       | 47.7 |   | 22.8 |   | 27.6 |   | — |   | 50.4 |   | 0.1 |   | 2.6 |   | — |   | 2.7 |   |
| Total      |       | 29.1                                             |       | 27.9                                             |       | —                   |       | 57.0 |   | 30.6 |   | 28.6 |   | — |   | 59.2 |   | 1.5 |   | 0.7 |   | — |   | 2.2 |   |
| Assumed    |       |                                             |       |                                             |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | —                                           |       | —                                           |       | —                   |       | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   | — |   |
| Renewal    |       | —                                           |       | —                                           |       | 2.1                      |       | 2.1 |   | — |   | — |   | 1.6 |   | 1.6 |   | — |   | — |   | (0.5 | ) | (0.5 | ) |
| Total      |       | —                                           |       | —                                           |       | 2.1                      |       | 2.1 |   | — |   | — |   | 1.6 |   | 1.6 |   | — |   | — |   | (0.5 | ) | (0.5 | ) |
| Ceded      |       |                                             |       |                                             |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | (0.4                                             | )          | (1.8                                             | )          | —                   |       | (2.2 | ) | (0.4 | ) | (0.5 | ) | — |   | (0.9 | ) | — |   | 1.3 |   | — |   | 1.3 |   |
| Renewal    |       | (0.5                                             | )          | (4.4                                             | )          | —                   |       | (4.9 | ) | (0.5 | ) | (6.4 | ) | — |   | (6.9 | ) | — |   | (2.0 | ) | — |   | (2.0 | ) |
| Total      |       | (0.9                                             | )          | (6.2                                             | )          | —                   |       | (7.1 | ) | (0.9 | ) | (6.9 | ) | — |   | (7.8 | ) | — |   | (0.7 | ) | — |   | (0.7 | ) |
| Net        |       |                                             |       |                                             |       |                     |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| New        |       | 6.0                                              |       | 1.1                                              |       | —                   |       | 7.1 |   | 7.4 |   | 0.5 |   | — |   | 7.9 |   | 1.4 |   | (0.6 | ) | — |   | 0.8 |   |
| Renewal    |       | 22.2                                             |       | 20.6                                             |       | 2.1                      |       | 44.9 |   | 22.3 |   | 21.2 |   | 1.6 |   | 45.1 |   | 0.1 |   | 0.6 |   | (0.5 | ) | 0.2 |   |
| Total      |       | 28.2                                             |       | 21.7                                             |       | 2.1                      |       | 52.0 |   | 29.7 |   | 21.7 |   | 1.6 |   | 53.0 |   | 1.5 |   | — |   | (0.5 | ) | 1.0 |   |
|            |            |                                                  |            |                                                  |            |                          |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Worksite net new premiums increased $1.4 million, or 23.3%, to $7.4million for the six months ended June 30, 2005, from $6.0 million for thesix months ended June 30, 2004, due to increased sales volumes.  New sales increased $1.1 million, or 21.6%,to $6.2 million for the six months ended June 30, 2005, from $5.1 millionfor the six months ended June 30, 2004, due to increased emphasis on thiscore business segment.  Net renewalpremiums increased $0.1 million, or 0.5%, due to the increased amount ofinsurance in force created by prior year sales. Worksite net total premiums increased $0.8 million, or 5.6%, to $15.0million for the three months ended June 30, 2005, from $14.2 million forthe three months ended June 30, 2004, which is consistent with the sixmonths results.

 

Senior market net new premiums, comprised of long term care policies,decreased $0.6 million, or 54.6%, to $0.5 million for the six months ended June 30,2005, from $1.1 million for the six months ended June 30, 2004, due todecreased sales volumes.  New salesdecreased $1.4 million, or 60.9%, to $0.9 million for the six months ended June 30,2005, from $2.3 million for the six months ended June 30, 2004, due to thecontinuation of a sales decline that began in mid-2003, resulting from thediscontinuance of an older product and the introduction of a new product withsignificantly higher premiums.  Netrenewal premiums increased $0.6 million, or 2.9%, due to the increased amountof insurance in force created by prior year sales.  This increase is reflected in both the directrenewal premiums and the ceded renewal premiums.  Senior market net total premiums decreased$0.3 million, or 2.6%, to $11.1 million for the three months ended June 30,2005, from $11.4 million for the three months ended June 30, 2004, whichis consistent with the six months trends.

 

Acquired business premiums decreased $0.5 million, or 23.8%, to $1.6million for the six months ended June 30, 2005, from $2.1 million for thesix months ended June 30, 2004.  Acquiredbusiness premiums decreased $0.4 million, or 36.4%, to $0.7 million for thethree months ended June 30, 2005, from $1.1 million for the three monthsended June 30, 2004.  We and ourpredecessor have not acquired any blocks of business since 1999 and the declineis a result of policy lapses.

 

18

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##### *Net Investment Income*

##### * *

Net investmentincome increased $1.2 million, or 9.8%, to $13.5 million for the six monthsended June 30, 2005, from $12.3 million for the six months ended June 30,2004.  Net investment income for the sixmonths ended June 30, 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 six months ended June 30,2005, decreased by $0.4 million from the six months ended June 30,2004.  Net investment income for thethree months ended June 30, 2005, decreased by $0.1 million from the threemonths ended June 30, 2004.  Netinvestment income is primarily affected by changes in levels of invested assetsand interest rates.  The decline ininvestment income for the six months ended June 30, 2005, occurred despitean increase in total cash and investments of $103.1 million, or 21.2%, to$589.3 million as of June 30, 2005, from $486.2 million as of June 30,2004.  Invested assets increased by $98.1million or 20.6%, to $574.2 million as of June 30, 2005, from$476.1million as of December 31, 2004, reflecting the investment of cashgenerated by 2004 asset sales and our initial public offering.  Generally, the increase in cash and investedassets was due to retention of premiums to establish policy reserves for thepayment of future policyholder benefits.

 

The averageyield on cash and invested assets on an amortized cost basis was 4.64% for thesix months ended June 30, 2005, compared to an average yield of 5.90% forthe six months ended June 30, 2004, excluding the effects of thenon-recurring $1.6 million incentive payment to one of Kanawha’s outsideinvestment managers.  This declineresulted from lower interest rates combined with the significantly largeramount of assets held in cash during the six months ended June 30,2005.  The incentive payment made in 2004was charged 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 conjunctionwith the application of GAAP purchase accounting requirements, assetsattributed to the worksite insurance business, the senior insurance businessand the acquired business all increased significantly, as evidenced by acomparison of segment assets in the segment tables shown in Note 8., BusinessSegments, from June 30, 2004, to June 30, 2005.

 

##### *Commission and Fee Income*

##### * *

Commission andfee income increased $0.4 million, or 5.9%, to $7.2 million for the six monthsended June 30, 2005, from $6.8 million for the six months ended June 30,2004.  Commission and fee incomeincreased $0.2 million, or 5.7%, to $3.7 million for the three months ended June 30,2005, from $3.5 million for the three months ended June 30, 2004.  Most of the commission and fee income wasfrom administrative fees relating to third-party administration, and theincrease was due to an increase in business in force relating to increasedsales of administrative services.

 

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

##### * *

Realizedinvestment gains and losses occur as a result of the sale or impairment ofinvestments.  The net realized investmentgain for the six months ended June 30, 2005, decreased by $1.7 million to$0.0 million, from $1.7 million for the six months ended June 30,2004.  The net realized investment gainfor the three months ended June 30, 2005, decreased by $1.5 million to$0.0 million, from $1.5 million for the three months ended June 30, 2004.  The net gain realized on fixed maturitysecurities for the six months ended June 30, 2005, totaled $0.0 millioncompared to a net gain realized on fixed maturity securities of $1.7 millionfor the six months ended June 30, 2004. There were no net gains realized on equity securities for the six monthsended June 30, 2004, and June 30, 2005.  Realized investment gains and losses areallocated entirely to the corporate and other business segment.

 

##### *Other Income*

##### * *

Other incomeincreased $0.3 million, or 20.0%, to $1.8 million for the six months ended June 30,2005, from $1.5 million for the six months ended June 30, 2004.  Other income increased $0.3 million, or42.9%, to $1.0 million for the three months ended June 30, 2005, from $0.7million for the three months ended June 30, 2004.  These increases reflect increased commissionand expense allowances from reinsurance companies generated from an increase inrenewal ceded premiums.

 

19

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##### *Benefits and Expenses*

##### * *

Total benefitsand expenses increased $1.2 million, or 1.7%, to $73.0 million for the sixmonths ended June 30, 2005, from $71.8 million for the six months ended June 30,2004.  Total benefits and expensesincreased $0.4 million, or 1.1%, to $37.3 million for the three months ended June 30,2005, from $36.9 million for the three months ended June 30, 2004.  The primary factors causing this increase areexplained below under the captions “—Policyholder Benefits,” “—InsuranceCommissions,” “—General Insurance Expenses,” “—Insurance Taxes, Licenses andFees,” and “—Amortization of DAC and VOBA.”

 

##### *Policyholder Benefits*

##### * *

Policyholderbenefits decreased $5.4 million, or 11.6%, to $41.1 million for the six monthsended June 30, 2005, from $46.5 million for the six months ended June 30,2004.  Policyholder benefits decreased$3.4 million, or 14.2%, to $20.6 million for the three months ended June 30,2005, from $24.0 million for the three months ended June 30, 2004.  This produced a benefits to premium ratio of77.5% for the six months ended June 30, 2005, compared to 89.5% for thesix months ended June 30, 2004.  Thebenefits to premium ratio declined primarily as a result of the GAAP purchaseaccounting adjustments described in the next three paragraphs.

 

Worksite marketingpolicyholder benefits decreased $1.5 million, or 6.5%, to $21.6 million for thesix months ended June 30, 2005, from $23.1 million for the six monthsended June 30, 2004.  Worksitemarketing policyholder benefits decreased $0.9 million, or 7.8%, to $10.7million for the three months ended June 30, 2005, from $11.6 million forthe three months ended June 30, 2004. This produced benefits to premium ratios of 72.6% for the six monthsended June 30, 2005, compared to 82.0% for the six months ended June 30,2004.  In accordance with GAAP purchaseaccounting requirements, policy and contract reserves were recorded at fairvalue on December 31, 2004.  Thisadjustment produced increased reserve balances, which should result in smallerreserve increases in the future.  Thebenefits to premium ratio decreased primarily as a result of this reduction inthe increase in policy and contract reserves.

 

Senior marketpolicyholder benefits decreased $1.2 million, or 6.4%, to $17.5 million for thesix months ended June 30, 2005, from $18.7 million for the six monthsended June 30, 2004.  Senior marketpolicyholder benefits decreased $0.6 million, or 6.1%, to $9.2 million for thethree months ended June 30, 2005, from $9.8 million for the three monthsended June 30, 2004.  This producedbenefits to premium ratios of 80.6% for the six months ended June 30,2005, compared to 86.4% for the six months ended June 30, 2004.  In accordance with GAAP purchase accountingrequirements, policy and contract reserves were recorded at fair value on December 31,2004.  This adjustment produced increasedreserve balances, which should result in smaller reserve increases in thefuture.  The benefits to premium ratiodecreased primarily as a result of this reduction in the increase in policy andcontract reserves, partially offset by an increase in open active claims due toan increase in the number of policies in force and the aging of ourpolicyholders, which resulted in increases in actual claims paid and additionalclaims reserves.

 

Acquiredbusiness policyholder benefits decreased $2.7 million, or 57.4%, to $2.0million for the six months ended June 30, 2005, from $4.7 million for thesix months ended June 30, 2004.  Acquiredbusiness policyholder benefits decreased $1.8 million, or 69.2%, to $0.8million for the three months ended June 30, 2005, from $2.6 million forthe three months ended June 30, 2004. This produced benefits to premium ratios of 125.3% for the six monthsended June 30, 2005, compared to 221.9% for the six months ended June 30,2004.  These benefits to premium ratiosare affected by large portions of the acquired business that are no longerpremium paying with substantial reserves and investment income on reserves.  In accordance with GAAP purchase accountingrequirements, policy and contract reserves were recorded at fair value on December 31,2004.  This adjustment produced increasedreserve balances, which should result in smaller reserve increases goingforward.  The benefits to premium ratiodecreased as a result of this reduction in the increase in policy and contractreserves as well as a reduction in benefits incurred during the six months endedJune 30, 2005, on a block of insurance policies acquired from MetropolitanLife Insurance Company.

 

##### *Insurance Commissions*

##### * *

Commissionexpenses increased $0.2 million, or 4.2%, to $5.0 million for the six monthsended June 30, 2005, from $4.8 million for the six months ended June 30,2004.  Commission expenses of $2.4million for the three

 

20

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months ended June 30, 2005were unchanged from $2.4 million for the three months ended June 30,2004.  The overall increase consists ofnormal increases related to increased renewal premiums.

 

##### *General Insurance Expenses*

##### * *

Generalinsurance expenses increased $8.3 million, or 66.9%, to $20.7 million for thesix months ended June 30, 2005, from $12.4 million for the six monthsended June 30, 2004.  Generalinsurance expenses increased $4.9 million, or 77.8%, to $11.2 million for thethree months ended June 30, 2005, from $6.3 million for the three monthsended June 30, 2004.  Generalinsurance expenses for the six months ended June 30, 2005, includeapproximately $7.0 million of incremental costs associated with our continuingexpansion to a national insurance company, including the addition of managementand marketing personnel, occupancy costs, infrastructure development,back-office expenses, director and officer and related types of insurancecoverage, and costs associated with being a public company Overhead expensesthat are not directly associated with a particular business segment areallocated to the various business segments on a pro rata basis based ondifferent factors, such as headcount, policy count, number of policies issued, premiumsand other relevant factors.  During thesix months ended June 30, 2005, we incurred $0.2 million in defense costsrelated to the ReliaStar Litigation.

 

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

##### * *

Insurancetaxes, licenses and fees increased $0.2 million, or 8.7%, to $2.5 million forthe six months ended June 30, 2005, from $2.3 million for the six monthsended June 30, 2004.  Insurancetaxes, licenses and fees of $1.1 million for the three months ended June 30,2005 were unchanged from $1.1 million for the three months ended June 30,2004.  Employment taxes related toadditional staffing are the primary driver of the six months increase.

 

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

##### * *

First yearcommissions and general insurance expenses associated with the acquisition ofnew business are deferred and amortized over the premium-paying period of therelated policies.  The total deferrals ofpolicy acquisition costs were $7.2 million and $6.6 million for the six monthsended June 30, 2005 and 2004, respectively.  The total deferrals of policy acquisitioncosts were $3.7 million and $2.8 million for the three months ended June 30,2005 and 2004, respectively.  The increasein deferrals was primarily due to the increase in net new premiums in theworksite segment somewhat offset by the decrease in net new long-term carepremiums in the senior market.

 

Ourpredecessor assigned a value to the insurance in force of acquired companies orblocks of insurance business at the date of acquisition.  No companies or blocks of business were acquiredin the six months ended June 30, 2005 or 2004.

 

Theamortization of deferred acquisition costs (“DAC”) and the value of businessacquired (“VOBA”) decreased $2.1 million, or 47.7%, to $2.3 million for the sixmonths ended June 30, 2005, from $4.4 million for the six months ended June 30,2004.  The amortization of DAC and VOBAdecreased $1.1 million, or 47.8%, to $1.2 million for the three months ended June 30,2005, from $2.3 million for the three months ended June 30, 2004.  In accordance with GAAP purchase accountingrequirements, our predecessor’s DAC and VOBA were eliminated, and a new VOBAwas established for the value of the in-force business as of December 31,2004.  This adjustment resulted indecreased DAC and VOBA balances, which cause smaller amortization charges goingforward, as evidenced by the $2.1 million amortization decrease in the sixmonths ended June 30, 2005, compared to the six months ended June 30,2004.

 

*Provision for Income Taxes*

 

Total incometaxes may differ from the amount computed by applying the federal corporate taxrate of 35% due to tax-advantaged investments and net operating loss carrybacksavailable.  The effective income taxrates for the six months ended June 30, 2004, and 2005 were 30.8% and31.4% respectively.  The effective incometax rates for the three months ended June 30, 2004, and 2005 were 30.6%and 24.5% respectively.  The variationsin these rates is due to the fact that a portion of our consolidated income forthe six months ended June 30, 2004 and 2005 resulted from a subsidiarythat has net operating loss carrybacks available.  Due to the uncertainty of using these netoperating losses, a valuation allowance has been established offsetting thedeferred tax asset; therefore, the net income from this subsidiary has a taxrate of zero due to the use of net operating losses to offset taxable incomeincurred, which reduces the effective tax rate for the consolidated company.

 

21

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#### *Liquidity and Capital Resources*

#### * *

KMG America isa holding company and had minimal operations of its own prior to the completionof its initial public offering and the Kanawha acquisition.  KMG America’s assets consist primarily of thecapital stock of Kanawha and its other non-insurance subsidiaries.  Accordingly, KMG America’s cash flows dependupon the availability of dividends and other statutorily permissible payments,such as payments under tax allocation agreements and under managementagreements, from Kanawha.  Kanawha’sability to pay dividends and to make other payments is limited primarily 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 operationsat the end of the previous calendar year, *provided*that the dividend payment does not exceed earned surplus, in which case furtherlimitations apply.

 

For 2005, themaximum amount of dividends that Kanawha can pay to KMG America underapplicable laws and regulations without prior regulatory approval is $8.4million.  If KMG America is able 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 andpay its other corporate expenses.

 

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

 

As of June 30,2005, KMG America had outstanding debt of approximately $15.4 million because aportion of the purchase price for the Kanawha acquisition was paid in the formof 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 anticipatethat these costs will be offset over time by increased sales productionresulting from hiring additional sales personnel and increased cross-selling,as well as efficiencies resulting from greater scale.  However, during 2005, we do not expect thatthe anticipated costs described above to implement our business strategy willbe offset by incremental revenues, resulting in an aggregate net use of cash in2005.  As of June 30, 2005, we haddisbursed approximately $5.9 million of those costs, net of investmentincome.  We expect that net incrementalcash

 

22

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flows resulting from theincreased sales production and efficiencies anticipated from our new businessstrategy will be positive after 2005 but can provide no assurance that thiswill occur.

 

##### *Analysis of Change in Financial Condition andCash Flows*

##### * *

The nature ofthe life insurance business is that premiums are collected and invested andwill be used for the payment of claims when they arise, and policy reserveliabilities are established in anticipation of these future claims.  As a result, the change in financialcondition directly corresponds to the cash flows and they are discussed here intandem.

 

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

 

The tablebelow shows our predecessor’s and our net cash flows in the indicated periods:

 

| ** **                          | ** ** | **Predecessor**                            | ** ** | **KMG America** | ** ** |
|-------------------------------------|------------|--------------------------------------------|------------|-----------------|------------|
| ** **                          | ** ** | **For the Six Months Ended June 30,** | ** ** |
| **Net cash provided by (used in):** | ** ** | **2004**                                   | ** ** | **2005**        | ** ** |
| ** **                          | ** ** | **(dollars in Thousands)**                 | ** ** |
| Operating activities                |       | $                                          | 13,737.1   |            | $          | 5,074.7 |   |
| Investing activities                |       | (10,792.8                                  | )          | (107,382.4      | )          |
| Financing activities                |       | —                                     |       | —          |       |
| Net change in cash                  |       | $                                          | 2,944.3    |            | $          | (102,307.7 | ) |

 

*Cash Flows forthe Six Months Ended June 30, 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 reinsurance companiesare reflected in reinsurance balances recoverable.

 

Other changes in cash flows for the sixmonths ended June 30, 2004, and June 30, 2005, are as follows:

 

We held approximately $117.4 million in cashat December 31, 2004, primarily consisting of cash proceeds from sales andmaturities of our invested assets and from our initial public offering ofcommon stock.  We invested a significantportion of this cash in the first six months of 2005, resulting in the net cashoutflow from investing activities of $107.2 million for the six months ended June 30,2005.  This produced a correspondingincrease in invested assets.

 

Other assets decreased by $0.4 million in thesix months ended June 30, 2004, representing normal fluctuations.  Other assets decreased by $1.4 million in thesix months ended June 30, 2005, primarily as a result of the receipt of$1.5 million of securities trade receivables as of December 31, 2004.

 

Accounts payable and accrued expensesincreased by $3.1 million in the six months ended June 30, 2004, primarilydue to increases in reinsurance settlements due related to the acquiredbusiness.  These balances increased by$0.5 million in the six months ended June 30, 2005, representing normalfluctuations.

 

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

 

Federal income tax recoverable increased by$1.3 million as a result of losses incurred in Kanawha Insurance Company thatwill be carried back to prior years.  Thedeferred tax asset increased by $1.1 million and the deferred tax liabilityincreased by $5.7 million.  Thecombination of the three items resulted in a net increase in tax liabilities of$3.3 million.  Of this amount, $2.6million related to the increase in fair market value of invested assets.

 

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

##### * *

The followingtable summarizes the unrealized gains and losses in our investment portfolio asof June 30, 2005.  Effective December 31,2004, the Company recorded the Predecessor’s investments at fair value andthereby eliminated all unrealized gains and losses in the Predecessor’sportfolio, as part of the application of GAAP purchase accounting requirements.

 
| ** **                                            | ** ** | **Amortized Cost** | ** **  | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  Losses** | ** ** | **Fair  Value** | ** ** |
|-------------------------------------------------------|------------|--------------------|-------------|------------------------------|------------|-------------------------------|------------|-----------------|------------|
| Available for sale securities at  June 30, 2005: |       |               |        |                         |       |                          |       |            |       |
| U.S. treasury securities                              |       | $                  | 12,475,085  |                         | $          | 454,637                       |       | $               | 7,559      |   | $ | 12,922,163 |   |
| U.S. government agency securities                     |       | 41,368,883         |        | 1,215,104                    |       | 31,172                        |       | 42,552,815      |       |
| States and political subdivision securities           |       | 14,447,729         |        | 469,199                      |       | 7,747                         |       | 14,909,181      |       |
| Foreign bonds                                         |       | 38,929,838         |        | 1,135,103                    |       | 86,716                        |       | 39,978,225      |       |
| Corporate bonds                                       |       | 179,882,124        |        | 3,898,724                    |       | 1,549,938                     |       | 182,230,910     |       |
| Mortgage/asset-backed securities                      |       | 223,054,708        |        | 2,443,550                    |       | 284,126                       |       | 225,214,132     |       |
| Preferred stocks—redeemable                      |       | 10,336,631         |        | 3,999                        |       | 108,123                       |       | 10,232,507      |       |
| Subtotal, fixed maturity securities                   |       | 520,494,998        |        | 9,620,316                    |       | 2,075,381                     |       | 528,039,933     |       |
| Equity securities                                     |       | 36,000             |        | —                       |       | 23,000                        |       | 13,000          |       |
| Securities available for sale                         |       | $                  | 520,530,998 |                         | $          | 9,620,316                     |       | $               | 2,098,381  |   | $ | 528,052,933 |   |

 

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

 

At June 30,2005, no securities in an unrealized loss position had been in a continuous lossposition for more than six months.

 

#### *Critical Accounting Policies and Estimates*

#### * *

Ourconsolidated financial statements and certain disclosures made in this reporthave been prepared in accordance with GAAP and require us to make estimates andassumptions that affect reporting amounts of assets and liabilities andcontingent assets and contingent liabilities at the dates of the financialstatements and the reported amounts of revenues and expenses during thereporting periods.  The estimates mostsusceptible to material changes due to significant judgment (identified as the “criticalaccounting policies”) are those used in determining investment impairments, thereserves for future policy benefits and claims, deferred acquisition costs andvalue of business acquired, and the provision for income taxes.  The results of these estimates are criticalbecause they affect our profitability and may affect key indicators used tomeasure our performance.  These estimateshave a material effect on our results of operations and financialcondition.  For more information aboutour critical accounting

 

24

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policies, please refer to ourdiscussion of critical accounting policies in our Annual Report on Form 10-Kfor the year ended December 31, 2004.

 

#### *Forward-Looking Statements*

#### * *

Forward-lookingstatements in the foregoing Management’s Discussion and Analysis of FinancialCondition and Results of Operations include statements that are identified bythe use of words or phrases including, but not limited to, the following: “willlikely result,” “expected to,” “will continue,” “is anticipated,” “estimated,” “project,”“believe,” “expect,” and words or phrases of similar import.  Changes in the following important factors,among others, could cause our actual results to differ materially from thoseexpressed in any such forward-looking statements: competitive products andpricing; fluctuations in demand; possible recessionary trends in the UnitedStates economy; governmental policies and regulations; interest rates; risksdisclosed in Exhibit 99.01 to our Annual Report on Form 10-K for theyear ended December 31, 2004; and other risks that are detailed from timeto time in reports we file with the Securities and Exchange Commission.

 

## **ITEM 3.**                             QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK.

## ** **

There are nomaterial changes to the disclosure on this matter made in our Annual Report on Form 10-Kfor the year ended December 31, 2004.

 

## **ITEM 4.**                             CONTROLS AND 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 theSEC, and that such information is accumulated and communicated to ourmanagement timely.  An evaluation wasperformed under the supervision and with the participation of our management,including our Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934) as of June 30,2005.  Based upon that evaluation, ourmanagement, including our Chief Executive Officer and our Chief FinancialOfficer, concluded that our disclosure controls and procedures were effectiveas of June 30, 2005.  There was nochange in our internal control over financial reporting during the quarterended June 30, 2005, that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

 

# **PART II**

# **OTHER INFORMATION**

# ** **

## **ITEM 1.**                             LEGAL PROCEEDINGS.

## ** **

The disclosuremade in the first two paragraphs of Note 7., Commitments and Contingencies, ofthe Notes to Consolidated Financial Statements included in this report, whichdiscuss certain legal proceedings in which we are involved, is incorporatedherein by reference.

 

**ITEM 2.****          UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS.**

 

In our initialpublic offering, we issued 21,735,000 shares of common stock, par value $0.01per share, pursuant to registration statement no. 333-117911, which wasdeclared effective by the Securities and Exchange Commission on December 14,2004.  The net proceeds from the initialpublic offering, after deducting the underwriting discount and offeringexpenses payable by us, were approximately $188.0 million.  From December 14, 2004, through andincluding June 30, 2005, we applied the net proceeds of the offering asfollows:

 

•                  $130.0million of the net proceeds was used to fund the cash portion of the purchaseprice to acquire all of the outstanding common stock of Kanawha, andapproximately $0.8 million of the net proceeds was used to pay our fees andexpenses incurred in connection with the Kanawha acquisition.

 

•                  Approximately$5.9 million of the net proceeds was used to fund negative cash flow associatedwith initial start-up costs and other expenditures, including expenditures toopen our principle executive

 

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offices in Minneapolis,Minnesota and regional sales offices in selected locations throughout theUnited States and to hire and train additional sales and support staff andmarketing personnel at these new facilities.

 

•                  The remainingnet proceeds, approximately $51.3 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,including opening additional facilities in selected locations throughout theUnited States and to hire and train additional sales and support staff andmarketing personnel at these new facilities and (ii) to maintain therequired capital of Kanawha, our insurance subsidiary, at the level necessaryto achieve our desired rating agency financial strength ratings and to complywith applicable regulatory requirements as we grow our insurance business.

 

**ITEM 4.      SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

At the annualmeeting of the shareholders on May 18, 2005, the shareholders voted uponnominees for election to the Board of Directors as Class I directors toserve three year terms expiring at the 2008 annual meeting ofshareholders.  Each of the three nomineeswas elected.  The following is a summaryof the votes cast.

 

| ** **             | ** ** | **Number of  Shares For** | ** ** | **Number of  Shares Withheld** | ** ** |
|------------------------|------------|---------------------------|------------|--------------------------------|------------|
| ** **             | ** ** | ** **                | ** ** | ** **                     | ** ** |
| **Stanley D. Johnson** |       | 19,160,836                |       | 1,618,300                      |       |
| ** **             |       |                      |       |                           |       |
| **Robert Laszewski**   |       | 19,212,981                |       | 1,566,155                      |       |
| ** **             |       |                      |       |                           |       |
| **Dennis M. Mathisen** |       | 19,849,131                |       | 930,005                        |       |

 

There were 0abstentions and 0 broker non-votes.

 

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

 
| **(a)** | ** ** | **Exhibits:** |
|---------|------------|---------------|
|    |       |          |   |   |
|    |       | 31.01         |   | Certification of Chief Executive Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|    |       |          |   |   |
|    |       | 31.02         |   | Certification of Chief Financial Officer  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
|    |       |          |   |   |
|    |       | 32.01         |   | Certification of Chief Executive Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|    |       |          |   |   |
|    |       | 32.02         |   | Certification of Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|                                  | ** KMG AMERICA CORPORATION** |
|---------------------------------------|-----------------------------------|
|                                  | * (Registrant)*              |
|                                  |                              |   |
| Date:  August 15, 2005 | By:                               | /s/ Scott H. DeLong III |   |
|                                  |                              | Name: Scott H. DeLong III |
|                                  |                              | Title:  Senior Vice President & Chief Financial Officer  (Principal Financial Officer) |
|                                  |                              |   |
| Date:  August 15, 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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