UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549    FORM 10-Q  (Mark One) xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  For the quarterly period ended September 30, 2005  OR oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from
        to  Commission file number:001-32377  KMG AMERICA CORPORATION  Incorporated pursuant to the Laws of the State of Virginia   Internal Revenue Service  Employer Identification No.20-1377270  12600 Whitewater Drive, Suite 150, Minnetonka, Minnesota  55343 (952) 930-4800   N/A (Former Name, Former Address and Former Fiscal Year, If Changed Since Last Report)  Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YesxNo o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o Nox Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o Nox As of November 1, 2005, the number of shares of Common Stock outstanding was 22,105,775.    TABLE OF CONTENTS




Item No.
        Page No.PART I. FINANCIAL STATEMENTS
        1ITEM 1. FINANCIAL STATEMENTS
        1CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 2004, AND SEPTEMBER 30, 2005 (UNAUDITED)
        1CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2004, AND 2005 AND THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2005
        3CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED) FOR THE NINE MONTHS ENDED SEPTEMBER 20, 2004, AND 2005
        4NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
        5ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
        15ITEM 3. QUANTITATIVE AND QUALIFTATIVE DISCLOSURES ABOUT MARKET RISK
        29ITEM 4. CONTROLS AND PROCEDURES
        29PART II. OTHER INFORMATION
        30ITEM 1. LEGAL PROCEEDINGS
        30ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
        30ITEM 6. EXHIBITS
        31






(i)


PART I

FINANCIAL INFORMATION




ITEM 1.
        FINANCIAL STATEMENTS

KMG AMERICA CORPORATION

CONSOLIDATED BALANCE SHEETS






December 31,
        
        September 30,2004
        
        2005Assets
        
        
        
        (unaudited)Investments:Fixed maturity securities available for sale, at fair value (amortized cost of $409,613,186 and $524,390,330 as of December 31, 2004, and September 30, 2005, respectively)
        
        $
        409,613,186
        
        $
        529,644,386Equity securities available for sale, at fair value (cost of $36,000 and $36,000 as of December 31, 2004, and September 30, 2005, respectively
        
        
        36,000
        
        
        18,500Mortgage loans
        
        
        23,678,639
        
        
        18,355,284Policy loans
        
        
        22,620,801
        
        
        21,894,209Other investments
        
        
        5,192,525
        
        
        5,307,457Total investments
        
        
        461,141,151
        
        
        575,219,836Cash and cash equivalents
        
        
        117,400,156
        
        
        17,623,890Reinsurance balances recoverable
        
        
        71,354,798
        
        
        75,974,273Accrued investment income
        
        
        4,912,216
        
        
        5,262,465Real estate and equipment
        
        
        9,701,754
        
        
        11,096,189Federal income tax recoverable
        
        
        4,239,906
        
        
        5,478,383Deferred income tax asset
        
        
        236,319
        
        
        5,049,317Amounts due from reinsurers
        
        
        1,940,903
        
        
        2,234,645Deferred policy acquisition costs
        
        
        
        
        
        10,305,950Value of business acquired
        
        
        74,481,295
        
        
        72,742,719Other assets
        
        
        24,642,833
        
        
        21,135,363Total assets
        
        $
        770,051,331
        
        $
        802,123,030

See accompanying notes.




1


KMG AMERICA CORPORATION

CONSOLIDATED BALANCE SHEETS

(Continued)






December 31,
        
        September 30,2004
        
        2005Liabilities and shareholders equity
        
        
        
        (unaudited)Liabilities:Policy and contract liabilities:Life and annuity reserves
        
        $
        309,940,285
        
        $
        301,192,793Accident and health reserves
        
        
        200,801,846
        
        
        221,195,807Policy and contract claims
        
        
        9,343,512
        
        
        9,588,662Other policyholder liabilities
        
        
        10,829,794
        
        
        11,092,121Total policy and contract liabilities
        
        
        530,915,437
        
        
        543,069,383Accounts payable and accrued expenses
        
        
        18,794,922
        
        
        32,889,174Taxes, other than federal income taxes
        
        
        6,502,042
        
        
        12,256,438Deferred income taxes
        
        
        528,262
        
        
        607,022Liability for benefits for employees and agents
        
        
        4,158,418
        
        
        4,939,333Funds held in suspense
        
        
        4,724,004
        
        
        3,261,027Long term notes payable
        
        
        15,000,000
        
        
        15,000,000Interest payable on long term notes
        
        
        22,603
        
        
        585,103Other liabilities
        
        
        1,617,778
        
        
        1,741,894Total liabilities
        
        
        582,263,466
        
        
        614,349,374Shareholders equity:Common Stock, par value $0.01 per share, 75,000,000 shares authorized and 22,071,641 and 22,105,775 shares issued at December 31, 2004 and September 30, 2005, respectively
        
        
        220,716
        
        
        221,058Paid-in capital
        
        
        187,742,702
        
        
        188,043,719Deferred stock based compensation
        
        
        
        
        
        (290,984
        )Retained earnings
        
        
        (175,553
        )
        
        2,896,102Accumulated other comprehensive (loss)
        
        
        
        
        
        (3,096,239
        )Total shareholders equity
        
        
        187,787,865
        
        
        187,773,656Total liabilities and shareholders equity
        
        $
        770,051,331
        
        $
        802,123,030See accompanying notes.




2


KMG AMERICA CORPORATION AND PREDECESSOR

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)




KMG America
        
        
        
        KMG AmericaPredecessor
        
        Corporation
        
        Predecessor
        
        CorporationFor the Three Months Ended
        
        For the Nine Months EndedSeptember 30,
        
        September 30,2004
        
        
        2005
        
        
        2004
        
        
        2005Revenue:Insurance Premiums
        
        $
        25,245,066
        
        $
        26,422,849
        
        $
        77,231,931
        
        $
        79,437,198Net investment income
        
        
        6,851,985
        
        
        7,088,996
        
        
        19,172,512
        
        
        20,542,548Commission and fee income
        
        
        3,336,685
        
        
        3,773,422
        
        
        10,172,875
        
        
        11,012,161Realized investment gains
        
        
        4,563,516
        
        
        278,153
        
        
        6,291,619
        
        
        324,115Other income
        
        
        799,327
        
        
        1,199,521
        
        
        2,256,803
        
        
        2,969,498Total revenues
        
        
        40,796,579
        
        
        38,762,941
        
        
        115,125,740
        
        
        114,285,520Benefits and expenses:Policyholder benefits
        
        
        21,667,338
        
        
        21,890,367
        
        
        68,214,575
        
        
        62,966,111Insurance commissions, net of deferrals
        
        
        2,371,104
        
        
        2,239,283
        
        
        7,150,273
        
        
        7,281,608General insurance expenses, net of deferrals
        
        
        7,124,059
        
        
        10,258,446
        
        
        19,554,273
        
        
        30,963,785Insurance taxes, licenses and fees
        
        
        1,063,725
        
        
        1,193,176
        
        
        3,372,352
        
        
        3,643,402Depreciation
        
        
        538,070
        
        
        746,506
        
        
        1,956,400
        
        
        2,170,790Amortization of deferred policy acquisition costs and value of business acquired
        
        
        2,471,939
        
        
        462,539
        
        
        6,827,698
        
        
        2,762,043Total benefits and expenses
        
        
        35,236,235
        
        
        36,790,317
        
        
        107,075,571
        
        
        109,787,739Income before income taxes
        
        
        5,560,344
        
        
        1,972,624
        
        
        8,050,169
        
        
        4,497,781Provision for income taxes
        
        
        (1,980,490
        )
        
        (634,178
        )
        
        (2,746,531
        )
        
        (1,426,126
        )Net income
        
        $
        3,579,854
        
        $
        1,338,446
        
        $
        5,303,638
        
        $
        3,071,655Net income per share:Basic
        
        $
        1,370.11
        
        $
        0.06
        
        $
        2,029.84
        
        $
        0.14Diluted
        
        $
        1,237.06
        
        $
        0.06
        
        $
        1,832.73
        
        $
        0.14Weighted average shares outstanding:Basic
        
        $
        2,612.83
        
        $
        22,090,273
        
        $
        2,612.83
        
        $
        22,077,950Diluted
        
        $
        2,893.84
        
        $
        22,093,854
        
        $
        2,893.84
        
        $
        22,083,674

See accompanying notes.





3


KMG AMERICA CORPORATION AND PREDECESSOR

CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)




KMG AmericaPredecessor
        
        CorporationNine Months EndedSeptember 30,2004
        
        2005Operating activitiesNet income
        
        $
        5,303,638
        
        $
        3,071,655Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization
        
        
        1,832,648
        
        
        2,882,842Policy acquisition costs deferred
        
        
        (9,813,858
        )
        
        (11,225,417
        )Amortization of deferred policy acquisition costs and value of business acquired
        
        
        6,827,698
        
        
        2,762,043Realized investment (gains), net
        
        
        (6,291,619
        )
        
        (324,115
        )Deferred income tax expense
        
        
        1,835,882
        
        
        2,664,603Changes in operating assets and liabilities:Reinsurance balances recoverable
        
        
        (4,748,144
        )
        
        (4,619,475
        )Accrued investment income
        
        
        420,537
        
        
        (350,249
        )Federal income tax recoverable
        
        
        477,574
        
        
        (1,238,477
        )Federal income tax payable
        
        
        744,704
        
        
        Other assets
        
        
        (14,448,925
        )
        
        3,507,470Amounts due from reinsurers
        
        
        (1,616,692
        )
        
        (293,742
        )Policy and contract liabilities
        
        
        19,246,330
        
        
        12,153,946Accounts payable and accrued expenses
        
        
        6,972,842
        
        
        14,094,252Interest payable on long term notes
        
        
        
        
        
        562,500Deferred stock based compensation expense
        
        
        105,885
        
        
        10,375Taxes, other than federal income taxes
        
        
        149,213
        
        
        78,760Funds held in suspense
        
        
        6,496,075
        
        
        (1,462,977
        )Liability for benefits for employees and agents
        
        
        585,689
        
        
        780,915Other liabilities
        
        
        279,110
        
        
        124,116Net cash provided by operating activities
        
        
        14,358,587
        
        
        23,179,025Investing activitiesSecurities available for sale:Sales
        
        
        65,048,602
        
        
        46,310,947Maturities, calls and redemptions
        
        
        4,952,726
        
        
        266,272,077Purchases
        
        
        (67,997,635
        )
        
        (438,788,713
        )Repayment of mortgage loans
        
        
        6,558,142
        
        
        5,323,355Mortgage loans originated
        
        
        (792,982
        )
        
        Decrease in policy loans, net
        
        
        238,362
        
        
        726,592Sale of real estate and property and equipment
        
        
        
        
        
        85,564Purchases of real estate, property and equipment
        
        
        (338,051
        )
        
        (2,725,113
        )Acquisition of Predecessor, net of cash acquired
        
        
        
        
        
        (160,000
        )Net cash provided by (used in) investing activities
        
        
        7,669,164
        
        
        (122,955,291
        )Net increase (decrease) in cash and cash equivalents
        
        
        22,027,751
        
        
        (99,776,266
        )Cash and cash equivalents at beginning of period
        
        
        7,204,805
        
        
        117,400,156Cash and cash equivalents at end of period
        
        $
        29,232,556
        
        $
        17,623,890Supplemental disclosures of cash flow informationFederal income taxes paid
        
        $
        600,000
        
        $
        See accompanying notes.




4


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





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

KMG America Corporation (KMG America or the Company) is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. KMG America commenced operations shortly before it completed its initial public offering of common stock on December 21, 2004, and its shares trade on the New York Stock Exchange under the symbol KMA.  Concurrently with the completion of its initial public offering, KMG America completed its acquisition of Kanawha Insurance Company (Kanawha or the Predecessor) and its subsidiaries, which are KMG Americas primary operating subsidiaries and which underwrite and sell life and health insurance products that historically have been marketed primarily in the southeastern United States but are now being actively marketed nationwide.

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

The Companys primary businesses are life and health insurance risk assumption, third-party administration and medical management services. Included in risk assumption are the Companys product lines of individual and group life, annuity, supplemental health, excess risk and short-term disability. The Company sold its agency office in Ft. Myers, Florida that distributes senior market insurance products on October 5, 2005, and it expects to cease actively underwriting new long-term care insurance policies after December 31, 2005. The Company intends to retain and actively manage its existing block of in force long-term care policies. The Companys third-party administration and medical management businesses include a wide array of services with the primary emphasis in the offering of administrative service-only products.

The Predecessors marketing efforts and sales were primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina. Since acquiring the Predecessor, the Company has begun to implement its business strategy to market its products nationwide. While the Companys sales in the first nine months of 2005 were primarily in the southeastern United States, the Company expects its nationwide marketing effort to generate significant nationwide sales in the future.

2. Significant Accounting Policies

Basis of Presentation

For accounting purposes, Kanawha is treated as KMG Americas predecessor entity and is referred to in these Notes as the Predecessor.  For financial reporting purposes, management has 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 the effects of the acquisition for the period from December 21, 2004, to December 31, 2004, were not material to the Predecessors consolidated statements of operations, cash flows, and changes in shareholders equity for the year ended December 31, 2004. Accordingly, financial information in the following discussion that relates to the Predecessors consolidated results of operations for the nine months ended September 30, 2004 and the three months ended September 30, 2004, and cash flows and changes in shareholders equity for
the nine months ended September 30, 2004, are reported on a historical basis without GAAP (generally accepted accounting principles in the United States) purchase accounting adjustments reflecting the acquisition of the Predecessor. Financial information relating to the Companys consolidated results of operations for the nine months ended September 30, 2005 and three months ended September 30, 2005, and cash flows and changes in shareholders equity for the nine months ended September 30, 2005, and the Companys financial position as of December 31, 2004, and September 30, 2005, has been adjusted for GAAP purchase accounting adjustments reflecting the Predecessors acquisition.

The accompanying unaudited consolidated financial statements (other than the December 31, 2004, balance sheet data, which has been derived from audited financial statements) have been prepared in accordance with GAAP for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, the unaudited consolidated financial statements included herein reflect all adjustments consisting only of normal recurring accruals which are necessary for the fair presentation of the financial condition and results of operations for the interim periods presented. All significant inter-company accounts and transactions have been eliminated in consolidation. Operating results for the



5


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





three and nine month periods ended September 30, 2005, are not necessarily indicative of the results that may be expected for the year ended December 31, 2005. Certain prior year amounts have been reclassified to conform with the current year presentation.

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

Use of Estimates and Assumptions

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

Investments

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

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

Investments are reported on the following basis:



        Fixed maturity securities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders equity as accumulated other comprehensive income. Fair values for fixed maturity securities are based on quoted market prices, where available. For fixed maturity securities not actively traded, fair values are estimated using values obtained from independent pricing services.
        Equity securities classified as available-for-sale are stated at fair value with unrealized gains and losses reported directly in shareholders equity as accumulated other comprehensive income.
        Assets supporting the deferred compensation plan are classified as trading. Trading account assets are held for resale in anticipation of short-term market movements. Trading account assets, consisting of mutual funds, are stated at fair value. Gains and losses, both realized and unrealized, are included in realized gains and losses on deferred compensation investments.
        Mortgage loans on real estate are typically stated at unpaid balances, net of allowances for unrecoverable amounts. However, due to the Companys acquisition of the Predecessor, effective December 31, 2004, under GAAP purchase accounting rules, mortgage loans were recorded at fair value. Valuation allowances for mortgage loans are established when the Company determines it is probable that it will be unable to collect all amounts (both principal and interest) due according to the contractual terms of the loan agreement. Such allowances are based on the present value of expected future cash flows discounted at the loans effective interest rate or, if foreclosure is probable, on the estimated fair value of the underlying real estate.
        Policy loans are stated at their unpaid balances.
        Interest on loans is generally recorded over the term of the loan based on the unpaid principal balance. Accrual of interest is discontinued when either principal or interest becomes 90 days past due or when, in managements opinion, collection of such interest is doubtful. In addition, any previously accrued interest is reversed when the loan becomes 90 days past due.

6


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS







        Other investments are stated at fair value, or the lower of cost or fair value, as appropriate.
        Amortization of premiums and accrual of discounts on investments in fixed maturity securities are reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Realized gains and losses on dispositions of securities are determined by the specific-identification method.Deferred Policy Acquisition Costs

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

For most insurance products, the amortization of deferred acquisition costs is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. Deferred acquisition costs are amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves. For interest-sensitive life insurance and investment products such as deferred annuities (no longer sold by the Company) to the extent recoverable from future gross profits, deferred policy acquisition costs are amortized generally in proportion to the present value of expected gross profits from surrender charges and investment, mortality and expense margins.

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

The Company completed an internal review of the acquisition costs that are being deferred and made certain adjustments relative to historical deferral policies at Kanawha to reflect the new business model which resulted in an increase of deferrals in the third quarter. We expect this new deferral policy to continue going forward.

Value of Business Acquired

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

The amortization of value of business acquired is recognized using amortization schedules established at the time of the acquisitions based upon expected annual premium. Certain of these amortization schedules include actual to expected adjustments to reflect actual experience as it emerges. The value of business acquired for premium paying policies is amortized in proportion to future expected premiums. The value of business acquired for policies paid up as of the acquisition date is amortized in proportion to expected future earnings.

The Predecessors historical value of business acquired was eliminated upon the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. Value of business acquired was simultaneously re-established, by the Company, for the value of the Predecessors in force business. Interest rate assumptions used to amortize the value of business acquired were reset upon the closing of the Kanawha acquisition.

Benefit Reserves

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



7


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





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

The Predecessors benefit reserves, net of related reinsurance recoverable, at December 31, 2004, were adjusted to reflect the closing of the Kanawha acquisition as part of the application of GAAP purchase accounting requirements. The valuation interest rate assumptions were generally lowered to reflect the current and expected interest rate environment at the time the acquisition closed. This change resulted in an increase in benefit reserves. Valuation assumptions for mortality, morbidity and withdrawal were changed to reflect current expectations, which resulted in an increase in benefit reserves. Finally, the valuation assumptions for future premium rates on long term care coverage were increased to account for implemented and expected rate increases. While the assumption change for future premium rates taken alone would reduce benefit reserves for the long term care coverage,
the overall impact of the changes to valuation assumptions taken together resulted in an increase in reserves for this coverage.

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

Stock-Based Compensation

The Company has adopted the disclosure-only requirements of SFAS No. 123,Accounting for Stock-Based Compensation(SFAS 123), as amended by FASB Statement No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure(SFAS 148). As permitted by the provisions of this Statement, the Predecessor accounted for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and Related Interpretations.

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

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

The following is a reconciliation of reported net income and pro forma information as if the Company and the Predecessor had adopted the fair value method permitted under SFAS 123 for its employee and director stock option awards for the three and nine month periods presented:




8


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS








KMG America
        
        
        
        KMG AmericaPredecessor
        
        Corporation
        
        Predecessor
        
        CorporationThree Months Ended
        
        Nine Months EndedSeptember 30,
        
        September 30,2004
        
        2005
        
        2004
        
        2005Net income as reported
        
        $
        3,579,854
        
        $
        1,338,446
        
        $
        5,303,638
        
        $
        3,071,655Add:  Stock-based employee compensation expense included in reported net income, net of related tax effects
        
        
        23,296
        
        
        
        
        
        69,885
        
        
        Deduct:  Total stock-based employee compensation determined under fair value based method for all awards, net of related tax effects
        
        
        (28,399
        )
        
        (181,661
        )
        
        (85,191
        )
        
        (526,745
        )Pro forma net income available to common stockholders
        
        $
        3,574,751
        
        $
        1,156,785
        
        $
        5,288,332
        
        $
        2,544,910Net income per share-basic:As reported
        
        $
        1,370.11
        
        $
        0.06
        
        $
        2,029.84
        
        $
        0.14Pro forma
        
        $
        1,368.15
        
        $
        0.05
        
        $
        2,023.99
        
        $
        0.12Net income per share-diluted:As reported
        
        $
        1,237.06
        
        $
        0.06
        
        $
        1,832.73
        
        $
        0.14Pro forma
        
        $
        1,235.30
        
        $
        0.05
        
        $
        1,827.45
        
        $
        0.12

Recently Issued Accounting Standards

In March 2004, the Emerging Issues Task Force (EITF) reached a final consensus on EITF 03-1, which is effective for fiscal periods beginning after September 15, 2004. EITF 03-1 requires that when the fair value of an investment security is less than its carrying value, an impairment exists for which a determination must be made as to whether the impairment is other-than-temporary. An impairment loss should be recognized equal to the difference between the investments carrying value and its fair value when an impairment is other-than-temporary. Subsequent to an other-than-temporary impairment loss, a debt security should be accounted for in accordance with Statement of Position No. 03-3,Accounting for Loans and Certain Debt Securities Acquired in a Transfer, which allows the accretion of the discount between the
carrying value and expected value of a security if the amount and timing of the recognition of that difference in cash is reasonably estimable. EITF 03-1 also indicates that, although not presumptive, a pattern of selling investments prior to the forecasted recovery may call into question an investors intent to hold the security until it recovers its value.

The final consensus on EITF 03-1 included additional disclosure requirements incremental to those adopted by the Predecessor effective December 31, 2003, that are effective for fiscal years ending after September 15, 2004.

In October 2004, the FASB delayed the implementation of the accounting requirements included in EITF 03-1 until further study could be completed regarding the impact of this guidance, particularly with respect to available-for-sale portfolios. The disclosure requirements included in EITF 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-Based Compensation, and supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees. SFAS 123 (revised 2004) requires the measurement of all share-based payments to employees, including grants of employee stock options, using a fair-value-based method and the recording of such expense in the Companys consolidated statements of income. The accounting provisions of SFAS 123 (revised 2004) are effective for reporting periods beginning after January 1, 2006. The Company is required to adopt SFAS 123 (revised 2004) in the first quarter of 2006.



9


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Although the Company has not yet determined whether the adoption of SFAS 123 (revised 2004) will result in amounts that are similar to the current pro forma disclosures under SFAS 123, the Company is evaluating the requirements under SFAS 123 (revised 2004) and expects the adoption to have an impact on its consolidated statements of income and net income per share that is substantially similar to the current pro forma disclosure under SFAS 123.

3. Investments

Aggregate amortized cost, aggregate fair value and gross unrealized gains and losses of investments in fixed maturity and equity securities are summarized in the following table. Effective December 31, 2004, the Company recorded the Predecessors investments at fair value and thereby eliminated all unrealized gains and losses in the Predecessors portfolio, as part of the application of GAAP purchase accounting requirements.


Amortized Cost
        
        GrossUnrealizedGains
        
        GrossUnrealizedLosses
        
        FairValueAvailable for sale securities at September 30, 2005:Fixed maturity securities
        
        $
        534,390,330
        
        $
        1,872,806
        
        $
        6,618,750
        
        $
        529,644,386Equity securities
        
        
        36,000
        
        
        
        
        
        17,500
        
        
        18,500Securities available for sale
        
        $
        534,426,330
        
        $
        1,872,806
        
        $
        6,636,250
        
        $
        529,662,8864. Statutory Financial Information

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

Under South Carolina insurance regulations, Kanawha is required to maintain minimum capital of $1.2 million and minimum surplus of $1.2 million. Additionally, Kanawha is restricted as to amounts that can be transferred in the form of dividends, loans, or advances without the approval of the South Carolina Insurance Commissioner. Under these restrictions, during 2005, dividends, loans or advances by Kanawha in excess of $8.4 million will require the approval of the South Carolina Insurance Commissioner.

5. Employee Benefits

The net periodic retirement benefit cost of the Companys defined benefit pension plan for the three and nine month periods presented included the following components:


KMG America
        
        
        
        KMG AmericaPredecessor
        
        Corporation
        
        Predecessor
        
        CorporationThree Months Ended
        
        Nine Months EndedSeptember 30,
        
        September 30,2004
        
        2005
        
        2004
        
        2005Components of net periodic benefit cost:Service cost
        
        $
        206,269
        
        $
        227,579
        
        $
        618,807
        
        $
        682,737Interest cost
        
        
        200,514
        
        
        228,171
        
        
        601,541
        
        
        684,513Expected return on plan assets
        
        
        (131,529
        )
        
        (207,384
        )
        
        (394,586
        )
        
        (622,152
        )Amortization of transition liability
        
        
        4,343
        
        
        4,343
        
        
        13,029
        
        
        13,029Recognized net actuarial loss
        
        
        51,913
        
        
        42,608
        
        
        155,739
        
        
        127,824Net periodic benefit cost
        
        $
        331,510
        
        $
        295,317
        
        $
        994,530
        
        $
        885,951



10


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS







The Company expects that its aggregate contributions to its defined benefit pension plan will be between $0 and $850,000 in 2005. No contributions were made during the nine months ended September 30, 2005.

In the three months and nine months ended September 30, 2005, the Company granted options to purchase an aggregate of 43,500 and 200,250 shares of its common stock, respectively. The options vest in four equal annual installments beginning on the first anniversary of the date of grant. Subject to certain conditions set forth in the option agreements, options are exercisable upon vesting until the tenth anniversary of the date of grant.

6. Comprehensive Income (Loss)

Total comprehensive income for the nine month periods ended September 30, 2004 and 2005 was $3.3 million and $0.0 million, respectively. The difference between comprehensive income and net income for these periods was unrealized losses of $(2.0) million and $(3.1) million, respectively.

Total comprehensive income (loss) for the three month periods ended September 30, 2004 and 2005 was $9.7 million and $(6.6) million, respectively. The difference between comprehensive income and net income for these periods was unrealized gains (losses) of $6.1 million and $(8.0) million, respectively.

7. Commitments and Contingencies

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

On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York, both indirect wholly-owned subsidiaries of ING America US, in the Fourth Judicial District Court in Hennepin County, Minnesota (the Court), against KMG America, Kanawha, Kenneth U. Kuk, Paul F. Kraemer, Paul P. Moore and Thomas J. Gibb (the ReliaStar Litigation). Messrs. Kuk, Kraemer and Moore are officers of KMG America and former employees of the plaintiffs. Mr. Gibb is an employee of KMG America and a former employee of the plaintiffs. The complaint alleges misappropriation of trade secrets, conversion, tortious interference with business and employment relationships, breach of fiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive
relief and unspecified monetary damages.  On August 24, 2005, the plaintiffs   amended their complaint to add Scott H. DeLong III and Thomas D. Sass as defendants. Messrs. DeLong and Sass are officers of KMG America and former employees of the plaintiffs. The plaintiffs amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentation and civil theft.  On August 9, 2005, a hearing was held before the Court to consider Plaintiffs motion for a temporary injunction. The Court issued a ruling on August 26, 2005 denying Plaintiffs motion, and since that date, the Plaintiffs have filed a notice of appeal of the Courts ruling with the Minnesota Court of Appeals.  KMG America believes the allegations in the Plaintiffs complaint are without merit, intends to defend the action and believes that the outcome of this matter will not have a material adverse effect on its financial
position or results of operations; however, defense costs may have a material adverse effect on its consolidated financial position or results of operations.

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

8. Business Segments

The Company has five reportable segments that are differentiated by their operations and functions, including their respective methods of distributing insurance products and services and the nature of the insurance products and services they provide: worksite insurance business, senior market insurance business, third party



11


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





administration business, acquired business and corporate and other. Management makes decisions regarding the Companys business based on these segment classifications. No segments have been aggregated other than including the marketing business in the corporate and other segment.

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

The senior market insurance provides individual insurance products, primarily long-term care insurance, tailored to the needs of older individuals.   On October 5, 2005, the Company sold its agency office in Ft. Myers, Florida that distributes senior market products. The Company expects to cease actively underwriting new long term care insurance policies after December 31, 2005. The Company intends to maintain and actively manage its existing block of in force long term care insurance policies.

The third party administration business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business, but also provides fee-based administrative and managed care services to employers with self funded health care plans, other insurance carriers, reinsurance companies, managed care plans and others.

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

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

The following represents a summary of the Companys and the Predecessors statements of income and asset composition by reportable segment. The financial statement information of the Predecessor for the nine months ended September 30, 2004, and the three months ended September 30, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition of the Predecessor, while the Companys financial statement information for the nine months ended September 30, 2005 and the three months ended September 30, 2005, has been adjusted for GAAP purchase accounting adjustments reflecting the acquisition.


KMG America
        
        
        
        KMG AmericaPredecessor
        
        Corporation
        
        Predecessor
        
        CorporationThree Months Ended
        
        Nine Months EndedSeptember 30,
        
        September 30,2004
        
        2005
        
        2004
        
        2005Worksite Insurance BusinessInsurance premiums
        
        $
        14,109,006
        
        $
        15,105,546
        
        $
        42,306,778
        
        $
        44,791,793Net investment income
        
        
        1,251,936
        
        
        1,537,580
        
        
        3,949,872
        
        
        4,922,481Commission and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        54,899
        
        
        39,898
        
        
        219,137
        
        
        129,619Total revenues
        
        
        15,415,841
        
        
        16,683,024
        
        
        46,475,787
        
        
        49,843,893Policyholder benefits
        
        
        10,835,248
        
        
        11,501,803
        
        
        33,969,649
        
        
        33,052,454Commissions
        
        
        900,955
        
        
        847,974
        
        
        2,719,231
        
        
        2,726,454Expenses, taxes, fees and depreciation
        
        
        2,648,922
        
        
        4,043,392
        
        
        7,277,937
        
        
        11,796,341Amortization of DAC and VOBA
        
        
        1,619,170
        
        
        1,112,928
        
        
        4,494,061
        
        
        2,827,308Total benefits and expenses
        
        
        16,004,295
        
        
        17,506,097
        
        
        48,460,878
        
        
        50,402,557



12


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS








(Loss) income before Federal income tax
        
        $
        (588,454
        )
        $
        (823,073
        )
        $
        (1,985,091
        )
        $
        (558,664
        )Total assets
        
        $
        152,110,214
        
        $
        167,106,744
        
        $
        152,110,214
        
        $
        167,106,744Senior Market Insurance BusinessInsurance premiums
        
        $
        10,119,610
        
        $
        10,376,261
        
        $
        31,793,261
        
        $
        32,104,963Net investment income
        
        
        1,022,906
        
        
        1,195,795
        
        
        2,896,594
        
        
        3,344,360Commission and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        618,616
        
        
        731,410
        
        
        1,670,012
        
        
        2,187,982Total revenues
        
        
        11,761,132
        
        
        12,303,466
        
        
        36,359,866
        
        
        37,637,305Policyholder benefits
        
        
        8,821,974
        
        
        8,845,120
        
        
        27,541,489
        
        
        26,366,213Commissions
        
        
        1,366,089
        
        
        1,294,005
        
        
        4,109,242
        
        
        4,255,366Expenses, taxes, fees and depreciation
        
        
        1,076,462
        
        
        1,098,722
        
        
        2,674,244
        
        
        3,225,266Amortization of DAC and VOBA
        
        
        221,653
        
        
        (392,462
        )
        
        367,631
        
        
        403,240Total benefits and expenses
        
        
        11,486,178
        
        
        10,845,385
        
        
        34,692,606
        
        
        34,250,085Income before Federal income tax
        
        $
        274,954
        
        $
        1,458,081
        
        $
        1,667,260
        
        $
        3,387,220Total assets
        
        $
        144,409,142
        
        $
        185,674,997
        
        $
        144,409,142
        
        $
        185,674,997Third-Party Administration BusinessInsurance premiums
        
        $
        
        
        $
        
        
        $
        
        
        $
        Net investment income
        
        
        
        
        
        
        
        
        
        
        
        Commission and fees
        
        
        3,260,768
        
        
        3,695,647
        
        
        10,060,298
        
        
        10,761,455Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        
        
        
        573
        
        
        626
        
        
        1,435Total revenues
        
        
        3,260,768
        
        
        3,696,220
        
        
        10,060,924
        
        
        10,762,890Policyholder benefits
        
        
        
        
        
        
        
        
        
        
        
        Commissions
        
        
        
        
        
        
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        3,048,357
        
        
        3,130,480
        
        
        9,067,920
        
        
        9,597,648Amortization of DAC and VOBA
        
        
        
        
        
        
        
        
        
        
        
        Total benefits and expenses
        
        
        3,048,357
        
        
        3,130,480
        
        
        9,067,920
        
        
        9,597,648Income before Federal income tax
        
        $
        212,411
        
        $
        565,740
        
        $
        993,004
        
        $
        1,165,242Total assets
        
        $
        8,032,006
        
        $
        10,326,878
        
        $
        8,032,006
        
        $
        10,326,878Acquired BusinessInsurance premiums
        
        $
        1,016,450
        
        $
        941,042
        
        $
        3,131,893
        
        $
        2,540,442Net investment income
        
        
        2,131,109
        
        
        1,865,737
        
        
        6,658,881
        
        
        5,844,126Commission and fees
        
        
        
        
        
        
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        
        
        
        
        
        
        Other income
        
        
        30,306
        
        
        19,655
        
        
        80,512
        
        
        51,367Total revenues
        
        
        3,177,865
        
        
        2,826,434
        
        
        9,871,286
        
        
        8,435,935Policyholder benefits
        
        
        2,010,116
        
        
        1,543,444
        
        
        6,703,437
        
        
        3,547,444Commissions
        
        
        104,060
        
        
        97,304
        
        
        321,800
        
        
        299,788Expenses, taxes, fees and depreciation
        
        
        686,753
        
        
        674,650
        
        
        2,047,252
        
        
        2,046,264



13


KMG AMERICA CORPORATION AND PREDECESSOR

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS








Amortization of DAC and VOBA
        
        
        631,116
        
        
        (257,927
        )
        
        1,966,006
        
        
        (468,505
        )Total benefits and expenses
        
        
        3,432,045
        
        
        2,057,471
        
        
        11,038,495
        
        
        5,424,991(Loss) income before Federal income tax
        
        $
        (254,180
        )
        $
        768,963
        
        $
        (1,167,209
        )
        $
        3,010,944Total assets
        
        $
        199,787,497
        
        $
        207,228,787
        
        $
        199,787,497
        
        $
        207,228,787Corporate and OtherInsurance premiums
        
        $
        
        
        $
        
        
        $
        
        
        $
        Net investment income
        
        
        2,446,034
        
        
        2,489,884
        
        
        5,667,165
        
        
        6,431,581Commission and fees
        
        
        75,917
        
        
        77,775
        
        
        112,577
        
        
        250,706Net realized gains
        
        
        4,563,516
        
        
        278,153
        
        
        6,291,619
        
        
        324,115Other income
        
        
        95,506
        
        
        407,985
        
        
        286,516
        
        
        599,095Total revenues
        
        
        7,180,973
        
        
        3,253,797
        
        
        12,357,877
        
        
        7,605,497Policyholder benefits
        
        
        
        
        
        
        
        
        
        
        
        Commissions
        
        
        
        
        
        
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        1,265,360
        
        
        3,250,884
        
        
        3,815,672
        
        
        10,112,458Amortization of DAC and VOBA
        
        
        
        
        
        
        
        
        
        
        
        Total benefits and expenses
        
        
        1,265,360
        
        
        3,250,884
        
        
        3,815,672
        
        
        10,112,458Income (loss) before Federal income tax
        
        $
        5,915,613
        
        $
        2,913
        
        $
        8,542,205
        
        $
        (2,506,961
        )Total assets
        
        $
        219,567,381
        
        $
        231,785,624
        
        $
        219,567,381
        
        $
        231,785,624Total CompanyInsurance premiums
        
        $
        25,245,066
        
        $
        26,422,849
        
        $
        77,231,931
        
        $
        79,437,198Net investment income
        
        
        6,851,985
        
        
        7,088,996
        
        
        19,172,512
        
        
        20,542,548Commission and fees
        
        
        3,336,685
        
        
        3,773,422
        
        
        10,172,875
        
        
        11,012,161Net realized gains
        
        
        4,563,516
        
        
        278,153
        
        
        6,291,619
        
        
        324,115Other income
        
        
        799,327
        
        
        1,199,521
        
        
        2,256,803
        
        
        2,969,498Total revenues
        
        
        40,796,579
        
        
        38,762,941
        
        
        115,125,740
        
        
        114,285,520Policyholder benefits
        
        
        21,667,338
        
        
        21,890,367
        
        
        68,214,575
        
        
        62,966,111Commissions
        
        
        2,371,104
        
        
        2,239,283
        
        
        7,150,273
        
        
        7,281,608Expenses, taxes, fees and depreciation
        
        
        8,725,854
        
        
        12,198,128
        
        
        24,883,025
        
        
        36,777,977Amortization of DAC and VOBA
        
        
        2,471,939
        
        
        462,539
        
        
        6,827,698
        
        
        2,762,043Total benefits and expenses
        
        
        35,236,235
        
        
        36,790,317
        
        
        107,075,571
        
        
        109,787,739Income before Federal income tax
        
        $
        5,560,344
        
        $
        1,972,624
        
        $
        8,050,169
        
        $
        4,497,781Total assets
        
        $
        723,906,240
        
        $
        802,123,030
        
        $
        723,906,240
        
        $
        802,123,030



14


ITEM 2.
        MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.Business Overview



KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. We commenced our operations shortly before we completed our initial public offering of common stock on December 21, 2004, and our shares trade on the New York Stock Exchange under the symbol KMA.  Concurrently with the completion of our initial public offering, we completed our acquisition of Kanawha Insurance Company (Kanawha) and its subsidiaries, which are our primary operating subsidiaries and which underwrite and sell life and health insurance products. For GAAP accounting purposes, Kanawha is treated as KMG Americas predecessor entity and is referred to herein as our predecessor.  Financial information in the following discussion that relates to our predecessors consolidated results of operations for the three and nine
month periods ended September 30, 2004, and cash flows and changes in shareholders equity for the nine months ended September 30, 2004, are reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition. Financial information relating to our consolidated results of operations for the three and nine month periods ended on September 30, 2005, and cash flows and changes in shareholders equity for the nine months ended September 30, 2005, and our financial position as of December 31, 2004, and September 30, 2005, has been adjusted for GAAP purchase accounting adjustments reflecting the acquisition. Our operations are conducted in the five following business segments.

Worksite insurance business. Our worksite insurance business is a provider of voluntary life and health insurance products to employers and their employees. The primary insurance products that we underwrite include: life insurance; short-term disability insurance; dental insurance; indemnity health insurance; critical illness insurance; and employer excess risk insurance. For the nine months ended September 30, 2005, our worksite insurance business reported premiums, commissions and fees, excluding inter-company payments, of $44.8 million, which accounted for 49.6% of our premiums, commissions and fees, excluding inter-company payments in that period. Our Predecessors marketing efforts and sales were primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina. Since acquiring our predecessor, we have begun to
implement our business strategy to operate our existing worksite insurance business efficiently while developing a new worksite marketing and distribution organization that targets larger employer groups nationwide with an expanded variety of life and health insurance products which will add a new set of employer-paid life insurance, disability and health products to our existing voluntary products. While our sales in the first nine months of 2005 were primarily in the southeastern United States, we expect our nationwide marketing effort to generate significant sales nationwide in the future. In December 2004, we opened sales offices hosting regional sales managers in Boston, Massachusetts and Irvine, California, a Los Angeles suburb. During 2005, we have opened regional sales offices in Tampa, Florida; Chicago, Illinois; New York, New York (serves New Jersey, Pennsylvania and Connecticut; we are not currently licensed for sales in New York State); Atlanta, Georgia; Dallas, Texas;
Cleveland, Ohio; Kansas City, Missouri; Minneapolis, Minnesota;  New Orleans, Louisiana; Philadelphia, Pennsylvania; and San Diego and San Francisco, California. We expect to continue to add and train additional sales and support staff and marketing personnel at these facilities, and will recognize the costs associated with these additions before we recognize revenues resulting from new sales activity. Consequently, we expect negative cash flow and operating losses in the short term.

Senior market insurance business. Our senior market insurance business is a provider in the southeastern United States of individual insurance products tailored to the needs of older individuals. The primary insurance products that this business offers include long-term care insurance that we underwrite and Medicare supplement insurance underwritten by another carrier. For the nine months ended September 30, 2005, our senior market insurance business reported premiums, commissions and fees, excluding inter-company payments, of $32.1 million, which accounted for 35.5% of our premiums, commissions and fees, excluding inter-company payments, in that period.

In June 2005, after completing an internal review of our operations and business strategies, we decided to sell or otherwise dispose of our agency office in Ft. Myers, Florida that distributes senior market insurance products. On October 5, 2005, the Company sold the agency office, which consists of 16 marketing employees.   We expect to cease actively underwriting new long-term care insurance policies after December 31, 2005. We intend to retain and actively manage the existing block of in-force long-term care insurance policies (including the right to receive future premiums and the liability of future claims).



15


Significant factors that contributed to the foregoing decisions include, among others:  (1) year-to-date sales for this business are significantly lower than originally projected; and (2) the lack of strategic fit between the underwriting and distribution of long-term care products and our current strategy of focusing on worksite marketing of life and health insurance products.

The sale of the agency office resulted in $0.3 million of shut down expenses incurred in the third quarter of 2005 primarily due to severance payments, which is expected to be offset in later quarters by the savings resulting from no longer supporting the office. Aside from the shut down costs, the overall impact of the sale of the agency office is not expected to have a material effect on the financial performance or condition of the Company in the short- or long-term. In the short-term, the expected level of new sales of long-term care products was minimal compared to the expected sales of worksite products. In the long-term, as the existing block of long-term care insurance policies runs off, the reduced premium revenue from long-term care products is expected to be more than offset by increased revenues from the Companys core worksite marketing business.

Third-party administration business. Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services. This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business. Our third-party administration business also provides fee based administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, reinsurers and managed care plans. For the nine months ended September 30, 2005, our third-party administration business reported commissions and fees, excluding inter-company payments, of $10.8 million, which accounted for 11.9% of our premiums, commissions and fees, excluding inter-company payments, in that period.
Our primary business strategy for this business is to grow this business as it administers the increasing volume of policies and products that we anticipate will be sold by the worksite insurance business as we attempt to grow that business. In addition, as our national worksite marketing business develops, we intend to opportunistically market our third-party administration services to self-insured plans, stop loss insurers, pharmacy benefit organizations, managed care service providers, other insurance carriers and reinsurers nationwide. It is expected that any incremental costs associated with this expanded marketing will be modest and will be funded out of the operations of our third-party administration business.

Acquired business.  We have retained our predecessors closed block of life and health insurance business reported in the acquired business segment. While acquisitions of books of business from other insurance carriers is not one of our principal growth strategies, we will consider making acquisitions on an opportunistic basis if we can complete the acquisitions on favorable financial terms that we expect to be generally accretive to earnings per share and return on equity while maintaining our financial strength ratings.

Corporate and other. We have also retained our predecessors investment and marketing activities reported in the corporate and other segment. We expect to realize earnings from our investment portfolio. Insurance companies in the life and health insurance industry earn profits on the investment float, which reflects the investment income earned on the premiums paid to the insurer between the time of receipt and the time benefits are paid-out under the policy. Volatility in the capital markets, changes in interest rates and changes in economic conditions can all impact the amount of earnings that we will realize from our investment portfolio. Defense costs related to the ReliaStar Litigation are reported in the corporate and other segment. We believe the outcome of this matter will not have a material adverse effect on our financial position or results of
operations; however, defense costs may have a material adverse effect on our consolidated financial position or results of operations.




16


Results of Operations

Consolidated Overview

The following table presents historical consolidated financial information for the three and nine month periods ended September 30, 2004, for our predecessor, and consolidated financial information for the three and nine months periods ended September 30, 2005, for KMG America.




KMG America
        
        
        
        KMG AmericaPredecessor
        
        Corporation
        
        Predecessor
        
        CorporationThree Months Ended
        
        Nine Months EndedSeptember 30,
        
        September 30,2004
        
        2005
        
        2004
        
        2005(dollars in thousands)Revenues:Insurance premiums
        
        $
        25,245
        
        $
        26,423
        
        $
        77,232
        
        $
        79,438Net investment income (1)
        
        
        6,852
        
        
        7,089
        
        
        19,173
        
        
        20,542Commission and fees
        
        
        3,337
        
        
        3,773
        
        
        10,173
        
        
        11,012Net realized gains
        
        
        4,563
        
        
        278
        
        
        6,291
        
        
        324Other income
        
        
        799
        
        
        1,200
        
        
        2,257
        
        
        2,970Total revenues
        
        
        40,796
        
        
        38,763
        
        
        115,126
        
        
        114,286Benefits and expenses:Policyholder benefits
        
        
        21,667
        
        
        21,890
        
        
        68,215
        
        
        62,966Commissions
        
        
        2,371
        
        
        2,239
        
        
        7,150
        
        
        7,282General expenses
        
        
        7,124
        
        
        10,259
        
        
        19,554
        
        
        30,964Taxes, licenses and fees
        
        
        1,064
        
        
        1,193
        
        
        3,373
        
        
        3,643Depreciation and amortization
        
        
        538
        
        
        747
        
        
        1,956
        
        
        2,171Amortization of DAC and VOBA
        
        
        2,472
        
        
        463
        
        
        6,828
        
        
        2,762Total benefits and expenses
        
        
        35,236
        
        
        36,791
        
        
        107,076
        
        
        109,788Income before income taxes
        
        
        5,560
        
        
        1,972
        
        
        8,050
        
        
        4,498Provision for income taxes
        
        
        (1,980
        )
        
        (634
        )
        
        (2,746
        )
        
        (1,426
        )Net income
        
        $
        3,580
        
        $
        1,338
        
        $
        5,304
        
        $
        3,072Benefits to premiums ratio(2)
        
        
        85.8
        %
        
        82.8
        %
        
        88.3
        %
        
        79.3
        %


(1)
        Net investment income for the nine months ended September 30, 2004, was negatively impacted by a $1.6 million incentive payment in the first quarter of 2004 to one of Kanawhas outside investment managers at the conclusion of the contract period. There are no other incentive arrangements of this type in force, and this contract was terminated upon the closing of our acquisition of Kanawha.


(2)
        The benefits to premiums ratio is equal to policyholder benefits (equal to incurred claims plus increases in policyholder active life reserves) divided by insurance premiums.

17


Consolidated Results of Operations by Business Segment

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

Nine Months Ended September 30, 2005, Compared to Nine Months Ended September 30, 2004


Financial Results OverviewNet income for the nine months ended September 30, 2005, decreased $2.2 million, or 41.5%, to $3.1 million from $5.3 million for the nine months ended September 30, 2004. Contributing factors were increases in premiums and net investment income combined with decreases in policyholder benefits, offset by an increase in general expenses and a decrease in realized investment gains, all of which are described in greater detail below. A decrease in pre-tax realized investment gains of $6.0 million was a primary contributing factor.

Revenues

Total revenues for the nine months ended September 30, 2005, decreased $0.8 million, or 0.7%, to $114.3 million from total revenues of $115.1 million for the nine months ended September 30, 2004. The primary factors causing the fluctuations are explained below under the captions Premiums, Net Investment Income, Commission and Fee Income, Realized Investment Gains and Losses and Other Income.

Premiums

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


For the Nine Months Ended September 30,2004
        
        2005
        
        Increase (decrease)Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        TotalDirectNew
        
        $
        9.8
        
        $
        3.7
        
        $
        
        
        $
        13.5
        
        $
        12.7
        
        $
        1.5
        
        $
        
        
        $
        14.2
        
        $
        2.9
        
        $
        (2.2
        )
        $
        
        
        $
        0.7Renewal
        
        
        33.9
        
        
        37.6
        
        
        
        
        
        71.5
        
        
        34.0
        
        
        40.9
        
        
        
        
        
        74.9
        
        
        0.1
        
        
        3.3
        
        
        
        
        
        3.4Total
        
        
        43.7
        
        
        41.3
        
        
        
        
        
        85.0
        
        
        46.7
        
        
        42.4
        
        
        
        
        
        89.1
        
        
        3.0
        
        
        1.1
        
        
        
        
        
        4.1AssumedNew
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        Renewal
        
        
        
        
        
        
        
        
        3.0
        
        
        3.0
        
        
        
        
        
        
        
        
        2.5
        
        
        2.5
        
        
        
        
        
        
        
        
        (0.5
        )
        
        (0.5
        )Total
        
        
        
        
        
        
        
        
        3.0
        
        
        3.0
        
        
        
        
        
        
        
        
        2.5
        
        
        2.5
        
        
        
        
        
        
        
        
        (0.5
        )
        
        (0.5
        )CededNew
        
        
        (0.6
        )
        
        (2.4
        )
        
        
        
        
        (3.0
        )
        
        (1.2
        )
        
        (0.8
        )
        
        
        
        
        (2.0
        )
        
        (0.6
        )
        
        1.6
        
        
        0.0
        
        
        1.0Renewal
        
        
        (0.8
        )
        
        (7.1
        )
        
        0.1
        
        
        (7.8
        )
        
        (0.7
        )
        
        (9.5
        )
        
        
        
        
        (10.2
        )
        
        0.1
        
        
        (2.4
        )
        
        (0.1
        )
        
        (2.4
        )Total
        
        
        (1.4
        )
        
        (9.5
        )
        
        0.1
        
        
        (10.8
        )
        
        (1.9
        )
        
        (10.3
        )
        
        
        
        
        (12.2
        )
        
        (0.5
        )
        
        (0.8
        )
        
        (0.1
        )
        
        (1.4
        )NetNew
        
        
        9.2
        
        
        1.3
        
        
        
        
        
        10.5
        
        
        11.5
        
        
        0.7
        
        
        
        
        
        12.2
        
        
        2.3
        
        
        (0.6
        )
        
        0.0
        
        
        1.7Renewal
        
        
        33.1
        
        
        30.5
        
        
        3.1
        
        
        66.7
        
        
        33.3
        
        
        31.4
        
        
        2.5
        
        
        67.2
        
        
        0.2
        
        
        0.9
        
        
        (0.6
        )
        
        0.5Total
        
        
        42.3
        
        
        31.8
        
        
        3.1
        
        
        77.2
        
        
        44.8
        
        
        32.1
        
        
        2.5
        
        
        79.4
        
        
        2.5
        
        
        0.3
        
        
        (0.6
        )
        
        2.2(dollars in millions)

Worksite net new premiums increased $2.3 million, or 25.0%, to $11.5 million for the nine months ended September 30, 2005, from $9.2 million for the nine months ended September 30, 2004, due to increased sales volumes. New sales increased $1.7 million, or 20.7%, to $9.9 million for the nine months ended September 30, 2005, from $8.2 million for the nine months ended September 30, 2004, due to increased emphasis on this core business segment. Net renewal premiums increased $0.2 million, or 0.6%, due to the increased amount of insurance in force created by prior year sales.



18


Senior market net new premiums, comprised of long term care policies, decreased $0.6 million, or 46.1%, to $0.7 million for the nine months ended September 30, 2005, from $1.3 million for the nine months ended September 30, 2004, due to decreased sales volumes. New sales decreased $1.5 million, or 53.6%, to $1.3 million for the nine months ended September 30, 2005, from $2.8 million for the nine months ended September 30, 2004, due to the continuation of a sales decline that began in mid-2003, resulting from the discontinuance of an older product and the introduction of a new product with significantly higher premiums. Also contributing to the sales decline was  our announcement earlier this year that we intend to sell or otherwise dispose of the Ft. Myers agency office and cease actively underwriting new long term care insurance policies after December 31, 2005.  Net renewal premiums
increased $0.9 million, or 3.0%, due to the increased amount of insurance in force created by prior year sales. This increase is reflected in both the direct renewal premiums and the ceded renewal premiums.

Acquired business premiums decreased $0.6 million, or 19.4%, to $2.5 million for the nine months ended September 30, 2005, from $3.1 million for the nine months ended September 30, 2004. Neither we nor our predecessor has  acquired any blocks of business since 1999 and the decline is a result of policy lapses.

Net Investment Income

Net investment income increased $1.3 million, or 6.8%, to $20.5 million for the nine months ended September 30, 2005, from $19.2 million for the nine months ended September 30, 2004. Net investment income for the nine months ended September 30, 2004, was negatively impacted by a non-recurring $1.6 million incentive payment to one of Kanawhas outside investment managers at the conclusion of the contract period. Excluding this item, net investment income for the nine months ended September 30, 2005, decreased by $0.3 million from the nine months ended September 30, 2004. Net investment income is primarily affected by changes in levels of invested assets and interest rates. The decline in investment income for the nine months ended September 30, 2005, occurred despite an increase in total cash and investments of $91.5 million, or 18.3%, to $592.8 million as of September 30, 2005, from
$501.3 million as of September 30, 2004.  Invested assets increased by $114.1 million or 24.7%, to $575.2 million as of September 30, 2005, from $461.1 million as of December 31, 2004, reflecting the investment of cash generated by 2004 asset sales and our initial public offering. Generally, the increase in cash and invested assets was due to retention of premiums to establish policy reserves for the payment of future policyholder benefits.

The average yield on cash and invested assets on an amortized cost basis was 4.66% for the nine months ended September 30, 2005, compared to an average yield of 5.84% for the nine months ended September 30, 2004, excluding the effects of the non-recurring $1.6 million incentive payment to one of Kanawhas outside investment managers. This decline resulted from lower interest rates combined with the significantly larger amount of assets held in cash during the nine months ended September 30, 2005. The incentive payment made in 2004 was charged directly to the corporate and other segment, while all other net investment income is allocated to our various business segments on a pro rata basis based on the invested assets attributed to the business segment.

In conjunction with the application of GAAP purchase accounting requirements, assets attributed to the worksite insurance business, the senior insurance business and the acquired business all increased significantly, as evidenced by a comparison of segment assets in the segment tables shown in Note 8., Business Segments, from September 30, 2004, to September 30, 2005.

Commission and Fee Income

Commission and fee income increased $0.8 million, or 7.8%, to $11.0 million for the nine months ended September 30, 2005, from $10.2 million for the nine months ended September 30, 2004. Most of the commission and fee income was from administrative fees relating to third-party administration, and the increase was due to an increase in business in force relating to increased sales of administrative services.

Realized Investment Gains and Losses

Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain for the nine months ended September 30, 2005, decreased by $6.0 million to $0.3 million, from $6.3 million for the nine months ended September 30, 2004. The net gain realized on fixed maturity securities



19


for the nine months ended September 30, 2005, totaled $0.2 million compared to a net gain realized on fixed maturity securities of $3.9 million for the nine months ended September 30, 2004. The net gain realized on equity securities for the nine months ended September 30, 2005, totaled $0.0 million compared to a net gain realized on equity securities of $2.4 million for the nine months ended September 30, 2004. The net gain realized on other investments for the nine months ended September 30, 2005, totaled $0.1 million compared to a net gain realized on other investments of $0.1 million for the nine months ended September 30, 2004. Other investments represent the assets purchased to support the deferred compensation liability of the company, and realized gains and or losses are directly offset with increases and or decreases in compensation expenses. Realized investment gains and losses are allocated
entirely to the corporate and other business segment.

Other Income

Other income increased $0.7 million, or 30.4%, to $3.0 million for the nine months ended September 30, 2005, from $2.3 million for the nine months ended September 30, 2004. In 2005, other income includes $0.3 million of proceeds from litigation settlements, resulting from our participation in various class action litigations. The remaining increases reflect increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums.

Benefits and Expenses

Total benefits and expenses increased $2.7 million, or 2.5%, to $109.8 million for the nine months ended September 30, 2005, from $107.1 million for the nine months ended September 30, 2004. The primary factors causing this increase are explained below under the captions Policyholder Benefits, Insurance Commissions, General Insurance Expenses, Insurance Taxes, Licenses and Fees, and Amortization of DAC and VOBA.

Policyholder Benefits

Policyholder benefits decreased $5.2 million, or 7.6%, to $63.0 million for the nine months ended September 30, 2005, from $68.2 million for the nine months ended September 30, 2004. This produced a benefits to premium ratio of 79.3% for the nine months ended September 30, 2005, compared to 88.3% for the nine months ended September 30, 2004. The benefits to premium ratio declined primarily as a result of the GAAP purchase accounting adjustments described in the next three paragraphs.

Worksite marketing policyholder benefits decreased $0.9 million, or 2.6%, to $33.1 million for the nine months ended September 30, 2005, from $34.0 million for the nine months ended September 30, 2004. This produced benefits to premium ratios of 73.8% for the nine months ended September 30, 2005, compared to 80.3% for the nine months ended September 30, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the near future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves.

Senior market policyholder benefits decreased $1.1 million, or 4.0%, to $26.4 million for the nine months ended September 30, 2005, from $27.5 million for the nine months ended September 30, 2004. This produced benefits to premium ratios of 82.2% for the nine months ended September 30, 2005, compared to 86.6% for the nine months ended September 30, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves, partially offset by an increase in open active claims due to an increase in the number of policies in force and the aging of our policyholders, which resulted
in increases in actual claims paid and additional claims reserves.

Acquired business policyholder benefits decreased $3.2 million, or 47.8%, to $3.5 million for the nine months ended September 30, 2005, from $6.7 million for the nine months ended September 30, 2004. This produced benefits to premium ratios of 140.0% for the nine months ended September 30, 2005, compared to 214.0% for the



20


nine months ended September 30, 2004. These benefits to premium ratios are affected by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases going forward. The benefits to premium ratio decreased as a result of this reduction in the increase in policy and contract reserves.

Insurance Commissions

Commission expenses increased $0.1 million, or 1.4%, to $7.3 million for the nine months ended September 30, 2005, from $7.2 million for the nine months ended September 30, 2004. The increase consists of normal increases related to increased renewal premiums.

General Insurance Expenses

General insurance expenses increased $11.4 million, or 58.2%, to $31.0 million for the nine months ended September 30, 2005, from $19.6 million for the nine months ended September 30, 2004. General insurance expenses for the nine months ended September 30, 2005, include approximately $10.0 million of incremental costs associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel, occupancy costs, infrastructure development, back-office expenses, director and officer and related types of insurance coverage, and costs associated with being a public company  Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other
relevant factors. During the nine months ended September 30, 2005, we incurred $0.4 million in defense costs related to the ReliaStar Litigation and shut down costs of $0.3 million associated with the sale of our senior market insurance Ft. Myers agency office. We also incurred deferred compensation expenses of $0.1 million associated with the increase in market value of the deferred compensation plan. The deferred compensation expenses are directly offset with realized gains of the same amount.

Insurance Taxes, Licenses and Fees

Insurance taxes, licenses and fees increased $0.2 million, or 5.9%, to $3.6 million for the nine months ended September 30, 2005, from $3.4 million for the nine months ended September 30, 2004. Employment taxes related to additional staffing are the primary drivers of the nine months increase.

Amortization of DAC and VOBA

First year commissions and general insurance expenses associated with the acquisition of new business are deferred and amortized over the premium-paying period of the related policies. The total deferrals of policy acquisition costs were $11.2 million and $9.8 million for the nine months ended September 30, 2005 and 2004, respectively. The increase in deferrals was primarily due to the increase in net new premiums in the worksite segment somewhat offset by the decrease in net new long-term care premiums in the senior market.

Our predecessor assigned a value to the insurance in force of acquired companies or blocks of insurance business at the date of acquisition. No companies or blocks of business were acquired in the nine months ended September 30, 2005 or 2004.

The amortization of deferred acquisition costs (DAC) and the value of business acquired (VOBA) decreased $4.0 million, or 58.8%, to $2.8 million for the nine months ended September 30, 2005, from $6.8 million for the nine months ended September 30, 2004. In accordance with GAAP purchase accounting requirements, our predecessors DAC and VOBA were eliminated, and a new VOBA was established for the value of the in-force business as of December 31, 2004. This adjustment resulted in decreased DAC and VOBA balances, which cause smaller amortization charges going forward, as evidenced by the $4.0 million amortization decrease in the nine months ended September 30, 2005, compared to the nine months ended September 30, 2004.



21


Provision for Income Taxes

Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carrybacks available. The effective income tax rates for the nine months ended September 30, 2004, and 2005 were 34.1% and 31.7% respectively. The variations in these rates is due to the fact that a portion of our consolidated income for the nine months ended September 30, 2005 resulted from a subsidiary that has net operating loss carrybacks available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the tax on the net income from this subsidiary has been offset by the release of the associated valuation allowance, which reduces the effective tax rate for the consolidated company.

Three Months Ended September 30, 2005, Compared to Three Months Ended September 30, 2004


Financial Results OverviewNet income for the three months ended September 30, 2005, decreased $2.3 million, or 63.9%, to $1.3 million from $3.6 million for the three months ended September 30, 2004. Contributing factors were increases in premiums and net investment income offset by an increase in general expenses and a decrease in realized investment gains, all of which are described in greater detail below. A decrease in pre-tax realized investment gains of $4.3 million, as discussed below, was a primary contributing factor.

Revenues

Total revenues for the three months ended September 30, 2005, decreased $2.0 million, or 4.9% to $38.8 million from total revenues of $40.8 million for the three months ended September 30, 2004. The primary factors causing the fluctuations are explained below under the captions Premiums, Net Investment Income, Commission and Fee Income, Realized Investment Gains and Losses and Other Income.

Premiums

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


For the Three Months Ended September 30,2004
        
        2005
        
        Increase (decrease)Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        Total
        
        Worksite
        
        Senior
        
        Acquired
        
        TotalDirectNew
        
        $
        3.4
        
        $
        0.8
        
        $
        
        
        $
        4.2
        
        $
        4.9
        
        $
        0.5
        
        $
        
        
        $
        5.4
        
        $
        1.5
        
        $
        (0.3
        )
        $
        
        
        $
        1.2Renewal
        
        
        11.2
        
        
        12.6
        
        
        
        
        
        23.8
        
        
        11.2
        
        
        13.3
        
        
        
        
        
        24.5
        
        
        
        
        
        0.7
        
        
        
        
        
        0.7Total
        
        
        14.6
        
        
        13.4
        
        
        
        
        
        28.0
        
        
        16.1
        
        
        13.8
        
        
        
        
        
        29.9
        
        
        1.5
        
        
        0.4
        
        
        
        
        
        1.9AssumedNew
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        
        Renewal
        
        
        
        
        
        
        
        
        0.9
        
        
        0.9
        
        
        
        
        
        
        
        
        0.9
        
        
        0.9
        
        
        
        
        
        
        
        
        
        
        
        Total
        
        
        
        
        
        
        
        
        0.9
        
        
        0.9
        
        
        
        
        
        
        
        
        0.9
        
        
        0.9
        
        
        
        
        
        
        
        
        
        
        
        CededNew
        
        
        (0.2
        )
        
        (0.6
        )
        
        
        
        
        (0.8
        )
        
        (0.8
        )
        
        (0.3
        )
        
        
        
        
        (1.1
        )
        
        (0.6
        )
        
        0.3
        
        
        
        
        
        (0.3
        )Renewal
        
        
        (0.3
        )
        
        (2.7
        )
        
        0.1
        
        
        (2.9
        )
        
        (0.2
        )
        
        (3.1
        )
        
        
        
        
        (3.3
        )
        
        0.1
        
        
        (0.4
        )
        
        (0.1
        )
        
        (0.4
        )Total
        
        
        (0.5
        )
        
        (3.3
        )
        
        0.1
        
        
        (3.7
        )
        
        (1.0
        )
        
        (3.4
        )
        
        
        
        
        (4.4
        )
        
        (0.5
        )
        
        (0.1
        )
        
        (0.1
        )
        
        (0.7
        )NetNew
        
        
        3.2
        
        
        0.2
        
        
        
        
        
        3.4
        
        
        4.1
        
        
        0.2
        
        
        
        
        
        4.3
        
        
        0.9
        
        
        
        
        
        
        
        
        0.9Renewal
        
        
        10.9
        
        
        9.9
        
        
        1.0
        
        
        21.8
        
        
        11.0
        
        
        10.2
        
        
        0.9
        
        
        22.1
        
        
        0.1
        
        
        0.3
        
        
        (0.1
        )
        
        0.3Total
        
        
        14.1
        
        
        10.1
        
        
        1.0
        
        
        25.2
        
        
        15.1
        
        
        10.4
        
        
        0.9
        
        
        26.4
        
        
        1.0
        
        
        0.3
        
        
        (0.1
        )
        
        1.2(dollars in millions)





22


Worksite net new premiums increased $0.9 million, or 28.1%, to $4.1 million for the three months ended September 30, 2005, from $3.2 million for the three months ended September 30, 2004, due to increased sales volumes. New sales increased $0.6 million, or 19.4%, to $3.7 million for the three months ended September 30, 2005, from $3.1 million for the three months ended September 30, 2004, due to increased emphasis on this core business segment. Net renewal premiums increased $0.1 million, or 0.9%, due to the increased amount of insurance in force created by prior year sales.

Senior market net new premiums, comprised of long term care policies, remained unchanged at $0.2 million for the three months ended September 30, 2005, from $0.2 million for the three months ended September 30, 2004. New sales decreased $0.1 million, or 20.0%, to $0.4 million for the three months ended September 30, 2005, from $0.5 million for the three months ended September 30, 2004, due to the continuation of a sales decline that began in mid-2003, resulting from the discontinuance of an older product and the introduction of a new product with significantly higher premiums.  Also contributing to the sales decline was our announcement earlier this year that we intend to sell or otherwise dispose of the Ft. Myers agency office and our announcement that we will stop actively underwriting new long term care insurance policies after December 31, 2005. Net renewal premiums increased $0.3
million, or 3.0%, due to the increased amount of insurance in force created by prior sales. This increase is reflected in both the direct renewal premiums and the ceded renewal premiums.

Acquired business premiums decreased $0.1 million, or 10.0%, to $0.9 million for the three months ended September 30, 2005, from $1.0 million for the three months ended September 30, 2004. We and our predecessor have not acquired any blocks of business since 1999 and the decline is a result of policy lapses.

Net Investment Income

Net investment income for the three months ended September 30, 2005, increased by $0.2 million from the three months ended September 30, 2004. Net investment income is primarily affected by changes in levels of invested assets and interest rates. For the three months ended September 30, 2005, average cash and investments  increased by $109.5 million, or 22.8%, to $589.7 million  from $480.2 million in the three months ended September 30, 2004. Although average cash and investments increased significantly during the three month period, net investment income only increased slightly primarily because of the shorter duration of invested assets during the three months ended September 30, 2005. As a result, the average yield on cash and invested assets on an amortized cost basis was 4.81% for the three months ended September 30, 2005, compared to an average yield of 5.71% for the three months
ended September 30, 2004.

In conjunction with the application of GAAP purchase accounting requirements, assets attributed to the worksite insurance business, the senior insurance business and the acquired business all increased significantly, as evidenced by a comparison of segment assets in the segment tables shown in Note 8., Business Segments, from September 30, 2004, to September 30, 2005.

Commission and Fee Income

Commission and fee income increased $0.5 million, or 15.2%, to $3.8 million for the three months ended September 30, 2005, from $3.3 million for the three months ended September 30, 2004. Most of the commission and fee income was from administrative fees relating to third-party administration, and the increase was due to an increase in business in force relating to increased sales of administrative services.

Realized Investment Gains and Losses

Realized investment gains and losses occur as a result of the sale or impairment of investments. The net realized investment gain for the three months ended September 30, 2005, decreased by $4.3 million to $0.3 million, from $4.6 million for the three months ended September 30, 2004. The net gain realized on fixed maturity securities for the three months ended September 30, 2005, totaled $0.1 million compared to a net gain realized on fixed maturity securities of $2.2 million for the three months ended September 30, 2004. The net gain realized on equity securities for the three months ended September 30, 2005, totaled $0.0 million compared to a net gain realized on equity securities of $2.4 million for the three months ended September 30, 2004. The net gain realized on other



23


investments for the three months ended September 30, 2005, totaled $0.1 million compared to a net gain realized on other investments of $0.0 million for the three months ended September 30, 2004. Other investments represent the assets purchased to support the deferred compensation liability of the company, and realized gains and or losses are directly offset with increases and or decreases in compensation expenses. Realized investment gains and losses are allocated entirely to the corporate and other business segment.

Other Income

Other income increased $0.4 million, or 50.0%, to $1.2 million for the three months ended September 30, 2005, from $0.8 million for the three months ended September 30, 2004. In the three months ended September 30, 2005, other income includes $0.3 million of proceeds from litigation settlements, resulting from our participation in various class action litigation. The remaining increases reflect increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums.

Benefits and Expenses

Total benefits and expenses increased $1.6 million, or 4.5%, to $36.8 million for the three months ended September 30, 2005, from $35.2 million for the three months ended September 30, 2004. The primary factors causing this increase are explained below under the captions Policyholder Benefits, Insurance Commissions, General Insurance Expenses, Insurance Taxes, Licenses and Fees, and Amortization of DAC and VOBA.

Policyholder Benefits

Policyholder benefits increased $0.2 million, or 0.9%, to $21.9 million for the three months ended September 30, 2005, from $21.7 million for the three months ended September 30, 2004. This produced a benefits to premium ratio of 82.8% for the three months ended September 30, 2005, compared to 85.8% for the three months ended September 30, 2004. The benefits to premium ratio declined primarily as a result of the GAAP purchase accounting adjustments described in the next three paragraphs.

Worksite marketing policyholder benefits increased $0.7 million, or 6.5%, to $11.5 million for the three months ended September 30, 2005, from $10.8 million for the three months ended September 30, 2004. This produced benefits to premium ratios of 76.1% for the three months ended September 30, 2005, compared to 76.8% for the three months ended September 30, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves, partially offset by higher benefit ratios in certain disability income cases.

Senior market policyholder benefits remained unchanged at $8.8 million for the three months ended September 30, 2005, from $8.8 million for the three months ended September 30, 2004. This produced benefits to premium ratios of 85.2% for the three months ended September 30, 2005, compared to 87.1% for the three months ended September 30, 2004. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases in the future. The benefits to premium ratio decreased primarily as a result of this reduction in the increase in policy and contract reserves, partially offset by an increase in open active claims due to an increase in the number of policies in force and the aging of our policyholders, which resulted in increases
in actual claims paid and additional claims reserves.



24


Acquired business policyholder benefits decreased $0.5 million, or 25.0%, to $1.5 million for the three months ended September 30, 2005, from $2.0 million for the three months ended September 30, 2004. This produced benefits to premium ratios of 164.0% for the three months ended September 30, 2005, compared to 197.8% for the three months ended September 30, 2004. These benefits to premium ratios are affected by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves. In accordance with GAAP purchase accounting requirements, policy and contract reserves were recorded at fair value on December 31, 2004. This adjustment produced increased reserve balances, which should result in smaller reserve increases going forward. The benefits to premium ratio decreased as a result of this reduction in the increase in policy
and contract reserves.

Insurance Commissions

Commission expenses decreased $0.2 million, or 8.3%, to $2.2 million for the three months ended September 30, 2005 from $2.4 million for the three months ended September 30, 2004. The decrease resulted from an increase in direct commissions of $0.2 million offset by an increase in ceded commissions of $0.4 million, which are generated from the fluctuations in direct and ceded premiums.

General Insurance Expenses

General insurance expenses increased $3.2 million, or 45.1%, to $10.3 million for the three months ended September 30, 2005, from $7.1 million for the three months ended September 30, 2004. General insurance expenses for the three months ended September 30, 2005, include approximately $3.5 million of incremental costs associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel, occupancy costs, infrastructure development, back-office expenses, director and officer and related types of insurance coverage, and costs associated with being a public company  Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other
relevant factors. During the three months ended September 30, 2005, we incurred $0.2 million in defense costs related to the ReliaStar Litigation and shut down costs of $0.3 million associated with the sale of the Fort Myers agency. We also incurred deferred compensation expenses of $0.1 million associated with the increase in market value of the deferred compensation plan. The deferred compensation expenses are directly offset with realized gains of the same amount.

Insurance Taxes, Licenses and Fees

Insurance taxes, licenses and fees increased $0.1 million, or 9.1%, to $1.2 million for the three months ended September 30, 2005, from $1.1 million for the three months ended September 30, 2004. Employment taxes related to additional staffing are the primary drivers of the increase.

Amortization of DAC and VOBA

First year commissions and general insurance expenses associated with the acquisition of new business are deferred and amortized over the premium-paying period of the related policies. The total deferrals of policy acquisition costs were $4.0 million and $3.2 million for the three months ended September 30, 2005 and 2004, respectively. The increase in deferrals was primarily due to the increase in net new premiums in the worksite segment somewhat offset by the decrease in net new long-term care premiums in the senior market.

Our predecessor assigned a value to the insurance in force of acquired companies or blocks of insurance business at the date of acquisition. No companies or blocks of business were acquired in the three months ended September 30, 2005 or 2004.

The amortization of DAC and VOBA decreased $2.0 million, or 80.0%, to $0.5 million for the three months ended September 30, 2005, from $2.5 million for the three months ended September 30, 2004. In accordance with GAAP purchase accounting requirements, our predecessors DAC and VOBA were eliminated, and a new VOBA was established for the value of the in-force business as of December 31, 2004. This adjustment resulted in



25


decreased DAC and VOBA balances, which cause smaller amortization charges going forward, as evidenced by the $2.0 million amortization decrease in the three months ended September 30, 2005, compared to the three months ended September 30, 2004.

Provision for Income Taxes

Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carrybacks available. The effective income tax rates for the three months ended September 30, 2004, and 2005 were 35.6% and 32.1% respectively. The variations in these rates is due to the fact that a portion of our consolidated income for the three months ended September 30, 2005 resulted from a subsidiary that has net operating loss carrybacks available. Due to the uncertainty of using these net operating losses, a valuation allowance had been established offsetting the deferred tax asset; therefore, the net income from this subsidiary has a tax rate of zero due to the use of net operating losses to offset taxable income incurred, which reduces the effective tax rate for the consolidated company.

Liquidity and Capital Resources

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

For 2005, the maximum amount of dividends that Kanawha can pay to KMG America under applicable laws and regulations without prior regulatory approval is $8.4 million. If KMG America is able to successfully execute its business plan and accelerate Kanawhas earnings growth in its insurance operations, KMG America expects that the maximum allowable dividend from Kanawha to the holding company will increase at an accelerated rate year-over-year. If the ability of Kanawha to pay dividends or make other payments to KMG America is materially restricted by regulatory requirements, it could adversely affect KMG Americas ability to pay any dividends on its common stock and/or service its debt and pay its other corporate expenses.

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

As of September 30, 2005, KMG America had outstanding debt of approximately $15.6 million because a portion of the purchase price for the Kanawha acquisition was paid in the form of a $15.0 million subordinated promissory note with a five-year term beginning on the closing date of the acquisition. Interest on the promissory note is accruing at 5% per annum and is added to the principal balance on December 31 of each year and is payable on the maturity date. No cash payments are required under the promissory note until maturity, at which time approximately $19.1 million of principal and accrued interest will be due and payable. The terms of the promissory note limit KMG Americas and Kanawhas ability to incur additional debt. KMG America maintains a $2.0 million line of credit available to meet short-term cash flow needs.



26


We are not currently planning to make any other significant capital expenditures or acquisitions in 2005 or subsequent years. However, we plan to significantly expand outlays relating to marketing and sales activities over the next several years including outlays required to build a national sales organization, which is a key component of our strategy. These outlays will include expenses such as salaries and cash incentive compensation, employee benefits, occupancy and information technology expenses of additional sales personnel, advertising and marketing costs, consulting and recruiting. The execution of our business plan will require additional outlays associated with the development of a national insurance company including home office expenses for executive management and additional financial, actuarial and underwriting personnel, infrastructure development and back-office expenses,
as well as costs associated with our being a public company.

We anticipate that these costs will be offset over time by increased sales production resulting from hiring additional sales personnel and increased cross-selling, as well as efficiencies resulting from greater scale. However, during 2005, we do not expect that the anticipated costs described above to implement our business strategy will be offset by incremental revenues, resulting in an aggregate net use of cash in 2005. As of September 30, 2005, we had disbursed approximately $9.8 million of those costs, net of investment income. We expect that net incremental cash flows resulting from the increased sales production and efficiencies anticipated from our new business strategy will be positive after 2005 but can provide no assurance that this will occur.

Analysis of Change in Financial Condition and Cash Flows

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

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

The table below shows our predecessors and our net cash flows in the indicated periods:


Predecessor
        
        KMG AmericaFor the Nine Months Ended September 30,Net cash provided by (used in):
        
        2004
        
        2005(dollars in thousands)Operating activities
        
        $
        14,358.6
        
        $
        23,179.0Investing activities
        
        
        7,669.2
        
        
        (122,955.3
        )Financing activities
        
        
        
        
        
        Net change in cash
        
        $
        22,027.8
        
        $
        (99,776.3
        )

Cash Flows for the Nine Months Ended September 30, 2004 and 2005.In the table shown above, increases in net cash provided by operating activities generally result from collected premiums while decreases in net cash flow provided by investing activities generally are a result of the investment of collected premiums. Policy and contract liabilities increase when premiums collected are retained to establish policy reserves. The portions of these liabilities that are reinsured by reinsurance companies are reflected in reinsurance balances recoverable.

Other changes in cash flows for the nine months ended September 30, 2004, and September 30, 2005, are as follows:

We held approximately $117.4 million in cash at December 31, 2004, primarily consisting of cash proceeds from sales and maturities of our invested assets and from our initial public offering of common stock. We invested a significant portion of this cash in the first nine months of 2005, resulting in the net cash outflow from investing activities of $123.0 million for the nine months ended September 30, 2005. This produced a corresponding increase in invested assets.



27


Other assets increased by $14.4 million in the nine months ended September 30, 2004, primarily representing a $14.0 million receivable for a securities trade that had not settled as of September 30. Other assets decreased by $3.5 million in the nine months ended September 30, 2005, primarily as a result of the receipt of $2.2 million of securities trade receivables as of December 31, 2004 and the receipt of other miscellaneous receivables of $1.4 million that represent routine timing of payments and receipts.

Accounts payable and accrued expenses increased by $7.0 million in the nine months ended September 30, 2004, primarily due to a $6.7 million increase in reinsurance settlements due related to the acquired business. These balances increased by $14.1 million in the nine months ended September 30, 2005, primarily resulting from the purchase of $12.6 million of securities in which the settlement had not occurred as of September 30 in addition to a $1.8 million increase in reinsurance settlements due related to the acquired business.

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

Federal income tax recoverable increased by $1.2 million as a result of losses incurred in Kanawha Insurance Company that will be carried back to prior years. The deferred tax asset increased by $4.8 million and the deferred tax liability increased by $5.8 million. The combination of the three items resulted in a net decrease in tax liabilities of $0.2 million, inclusive of a decrease of $1.7 million related to the decrease in fair market value of invested assets.

Investments

The following table summarizes the unrealized gains and losses in our investment portfolio as of September 30, 2005. Effective December 31, 2004, the Company recorded the Predecessors investments at fair value and thereby eliminated all unrealized gains and losses in the Predecessors portfolio, as part of the application of GAAP purchase accounting requirements.




Amortized Cost
        
        GrossUnrealizedGains
        
        GrossUnrealizedLosses
        
        FairValueAvailable for sale securities at September 30, 2005:U.S. treasury securities
        
        $
        8,118,859
        
        $
        
        
        $
        118,775
        
        $
        8,000,084U.S. government agency securities
        
        
        30,294,615
        
        
        108,943
        
        
        237,684
        
        
        30,165,874States and political subdivision securities
        
        
        14,386,707
        
        
        62,487
        
        
        69,215
        
        
        14,379,979Foreign bonds
        
        
        36,974,837
        
        
        136,264
        
        
        457,995
        
        
        36,653,106Corporate bonds
        
        
        188,359,609
        
        
        807,892
        
        
        3,816,323
        
        
        185,351,178Mortgage/asset-backed securities
        
        
        245,934,141
        
        
        757,220
        
        
        1,668,875
        
        
        245,022,486Preferred stocksredeemable
        
        
        10,321,562
        
        
        
        
        
        249,883
        
        
        10,071,679Subtotal, fixed maturity securities
        
        
        534,390,330
        
        
        1,872,806
        
        
        6,618,750
        
        
        529,644,386Equity securities
        
        
        36,000
        
        
        
        
        
        17,500
        
        
        18,500Securities available for sale
        
        $
        534,426,330
        
        $
        1,872,806
        
        $
        6,636,250
        
        $
        529,662,886

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



28


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

At September 30, 2005, all securities in a continuous loss position for more than six months were reviewed for potential impairments, with decisions made specifically for each security. In the third quarter of 2005, other than temporary impairments were recognized on two securities, Delta Airlines and NWA (Northwest Airlines) Leasing, resulting in total impairment charges of $0.2 million. These impairments were recognized in light of bankruptcy filings and rating downgrades that occurred in the quarter.

Critical Accounting Policies and Estimates

Our consolidated financial statements and certain disclosures made in this report have been prepared in accordance with GAAP and require us to make estimates and assumptions that affect reporting amounts of assets and liabilities and contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment (identified as the critical accounting policies) are those used in determining investment impairments, the reserves for future policy benefits and claims, deferred acquisition costs and value of business acquired, and the provision for income taxes. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure our performance. These
estimates have a material effect on our results of operations and financial condition. For more information about our critical accounting policies, please refer to our discussion of critical accounting policies in our Annual Report on Form 10-K for the year ended December 31, 2004.

Forward-Looking Statements

Forward-looking statements in the foregoing Managements Discussion and Analysis of Financial Condition and Results of Operations include statements that are identified by the use of words or phrases including, but not limited to, the following: will likely result, expected to, will continue, is anticipated, estimated, project, believe, expect, and words or phrases of similar import. Changes in the following important factors, among others, could cause our actual results to differ materially from those expressed in any such forward-looking statements: competitive products and pricing; fluctuations in demand; possible recessionary trends in the United States economy; governmental policies and regulations; interest rates; risks disclosed in Exhibit 99.01 to our Annual Report on Form 10-K
for the year ended December 31, 2004; and other risks that are detailed from time to time in reports we file with the Securities and Exchange Commission.


ITEM 3.
        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.There are no material changes to the disclosure on this matter made in our Annual Report on Form 10-K for the year ended December 31, 2004.




ITEM 4.
        CONTROLS AND PROCEDURES.We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management timely. An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief



29


Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of September 30, 2005. Based upon that evaluation, our management, including our Chief Executive Officer and our Chief Financial Officer, concluded that our disclosure controls and procedures were effective as of September 30, 2005. There was no change in our internal control over financial reporting during the quarter ended September 30, 2005, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II

OTHER INFORMATION


ITEM 1.
        LEGAL PROCEEDINGS.The disclosure made in the first two paragraphs of Note 7., Commitments and Contingencies, of the Notes to Consolidated Financial Statements included in this report, which discuss certain legal proceedings in which we are involved, is incorporated herein by reference.


ITEM 2.
        UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

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



        $130.0 million of the net proceeds were used to fund the cash portion of the purchase price to acquire all of the outstanding common stock of Kanawha, and approximately $0.8 million of the net proceeds was used to pay our fees and expenses incurred in connection with the Kanawha acquisition.
        Approximately $9.8 million of the net proceeds were used to fund negative cash flow associated with initial start-up costs and other expenditures, including expenditures to open our principle executive offices in Minneapolis, Minnesota and regional sales offices in selected locations throughout the United States and to hire and train additional sales and support staff and marketing personnel at these new facilities.
        The remaining net proceeds, approximately $47.4 million, were invested in short- and long-term, fixed maturity, interest bearing investments to be used for working capital needs and other general corporate purposes, including, among other things, (i) to fund additional start-up costs and other expenditures, including opening additional facilities in selected locations throughout the United States and to hire and train additional sales and support staff and marketing personnel at these new facilities and (ii) to maintain the required capital of Kanawha, our insurance subsidiary, at the level necessary to achieve our desired rating agency financial strength ratings and to comply with applicable regulatory requirements as we grow our insurance business.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 the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.




KMG AMERICA CORPORATION
(Registrant)Date:  November 14, 2005
        By:
        /s/ Scott H. DeLong IIIName: Scott H. DeLong IIITitle: Senior Vice President & Chief Financial Officer(Principal Financial Officer)Date:  November 14, 2005
        By:
        /s/ Robert E. MatthewsName: Robert E. MatthewsTitle: Executive Vice President, Chief Financial Officer &Treasurer of Kanawha Insurance Company(Principal Accounting Officer)





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