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 March 31, 2007

OR

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



For the transition period fromto



Commission file number:001-32377



KMG AMERICA CORPORATION

(Exact Name of Registrant as Specified in Its Charter)



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




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



Former name, former address and former fiscal year, if changed since last report:



Indicate by check mark whether the registrant:  (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.xYes  o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of  accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer oAccelerated filerxNon-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  o YesxNo



As of May 3, 2007, the number of shares of Common Stock outstanding was 22,327,319.

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TABLE OF CONTENTS



ITEM NO.
        PAGE NO.PART I. FINANCIAL INFORMATION
        1ITEM 1. FINANCIAL STATEMENTS
        1CONSOLIDATED BALANCE SHEETS AS OF MARCH 31, 2007 (UNAUDITED) AND DECEMBER 31, 2006
        1CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED) FOR THE QUARTERS ENDED MARCH 31, 2007 AND 2006
        3CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)FOR THE QUARTERS ENDED MARCH 31, 2007 AND 2006
        4NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
        5ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
        19ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
        33ITEM 4. CONTROLS AND PROCEDURES
        33PART II. OTHER INFORMATION
        34ITEM 1. LEGAL PROCEEDINGS
        34ITEM 1A. RISK FACTORS
        34ITEM 6. EXHIBITS
        38SIGNATURES
        39








i

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PART I

FINANCIAL INFORMATION



ITEM 1.
        FINANCIAL STATEMENTS




KMG AMERICA CORPORATION

CONSOLIDATED BALANCE SHEETS





March 31,
        
        December 31,2007
        
        2006Assets
        
        
        (unaudited)Investments:Fixed maturity securities available for sale, at fair value (amortized cost of $547,612,178 and $531,477,537 as of March 31, 2007 and December 31, 2006, respectively)
        
        $
        537,512,821
        
        $
        520,624,942Equity securities available for sale, at fair value (cost of $156,840 and $101,945 as of March 31, 2007 and December 31, 2006, respectively)
        
        
        156,340
        
        
        103,545Mortgage loans
        
        
        13,463,447
        
        
        13,921,019Policy loans
        
        
        17,954,398
        
        
        18,163,223Investment in subsidiary
        
        
        1,083,000
        
        
        Other investments
        
        
        5,465,263
        
        5
        5,523,232Total investments
        
        
        575,635,269
        
        
        558,335,961Cash and cash equivalents
        
        
        45,729,559
        
        
        21,744,137Reinsurance balances recoverable
        
        
        89,553,370
        
        
        89,091,232Accrued investment income
        
        
        6,740,007
        
        
        6,502,801Real estate and equipment (net of accumulated depreciation of $4,198,105 and $3,652,073 as of March 31, 2007 and December 31, 2006, respectively)
        
        
        15,667,992
        
        
        15,068,506Federal income tax recoverable
        
        
        5,111,539
        
        
        5,111,539Deferred income tax asset
        
        
        324,581
        
        
        6,578,604Amounts due from reinsurers
        
        
        3,918,984
        
        
        2,906,176Deferred policy acquisition costs
        
        
        31,813,267
        
        
        28,453,929Value of business acquired
        
        
        69,671,397
        
        
        70,766,211Other assets
        
        
        25,417,928
        
        
        27,154,750Total assets
        
        $
        869,583,893
        
        $
        831,713,846






1

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KMG AMERICA CORPORATION

CONSOLIDATED BALANCE SHEETS



March 31,
        
        December 31,2007
        
        2006(unaudited)Liabilities and shareholders equityLiabilities:Policy and contract liabilities:Life and annuity reserves
        
        $
        250,555,522
        
        $
        252,658,190Accident and health reserves
        
        
        298,802,779
        
        
        294,581,002Policy and contract claims
        
        
        24,215,663
        
        
        14,530,782Other policyholder liabilities
        
        
        10,849,778
        
        
        10,594,225Total policy and contract liabilities
        
        
        584,423,742
        
        
        572,364,199Accounts payable and accrued expenses
        
        
        27,360,742
        
        
        24,497,525Taxes, other than federal income taxes
        
        
        672,549
        
        
        1,037,508Federal income taxes accrued
        
        
        15,889
        
        
        523,889Deferred income taxes
        
        
        13,707,209
        
        
        14,735,262Liability for benefits for employees and agents
        
        
        5,884,520
        
        
        5,847,970Funds held in suspense
        
        
        3,005,606
        
        
        4,832,579Notes payable
        
        
        14,000,000
        
        
        14,000,000Interest payable on note
        
        
        25,700
        
        
        50,350Subordinated debt securities
        
        
        36,083,000
        
        
        Interest payable on subordinated debt
        
        
        77,972
        
        
        Other liabilities
        
        
        1,673,773
        
        
        1,773,077Total liabilities
        
        
        686,930,702
        
        
        639,662,359Shareholders equity:Common Stock, par value $0.01 per share, 75,000,000 shares authorized and 22,213,685 and 22,211,589 shares issued and outstanding as of March 31, 2007 and December 31, 2006, respectively
        
        
        222,137
        
        
        222,116Paid-in capital
        
        
        189,527,616
        
        
        189,150,959Retained earnings
        
        
        1,439,715
        
        
        11,702,929Accumulated other comprehensive loss
        
        
        (8,536,277
        )
        
        (9,024,517
        )Total shareholders equity
        
        
        182,653,191
        
        
        192,051,487Total liabilities and shareholders equity
        
        $
        869,583,893
        
        $
        831,713,846


See accompanying notes.

2

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KMG AMERICA CORPORATION

CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)



Quarter EndedMarch 31, 2007
        
        Quarter EndedMarch 31, 2006Revenue:Insurance premiums
        
        $
        39,915,908
        
        $
        29,810,626Net investment income
        
        
        7,875,667
        
        
        7,206,068Commission and fee income
        
        
        4,168,149
        
        
        4,219,115Realized investment (losses) gains
        
        
        (52,908
        )
        
        211,107Other income
        
        
        1,059,068
        
        
        986,533Total revenues
        
        
        52,965,884
        
        
        42,433,449Benefits and expenses:Policyholder benefits
        
        
        37,542,622
        
        
        23,353,714Insurance commissions, net of deferrals
        
        
        4,152,444
        
        
        2,981,285General insurance expenses, net of deferrals
        
        
        12,170,117
        
        
        10,893,351Insurance taxes, licenses and fees
        
        
        1,615,015
        
        
        1,515,052Depreciation and amortization
        
        
        705,147
        
        
        640,866Amortization of deferred policy acquisition costs and value of business acquired
        
        
        2,080,681
        
        
        1,178,101Total benefits and expenses
        
        
        58,266,026
        
        
        40,562,369(Loss) income before income taxes
        
        
        (5,300,142
        )
        
        1,871,080Provision for income taxes
        
        
        (4,963,071
        )
        
        (634,883
        )Net (loss) income
        
        $
        (10,263,213
        )
        $
        1,236,197Net income per share:Basic
        
        $
        (.46
        )
        $
        .06Diluted
        
        $
        (.46
        )
        $
        .06Weighted-average shares outstanding:Basic
        
        
        22,211,761
        
        
        22,133,240Diluted
        
        
        22,258,099
        
        
        22,138,078




See accompanying notes.



3

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KMG AMERICA CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOW (UNAUDITED)



Quarter EndedMarch 31, 2007
        
        Quarter EndedMarch 31, 2006Operating ExpensesNet (loss) income
        
        $
        (10,263,213
        )
        $
        1,236,197Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities:Depreciation and amortization
        
        
        1,093,546
        
        
        1,222,193Policy acquisition costs deferred
        
        
        (4,345,205
        )
        
        (3,810,992
        )Amortization of deferred policy acquisition costsand value of business acquired
        
        
        2,080,681
        
        
        1,178,101Realized investment losses (gains), net
        
        
        52,908
        
        
        (211,107
        )Deferred income tax expense
        
        
        4,963,072
        
        
        632,537Changes in operating assets and liabilities:Reinsurance balances recoverable
        
        
        (462,138
        )
        
        (3,030,874
        )Accrued investment income
        
        
        (237,205
        )
        
        (80,351
        )Other assets
        
        
        1,736,822
        
        
        (3,036,002
        )Amounts due from reinsurers
        
        
        (1,012,808
        )
        
        (245,444
        )Policy and contract liabilities
        
        
        12,059,543
        
        
        6,833,156Accounts payable and accrued expenses
        
        
        2,863,217
        
        
        (385,214
        )Interest payable
        
        
        53,322
        
        
        196,875Stock-based compensation expense
        
        
        376,678
        
        
        303,951Taxes, other than federal income taxes
        
        
        (364,959
        )
        
        (123,603
        )Federal income taxes accrued
        
        
        (508,000
        )
        
        Funds held in suspense
        
        
        (1,826,973
        )
        
        (1,031,286
        )Liability for benefits for employees and agents
        
        
        36,550
        
        
        (232,517
        )Other liabilities
        
        
        (99,304
        )
        
        (67,468
        )Net cash provided by (used in) operating activities
        
        
        6,196,534
        
        
        (651,848
        )Investing activitiesSecurities available for sale:Sales
        
        
        7,144,945
        
        
        646,599Maturities, calls and redemptions
        
        
        7,744,830
        
        
        6,119,115Purchases
        
        
        (31,621,765
        )
        
        (27,097,921
        )Repayments of mortgage loans
        
        
        457,572
        
        
        725,545Decrease in policy loans, net
        
        
        208,824
        
        
        311,116Investment in subsidiary
        
        
        (1,083,000
        )
        
        Purchases of real estate, property and equipment
        
        
        (1,145,518
        )
        
        (1,274,228
        )Net cash (used in) investing activities
        
        
        (18,294,112
        )
        
        (20,569,774
        )Financing activitiesIssuance of subordinated debt securities
        
        
        36,083,000
        
        
        Net cash provided by (used in) financing activities
        
        
        36,083,000
        
        
        Net increase (decrease) in cash and cash equivalents
        
        
        23,985,422
        
        
        (21,221,622
        )Cash and cash equivalents at beginning of period
        
        
        21,744,137
        
        
        32,582,964Cash and cash equivalents at end of period
        
        $
        45,729,559
        
        $
        11,361,342Supplemental disclosures of cash flow informationFederal income taxes paid
        
        $
        508,000
        
        $
        






See accompanying notes.



4

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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



1.
        Organization and Nature of Operations




Unless the context requires otherwise, references to we, us, our, KMG America or the Company are intended to mean KMG America Corporation and its consolidated subsidiaries, including, without limitation, Kanawha Insurance Company (Kanawha). References to our predecessor mean Kanawha prior to it being acquired by KMG America.



KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. KMG America commenced operations shortly before it completed its initial public offering of common stock on December 21, 2004, and its shares trade on the New York Stock Exchange under the symbol KMA.  Concurrently with the completion of its initial public offering, KMG America completed its acquisition of Kanawha and its subsidiaries, which are KMG Americas primary operating subsidiaries and which underwrite and sell life and health insurance products.



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



The primary insurance products that the Company underwrites include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. The Company ceased actively underwriting new long-term care insurance policies after December 31, 2005.  The Company intends to retain and actively manage the Company's existing block of in force long-term care policies. The Company's third-party administration and medical management businesses include a wide array of services with the primary emphasis on the offering of administrative service-only products.



The Company's sales historically have been primarily in the southeastern United States, predominantly in Florida, South Carolina and North Carolina, but are now expanding nationwide. Sales are made through an internal sales force, full-time agents, general agents and brokers. Under the Companys current business strategy, the Company expects group lines of business to account for an increasing percentage of the Company's premium revenues.

2.
        Significant Accounting Policies


Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All significant intercompany accounts and transactions have been eliminated in consolidation. Operating results for the quarter ended March 31, 2007, are not necessarily indicative of the results that may be expected for the year ended December 31, 2007.

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

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.





5

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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Cash and Cash Equivalents

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

Investments

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

Investments are reported on the following basis:



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



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



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



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



Policy loans are stated at their unpaid balances.



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



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



Amortization of premiums and accrual of discounts on investments in fixed maturity securities is reflected in earnings over the contractual terms of the investments in a manner that produces a constant effective yield. Realized gains and losses on dispositions of securities are determined by the specific-identification method.



The Company regularly reviews its investment portfolio to identify securities that may have suffered impairments in value that will not be recovered, termed potentially distressed securities. In identifying potentially distressed securities, the Company first screens for all securities that have a fair value to cost or amortized cost ratio of less than 80%. Additionally, as part of this identification process, the Company utilizes the following information:




        length of time the fair value was below amortized cost;



        industry factors or conditions related to a geographic area negatively affecting the security;



        downgrades by a rating agency;



        past due interest or principal payments or other violation of covenants; and



        deterioration of the overall financial condition of the specific issuer.




In analyzing its potentially distressed securities list for other-than-temporary impairments, the Company pays special attention to securities that have been on the list for a period greater than six months. The Company



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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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



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

Real Estate and Equipment

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

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

Deferred Policy Acquisition Costs

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



For most insurance products, the amortization of deferred acquisition costs is recognized in proportion to the ratio of annual premium revenue to the total anticipated premium revenue, which gives effect to expected terminations. Deferred acquisition costs are amortized over the premium-paying period of the related policies. Anticipated premium revenue is determined using assumptions consistent with those utilized in the determination of liabilities for insurance reserves.



Value of Business Acquired

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



The amortization of value of business acquired is generally recognized using amortization schedules established at the time of the acquisitions based upon expected revenue.  The amortization is further impacted by actual-to-expected persistency adjustments which reflect our actual experience as it emerges over time relative to what we expected in the development of the amortization schedules.



Impairment of Long-Lived Assets



Long-lived assets include property and equipment, other intangible assets, systems development and other deferred costs and other assets. In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), the Company regularly evaluates whether events and circumstances have occurred which indicate that the carrying amount of long-lived assets may warrant revision or may not be recoverable. When factors indicate that long-lived assets should be evaluated for possible impairment, the Company uses an estimate of the future undiscounted net cash flows of the related business over the remaining life of the asset in measuring whether the carrying amount of the related asset is recoverable. To the extent these projections indicate that future undiscounted net cash flows are not sufficient to recover the carrying amounts of the related assets, the
underlying assets are written down by charges to expense so that the carrying amount is equal to fair value, primarily determined based on future discounted cash flows. In the opinion of management, the Companys long-lived assets are appropriately valued at March 31, 2007 and December 31, 2006.



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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Benefit Reserves

Insurance reserves for individual life insurance, individual accident and health insurance, group life insurance and group accident and health insurance are associated with earned premiums so as to recognize profits over the premium-paying period. This association is accomplished by recognizing the liabilities for insurance reserves on a net level premium method based on assumptions deemed appropriate at the date of issue as to future investment yield, mortality, morbidity, withdrawals and maintenance expenses, and including margins for adverse deviations. Interest assumptions are based on the Companys experience. Mortality, morbidity and withdrawal assumptions are based on recognized actuarial tables or the Companys experience, as appropriate. Life reserves are calculated using mean reserve factors. Accident and health reserves are calculated using mid-terminal reserve factors.
Benefit reserves for investment products are computed under a retrospective deposit method and represent policy account balances before applicable surrender charges. Policy benefits and claims that are charged to expense include benefit claims incurred in the period in excess of related policy account balances.



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



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



Claims and Claim Adjustment Expenses



Claim reserves relating to short duration contracts generally are recorded when insured events occur. The liability is based on the expected ultimate cost of settling the claims. The claims and benefits payable reserves include: (1) case base reserves for known but unpaid claims as of the balance sheet date; (2) incurred but not reported (IBNR) reserves for claims where the insured event has occurred but has not been reported as of the balance sheet date; and (3) loss adjustment expense reserves for the expected handling costs of settling the claims. Case base reserves and the IBNR reserves are recorded at an amount equal to the net present value of the expected future claims payments. Factors considered when setting IBNR reserves include patterns in elapsed time from claim incidence to claim reporting, and elapsed time from claim reporting to claim payment. Claim reserves
generally equal the Companys estimate, at the end of the current reporting period, of the present value of the liability for future benefits and expenses to be paid on claims incurred as of that date. A claim reserve for a specific claim is based on assumptions derived from historical experience as to claim duration, as well as the specific characteristics of the claimant such as benefits available under the policy, the benefit period, and the age and occupation of the claimant. Although considerable variability is inherent in such estimates, management believes that the reserves for claims and claim adjustment expenses are adequate. The estimates are continually reviewed and adjusted as necessary as experience develops or new information becomes known; such adjustments are included in current operations.



Reinsurance



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



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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Recognition of Revenue



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



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



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



Realized Capital Gains (Losses)



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



Recognition of Benefits



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

Share-Based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)) which requires the measurement and recognition of compensation expense for all share-based payment awards made to employees and directors including stock options and restricted common stock based on estimated fair values. SFAS 123(R) supersedes the Companys previous accounting for periods beginning in 2006.

The Company had adopted the disclosure-only requirements of SFAS No. 123,Accounting for Stock-Based Compensation(SFAS 123), as amended by FASB Statement No. 148,Accounting for Stock-Based Compensation-Transition and Disclosure(SFAS 148) through December 31, 2005. As permitted by the provisions of this Statement, the Predecessor accounted for stock-based compensation using the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and Related Interpretations("APB No. 25").  Accordingly, the Company recognized no compensation expense for stock option awards to employees or directors when the option exercise price was not less than the market value of the
stock at the date of award.

The Company adopted SFAS 123(R) using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of the Companys fiscal year 2006.  The Companys Consolidated Financial Statements as of December 31, 2006 reflect the impact of SFAS 123(R).  In accordance with the modified prospective transition method, the Companys Consolidated Financial Statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123(R).



SFAS 123(R) requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The Company has used a Black-Scholes option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Companys Consolidated Statement of Income.



On November 10, 2005, the Financial Accounting Standards Board (FASB) issued FASB Staff Position No. FAS 123(R)-3 Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.  The Company has elected to adopt the alternative transition method provided in the FASB Staff Position for



9

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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



calculating the tax effects of stock-based compensation pursuant to SFAS 123(R). The alternative transition method includes simplified methods to establish the beginning balance.



Defined Benefit Retirement Plan




In September 2006, the FASB issued SFAS No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans  An Amendment of FASB Statements No. 87, 88, 106, and 132R (SFAS No. 158).  SFAS No. 158 requires companies to (1) recognize as an asset or liability, the overfunded or underfunded status of defined pension and other postretirement benefit plans; (2) recognize changes in the funded status through other comprehensive income in the year in which the changes occur; (3) measure the funded status of defined pension and other postretirement benefit plans as of the date of the companys fiscal year-end; and (4) provide enhanced disclosures.  The provisions of SFAS No. 158 are effective for the Companys year-ending December 31, 2006.  The Company adopted SFAS 158 at December 31, 2006.



Income Taxes



Income taxes are computed using the liability method required by SFAS No. 109, Accounting for Income Taxes. Under this Statement, deferred tax assets and liabilities are determined based on the differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the differences are expected to reverse. Recorded amounts are adjusted to reflect changes in income tax rates and other tax law provisions as they become enacted.



Recently Issued Accounting Standards

In June 2006, the Financial Accounting Standards Board (FASB), issued Interpretation (FIN) No. 48, Accounting for Uncertainty in Income Taxes  an interpretation of FASB Statement 109. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return, and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company adopted FIN 48 effective January 1, 2007 and has determined that there is no material impact on its financial statements upon adoption.

In September 2005, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants (AcSEC) issued Statement of Position 05 -1 (SOP 05 -1), Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection with Modifications or Exchanges of Insurance Contracts. SOP 05 -1 provides guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in Statement of Financial Accounting Standards (SFAS) No. 97, Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and for Realized Gains and Losses from Sale of Investments. SOP 05 -1 defines an internal replacement as a modification in product benefits, features, rights, or coverages that occur by the exchange of a contract for a new contract, or by
amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. SOP 05 -1 is effective for internal replacements occurring in fiscal years beginning after December 15, 2006 with earlier adoption encouraged. Retrospective application of SOP 05 -1 to previously issued financial statements is not permitted. The Company adopted SOP 05-1 effective January 1, 2007 and determined that there was no material financial impact on its financial statements upon adoption.

3.
        Investments


Aggregate amortized cost, aggregate fair value and gross unrealized gains and losses of investments in fixed maturity and equity securities are summarized in the following table.







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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS





Amortized Cost
        
        GrossUnrealizedGains
        
        GrossUnrealizedLosses
        
        FairValueAvailable for sale securities at March 31, 2007:Fixed maturity securities
        
        $
        547,612,178
        
        $
        1,905,596
        
        $
        12,004,954
        
        $
        537,512,820Equity securities
        
        
        156,840
        
        
        
        
        
        500
        
        
        156,340Securities available for sale
        
        $
        547,769,018
        
        $
        1,905,596
        
        $
        12,005,454
        
        $
        537,669,160


4.
        Statutory Financial Information


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

Under South Carolina insurance regulations, Kanawha is required to maintain minimum capital of $1.2 million and minimum surplus of $1.2 million. Additionally, Kanawha is restricted as to amounts that can be transferred in the form of dividends, loans, or advances. While the South Carolina Insurance Department acknowledges distinctions between ordinary and extraordinary dividends, their approval is required before any dividend payments can be made.

5.
        Employee Benefits


Defined Benefit Retirement Plan

As of the dates indicated, the net periodic retirement benefit cost of the Companys defined benefit pension plan for the quarters presented included the following components:



Quarter EndedMarch 31, 2007
        
        Quarter EndedMarch 31, 2006Components of net periodic benefit cost:Service cost
        $
        
        
        $
        47,778Interest cost
        
        240,000
        
        
        232,510Expected return on plan assets
        
        (360,000)
        
        
        (309,641
        )Amortization of transition liability
        
        
        
        
        362Recognized net actuarial loss
        
        50,000
        
        
        52,646Net periodic benefit cost
        $
        (70,000)
        
        $
        23,655Curtailment Expense
        $
        
        
        $
        120,170




On January 31, 2006, the Company adopted two amendments to the defined benefit retirement plan that froze participation in the plan and froze accrual of any additional benefits under the plan. As of March 31, 2006, no new participants were allowed to enter the plan. Effective as of September 30, 2006, no additional benefits accrue under the plan with respect to service after that date. As a result, final average earnings will be determined as of September 30, 2006, for all future benefit payments, and will not be adjusted for future changes in employee compensation.



The curtailment expense recognized as a result of the plan freeze was $120,170 as of March 31, 2006.



Defined Contribution Plan

The Company offers a 401(k) qualified savings plan for which substantially all employees and agents are eligible.  Plan participants may contribute up to 15% of pretax annual compensation, which includes overtime, bonuses and commissions. Participants may also contribute amounts representing distributions from other qualified



11

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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



defined benefit or defined contribution plans.  Until October 1, 2006, the Company contributed 25% of the first 6% of base compensation that a participant contributed to the Plan. The Company also could make an additional contribution up to 25% at its discretion.

Effective as of October 1, 2006, the Company matches 100% of the first 3% of salary deferral contributions that a participant contributes to the plan and 50% of the next 2% of salary deferral contributions a participant contributes to the plan.  Effective January 1, 2007, participants will be 100% vested in all matching contributions made by the Company to the plan on and after that date.

Effective January 1, 2007, the Company began additional annual employer contributions to the 401(k) plan accounts of associates who: have at least five years of service (were hired before January 1, 2002); are at least age 45 on January 1, 2007; and have at least 1,000 hours of service in the calendar year for which the contribution is being made, and are actively employed on December 31 of that year.  The contribution will be equal to the amount of the eligible associates earned salary and bonus in the calendar year for which the contribution is being made, multiplied by the percentage in the table below corresponding to that associates age as of January 1, 2007:

Age 45-49

        1.5%Age 50-54

        2.75%Age 55+

        4.0%


The initial contribution will be made in January 2008, and annually thereafter.  The contribution vests immediately after being made.

Deferred Compensation Plan



The Company has a non-qualified deferred compensation plan for senior management that allows the deferment of a portion of their compensation until their services with the Company have terminated. The plan includes deferred contributions, which were not elected by employees to be transferred to the 401(k) plan upon adoption of the 401(k) plan. The plans investments include mutual funds and are recorded in investments as held for trading. The corresponding deferred obligations to participants are recorded in other liabilities.



KMG America 2004 Equity Incentive Plan


The KMG America 2004 Equity Incentive Plan was established in 2004 and amended in 2006 with 2,827,500 shares of KMG America Common Stock reserved for issuance under the Plan.  Through March 31, 2007, net of forfeitures, 142,044 shares of Common Stock have been granted which generally vest with respect to one-fourth of the shares granted on each of the first, second, third, and fourth anniversaries of the date of grant.  To date, 47,701 shares of Common Stock granted are fully vested.  Also, through March 31, 2007, net of forfeitures, options to purchase 1,892,675 shares of Common Stock have been issued which generally vest with respect to one-fourth of the shares subject to the option on each of the first, second, third and fourth anniversaries of the date of grant.  With respect to options issued to one optionholder, they vest one-third on each of the first, second and third anniversaries
of the date of grant, subject to earlier immediate vesting upon the termination of the optionholders employment with the Company, by the Company without cause, by him with good reason, upon a change in control of the Company and upon his receipt of a notice of non-renewal of his employment agreement, or upon his death or disability.

The Company has adopted SFAS 123(R) as of January 1, 2006. Below is the presentation of our employee and director stock options and common stock grants under the fair value method.







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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Common Stock Grants

The activity related to the common stock grants is set forth below:


Common Stock Grants Outstanding
        
        
        Weighted Average Grant Date Fair Value Per Share ofCommon Stock Grants OutstandingNonvested
        
        
        Vested
        
        
        Nonvested
        
        
        VestedOutstanding as of December 31, 2006
        
        114,042
        
        
        25,906
        
        
        8.29
        
        
        8.45Granted
        
        0
        
        
        2,503
        
        
        
        
        
        8.74Vested
        
        (19,292
        )
        
        19,292
        
        
        8.01
        
        
        8.01Forfeited
        
        (407
        )
        
        0
        
        
        8.85
        
        
        Outstanding as of March 31, 2007
        
        94,343
        
        
        47,701
        
        
        8.35
        
        
        8.29




Stock Options



Black-Scholes option-pricing model assumptions used:



Average Risk-free Interest Rate
        4.54%Expected Dividend Yield
        Expected Volatility
        20.0%Expected Life (years)
        5




The activity related to the stock options is set forth below:



Options Outstanding
        
        Weighted Average Exercise Price
        
        
        Aggregate Intrinsic Value
        
        Weighted Average Remaining Life (in years)Outstanding as of December 31, 2006
        1,913,425
        
        9.16Granted
        10,000
        
        8.74Exercised
        0
        
        0Forfeited
        (30,750
        )
        9.05Outstanding as of March 31, 2007
        1,892,675
        
        9.16
        
        
        4,632,283
        
        8.24Exercisable as of March 31, 2007
        719,792
        
        9.49
        
        
        1,771,906
        
        7.79




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



Quarter EndedMarch 31, 2007Total Share-Based CompensationIncluded in loss before income taxes
        $
        376,678Included in net loss, net of tax effects
        $
        244,841Excess tax benefits related to options exercised
        $
        0Excess tax benefits related to share-based compensation(1)
        $
        0


________________________

(1)Represents the tax benefit, recognized in additional paid-in-capital for stock options exercised.



As of March 31, 2007, there was $3,105,243 of total unrecognized compensation cost related to nonvested share-based compensation arrangements.



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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



6.
        Comprehensive Income (Loss)


Total comprehensive income (loss) for the quarters ended March 31, 2007 and 2006 was ($9,774,973) and ($6,704,072), respectively. The difference between comprehensive income and net income for these periods was unrealized investment gains (losses) of $488,240 and ($7,940,269), 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 (ReliaStar), both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore and Gibb are officers of KMG America and former employees of the plaintiffs.  The complaint alleges misappropriation of trade secrets, conversion, tortious interference with business and employment relationships, breach of fiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive relief and unspecified monetary damages. On August 24, 2005, the plaintiffs amended their complaint to add Scott H. DeLong III and
Thomas D. Sass as defendants. Messrs. DeLong and Sass are officers of KMG America and former employees of the plaintiffs. The plaintiffs amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentations and civil theft.  On April 17, 2007, the Court dismissed nine of the twelve claims alleged by the plaintiffs, leaving three claims against individual defendants Messrs. Kraemer, Moore and Gibb, relating to breach of fiduciary duty, breach of the duty of loyalty and unjust enrichment.   On May 4, 2007, the Company entered into a settlement agreement with ReliaStar regarding all claims, ending the litigation.  Pursuant to the settlement agreement, the Company will make a cash payment of $825,000 to ReliaStar in the second quarter of 2007. This amount has been accrued for the quarter ended March 31, 2007 and reflected in the financial statements.  The amount paid by the Company in settlement of the
litigation is less than the amount of defense costs the Company expected to pay through trial of the litigation. The Company has been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will reimburse the Company for only a portion of the amount paid by the Company in settlement of the litigation.  The Company disputes the insurance carriers decision and will pursue additional reimbursement from the insurance carrier under the insurance policy.

8.
        Debt and Other Obligations


Wachovia Credit Agreement.



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 accrued at 5% per annum and was added to the principal balance on December 31 of each year.



On December 21, 2006, the Company entered into a credit agreement with Wachovia, which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the five-year subordinated promissory note we issued to fund a portion of the purchase price for the Kanawha acquisition.  The remaining $1.0 million available under the credit facility may be used to finance the Companys working capital, liquidity needs and general working requirements and those of its subsidiaries.  Amounts outstanding under the credit agreement will bear interest at a rate calculated according to, at the Companys option, a base rate or the LIBOR rate plus an applicable percentage.  The applicable percentage is based on the A.M. Best financial strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans and from 1.25% to 1.35% for LIBOR rate loans. In
the case of LIBOR rate loans, interest on amounts outstanding is payable at the end of the interest period, which can be one, two, three or six months, as selected by the Company in its notice of borrowing.  Wachovias obligation to fund the credit agreement terminates, and all principal outstanding under the credit agreement is due and payable, no later than December 31, 2007.  As of March 31, 2007, the $14.0 million outstanding under the credit agreement was a LIBOR rate plus applicable percentage loan with an initial interest rate of 6.57%.



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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The credit agreement requires the Company to comply with certain covenants, including, among others, maintaining a maximum ratio of consolidated indebtedness to total capitalization, a minimum available dividend amount for Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha.  The Company must also comply with limitations on certain payments, additional debt obligations, dispositions of assets and its lines of business.  The credit agreement also restricts the Company from creating or allowing certain liens on its assets and from making certain investments.



Subordinated Debt Securities.



On March 22, 2007, KMG America completed the issuance and sale in a private placement of $35,000,000 in aggregate principal amount of trust preferred securities (the Trust Preferred Securities) issued by the Companys newly-formed subsidiary, KMG Capital Statutory Trust I, a Delaware statutory trust (the Trust). The Trust Preferred Securities will mature on March 15, 2037, may be called at par by the Company any time after March 15, 2012, and require quarterly distributions of interest by the Trust to the holder of the Trust Preferred Securities. Distributions will be payable quarterly at a fixed interest rate equal to 8.02% per annum through March 15, 2012, and then will be payable at a floating interest rate equal to the 3-month London Interbank Offered Rate (LIBOR) plus 310 basis points per annum. The Trust simultaneously issued one of the
Trusts common securities (the Common Securities) to the Company for a purchase price of $1,083,000, which constitutes all of the issued and outstanding common securities of the Trust.



The Trust used the proceeds from the sale of the Trust Preferred Securities together with the proceeds from the sale of the Common Securities to purchase $36,083,000 in aggregate principal amount of unsecured junior subordinated deferrable interest debt securities due March 15, 2037, issued by the Company (the Junior Subordinated Debt). The net proceeds to the Company from the sale of the Junior Subordinated Debt to the Trust will be used by the Company for general corporate purposes.



The Junior Subordinated Debt was issued pursuant to an Indenture, dated March 22, 2007 (the Indenture), between the Company, as issuer, Wilmington Trust Company, as trustee, and the administrators named therein. The terms of the Junior Subordinated Debt are substantially the same as the terms of the Trust Preferred Securities. The interest payments on the Junior Subordinated Debt paid by the Company will be used by the Trust to pay the quarterly distributions to the holders of the Trust Preferred Securities. The Indenture permits the Company to redeem the Junior Subordinated Debt (and thus a like amount of the Trust Preferred Securities) on or after March 15, 2012. If the Company redeems any amount of the Junior Subordinated Debt, the Trust must redeem a like amount of the Trust Preferred Securities.



The Trust was not consolidated based on the guidance issued by the FASB in Interpretation (FIN) No. 46(R), Consolidation of Variable Interest Entities, but rather is treated like an equity-method investment.  Thus, the Companys $1.1 investment in the Trust is recorded as an Investment in subsidiary.

9.
        Federal Income Taxes


The actual effective rate for the three months ended March 31, 2007 varies from the expected statutory rate of approximately 35% primarily as a result of the establishment of a $6.8 million valuation allowance to offset the portion of the deferred tax asset relating to the holding company.  The decision by A.M. Best to change the outlook of our rating from stable to negative, and the resulting strategic options being considered, has created uncertainty about our ability and timing to generate taxable income at the holding company.  Because of this uncertainty, the Company has deemed it appropriate to establish the valuation allowance.  The Company will continue to evaluate tax planning strategies to utilize the operating losses prior to their expiration.

The Company had no interest and penalties for the three months ended March 31, 2007 and no amounts were accrued.  To the extent, the Company incurred interest and penalties such amounts would be recognized in provision for income taxes.  For KMG Americas subsidiaries, tax years 2002 through 2006 are subject to examination by the internal revenue service.  There are no income tax examinations currently in process.  The Company has no unrecognized tax positions at March 31, 2007 and expects no material change in their unrecognized tax positions within the next 12 months.



15

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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



10.
        Business Segments


The Company has five reportable segments that are differentiated by their respective methods of distribution and the nature of the related products: worksite insurance business, senior market insurance business, third party administration business, acquired business and corporate and other. Management makes decisions regarding the Companys business based on these segment classifications. No segments have been aggregated other than including the marketing business in the corporate and other segment.

The worksite insurance business provides life and health insurance products to employers and employees. The primary insurance products that the Company underwrites include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. This segment also includes business sold through the career agency distribution channel, which is a group of agents and managers that are employees of the Company or its subsidiaries.



The senior market insurance business consists primarily of the Companys in-force block of long-term care insurance policies that the Company actively manages, including the right to receive renewal premiums and liability for future claims. Effective January 1, 2006, the Company ceased actively underwriting long-term care insurance policies.

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

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

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



16

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KMG AMERICA CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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



Quarter EndedMarch 31, 2007
        
        
        Quarter EndedMarch 31, 2006Worksite Insurance BusinessInsurance premiums
        
        $
        29,194,304
        
        $
        18,506,556Net investment income
        
        
        2,050,766
        
        
        1,595,008Commissions and fees
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        Other income
        
        
        160,841
        
        
        46,282Total revenues
        
        
        31,405,911
        
        
        20,147,846Policyholder benefits
        
        
        27,513,279
        
        
        13,594,835Commissions
        
        
        2,683,392
        
        
        1,520,818Expenses, taxes, fees and depreciation
        
        
        4,800,570
        
        
        4,223,622Amortization of DAC
        
        
        1,614,586
        
        
        778,202Total benefits and expenses
        
        
        36,611,827
        
        
        20,117,477(Loss) income before Federal income tax
        
        $
        (5,205,916
        )
        $
        30,369Total assets
        
        $
        179,721,428
        
        $
        168,692,512Senior Market Insurance BusinessInsurance premiums
        
        $
        10,778,289
        
        $
        10,674,620Net investment income
        
        
        2,703,959
        
        
        1,411,613Commissions and fees
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        Other income
        
        
        780,312
        
        
        809,075Total revenues
        
        
        14,262,560
        
        
        12,895,308Policyholder benefits
        
        
        7,752,477
        
        
        8,535,221Commissions
        
        
        1,379,930
        
        
        1,366,810Expenses, taxes, fees and depreciation
        
        
        731,753
        
        
        765,159Amortization of DAC
        
        
        326,657
        
        
        472,114Total benefits and expenses
        
        
        10,190,817
        
        
        11,139,304Income before Federal income tax
        
        $
        4,071,743
        
        $
        1,756,004Total assets
        
        $
        264,624,236
        
        $
        201,603,321Third-Party Administration BusinessInsurance premiums
        
        $
        
        
        $
        Net investment income
        
        
        
        
        
        Commissions and fees
        
        
        4,119,444
        
        
        4,133,717Net realized gains
        
        
        
        
        
        Other income
        
        
        
        
        
        Total revenues
        
        
        4,119,444
        
        
        4,133,717Policyholder benefits
        
        
        
        
        
        Commissions
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        3,622,899
        
        
        3,503,156Amortization of DAC
        
        
        
        
        
        Total benefits and expenses
        
        
        3,622,899
        
        
        3,503,156Income before Federal income tax
        
        $
        496,545
        
        $
        630,561Total assets
        
        $
        8,549,046
        
        $
        10,063,461




17

---



Quarter EndedMarch 31, 2007
        
        
        Quarter EndedMarch 31, 2006Acquired BusinessInsurance Premiums
        
        $
        (56,686
        )
        $
        629,450Net investment income
        
        
        2,009,456
        
        
        1,980,656Commission and fees
        
        
        
        
        
        Net realized gains
        
        
        
        
        
        Other income
        
        
        16,223
        
        
        15,801Total revenues
        
        
        1,968,993
        
        
        2,625,907Policyholder benefits
        
        
        2,276,866
        
        
        1,223,657Commissions
        
        
        89,123
        
        
        93,658Expenses, taxes, fees and depreciation
        
        
        596,343
        
        
        607,974Amortization of DAC
        
        
        139,438
        
        
        (72,215
        )Total benefits and expenses
        
        
        3,101,770
        
        
        1,853,074(Loss) income before Federal income tax
        
        $
        (1,132,777
        )
        $
        772,883Total assets
        
        $
        159,760,673
        
        $
        201,879,631Corporate and OtherInsurance Premiums
        
        $
        
        
        $
        Net investment income
        
        
        1,111,487
        
        
        2,218,790Commission and fees
        
        
        48,706
        
        
        85,398Net realized gains
        
        
        (52,908
        )
        
        211,107Other income
        
        
        101,692
        
        
        115,374Total revenues
        
        
        1,208,977
        
        
        2,630,669Policyholder benefits
        
        
        
        
        
        Commissions
        
        
        
        
        
        Expenses, taxes, fees and depreciation
        
        
        4,738,714
        
        
        3,949,357Amortization of DAC
        
        
        
        
        
        Total benefits and expenses
        
        
        4,738,714
        
        
        3,949,357(Loss) before Federal income tax
        
        $
        (3,529,737
        )
        $
        (1,318,688
        )Total assets
        
        $
        256,928,510
        
        $
        211,677,113Total CompanyInsurance Premiums
        
        $
        39,915,908
        
        $
        29,810,626Net investment income
        
        
        7,875,667
        
        
        7,206,068Commission and fees
        
        
        4,168,149
        
        
        4,219,115Net realized gains
        
        
        (52,908
        )
        
        211,107Other income
        
        
        1,059,068
        
        
        986,533Total revenues
        
        
        52,965,884
        
        
        42,433,449Policyholder benefits
        
        
        37,542,622
        
        
        23,353,714Commissions
        
        
        4,152,444
        
        
        2,981,285Expenses, taxes, fees and depreciation
        
        
        14,490,279
        
        
        13,049,269Amortization of DAC
        
        
        2,080,681
        
        
        1,178,101Total benefits and expenses
        
        
        58,266,026
        
        
        40,562,369(Loss) Income before Federal income tax
        
        $
        (5,300,142
        )
        $
        1,871,080Total assets
        
        $
        869,583,893
        
        $
        793,916,038






18

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


Overview



KMG America is a holding company incorporated under the laws of the Commonwealth of Virginia on January 21, 2004. We commenced our operations shortly before we completed our initial public offering of common stock on December 21, 2004, and our shares trade on the New York Stock Exchange under the symbol KMA.  Concurrently with the completion of our initial public offering, we completed our acquisition of Kanawha and its subsidiaries, which are our primary operating subsidiaries and which underwrite and sell life and health insurance products.



For GAAP accounting purposes, Kanawha is treated as KMG Americas predecessor entity and is referred to herein as our predecessor.  For financial reporting purposes, we have treated the acquisition as if it closed on December 31, 2004, rather than the actual closing date of December 21, 2004, as the effects of the acquisition for the period from December 21, 2004, through December 31, 2004, were not material. Accordingly, in the following discussion any financial information as of any date prior to, or for any period ending on or prior to, December 31, 2004, is reported on a historical basis without GAAP purchase accounting adjustments reflecting the acquisition, and any financial information as of any date on or after, or for any period ending after, December 31, 2004, reflects GAAP purchase accounting adjustments made as of December 31, 2004, reflecting the acquisition.



Worksite insurance business. Our worksite insurance business is a provider of life and health insurance products to employers and their employees.  Our predecessor's marketing and sales efforts were primarily in the southeastern United States, predominately in Florida, South Carolina and North Carolina.  Since acquiring our predecessor, we have begun to implement our business strategy to market our products nationwide. The primary insurance products that we underwrite include: group and individual life insurance; group long term disability; group and individual short term disability; group and individual dental insurance; group and individual indemnity health insurance; group critical illness insurance and employer group excess risk insurance. For the three months ended March 31, 2007, our  worksite insurance business produced premiums, commissions and fees,
excluding intercompany payments, of $29.2 million, which accounted for 66.2% of our premiums, commissions and fees, excluding intercompany payments in that period. Our business strategy is to operate our existing worksite insurance business efficiently while developing a new worksite marketing and distribution organization that targets larger employer groups nationwide with an expanded variety of life and health insurance products which have added a new set of employer-paid life insurance, disability and health products to our existing voluntary products. Since December 2004, we have opened sales offices hosting regional sales managers in Boston, Massachusetts and Irvine, California, a Los Angeles suburb and we have opened regional sales offices in Tampa, Florida; Chicago, Illinois; Morristown, New Jersey; Atlanta, Georgia; Dallas, Texas; Kansas City, Missouri; Cleveland, Ohio; Philadelphia, Pennsylvania; New Orleans, Louisiana; San Diego and San Francisco, California; Phoenix,
Arizona; Denver, Colorado; and Minneapolis, Minnesota. We will base future expansion of our sales organization on developing market trends and our profit margins.  The costs associated with any expansion of our sales organization will be recognized before we recognize revenues resulting from new sales activity.  Consequently, we expect negative cash flow and operating losses in the short term.



Senior market insurance business. Our senior market insurance business has been a provider in the southeastern United States of individual insurance products tailored to the needs of older individuals. The primary insurance product included in this business is long-term care insurance that we underwrote. For the three months ended March 31, 2007, our senior market insurance business produced premiums, commissions and fees, excluding intercompany payments, of $10.8 million, which accounted for 24.5% of our premiums, commissions and fees, excluding intercompany payments, in that period.



Effective January 1, 2006, we ceased actively underwriting long-term care insurance policies. Significant factors that contributed to our decision to cease actively underwriting long-term care insurance policies include, among others:  (1) sales for this business were significantly lower than originally projected; and (2) the lack of strategic fit between the underwriting and distribution of long-term care products and our current strategy of focusing on worksite marketing of life and health insurance products.  We intend to retain and actively manage the



19

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existing block of in-force long-term care insurance policies (including the right to receive future premiums and the liability for future claims).



Third-party administration business. Our third-party administration business provides a wide range of insurance product administration, claims handling, eligibility administration, call center and support services. This business primarily administers the insurance plans offered by our worksite insurance business and senior market insurance business. Our third-party administration business also provides administrative and managed care services to third parties, such as employers with self-funded health care plans, other insurance carriers, reinsurers and managed care plans. For the three months ended March 31, 2007, our third-party administration business produced commissions and fees, excluding intercompany payments, of $4.1 million, which accounted for 9.3% of our premiums, commissions and fees, excluding intercompany payments, in that period. Our primary
business strategy for this business is to grow this business as it administers the increasing volume of policies and products that we anticipate will be sold by the worksite insurance business as we attempt to grow that business. In addition, as our national worksite marketing business develops, we intend to opportunistically market our third-party administration services to self-insured plans, stop loss insurers, pharmacy benefit organizations, managed care service providers, other insurance carriers and reinsurers nationwide. It is expected that any incremental costs associated with this expanded marketing will be modest and will be funded out of the operations of our third-party administration business.



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



We expect to realize earnings from our investment portfolio. Insurance companies in both the life and health and property and casualty insurance industries earn profits on the investment float, which reflects the investment income earned on the premiums paid to the insurer between the time of receipt and the time benefits are paid-out under the policy. Volatility in the capital markets, changes in interest rates and changes in economic conditions can all impact the amount of earnings that we will realize from our investment portfolio.



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Financial Strength Ratings Outlook

Kanawha has an A.M. Best financial strength rating of A- (excellent).  Recently, A.M. Best changed its outlook for Kanawhas rating from stable to negative.  S&Ps current financial strength rating for Kanawha is A- (strong).  Recently, S&P placed Kanawhas rating on a credit watch.  Rating agencies review their ratings periodically and Kanawhas current ratings may not be maintained in the future.

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

Our continued stop loss claims volatility and the adverse effect it is having on our results of operations, including the $6 million charge for increased stop loss claims and reserves we incurred in the first quarter of 2007, could induce A.M. Best or S&P to downgrade Kanawhas financial strength rating.

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

First Quarter Developments

After a comprehensive review of its stop loss book of business, the Company recognized a $6 million charge for increased claims and reserves that reflects recent experience on stop loss cases.  The Company began writing annually renewable stop loss in mid-2005, and initially relied on pricing assumptions, a common industry practice relative to new books of stop loss business, to establish expected loss ratios due to lack of credible actual claim experience.  As a contrast, companies with mature books of stop loss business typically establish claim reserves as a function of experience studies of its business.  Because actual claims on stop loss cases typically are not fully reported until after the end of the policy period, it is a common practice to increase or decrease claims reserves once the actual claims experience becomes known.



As experience has emerged, the Company has recognized additional claims and reserves reflecting the recent adverse claims experience.  The Company also decided to increase claims assumptions on business prospectively, reflecting a more conservative estimate of future claims on this business.  The Companys experience has been that it takes four quarters after a case has been written before a clear picture becomes apparent regarding claims for that case.  While some of the unfavorable claims data began to emerge late in the fourth quarter of 2006 and guided our reserving at year-end, new more meaningful data came to the Companys attention late in the first quarter of this year after the year-end books were closed and earnings reported.  As a result of the new data the Company has concluded that it would be prudent to increase the estimated loss ratios on newer cases for claims
before credible claims experience has developed on this business.  As a result of these actions, the Company believes its March 31, 2007 claim reserves on stop loss business adequately reflects both the development of recent experience and the Companys more conservative outlook on loss experience related to current premiums.



In order to address the imbalance in its overall new sales mix, which has a disproportionate concentration of stop loss business, the Company has restructured the sales incentive compensation plan for its sales organization with increased incentives for sales of core group life/disability and voluntary benefit products.  Additionally, the Company is limiting new sales of stop loss by means of pricing new business at a higher expected profit margin and a requirement that sales of stop loss be packaged with other products.



21

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The Company also established a $6.8 million valuation allowance as a non-cash charge to offset the portion of the deferred tax asset relating to the holding company.  The decision by A.M. Best to change the outloook of our rating from stable to negative, and the resulting strategic options being considered, has created uncertainty about our ability and timing to generate taxable income at the holding company.  Because of this uncertainty, the Company has deemed it appropriate to establish the valuation allowance.  The Company will continue to evaluate tax planning strategies to utilize the operating losses prior to their expiration.



See Item 1A. Risk Factors  We may be unable to accurately predict benefits, claims and other costs or to manage those costs through our loss limitation methods, which could result in our incurring greater claims losses than we anticipate and Item 1A. Risk Factors  Our actual claims losses may exceed our reserves for claims, which may require us to establish additional reserves that may materially reduce our earnings, profitability and capital in Part II of this report.



Strategic Alternatives



The Company retained Keefe, Bruyette & Woods (KBW), an investment banking firm, to help us explore a variety of strategic alternatives, including, among other things, the possible sale or merger of the Company with another entity, modifying and further executing the Companys business plan or a recapitalization of the Company.  The strategic review process is underway.  No decision has been reached regarding any option.  There can be no assurance that this process will result in a transaction or, if one is undertaken, of its potential terms or timing.  The Company does not intend to publicly disclose updates or developments in its strategic alternatives process until such time as the Company enters into a definitive agreement with a third party in connection with a transaction or terminates the strategic alternatives process.



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Results of Operations

Consolidated Overview

The following table presents consolidated financial information for the quarters ended March 31, 2007 and March 31, 2006 for KMG America.

Quarter EndedMarch 31, 2007
        
        
        Quarter EndedMarch 31, 2006Revenues:
        
        
        (000s omitted)Insurance premiums
        
        $
        39,915.9
        
        $
        29,810.6Net investment income
        
        
        7,875.7
        
        
        7,206.1Commission and fees
        
        
        4,168.1
        
        
        4,219.1Net realized gains
        
        
        (52.9
        )
        
        211.1Other income
        
        
        1,059.1
        
        
        986.5Total revenues
        
        
        52,965.9
        
        
        42,433.4Benefits and expenses:Policyholder benefits
        
        
        37,542.6
        
        
        23,353.7Commissions
        
        
        4,152.4
        
        
        2,981.3General expenses
        
        
        12,170.1
        
        
        10,893.3Taxes, licenses and fees
        
        
        1,615.0
        
        
        1,515.0Depreciation and amortization
        
        
        705.2
        
        
        640.9Amortization of DAC and VOBA
        
        
        2,080.7
        
        
        1,178.1Total benefits and expenses
        
        
        58,266.0
        
        
        40,562.3Income before income taxes
        
        
        (5,300.1
        )
        
        1,871.1Provision for income taxes
        
        
        (4,963.1
        )
        
        (634.9
        )Net income
        
        $
        (10,263.2
        )
        $
        1,236.2Benefits to premiums ratio(1)
        
        
        94.1
        %
        
        78.3
        %




(1)
        The benefits to premiums ratio is equal to policyholder benefits (equal to incurred claims plus increases in policyholder active life reserves) divided by insurance premiums.




Consolidated Results of Operations by Business Segment



Note 10, Business Segments, of the Notes to Consolidated Financial Statements included in this report, which includes a summary of our statements of income and asset composition by reportable segment, is incorporated herein by reference.



Quarter Ended March 31, 2007 Compared to Quarter Ended March 31, 2006



Financial Results Overview

KMG America reported a net loss for the quarter ended March 31, 2007 of $10.3 million compared to net income of $1.2 million for the quarter ended March 31, 2006. The decrease in net income of $11.5 million was primarily due to $6 million of reserve strengthening in the stop loss book of business which will be discussed in the policyholder benefits analysis in greater detail below as well as establishing a valuation allowance of $6.8 million which will be discussed in the provision for income taxes section below.



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Revenues.  Total revenues for the quarter ended March 31, 2007, increased $ 10.6 million, or 25.0%, to $53.0 million from total revenues of $42.4 million for the quarter ended March 31, 2006. The primary factors causing the increase are explained below under the captions Premiums, Net Investment Income, Commission and Fee Income, Realized Investment Gains and Losses and Other Income.

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

For the quarter ended March 31, 2007
        For the quarter ended March 31, 2006
        Increase (decrease)Worksite
        Senior
        Acquired
        Total
        Worksite
        Senior
        Acquired
        Total
        Worksite
        Senior
        Acquired
        Total(dollars in millions)DirectNew
        $19.7
        $
        $
        $19.7
        $9.4
        $0.3
        $        
        $9.7
        $10.3
        $(0.3)
        $
        $10.0Renewal
        11.7
        14.3
        
        26.0
        11.3
        13.9
        
        25.2
        0.4
        0.4
        
        0.8Total
        31.4
        14.3
        
        45.7
        20.7
        14.2
        
        34.9
        10.7
        0.1
        
        10.8AssumedNew
        (0.1)
        
        
        (0.1)
        
        
        
        
        (0.1)
        
        
        (0.1)Renewal
        0.4
        
        (0.1)
        0.3
        
        
        0.6
        0.6
        0.4
        
        (0.7)
        (0.3)Total
        0.3
        
        (0.1)
        0.2
        
        
        0.6
        0.6
        0.3
        
        (0.7)
        (0.4)CededNew
        (2.2)
        
        
        (2.2)
        (1.9)
        (0.2)
        
        (2.1)
        (0.3)
        0.2
        
        (0.1)Renewal
        (0.3)
        (3.5)
        
        (3.8)
        (0.3)
        (3.3)
        
        (3.6)
        
        (0.2)
        
        (0.2)Total
        (2.5)
        (3.5)
        
        (6.0)
        (2.2)
        (3.5)
        
        (5.7)
        (0.3)
        --
        
        (0.3)NetNew
        17.4
        
        
        17.4
        7.5
        0.1
        
        7.6
        9.9
        (0.1)
        
        9.8Renewal
        11.8
        10.8
        (0.1)
        22.5
        11.0
        10.6
        0.6
        22.2
        0.8
        0.2
        (0.7)
        0.3Total
        $29.2
        $10.8
        $(0.1)
        $39.9
        $18.5
        $10.7
        $0.6
        $29.8
        $10.7
        $0.1
        $(0.7)
        $10.1




Worksite net new premiums increased $9.9 million, or 132.0%, to $17.4 million for the quarter ended March 31, 2007, from $7.5 million for the quarter ended March 31, 2006, due to increased sales volumes. The primary driver of this increase was new stop loss premium generated by the new KMG America sales force. In order to address the imbalance in its overall new sales mix, which has a disproportionate concentration of stop loss business, the Company has restructured the sales incentive compensation plan for its sales organization with increased incentives for sales of core group life/disability and voluntary benefit products.  Additionally, the Company is limiting new sales of stop loss by means of pricing new business at a higher expected profit margin and a requirement that sales of stop loss be packaged with other products.  There were direct new premiums of $19.7 million, offset by $2.2
million of ceded new premiums.  Net renewal premiums increased $0.8 million or 7.3% as a result of $0.4 million of renewal premium assumed from the block acquisition of voluntary term life insurance and universal life insurance policies from Columbian Life Insurance Company and Columbian Mutual Life Insurance Company.  Senior market net new premiums, composed of long term care policies, decreased $0.1 million, or 100.0%, to $0.0 million for the quarter ended March 31, 2007, from $0.1 million for the quarter ended March 31, 2006 due to decreased sales volumes as the Company effective December 31, 2005, ceased actively underwriting new long term care policies.  Net renewal premiums increased $0.2 million, or 1.9%, to $10.8 million for the quarter ended March 31, 2007, from $10.6 million for the quarter ended March 31, 2006. This business represents the insurance in force created by prior year sales.



Acquired business premiums decreased $0.7 million, or 116.7%, to $(0.1) million for the quarter ended March 31, 2007, from $0.6 million for the quarter ended March 31, 2006. We have not acquired any blocks of business since 1999 and the decline is a result of policy lapses. The $(0.1) million of premium for the quarter ended March 31, 2007 resulted from increased experience refunds related to certain reinsurance treaties.

Net Investment Income.  Net investment income increased $0.7 million, or 9.7%, to $7.9 million for the quarter ended March 31, 2007, from $7.2 million for the quarter ended March 31, 2006.  Net investment income is primarily affected by changes in levels of invested assets and interest rates. However, the interest income earned fluctuation on our long term invested assets was relatively flat for the quarter ended March 31, 2007 as compared to the quarter ended March 31, 2006. The primary driver of the increase in investment income is a $0.9 million increase in dividend income on fixed maturity securities.  Assets attributed to the senior segment continue to increase as a result of policy reserve increases in this segment, while assets attributed to the acquired segment continue to decline as this business lapses. There were no other significant asset shifts in the
business segments.

Commission and Fee Income.  Commission and fee income was flat at $4.2 million for the quarter ended March 31, 2007, and also $4.2 million for the quarter ended March 31, 2006. Most of the commission and fee income was from administrative fees relating to third-party administration services.



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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 loss of $0.1 million for the quarter ended March 31, 2007compares to a $0.2 million net realized investment gain for the quarter ended March 31, 2006 or a decrease of $0.3 million.. The net loss realized of $0.1 million was on our fixed maturity securities for the quarter ended March 31, 2007. The capital losses recognized result from the sale of assets as is necessary from time to time in order to keep the portfolio properly structured.  Realized investment gains and losses are allocated entirely to the corporate and other business segment.

Other Income.  Other income increased $0.1 million, or 10.0%, to $1.1 million for the quarter ended March 31, 2007, from $1.0 million for the quarter ended March 31, 2006, reflecting increased commission and expense allowances from reinsurance companies generated from an increase in renewal ceded premiums.

Benefits and Expenses.Total benefits and expenses increased $17.7 million, or 43.6%, to $58.3 million for the quarter ended March 31, 2007, from $40.6 million for the quarter ended March 31, 2006. The primary factors causing this increase are explained below under the captions Policyholder Benefits, Insurance Commissions, General Insurance Expenses, Insurance Taxes, Licenses and Fees, and Amortization of DAC and VOBA.

Policyholder Benefits.Policyholder benefits increased $14.1 million, or 60.3%, to $37.5 million for the quarter ended March 31, 2007, from $23.4 million for the quarter ended March 31, 2006. This produced a benefits to premium ratio of 94.1% for the quarter ended March 31, 2007, compared to 78.3% for the quarter ended March 31, 2006.

Worksite marketing policyholder benefits increased $13.9 million, or 102.2%, to $27.5 million for the quarter ended March 31, 2007, from $13.6 million for the quarter ended March 31, 2006. This produced benefits to premium ratios of 94.2% for the quarter ended March 31, 2007, compared to 73.5% for the quarter ended March 31, 2006.  After a comprehensive review of its stop loss book of business, the Company recognized a $6 million charge for increased claims and reserves that reflects recent experience on stop loss cases.  The Company began writing annually renewable stop loss in mid-2005, and initially relied on pricing assumptions, a common industry practice relative to new books of stop loss business, to establish expected loss ratios due to lack of credible actual claim experience.  As a contrast, companies with mature books of stop loss business typically establish claim reserves as a
function of experience studies of its business.  Because actual claims on stop loss cases typically are not fully reported until after the end of the policy period, it is a common practice to increase or decrease claims reserves once the actual claims experience becomes known.



As experience has emerged, the Company has recognized additional claims and reserves reflecting the recent adverse claims experience.  The Company also decided to increase claims assumptions on business prospectively, reflecting a more conservative estimate of future claims on this business.  The Companys experience has been that it takes four quarters after a case has been written before a clear picture becomes apparent regarding claims for that case.  While some of the unfavorable claims data began to emerge late in the fourth quarter of 2006 and guided our reserving at year-end, new more meaningful data came to the Companys attention late in the first quarter of this year after the year-end books were closed and earnings reported.  As a result of the new data the Company has concluded that it would be prudent to increase the estimated loss ratios on newer cases for claims
before credible claims experience has developed on this business.  As a result of these actions, the Company believes its March 31, 2007 claim reserves on stop loss business adequately reflects both the development of recent experience and the Companys more conservative outlook on loss experience related to current premiums.



In order to address the imbalance in its overall new sales mix, which has a disproportionate concentration of stop loss business, the Company has restructured the sales incentive compensation plan for its sales organization with increased incentives for sales of core group life/disability and voluntary benefit products.  Additionally, the Company is limiting new sales of stop loss by means of more conservative pricing and a requirement that sales of stop loss be packaged with other products.



Senior market policyholder benefits decreased $0.8 million, or 9.4%, to $7.7 million for the quarter ended March 31, 2007, from $8.5 million for the quarter ended March 31, 2006. This produced benefits to premium ratios of 71.9% for the quarter ended March 31, 2007, compared to 80.0% for the quarter ended March 31, 2006. The



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benefits to premium ratio improved primarily as a result of a return to normal claims experience for the quarter ended March 31, 2007 as compared to the quarter ended March 31, 2006 which had a larger increase in the claim reserves as a result of the increase in the open active claims for that quarter. The first quarter of 2007 benefits to premium ratio of 71.9% compares favorably to the average benefit ratio for the first three quarters of 2006 of 75.0%.

Acquired business policyholder benefits increased $1.1 million, or 91.7%, to $2.3 million for the quarter ended March 31, 2007, from $1.2 million for the quarter ended March 31, 2006. The benefits to premium ratio for the quarter ended March 31, 2007 was impacted by experience refunds which reduce both premiums and policyholder benefits equally. Excluding the impact of these experience refunds, the benefits to premium ratio was 190.9% for the quarter ended March 31, 2007 compared to 161.5% for the quarter ended March 31, 2006. These benefits to premium ratios are affected by large portions of the acquired business that are no longer premium paying with substantial reserves and investment income on reserves.

Insurance Commissions.Commission expenses increased $1.2 million, or 40.0%, to $4.2 million for the quarter ended March 31, 2007, from $3.0 million for the quarter ended March 31, 2006. This increase consists of normal increases related to increased renewal premiums, in addition to an increase in first year commissions that were not deferred.

General Insurance Expenses.General insurance expenses increased $1.3 million, or 11.9%, to $12.2 million for the quarter ended March 31, 2007, from $10.9 million for the quarter ended March 31, 2006. The increased expenses for the quarter ended March 31, 2007 are attributable to a $0.6 million increase in salaries due to the additional staff associated with our continuing expansion to a national insurance company, including the addition of management and marketing personnel, as well as $0.8 million in litigation settlement expenses.

Overhead expenses that are not directly associated with a particular business segment are allocated to the various business segments on a pro rata basis based on different factors, such as headcount, policy count, number of policies issued, premiums and other relevant factors.

Insurance Taxes, Licenses and Fees.Insurance taxes, licenses and fees increased $0.1 million, or 6.7%, to $1.6 million for the quarter ended March 31, 2007, from $1.5 million for the quarter ended March 31, 2006. Employment taxes related to additional staffing and additional premium taxes due to the increased premiums as a result of the new worksite business are the primary drivers of this increase.

Amortization of DAC and VOBA.First year commissions and general insurance expenses associated with the acquisition of new business are deferred and amortized over the premium-paying period of the related policies. The total deferrals of policy acquisition costs were $4.3 million and $3.8 million for the quarters ended March 31, 2007 and 2006, respectively. The increase in deferrals was primarily due to the increase in net new premiums and the associated increase in commissions and expenses in the worksite segment somewhat offset by the decrease in net new long term care premiums in the senior segment.

The amortization of deferred acquisition costs (DAC) and the value of business acquired (VOBA) increased $0.9 million, or 75.0%, to $2.1 million for the quarter ended March 31, 2007, from $1.2 million for the quarter ended March 31, 2006, reflecting the increased deferrals described above. The DAC balance at March 31, 2007 has increased $14.3 million, or 81.7%, over the balance at March 31, 2006. The increase in the DAC balance accounts for the increase in amortization expense.

Provision for Income Taxes.Total income taxes may differ from the amount computed by applying the federal corporate tax rate of 35% due to tax-advantaged investments and net operating loss carry forwards available. The effective income tax rates for the quarters ended March 31, 2007 and 2006 were 110.9 % and 33.9%, respectively. The variation in these rates is due to a valuation allowance of $6.8 million being established for the quarter ended March 31, 2007.

Under SFAS No. 109, management must provide a valuation allowance for any deferred tax amounts that it believes are uncertain to be realized. The decision by A.M. Best to change the outlook of our rating from stable to negative, and the resulting strategic options being considered, has created uncertainty about our ability and timing to



26

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generate taxable income at the holding company. Because of this uncertainty, the Company has deemed it appropriate to establish a valuation allowance of $6.8 million which represents the portion of the deferred tax asset that was generated by net operating losses at the holding 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 non-insurance subsidiary. Accordingly, KMG Americas cash flows depend upon the availability of dividends and other statutorily permissible payments, such as payments under tax allocation agreements and under management agreements, from Kanawha. Kanawhas ability to pay dividends and to make other payments is limited primarily by applicable laws and regulations of South Carolina, the state in which Kanawha is domiciled, which subjects insurance operations to significant regulatory restrictions. These laws and regulations require, among other things, that Kanawha, KMG Americas insurance subsidiary, maintain minimum solvency requirements and
limit the amount of dividends it can pay to the holding company. Solvency regulations, capital requirements, types of insurance offered and rating agency status are some of the factors used in determining the amount of capital available for dividends. In general, South Carolina will permit annual dividends from insurance operations equal to the greater of (1) the most recent calendar years statutory net income or (2) 10% of total capital and surplus of the insurance operations at the end of the previous calendar year, provided that the dividend payment does not exceed earned surplus, in which case further limitations apply.



For 2007, the maximum amount of dividends that Kanawha can pay to KMG America under applicable laws and regulations without prior regulatory approval is $7.2 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.



On March 22, 2007, KMG America completed the issuance and sale in a private placement of $35,000,000 in aggregate principal amount of trust preferred securities (the Trust Preferred Securities) issued by the Companys newly-formed subsidiary, KMG Capital Statutory Trust I, a Delaware statutory trust (the Trust). The Trust Preferred Securities will mature on March 15, 2037, may be called at par by the Company any time after March 15, 2012, and require quarterly distributions of interest by the Trust to the holder of the Trust Preferred Securities. Distributions will be payable quarterly at a fixed interest rate equal to 8.02% per annum through March 15, 2012, and then will be payable at a floating interest rate equal to the 3-month London Interbank Offered Rate (LIBOR) plus 310 basis points per annum. The Trust simultaneously issued one of the
Trusts common securities (the Common Securities) to the Company for a purchase price of $1,083,000, which constitutes all of the issued and outstanding common securities of the Trust.



The Trust used the proceeds from the sale of the Trust Preferred Securities together with the proceeds from the sale of the Common Securities to purchase $36,083,000 in aggregate principal amount of unsecured junior subordinated deferrable interest debt securities due March 15, 2037, issued by the Company (the Junior Subordinated Debt). The net proceeds to the Company from the sale of the Junior Subordinated Debt to the Trust will be used by the Company for general corporate purposes.



The Junior Subordinated Debt was issued pursuant to an Indenture, dated March 22, 2007 (the Indenture), between the Company, as issuer, Wilmington Trust Company, as trustee, and the administrators named



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therein. The terms of the Junior Subordinated Debt are substantially the same as the terms of the Trust Preferred Securities. The interest payments on the Junior Subordinated Debt paid by the Company will be used by the Trust to pay the quarterly distributions to the holders of the Trust Preferred Securities. The Indenture permits the Company to redeem the Junior Subordinated Debt (and thus a like amount of the Trust Preferred Securities) on or after March 15, 2012. If the Company redeems any amount of the Junior Subordinated Debt, the Trust must redeem a like amount of the Trust Preferred Securities.



On December 21, 2006, the Company entered into a credit agreement with Wachovia, which provides a $15.0 million unsecured revolving credit facility from which we borrowed $14.0 million to repay the five-year subordinated promissory note we issued to fund a portion of the purchase price for the Kanawha acquisition.  The remaining $1.0 million available under the credit facility may be used to finance the Companys working capital, liquidity needs and general working requirements and those of its subsidiaries.  Amounts outstanding under the credit agreement will bear interest at a rate calculated according to, at the Companys option, a base rate or the LIBOR rate plus an applicable percentage.  The applicable percentage is based on the A.M. Best financial strength rating of Kanawha, and ranges from 0.25% to 0.35% for base rate loans and from 1.25% to 1.35% for LIBOR rate loans. In
the case of LIBOR rate loans, interest on amounts outstanding is payable at the end of the interest period, which can be one, two, three or six months, as selected by the Company in its notice of borrowing.  Wachovias obligation to fund the credit agreement terminates, and all principal outstanding under the credit agreement is due and payable, no later than December 31, 2007.  As of December 31, 2007, the $14.0 million outstanding under the credit agreement was a LIBOR rate plus applicable percentage loan with an interest rate of 6.57%.



The credit agreement requires the Company to comply with certain covenants, including, among others, maintaining a maximum ratio of consolidated indebtedness to total capitalization, a minimum available dividend amount for Kanawha and a minimum A.M. Best financial strength rating of B++ for Kanawha.  The Company must also comply with limitations on certain payments, additional debt obligations, dispositions of assets and its lines of business.  The credit agreement also restricts the Company from creating or allowing certain liens on its assets and from making certain investments.



On February 18, 2005, a complaint was filed by plaintiffs ReliaStar Life Insurance Company and ReliaStar Life Insurance Company of New York (ReliaStar), both indirect wholly-owned subsidiaries of ING America U.S., in the Fourth Judicial District Court in Hennepin County, Minnesota, against KMG America, Kanawha, Kenneth U. Kuk, Paul Kraemer, Paul Moore and Thomas J. Gibb. Messrs. Kuk, Kraemer, Moore and Gibb are officers of KMG America and former employees of the plaintiffs.  The complaint alleges misappropriation of trade secrets, conversion, tortious interference with business and employment relationships, breach of fiduciary duties and breach of contract by KMG America, Kanawha and Messrs. Kuk, Kraemer, and Moore. The complaint seeks injunctive relief and unspecified monetary damages. On August 24, 2005, the plaintiffs amended their complaint to add Scott H. DeLong III and
Thomas D. Sass as defendants. Messrs. DeLong and Sass are officers of KMG America and former employees of the plaintiffs. The plaintiffs amended complaint adds claims alleging unfair competition, interference with contractual relationships, civil conspiracy, fraudulent misrepresentations and civil theft.  On April 17, 2007, the Court dismissed nine of the twelve claims alleged by the plaintiffs, leaving three claims against individual defendants Messrs. Kraemer, Moore and Gibb, relating to breach of fiduciary duty, breach of the duty of loyalty and unjust enrichment.   On May 4, 2007, the Company entered into a settlement agreement with ReliaStar regarding all claims, ending the litigation.  Pursuant to the settlement agreement, the Company will make a cash payment of $825,000 to ReliaStar in the second quarter of 2007. The amount paid by the Company in settlement of the litigation is less than the amount of defense costs the Company expected to pay through trial of the
litigation. The Company has been advised by the insurance carrier for its primary directors and officers insurance policy that the insurance carrier will reimburse the Company for only a portion of the amount paid by the Company in settlement of the litigation.  The Company disputes the insurance carriers decision and will pursue additional reimbursement from the insurance carrier under the insurance policy.



While our primary focus is organic growth of our existing businesses by expanding our product and marketing capabilities, we do evaluate opportunities to grow through strategic alliances and acquisitions of blocks of business and/or companies that are compatible with our core businesses.  If such opportunities arise we may make significant capital expenditures or acquisitions in 2007 or subsequent years. However, our primary focus is on significantly expanding outlays relating to marketing and sales activities over the next several years including outlays required to continue to build a national sales organization, which is a key component of our strategy. These



28

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outlays will include expenses such as salaries and cash incentive compensation, employee benefits, occupancy and information technology expenses of additional sales personnel, advertising and marketing costs, consulting and recruiting. The execution of our business plan will require additional outlays associated with the development of a national insurance company including home office expenses for executive management and additional financial, actuarial and underwriting personnel, infrastructure development and back-office expenses, as well as costs associated with our being a public company.



We anticipate that these costs will be offset over time by increased sales production resulting from hiring additional sales personnel and increased cross-selling, as well as efficiencies resulting from greater scale.



Analysis of Change in Financial Condition and Cash Flows



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



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

The table below shows the Companys net cash flows in the indicated periods:




Net cash provided by (used in)
        
        
        Quarter EndedMarch 31, 2007
        
        
        Quarter EndedMarch 31, 2006Operating activities
        
        $
        6,196.5
        
        $
        (651.8
        )Investing activities
        
        
        (18,294.1)
        
        
        (20,569.8
        )Financing activities
        
        
        36,083.0
        
        
        0.0Net change in cash
        
        $
        23,985.4
        
        $
        (21,221.6
        )




Cash Flows for the Quarters Ended March 31, 2007 and 2006.In the table shown above, increases in net cash provided by operating activities generally result from collected premiums while decreases in net cash flow provided by investing activities generally are a result of the investment of collected premiums. Policy and contract liabilities increase when premiums collected are retained to establish policy reserves. The portions of these liabilities that are reinsured by reinsurance companies are reflected in reinsurance balances recoverable.

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

Other changes in cash flows for the quarters ended March 31, 2007 and March 31, 2006, are as follows:

We held approximately $21.7 million in cash and cash equivalents at December 31, 2006, primarily consisting of investments in short term commercial paper. We invested a significant portion of this in longer term securities in the first three months of 2007, resulting in the net cash outflow from investing activities of $18.3 million for the three months ended March 31, 2007. This produced a corresponding increase in invested assets.



We also had $36.1 million net cash provided from financing activities as the result of the issuance of subordinated debt securities discussed previously in the Liquidity and Capital Resources section.



Other assets decreased by $1.7 million in the three months ended March 31, 2007 primarily as a result of claims reimbursements due from self funded Administrative Services Only (ASO) clients decreasing $1.3 million. These claims are not actually disbursed until receipt of these funds, so there is nothing at risk with these assets, and fluctuations from day to day are typical.



29

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Accounts payable and accrued expenses increased $2.9 million in the three months ended March 31, 2007, compared to a decrease of $0.4 million in the three months ended March 31, 2006 due to increases in our reinsurance settlements related to the acquired business and also due to a litigation settlement expense accrued of $0.8 million.



Federal income tax recoverable remained constant from the December 31, 2006 balance. The deferred tax asset decreased by $6.3 million and the deferred tax liability decreased by $1.0 million. The combination of these items resulted in a net decrease in tax assets of $5.3 million, inclusive of an increase of $0.3 million related to the increase in fair market value of invested assets.



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Investments

The following table summarizes the unrealized gains and losses in our investment portfolio as of March 31, 2007.

Amortized Cost
        
        GrossUnrealizedGains
        
        GrossUnrealizedLosses
        
        FairValueAvailable for sale securities at March 31, 2007:U.S. Treasuries
        
        $
        8,247,371
        
        $
        3,172
        
        $
        163,741
        
        $
        8,086,802U.S. Government Agencies
        
        
        19,510,116
        
        
        30,724
        
        
        166,071
        
        
        19,374,769States and Political Subdivisions
        
        
        13,429,525
        
        
        50,849
        
        
        242,032
        
        
        13,238,342Foreign Bonds
        
        
        33,476,401
        
        
        67,965
        
        
        986,894
        
        
        32,557,472Corporate Bonds
        
        
        227,102,348
        
        
        838,701
        
        
        7,019,291
        
        
        220,921,758Mortgage/Asset-Backed Securities
        
        
        219,537,232
        
        
        812,889
        
        
        2,919,512
        
        
        217,430,609Preferred StocksRedeemable
        
        
        26,309,185
        
        
        101,296
        
        
        507,413
        
        
        25,903,068Subtotal, Fixed Maturity Securities
        
        $
        547,612,178
        
        $
        1,905,596
        
        $
        12,004,954
        
        $
        537,512,820Equity Securities
        
        
        156,840
        
        
        0
        
        
        500
        
        
        156,340Securities Available For Sale
        
        $
        547,769,018
        
        $
        1,905,596
        
        $
        12,005,454
        
        $
        537,669,160




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



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

The substantial majority of our unrealized losses at March 31, 2007, can be attributed to increases in interest rates that caused the value of the fixed income securities in our investment portfolio to decrease.

Number ofIssues
        
        Aggregate UnrealizedLoss
        
        Aggregate Estimated Fair Value(in thousands)Securities at a loss for 12 months or less
        
        123
        
        $
        (2,328.8
        )
        $133,631.0Securities at a loss for more than 12 months
        
        334
        
        $
        (9,676.7
        )
        $278,650.8




Management has reviewed these securities which either have been in an unrealized loss position for more than twelve months or have significant unrealized loss relative to cost and have concluded that these securities have not



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experienced any other than temporary impairment. Factors considered in making this evaluation included issue specific drivers of the decrease in price, near term prospects of the issuer, the length of time and degree of volatility of the depressed  value, and the financial condition of the industry. Based on this review, no unrealized losses were considered to be other than temporary during the first quarter of 2007.



As a result of purchase accounting adjustments as required in connection with our acquisition of Kanawha as of December 31, 2004, the mark to market adjustments to the investment portfolio occurred at a time when very low market interest rates prevailed. Therefore, as interest rates rise, we would expect substantial unrealized investment losses. Due to the long range nature of our liabilities, the majority of these interest related unrealized losses are not expected to materialize into realized losses, and therefore should not have an adverse effect on our operations.

Reserves

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



As ofMarch 31, 2007
        
        As ofDecember 31, 2006(dollars in thousands)Life and annuity reserves
        
        $
        250,555.5
        
        $
        252,658.2Accident and health reserves
        
        
        298,802.8
        
        
        294,581.0Policy and contract claims
        
        
        24,215.6
        
        
        14,530.8Other policyholder liabilities
        
        
        10,849.8
        
        
        10,594.2Total policy liabilities
        
        $
        584,423.7
        
        $
        572,364.2




Life and annuity reserves decreased by $2.1 million, or 0.8%, to $250.6 million as of March 31, 2007, from $252.7 million as of December 31, 2006. A large portion of the life and annuity reserves relates to acquired blocks of business that are lapsing at a steady pace because no new blocks of business have been acquired since 1999, and therefore represents a significant portion of the decrease in reserves for the three months ended March 31, 2007. Accident and health reserves increased by $4.2 million, or 1.4%, to $298.8 million as of March 31, 2007 from $294.6 million as of December 31, 2006. These reserve increases are consistent with growth in the underlying business, with the majority of the reserve growth being accumulated from long-term care renewal premiums received. Policy and contract claims, which represent liabilities for actual claims incurred, increased by $9.7 million, or
66.9%, to $24.2 million as of March 31, 2007 from $14.5 million as of December 31, 2006.



After a comprehensive review of its stop loss book of business, the Company recognized a $6 million charge for increased claims and reserves that reflects recent experience on stop loss cases.  The Company began writing annually renewable stop loss in mid-2005, and initially relied on pricing assumptions, a common industry practice relative to new books of stop loss business, to establish expected loss ratios due to lack of credible actual claim experience.  As a contrast, companies with mature books of stop loss business typically establish claim reserves as a function of experience studies of its business.  Because actual claims on stop loss cases typically are not fully reported until after the end of the policy period, it is a common practice to increase or decrease claims reserves once the actual claims experience becomes known.



As experience has emerged, the Company has recognized additional claims and reserves reflecting the recent adverse claims experience.  The Company also decided to increase claims assumptions on business prospectively, reflecting a more conservative estimate of future claims on this business.  The Companys experience has been that it takes four quarters after a case has been written before a clear picture becomes apparent regarding claims for that case.  While some of the unfavorable claims data began to emerge late in the fourth quarter of 2006 and guided our reserving at year-end, new more meaningful data came to the Companys attention late in the first quarter of this year after the year-end books were closed and earnings reported.  As a result of the new data the Company has concluded that it would be prudent to increase the estimated loss ratios on newer cases for claims
before credible claims experience has developed on this business.  As a result of these actions, the Company



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believes its March 31, 2007 claim reserves on stop loss business adequately reflects both the development of recent experience and the Companys more conservative outlook on loss experience related to current premiums.



Other policyholder liabilities, which are comprised primarily of dividend accumulations and advance premiums, increased by $0.2 million, or 1.9%, to $10.8 million as of March 31, 2007 from $10.6 million as of December 31, 2006.



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



As ofMarch 31, 2007
        
        As ofDecember 31, 2006(dollars in thousands)Ceded future policyholder benefits and expense
        
        $
        86,079.6
        
        $
        86,296.1Ceded claims and benefits payable
        
        
        3,473.8
        
        
        2,795.1Reinsurance recoverables
        
        $
        89,553.4
        
        $
        89,091.2




Reinsurance recoverables increased by $0.5 million, or 0.5%, to $89.6 million as of March 31, 2007, from $89.1 million as of December 31, 2006. The increase in the recoverable balance is attributable to underlying business growth, specifically the growth in long-term care and excess risk business reinsured.

Critical Accounting Policies and Estimates

Our consolidated financial statements and certain disclosures made in this report have been prepared in accordance with GAAP and require us to make estimates and assumptions that affect reporting amounts of assets and liabilities and contingent assets and contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. The estimates most susceptible to material changes due to significant judgment (identified as the critical accounting policies) are those used in determining investment impairments, the reserves for future policy benefits and claims, deferred acquisition costs and value of business acquired, and the provision for income taxes. The results of these estimates are critical because they affect our profitability and may affect key indicators used to measure our performance. These estimates
have a material effect on our results of operations and financial condition. For more information about our critical accounting policies, please refer to our discussion of critical accounting policies in our Annual Report on Form 10-K for the year ended December 31, 2006.

Forward-Looking Statements

Forward-looking statements in the foregoing Managements Discussion and Analysis of Financial Condition and Results of Operations include statements that are identified by the use of words or phrases including, but not limited to, the following: will likely result, expected to, will continue, is anticipated, estimated, project, believe, expect, and words or phrases of similar import. Changes in the following important factors, among others, could cause our actual results to differ materially from those expressed in any such forward-looking statements: competitive products and pricing; fluctuations in demand; possible recessionary trends in the United States economy; governmental policies and regulations; interest rates; risks disclosed in Part I Item 1A to Annual Report of Form 10-K for the
year ended December 31, 2006; and other risks that are detailed from time to time in reports we file with the Securities and Exchange Commission. We undertake no obligation to update any forward-looking statements, whether as a result of new information, future events or otherwise.

ITEM 3.
        QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK


There are no material changes to the disclosure on this matter made in our Annual Report on Form 10-K for the year ended December 31, 2006.

ITEM 4.
        CONTROLS AND PROCEDURES


We maintain disclosure controls and procedures that are designed to ensure that information required to be




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disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of March 31, 2007. Based upon that evaluation, our management, including our Chief Executive Officer and our Chief Financial Officer, concluded that our disclosure controls and
procedures were effective as of March 31, 2007. There was no change in our internal control over financial reporting during the quarter ended March 31, 2007, 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 Note 7, Commitments and Contingencies, of the Notes to Consolidated Financial Statements included in this report, which discuss certain legal proceedings in which we are involved, is incorporated herein by reference.

ITEM 1A.
        RISK FACTORS


As of March 31, 2007, the following  risk factors of the Company, as previously disclosed in the Companys  Annual Report on Form 10-K for the fiscal year ended December 31, 2006, have had material changes.

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



Kanawha has an A.M. Best financial strength rating of A- (excellent), which is the second highest of ten categories and the lowest within the category based on modifiers (i.e., A and A- are excellent).  Recently, A.M. Best changed its outlook of Kanawhas rating from stable to negative.  A negative outlook indicates a company is experiencing unfavorable financial/market trends, relative to its current rating level and, if continued, the company has a good possibility of having its rating downgraded.



S&Ps current financial strength rating for Kanawha is A- (strong), which is the third highest of nine categories and the lowest within the category based on modifiers (i.e., A+, A and A- are strong).  Recently, S&P placed Kanawhas A- financial strength rating on a credit watch.  A rating may be placed on credit watch when an event or deviation from an expected trend has occurred or is expected, when this event or deviation increases the probability of a rating action, and when additional information is necessary to take a rating action.  Normally, S&P makes a decision on a rating action within 90 days after a rating has been placed on credit watch.



Rating agencies review their ratings periodically and Kanawhas current ratings may not be maintained in the future. If Kanawhas ratings are reduced from their current levels by A.M. Best or S&P, or as recently occurred, are placed under surveillance or review with possible negative implications, our competitive position in the insurance industry would likely suffer and we would likely lose customers.  Since A.M. Best changed Kanawhas rating outlook from stable to negative, we have not been precluded from bidding on group cases, although we have lost some cases we expected to be awarded.  If Kanawhas financial strength ratings are reduced,  the negative impact may be more pronounced.  Our cost of borrowing would likely increase, our sales and earnings would likely decrease and our results of operations and financial condition would likely be materially adversely affected.



For example, a minimum A.M. Best rating of A- is generally required to participate in the group life and disability and excess risk insurance markets.  If Kanawhas A.M. Best rating of A- is reduced, we likely will be precluded from participating in those markets, which are key to our growth and financial strength.



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Factors that could cause the rating agencies to reduce Kanawhas ratings include:




        a continuation of statutory losses in the future;



        claims experience in excess of expectations;



        decline in the share price of our common stock, which could jeopardize our ability to raise capital to fund Kanawhas financial and growth needs;



        a continuation of current competitive environment in the insurance industry, particularly in the medical excess risk insurance markets;



        the inherent uncertainty in determining reserves for future claims, which may cause us to increase our reserve for claims (for example, the $6 million additional claims and reserves reflecting the recent adverse claims experience may be a factor causing A.M. Best to downgrade Kanawha);



        possible changes in the methodology or criteria applied by the rating agencies;



        inability to maintain our existing sales organization or recruit additional sales representatives; and



        our financial performance compared to other similarly rated companies.




The methodology, criteria and judgment applied by the ratings agencies in performing their financial strength evaluations are proprietary to each ratings agency and cannot be replicated by us to predict what rating they may assign to Kanawha in the future.  Moreover, the ratings agencies may change the methodology, criteria and judgment they apply at any time, without advance notice to us.  Further, they may apply their methodology, criteria and judgment uniformly across all companies in the insurance industry or they may choose to apply different methodology, criteria and judgment to individual companies.  Accordingly, there can be no assurance that the rating agencies will maintain Kanawhas current ratings.



In addition to the financial strength ratings of our insurance subsidiary, A.M. Best also publishes an indicative credit rating, which reflects its opinion of our ability to repay our indebtedness.  The indicative credit rating may have an impact on the interest rates we pay on the money we borrow.  Therefore, a downgrade in this indicative credit rating would increase our cost of borrowing and have an adverse effect on our results of operations and financial condition.



We may be unable to accurately predict benefits, claims and other costs or to manage those costs through our loss limitation methods, which could result in our incurring greater claims losses than we anticipate.



Our profitability depends in large part on accurately predicting benefits, claims and other costs, including medical and dental costs, as well as the frequency and magnitude of claims on our disability and other coverages. It also depends on our ability to manage future benefit and other costs through product design, underwriting criteria, utilization review or claims management (our efforts to mitigate the extent of losses incurred by those insured under our policies and the corresponding benefit costs) and, in health and dental insurance, negotiation of favorable provider contracts.



Our ability to predict and manage costs and claims, as well as our results of operations and financial condition may be adversely affected by:




        changes in health and dental care practices;



        inflation;



        new technologies;



        the cost of prescription drugs;



        clusters of high cost cases;



        changes in the regulatory environment;



        economic factors;



        inherent claims volatility in new insurance products with little actual claims history, such as our employer excess risk insurance (which we sometimes refer to as employer medical stop loss insurance);



        the occurrence of catastrophes; and



        numerous other factors affecting the cost of health and dental care and the frequency and severity of claims in all our business segments.




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Claims volatility in the Companys new medical stop loss insurance line of business is an example of the difficulty to predict and manage claims and the adverse effect it can have on the Companys operations and financial condition.



After a comprehensive review of its stop loss book of business, the Company recognized a $6 million charge for increased claims and reserves that reflects recent experience on stop loss cases.  The Company began writing annually renewable stop loss in mid-2005, and initially relied on pricing assumptions, a common industry practice relative to new books of stop loss business, to establish expected loss ratios due to lack of credible actual claim experience.  As a contrast, companies with mature books of stop loss business typically establish claim reserves as a function of experience studies of its business.  Because actual claims on stop loss cases typically are not fully reported until after the end of the policy period, it is a common practice to increase or decrease claims reserves once the actual claims experience becomes known.



As experience has emerged, the Company has recognized additional claims and reserves reflecting the recent adverse claims experience.  The Company also decided to increase claims assumptions on business prospectively, reflecting a more conservative estimate of future claims on this business.  As a result of these actions, the Company believes its March 31, 2007 claim reserves on stop loss business adequately reflects both the development of recent experience and the Companys more conservative outlook on loss experience related to current premiums.



The Companys experience has been that it takes four quarters after a case has been written before a clear picture becomes apparent regarding claims for that case.  While some of the unfavorable claims data began to emerge late in the fourth quarter of 2006 and guided our reserving at year-end, new more meaningful data came to the Companys attention late in the first quarter of this year after the year-end books were closed and earnings reported.  As a result of new data, the Company has concluded that it would be prudent to increase the estimated loss ratios on newer cases for claims before credible claims experience has developed on this business.



The judicial and regulatory environments, changes in the composition of the kinds of work available in the economy, market conditions and numerous other factors may also materially adversely affect our ability to manage claim costs. As a result of one or more of these factors or other factors, claims could substantially exceed our expectations, which could have a material adverse effect on our results of operations and financial condition. We also may be limited in our ability to respond to such changes by insurance regulations, existing contract terms, contract filing requirements, market conditions or other factors.



Our actual claims losses may exceed our reserves for claims, which may require us to establish additional reserves that may materially reduce our earnings, profitability and capital.



We maintain reserves to cover our estimated ultimate exposure for claims and claim adjustment expenses with respect to reported claims as well as claims that have been incurred but not yet reported to us as of the end of each accounting period. Reserves, whether calculated under United States generally accepted accounting principles (GAAP) or statutory accounting principles (SAP) (rules and procedures prescribed or permitted by state insurance regulatory authorities which, in general, reflect a liquidity, rather than going concern, concept of accounting), do not represent an exact calculation of our exposure. Instead, they represent our best estimates, generally involving actuarial projections at a given time, of what we expect the ultimate settlement and administration of a claim or group of claims will cost based on our assessment of facts and circumstances then known. The adequacy of
reserves is impacted by future trends in claims severity, frequency, judicial theories of liability and other factors. These variables are affected by both external and internal events over which we have little or no control, such as:




        changes in the economic cycle;



        emerging medical perceptions regarding physiological or psychological causes of disability or the need for long-term care services;



        emerging health issues and new methods of treatment or accommodation;



        inflation;



        judicial trends;




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
        legislative changes;



        inherent claims volatility in new insurance products with little actual claims history, such as our employer excess risk insurance (which we sometimes refer to as employer medical stop loss insurance); and



        claims handling procedures.


Many of these items are not directly quantifiable, particularly on a prospective basis. Reserve estimates are refined as experience develops.  Adjustments to reserves, both positive and negative, are reflected in the statement of operations of the period in which such estimates are updated. Because establishment of reserves is an inherently uncertain process involving estimates of future losses, we cannot assure you that our ultimate losses will not exceed existing claims reserves. Moreover, future loss development could require reserves to be increased, which could have a material adverse effect on our earnings in the periods in which such increases are made.



Policy and claim reserves were $531 million, and $548 million and $572 million as of December 31, 2004, 2005 and 2006, respectively. These reserves are reevaluated each year, and we determined to increase our policy and claim reserves by $2.2 million as of December 31, 2006 to adjust for higher than estimated claims experience on our stop loss policies sold during the fourth quarter of 2005 and the first, second and third quarters of 2006.



After a comprehensive review of its stop loss book of business, the Company recognized a $6 million charge for increased claims and reserves that reflects recent experience on stop loss cases.  The Company began writing annually renewable stop loss in mid-2005, and initially relied on pricing assumptions, a common industry practice relative to new books of stop loss business, to establish expected loss ratios due to lack of credible actual claim experience.  As a contrast, companies with mature books of stop loss business typically establish claim reserves as a function of experience studies of its business.  Because actual claims on stop loss cases typically are not fully reported until after the end of the policy period, it is a common practice to increase or decrease claims reserves once the actual claims experience becomes known.



As experience has emerged, the Company has recognized additional claims and reserves reflecting the recent adverse claims experience.  The Company also decided to increase claims assumptions on business prospectively, reflecting a more conservative estimate of future claims on this business.  As a result of these actions, the Company believes its March 31, 2007 claim reserves on stop loss business adequately reflects both the development of recent experience and the Companys more conservative outlook on loss experience related to current premiums.



The Companys experience has been that it takes four quarters after a case has been written before a clear picture becomes apparent regarding claims for that case.  While some of the unfavorable claims data began to emerge late in the fourth quarter of 2006 and guided our reserving at year-end, new more meaningful data came to the Companys attention late in the first quarter of this year after the year-end books were closed and earnings reported.  As a result of new data, the Company has concluded that it would be prudent to increase the estimated loss ratios on newer cases for claims before credible claims experience has developed on this business.



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ITEM 6.
        EXHIBITS




(a)
        Exhibits:


4.1
        Indenture between KMG America Corporation and Wilmington Trust Company, as indenture trustee, dated March 22, 2007 (incorporated by reference from Exhibit 4.1 attached to KMG America Corporations Current Report on Form 8-K, filed on March 23, 2007).




4.2
        Amended and Restated Declaration of Trust among KMG America Corporation and Wilmington Trust Company, as institutional trustee and Delaware trustee, and the administrators named therein, dated March 22, 2007 (incorporated by reference from Exhibit 4.2 attached to KMG America Corporations Current Report on Form 8-K, filed on March 23, 2007).




10.1
        Guarantee Agreement between KMG America Corporation and Wilmington Trust Company, as guarantee trustee, dated March 22, 2007 (incorporated by reference from Exhibit 10.1 attached to KMG America Corporations Current Report on Form 8-K, filed on March 23, 2007).




10.2
        Placement Agreement among KMG America Corporation, KMG Capital Statutory Trust I, FTN Financial Capital Markets and Keefe, Bruyette & Woods, Inc., dated March 22, 2007 (incorporated by reference from Exhibit 10.2 attached to KMG America Corporations Current Report on Form 8-K, filed on March 23, 2007).




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:  May 10, 2007
        By:
        /s/ Scott H. DeLong IIIName: Scott H. DeLong III
Title: Senior Vice President & Chief Financial Officer
(Principal Financial Officer)Date:  May 10, 2007
        By:
        /s/ Glenn S. SackettName: Glenn S. Sackett
Title: Vice President & Controller
(Principal Accounting Officer)














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