Income before extraordinary Items .....................$ 2,998 $ 1,356 $ 214 $ 3,674 $ 3,438 Extraordinary gain ............. 0 0 0 0 263 $ 2,998 $ 1,356 $ 214 $ 3,674 $ 3,701
Consolidated Results of Operations: Consolidated net income from The National Security Group was $2.998 million in 1997, more than double the 1996 results of $1.356 million. Net income from 1996 was up over $1.1 million from the 1995 total of $215,000. Earnings per share were $1.28 in 1997 compared to $.58 in 1996, and $.09 in 1995. The increase in net income is primarily due to a reduction in litigation expenses and an increase in realized capital gains from the sale of common stock investments which have flourished in the current Bull Market. Consolidated revenues grew 17% to $38.8 million compared to $33.0 million in 1996. Revenues in 1996 increased $2.2 million from $30.8 million in 1995. Revenue increases are primarily due to growth in the property/casualty subsidiaries private passenger automobile programs in Louisiana and Georgia.
Life and Accident and Health Insurance Operations: Pretax earnings in 1997 of $2.2 million were significantly better than 1996 earnings of $1.1 million. There was a pretax loss in 1995 of $178,000. The primary factor contributing to the improvement in earnings was a reduction in litigation expenses. In 1997 litigation expenses were only $80,000 compared to $760,000 in 1996. Litigation expenses in 1995 were $2.3 million. Also contributing to the increase in earnings was realized capital gains which increased over $400,000 in 1997 compared to 1996.
Premium income, which totaled $4.0 million in 1997, has declined gradually over the last five years and has decreased by 27% over this period of time. The reduction in premium income is due to a reduction in the number of sales agents. The number of sales agents has declined by 69% over the last five years to the current total of 31. Premium income decreased $400,000 to $4.0 million in 1997 compared to 1996 premium income of $4.4 million. Premium income in 1996 was down $500,000 from the total in 1995 of $4.9 million. A new agents contract which became effective January 1, 1998 is expected to improve retention of premiums. Also, new products and distribution methods will be introduced in 1998 which is expected to improve prospects for future premium growth.
The combined ratio for 1997 did not improve compared to 1996 due to increased losses in the private passenger automobile programs. The low value dwelling program loss ratio improved greatly in 1997 but was offset by the increase in automobile losses. The combined ratio for 1996, though improved over 1995 was still higher than historical averages for the property-casualty subsidiaries. The primary reason for the high combined ratio was higher than normal incurred losses in the low value dwelling program in the first quarter of 1996. These losses were attributable to the colder than normal winter which led to more fire losses and several tornado producing storms which hit the Southeastern United States. The combined ratio for 1995 was abnormally high due to losses sustained in Hurricane Opal.
Asset Portfolio Review: The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. At December 31, 1997, the company's holdings in debt securities amounted to 57% of total investments and 48% of total assets. The following is a breakdown of the bond portfolio quality according to National Association of Insurance Commissioners (NAIC) Securities Valuation Office (SVO) rating standards, and the nationally recognized rating organization equivalents of Moody's and Standard and Poor's:
As of January 1, 1994, the Company adopted Financial Accounting Standards Board Statement 115 and reclassified a portion of its fixed maturity securities portfolio as "available-for-sale," with the remainder being classified as "held-to-maturity." With that reclassification, the fixed maturity securities classified as "available-for-sale" are carried at fair value and changes in fair values, net of related income taxes, are charged or credited to shareholders' equity (see Note 3 to the consolidated financial statements).
The National Security Group's consolidated statement of cash flows indicate that operating activities provided (used) cash of $7.48 million, $1.45 million, $(3.6) million in 1997, 1996, and 1995 respectively. Those statements also classify the other sources and uses of cash by investing activities, and financing activities and disclose the amount of cash available at the end of the year to meet the Company's obligations. An increase in profits of $1.6 million, and a large decrease in reinsurance recoveries of $4 million are the major causes of a $6 million increase in cash provided from operations in 1997.
The primary reason for the increase in cash provided by operating activities for 1996 was the increased cash flow from the new automobile programs. The primary reason for the large increase in cash used for operating activities in 1995 was Hurricane Opal which hit Alabama in early October. The cash provided from the sale of available-for-sale securities helped offset the increase in cash required to pay hurricane claims.
The ratios of Total Adjusted Capital to Authorized Control Level RBC for The National Security Group's life/health and property/casualty insurance subsidiaries are all in excess of five to one at December 31, 1997.
National Security Insurance Company (life insurer) has regulatory adjusted capital of $13.4 million and $10.1 million at December 31, 1997 and 1996, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 8.5 and 8.3 at December 31, 1997 and 1996 respectively. Accordingly, National Security Insurance Company meets the minimum RBC requirements.
The year 2000 issue relates to computer system programs which may not properly recognize the change in date years from 1999 to 2000. As a result of this time sensitivity of existing software, any business entity is at risk for possible system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions, send billings, or engage in similar normal business activities.
The Company is utilizing internal resources to reprogram and test software for year 2000 modifications. The Company anticipates completing the year 2000 project no later than June 30, 1999. The total cost of the year 2000 project is not material to the financial results of the Company.
We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
(Dollars in thousands except per share amounts) Years Ended December 31, 1997 1996 1995
Principles of Consolidation The accompanying consolidated financial statements include the accounts of The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries: National Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and NATSCO, Inc. (NATSCO). During 1993, NSFC formed a wholly-owned subsidiary - Omega One Insurance Company (OMEGA). All significant intercompany transactions and accounts have been eliminated.
Description of Major Products NSIC is licensed in the states of Alabama, Georgia, Mississippi, Texas and Florida and was organized in 1947 to provide life and burial insurance policies to the home service market. Premiums sold and serviced by company agents primarily include industrial life, larger ordinary life, accident and health, limited hospital, cancer and low valued life insurance. NSFC operates in various property and casualty lines, the most significant of which are low valued dwelling property, home service fire, nonstandard automobile physical damage and liability, nonstandard commercial, ocean marine and inland marine. Omega operates in property and casualty lines, the most significant of which is commercial auto liability.
Unrealized holding gains and losses, net of tax, on securities available-for-sale are reported as a net amount in a separate component of shareholders' equity until realized.
Disclosures About Fair Value of Financial Instruments In 1995, the Company adopted Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments (SFAS 107) which requires companies to disclose fair value information about certain financial instruments. SFAS No. 107 defines fair value as the quoted market prices for those instruments that are actively traded in financial markets. In cases where quoted market prices are not available, fair values are estimated using present value or other valuation techniques. The fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, such as estimates of timing and amount of expected future cash flows. Such estimates do not reflect any premium or discount that could result from offering for sale at one time the Company's entire holdings of a particular financial instrument, nor do they consider the tax impact of the realization of unrealized gains or losses. In many cases, the fair value estimates cannot be substantiated by comparison to independent markets, nor can the disclosed value be realized in immediate settlement of the instrument.
The fair value of the mortgage loan portfolio was approximately equal to the carrying amount of $320,000 on December 31, 1997 and $405,000 on December 31, 1996.
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) which vary in certain respects from reporting practices prescribed or permitted by insurance regulatory authorities. The significant differences for statutory reporting include: (a) acquisition costs of acquiring new business are charged to operations as incurred, (b) life policy liabilities are established utilizing interest and mortality factors specified by regulatory authorities, (c) the Asset Valuation Reserve (AVR) and the Interest Maintenance Reserve (IMR) are recorded as liabilities, (d) deferred income taxes are not provided, and (e) non-admitted assets (furniture and equipment, agents' debit balances and prepaid expenses) are charged directly to surplus.
Statutory net gains from operations and capital and surplus, excluding intercompany transactions, are summarized as follows:
Held-to-maturity securities: Due in one year or less $ 1,976,325 $ 1,989,228 Due after one year through five years 7,717,801 7,987,579 Due after five years through ten year 10,484,881 10,881,124 Due after ten years 9,815,890 9,949,631
Proceeds from the maturity or call of held-to-maturity securities during 1997 and 1996 were $5,258,588 and $5,773,992, respectively. Gross gains of $50,619 and $29,565 and gross losses of $531 and $342 for 1997 and 1996, respectively, were realized on those maturities or calls.
An analysis of investment gains follows: Year ended December 31, 1997 1996 1995
Net realized investment gains: Fixed maturities ........................... $ 66 $ 12 $ 56 Other, principally equity securities 2,654 1,827 1,594 ------- ------- ------- $ 2,720 $ 1,839 $ 1,650
The approximate income tax effects of changes in temporary differences are as follows: Year ended December 31, 1997 1996 1995
Under pre-1984 life insurance company tax laws, a portion of NSIC's gain from operations was not subject to current income taxation, but was accumulated for tax purposes in a memorandum account designated "policyholders' surplus". The aggregate balance in this account, $3,720,000 at December 31, 1997, would be taxed at current rates only if distributed to shareholders or if the account exceeded a prescribed minimum. The Deficit Reduction Act of 1984 eliminated additions to policyholders' surplus for 1984 and thereafter. Deferred taxes have not been provided on amounts designated as policyholders' surplus. The deferred tax liability not recognized is approximately $1,270,000 at December 31, 1997.
NOTE 6 - REINSURANCE: NSFC is involved as a reinsurer in which it assumes some of the risk originally undertaken by another insurance company. Conversely, NSFC and NSIC also are involved in transactions in which another insurance company assumes some of the risk originally undertaken by NSFC and NSIC. Reinsurance contracts do not relieve NSIC and NSFC from their obligations to policyholders. Failure of reinsurers to honor their obligations could result in losses to NSIC and NSFC. NSIC and NSFC evaluate the financial condition of their reinsurers and monitor concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize their exposure to significant losses from reinsurance insolvences. At December 31, 1997, reinsurance receivables with a carrying value of $406,000 and prepaid reinsurance premiums of $341,000 were associated with a single reinsurer.
The effect of reinsurance on premiums written and earned is as follows: (Dollars in Thousands) ---------------------------------- NSIC NSFC ---------------- ---------------- Written Earned Written Earned ------- ------ ------- -------- Direct ......... $ 4,118 $ 4,039 $ 29,270 $ 30,815 Assumed ........ -- -- -- -- Ceded .......... (48) (48) (2,086) (520) -------- -------- -------- -------- Net ............ $ 4,070 $ 3,991 $ 27,185 $ 30,295 -------- -------- -------- --------
NSFC also reinsures certain portions of insurance risk which exceed various retention limits. Claim liabilities for NSFC are stated after a deduction for reinsurance ceded to other companies totaling $7,146,000 at December 31, 1997. Reinsurance recoveries for claims and claim settlement expense were $1,343,000 during 1997.
NOTE 7 - EMPLOYEE BENEFIT PLAN: In 1989, the Company and its subsidiaries established a retirement savings plan and transferred the assets from the defined contribution profit sharing plan into the new plan. All full-time employees who have completed one year of service at January 1 or July 1 are eligible to participate and all employee contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Contributions for 1997, 1996 and 1995 amounted to $170,000, $90,708 and $-0-, respectively. Contributions are at the Board of Directors' discretion subject to governmental limitations.
In 1987, the Company established a deferred compensation plan for its Board of Directors. The Board members have an option of deferring their fees to a cash account or to a stock account and all share deferrals are recorded at the fair market value on the date of the award. Costs of the deferred compensation plan for 1997, 1996 and 1995 amounted to approximately $228,525, $61,813 and $13,000, respectively.
NOTE 10 - INDUSTRY SEGMENTS: The Company and its subsidiaries operate primarily in the insurance industry. Premium revenues and operating income by industry segment for the years ended December 31, 1997, 1996 and 1995 are summarized below:
NOTE 11 - CONTINGENCIES: The Company and its subsidiaries continue to be named as parties to litigation related to the conduct of their insurance operations. These suits involve alleged breaches of contracts, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of the Company's subsidiaries, and miscellaneous other causes of action. Most of these lawsuits include claims for punitive damages in addition to other specified relief. The frequency of these lawsuits has increased significantly in recent years, particularly in Alabama where the Company conducts the majority of its business. Certain of these actions are filed in jurisdictions in Alabama where local juries have returned large punitive damage verdicts against insurance companies and financial institutions with, in many cases, the punitive damage award bearing little or no relation to the actual damages. It is not feasible to predict or determine the ultimate outcome of these matters.
On October 4, 1996, a jury in the Circuit Court of Palm Beach County, Florida returned a verdict against National Security Fire & Casualty Company, a subsidiary of the Company, in the amount of $995,252. The plaintiff, Leon B. King, had alleged that the Company's subsidiary had acted in bad faith in, among other actions, failing to timely deliver a settlement check in connection with a 1986 automobile accident. This same case was previously tried in 1993 with the jury returning a verdict in favor of the Company's subsidiary on all counts alleged. This verdict was subsequently reversed on appeal which resulted in the subject trial. Various post-trial motions including a motion for a new trial were denied and this verdict is being appealed. The amount of this verdict is reflected in the accompanying financial statements. It should be noted, however, that in the event that this verdict is ultimately upheld, there could be an award of additional amounts including interest and attorneys' fees.
A resolution of these matters may significantly impact consolidated earnings and may significantly impact the Company's consolidated financial position, although it remains management's opinion, based upon information presently available, that the ultimate resolution of these matters will not have a material impact on the Company's consolidated financial position. It should be noted, however, that management is unable to assess with any degree of accuracy the potential liability to the Company arising from these matters. The civil tort system, particularly in Alabama, must be presently regarded as, for the most part, hostile to insurance companies.
NOTE 12 - CONCENTRATION OF CREDIT RISK: The Company maintains its cash accounts primarily with banks located in Alabama. The total cash balances are insured by the FDIC up to $100,000 per bank. A summary of the total insured and uninsured amounts held by all banks at December 31, 1997 follows: (Dollars in thousands)
Deposit in transit ( 771) Outstanding checks 2,666 -------- Total cash held at banks 1,069 Portion secured by FDIC ( 613) -------- Uninsured cash balances $ 456 --------
Note: Net reinsurance assumed premiums were, $0, $0, and $(2) for 1997, 1996, and 1995, respectively.