The following analysis of the Results of Operations should be read in conjunction with the Consolidated Financial Statements, which begin on Page 31 of this Form 10-K. Primary reference is made to the Consolidated Statements of Income on page 33 and segment information provided in Note 14 to the Consolidated Financial Statements.
For the fourth consecutive year, 2005 premium revenue reached a new Company record high despite reductions for reinstatement premiums related to Hurricane Katrina. Total premium revenue was $53,563,000, an increase of just over 1% over 2004 premium revenue of $52,985,000. Premium revenue in 2005 included reductions for catastrophe reinsurance reinstatement premium triggered by Hurricane Katrina of $2,400,000 and premium revenue in 2004 included reductions for catastrophe reinsurance reinstatement premium triggered by Hurricane Ivan of $1,400,000. Life segment revenue accounted for 11.6% of consolidated premium revenue while property and casualty segment revenue accounted for 88.4% of consolidated premium, virtually no change from the same period last year.
Consolidated income before income taxes declined 37.5% in 2005 to $2,400,000 compared to $3,853,000 in 2004. Third quarter hurricanes Dennis, Katrina and Rita were the primary factors contributing to the decline in income before taxes in 2005 compared to the same period last year. Gross incurred losses, before reinsurance recoveries, from the third quarter hurricanes totaled $38,949,000.
For the third consecutive year, 2004 premium revenue reached a new Company record high. Total premium revenue was $52,985,000, an increase of 11.5% over 2003 premium revenue of $47,536,000. Life segment revenue accounted for 11.7% of consolidated premium revenue and increased 6.5% over 2003. Property and casualty segment revenue accounted for 88.5% of consolidated premium revenue and increased 12.2% over 2003. Continued strong growth in the dwelling property lines of business, particularly the homeowners line of business, were the major contributor to increases in property and casualty premium revenue.
Consolidated income before income taxes declined 31.5% in 2005 to $3,853,000 compared to $5,628,000 in 2003. Hurricane Ivan, which struck the Alabama Gulf coast in September of 2004, is the primary factor leading to the decline in consolidated income before income taxes. Gross incurred losses, before reinsurance recoveries, from Hurricane Ivan totaled $14,577,000 including paid losses of $12,806,000, case unpaid losses and adjustment expenses of $1,077,000 and incurred but not reported reserve (IBNR) estimates of $694,000. After reinsurance recoveries, pre-tax losses from Hurricane Ivan totaled over $4,100,000 and a catastrophe reinsurance reinstatement premium of $1,400,000 was also incurred in the third quarter of 2004. As for the bottom line impact from Hurricane Ivan, consolidated net income declined by over $3,600,000 due to losses and expenses related to Hurricane Ivan. As a result of Hurricane Ivan earnings per share, for 2004, declined by $1.46.
Consolidated net income for 2004 was $3,113,000 compared to $4,090,000 in 2003, a decline of 23.9%. Again, Hurricane Ivan was the primary factor contributing to the decline in consolidated net income. On a per share basis earnings were $1.26 in 2004 compared to $1.66 in 2003.
Additional details on the sources of premium revenue growth and the impact of individual segments on consolidated income will be discussed in the respective Segment Results of Operations sections that follow.
Commission expense, including field servicing cost from the home service method of distribution, as a percent of premium revenue increased 2 percentage points in 2005 compared to 2004. This increase was primarily due to increased separation cost associated in reducing home service management personnel. Independent agent commission expense and other cost of distribution decline 3.7 percentage points in 2005 compared to 2004. These costs are expected to continue to decline 3 to 5 percentage points per year for the next couple of years until the renewal book of business reaches a point of maturity to support short term profitability. Life insurance commission rates for independent agents are typically front loaded meaning that higher commissions are paid in the early years of a policy and commission rates decline as the policy ages. Because the independent agent method of distribution is a relatively new method of distribution, overall commission rates are skewed higher because the majority of in force policies are still paying the higher commission rates of the early years. Management is continuing to focus on reducing commissions through improving the rate of retention of new and existing business.
Premium revenue increased to $6,173,000 in 2004 compared to $5,799,000 in 2003, an increase of 6.5%. Premium revenue produced by independent agents totaled $2,537,000 in 2004 compared to $2,186,000 in 2003, a 16% increase. While NSIC is continuing to focus on growth through the independent agent method of distribution, we will begin to shift focus to an increased focus on quality. Premium revenue produced by NSIC home service agency force increased slightly in 2004 to $2,996,000 from $2,970,000 in 2003. Due to changing market conditions, the home service market is not considered to be a growth market, but the Company intends to maintain a niche in this market to serve our current policyholders that prefer this method of service. At December 31, 2004 NSIC had 17 home service agents that serviced this book of business.
Claims frequency increased significantly in 2005 compared to 2004 with claims on dwelling lines of business (homeowners and dwelling fire) exceeding 15,800 claims compared to 12,500 claims in 2004. Approximately 8,450 claims were reported from Hurricane Katrina in 2005, very close to the 8,500 claims were reported from Hurricane Ivan in 2004. However, the average severity of claims from Hurricane Katrina was much higher with losses averaging over $3,500 each compared to less than $2,000 per occurrence from Hurricane Ivan. The increase in the average loss per claim is due to the widespread
impact of this huge storm causing severe damage in coastal areas of Alabama, Louisiana and the most heavily impacted coastal area, Mississippi. The most heavily impacted coastal area for us from Hurricane Ivan was concentrated in Baldwin County, Alabama. Additionally, we paid nearly $3.5 million in underwriting association assessments due to losses from Hurricane Katrina. In addition to Katrina, we incurred over 1,600 claims from Hurricane Rita with an average severity of $3,000 and Hurricane Dennis with over 500 claims and an average severity of $1,300. Non-hurricane related dwelling property claims totaled 5,200 in 2005 which remained consistent with 2004 non-hurricane related claims of just over 5,000. Average severity for all dwelling property claims was $4,000 per occurrence in 2005 compared to $2,900 in 2004. As discussed earlier, 2004 average severity was skewed downward due to lower average claims from Hurricane Ivan. Hurricanes typically cause higher number of claims (frequency) and a lower average cost per claim (severity) than tornado related losses. Tornadoes tend to affect a more isolated area and therefore have a lower frequency but typically cause more structural damage including a higher proportion of total losses therefore severity is greater from tornado losses. Non-catastrophe related dwelling losses typically have an average per loss severity in the $3,500 to $4,000 range for the P&C subsidiaries.
While we would like to think that the events of the last two years are statistical anomalies, we are taking a critical look at our hurricane risk mitigation program with a goal of better managing this risk should we actually be entering an era of more frequent and severe Atlantic and Gulf Coast hurricanes. This is especially challenging for us as a regional carrier with a large percentage of total business concentrated primarily in the Southeastern United States. Because of our geographic concentration of risk, we will be unable to totally eliminate the impact of future storms, but we do believe that the events of the last two years will allow some changes in the markets we serve to help mitigate the impact of future storms on short term profits.
Another challenge posed by the events of 2005 that will have an impact on future earnings of the property and casualty subsidiaries is the cost that we pay for catastrophe reinsurance. We incurred an increase in catastrophe reinsurance in 2006 of 18% as a result the frequency of storm related losses over the last two years. In addition, we had to increase our catastrophe deductible by 50% to $3,000,000 in order to keep the increase in catastrophe reinsurance rates to only 18%. This has necessitated that we increase rates in many of the areas we serve. Our reinsurance rate increase took effect January 1, 2006. Unfortunately, due to regulatory hurdles and backlogs created from a large number of other insurers filing revised rates in the affected states as well, we will be unable to reflect the increased reinsurance rates we pay in rates charged to our insured for up to a year. This will result in a drag on 2006 earnings of approximately $500,000 pre-tax. However, we believe that the short term earnings drag will be offset by increased pricing power and less competition in many of the areas impacted by the 2005 hurricane season.
P&C segment revenue before income taxes was $4,224,000 in 2004 compared to $5,720,000 in 2003. The decline in pretax earnings was due to losses incurred from Hurricane Ivan. Pretax losses from Ivan, including catastrophe reinstatement premium of $1,400,000 reduced P&C segment income before taxes by over $5,500,000. As shown in the combined ratio comparison that follows, the P&C companies still managed to achieve a combined ratio below 100% even after the impact of Hurricane Ivan.
The combined ratio for 2005 compared to 2004 increased 7.02 percentage points. This increase was entirely due to losses incurred from Hurricanes Dennis, Katrina and Rita which each added 1.4, 10.7 and 4.6 percentage points to the combined ratio respectively. Hurricane Ivan added 8.9 percentage points to the combined ratio for 2004.
In 2004, Mobile Attic generated a net loss of $211,000 which was primarily related to a decrease in revenues from dealership sales fees and utilization fees below expected ultimate levels coupled with the cost of shifting to a franchise method of establishing new locations.
The insurance subsidiaries’ fixed maturity securities include mortgage-backed bonds, primarily collateralized mortgage obligations (CMO’s), of $13.1 million and $8.7 million at December 31, 2005 and 2004 respectively. The mortgage-backed bonds are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than that expected at the time of purchase. Securities that are purchased at a premium to par value and prepay faster than expected will incur a reduction in yield or loss. Securities that are purchased at a discount to par value and prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between amortized cost and par value, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. In order to minimize risk associated with prepayments on collateralized mortgage obligations, the Company typically invests primarily in more predictable planned amortization class (PAC) structures of CMO’s and typically avoids investment in CMO’s priced at significant premiums above par value.
The National Security Group’s consolidated statement of cash flows indicate that operating activities (used) provided cash of $(5,449,000), $886,000, and $11,398,000 in 2005, 2004, and 2003 respectively. The significant decline in cash flow from operating activities in 2005 compared to 2004 was primarily due to the significant increase in claims associated with Hurricanes Dennis, Katrina and Rita. Cash flow in 2004 compared to 2003 declined primarily due to the increase in claims associated with Hurricane Ivan.
Also in December of 2005, the consolidated joint venture, Mobile Attic paid down debt of approximately $2,000,000 through the sale of portable storage units to new franchisees. As discussed previously, we do not own a controlling interest in Mobile Attic but through the existence of certain debt guarantees established in 2001 and the subsequent issuance of Financial Interpretation 46R by the Financial Accounting Standards Board in December of 2003, we are obligated to consolidate Mobile Attic Financial Statements. It is a primary focus of management to continue to reduce Mobile Attic debt; to remove the impact of the debt guarantees and return the presentation Mobile Attic Financial Statements of the Company to the equity method.
Long-term debt obligations include $11,718,000 in debt held directly by the Company. It is anticipated that $2,439,000 will be retired in 2007. Included in long term debt held directly by the Company is the issuance of $9,279,000 in subordinated debentures on December 15, 2005. The proceeds from the debentures were used to make a $6,000,000 capital infusion in the P&C subsidiary National Security Fire and Casualty with the remainder to be held for general corporate purposes. The subordinated debentures mature December 15, 2035. It is anticipated that principal payments will not be made until the expiration of the fixed rate period on the debt in 2015. For further discussion of the subordinated debentures please review Note 8 to the consolidated financial statements and Form 8-K filed December 12, 2005 which is incorporated herein by reference. Long-term debt obligations also include $11,188,000 in debt held by a 50% owned subsidiary, The Mobile Attic. The current debt obligation of Mobile Attic matures in 2007, but it is currently anticipated that Mobile Attic will seek to refinance approximately 50% of this debt under a longer term financing prior to maturity.
NSFC and Omega generally reinsure with third parties any liability in excess of $150,000 on any single policy. In addition, the property-casualty subsidiaries have catastrophe excess reinsurance, which protects it in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane. In 2005, the property-casualty subsidiaries had catastrophe protection up to a $37.5 million loss. Based on an evaluation using actual NSFC and Omega exposures and catastrophe modeling based on a 250 year loss, that is a loss that has a less than ½ of 1% chance of occurring in any given year, the property and casualty subsidiaries would pay (pre-tax) $6.9 million in losses and reinstatement and reinsurers would pay (pre-tax) $39.1 million.
It should be noted that, due to an increase in reinsurance rates, effective January 1, 2006 the property and casualty insurance subsidiaries incurred an 18% increase in the cost of reinsurance coverage. Also, due to the level of rate increases on the first layer of coverage, which began at $2,000,000 in 2005, we increased our deductible to $3,000,000 for 2006. However, management also placed coverage on a book of run-off business that was previously not insured under the catastrophe reinsurance arrangement. Catastrophe losses on this book of business exceeded $1,000,000 in each of the last two years. So, we believe the increase in deductible coupled with the addition of catastrophe coverage to this book of business does not materially change our catastrophe reinsurance profile and is the most cost effective risk management solution in the current rate environment. Also in light of the magnitude of Hurricane Katrina in 2005, we felt it prudent to increase the top end of our catastrophe reinsurance coverage for 2006. For 2006, we will have in place catastrophe reinsurance protection for a single event of up to $42.5 million in excess of $3,000,000 with one reinstatement.
At December 31, 2005, we had recorded $6,567,000 as an asset for DAC in our financial statements. For more information regarding deferred policy acquisition costs, please see Note 1 to our financial statements.
Deferred income taxes are created when there are differences between assets and liabilities for tax and financial reporting purposes, as well as tax credits, net operating losses and other carryforwards. SFAS 109 “Accounting for Income Taxes,” requires that deferred tax assets be reduced by a valuation allowance if, based on the available evidence, it is more likely than not that all of the recorded deferred
tax assets will not be realized in future periods. This standard requires management to exercise judgment in determining whether or not the deferred tax asset is realizable.
At December 31, 2005 there is no evidence to suggest to management that the deferred tax asset is unrealizable. For more information regarding deferred income taxes, please see Note 7 to our financial statements.
Investments are recorded at fair value based upon quoted prices when available. Quoted prices are available for every investment debt and equity security included in the financial statements. Periodically, the carrying values of an individual investment may become temporarily impaired because of time value, volatility, credit quality and existing market conditions. Management evaluates investments to determine whether the impairment is other-than-temporary. Evaluation criteria include credit quality of security, severity of decrease between cost and market value, length of time of the impairment and likelihood that the impairment will reverse in the near future. This evaluation requires significant assumptions, estimates and judgments by management. If the impairment is determined to be other-than-temporary, the investment is written down to the current fair value and a realized loss is recorded on the income statement.
At December 31, 2005 the recorded liability for loss and loss and adjustment expense was $19,511,000. For more information regarding loss and loss adjustment expense, see Note 9 to our financial statements.
Receivable from agents, less allowance for credit losses (2005 - $110; 2004 - $110)
NATSCO, Inc. (NATSCO). NSFC includes a wholly-owned subsidiary - Omega One Insurance
The accompanying consolidated financial statements also include an investment in affiliate,
December 31, 2003, the Company adopted Financial Accounting Standards Board Interpretation 46 as revised December 2003 (FIN 46R), in the first quarter of 2004. As a result of the adoption of FIN 46R, triggered by previously existing and disclosed guarantees of Mobile Attic debt by the Company, the Company consolidated an investment in a subsidiary Mobile Attic, Inc. Further details of the debt guarantees are discussed in Note 2 to these consolidated financial statements.
Mobile Attic was previously reported using the equity method of accounting. For comparative
purposes, the Company made adjustments to the December 31, 2003 Balance Sheet and the Income Statement and Statement of Cash Flows for the period ended December 31, 2003. These adjustments increased December 31, 2003 assets by $15,109,000 and liabilities by $13,394,000. The adjustment had no effect on consolidated stockholders’ equity. Certain accounts in the Income Statement for the period ended December 31, 2003 were adjusted as a result of the consolidation of Mobile Attic, but because the results of Mobile Attic were previously reported under the equity method, the adjustments had no effect on the consolidated results of operations for the period ended December 31, 2003. Cash flow, for the year ended December 31, 2003 from operating activities increased $79,000; from investing activities decreased $7,224,000; and from financing activities increased $7,862,000. Total cash increased $169,000.
NSIC is licensed in the states of Alabama, Florida, Georgia, Mississippi, South Carolina and
Primary products include ordinary life, accident and health, supplemental hospital, and cancer insurance products.
Missouri, and Texas. NSFC operates in various property and casualty lines, the most
The significant accounting policies followed by the Company and subsidiaries that materially
• Securities Held-to-Maturity. Bonds, notes and redeemable preferred stock for which
preferred stock not classified as either held-to-maturity, or trading are reported at fair value, adjusted for other-than-temporary declines in fair value. The Company and its subsidiaries have no trading securities.
investment yield derived from insurance premium tax credits. These investments are
Agent balances are reported at unpaid balances, less a provision for credit losses.
Accounts receivable are reported at net realizable value. Management determines the
Mobile Attic, Inc. recognizes leasing revenues from royalties, storage unit rentals and sales on a
monthly basis. Revenues from delivery charges are recognized when these services are billed. Mobile Attic executes franchise agreements that set the terms of its arrangement with each franchisee. The franchisee agreement requires the franchisee to pay an initial, non-refundable fee ranging from $35,000 to $55,000 and continuing fees based on percentage of rents. The initial term of the franchise is 20 years and, subject to Mobile Attic’s approval and payment of a renewal fee, a franchise may generally renew its agreement upon its expiration for an additional 10 years.
policies. Deferred costs include commissions, other agency compensation and expenses, and other underwriting expenses directly related to the level of new business produced.
limits the amount deferred to a percentage of related unearned premiums.
The liability for future life insurance policy benefits is computed using a net level premium
Mortality assumptions include various percentages of the 1955-60 and 1965-70 Select and
Ultimate Basic Male Mortality Table. Withdrawal assumptions are based on the Company’s experience.
Company and its subsidiaries plus claims incurred but not yet reported and the related adjustment expenses. The liabilities for claims and related adjustment expenses are determined using case-basis evaluations and statistical analyses and represent estimates of the ultimate net cost of all losses incurred through December 31 of each year. Although considerable variability is inherent in such estimates, management believes that the liabilities for unpaid claims and related adjustment expenses are adequate. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations.
Earnings per share of common stock is based on the weighted average number of shares
coverage per individual life. The cost of reinsurance is amortized over the contract period of the reinsurance.
Certain reclassifications have been made in the previously reported financial statements to
The Company expenses advertising costs as incurred except for nondirect-response advertising
limits. These amounts represent actual account balances held by financial institutions at the end of the period, and unlike the balance reported in the financial statements, the account balances do not reflect timing delays inherent in reconciling items such as outstanding checks and deposits in transit. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.
During 2005, the Financial Accounting Standards Board (FASB) issued the following pronouncements:
SFAS No. 154, Accounting Changes and Error Corrections-a replacement of APB Opinion No. 20 and FASB Statement No. 3, changes the requirements for accounting and reporting of a change in accounting principle. The statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impractical to determine either the period-specific effects or the cumulative effect of the change. The adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.
FIN No. 47, Accounting for Conditional Asset Retirement Obligations-an interpretation of FASB Statement No. 143, clarifies that the term conditional asset retirement obligation as used in SFAS No. 143 refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The interpretation also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement
SOP 05-01, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection
A summary of securities available-for-sale with unrealized losses as of December 31, 2005 and 2004 along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows:
An analysis of the net (decrease) increase in unrealized appreciation on available-for-sale securities follows:
Depreciation expense for the year ended December 31, 2005 was $905,000 ($805,000 for the year ended December 31, 2004 and $686,000 for the year ended December 31, 2003).
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, 2005, 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 income tax liability not recognized is approximately $1,270,000 at December 31, 2005.
The subordinated debentures (debentures) have the same maturities and other applicable terms and features as the associated trust preferred securities (TPS). The debentures bear a fixed interest rate until December 15, 2015. Payment of interest may be deferred for up to 20 consecutive quarters; however, stockholder dividends cannot be paid during any extended interest payment period or any time the debentures are in default. All have stated maturities of thirty years but may be redeemed at any time following the tenth anniversary of issuance. None of the securities require the Company to maintain minimum financial covenants. The Company has guaranteed that amounts paid to the Trust (discussed in Note 2) will be remitted to the holders of the associated TPS. This guarantee, when taken together with the obligations of the Company under the debentures, the Indentures pursuant to which the debentures were issued, and the related trust agreement (including obligations to pay related trust fees, expenses, debt and other obligations with respect to the TPS), provides a full and unconditional guarantee of amounts due the Trust. The amount guaranteed is not expected to at any time exceed the obligations of the TPS, and no additional liability has been recorded related to the guarantee.
In 1989, the Company and its subsidiaries established a retirement savings plan (401K 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. Company matching contributions for 2005, 2004, and 2003 amounted to $217,000, $189,000, and $228,000, respectively. The Company contributes matching contributions up to 5% of compensation subject to government limitations.
NSFC is similarly restricted in the amount of dividends payable to the Company; dividends may not exceed the greater of 10% of statutory surplus as of the end of the preceding year, or net income for the preceding year. At December 31, 2005, NSFC’s retained earnings unrestricted for the payment of dividends in 2006 amounted to $2,721,000.
At December 31, 2005, securities with market values of $3,780,000 ($3,655,000 at December 31, 2004) were deposited with various states pursuant to statutory requirements.
On December 12, 2005, the United States District court for the Middle District of Alabama (the “Court”) entered an order preliminarily approving a proposed settlement of a case pending against a subsidiary of the Company styled Mary W. Williams, et al v. National Security Insurance Company (“Williams Litigation”) and preliminarily certifying such case as a class action. The Williams Litigation relates primarily to claims that a subsidiary of the Company sold industrial burial insurance policies to racial minorities on which it charged higher premiums or provided inferior benefits than premiums charged to or policy benefits provided to similarly situated non-minority policyholders. The Company’s subsidiary has not sold industrial burial insurance for more than 20 years. The proposed settlement provides for the Company’s subsidiary to, among other matters, provide additional policyholder benefits, including premiums adjustments and benefits enhancements on existing policies and additional benefits on matured policies and pay attorneys fees. The Company has previously established litigation reserves with respect to this matter and has taken a policy reserve charge with respect to adjustments to the subject policies that were voluntarily made in 2000. The costs associated with prospective enhancements will be based on actuarial analysis not yet completed and accordingly, no provision has yet been made for them. However, based on preliminary discussions with the Company’s independent consulting actuary and the Alabama Department of Insurance, it is believed that the necessary reserve adjustments in the subsidiary will not have a material adverse impact on the Company’s consolidated financial position.
Cash paid for interest during 2005 was $1,139,000 ($645,000 in 2004, and $611,000 in 2003). Cash paid for income taxes in 2005 was $400,000 ($2,000,000 in 2004, and $400,000 in 2003). In 2003, Mobile Attic acquired $7,134,950 of assets through debt.
principles. It is, therefore, suggested that this Condensed Financial Information be read in
Registrant’s Annual Report as referenced in Form 10-K, Part II, Item 8, page 31.