The Company's subsidiaries own certain real estate investment properties. We own approximately 2,950 acres of undeveloped timberland in Pike, Coffee and Covington counties in Alabama. The only depreciable improvements on this land include a small pavilion with current accumulated depreciation of $23,000. The timber is accounted for as a natural resource and depleted in accordance with applicable accounting standards, which identify total costs as including acquisition costs, exploration costs, development costs, production costs and support equipment and facilities cost. We include in total costs timberland purchases and reforestation costs and other costs associated with the planting and growing of timber, such as site preparation, growing or purchases of seedlings, planting, fertilization, herbicide application and the thinning of tree stands to improve growth. We allocate total cost of the timberland over periods benefited by means of depletion. Timber related sales during 2011 totaled $14,000 compared to $2,000 during 2010. Gains on timber sales during 2011 totaled $12,000 compared to $1,000 in 2010.
The following discussion highlights significant factors influencing the consolidated financial position and results of operations of The National Security Group, Inc. (referred to in this document as we, our, us, the Company or NSG) and its subsidiaries. We are a “smaller reporting company” under Securities and Exchange Commission (SEC) regulations and therefore qualify for the scaled disclosure of smaller reporting companies. In general, the same information is required to be disclosed in the management discussion and analysis by smaller reporting companies
except that the discussion need only cover the latest two year period and disclosures relating to contractual obligations are not required. In accordance with the scaled disclosure requirements, this discussion covers the two year period ended December 31, 2011.
For the year ended December 31, 2011, total revenues were $62,092,000 compared to $69,392,000 for the same period last year; a decrease of 10.5%. A decrease in earned premium in the P&C segment along with a decline in net realized investment gains were the primary contributing factors to the decrease in total revenue for 2011 over 2010.
The Company ended 2011 with premiums earned totaling $56,243,000 compared to $61,263,000 for the same period last year. Premium revenue is generated from our two operating segments: P&C segment and Life segment. The P&C segment accounts for approximately 88% of total premium revenue while our Life segment contributes the remaining 12%. The P&C segment operates in personal lines insurance products primarily generating premium revenue from dwelling fire, allied lines and homeowners policies. Our Life segment produces premium revenue primarily from whole life, accident and critical illness insurance policies.
Policyholder benefits paid (claims) increased 12.8%, ending 2011 at $44,025,000 compared to $39,031,000 for the same period last year. Claims as a percentage of net premiums earned totaled 78.3% for 2011 compared to 63.7% in 2010. The primary reason for the $4,994,000 increase was higher claims activity in the P&C segment associated with an increase in storm activity during 2011 coupled with increased claims in the automobile line of business.
The gross losses and loss adjustment expenses (LAE) incurred in the P&C segment from claims associated with storm systems classified as "catastrophic" (referred to as cat events hereafter), totaled $14,040,000 in 2011 compared to $1,709,000 in 2010. The current year claims were incurred from seventeen separate cat events and accounted for 31.9% of total claims during the year compared to 4.4% of claims from ten cat events during the prior year.
Prior to April 2011, the single worst tornadic outbreak affecting the P&C segment occurred in April 2009 and produced $1,526,000 in incurred losses and incurred LAE for that month. In comparison, the tornado and windstorms during the month of April 2011 produced incurred losses and incurred LAE totaling $12,260,000 which was over eight times worse than the April 2009 storms.
A cat event on April 25th-27th, 2011 (catastrophe 46) was the primary source of the overall losses and LAE incurred during April 2011. The incurred losses and LAE from this single cat event totaled $10,432,000 or 85% of the total claims reported during the month of April in the current year. The P&C segment maintains catastrophe reinsurance to reduce risk associated with losses from cat events. The reinsurance is structured with a $3,500,000 deductible with 5% coinsurance retained on the first two layers of coverage. Any claim activity exceeding the first two layers is 100% reinsured up to $72,500,000 in ultimate incurred losses and LAE. Because the P&C segment incurred losses and LAE from catastrophe 46 that exceeded the reinsurance deductible, the P&C segment recovered $6,204,000 from reinsurers. The P&C segment retained $4,228,000 of the incurred losses and incurred LAE from catastrophe 46.
General and administrative expenses decreased $212,000 in 2011 compared to the same period last year. General expenses were down primarily due to various cost saving measures implemented during the year coupled with an overall decline in revenue. With the discontinuation of the automobile program in late 2011, further reductions in general expenses in the insurance subsidiaries are expected in 2012.
Interest expense for the year ended December 31, 2011 was virtually unchanged from the prior year at $1,153,000 compared to $1,156,000 in 2010.
Our life segment is the smaller of our insurance segments contributing 12.2% of total insurance premium revenue in 2011 and 11.5% in 2010. Premium revenues and operating income for the life segment for the year ended December 31, 2011 and 2010 are summarized below (amounts in thousands):
NSIC ended 2011 with premium revenue of $6,870,000 compared to $7,027,000 for the same period last year; a decrease of 2.2%. The $157,000 decrease in premium revenue was primarily due to the 4.6% decline in ordinary business related to the independent agent distribution method. The home service distribution method also contributed to the overall decline in premium revenue ending 2011 down 2.4% compared to the same period last year.
Deferred policy acquisition costs and commission expenses increased $165,000 for the year ended December 31, 2011 at $1,307,000 compared to $1,142,000 for the same period last year. An adjustment in the estimate of expenses
capitalized as a component of DAC was the primary reason for the increase in the current year compared to the prior year.
For the year ended December 31, 2011 and 2010, insurance taxes, licenses and fees were $316,000 and $387,000, respectively. The primary reason for the $71,000 decrease was a decline in fees associated with the Alabama Insurance Department Examination which concluded during the first half of 2011.
Interest expense, which is primarily related to life insurance deposit accounts, was down slightly at $60,000 in 2011 compared to $65,000 in 2010.
The life segment ended 2011 with a year to date net loss of $502,000 compared to a net loss of $128,000 for the same period last year. The $157,000 decline in premium revenue coupled with the $554,000 decrease in investment income and capital gains were the primary reasons for the higher net loss in 2011 compared to 2010.
In our fire, allied lines and homeowner lines of business, we have slowed our rate of growth through a combination of rate increases, stricter underwriting standards and fewer appointments of new agents. We have also limited production of new business in areas in which we have larger concentrations of risk in order to better manage the severity of catastrophe events. These measures have been undertaken in an effort to improve underwriting profitability, particularly in our homeowners line of business. The implementation of the above mentioned changes was the primary reason for the 6.8% decrease in homeowners premium revenue in 2011 compared to 2010.
The catastrophe event in late April 2011, which exceeded our single event retention, triggered additional ceded premium payments (reinstatement premium) in order to reinstate coverage under our catastrophe reinsurance agreement. As mentioned above, this catastrophe reinstatement premium was $1,621,000 and decreased the P&C segment net premium earned three percentage points in 2011. We maintain a catastrophe reinsurance agreement in the P&C segment to cover losses related to a cat event exceeding our deductible of $3,500,000 (details regarding the structure of this agreement can be found in Note 1 to the Consolidated Financial Statements).
Net investment income totaled $2,246,000 in 2011 compared to $2,900,000 in 2010; a decrease of $654,000. The decrease in investment income in the P&C segment was primarily attributable to an $8,769,000 decline in invested assets in 2011 compared to 2010. The decrease in invested assets was driven by selling of securities during the first half of 2011 in order to increase liquidity for the payment of storm claims incurred during the spring storm season of 2011.
Other income was $916,000 in 2011 compared to $1,158,000 for the same period last year; a $242,000 decrease. Other income consists primarily of fees related to the issuance of our property and automobile insurance policies as well as miscellaneous income. The primary reason for the $242,000 decrease was policy fee income related to the automobile program. The fees associated with the automobile business totaled $202,000 in 2011 compared to $340,000 in 2010; a decrease of $138,000. The decrease in policy fees associated with the automobile line of business accounted for 57% of the total decrease in other income in 2011 compared to 2010.
Claims were $38,836,000 in 2011, up $5,091,000 from $33,745,000 for the same period last year. The primary reasons
for the increase were losses from tornado, wind and hail related weather events as well as claims associated with our automobile line of business.
The gross losses and adjustment expenses incurred in the P&C segment from claims associated with cat events during 2011 totaled $14,040,000. These claims were incurred from seventeen separate cat events and accounted for 36.2% of P&C segment claims during the current year. In comparison, the P&C segment incurred gross losses and adjustment expenses from ten cat events during 2010 totaling $1,704,000 or 5.1% of P&C segment claims during the prior year.
The Property Claims Service (PCS) classifies storms and other weather related events that exceed $25 million in insured losses, on an industry-wide basis, as a "catastrophic event". The P&C segment was heavily affected by these catastrophic storm systems during 2011, primarily in the month of April. The storm activity in April 2011 was primarily tornado, wind and hail related, and was ranked the most active tornado month on record and caused widespread damage in the Southeast United States. According to statistics from the National Oceanic and Atmospheric Administration (NOAA), the April storms spawned 753 tornadoes and caused an estimated 364 fatalities (the previous record for tornadoes incurred in a one month period was set in April 1974 with 267 tornadoes). The most significant of the April storm systems swept across Mississippi, Alabama and Georgia from April 25th-27th, 2011. This storm system (classified as catastrophe 46 by PCS) was by far the largest during April and created $10,432,000 in incurred losses and LAE in the P&C segment in 2011. While this event was covered by our catastrophe reinsurance coverage, we incurred significant costs associated with deductibles and reinstatement premium. In our catastrophe reinsurance model results, which we utilize to establish reinsurance coverage limits, this tornado event exceeded a one in 250 year return period, which means that this event had a probability of occurrence in the models of less than four tenths of one percentage point in any given year.
As mentioned previously, the P&C segment incurred losses from all April 2011 cat events totaling $12,260,000 from 2,237 claims. The losses and LAE incurred from the cat events in April 2011 were over eight times higher than claims related to cat events during any prior one month period ever experienced by the P&C companies. The losses from the cat event from April 25th-27th, 2011 (catastrophe 46), which contributed $10,432,000 or 85.1% of the April 2011 incurred losses and LAE, exceeded our $3,500,000 deductible for reinsurance; therefore, we recovered just under $6,204,000 from reinsurers. On a net of reinsurance basis, the claims retained by the P&C segment from catastrophe 46 totaled $4,228,000.
Deferred policy acquisition costs totaled $3,246,000 in 2011 compared to $3,354,000 in 2010. The deferred policy acquisition costs were 6.6% of premium revenue for 2011; up 0.4 percentage points compared to 6.2% of premium revenue for the same period last year. Deferred policy acquisition costs consist of amortization of previously capitalized distribution costs which are primarily commissions.
General and administrative expenses totaled $6,322,000, or 12.8% of premium revenue in 2011 compared to $6,203,000, or 11.4% of premium revenue, in 2010. The primary reason for the $119,000 increase in general and administrative expenses was an increase in professional and consulting related fees in the current year compared to the same period last year.
Insurance taxes, licenses and fees were $1,569,000 in 2011 compared to $1,694,000 for the same period last year. Insurance taxes, licenses and fees were 3.2% of premium revenue in 2011; virtually unchanged compared to 3.1% in 2010.
The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. The types of assets in which the Company can invest are influenced by various state insurance laws which prescribe qualified investment assets. While working within the parameters of these prescribed regulatory requirements as well as liquidity and capital needs, the Company considers investment quality, investment return, asset/liability matching and composition of the investment portfolio when choosing investments.
A summary of debt and equity securities available-for-sale with unrealized losses as of December 31, 2011 along with related fair value, aggregated by length of time that the investments have been in a continuous unrealized loss position follows:
The amortized cost and aggregate fair values of investments in securities at December 31, 2011 and December 31, 2010 are as follows (dollars in thousands):
The insurance subsidiaries' fixed maturity securities include residential mortgage-backed securities (RMBS) of $19.3 million and $23.1 million at amortized value at December 31, 2011 and 2010 respectively. We own no commercial mortgage backed securities. We also have no material direct exposure in sub-prime mortgage loans in our private label RMBS portfolio.
As for the composition of the RMBS portfolio, agency mortgage backed securities compose 49% and 42% of the RMBS portfolio at December 31, 2011 and 2010, respectively. The remainder of the RMBS portfolio is composed of private label mortgage backed securities. These securities consist primarily of conventional 15 and 30 year loans with an average borrower FICO score at origination of 740. We own no mortgage backed securities with direct exposure to subprime loans and less than 1% of the RMBS portfolio is composed of loans subject to rate resets. Three securities in the private label mortgage backed security portfolio are rated below investment grade and compose less than 2% of total invested assets.
Due to regulatory restrictions, the majority of the Company's cash is required to be invested in investment-grade securities to provide ample protection for policyholders. The liabilities of the property and casualty insurance subsidiaries are of various terms and, therefore, those subsidiaries invest in securities with various effective maturities spread over periods usually not exceeding 10 years. The liabilities of the life insurance subsidiary are typically of a longer duration, and therefore, a higher percentage of securities in the life insurance subsidiary are invested for periods exceeding 10 years.
Virtually all invested assets of the Company are held in the insurance subsidiaries. As of December 31, 2011, the maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows (dollars in thousands):
Cash used by financing activities during 2011 was $1,315,000 compared to $976,000 in 2010. Cash flows from financing activities in 2011 were reduced by dividends paid of $1,357,000 compared to $1,480,000 during 2010. During 2011, net repayments of $15,000 on a short-term line of credit were made compared to cash provided of $500,000 during 2010.
The following table reflects the anticipated cash flows associated with our short- and long-term contractual obligations and commitments as of December 31, 2011 (dollars in thousands):
The Company's subsidiaries require cash in order to fund policy acquisition costs, claims, other policy benefits, interest expense, general expenses, and dividends to the Company. Premium and investment income, as well as maturities, calls, and sales of invested assets, provide the primary sources of cash for both subsidiaries. A significant portion of the Company's investment portfolio consists of readily marketable securities, which can be sold for cash.
Except as discussed above and in Note 15 to the Consolidated Financial Statements, the Company is aware of no known trends, events, or uncertainties reasonably likely to have a material effect on its liquidity, capital resources, or operations. Additionally, the Company has not been made aware of any recommendations of regulatory authorities, which if implemented, would have such an effect.
As disclosed in Note 12 to the Consolidated Financial Statements, in 2012, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company is limited to $1,039,000 in the life insurance subsidiary and $2,546,000 in the property/casualty insurance subsidiary. The payment of any subsidiary dividend requires prior notice to the regulatory authorities who may disallow the dividend if, in their judgment, payment of the dividend would have an adverse effect on the surplus of the subsidiary.
At December 31, 2011 and 2010, the Company recorded $9,558,000 and $10,189,000, respectively, as an asset for DAC in the financial statements. We do not foresee any issues related to recoverability of these capitalized costs. For more information regarding deferred policy acquisition costs, see Note 1 to our financial statements.
At December 31, 2011, there is no evidence to suggest to management that any deferred tax asset is unrealizable. For more information regarding deferred income taxes, see Note 7 to our financial statements.
Effective for interim and annual reporting periods beginning after December 15, 2011, the FASB revised guidance related to the way other comprehensive income (“OCI”) appears within the financial statements. Companies will be required to show net income, OCI and total comprehensive income in one continuous statement or in two separate but consecutive statements. Components of OCI may no longer be presented solely in the statement of changes in shareholders’ equity. Any reclassification between OCI and net income will be presented on the face of the financial statements. We do not expect the impact of this revised guidance to change reported net income or comprehensive income upon adoption in 2012.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement and financial statement schedules presentation. We believe that our audits provide a reasonable basis for our opinion.
See accompanying notes to consolidated financial statements which are an integral part of the financial statements.
NSIC is licensed in the states of Alabama, Florida, Georgia, Mississippi, South Carolina and Texas and was organized in 1947 to provide life and burial insurance policies to the home service market. Business is now produced by both company and independent agents. Primary products include ordinary life, accident and health, supplemental hospital, and cancer insurance products.
NSFC is licensed in Alabama, Arkansas, Florida, Georgia, Kentucky, Mississippi, Oklahoma, South Carolina, Tennessee and West Virginia. In addition, NSFC operates on a surplus lines basis in Louisiana, Missouri, and Texas. NSFC operates in various property and casualty lines, the most significant of which are: dwelling property fire and extended coverage, homeowners, mobile homeowners, ocean marine, private passenger automobile physical damage and liability and commercial auto liability.
The Company is incorporated under the laws of the State of Delaware. Its common stock is traded on the NASDAQ Global Market under the ticker symbol NSEC. Pursuant to the regulations of the United States Securities and Exchange Commission (SEC), the Company is considered a “Smaller Reporting Company” as defined by SEC Rule 12b-2 of the Exchange Act. The Company has elected to comply with the scaled disclosure requirements of Regulation S-K and only two years of financial statements are included herein. The Company previously used a non-accelerated filer status.
For the year ended December 31, 2011, one agency individually produced greater than 5% of the Company's direct written premium.
If the Company intends to sell the security or if it is more-likely-than not the Company will be required to sell the security before recovery, an OTTI is recognized as a realized loss in the income statement equal to the difference between the security's amortized cost and its fair value. If the Company does not intend to sell the security or it is not more-likely-than not that the Company will be required to sell the security before recovery, the OTTI is separated into an amount representing the credit loss, which is recognized as a realized loss in the statement of operations, and the amount related to all other factors, which is recognized in other comprehensive income.
Investment real estate is reported at cost, less allowances for depreciation computed on the straight-line basis. Investment real estate consists primarily of timberland and undeveloped commercial real estate. Real estate is carried at cost.
Other investments consist primarily of investments in notes and equity investments in limited liability companies. The Company has no influence or control over the operating or financial policies of the investee limited liability companies and consequently, these investments are accounted for using the cost method.
The Company owns 21 life insurance contracts on certain management and supervisory employees each having a face amount of approximately $2,000,000. The Company's original investment in company owned life insurance was $5,000,000. The primary purpose of the program is to offset future employee benefit expenses through earnings on the cash value of the policies. The Company is the owner and principal beneficiary of these policies. The life insurance contracts are carried at their current cash surrender value. Cash surrender value at December 31, 2011 and 2010 was $5,660,000 and $5,520,000, respectively. Changes in cash surrender values are included in income in the current period. The change in surrender value included in earnings for the periods ended December 31, 2011 and 2010 was $140,000 and $323,000, respectively. Death proceeds from the contracts are recorded when the proceeds become payable under the terms of the policy. There were no proceeds received from the COLI during 2011 or 2010.
Accounts receivable are reported at net realizable value. Management determines the allowance for doubtful accounts based on historical losses and current economic conditions. On a continuing basis, management analyzes delinquent receivables, and once these receivables are determined to be uncollectible, they are written off through a charge against an existing allowance account or against earnings.
Property and equipment is carried at cost less accumulated depreciation and includes expenditures that substantially increase the useful lives of existing property and equipment. Significant costs incurred for internally developed software are capitalized and amortized over estimated useful lives of 3 years. Maintenance, repairs, and minor renovations are charged to expense as incurred. Upon sale or retirement of property and equipment, the costs and related accumulated depreciation are eliminated from the respective account and the resulting gain or loss is included in the results of operations. The Company provides for depreciation of property and equipment using the straight-line method designed to amortize costs over estimated useful lives. Estimated useful lives range up to 40 years for buildings and from 3-8 years for electronic data processing equipment and furniture and fixtures. Property and equipment are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.
The liability for unpaid claims represents the estimated liability for claims reported to the Company and its subsidiaries plus claims incurred but not yet reported and the related loss adjustment expenses. The liabilities for claims and related adjustment expenses are determined using case-basis evaluations and statistical analysis 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 loss adjustment expenses are adequate. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in the period in which they are determined.
Under the 2011 catastrophe reinsurance program, the Company retained the first $3.5 million in losses from each event with reinsurance maintained in four layers as follows:
Layers 1-4 cover events occurring from January 1-December 31 of the contract year. All significant reinsurers under the program carry A.M. Best ratings of A- (Excellent) or higher, or equivalent ratings.
In the normal course of business, NSIC seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage contracts. NSIC retains a maximum of $50,000 of coverage per individual life policy. The cost of reinsurance is amortized over the contract period of the reinsurance.
The Company expenses advertising costs as incurred. Advertising costs charged to expense were $107,000 for the year ended December 31, 2011 ($113,000 for the year ended December 31, 2010). Advertising cost consists primarily of agent convention expense and print media.
Reinsurance contracts do not relieve the Company of its obligations to policyholders. A failure of a reinsurer to meet their obligation could result in losses to the insurance subsidiaries. Allowances for losses are established if amounts are believed to be uncollectible. At December 31, 2011 and 2010, no amounts were deemed uncollectible. The Company, at least annually, evaluates the financial condition of all reinsurers and evaluates any potential concentrations of credit risk. At December 31, 2011, management does not believe the Company is exposed to any significant credit risk related to its reinsurance program.
Effective for interim and annual reporting periods beginning after December 15, 2010, the FASB revised guidance to require additional disclosure about purchases, sales, issuances, and settlements in the roll forward activity in Level 3 fair value measurements. We adopted the guidance on January 1, 2011. Adoption did not have a material effect on our results of operations or financial position.
In June 2007, the Company formed National Security Capital Trust II for the sole purpose of issuing, in private placement transactions, $3,000,000 of trust preferred securities (TPS) and using the proceeds thereof, together with the equity proceeds received from the Company in the initial formation of the Trust, to purchase $3,093,000 unsecured junior subordinated deferrable interest debentures. The Company owns all voting securities of the Trust and the subordinated debentures are the sole assets of the Trust. The Trust will meet the obligations of the TPS with the interest and principal paid on the subordinated debentures. The Company received net proceeds from the TPS transactions, after commissions and other costs of issuance, of $2,995,000. The Company also holds all the voting securities issued by the Trust and such trusts are considered to be VIE's. The Trust is not consolidated because the Company is not the primary beneficiary of the Trust. The Subordinated Debentures, disclosed in Note 8, are reported in the accompanying Consolidated Balance Sheets as a component of long-term debt. The Company's equity investments in the Trust total $93,000 and are included in Other Assets in the accompanying consolidated balance sheets.
The amortized cost and aggregate fair values of investments in securities are as follows (dollars in thousands):
A summary of securities available-for-sale with unrealized losses as of December 31, 2011 and 2010 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 (dollars in thousands):
Of the remaining securities in an unrealized loss position, the single largest accumulated loss was in the equity portfolio and totaled $501,000. The second largest loss position was in the bond portfolio and totaled $70,000. The third largest loss position was in the bond portfolio and totaled $58,000. For the year ended December 31, 2010, the Company realized no other-than-temporary impairments. The single largest accumulated loss was in the equity portfolio and totaled $360,000. The second largest loss position was in the bond portfolio and totaled $185,000. The third largest loss position was in the equity portfolio and totaled $83,000.
NOTE 5 - FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES
Level 1 assets and liabilities consist of money market fund deposits and certain of our marketable debt and equity instruments, including equity instruments offsetting deferred compensation, that are traded in an active market with sufficient volume and frequency of transactions.
The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2011 (dollars in thousands):
Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 are summarized in the following table by the type of inputs applicable to the fair value measurements (dollars in thousands):
The Company is exposed to certain risks in the normal course of its business operations. The primary risk that is managed through the use of derivatives is interest rate risk on floating rate borrowings. This risk is managed through the use of interest rate swaps which are designated as cash flow hedges. For cash flow hedges, the effective portion of the gain or loss on the interest rate swap is included as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction is recognized in earnings. The Company does
not hold or issue derivatives that are not designated as hedging instruments. See Note 8 for additional information about the interest rate swaps.
Mortgage receivables-the carrying amount is a reasonable estimate of fair value due to the restrictive nature and limited marketability of the mortgage notes.
Other policyholder funds-the carrying amount is a reasonable estimate of fair value.
Depreciation expense for the year ended December 31, 2011 was $382,000 ($394,000 for the year ended December 31, 2010).
The Company recognizes tax-related interest and penalties as a component of tax expense. The Company incurred $1,000 in interest and penalties as of December 31, 2011. The Company did not incur any interest or penalties as
of December 31, 2010. The Company files income tax returns in the U.S. federal jurisdiction and various states. The Company is not subject to examinations by authorities related to its U.S. federal or state income tax filings for years prior to 2006. Tax returns have been filed through the year 2010.
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".
Short-term notes payable consisted of the following as of December 31, 2011 and December 31, 2010 (dollars in thousands):
The subordinated debentures (debentures) have the same maturities and other applicable terms and features as the associated trust preferred securities (TPS). 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. None of the securities require the Company to maintain minimum financial covenants. The Company has guaranteed that amounts paid to the Trusts 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 Trusts. 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.
On September 13, 2007, the Company entered into a 5 year swap effective September 17, 2007, with a notional amount of $3,000,000 and designated the swap as a hedge against changes in cash flows attributable to changes in the benchmark interest rate (LIBOR) associated with the subordinated debentures issued on June 21, 2007. Commencing December 17, 2007, under the terms of the swap, the Company will receive interest at the three-month LIBOR rate plus 3.4% and pay interest at the fixed rate of 8.34%.
The Company has a geographic exposure to catastrophe losses in certain areas of the country. Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes, hail, severe winter weather, explosions and fires, and the incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophe losses are restricted to small geographic areas; however, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. The Company generally seeks to reduce its exposure to catastrophes through individual risk selection and the purchase of catastrophe reinsurance. At December 31, 2011, the Company's estimate of unpaid losses and adjustment expenses for hurricane related claims incurred in prior years totaled $1,793,000 before reinsurance ($1,320,000 in 2010). The increase in unpaid losses and adjustment expenses for hurricane related claims incurred in prior years is related to adverse development from Hurricane Ike. Because the Company has exhausted its catastrophe coverage limits available for Hurricane Katrina any additional development will not be covered by reinsurance. The Company maintains case reserves of $266,000 for losses in excess of catastrophe reinsurance ($254,000 in 2010).
In 1987, the Company established a non-qualified deferred compensation plan for its Board of Directors. The Board members had an option of deferring their fees to a cash account or to a stock account and all share deferrals were recorded at the fair market value on the date of the award. The directors' non-qualified deferred compensation plan was frozen on December 31, 2004, and deferrals are no longer allowed. A new non-qualified plan became effective January 1, 2006 under which directors are allowed to defer all or a portion of directors' fees into various investment options. The supplemental executive retirement plan (SERP) became effective March 1, 2008 and covers named executive officers with the Company contributing 15% of executive compensation to the plan.
The amount of dividends paid from NSIC to the Company in any year may not exceed, without prior approval of regulatory authorities, the greater of 10% of statutory surplus as of the end of the preceding year, or the statutory net gain from operations for the preceding year. At December 31, 2011, NSIC's retained earnings unrestricted for the payment of dividends in 2012 amounted to $1,039,000.
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, 2011, NSFC's retained earnings unrestricted for the payment of dividends in 2012 amounted to $2,546,000.
The table below provides information regarding the Company's preferred and common stock as of December 31, 2011 and December 31, 2010:
The Company and its subsidiaries operate primarily in the insurance industry. The Company’s property and casualty insurance operations comprise one business segment. The property and casualty insurance segment consists of seven lines of business: dwelling fire and extended coverage, homeowners (including mobile homeowners), ocean marine, other liability, private passenger auto liability, commercial auto liability and auto physical damage. Management organizes the business utilizing a niche strategy focusing on lower valued dwellings as well as non-standard automobile products. Our chief decision makers (President, Chief Financial Officer and Chief Executive Officer) review results and operating plans making decisions on resource allocations on a company-wide basis. The Company’s products are primarily produced through agents within the states in which we operate. The Company’s life and accident and health operations comprise the second business segment. The life and accident and health insurance segment consists of two lines of business: traditional life insurance and accident and health insurance.
Premium revenues and operating income by industry segment for the years ended December 31, 2011 and 2010 are summarized below (dollars in thousands):
The following table presents the Company’s gross and net premiums written for the property and casualty segment and the life and accident and health segment for the years ended December 31, 2011 and 2010, respectively:
The following table presents the Company’s gross and net premiums earned for the property and casualty segment and the life and accident and health segment for the years ended December 31, 2011 and 2010, respectively:
The Company and its subsidiaries continue to be named individually 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 Company's property & casualty subsidiaries are defending a number of matters filed in the aftermath of Hurricanes Katrina and Rita in Mississippi, Louisiana and Alabama. These actions include individual lawsuits and purported statewide class action lawsuits, although to date no class has been certified in any action. These actions make a number of allegations of underpayment of hurricane-related claims, including allegations that the flood exclusion found in the Company's subsidiaries' policies, and in certain actions other insurance companies' policies, is either ambiguous, unenforceable as unconscionable or contrary to public policy, or inapplicable to the damage sustained.
On January 9, 2009, Mobile Attic Inc., MA Manufacturing Company, Inc., and Purchaser initiated an action against Peter Cash, Cash Brothers Leasing, Inc., Bridgeville Trailers, Inc., and Barfield, Murphy, Shank & Smith, P.C. in the United States District Court for the Middle District of Alabama. In the complaint, Plaintiffs asserted, among other claims, a claim for damages resulting from a breach of certain of the warranties regarding the financial statements of Mobile Attic and other financial information provided by Mobile Attic. Purchaser then notified the Company of its claim for breach of warranty under the Stock Purchase Agreement and requested indemnity from the Company.
On July 9, 2009, the Company filed a complaint in intervention requesting the Court to find that the Company is not liable for indemnity under the Stock Purchase Agreement, or in the alternative, to award damages to the Company for any loss suffered as a result of the fraudulent actions of Peter Cash and as a result of the negligence of Mobile Attic and its auditors in the preparation of Mobile Attic's financial statements. [Mobile Attic, Inc., MA Manufacturing Company, Inc., and Bagley Family Revocable Trust, plaintiffs, v. Peter L. Cash, Cash Brothers Leasing, Inc., Bridgeville Trailers, Inc., and Barfield, Murphy, Shank & Smith, P.C, defendants, v. The National Security Group, Inc., intervenor plaintiff, v. Peter L. Cash, Barfield, Murphy, Shank & Smith, P.C. and Bagley Family Revocable Trust, intervenor defendants, U.S. District Court, Middle District of Alabama, Eastern Division, Civil Action No. 09-cv-00024.]
Cash paid for interest during 2011 was $1,144,000 ($1,156,000 in 2010). Cash paid for income taxes in 2011 was $316,000 compared to cash received for income taxes in 2010 of $662,000.
In 2011, dividends of $2.1 million were paid to the Registrant by its subsidiaries ($2.8 million in 2010).