Under smaller reporting company rules we are not required to disclose information required under Item 6. However, in order to provide information to our investors, we have elected to provide certain selected financial data.
Information in this discussion is presented in whole dollars rounded to the nearest thousand.
Omega One Insurance Company (Omega) is a property and casualty insurance company incorporated in 1992. Omega is a wholly owned subsidiary of National Security Fire and Casualty Company (NSFC) and is the smallest of the
insurance subsidiaries, accounting for approximately 2.3% of consolidated premium revenue. Omega is licensed and underwrites property and casualty insurance in the states of Alabama and Louisiana. There is no material product differentiation between those products underwritten by NSFC and Omega as both primarily underwrite personal lines of insurance.
National Security Fire and Casualty Company (NSFC) is a property and casualty insurance company and is the largest of the insurance subsidiaries, accounting for over 84.9% of total premium revenue of the Company. NSFC operates primarily in the personal lines segment of the property and casualty insurance market. NSFC has been in operation since 1959. NSFC is licensed and underwrites property and casualty insurance in the states of Alabama, Arkansas, Florida, Georgia, Mississippi, Oklahoma, South Carolina and Tennessee. NSFC is licensed, but does not currently underwrite any business, in the states of Kentucky and West Virginia. NSFC also underwrites insurance on a non-admitted or surplus lines basis in the states of Louisiana, Missouri and Texas.
All of the insurance subsidiaries are Alabama domiciled insurance companies; therefore, the Alabama Department of Insurance is the primary insurance regulator. However, each subsidiary is subject to regulation by the respective insurance regulators of each state in which it is licensed to transact business. Insurance rates charged by each of the insurance subsidiaries are typically reviewed and approved by each insurance department for the respective state to which the rates will apply.
The two primary segments in which we report insurance operations are the personal lines property and casualty segment (NSFC) and the life, accident and health insurance segment (NSIC). Due to the small amount of premium revenue produced by Omega and the fact that Omega is a wholly owned subsidiary of NSFC underwriting similar lines of business, all references to NSFC in the remainder of this management discussion and analysis will include the insurance operations of both NSFC and Omega. Our income is principally derived from net underwriting profits and investment income. Net underwriting profit is principally derived from earned premiums received less claims paid, sales commissions to agents, costs of underwriting and insurance taxes and fees. Investment income includes interest and dividend income and gains and losses on investment holdings.
Year-to-date net premiums earned were down 7.9% in 2012 compared to 2011. The decrease was composed of a $244,000 or 3.5% decline in total life, accident and health premium revenue and a $4,184,000 or 8.5% decrease in P&C net premiums earned. Primary drivers of the decline in net premiums earned were an increase in catastrophe reinsurance costs and a decline in automobile premium; both in the P&C segment. Catastrophe reinsurance cost was up approximately 19% in 2012 compared to 2011. In addition, we added reinsurance premium protection (RPP) coverage to our reinsurance coverage during 2012 to help reduce capital exposure in the event of a major catastrophe in the P&C segment. The RPP coverage cost increased reinsurance ceded and reduced premium revenue by $1,325,000. Furthermore, due to the termination of the automobile program in late 2011, P&C segment premium revenue was reduced $2,882,000 in the current year compared to the same period last year.
The Company ended 2012 with a net loss totaling $6,671,000 compared to a net loss of $4,956,000 in 2011. The Company ended 2012 with a net loss per share of $2.70 compared to net loss per share of $2.01 in 2011. The primary reasons for the net loss in 2012 were an increase of $11,702,000 in litigation settlement and defense costs and an increase in incurred losses from Hurricane Isaac claims. During 2012, we settled longstanding litigation related to the sale of The Mobile Attic, Inc. This settlement was the primary reason for the significant increase in litigation settlement and defense costs in the current year compared to the same period last year. The final settlement totaled $13,000,000, and the impact of the settlement and remaining legal fees are reflected in these consolidated financial statements. Additional information related to the settlement can be found below in the litigation settlement and defense costs discussion, liquidity and capital resources section of the Management Discussion and Analysis and in Note 15 to the consolidated financial statements. Also contributing to the net loss in 2012 were Hurricane Isaac reported losses and LAE which totaled $3,390,000 from 1,147 claims. The claims from this cat event increased the P&C segment loss ratio by 7.5 percentage points. Additional discussion regarding this catastrophe follows in the industry segment data section of the Management Discussion and Analysis.
Results of Operations for Years Ended December 31, 2012 and 2011
A primary reason for the 7.9% decline in net premium revenue was an increase in catastrophe reinsurance cost in 2012. In addition to a 19% increase in catastrophe reinsurance cost related to our cat coverage, we also incurred $1,325,000 related to the cost of adding reinsurance premium protection (RPP) to our catastrophe reinsurance structure in 2012. The RPP coverage reduces our risk from a major catastrophe and helps strengthen our capital position. In the event of a major catastrophe, the RPP coverage limits the pretax impact on earnings of a modeled 100 year cat event by approximately $4.5 million. A 100 year event is defined as an event that has approximately a 1% probability of occurring in a given year. Reinsurance ceded in the prior year was up $1,621,000 due to reinstatement premium related to catastrophe 46 discussed previously.
Other income was $720,000 for the period ended December 31, 2012 compared to $919,000 for the same period last year; a $199,000 decrease. Other income consists primarily of billing, payment and policy fees related to the issuance of our property and automobile insurance policies in the P&C segment as well as other, primarily non-recurring, miscellaneous income. The primary reason for the decrease during 2012 compared to 2011 was a decline in fee income related to the discontinuance of our automobile program in the P&C segment.
Amortization of deferred policy acquisition costs (DAC) and commissions totaled $11,267,000 compared to $12,168,000 for the same period last year; a decrease of $901,000. The primary reason for the decrease was a reduction in premium revenue in the P&C segment.
Litigation settlement and defense costs were $13,328,000 for the year ended December 31, 2012 compared to $1,626,000 for the year ended December 31, 2011. On June 18, 2012, the Company settled longstanding litigation related to the Company's sale of Mobile Attic, Inc. which was the primary reason for the increase in the current year compared to the prior year. The Company believed that the damages claimed in the litigation were excessive in amount and that a substantial portion of the claimed damages was unrelated to the Company's involvement in the Mobile Attic transaction. However, with no guidance on damages, in the event of an excessive verdict we would have faced
The Company ended 2012 with a net loss of $6,671,000 compared to a net loss of $4,956,000 for the same period last year. The litigation settlement and $3.4 million in pretax Hurricane Isaac losses mentioned above were the primary reasons for the net loss in 2012. The claims incurred from cat events and adverse underwriting results in the automobile program were the primary contributing factors to the net loss in 2011.
Premium revenues for The National Security Group's two operating segments (Life segment, Property and Casualty segment) are summarized as follows (amounts in thousands):
The property and casualty segment composed 87.2% of total premium revenue in 2012 compared to 87.8% in 2011. The P&C segment is primarily composed of dwelling fire and homeowners lines of business. The life segment composed 12.8% of premium revenue in 2012 compared to 12.2% in 2011 with revenue produced primarily from life, accident and supplemental health insurance products.
Our life segment is the smaller of our insurance segments contributing 12.8% of total insurance premium revenue in 2012 and 12.2% in 2011. Premium revenues and operating income for the life segment for the year ended December 31, 2012 and 2011 are summarized below (amounts in thousands):
Net investment income was $2,029,000 for the year ended December 31, 2012 compared to $1,939,000 for the same period last year. Investment income in NSIC is generated from securities held in our investment portfolio as well as mortgage and policy loan interest. The $90,000 increase was primarily related to a 1% increase in invested assets in 2012 compared to 2011.
NSIC ended 2012 with net realized investment gains totaling $1,635,000 compared to $43,000 for the same period last year. The primary reason for the $1,592,000 increase in net realized investment gains was increased selling activity in 2012 compared to 2011. A primary focus during the current year was to moderately reduce the equity portfolio in order to increase the allocation to fixed income. These efforts were made to improve duration matching of liabilities and strengthen regulatory cash flow testing results. Net realized capital gains were also impacted during the current year by recognized other-than-temporary impairment losses on one security totaling $87,000; however, we had recoveries from previously recognized other-than-temporary impairments totaling $364,000. The life segment recognized other-than-temporary impairment losses totaling $398,000 during 2011 with recoveries of previously recognized other-than-temporary impairments of $384,000.
Policyholder claims were $5,294,000 through December 31, 2012 compared to $5,189,000 through December 31, 2011; an increase of $105,000. The primary reason for higher claims in the current year compared to the prior year was a 15% increase in death and maturity benefit incurred losses.
For the year ended December 31, 2012 and 2011, insurance taxes, licenses and fees were $218,000 and $316,000, respectively. As a percent of earned premium, insurance taxes, licenses and fees were 3.3% in 2012 compared to 4.6% in 2011. The primary reasons for the $98,000 decrease were the 3.8% decline in premium revenue combined with an increase in fees in the prior year associated with a periodic examination which concluded during the first half of 2011.
NSIC had interest expense of $53,000 in 2012 compared to $60,000 in 2011. As a percent of earned premium, interest expense was 0.8% at December 31, 2012 compared to 0.9% at December 31, 2011.
Year Ended December 31, 2012 Compared to Year Ended December 31, 2011:
Production of premium revenue in the P&C segment is primarily driven by our dwelling fire and homeowner lines of business. The following table provides premiums earned by line of business:
Another contributing factor to the decline in P&C premium revenue was a slight decrease related to our property programs. For the year ended December 31, 2012, premium revenue from our property programs totaled $51,905,000 compared to $52,417,000 for the same period last year; a decrease of 1%. A re-underwriting project in the first half of 2012 led to a net decline in homeowners policies in-force contributing to the decline in homeowners premium but should help improve future underwriting profits.
An additional factor contributing to the decline in current year premium revenue was an increase in ceded premium; up 14% in 2012 compared to 2011. The Company maintains catastrophe reinsurance coverage to mitigate loss exposure from catastrophic events. The premium related to this coverage increased approximately 19% in 2012 with our deductible increasing to $4 million from $3.5 million in the prior year. In addition to the 19% increase in catastrophe reinsurance cost, we also incurred $1,325,000 related to reinsurance premium protection (RPP) in 2012. The decision to add the RPP coverage was made by management in an effort to reduce earnings volatility in the P&C segment. The RPP coverage reduces our risk from a major catastrophe and helps strengthen our capital position.
Under the catastrophe reinsurance program for 2012, the Company retains the first $4,000,000 in losses from each event. Reinsurance coverage is maintained in four layers as follows:
Claims were $28,811,000 in 2012 compared to $38,836,000 for the same period last year; a decrease of $10,025,000 or 25.8%. The primary reason for the decrease was a reduction in losses from tornado, wind and hail related cat
events as well as claims associated with our automobile line of business. However, partially offsetting this decrease was adverse claim activity related to Hurricane Isaac which predominantly impacted Louisiana and Mississippi in late August 2012.
The gross losses and adjustment expenses reported in the P&C segment from claims associated with cat events during 2012 totaled $4,295,000. These claims were incurred from nine separate cat events and accounted for 14.9% of P&C segment claims during the current year. In comparison, the P&C segment had gross losses and adjustment expenses reported from seventeen cat events during 2011 totaling $14,040,000 or 36.2% of P&C segment claims during the prior year.
Of the nine cat events during 2012, the most notable was Hurricane Issac which made landfall late in August 2012. Reported losses and LAE from this cat event totaled $3,390,000 and accounted for 78.9% of total claims related to 2012 cat events. The Company had 1,147 claims reported from Hurricane Isaac with an average severity per claim of $3,000. Because the losses and LAE from Hurricane Isaac did not exceed the 2012 catastrophe reinsurance retention of $4 million, the Company did not have any ceded losses or LAE related to this cat event.
The P&C segment had fewer losses and LAE from fire related claims reported in 2012 compared to 2011. For 2012, the P&C segment had reported fire losses and LAE of $12,728,000 compared to $14,149,000 for the same period last year; a decrease of 10%. The P&C segment had 525 claims reported from fire losses and LAE in 2012 compared to 596 fire claims reported during 2011 with an average severity per claim of $24,000 for both years.
6.6% 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 $6,262,000 in 2012 compared to $6,322,000 in 2011; a 0.9% decrease. The primary reason for the $60,000 decline in general and administrative expenses was a reduction in costs associated with the discontinued automobile programs along with continued company wide cost reduction efforts.
The underwriting expense ratio, which measures underwriting expenses incurred (e.g., agents' commissions, premium taxes, and other administrative underwriting expenses) as a percentage of premium revenue.
Interest cost remains a significant expense for NSG. NSG's borrowings include $25,339,000 in long-term debt and $1,292,000 in short-term notes payable and current portion of long-term debt. Long-term debt is composed of subordinated debentures, an installment note and a secured line of credit. The $12,372,000 in subordinated debentures consists of two trust preferred security offerings. The first being $9,279,000 issued in December 2005 and the second being $3,093,000 issued in June 2007. The primary use for these proceeds was to add capital to the property and casualty subsidiaries following the hurricanes of 2004 and 2005. A $13,000,000 promissory note was executed to finance the Mobile Attic related settlement obligation. As of December 31, 2012, a total of $10,500,000 ($1,167,000 included in short-term debt) was outstanding with principal payments due in equal installments of $1,167,000 payable each November beginning in 2013. The Company also has a $4,000,000 secured line of credit obtained in September 2012. As of December 31, 2012, $3,634,000 was drawn on this line. The line of credit is secured by timber property. NSG maintains an unsecured line of credit in the amount of $700,000 ($125,000 drawn at December 31, 2012 and $485,000 drawn at December 31, 2011). Total interest expense for the Group associated with these borrowings in both 2012 and 2011 was $1,227,000 and $1,091,000, respectively.
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.
At December 31, 2012, the Company's holdings in debt securities amounted to 77.7% of total investments and 57.3% of total assets. The Company utilizes the ratings of various Nationally Recognized Statistical Rating Organizations when classifying fixed maturity investments by quality rating. The most significant shift in quality ratings occurring in 2011 was the downgrade of US Government debt by S&P from their highest rating of AAA to AA+. Moody's and Fitch continued to carry US Government debt at their highest rating throughout 2012. Due to the split ratings of the major rating agencies, US Government and agency debt is shown in the table below in the category of AAA/AA+.
A summary of debt and equity securities available-for-sale with unrealized losses as of December 31, 2012 along with related fair value, aggregated by length of time that the investments have been in a continuous unrealized loss position follows:
At December 31, 2012, 4.28% of total investments in the fixed income portfolio were classified as below investment grade. Management has evaluated each security in a significant unrealized loss position. For the year ended December 31, 2012, the Company realized $87,000 in other-than-temporary impairments. Most of the remaining unrealized losses in the fixed income portfolio, for which no impairment has been realized, are interest rate driven as opposed to credit quality driven and management believes no ultimate loss will be realized. In evaluating whether or not the equity loss positions were other-than-temporary impairments, Management evaluated financial information on each company and where available reviewed analyst reports from at least two independent sources. Based on a review of the available financial information, the prospect for future earnings of each company and consideration of the Company’s intent and ability to hold the securities until market values recovered, it was determined that the remaining securities in an accumulated loss position in the portfolio were temporary impairments. There were no recoveries on securities for a portion of which other-than-temporary impairments were realized during 2012. During 2011, recoveries on securities for a portion of which other-than-temporary impairments were realized totaled $384,000.
The Company was able to maintain current yield on investments primarily by shifting invested dollars into investment grade securities with slightly lower credit quality. As discussed previously, the shift occurred primarily within the life insurance subsidiary in order to increase yield and extend duration in order to better match life company liabilities.
Virtually all invested assets of the Company are held in the insurance subsidiaries. As of December 31, 2012, the maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows (dollars in thousands):
It should be noted that the above table represents maturities based on stated maturity. Due to call and prepayment features inherent in some debt securities, actual repayment, or effective maturities, will differ from stated maturities. The Company routinely evaluates the impact of changing interest rates on the projected maturities of bonds in the portfolio and actively manages the portfolio in order to minimize the impact of interest rate risk. Currently, for every 100 basis point change in interest rates, the Company will incur a change in market price of the fixed income portfolio of approximately 4%.
The Company has $25,339,000 of long-term debt including $12,372,000 from the proceeds of two separate trust preferred securities issuances, $3,634,000 drawn on a $4,000,000 secured line of credit and an outstanding promissory note balance of $9,333,000. The line of credit is secured by timber property transferred to the Holding Company from the P&C subsidiary. The Company also has $1,292,000 in short-term notes payable and current portion of long-term debt. This debt includes a $700,000 operating line of credit to allow flexibility with respect to cash management at the holding company level. The outstanding balance on the line, at December 31, 2012, was $125,000. We had $575,000 available at December 31, 2012, under the operating credit line. Also included in short-term debt is $1,167,000, the current portion due on a long-term notes payable.
The Company, primarily through its insurance subsidiaries, had $6,779,000 in cash and cash equivalents at December 31, 2012, compared to $3,393,000 at December 31, 2011. Cash used in operations for the year ended December 31, 2012 totaled $13,706,000, compared to cash used in the same period last year totaling $6,752,000.
The following table reflects the anticipated cash flows associated with our short- and long-term contractual obligations and commitments as of December 31, 2012 (dollars in thousands):
dividends and fees from the insurance subsidiaries. Also, dividends from the insurance subsidiaries are subject to regulatory restrictions and, therefore, are limited depending on capital levels and earnings of the subsidiaries.
Dividends paid from the insurance subsidiaries are subject to regulatory restrictions and prior approval of the Alabama Department of Insurance. As disclosed in Note 12 to the consolidated financial statements included in the 2012 Form 10-K, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company during 2013 is limited to $1,034,000 in the life insurance subsidiary and $2,468,000 in the property/casualty insurance subsidiary. Dividends are limited to the greater of net income (operating income for life subsidiary) or 10% of statutory capital and Regulators consider dividends paid within the preceding twelve months when calculating the available dividend capacity. Therefore, all of the above referenced dividend capacity will not be available for consideration of payment until dividends paid in the preceding twelve months have been considered on a rolling basis. The Company also has to continuously evaluate other factors such as subsidiary operating performance, subsidiary capital requirements and potential impact by rating agencies in making decisions on how much capital can be allocated for dividends to NSG. These factors are considered along with the goal of growing year over year statutory surplus in the subsidiaries and these considerations along with recent adverse impacts on regulatory surplus will likely lead to dividend payments to NSG substantially below the above referenced regulatory maximums.
In late 2011, we discontinued both our private passenger and commercial automobile programs. These two programs accounted for approximately 6% of net written premium in 2011, down from nearly 10% in 2010 but had produced significant underwriting losses over the last five years. Due to a combination of reduced capital levels and a view that it would take some time to achieve underwriting profitability, we made the decision to discontinue the program in order to reduce surplus strain and underwriting leverage in the P&C subsidiaries. The final in-force policies in this program expired in mid 2012.
additional cover added $1.3 million to our cat reinsurance cost in 2012 and due to time lags in the rate adjustment process compressed margins in 2012 but will help protect capital from major events going forward.
Several events unfolded in June of 2012, leading up to trial that caused the Company to reexamine positions with regard to the litigation. First, shortly before trial, Mobile Attic's former auditors and our co-defendant in the matter reached an out of court settlement with the plaintiff and therefore would not be defending their actions, which were expected to help support the defense of claims. Second, one of the remaining co-defendants with whom the Company was jointly liable for claims under the stock purchase agreement was the former president of Mobile Attic who was sentenced to Federal Prison for bank fraud in 2010 and is currently serving a five year sentence in a West Virginia Federal Penitentiary. Third, the Court had not made a definitive ruling prior to commencement of the trial on how damages would be calculated. Fourth, with the lack of clarity on potential damages, it appeared that damage amounts were potentially going to be left in the hands of a jury in a matter that involved very complex legal and accounting issues with the potential to include damages for other actions involving our co-defendants in which we had no involvement. Fifth, while we believe it is possible that a jury would have returned a verdict for less than the amount for which we settled, we believe it would have been difficult to negotiate post trial settlement terms that would allow us to support our insurance operations and maintain our rating agency ratings. Finally, with no guidance on damages, in the event of an excessive verdict we would have faced significant liquidity constraints in supporting a potentially long, expensive and arduous appeal process.
Cash to fund the litigation settlement will come from three primary sources. First, the Company owns 3,000 acres of timber property with a carrying value of approximately $1.4 million and an estimated fair market value of $5 million. As previously discussed, this property was used as collateral to obtain a $4,000,000 operating line of credit through a regional bank to aide in restoring short-term liquidity and allow flexibility in managing holding company liquidity. Ultimately, the Company will seek to sell the property or use the proceeds from timber sales on the property to retire the debt. Second, the holding Company has significant deferred tax assets associated with a net operating loss (NOL) carryforward generated by a combination of this settlement and defense costs incurred over the last two years. This NOL carryforward will generate tax benefits that will offset a portion of future tax liabilities of the P&C insurance subsidiaries in our consolidated tax returns. It is expected that this NOL carryforward will generate approximately $5 million in tax benefits over the term of the settlement. Finally, dividends and management fees paid by the insurance subsidiaries will provide an additional source of proceeds to pay this obligation. Although not a preferred source of flexibility, the Company can also defer interest payments on the trust preferred securities to provide additional operating cash flow. In the event that the Company elects to defer interest payments, shareholder dividends will be suspended until interest payments are current.
The Company maintains an unsecured operating line of credit, with a $700,000 limit, to allow flexibility with respect to cash management at the holding company level. The outstanding balance at December 31, 2012 was $125,000. The Company obtained a $4,000,000 secured line of credit in September 2012 to provide additional operating flexibility to the holding company. The outstanding balance at December 31, 2012 was $3,634,000.
National Security Insurance Company (life insurer) has regulatory adjusted capital of $11.1 million and $11.5 million at December 31, 2012 and 2011, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 15.7 and 14.6 at December 31, 2012 and 2011, respectively. Accordingly, National Security Insurance Company exceeds the minimum RBC requirements.
Omega One Insurance Company (property/casualty insurer), which began writing business in late 1995, has regulatory adjusted capital of $8.0 million and $7.4 million at December 31, 2012 and 2011, respectively, and a ratio of regulatory
total adjusted capital to authorized control level RBC of 23.6 and 11.3 at December 31, 2012 and 2011, respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.
Our consolidated financial statements are based upon the development and application of accounting policies that require management to make significant estimates and assumptions. Accounting policies may be based on (including but not limited to) GAAP authoritative literature, statutory authoritative literature, regulations and industry standards. The Company's financial results would be directly impacted by changes in assumptions and judgments used to select and apply our accounting policies. It is management's opinion that the following are some of the more critical judgment areas in regards to the application of our accounting policies and their effect on our financial condition and results of operations.
Risk management involves ceding risks to reinsurers for policies underwritten based on contractual agreements. The reinsurance purchased helps provide protection by individual loss or catastrophic event when claims exceed specified amounts. Although the reinsurance protects our Company in the event a loss penetrates into a particular reinsurance agreement; ultimate responsibility for claim settlement rests with our company if any reinsurer defaults on payments due. We record an asset for reinsurance recoverable on the financials for amounts due from reinsurers and monitor the balances due by reinsurer to ensure the asset is ultimately going to be collectible. If we discover an amount due may not be received, we remove the balance and charge it to an allowance for doubtful accounts or charge it off to expense based on the information available at the time.
NSFC and Omega generally reinsure with third parties any liability in excess of $225,000 on any single policy. During 2012, the property and casualty segment maintained a catastrophe contract, which covered losses related to a catastrophic event with multiple policyholders affected. In the event a catastrophe exceeded the $4 million retention stated in the contract, reinsurers would reimburse the company 95% (5% co-pay) of gross losses and loss adjustment expenses paid up to $17.5 million (layer one and layer two of the contract). If losses exceeded $17.5 million, the contract allowed for 100% reimbursement of losses and loss adjustment expenses up to $72.5 million. Any losses above the $72.5 million upper limit were the responsibility of our Company. The contract in place during 2012 also allowed one reinstatement for coverage under the contract for a second catastrophic event if needed. The contract provided protection which exceeded a 100 year “near term” event as depicted in catastrophe modeling results. The “near term” catastrophe modeling results reflect a predicted increase in storm activity given the current weather pattern and various factors projected to impact our weather patterns in the near term.
Investments are recorded at fair value based upon quoted prices when available. Quoted prices are available for most investment debt and equity securities included in the financial statements. Further discussion of fair value methodology is discussed in Note 5 to the consolidated 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. We have very limited exposure to less liquid and difficult to value investments such as collateralized debt obligations.
In June and December 2011, the Financial Accounting Standards Board (FASB) issued guidance amending the presentation of comprehensive income and its components. Under the new guidance, a reporting entity has the option to present comprehensive income in a single continuous statement or in two separate but consecutive statements. The Company adopted the new guidance in the first quarter of 2012. The Company opted to present the total of comprehensive income, the components of net income, and the components of other comprehensive income in two separate but consecutive statements. The Condensed consolidated financial statements included herein reflect the adoption of this updated guidance. The new guidance affects presentation only and therefore had no impact on the Company's results of operations or financial position.
In October 2010, the FASB issued guidance modifying the definition of the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts. The guidance specifies that the costs must be directly related to the successful acquisition of insurance contracts. The guidance also specifies that advertising costs should be included as deferred acquisition costs ("DAC") only when the direct-response advertising accounting criteria are met. Under the new guidance, only acquisition costs associated with "successful sales" are allowed to be deferred. Successful sales ratios will be reviewed quarterly and the new guidance will reduce the amount of acquisition cost that can be deferred to future periods. The Company adopted the new guidance on a prospective basis as of January 1, 2012.
We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. as of December 31, 2012 and 2011, and the related consolidated statements of income (loss), comprehensive income (loss), shareholders' equity and cash flows for the years then ended. The Company's management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
The Notes to the Consolidated Financial Statements are an integral part of these statements.
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). NSFC includes a wholly-owned subsidiary - Omega One Insurance Company (Omega). The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). All significant intercompany transactions and accounts have been eliminated. The financial information presented herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2012, which includes information and disclosures not presented herein.
The Company's property and casualty subsidiaries, composing nearly 88% of consolidated revenues, are licensed to operate on a surplus lines basis in 13 states. However, over 60% of segment revenue is generated in the states of Alabama, Mississippi and Louisiana, subjecting the Company to significant geographic concentration. Consequently, adverse weather conditions or changes in the legal, regulatory or economic environment could adversely impact the Company.
For the year ended December 31, 2012, one agency individually produced greater than 5% of the Company's direct written premium.
When an equity security has a decline in value, where fair value is below cost, that is deemed to be other-than-temporary, the Company reduces the book value of the security to its current fair value, recognizing the decline as a realized loss in the statement of operations. Any future increases in the market value of investments written down are reflected as changes in unrealized gains as part of accumulated other comprehensive income within shareholders' equity.
Mortgage loans and policy loans are stated at the unpaid principal balance of such loans, net of any related allowance for uncollectible amounts.
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 method of computing the deferred policy acquisition costs for property and casualty policies limits the amount deferred to a percentage of related unearned premiums.
Earnings per share of common stock is based on the weighted average number of shares outstanding during each year. The adjusted weighted average shares outstanding were 2,466,600 in both 2012 and 2011.
Certain 2011 amounts have been reclassified from the prior year consolidated financial statements to conform to the 2012 presentation.
The Company maintains cash balances which are generally held in non-interest bearing demand deposit accounts. Through December 31, 2012 these balances are insured by the FDIC with no balance limits. 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.
In June and December 2011, the Financial Accounting Standards Board (FASB) issued guidance amending the presentation of comprehensive income and its components. Under the new guidance, a reporting entity has the option to present comprehensive income in a single continuous statement or in two separate but consecutive statements. The Company adopted the new guidance in the first quarter of 2012. The Company opted to present the total of comprehensive income, the components of net income, and the components of other comprehensive income in two separate but consecutive statements. The Condensed Consolidated Financial Statements included herein reflect the adoption of this updated guidance. The new guidance affects presentation only and therefore had no impact on the Company's results of operations or financial position.
In October 2010, the FASB issued guidance modifying the definition of the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts. The guidance specifies that the costs must be directly related to the successful acquisition of insurance contracts. The guidance also specifies that advertising costs should be included as deferred acquisition costs ("DAC") only when the direct-response advertising accounting criteria are met. Under the new guidance, only acquisition costs associated with "successful sales" are allowed to be deferred. Successful sales ratios will be reviewed quarterly and the new guidance will reduce the amount of acquisition cost that can be deferred to future periods. The Company adopted the new guidance on a prospective basis as of January 1, 2012. The adoption did not have a material impact on the Consolidated Financial Statements.
In May 2011, the FASB issued guidance that clarifies the application of existing fair value measurement and disclosure requirements and amends certain fair value measurement principles, requirements and disclosures. The guidance is to be applied prospectively for reporting periods beginning after December 15, 2011. The adoption of this guidance as of January 1, 2012 had no impact on the Company's results of operations or financial position. The expanded disclosures required by this guidance are included in Note 5.
In July 2012, the FASB issued guidance related to impairment of indefinite-lived intangible assets other than goodwill. The new guidance will allow an entity to first make a qualitative assessment of whether it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount before applying the quantitative impairment test. An entity is required to perform the quantitative test only if it determines that it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount. We are currently evaluating the impact of this revised guidance on our financial statements. However, we do not expect a material effect on our results of operations or financial position upon adoption in 2013.
Disclosures about Offsetting Assets and Liabilities for Financial Instruments and Derivative Instruments
The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2012 are as follows:
The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2012 are as follows:
The amortized cost and aggregate fair value of debt securities at December 31, 2012, by contractual maturity, are presented in the following table. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
A summary of securities available-for-sale with unrealized losses as of December 31, 2012, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as
The Company conducts periodic reviews to identify and evaluate securities in an unrealized loss position in order to identify other-than-temporary impairments. For securities in an unrealized loss position, the Company assesses whether the Company has the intent to sell the security or more-likely-than-not will be required to sell the security before the anticipated recovery. If either of these conditions is met, the Company is required to recognize an other-than-temporary impairment with the entire unrealized loss reported in earnings. For securities in an unrealized loss position that do not meet these conditions, the Company assesses whether the impairment of a security is other-than-
For the year ended December 31, 2012, the Company realized $87,000 in additional other-than-temporary impairments. The single largest accumulated loss not realized as an impairment was in the equity portfolio and totaled $457,000. The second largest loss position was in the bond portfolio and totaled $39,000. The third largest loss position was in the bond portfolio and totaled $27,000.
For the year ended December 31, 2011, the Company realized $398,000 in other-than-temporary impairments. The single largest accumulated loss not realized as an impairment 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.
Major categories of investment gains and losses are summarized as follows (dollars in thousands):
Level 2 assets include certain of our marketable debt and equity instruments with quoted market prices that are traded in less active markets or priced using a quoted market price for similar instruments. Level 2 assets also include marketable equity instruments with security-specific restrictions that would transfer to the buyer, marketable debt instruments priced using indicator prices which represent non-binding market consensus prices that can be
corroborated by observable market quotes, as well as derivative contracts and debt instruments priced using inputs that are observable in the market or can be derived principally from or corroborated by observable market data. Marketable debt instruments in this category generally include commercial paper, bank time deposits, repurchase agreements for fixed-income instruments, and a majority of floating-rate notes, corporate bonds, and municipal bonds.
Level 3 assets and liabilities include marketable debt instruments, non-marketable equity investments, derivative contracts, and company issued debt whose values are determined using inputs that are both unobservable and significant to the values of the instruments being measured. Level 3 assets also include marketable debt instruments that are priced using indicator prices that we were unable to corroborate with observable market quotes.
Trading securities - Trading securities consist primarily of mutual funds whose fair values are determined consistent with similar instruments described above under “Fixed Maturity Securities” and below under “Equity Securities” and “Derivative Instruments.”
Equity securities - Equity securities consist principally of investments in common and preferred stock of publicly traded companies and privately traded securities. The fair values of our publicly traded equity securities are based on quoted market prices in active markets for identical assets and are classified within Level 1 in the fair value hierarchy. Estimated fair values for our privately traded equity securities require a substantial level of judgment. Privately traded equity securities are classified within Level 3.
Interest rate swaps - Interest rate swaps are recorded at fair value either as assets, within other assets or as liabilities, within other liabilities. The fair values of our interest rate swaps are provided by a third party broker and are classified within Level 3.
As of December 31, 2012, Level 3 fair value measurements of assets include $829,000 of equity securities in a local community bank whose value is based on an evaluation of the financial statements of the entity. The Company does not develop the unobservable inputs used in measuring fair value.
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, 2012 (in thousands):
For the year ended December 31, 2012, there were no assets or liabilities measured at fair values on a nonrecurring basis.
Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2011 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):
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 (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 swap agreements which are designated as cash flow hedges. For cash flow hedges, the
At December 31, 2012, the Company has approximately $7,974,000 of net operating loss carryforwards available ($2,711,000 tax benefit) to be applied to future periods. These carryforwards expire in 2021 and 2022.
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 TPS 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.
The Company has entered into various swap agreements related to the trust preferred securities. On March 19, 2009, the Company entered into a forward swap effective September 17, 2012, 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 June 21, 2007. Commencing September 17, 2012, under the terms of the forward swap, the Company receives interest at the three-month LIBOR rate plus 3.4% and pay interest at the fixed rate of 7.02%. This forward swap will effectively fix the interest rate on $3,000,000 in debt until September of 2019.
We use dollar offset at the hedge's inception and for each reporting period thereafter to assess whether the derivative used in a hedging transaction is expected to be, and has been, effective in offsetting changes in the fair value of the hedged item. Since inception, no portion of the hedged item has been deemed ineffective. For all hedges, we discontinue hedge accounting if it is determined that a derivative is not expected to be, or has ceased to be, effective as a hedge.
In January 2012, the Company renewed an unsecured line of credit for $700,000, with an interest rate of 5%, to be made available for general corporate purposes. As of December 31, 2012, $125,000 was drawn on this line ($485,000 at December 31, 2011). The Company renewed this line of credit in January 2013 under the same terms as disclosed in the table above.
In July 2012, the Company executed a promissory note in the amount of $13,000,000 payable to the Bagley Family Revocable Trust with an interest rate of WSJ prime plus 1% (5.25% at December 31, 2012. The purpose of this promissory note is to finance the settlement obligation related to the Mobile Attic litigation. As of December 31, 2012, a total of $10,500,000 was outstanding with principal payments due in equal annual installments of $1,167,000 payable each November beginning in 2013. Installment payments due within 12 months of the balance sheet date are classified as current portion of long term debt.
The following table is a reconciliation of beginning and ending property and casualty reserve balances for claims and claim adjustment expense (dollars in thousands):
The 2012 decrease in property and casualty benefit loss reserves was primarily due to a reduction in claim and claim adjustment expense estimates arising in prior years primarily attributable to reductions in loss reserves associated with the now discontinued private passenger auto line of business.
The Company's insurance operations utilize reinsurance in order to limit losses, minimize exposure to large risks, provide additional capacity for future growth and effect business-sharing arrangements. Life reinsurance is accomplished through yearly renewable term coverage. Property and casualty reinsurance is placed on both a quota-share and excess of loss basis. Reinsurance ceded arrangements do not discharge the insurance subsidiaries as the primary insurer, except for cases involving a novation. Failure of re-insurers to honor their obligations could result in losses to the insurance subsidiaries. The insurance subsidiaries evaluate the financial conditions of their reinsurance
companies and monitor concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the companies to minimize their exposure to significant losses from reinsurance insolvencies.
In the normal course of business, NSFC seeks to reduce the loss that may arise from catastrophes or other individually significant large loss events that cause unfavorable underwriting results by re-insuring certain levels of risk in various areas of exposure with reinsurance companies. NSFC maintains a catastrophe reinsurance agreement to cover losses from catastrophic events, primarily hurricanes.
At December 31, 2012, the largest reinsurance recoverable of a single reinsurer was $295,000 ($574,000 in 2011). Amounts reported as ceded incurred losses in 2012 were related to the development of losses from prior year catastrophes. During 2011, amounts reported as ceded incurred losses were related to April tornado losses in excess of the Company's retention in addition to development from prior year catastrophes.
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. Contributions to the plan are fully vested upon the earlier of death, disability, change in control, or ten years of participation in the plan. Costs for amounts credited of the non-qualified deferred compensation plans for 2012 and 2011 amounted to approximately $158,000 and $68,000, respectively.
Premium revenues and operating income by industry segment for the years ended December 31, 2012 and 2011 are summarized below (dollars in thousands):
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, 2012 and 2011, respectively:
The Company's property & casualty subsidiaries are defending a limited number of matters filed in the aftermath of Hurricanes Katrina and Rita in Mississippi, Louisiana and Alabama. These actions include individual lawsuits with 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.
The various suits seek a variety of remedies, including actual and/or punitive damages in unspecified amounts and/or declaratory relief. All of these matters are in various stages of development and the Company's subsidiaries intend to vigorously defend them. The outcome of these disputes is currently uncertain.
In April 2007, the Company sold substantially all of its 50% interest in Mobile Attic, Inc., to Bagley Family Revocable Trust (the "Purchaser"). The Company, Peter L. Cash and Russell L. Cash (collectively the "Sellers") sold to Purchaser 61% of the outstanding stock of Mobile Attic under the terms of a Stock Purchase Agreement dated April 5, 2007, executed by Sellers, Mobile Attic and Purchaser's assignor, James W. Bagley (the "Stock Purchase Agreement").
Under the terms of the Stock Purchase Agreement, the Purchaser paid the Company $2,700,000 for 45% of the total outstanding stock of Mobile Attic and paid the other Sellers $960,000 for an additional 16% of the total outstanding stock in Mobile Attic, thus obtaining a controlling interest of 61% of the outstanding stock. The Stock Purchase Agreement provided that Purchaser was to use his best efforts to cause the Company to be released from its guaranty of a bank loan to Mobile Attic having an outstanding principal balance of approximately $9,400,000. The bank loan was secured by portable storage containers of Mobile Attic. The Sellers made certain warranties to the Purchaser in the Stock Purchase Agreement regarding the financial condition of Mobile Attic and agreed to jointly and severally indemnify the Purchaser for any damages resulting from a breach of any of the warranties.
On June 20, 2012, the Company and Bagley Trust reached a settlement agreement to dispose of this action. Under the terms of the settlement, the Company agreed to pay Bagley Trust $13,000,000. The terms of the agreement were formalized in the form of a promissory note in accordance with the following payment schedule: $2.5 million on September 18, 2012, and the balance payable in 9 equal annual installments on November 15 each year beginning in 2013 with a final payment in 2021. The unpaid principal will bear interest at WSJ prime rate plus 1% per annum. The settlement allows for the Company to defer payments in years in which its P&C subsidiaries incur substantial catastrophe losses thus allowing capital management flexibility in the P&C subsidiaries. Under the terms of the agreement, annual debt service payments on the note must equal or exceed any payment of dividends to shareholders in the preceding twelve months.
Pursuant to the rules and regulations of the Securities and Exchange Commission, the Condensed Financial Information of the Registrant does not include all of the information and notes normally included with financial statements prepared in accordance with generally accepted accounting principles. It is, therefore, suggested that this Condensed Financial Information be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Registrant’s Annual Report as referenced in Form 10-K, Part II, Item 8, page 40.