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 NSEC) 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, 2018.
The Property and Casualty (P&C) segment is the most significant segment, accounting for 90.9% of gross earned premium in 2018. The P&C segment has insurance in-force in the states of Alabama, Arkansas, Georgia, Louisiana, Mississippi, Oklahoma, South Carolina, and Tennessee.
The Company's P&C segment is conducted through National Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of National Security Fire & Casualty Company organized in 1992. Due to Omega producing no direct written premium and the fact that Omega is a wholly owned subsidiary of NSFC authorized to underwrite similar lines of business, all references to NSFC or P&C segment in the remainder of this management discussion and analysis will include the insurance operations of both NSFC and Omega.
Life segment business is conducted through National Security Insurance Company (NSIC), a wholly owned subsidiary of the Company organized in 1947. All references to NSIC or life segment in the remainder of this management discussion and analysis will refer to the combined life, accident and health insurance operations.
All of our insurance companies have been assigned ratings by A.M. Best Co (Best). On April 12, 2018, A. M. Best affirmed the financial strength rating (FSR) of B++ (Good) and the issuer credit rating (ICR) of "bbb" of NSFC. In addition, Best affirmed the FSR of B+(Good) and ICR of "bbb-" of Omega and NSIC. The A.M. Best outlook for all of the ratings is "stable" for NSFC and Omega. Best upgraded the outlook from "stable" to "positive" for NSIC. Best also affirmed the ICR of "bb" of the parent holding company, NSEC, with a "stable" outlook.
The property and casualty subsidiaries have been assigned ratings by Demotech, Inc. On September 30, 2018, Demotech affirmed a Financial Stability Rating of A (Exceptional) for both NSFC and Omega.
Overview - Balance Sheet highlights at December 31, 2018 compared to December 31, 2017
Invested assets as of December 31, 2018 were $112,690,000 compared to $114,731,000 as of December 31, 2017. The primary reason for the decline in invested assets was the increase in market interest rates which reduced the market value of our bond portfolio held for sale by $3,043,000.
The Company, primarily through its insurance subsidiaries, had $5,676,000 in cash and cash equivalents at December 31, 2018, compared to $6,644,000 at December 31, 2017. The moderate decline in cash for 2018 was primarily due to payment of claims from Hurricane Michael which occurred in the fourth quarter of 2018.
Policy liabilities were $77,988,000 at December 31, 2018, compared to $76,674,000 at December 31, 2017; an increase of $1,314,000 or 1.7%. The primary reason for the increase in policy liabilities in 2018 compared to the same period last year was a $1,133,000 increase in P&C segment loss reserves.
Shareholders' equity as of December 31, 2018 was $45,866,000, down $1,759,000 compared to December 31, 2017 Shareholders' equity of $47,625,000. Book value per share was $18.15 at December 31, 2018, compared to $18.88 per share at December 31, 2017, a decrease of $0.73 per share. The primary factors contributing to the decrease in both book value per share and Shareholders' equity were an accumulated other comprehensive loss of $2,109,000, shareholder dividends of $505,000 and new shares issued under our director compensation plan which totaled $76,000. Partially offsetting these factors was net income of $779,000. The accumulated other comprehensive loss was largely driven by a $2,404,000 net of tax decline in market values in our bond portfolio due to an increase in market interest rates.
The property and casualty segment composed 90.1% of total net earned premium revenue in 2018 compared to 90.0% in 2017. Through the P&C segment, we offer primarily dwelling fire and homeowners insurance coverage to our customers. The life segment composed 9.9% of net earned premium revenue in 2018 compared to 10.0% in 2017 with revenue produced from life, accident and supplemental health insurance products. While reading this discussion regarding segment information, reference is made to Note 15 to the Consolidated Financial Statements which provides additional segment related information.
Premium revenues and operating income for the life segment for the year ended December 31, 2018 and 2017 are summarized below (amounts in thousands):
Net earned premium revenue in the life segment was $6,019,000 at December 31, 2018 compared to $6,119,000 at December 31, 2017; a decrease of 1.6%. The $100,000 decrease in net earned premium revenue was primarily due to a decline in new business production in both the traditional life and supplemental accident and health insurance products offered in NSIC.
While NSIC composes only 9.9% of premium revenue, the segment makes up 41.2% of consolidated assets. The majority of these assets consist of fixed maturity investments. Net investment income was up $171,000 or 6.7% at $2,722,000 for the year ended December 31, 2018 compared to $2,551,000 for the same period last year. A combination of increased investment in fixed income securities due to positive cash flow from operations and the recent rise in interest rates was the primary factor contributing to the increase in investment income.
Other income was $1,078,000 in 2018 compared to $1,045,000 for the same period in 2017; an increase of $33,000. Other income consists primarily of adjuster fees paid to NSIC from the P&C segment and rent from affiliates which is eliminated upon consolidation. As a percent of net earned premium, other income was 17.9% in 2018 and 17.1% in 2017.
Claims were $5,242,000 through December 31, 2018 compared to $5,045,000 through December 31, 2017; an increase of $197,000 or 3.9%. NSIC experienced a moderate increase in life insurance claims in 2018 compared to the same period last year due to an increase in both ordinary life and industrial life related claims.
For the year ended December 31, 2018 and 2017, insurance taxes, licenses and fees were $220,000 and $208,000, respectively. As a percent of earned premium, insurance taxes, licenses and fees were comparable at 3.7% in 2018 and 3.4% in 2017.
Interest expense was $48,000 for the year ended December 31, 2018 compared to $73,000 for the year ended December 31, 2017. Interest expense is related to our life insurance policies which contain a savings account component. The primary reason for the $25,000 decrease in interest expense, in 2018 compared to 2017, was a reduction in the minimum interest rate required to be paid to policyholders from 5% to 3%.
Premium revenues and operating income for the P&C segment for the year ended December 31, 2018 and 2017 are summarized below:
Property and casualty segment net premium earned for 2018 was $54,837,000 compared to 55,044,000 for the same period in 2017. The primary reason for the moderate decline in 2018 compared to 2017 was a 4.5% decrease in gross premium revenue in our homeowners program primarily driven by a reduction in premium revenue in coastal Louisiana. An increase in catastrophe reinsurance cost (ceded premium) of 1.7% also contributed to our 0.4% decrease in net premium earned.
The primary source of premium revenue growth in the P&C segment was in our non-coastal states; primarily the states of Georgia and Oklahoma. Premium revenue in Georgia increased 8.0% in 2018 with policy counts up 3.7% compared to December 31, 2017. Increased rates were implemented in Georgia, along with growth in policy count, which lead to the year over year increase in premium revenue in the state. In addition, Oklahoma premium revenue increased 4.1% in 2018, with policy counts up 3.7%. An increase in new business production coupled with the implementation of increased rates were the primary reasons for the increase in premium revenue in Oklahoma in 2018 compared to the same period last year. We expect to continue to look for opportunities to increase premium revenue in non-coastal and less hurricane prone regions of the states in which we operate in order to create more geographic diversification and seek appropriate risk adjusted rates in coastal areas.
The Company maintains catastrophe reinsurance coverage to mitigate loss exposure from catastrophic events. Our per event catastrophe retention remained unchanged at $4 million in 2018 and we maintain catastrophe reinsurance coverage with an upper limit of $72.5 million. Our catastrophe reinsurance also covers the cost of a second event up to the same $72.5 million upper limit, again with a $4 million retention.
Under the catastrophe reinsurance program in 2018, the Company retained the first $4,000,000 in losses from each event. Reinsurance coverage for 2018 was maintained in three layers as follows:
We use the results of the Risk Management Solutions (RMS) and AIR Worldwide (AIR) models in our review of exposure to hurricane risk. Each of these third party vendors provides two views of the modeled results as follows: (i) a long-term view that closely relates modeled event frequency to historical hurricane activity; and (ii) a shorter-term view that adjusts historical frequencies to reflect expectations of elevated hurricane activity in the near future. We believe that modeled estimates provide a range of potential outcomes and we review multiple estimates for purposes of understanding our catastrophic risk and variability. However, due to regulatory and competitive limitations, we generally utilize long-term model output in the development of our product pricing.
In 2018, the P&C segment was impacted by Hurricane Michael which exceeded our $4 million catastrophe reinsurance retention. The P&C segment was also impacted, in 2018, by 18 smaller catastrophe events that individually did not exceed our catastrophe reinsurance retention; but contributed incurred losses totaling $5,138,000. In 2017, we incurred losses from 26 catastrophe events totaling $14,280,000 with none exceeding our reinsurance retention. This lead to a record year for retained catastrophe losses for the Company and adversely impacted our 2017 underwriting results. While we have sought reinsurance coverage to reduce the impact of smaller serial events, it has been challenging to obtain cost effective coverage and structure. However, through improvement in our rate structure and implementation of more adequate risk adjusted rates over the past five years, we are able to limit the adverse impact of catastrophe losses on our capital position.
Net investment income totaled $1,330,000 in 2018 compared to $1,571,000 in 2017; a decrease of $241,000. The primary reason for the decrease in net investment income was a $374,000 decline in the value of investments in the cash value of our company owned life insurance in the current year compared to the same period last year.
Other income was $609,000 in 2018 compared to $592,000 for the same period in 2017; an increase of $17,000. Other income consists primarily of fees related to the issuance of our property insurance policies as well as other miscellaneous income. As a percent of net earned premium, other income was 1.1% in both 2018 and 2017.
Policyholder benefits and settlement expenses in the property and casualty segment were $35,735,000 in 2018 compared to $38,391,000 for the same period in 2017; a decrease of $2,656,000 or 6.9%. The P&C segment ended 2018 with a loss ratio of 65.2% compared to 68.0% for the same period in 2017. The primary reason for the decrease in claims and the loss ratio in 2018 compared to 2017 was fewer losses and loss adjustment expenses (LAE) reported from cat events in the current year compared to the same period in the prior year.
Deferred policy acquisition costs totaled $2,759,000 in 2018 compared to $2,777,000 in 2017. Deferred policy acquisition costs were 5.0% of net earned premium revenue for 2018 and 2017. Deferred policy acquisition costs consist of amortization of previously capitalized distribution costs, primarily commissions.
General and administrative expenses in the property and casualty segment totaled $8,472,000 in 2018 compared to $8,087,000 in 2017; an increase of $385,000 or 4.8%. General and administrative expenses were 15.4% of premium revenue in 2018 and 14.7% of premium revenue in 2017. The primary reason for the increase in general and administrative expenses in 2018 compared to 2017 was an increase in actuarial fees associated with rate filings in the P&C segment.
The P&C segment ended 2018 with pretax income of $506,000 compared to a pretax loss of $1,502,000 for the same period in 2017. The $2,008,000 increase in pretax income was primarily due to the reduction of claims incurred from catastrophe losses in 2018 compared to 2017.
further considering liquidity and capital needs, the Company considers investment quality, investment return, asset/liability matching and composition of the investment portfolio when making investment decisions.
Our holdings in below investment grade securities are primarily comprised of energy and natural resource sector investments and collateralized debt obligations (CDO's). We have evaluated our current below investment grade holdings for potential impairment, along with any other security with a market value substantially below our amortized cost. We currently have no investment below 80% of amortized cost and based on presently available information, we do not believe any below investment grade securities are other-than-temporarily impaired. We also currently have no fixed income investments in default.
A downside of investing in longer duration securities in the life segment is that the portfolio is exposed to more significant price volatility as market interest rates rise. This exposure to sudden interest rate changes can lead to declines in market value of fixed income securities in a rising interest rate environment. Management currently maintains the life insurance portfolio in the intermediate duration range of 6.0 to guard against the adverse impact of rising rates. However, due to the necessity of matching the longer duration of life policy liabilities as closely as possible in order to pass regulatory cash flow testing and avoid significant interest rate speculation in the asset liability matching process, some volatility in market value of the portfolio in a rising rate environment cannot be avoided.
At December 31, 2018, 4.69% of total investments in the fixed income portfolio were classified as below investment grade. 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 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 securities in an accumulated loss position in the portfolio were temporary impairments. Management has evaluated each security in a significant unrealized loss position. For the year ended December 31, 2018, the Company realized $16,000 in other-than-temporary impairments related to fixed maturities.
The amortized cost and aggregate fair value of debt securities at December 31, 2018, by contractual maturity, are as follows (dollars in thousands). 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.
Investment returns with respect to the investment portfolio for the years ended December 31, 2018 and 2017 follows:
Average current yield on investments in 2018 decreased 0.01% compared to 2017. The marginal decrease in average current yield was primarily due to a decline in cash value of our company owned life insurance investment of $374,000.
This decrease was primarily driven by the late 2018 decline in the equity markets. Our income on fixed maturity investments increased $426,000 in 2018, up 12.6%, due to an increase in market interest rates.
The total return on investments in 2018 was only 0.3% compared to 4.6% in 2017. The decreased total return was driven by a significant increase in market interest rates in 2018 which decreased the value of our fixed maturity investment holdings.
Virtually all invested assets of the Company are held in the insurance subsidiaries. As of December 31, 2018, the contractual maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows (dollars in thousands):
The Company, primarily through its insurance subsidiaries, had $5,676,000 in cash and cash equivalents at December 31, 2018, compared to $6,644,000 at December 31, 2017. Cash provided by operating activities increased cash by $3,177,000 during the year ended December 31, 2018. The increase in cash from operating activities was primarily driven by net income from operations. Cash provided by operating activities increased cash by $2,316,000 for the year ended December 31, 2017. The increase in cash provided by operating activities in 2017 was primarily related to collections of reinsurance recoverable balances associated with Hurricane Matthew. Net cash used in investing activities totaled $2,149,000 for the year ended December 31, 2018, compared to $1,113,000 in 2017. Cash used in investing activities in 2018 primarily consisted of the investment of positive cash flow from operations. Net cash used in financing activities totaled $1,996,000 for the year ended December 31, 2018, compared to $1,927,000 for the same period last year. During the year ended December 31, 2018, the Company repaid $1,300,000 in short-term debt. The Company maintains a $700,000 line of credit which matures in March of 2020. We had $700,000 available on our revolving line of credit at December 31, 2018.
The Company had a total of $12,152,000 of long-term debt outstanding as of December 31, 2018, compared to $14,339,000 at December 31, 2017, which includes $12,372,000 in trust preferred securities issued by the Company in addition to the installment note. Current year and prior year amounts were reduced by the unamortized portion of the placement fees associated with the issuance of the trust preferred securities, $220,000 and $233,000, respectively.
In estimating the time interval for payment of property and casualty claim reserves, the Company utilized historical payment patterns. By the nature of the insurance contracts under which these liabilities exist, there can be no certainty that actual payments will fall in the periods indicated above. However, management believes that current liquidity and capital resources are sufficient to pay these obligations as they come due. Also, due to the relatively short-tail nature of the majority of the Company's property and casualty claim liabilities, management can conclude with a reasonable level of confidence that historical patterns indicate that approximately 97.3% of claim liabilities at the end of a given year are settled within the following two year period. See Note 9 for additional details on payout patterns.
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 audited consolidated financial statements included in our 2018 Annual Report on 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 2019 is statutorily limited to $1,640,000 in the life insurance subsidiary and $3,464,000 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 released from insurance subsidiaries for payment of 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 potential adverse impacts on regulatory surplus, will likely lead to dividend payments to NSG substantially below the above referenced regulatory maximums. The Company received $750,000 dividends from its subsidiaries during the year ended December 31, 2018.
The Company continues to monitor liquidity and subsidiary capital closely. Despite challenging weather patterns in the property and casualty subsidiaries over the past three years, the insurance subsidiaries are well capitalized. However, further strengthening of subsidiary capital continues to be a top priority for management.
The ratios of Total Adjusted Capital to Authorized Control Level RBC for The National Security Group's life/health and property/casualty insurance subsidiaries are all in excess of 4 to 1 at December 31, 2018.
National Security Insurance Company (life insurer) has regulatory adjusted capital of $16.1 million and $15.7 million at December 31, 2018 and 2017, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 16.2 and 17.6 at December 31, 2018 and 2017, 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 $10.8 million and $10.9 million at December 31, 2018 and 2017, and a ratio of regulatory total adjusted capital to authorized control level RBC of 18.9 and 19.6 at December 31, 2018 and 2017, respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.
During 2018, 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 company retention stated in the contract, reinsurers would reimburse the company 100% of gross losses up to the upper limits of the reinsurance agreement, which was $72.5 million in 2018 and 2017. Any losses above the $72.5 million upper limit are the responsibility of our Company. The contract in place during 2018 also allowed one reinstatement for coverage under the contract for a second catastrophic event if needed.
At December 31, 2018, 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 Consolidated Financial Statements.
We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. as of December 31, 2018 and 2017 and the related consolidated statements of operations, comprehensive income (loss), changes in shareholders’ equity, and cash flows for the years then ended, and the related notes and financial statement schedules I, II, III, IV and V (collectively referred to as the consolidated financial statements). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of The National Security Group, Inc. as of December 31, 2018 and 2017, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
We have served as The National Group, Inc.’s auditor since 2009.
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 (GAAP). In the opinion of management, all adjustments, consisting of normal and recurring items, necessary for the fair presentation of the consolidated financial statements have been included. All significant intercompany transactions and accounts have been eliminated in the consolidated financial statements. 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, 2018, which includes information and disclosures not presented herein.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these consolidated financial statements are reserves for future life insurance policy benefits, liabilities for losses and loss adjustment expenses, reinsurance recoverable associated with loss and loss adjustment expense liabilities, deferred policy acquisition costs, deferred income tax assets and liabilities, assessments of other-than-temporary impairments on investments and accruals for contingencies. Actual results could differ from the estimates used in preparing these consolidated financial statements.
The Company's property and casualty subsidiaries, composing 90% of consolidated direct written premium, produced business during 2018 in eight states. However, 53% of property and casualty segment direct written premium 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.
Changes in fair value of equity securities available-for-sale are reported as investment gains/losses in the statement of operations. Prior to January 1, 2018, changes in fair value of equity securities available-for-sale were reported as net unrealized gains or losses as a component of other comprehensive income. Gains and losses were recorded in the statement of operations only when equity securities were sold or were other-than-temporarily impaired.
yield that will equate the carrying amount of the investment to the present value of the projected future cash flows. The recalculated yield is used to accrue income on investments for subsequent periods.
Receivable balances are reported at unpaid balances, less a provision for credit losses.
Life insurance premiums are recognized as revenues when due. Property and casualty insurance premiums include direct writings plus reinsurance assumed less reinsurance ceded and are recognized on a pro-rata basis over the terms of the policies. Unearned premiums represent that portion of direct premiums written that are applicable to the unexpired terms of policy contracts in force and is reported as a liability. Prepaid reinsurance premiums represent the unexpired portion of premiums ceded to reinsurers and are reported as an asset.
The Company uses the asset and liability method of accounting for income taxes. Deferred income taxes arise from the recognition of temporary differences between financial statement carrying amounts and the tax basis of the Company's assets and liabilities and capital or operating loss carry-forwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. A valuation allowance is provided when it is more likely than not that some portion of the deferred tax asset will not be realized. The effect of a change in tax rates is recognized in the period the new rate is enacted. Changes in deferred tax assets and liabilities are included as a component of income tax expense, with the exception of changes impacting other comprehensive income. Changes in deferred tax assets and liabilities associated with components of other comprehensive income are charged or credited to other comprehensive income.
Policy receivables are reported at unpaid balances. Policy receivables are generally offset by associated unearned premium liabilities and are not subject to significant credit risk. Receivables from agents, less provision for credit losses, are composed of balances due from independent agents. At December 31, 2018, the single largest balance due from one agent totaled $516,000.
In August 2018, the FASB issued guidance to that removes, modifies and adds to the disclosure requirements related to fair value measurements. The guidance removes the requirements to disclose the amount and reasons for transfers between Level 1 and Level 2 assets, the policy for timing and transfers between levels and the valuation process for Level 3 fair value measurements. The guidance modifies disclosure requirements for investments in certain entities that calculate net asset value and clarifies the purpose of the measurement uncertainty disclosure. The guidance adds requirements to disclose changes in unrealized gains or losses included in other comprehensive income for recurring Level 3 fair value measurements and to disclose the range and weighted average used to develop significant unobservable inputs for Level 3 fair value measurements. The guidance is effective for fiscal years beginning after December 15, 2019 and interim periods within those fiscal years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.
including interim periods within those years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.
In June 2018, the FASB issued guidance to simplify the accounting for nonemployee share-based payment awards. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within that fiscal year The Company does not make any material share-based payments. The Company adopted this guidance on January 1, 2019. The adoption of this guidance did not have a material impact on its financial position or results of operations.
In February 2016, the FASB issued guidance that requires lessees (for capital and operating leases) to recognize the lease liability and right-of-use asset at the commencement date of the lease. Additional transition guidance was issued in 2018. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those years. The Company adopted this guidance on January 1, 2019. The Company leases automobiles and some office equipment. These leases are not considered material. The adoption of this guidance did not have a material impact on its financial position or results of operations.
In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments shall be presented and classified in the statement of cash flows. This guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. The Company adopted this guidance as of January 1, 2018. The adoption of this guidance did not have a significant impact on our financial position, results of operations or cash flows.
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
Our investment in available-for-sale securities, which are reported at fair value, includes fixed maturity securities and equity securities. Net unrealized gains or losses on equity securities prior to January 1, 2018, and on fixed maturities are reported after-tax as a component of other comprehensive income. As of January 1, 2018, changes in fair value of equity securities are reported in investment gains/losses as a component of net income.
The amortized cost and aggregate fair value of debt securities at December 31, 2018, by contractual maturity, are presented in the following table (dollars in thousands). Expected maturities will differ from contractual maturities because issuers 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, 2018, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as
An analysis of the net change in unrealized gains and losses on available-for-sale securities follows (dollars in thousands):
Accounting standards define fair value as the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework to make the measurement of fair value more consistent and comparable. In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets. The Company categorizes assets and liabilities carried at their fair value based upon a fair value hierarchy:
Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities. 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.
Fixed maturities available-for-sale - The fair values of the Company’s public fixed maturity securities are generally based on prices obtained from independent pricing services. Consistent with the fair value hierarchy described above, securities with validated quotes from pricing services are generally reflected within Level 2, as they are primarily based on observable pricing for similar assets and/or other market observable inputs.
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, 2018, Level 3 fair value measurements of assets include $1,125,000 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.
As of December 31, 2018, Level 3 fair value measurements of liabilities include $234,000 net fair value of various interest rate swap agreements whose value is based on analysis provided by a third party that utilizes financial modeling tools and assumptions on interest and other factors. The Company does not develop the unobservable inputs used in measuring fair value. Additional information regarding the interest rate swap agreements is provided in Note 8.
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, 2018 (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 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 swap agreements.
The following methods and assumptions were used to estimate fair value of each class of financial instrument for which it is practical to estimate that value:
The carrying amount and estimated fair value of the Company’s financial instruments as of December 31, 2018 and December 31, 2017 are as follows (in thousands):
Major categories of property and equipment are summarized as follows (dollars in thousands):
The slight increase in claim and claim adjustment expense reserves before reinsurance recoverable is primarily due to the increase in reserves associated with Hurricane Florence which occurred in September of 2018. The estimate for claims arising in prior years was reduced $250,000 in 2018 (reduced $1,355,000 in 2017) due to favorable loss development during the year on claims arising in prior years.
Management periodically estimates the liability for claims that have been reported but not paid and for claims incurred but not reported (IBNR). Management utilizes expected losses along with historical data analysis of paid and incurred loss development patterns over the past ten years to aide in establishing the claims liability. Management also separately evaluates any recent large events in establishing claim reserves. The Company also engages a consulting actuary to review managements' estimates of claim liabilities each year. There has been no material change in reserving methodology in 2018 compared to prior years.
As shown in the table above depicting average annual payout of incurred claims, 87.8% of claims are settled within twelve months of the date of loss and cumulatively, 97.3% of claims are settled within two years of the date of loss. While reserves for reported but unpaid and incurred but not reported claims can ultimately prove to be excessive or deficient, the short duration of the Company's claim liabilities serves to lesson the uncertainty compared to longer tail lines of insurance. The Company has no material exposure to difficult to estimate long tail liabilities such as toxic waste cleanup, asbestos related illness or other environmental remediation exposures.
The Company, through its life insurance subsidiary, underwrites a limited number of short duration accident and health contracts. These claims are typically settled in three years or less and the reserve for unpaid claims totaled $358,000 at December 31, 2018 ($367,000 at December 31, 2017). These claims are a component of policy and contract claims which totaled $792,000 at December 31, 2018 ($903,000 at December 31, 2017).
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 or have adverse impacts on regulatory capital levels 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 and tropical storms.
Amounts recoverable from re-insurers are estimated in a manner consistent with the claim liability associated with the underlying insurance policies. Amounts paid for prospective reinsurance contracts are reported as prepaid reinsurance premiums and amortized over the remaining contract period.
The Company and its subsidiaries have an established retirement savings plan (401K Plan). All full-time employees are eligible to participate, and all employer contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Company matching contributions for the years ended December 31, 2018 and 2017 amounted to $201,000 and $187,000, respectively. The Company contributes dollar-for-dollar matching contributions up to 5% of compensation subject to government limits.
The Company established a non-qualified plan under which Company directors are allowed to defer all or a portion of directors' fees into various investment options. A supplemental executive retirement plan (SERP) 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 related to the non-qualified deferred compensation plans for the years ended December 31, 2018 and 2017 amounted to an approximate decrease of $128,000 and increase of $215,000 in employee benefit related expenses, respectively.
At December 31, 2018, securities with market values of $3,031,000 ($2,928,000 at December 31, 2017) were pledged with various states pursuant to statutory requirements.
During the year ended December 31, 2018 and year ended December 31, 2017, changes in shareholders' equity consisted of net income of $779,000 and net loss of $1,203,000, respectively; dividends paid of $505,000 in 2018 and $504,000 in 2017; other comprehensive loss of $2,109,000 in 2018 and other comprehensive income of $1,204,000 in 2017. Other comprehensive income/loss consisted of changes in accumulated unrealized gains/losses on securities available-for-sale and changes in accumulated unrealized losses on interest rate swaps.
The following table presents the amounts reclassified out of AOCI for the year ended December 31, 2018 (dollars in thousands):
The following table presents the amounts reclassified out of AOCI for the year ended December 31, 2017 (dollars in thousands):
Total assets by industry segment at December 31, 2018 and December 31, 2017 are summarized below (dollars in thousands):
Premium revenues and operating income by business segment for the years ended December 31, 2018 and 2017 are summarized below (dollars in thousands):
The Company's property & casualty subsidiaries had one action remaining in Texas filed in the aftermath of Hurricane Ike at December 31, 2018. This is an individual action with allegations of underpayment of a hurricane-related claim. The suit seeks a variety of remedies, including actual and/or punitive damages in unspecified amounts and/or declaratory relief.
During the year ended December 31, 2018, non-cash changes in equity included $5,000 in common stock issued to Directors in lieu of cash compensation along with a corresponding $71,000 increase in additional paid-in capital.
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 45.
In 2018, cash dividends of $750,000 were paid to the Registrant by its subsidiaries ($900,000 in 2017).