Our principal executive offices, owned by NSIC, are located at 661 East Davis Street, Elba, Alabama. The executive offices are shared by the insurance subsidiaries. The building was constructed in 1977 and is approximately 30,700 square feet. The Company completed a major expansion and renovation project in early 2008, adding an additional 4,684 square feet and renovating 3,017 square feet of the existing structure. The Company believes this space to be adequate for its immediate needs.
The Company’s subsidiaries own certain real estate properties, including approximately 2,700 acres of timberland in Alabama.
Financial results for the year 2007 marked the second consecutive year of considerable improvement. Results for 2005 were marred by losses incurred from Hurricanes Dennis, Katrina and Rita. Two primary major factors contributed to our improved results in 2007. First, our property and casualty insurance operations continued to improve as the year was, for the most part, free of significant storm activity other than some early spring tornadoes. Second, we realized a one time gain on the disposition of the majority of our interest in a 50% owned subsidiary, The Mobile Attic, Inc. in April of 2007. Through this transaction, we posted a gain on disposal of $1.5 million pushing our consolidated net income to a record $6.04 million easily topping 2006 results.
Net income for the year increased 42.12% to $6,040,000, or $2.45 per share, compared with net income of 4,250,000, or $1.72 per share for 2006. Net income from continuing operations was $4,721,000 compared to $4,439,000 in 2006, an increase of 6.35%. Again, increased earnings in the property and casualty subsidiaries were the primary contributor to the increase in net income from continuing operations. A decline in realized investment gains from $2,565,000 in 2006 to $1,493,000 in 2007 was primarily due to fewer disposals in the equity investment portfolio of the company. The decline in realized capital gains was offset by net income from discontinued operations of $1,319,000 which consisted of a gain on disposal of the majority of a 50% investment in Mobile Attic, Inc. in the second quarter of 2007. The Company maintained a 5% interest in Mobile Attic at 12/31/2007.
The year 2006 marked the sixth consecutive year of record premium revenue for the Company. Our premium revenue for 2006 increased 9.9% over levels achieved in 2005. However, premium revenue in 2005 was reduced by catastrophe reinsurance reinstatement premium totaling $2,400,000 as a result of reinstatement provisions of our catastrophe reinsurance contract triggered by Hurricane Katrina. We did not incur any hurricane losses in 2006 and therefore incurred no reduction in earned premium due to charges for catastrophe reinstatement premium. Without the impact of the reduction in 2005 premium revenue for catastrophe reinstatement premium, year over year premium revenue increased by 5.2%.
Premium revenue in the life and accident and health segment totaled $7,031,000 in 2007 compared to $6,550,000 in 2006, an increase of over 7%. Continued growth in the independent agent method of distribution was the primary contributing factor with an increase in premium revenue just under 15%. The growth in the independent agent distribution method helped offset the moderate decrease in premium revenue of 3% in the traditional home service method of distribution.
While the overall rate of premium revenue growth in the life segment has moderated, the quality of business has continued to improve. The lapse rate is a measure of the percentage of business in force that is cancelled during the year due to non-payment of premium or surrender for cash value by the policyholder. In our traditional home service market, the lapse rate has often approached 50%; however, with the shift to the independent agent method of distribution we have experienced significant improvement in our lapse rate. The lapse rate for 2007 was 14.9% a significant improvement over our lapse rate in 2006 of 19.6%. Our lapse rates will generally be higher than the insurance market as a whole because our products are primarily intended for low to middle income consumers that may face other economic pressures from time to time. With decreases in disposable income during economic downturns, often life and supplemental health insurance products are among the first items to be trimmed from household budgets. Also, lapse rates are significantly higher in the first year after an insurance policy is sold to a consumer. We remain cautious about our ability to continue to show improvement in our lapse rate as the current economic downturn we are experiencing could adversely impact our ability to retain business.
NSIC posted a net loss of $23,000 in 2007 compared to a net loss of $658,000 in 2006. Increased charges associated with a litigation settlement were the primary factor contributing to the higher net loss in 2006. Results for 2007 were adversely impacted by higher claims settlements with approximately $300,000 associated with a program discontinued in early 2007 and another $250,000 associated with final charges associated with the litigation settlement reached during 2006.
The lapse rate for 2006 was 19.6% a marginal improvement over our lapse rate in 2005 of 20.4%. As was discussed last year, during 2005 we became more selective in the appointment of new agents and terminated agreements with agents that produced little new business or had very high lapse rates. We believe these efforts are beginning to show results as our lapse rate continues to improve.
NSIC incurred a net loss of $(658,000) in 2006 compared to a net loss of $(297,000) in 2005. Litigation expenses totaling over $1.1 million and $375,000 in 2006 and 2005 respectively were the primary factors contributing to the poor results. The litigation related expenses are primarily related to a longstanding class action lawsuit that was settled in 2006. Due to the nature of this litigation, it was difficult to predict the ultimate outcome over the last five years and consequently, we have experienced several upward revisions in our estimates.
NSFC ended 2006 with four dwelling lines operating with an underwriting loss. During 2007 the company focused on rate adjustments where needed as well as an in-depth analysis of profitability by product which decreased the number of programs with underwriting losses from four in 2006 to two in 2007. The two programs experiencing underwriting losses were the limited homeowners program and the St. Louis taxicab program. The limited homeowners program and taxicab program ended 2007 with underwriting losses of $(2,238,721) and $(261,769), respectively compared to $(2,234,888) and $(72,707), respectively for the same period last year. A primary reason for the significant losses in the limited homeowners program was a high frequency of fire related losses. The taxicab program settled several large litigation claims which negatively impacted the results for this line of business. A primary focus in 2008 will be working toward improving results in the limited homeowners line of business as well as continued profitability in the other lines of business.
We routinely evaluate our claims frequency and severity statistics in order to better understand the nature of our risks and aid in the loss reserve liability evaluation process. Claims frequency is a measure of the number of claims incurred during a measurement period regardless of amount. Claims severity is a measure of the average dollar amount of claims during a measurement period.
Throughout 2007, the frequency of claims declined as compared to 2006 however the severity of claims increased. During 2007, the company incurred 5,633 dwelling and homeowner claims compared to 6,469 for the same period last year; a decrease of 836 claims. Gross claims for 2007 totaled $28,662,000 which was $1,021,000 more than 2006. The severity of claims increased from an average claim payment of $4,272 in 2006 to $5,088 in 2007 primarily due to an increase in larger fire losses.
Due to the increased cost of litigation associated with Hurricane Katrina claims in the states of Louisiana and Mississippi, we continued to incur adverse claims development associated with this storm. At December 31, 2007 our total projected (paid and unpaid) claims associated with Katrina were expected to exceed our available catastrophe reinsurance protection by approximately $300,000. The total remaining open claims total less than one tenth of 1% of the total claims reported during Hurricane Katrina. These remaining open claims (less than 100 claims) are in various stages of litigation. While we believe current reserves are adequate to cover remaining costs associated with settlement of these claims, due to the uncertainty of the litigation environment related to Hurricane Katrina claims we can not be certain that we will not have any additional adverse development.
Property and casualty income before income taxes was $8,594,000 for 2007 compared to $8,598,000 in 2006. Our combined ratio for 2007 was 94.2% compared to 95.7% in 2006. The combined ratio for 2007 of 94.2% included catastrophe related tornado and hail storm losses totaling over $921,000 and adding 1.7% to our combined ratio. The primary reason for the reduction in the combined ratio was a decline in catastrophe related losses. In 2006 catastrophe related tornado and hail storm losses totaled $1,386,000.
The primary line of business in which we are continuing to adjust rates in order to improve profitability is our homeowners line of business. This line of business composes 23% of our total property and casualty premium revenue. The line of business has not performed to our expectations with a combined ratio of 112% in 2006.
Property and casualty income before income taxes was $8,598,000 for 2006 compared to $2,687,000 in 2005. Our combined ratio for 2006 was 95.7% compared to 106.6% in 2005. The combined ratio for 2006 of 95.7% included catastrophe related tornado and hail storm losses totaling over $2,100,000 which added 4.0% to our combined ratio. Without the impact of hurricanes in 2005, our combined ratio was 89.9%. As discussed previously and as indicated by evaluation of our combined ratio, the significant decline in catastrophe losses was the primary driver of the improved results.
The combined ratio for 2007 improved slightly at 94.2% compared to 95.7% in 2006. No hurricane activity was experienced in 2007 along with reduced tornado and hail storm losses led to the reduction in the combined ratio.
The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. At December 31, 2007, the company’s holdings in debt securities amounted to 77.7% of total investments and 62% of total assets. The following is a breakdown of the bond portfolio quality according to the nationally recognized rating organization equivalents of Standard and Poor’s:
The results with respect to the foregoing investments are as follows:
The consolidated statement of cash flows also reflects a (decrease) increase in cash from financing activities of $(364,000), $(4,264,000), and $4,934,000, respectively. Cash flows from financing activities in 2007 reflect proceeds from a trust preferred securities offering of $3,093,000, repayment of debt of $2,171,000 and shareholder dividends of $2,220,000. The decrease in cash flow from financing activities in 2006 reflects the reduction of debt held by Mobile Attic of $1,779,000 and the payment of shareholder dividends of $2,183,000. Cash flow from financing activities in 2005 reflects proceeds from a trust preferred securities offering of $9,279,000, repayment of Mobile Attic debt of $2,209,000 and payment of shareholder dividends of $2,134,000.
As disclosed in Note 12 to the consolidated financial statements, in 2008, the amount that The National Security Group’s insurance subsidiaries can transfer in the form of dividends to the parent company is limited to $889,000 in the life insurance subsidiary and $4,609,000 in the property/casualty insurance subsidiary. However, that condition poses no current short-term or long-term liquidity concerns for the parent company.
National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $34.1 million and $32.6 million at December 31, 2007 and 2006, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 5.3 and 6.2 at December 31, 2007 and 2006 respectively. Accordingly, National Security Fire & Casualty 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 $9.6 million and $9.0 million at December 31, 2007 and 2006, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 24.4 and 21.8 at December 31, 2007 and 2006, respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.
As part of our risk management strategy, we routinely cede risks associated with insurance policies we underwrite to reinsurers pursuant to contractual agreements. Reinsurance provides protection for individual loss occurrences, including catastrophes, to alleviate fluctuation in the results of our underwriting activities and to limit our net liability for individual risks. The estimated reinsurance recoverable on paid losses, including an estimate for losses incurred but not reported, and amounts paid to reinsurers applicable to unexpired terms of policies in force are reported as assets.
When a claim is made under a policy we have reinsured, we initially pay the full amount owed to the policyholder or claimant. Subsequently, we initiate the process to recover any amounts due from reinsurers in accordance with the terms of applicable reinsurance treaties. The estimated recoverable is recorded as an asset on the financial statements.
NSIC generally reinsures all risks in excess of $50,000 with respect to any one insured.
NSFC and Omega generally reinsure with third parties any liability in excess of $225,000 on any single policy. In addition, the property and casualty subsidiaries have catastrophe excess reinsurance, which protects it in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane. In 2007, the property and casualty subsidiaries had catastrophe protection up to a $47.5 million loss with a retention/deductible of $3.5 million. This provided protection up to at least 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. We believe that maintaining protection to at least a 100 year near term event will be comparable with our past practice of maintaining catastrophe reinsurance protection up to a 250 year event under the previous models. Based on an evaluation using actual NSFC and Omega exposures and catastrophe modeling based on a 100 year loss, that is a probable maximum loss in which we have a 99% probability of not exceeding in any given year, the property and casualty subsidiaries would pay (pre-tax) approximately $8.7 million in losses and reinstatement and reinsurers would pay (pre-tax) $42.3 million. No significant changes in reinsurance coverage are expected during 2008. However, we will continue to evaluate the cost of expanding the upper limits of our coverage with a goal of lowering our value at risk related to probable maximum losses as upper limit coverage becomes more cost effective.
At December 31, 2007, we had recorded $8,993,000 as an asset for DAC in our financial statements. We do not foresee any issues related to recoverability of these capitalized costs. For more information regarding deferred policy acquisition costs, please see Note 1 to our financial statements.
At December 31, 2007, there is no evidence to suggest to management that any deferred tax asset is unrealizable. For more information regarding deferred income taxes, please see Note 7 to our financial statements.
At December 31, 2007, there were no other-than-temporary impairments. For more information regarding valuation of investments, see Note 1 to our financial statements.
At December 31, 2007, the recorded liability for loss and loss and adjustment expense was $11,973,000. We believe this estimate of unpaid losses and loss adjustment expense to be sufficient based on currently available information and a review of our historical reserving practices. For more information regarding loss and loss adjustment expense, see Note 9 to our financial statements.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The National Security Group, Inc. and subsidiaries as of December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.
the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts which are recognized in interest income using methods which approximate level yields over the period to maturity.
Trading Securities. The Company and its subsidiaries have no trading securities.
market prices are not available, fair values are estimated using present value or other valuation techniques. The fair value estimates are made at a specific point in time, based on available market
information and judgments about the financial instrument, such as estimates of timing and amount of expected future cash flows. Such estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument, nor do they consider the tax impact of the realization of unrealized gains or losses. In many cases, the fair value estimates cannot be substantiated by comparison to independent markets, nor can the disclosed value be realized in immediate settlement of the instrument.
The liability for future life insurance policy benefits is computed using a net level premium method including the following assumptions
In the normal course of business, NSFC seeks to reduce the loss that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. In 2007, NSFC maintained a catastrophe reinsurance agreement to cover losses from catastrophic events, primarily hurricanes. Under the agreement, the Company pays the first $3.5 million in covered losses from a catastrophic event. Under layer 1 of the reinsurance program, reinsurers pay 95% of covered losses in excess of $3.5 million up to $10 million. Under layer 2 of the reinsurance program, reinsurers pay 95% of covered losses in excess of $10 million up to $17.5 million. Under layer 3 of the reinsurance program, reinsurers pay 100% of covered losses in excess of $17.5 million up to $42.5 million. In July of 2007, the Company added an additional layer of coverage to the reinsurance program. Under layer 4, reinsurers pay 100% of covered losses in excess of $42.5 million up to $47.5 million. All reinsurers under the program carry A.M. Best ratings of A- (Excellent) or higher.
Certain reclassifications have been made in the previously reported financial statements to make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on the previously reported net income or shareholders’ equity.
The Company expenses advertising costs as incurred. Advertising costs charged to expense were $193,000 for the year ended December 31, 2007 ($195,000 and $113,000 for the years ended December 31, 2006 and 2005, respectively).
Reinsurance contracts do not relieve the Company of its obligations to policyholders. A failure of a reinsurer to meet their obligation could result in losses to the insurance subsidiaries. Allowances for losses are established if amounts are believed to be uncollectible. At December 31, 2007 and 2006, no amounts were deemed uncollectible. The Company, at least annually, evaluates the financial condition of all reinsurers and evaluates any potential concentrations of credit risk. At December 31, 2007, management does not believe the Company is exposed to any significant credit risk related to its reinsurance program.
During 2007, the Financial Accounting Standards Board (FASB) issued the following pronouncements:
In December 2005, the Company formed National Security Capital Trust I (the Trust), a statutory trust created under the Delaware Statutory Trust Act, for the sole purpose of issuing, in private placement transactions, $9 million 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 $9.3 million of variable rate subordinated debentures issued by the Company. The Company owns all voting securities of the Trust and the
TPS transactions, after commissions and other costs of issuance, of $9.005 million. The Company also holds all the voting securities issued by the Trust and such trusts are considered to be VIE’s. The Trust is not consolidated because the Company is not the primary beneficiary of the trust. The Subordinated Debentures, disclosed in Note 8 are reported in the accompanying Consolidated Balance Sheet as a component of long-term debt. The Company’s equity investments in the Trust total $279,000 and are included in Other Assets.
In June 2007, the Company formed National Security Capital Trust II for the sole purpose of issuing, in private placement transactions, $3 million 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 unsecured junior subordinated deferrable interest debentures. The Company owns all voting securities of the Trust and the subordinated debentures are the sole assets of the Trust. The Trust will meet the obligations of the TPS with the interest and principal paid on the subordinated debentures. The Company received net proceeds from the TPS transactions, after commissions and other costs of issuance, of $2.995 million. The Company also holds all the voting securities issued by the Trust and such trusts are considered to be VIE’s. The Trust is not consolidated because the Company is not the primary beneficiary of the trust. The Subordinated Debentures, disclosed in Note 8 are reported in the accompanying Consolidated Balance Sheet as a component of long-term debt. The Company’s equity investments in the Trust total $93,000 and are included in Other Assets.
The above amounts exclude allocation of overhead from the Company. NSIC, NSFC and Omega are in compliance with statutory restrictions with regard to minimum amounts of surplus and capital.
All unrealized losses are reviewed to determine whether the losses are other than temporary. Factors considered include whether the securities are backed by the U.S. Government or its agencies and concerns surrounding the recovery of full principal. Management has evaluated each security in a significant unrealized loss position. Most unrealized losses in the fixed income portfolio are interest rate driven as opposed to credit quality driven and management believes no ultimate loss will be realized. The Company has no material exposure to sub-prime mortgage loans and less than 1% of the fixed income investment portfolio is rated below investment grade.
An analysis of the net change in unrealized appreciation on available-for-sale securities follows:
The increase in provision for claims and claim adjustment expenses for prior years (net of reinsurance recoveries) for 2007 is primarily related to losses from Hurricane Katrina exceeding catastrophe reinsurance coverage. The 2006 increase in provision for claims and claim adjustment expenses for prior years (net of reinsurance recoveries) was caused by adverse development related to significant storm related losses in a concentrated coverage area in December of 2005 with the ultimate settlement of these claims exceeding preliminary estimates and due to adverse development of a single commercial auto policy with a loss occurring in 2004. Increases in reserves on these claims were made in late 2006.
The Company has a geographic exposure to catastrophe losses in certain areas of the country. Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes, hail, severe winter weather, explosions and fires, and the incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophe losses are restricted to small geographic areas; however,
In 1989, the Company and its subsidiaries established a retirement savings plan (401K Plan) and transferred the assets from the defined contribution profit sharing plan into the new plan. All full-time employees who have completed six months of service the beginning of any calendar quarter are eligible to participate and all employee contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Company matching contributions for 2007, 2006, and 2005 amounted to $229,000, $207,000, and $217,000, respectively. The Company contributes matching contributions up to 5% of compensation subject to government limitations.
In 1987, the Company established a non-qualified deferred compensation plan for its Board of Directors. The Board members had an option of deferring their fees to a cash account or to a stock account and all share deferrals are recorded at the fair market value on the date of the award. The directors’ non-qualified deferred compensation plan was frozen on December 31, 2004, and deferrals are no longer allowed. A new non-qualified plan became effective January 1, 2006 under which directors are allowed to defer all or a portion of directors’ fees into various investment options. Costs of the deferred compensation plan for 2007, 2006, and 2005 amounted to approximately ($23,000), $147,000, and ($259,000), respectively.
At December 31, 2007, securities with market values of $3,357,000 ($3,827,000 at December 31, 2006) were deposited with various states pursuant to statutory requirements.
Premium revenues and operating income by industry segment for the years ended December 31, 2007, 2006 and 2005 are summarized below:
The Company’s property & casualty subsidiaries are defending a number of matters filed in the aftermath of Hurricanes Katrina and Rita in Mississippi, Louisiana and Alabama. These actions include individual lawsuits and purported statewide class action lawsuits, although to date no class has been certified in any action. These actions make a number of allegations of underpayment of hurricane-related claims, including allegations that the flood exclusion found in the Company’s subsidiaries’ policies, and in certain actions other insurance companies’ policies, is either ambiguous, unenforceable as unconscionable or contrary to public policy, or inapplicable to the damage sustained. 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 the first quarter of 2007, the Company classified its investment in consolidated subsidiary Mobile Attic as available for sale as it became apparent that a transfer would occur within one year and consequently reclassified the results of the operations of Mobile Attic to discontinued operations in accordance with the provisions of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. In April of 2007, the Company entered into an agreement to sell the majority of its interest in Mobile Attic. Under the terms of the agreement, the Company will retain a minority ownership interest in Mobile Attic, not to exceed 5%. The Company will no longer be involved in the operations of Mobile Attic. Under the terms of the agreement, assets outlined below along with other immaterial amounts were transferred to the acquirer. Also, the acquirer refinanced all outstanding debt, also disclosed below, of Mobile Attic releasing the Company from all debt guarantees. Total net cash proceeds received by the Company in conjunction with the sale totaled $2,700,000.
The assets of Mobile Attic available for sale consist primarily of portable storage leasing equipment. The liabilities of Mobile Attic available for sale consist primarily of short term debt. The transaction to dispose of Mobile Attic was completed in April 2007, consequently, no material assets or liabilities associated with Mobile Attic remained on the Balance Sheet at December 31, 2007.
Financial Information of the Registrant does not include all of the information and notes normally
Registrant’s Annual Report as referenced in Form 10-K, Part II, Item 8, page 37.