The Company owns no property. The Life insurance subsidiary owns the Company's principal executive offices located at 661 East Davis Street, Elba, Alabama. The executive offices are shared by the insurance subsidiaries. The building was constructed in 1977 and consists of approximately 26,000 square feet. The Company believes this space to be adequate for its foreseeable future needs. The Company’s subsidiaries own certain real estate properties, including approximately 2,700 acres of timberland in Alabama.
The following are two words that will appear almost chronically throughout this discussion: Hurricane Ivan. Losses resulting from the impact of Hurricane Ivan significantly influenced the financial results for the year ended December 31, 2004. While total losses were mitigated through risk management using catastrophe excess of loss reinsurance; the Company’s share of total losses and catastrophe reinsurance reinstatement premium reduced net income by over $3,600,000.
The following analysis of the Results of Operations should be read in conjunction with the Consolidated Financial Statements, which begin on Page 28 of this Form 10-K. Primary reference is made to the Consolidated Statements of Income on page 29 and segment information provided in Note 14 to the Consolidated Financial Statements.
Consolidated income before income taxes declined 31.5% in 2004 to $3,853,000 compared to $5,628,000 in 2003. Hurricane Ivan, which struck the Alabama Gulf coast in September of 2004, is the primary factor leading to the decline in consolidated income before income taxes. Gross incurred losses, before reinsurance recoveries, from Hurricane Ivan totaled $14,577,000 including paid losses of $12,806,000, case unpaid losses and adjustment expenses of $1,077,000 and incurred but not reported reserve (IBNR) estimates of $694,000. After reinsurance recoveries, pre-tax losses from Hurricane Ivan totaled over $4,100,000 and a catastrophe reinsurance reinstatement premium of $1,400,000 was also incurred in the third quarter of 2004. As for the bottom line impact from Hurricane Ivan, consolidated net income declined by over $3,600,000 due to losses and expenses related to Hurricane Ivan.
Additional details on the sources of premium revenue growth and the impact of individual segments on consolidated income will be discussed in the respective segment results of operations sections that follow.
The Company’s life, accident and health insurance business is conducted through National Security Insurance Company (NSIC), a wholly owned subsidiary of the Company organized in 1947.
Income before income taxes in 2003 was $529,000 compared to $1,082,000 in 2002. Litigation related expenses decreased pretax earnings by over $565,000 and was the primary factor contributing to the 50% decline in pre-tax earnings. Pending litigation against NSIC is discussed further in Note 15 to the consolidated financial statements.
Premium revenue increased to $5,799,000 in 2003 compared to $5,395,000 in 2002, an increase of 7.5%. Insurance sales through independent agent distribution channels increased over 32% in 2003 over prior year; while sales through NSIC’s traditional home service distribution channel declined by 7%.
Income before income tax declined considerably in 2004 to $4.22 million compared to $ 5.72 million in 2003. As discussed earlier, results for 2004 were negatively impacted by losses and adverse claims experience related to hurricane losses in the third quarter of 2004. Claims frequency increased significantly in 2004 compared to 2003 with claims on dwelling lines of business (homeowners and dwelling fire) exceeding 12,500 claims compared to 5,100 claims in 2003. Over 7,500 claims were reported from Hurricane Ivan so without the impact of Ivan, claims frequency was in line with 2003 total of around 5,000 claims. Average severity on dwelling claims in 2004 declined to an average of $2,900 compared to $3,600 in 2003. Average severity declined primarily due to the large volume of Hurricane Ivan claims. Because most of the losses from Hurricane Ivan were inland and limited primarily to minor wind damage, claims from Ivan averaged less than $2,000 per occurrence, which skewed 2004 average severity downward. Hurricanes typically cause higher number of claims (frequency) and a lower average cost per claim (severity) than tornado related losses. Tornadoes tend to affect a more isolated area and therefore have a lower frequency but typically cause more structural damage including a higher proportion of total losses therefore severity is greater from tornado losses. Non-catastrophe related dwelling losses typically have an average per loss severity in the $3,500 to $4,000 range for the P&C subsidiaries.
The combined ratio for 2004 compared to 2003 increased 8.8 percentage points. This increase was entirely due to losses incurred from Hurricane Ivan. Hurricane Ivan added 8.9 percentage points to the combined ratio for 2004.
The combined ratio for 2003 compared to 2002 declined 16.6 percentage points due to much improved underwriting results on the dwelling lines of business in the P&C subsidiaries. A $400 decline in average severity discussed in the preceding property and casualty segment information along with a drop in frequency relative to premium volume were the primary factors contributing to the decline in the combined ratio in 2003 compared to 2002.
Mobile Attic began the steps to franchise its business model during 2004. Expansion through this new avenue will allow Mobile Attic to venture more rapidly into new areas and expand into larger cities while significantly reducing future capital requirements. Mobile Attic began selling franchised locations in the first quarter of 2004.
In 2004 Mobile Attic generated a $211,000 net loss. The business generated positive cash flow for the year, but a decrease in revenues from dealership sales fees and utilization fees below expected ultimate levels generated an operating loss for the year. The Mobile Attic discontinued the sales of dealerships in 2003 in anticipation of a change in strategy of growing Mobile Attic through a franchise system, which began in the third quarter of 2004. Mobile Attic completed the build out of company owned storage units in late 2004 and as the utilization rates on these units increase, cash flow and profits will improve significantly.
The insurance subsidiaries’ fixed maturity securities include mortgage-backed bonds, primarily collateralized mortgage obligations (CMO’s), of $8.7 million and $7.8 million at December 31, 2004 and 2003 respectively. The mortgage-backed bonds are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than that expected at the time of purchase. Securities that are purchased at a premium to par value and prepay faster than expected will incur a reduction in yield or loss. Securities that are purchased at a discount to par value and prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between amortized cost and par value, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. In order to minimize risk associated with prepayments on collateralized mortgage obligations, the Company typically invests primarily in more predictable planned amortization class (PAC) structures of CMO’s and typically avoids investment in CMO’s priced at significant premiums above par value.
Liquidity and Capital Resources: Due to increased claims from Hurricane Ivan, the Company sold approximately $2 million of primarily short-term securities to fund the payment of hurricane claims. Consequently, the amount of securities with maturities of less than one year declined below normal levels causing a temporary asset/liability mismatch. However, due to the large percentage of the fixed maturity portfolio with maturities ranging from 1 to 5 years, the mismatch can be corrected in short order with no material impact on earnings, liquidity or capital resources.
Due to regulatory restrictions, the majority of the Company’s cash is required to be invested in investment-grade securities to provide ample protection for policyholders. The liabilities of the property and casualty insurance subsidiaries are of various terms and, therefore, those subsidiaries invest in securities with various maturities spread over periods usually not exceeding 10 years. The liabilities of the life insurance subsidiaries are typically of a longer duration and therefore, a higher percentage of securities in the life insurance subsidiaries is invested for periods exceeding 10 years.
Long-term debt obligations include $2,731,000 in debt held directly by the Company. It is anticipated that this debt will be retired in 2007. Long-term debt obligations also include $13,105,000 in debt held by a 50% owned subsidiary, The Mobile Attic. The current debt obligation of Mobile Attic matures in 2007, but it is currently anticipated that Mobile Attic will seek to refinance approximately 50% of this debt under a longer term financing prior to maturity.
The ability of the Company to meet its commitments for timely payment of claims and other expenses depends, in addition to current cash flow, on the liquidity of its investments. On December 31, 2004, the Company had no known impairments of assets or changes in operation, which would have a material adverse effect upon liquidity. Approximately 85% of the Company’s insurance subsidiary assets are invested in cash; investment grade fixed income securities, short-term investments and broadly traded equity securities, which are highly liquid. The values of these investments are subject to the conditions of the markets in which they are traded. Past fluctuations in these markets have had little effect on the liquidity of the Company. The Company has relatively little exposure to lower grade fixed income investments which might be especially subject to liquidity problems due to thinly traded markets.
Omega One Insurance Company (property/casualty insurer), which began writing business in late 1995, has regulatory adjusted capital of $7.6 million and $6.7 million at December 31, 2004 and 2003, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 12.3 and 9.3 at December 31, 2004 and 2003 respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.
There is a possibility that the actual amounts recovered from reinsurers could be materially less than the estimates recorded. This possibility could result in a material adverse impact on our financial condition and results of operations. Reinsurers may dispute claims under reinsurance treaties, such as the calculated amount of reinsurance recoverable.
In addition to catastrophe reinsurance, NSFC also had a 60% quota share reinsurance agreement on ocean marine exposure with additional excess of loss coverage.
Managements Discussion and Analysis of Financial Condition and Results of Operations The National Security Group, Inc.
At December 31, 2004, we had recorded $6,217,000 as an asset for DAC in our financial statements. For more information regarding deferred policy acquisition costs, please see Note 1 to our financial statements.
Deferred income taxes are created when there are differences between assets and liabilities for tax and financial reporting purposes, as well as tax credits, net operating losses and other carryforwards. SFAS 109 “Accounting for Income Taxes,” requires that deferred tax assets be reduced by a valuation allowance if, based on the available evidence, it is more likely than not that all of the recorded deferred tax assets will not be realized in future periods. This standard requires management to exercise judgment in determining whether or not the deferred tax asset is realizable.
Investments are recorded at fair value based upon quoted prices when available. Quoted prices are available for every investment included in the financial statements. Periodically, the carrying values of an individual investment may become temporarily impaired because of time value, volatility, credit quality and existing market conditions. Management evaluates investments to determine whether an impairment is other-than-temporary. Evaluation criteria include credit quality of security, severity of decrease between cost and market value, length of time of the impairment and likelihood that the impairment will reverse in the near future. This evaluation requires significant assumptions, estimates and judgments by management. If the impairment is determined to be other-than-temporary, the investment is written down to the current fair value and a realized loss is recorded on the income statement.
At December 31, 2004 there were no other-than-temporary impairments. For more information regarding valuation of investments, see Note 1 to our financial statements.
At December 31, the recorded liability for loss and loss and adjustment expense was $13,094,000. For more information regarding loss and loss adjustment expense, see Note 9 to our financial statements.
Fixed maturities available-for-sale, at estimated fair value (cost: 2004 - $50,164;
Common stock, $1 par value, 10,000,000 and 2,500,000 shares authorized, respectively,
Purchase of property and equipment (1,327 ) (8,078 ) (2,911 )
Net cash (used in) provided by financing activities (2,274 ) 4,770
T he accompanying consolidated financial statements also include an investment in affiliate, which consists of a fifty percent interest in The Mobile Attic, Inc and its wholly owned subsidiary established in January of 2004, Mobile Attic Franchising Company (MAFCO). The Mobile Attic, Inc. is a portable storage leasing company that began operations in 2001. MAFCO was established in the first quarter of 2004 to conduct the business of selling Mobile Attic portable storage leasing franchises. Effective in the first quarter of 2004 the Company consolidated the accounts of Mobile Attic, Inc. and subsidiary MAFCO according to guidance in Financial Accounting Standards Board Interpretation 46 as revised December 2003 (FIN 46R).
C hanges in financial statement presentation as a result of the adoption of recently issued accounting standards:
N SIC is licensed in the states of Alabama, Florida, Georgia, Mississippi, South Carolina and Texas and was organized in 1947 to provide life and burial insurance policies to the home service market. Business is now produced by both company and independent agents. Primary products include ordinary life, accident and health, supplemental hospital, and cancer insurance products.
property fire and extended coverage, homeowners, mobile homeowners, ocean marine, nonstandard automobile physical damage and liability and nonstandard commercial auto liability.
O mega is licensed in the states of Alabama and Louisiana. Omega operates in property and casualty lines, the most significant of which are homeowners and nonstandard automobile physical damage and liability.
T he significant accounting policies followed by and subsidiaries that materially affect financial reporting are summarized below. The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) which, as to the subsidiary insurance companies, differ from statutory accounting practices permitted by regulatory authorities.
T he Company’s securities are classified in two categories and accounted for as follows:
o Securities Available-for-Sale. Bonds, notes, common stock and non-redeemable preferred stock not classified as either held-to-maturity, or trading are reported at fair value, adjusted for other-than-temporary declines in fair value. The Company and its subsidiaries have no trading securities.
U nrealized holding gains and losses, net of tax, on securities available-for-sale are reported as a net amount in a separate component of shareholders’ equity until realized.
M ortgage loans and policy loans are stated at the unpaid principal balance of such loans. Investment real estate is reported at cost, less allowances for depreciation computed on the straight-line basis. Short-term investments are carried at cost, which approximates market value. Investments with other than temporary impairment in value are written down to estimated realizable values.
A gent balances are reported at unpaid balances, less a provision for credit losses.
P roperty and equipment is carried at cost less accumulated depreciation and includes expenditures that substantially increase the useful lives of existing property and equipment. Maintenance, repairs, and minor renovations are charged to expense as incurred. Upon sale or retirement of property and
equipment, the cost and related accumulated depreciation are eliminated from the respective account and the resulting gain or loss is included in the results of operations. The Company provides for depreciation of property and equipment using the straight-line method designed to amortize costs over estimated useful lives. Estimated useful lives range up to 40 years for buildings and from 3-20 years for electronic data processing equipment and furniture and fixtures.
C ertain financial instruments, particularly insurance liabilities other than financial guarantees and investment contracts are excluded from the disclosures. In evaluating the Company’s management of interest rate and liquidity risk, the fair values of all assets and liabilities should be taken into consideration.
F or purposes of reporting cash flows, cash includes cash-on-hand, demand deposits with banks and overnight investments.
T he liability for future life insurance policy benefits is computed using a net level premium method including the following assumptions:
I n 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. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for prospective reinsurance contracts are reported as prepaid reinsurance premiums and amortized over the remaining contract period.
I n the normal course of business, NSIC seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage contracts. NSIC retains a maximum of $30,000 of coverage per individual life. The cost of reinsurance is amortized over the contract period of the reinsurance.
T he preparation of financial statements in conformity with generally accepted accounting principles 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 financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
I n December 2004, the Financial Accounting Standards Board (FASB) issued two pronouncements and a revision of Statement of Financial Accounting Standards (SFAS) No. 123:
I n December 2003, the FASB issued Revised FIN 46 (FIN 46R) to clarify certain aspects of FIN 46 including the determination of who is the primary beneficiary of a variable interest entity (VIE). FIN 46R postponed the effective date as to when companies are required to apply the provisions prospectively for all variable interest entities in existence prior to January 31, 2003 until the first financial reporting period that ends after March 15, 2004. However, for entities that are considered to be special purpose entities, the effective date of FIN 46R is financial reporting periods after December 15, 2003. The Company does not have an interest in any special purpose entities. The Company consolidated its affiliate, Mobile Attic, Inc., upon adoption of FIN 46R in the first quarter 2004 due to the Company’s guarantee of Mobile Attic’s line of credit. The consolidation of Mobile Attic increased total assets by approximately $15 million and total liabilities by approximately $13 million. There was no effect on total shareholders’ equity. The consolidation of Mobile Attic did not have a material impact on the results of operations as the Company previously accounted for the investment under the equity method. See Note 17 for additional information related to the VIE.
Omega - including realized capital gains of $35, $257 and $150,
NSIC - including AVR of $1,153, $1,180 and $580, respectively $ 10,298
Under pre-1984 life insurance company tax laws, a portion of NSIC’s gain from operations was not subject to current income taxation, but was accumulated for tax purposes in a memorandum account designated “policyholders’ surplus”. The aggregate balance in this account, $3,720,000 at December 31, 2004, would be taxed at current rates only if distributed to shareholders or if the account exceeded a prescribed minimum. The Deficit Reduction Act of 1984 eliminated additions to policyholders’ surplus for 1984 and thereafter. Deferred taxes have not been provided on amounts designated as policyholders’ surplus. The deferred income tax liability not recognized is approximately $1,270,000 at December 31, 2004.
Note payable to bank with an interest rate based on prime plus 50 basis
Note payable to bank with an interest rate based on LIBOR
Aggregate maturities of long-term debt for each of the three years subsequent to December 31, 2004 are as follows (dollars in thousands): 2005-$351; 2006-$365; 2007-$15,120.
At December 31, policy and claim reserves consisted of the following:
expenses for claims arising in prior years (1,091 ) (1,928 ) (1,547 )
In 1987, the Company established a deferred compensation plan for its Board of Directors. The Board members have 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. Costs of the deferred compensation plan for 2004, 2003, and 2002 amounted to
approximately $208,000, $421,000, and $19,000, respectively. The deferred compensation plan was frozen on December 31, 2004. It is anticipated that a new plan will be adopted during 2005 to allow directors to defer fees under a non-qualified plan. Until such plan is adopted all fees will be paid in cash.
NSFC is similarly restricted in the amount of dividends payable to the Company; dividends may not exceed the greater of 10% of statutory surplus as of the end of the preceding year, or net income for the preceding year. At December 31, 2004, NSFC’s retained earnings unrestricted for the payment of dividends in 2005 amounted to $2,376,000.
Cash paid for interest during 2004 was $645,000 ($611,000 in 2003 and $361,000 in 2002). Cash paid for income taxes in 2004 was $2,000,000 ($400,000 in 2003 and $110,000 in 2002). In 2003, Mobile Attic acquired $7,134,950 of assets through debt ($4,637,743 in 2002).
During the years ended December 31, 2004, 2003 and 2002 the Company’s affiliate Mobile Attic acquired $1,389,404, $7,199,700 and $6,497,400, respectively, of equipment from Cash Brothers Leasing, Inc. (Cash Brothers). The principal owners of Cash Brothers are also stockholders in Mobile Attic. Cash Brothers is also a distributor of the mobile storage units. During 2004, 2003 and 2002 Mobile Attic paid $100,526, $82,892 and $43,256, respectively, in commissions to Cash Brothers. At December 31, 2004, Mobile Attic had accrued expenses due Cash Brothers of $22,195.
Item 8.Consolidated Financial Statements and Supplementary Data The National Security Group, Inc.
Item 8. Consolidated Fianacial Statements and Supplementary Data National Security Group, Inc.
Dividends of $2.8 million in 2004, $2.3 million in 2003 and $2.7 million in 2002 were paid to the Registrant by its subsidiaries.
Property and casualty insurance . . . . . . 41,737
Property and casualty insurance . . . . . . . . 44,360