capital gains (net of tax) ($ 1,647 ) ($ 1,161 ) ($ 136 ) ($ 2,231 ) ($ 351 )
Consolidated net income for The National Security Group (The Company) was $908,000 in 2002 compared to $4.13 million in 2001. On a per share basis earnings were $0.37 in 2002 compared to $1.67 in 2001. Realized capital gains were $1.168 million in 2002 compared to $1.640 million in 2001. Consolidated revenues were $39.085 million in 2002 compared to $32.783 million in 2001. Increased insurance premium production in the property/casualty insurance subsidiaries was the primary factor contributing to the increase in revenues in 2002. However, adverse underwriting results in the property/casualty insurance segment were the primary factor contributing to the decline in earnings for 2002 compared to 2001.
A 50% owned subsidiary contributed $136,000 to net income in 2002. This subsidiary, The Mobile Attic, Inc., is in the business of leasing portable storage containers through independent dealers in Alabama, Florida, and Tennessee.
Consolidated net income for The National Security Group (The Company) was $4.130 million in 2001 compared to $3.776 million in 2000. On a per share basis earnings were 1.67 in 2001 compared to 1.53 in 2000. A second consecutive year of underwriting profits in the property/casualty insurance subsidiaries boosted earnings to the highest levels in more than a decade. Realized capital gains in 2001 were 1.64 million and 1.72 million in 2000. Consolidated revenues were $32.8 million in 2001 compared to $29.7 million in 2000.
Commission expense increased 16% in 2002 compared to 2001. The continuing increases in new sales through independent agents and a change in the home service agents commission contract were the primary factors contributing to the increase in commission. Independent agents typically receive much higher commission rates in the early years of a policy compared to employee agents in the home service market, which typically receive a lower and more level commission over a longer number of years. With premium growth generated exclusively through independent agents, commission expense will rise at a faster rate than premium growth until a more significant block of insurance business rolls into subsequent years at lower commission rates. The second factor contributing to the increase in commission expense was a change in employee home service agents’ contract in 2002. Under the new contract agents received an increase in base salary and could achieve bonuses upon obtaining varying levels of persistency. To offset the increase in salaries, management reduced the number of agents and combined sales territories. Because the salary increases were implemented early in 2002 and efficiency efforts were not fully implemented until later in 2002, no cost savings were realized and in fact total field cost in the home service program increased. However, as a result of these efforts, home service field cost are expected to stabilize in 2003 and subsequent years.
Year Ended December 31, 2001 Compared to Year Ended December 31, 2000:
NSIC increased premium income 12.3% to $5,161,000 in 2001 compared to $4,594,000 in 2000. Life insurance premium income increased 10.5% in 2001, and accident and health insurance also had an increase of 20.5% in 2001. The life insurance sales through independent agents were the source of premium growth in NSIC in 2001.
Year Ended December 31, 2002 Compared to Year Ended December 31, 2001:
Net income before income tax was $518,000 in 2002 compared to $5,440,000 in 2001. Adverse claims experience from hurricane losses in the fourth quarter of 2002 and an increased severity of losses on new business issued were the primary reasons for the significant decrease in income. In October of 2002 Hurricane Lili swept across Louisiana causing over $1,300,000 in insured losses in NSFC and Omega. However, the most significant impact on property/casualty net income for the year was poor underwriting results on new business issued. Historically, new property insurance business issued has carried a higher loss ratio than renewal business. In 2002 the property/casualty subsidiaries issued more new business than has been issued in recent history with an increase in premium revenue of over 35%.
In 2002 Mobile Attic contributed $136,000 in net income to the Company compared to net income of $52,000 in 2001. In 2001, the year in which operations began, gross rental revenues were $87,000. In 2002 gross rental revenues were $557,000. It is anticipated that Mobile Attic will produce rental revenue of over $2,000,000 in 2003 with over 3,000 storage containers available for lease by year-end 2003.
The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. At December 31, 2002, the company's holdings in debt securities amounted to 71% of total investments and 62% of total assets. The following is a breakdown of the bond portfolio quality according to National Association of Insurance Commissioners (NAIC) Securities Valuation Office (SVO) rating standards, and the nationally recognized rating organization equivalents of Moody's and Standard and Poor's:
As of January 1, 1994, the Company adopted Financial Accounting Standards Board Statement 115 and reclassified a portion of its fixed maturity securities portfolio as "available-for-sale," with the remainder being classified as "held-to-maturity." With that reclassification, the fixed maturity securities classified as "available-for-sale" are carried at fair value and changes in fair values, net of related income taxes, are charged or credited to shareholders' equity (see Note E to the consolidated financial statements).
The insurance subsidiaries' fixed maturity securities include mortgage-backed bonds, primarily collateralized mortgage obligations (CMO's), of $5.4 million and $9.2 million at December 31, 2002 and 2001 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.
Liquidity and 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 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 liquidity requirements for the Company are primarily met by funds generated from operations of the life insurance and property/casualty insurance subsidiaries. Premium and investment income as well as maturities and sales of invested assets provide the primary sources of cash for both the life and property/casualty businesses, while applications of cash are applied by both businesses to the payment of policy benefits, the cost of acquiring new business (principally commissions), operating expenses, purchases of new investment, and in the case of life insurance, policy loans.
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, 2002, the Company had no known impairments of assets or changes in operation, which would have a material adverse effect upon liquidity. Approximately 81% of the Company's 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.
Statutory Risk-Based Capital of Insurance Subsidiaries: The NAIC has adopted Risk-Based Capital (RBC) requirements for life/health and property/casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, mortality and morbidity, asset and liability matching, benefit and loss reserve adequacy, and other business factors. State insurance regulators will use the RBC formula as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines new minimum capital standards that will supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio of the company's regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Companies below specific trigger points or ratios are classified within levels, each of which requires corrective action.
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 five to one at December 31, 2002.
National Security Insurance Company (life insurer) has regulatory adjusted capital of $11.47 million and $13 million at December 31, 2002 and 2001, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 17.1 and 15.75 at December 31, 2002 and 2001 respectively. Accordingly, National Security Insurance Company meets the minimum RBC requirements.
Omega One Insurance Company (property/casualty insurer), which began writing business in late 1995, has regulatory adjusted capital of $5.7 million and $5.0 million at December 31, 2002 and 2001, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 8.7 and 8.4 at December 31, 2002 and 2001 respectively. Accordingly, Omega One Insurance Company meets the minimum RBC requirements.
Any statement contained in this report which is not a historical fact, or which might otherwise be considered an opinion or projection concerning the Company or its business, whether expressed or implied, is meant as and should be considered a forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and opinions concerning a variety of known and unknown risks, including but not limited to changes in market conditions, natural disasters and other catastrophic events, increased competition, changes in availability and cost of reinsurance, changes in governmental regulations, technological changes, political and legal contingencies and general economic conditions, as well as other risks and uncertainties more completely described in the Company’s filings with the Securities and Exchange Commission. If any of these assumptions or opinions prove incorrect, any forward-looking statements made on the basis of such assumptions or opinions may also prove materially incorrect in one or more respects and may cause future results to differ materially from those contemplated, projected, estimated or budgeted in such forward-looking statements.
We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of The National Security Group, Inc. and subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.
Securities held-to-maturity, at amortized cost (estimated fair value: 2002 - $20,267
Investment real estate, at book value (accumulated depr.: 2002 - $17; 2001 - $17) 1,581
Preferred stock, $1 par value, 500,000 shares authorized, none issued or outstanding --
Class A common stock, $1 par value, 2,500,000 shares authorized, none issued or outstanding --
Net cash (used in) provided by investing activities (4,961 ) (927 ) 1,875
The company’s investment in affiliate consists of a 50% interest in Mobile Attic, Inc., a portable storage leasing company. The company accounts for this investment using the equity method (see Notes B, P and R).
NSIC is licensed in the states of Alabama, Georgia, Mississippi, Texas, South Carolina and Florida and was organized in 1947 to provide life and burial insurance policies to the home service market. Premiums sold and serviced by company agents primarily include industrial life, larger ordinary life, accident and health, limited hospital, cancer and low valued life insurance. NSFC operates in various property and casualty lines, the most significant of which are low valued dwelling property, home service fire, nonstandard automobile physical damage and liability, nonstandard commercial, and ocean marine. Omega operates in property and casualty lines, the most significant of which are nonstandard personal lines and automobile liability.
The significant accounting policies followed by The National Security Group, Inc. 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.
The table below presents the carrying value and fair value of the Company’s financial instruments, as defined in accordance with applicable requirements. Fair values of the Company’s financial instruments are estimated by reference to quoted prices from market sources and financial institutions, as well as other valuation techniques. In cases where quoted 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 Company maintains cash depository accounts, which at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.
On January 1, 2001, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities”. SFAS No. 133, as amended by SFAS Nos. 137 and 138, requires the Company to record all derivative financial instruments at fair value on the balance sheet. Changes in fair value of a derivative instrument are reported in net income or other comprehensive income, depending on the designated use of the derivative instrument. The adoption of SFAS No. 133 did not have a material effect on the Company’s financial position or results of operations. Prospectively, the adoption of No. 133 may introduce volatility into the Company’s reported net income and other comprehensive income depending on future market conditions and the Company’s hedging activities.
In June 2001, the FASB issued SFAS Nos. 141, “Business Combinations”, and 142, “Goodwill and Other Intangible Assets”. SFAS No. 141 requires that business combinations initiated after June 30, 2001, be accounted for using the purchase method. SFAS No. 142 revises the standards for accounting for acquired goodwill and other intangible assets. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001, and effective for any goodwill or intangible asset acquired after June 30, 2001. The adoption of this accounting standard did not have a material effect on the Company’s financial position or results of operations.
In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses financial accounting and reporting for costs associated with exit or disposal activities, and must be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.
The purchase of LSIC was accounted for by the purchase method, whereby the underlying assets acquired and liabilities assumed from the purchased corporation are recorded by Omega at their fair value. The excess of the amount paid over the fair value of LSIC’s identifiable net assets was approximately $200,000, which has been recorded as a charge to earnings in year 2000. The operating results of LSIC have been included in the Company’s consolidated financial statements since the date of acquisition. The purchase agreement provides for additional consideration to be paid the former stockholders contingent upon specified premium growth of the LSIC block of business.
Pro forma results of consolidated operations for 2000, assuming the LSIC acquisition was made at the beginning of the year, is as follows:
The amortized cost and aggregate fair value of debt securities at December 31, 2002, by contractual maturity, are as follows. 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.
For 2002, gross gains of $1,411,676 ($1,785,394 for 2001) and gross losses of $317,862 ($323,829 for 2001) were realized on sales of available-for-sale-securities.
An analysis of the net decrease in unrealized appreciation on available-for-sale securities follows:
sale securities before deferred tax $ (2,495 ) $ (1,366 ) $ (191 )
sale securities $ (1,647 ) $ (1,161 ) $ (136 )
Small life insurance company deduction (230 ) (122 ) (209 )
expenses for claims arising in prior years (1,547 ) (3,089 ) (5,411 )
The Company’s insurance operations participate in reinsurance in order to limit losses, minimize exposure to large risks, provide additional capacity for future growth and effect business-sharing arrangements. Life reinsurance is accomplished through yearly renewable term. Property and casualty reinsurance is placed on both a quota-share and excess of loss basis. Reinsurance ceded arrangements do not discharge the insurance subsidiaries as the primary insurer, except for cases involving a novation. Failure of reinsurers to honor their obligations could result in losses to the insurance subsidiaries. The insurance subsidiaries evaluate the financial conditions of their reinsurers and monitor concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize their exposure to significant losses from reinsurance insolvencies. At December 31, 2002, reinsurance receivables with a carrying value of $220,000 ($618,000 at December 31, 2001) and prepaid reinsurance premiums of $343,000 ($291,000 at December 31, 2001) were associated with a single reinsurer. The amounts of recoveries pertaining to reinsurance contracts that were deducted from losses incurred during 2002, 2001 and 2000 were approximately $374,000, $989,000, and $605,000, respectively
In 1989, the Company and its subsidiaries established a retirement savings plan and transferred the assets from the defined contribution profit sharing plan into the new plan. All full-time employees who have completed one year of service at January 1 or July 1 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. Contributions for 2002, 2001, and 2000 amounted to $177,337, $130,000, and $127,000, respectively. Contributions are at the Board of Directors’ discretion subject to governmental limitations.
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. As a result, dividends from NSFC to the Company are limited to $2,020,058 in 2003.
At December 31, 2002, securities with market values of $3,563,587 ($3,458,441 at December 31, 2001) were deposited with various states pursuant to statutory requirements.
At December 31, 2002, the Company guaranteed the $5 million balance on the line of credit of its affiliate, Mobile Attic, Inc. The Company is paid a guaranty fee based on the average balance of the line of credit. For 2002, the Company received $14,683 in guaranty fees. The term of the guarantee is two years. Credit risk represents the accounting loss that would be recognized at the reporting date if Mobile Attic, Inc. failed to perform completely as contracted. The credit risk of $5 million assumes that no amounts could be recovered from other parties.
In two separate actions, NSIC is named as a defendant in purported class actions relating to the past sale of industrial burial insurance. The actions address whether the premiums charged were “excessive” relative to the benefit provided and whether the premiums charged were in any manner discriminatory relative to the race of the person insured. In addition, several individual actions on behalf of specifically named persons have been filed with similar allegations. These actions are in the initial phases and little discovery has been undertaken and no class has been certified. While the cases entail separate and distinguishable facts, the legal issues are similar to the issues pending in numerous other actions currently pending nationwide against numerous insurers. While NSIC did at one time sell industrial burial insurance, no such plans have been sold for several decades.
Cash paid for interest during 2002 was $261,000 ($241,000 in 2001 and $266,000 in 2000). Cash paid for income taxes in 2002 was $76,328 ($800,000 in 2001 and $500,000 in 2000). Noncash investing activity consisted of the conversion of a $725,000 note receivable to an equity investment.
During 2002, the balance on the convertible line of credit was increased to $1 million and, under the terms of the line of credit, $725,000 of the balance was converted to common equity of the affiliate. The remaining $275,000 was converted to the long-term note described above. On February 16, 2003, the short-term note was extended.
Dividends of $2.7 million in 2002, $2.5 million in 2001 and $2.4 million in 2000 were paid to the Registrant by its subsidiaries.