The Company and its subsidiaries own certain real estate investment properties. We own approximately 2,950 acres of undeveloped timberland in Pike, Coffee and Covington counties in Alabama. The timber is accounted for as a natural resource and depleted in accordance with applicable accounting standards, which identify total costs as including acquisition costs, exploration costs, development costs, production costs and support equipment and facilities cost. We include in total costs timberland purchases and reforestation costs and other costs associated with the planting and growing of timber, such as site preparation, growing or purchases of seedlings, planting, fertilization, herbicide application and the thinning of tree stands to improve growth. We allocate total cost of the timberland over periods benefited by means of depletion. Timber revenue during 2012 totaled $87,000 compared to $14,000 during 2011. Gains on timber sales during 2012 totaled $71,000 compared to $12,000 in 2011.
We also own approximately 100 acres of undeveloped commercial real estate in Greenville, Alabama. We sell undeveloped lots from this development, and the development has no depreciable improvements.
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 NSG) 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, 2012.
The National Security Group operates in the property and casualty and life, accident and supplemental health insurance businesses and markets products primarily through independent agents. The Company operates in ten states with 49.5% of gross premium revenue generated in the states of Alabama and Mississippi. Property and casualty insurance is the most significant segment, accounting for 87.2% of total insurance premium revenue for 2012. Revenue generated from the life segment accounted for 12.8% of total insurance premium revenue for 2012.
National Security Insurance Company (NSIC) is a life, accident and health insurance company founded in 1947 and is the oldest subsidiary of the Company. The premium revenue produced in NSIC from the traditional life products and accident and health products accounted for 9.4% and 3.5%, respectively, of total premium revenue. All references to NSIC in the remainder of this management discussion and analysis will refer to the combined life, accident and health insurance operations and will compose the life segment of the Company. NSIC is licensed to underwrite life and accident and health insurance in Alabama, Florida, Georgia, Mississippi, South Carolina and Texas.
All of our insurance companies have been assigned ratings by A.M. Best. The property and casualty group has been assigned a group rating of “B++” (Good) with a negative outlook. In addition, A.M. Best has assigned an issuer credit rating of “bbb” with a negative outlook. NSFC, the largest of the insurance subsidiaries, carries the same A.M. Best ratings as the group. Omega carries an A.M. Best rating of “B+” (Good) with a stable outlook and an issuer credit rating of “bbb-” with a stable outlook. The life insurance subsidiary, NSIC, has been assigned an upgraded rating of “B+” (Good) from "B" (Fair) with a stable outlook and an issuer credit ratio upgrade of "bbb-" up from “bb+” with a stable outlook. All ratings are reviewed at least annually by A.M. Best with the latest ratings' effective date of November 30, 2012. AM Best is currently undergoing its annual review process of our ratings.
For the year-ended December 31, 2012, total revenues were $59,552,000 compared to $62,092,000 for the same period last year; a decrease of 4.1%. A decline in net premiums earned, primarily in the P&C segment, was the main contributing factor to the decrease in total revenue for 2012 over 2011. Partially offsetting the decline in revenue was a $2,121,000 increase in realized investment gains in the current year compared to the same period last year. The increase in realized capital gains was primarily from the sale of equity securities in the life segment.
As a percent of net premiums earned, claims were 65.8% through December 31, 2012 compared to 78.3% for the same period last year; a decrease of 12.5 percentage points. Although claims were down in 2012 compared to 2011, both years were negatively impacted by a higher frequency of reported losses due to cat events. As mentioned in the preceding paragraph, the P&C segment was negatively impacted by Hurricane Isaac in 2012. During 2011, the P&C segment was impacted by an extremely active spring storm season with April 2011 being ranked as the most active tornado month on record. The largest of these spring storms occurred on April 25th-27th, 2011 (referred to as catastrophe 46) and caused widespread damage from tornado, wind and hail damage throughout the Southeastern United States. This cat event led to 1,652 reported claims during 2011 totaling $10,432,000 ($3,847,000 net of reinsurance recoveries).
P&C segment incurred losses and LAE from the automobile program also contributed to the elevated claims levels in 2011. The automobile program was terminated in late 2011 due to continued unprofitable underwriting results. Year-to-date incurred losses and LAE were $(177,000) in 2012 compared to $4,492,000 for the same period last year. The primary reason for the decline in current year claims was reserve releases. The decision to discontinue the automobile programs was made by management in an effort to improve the profitability of P&C underwriting results and stabilize earnings.
The table below provides a summary premium revenue by segment and line of business for the year ended December 31, 2012 and 2011:
To offset the increase in catastrophe reinsurance cost in the P&C segment, we are implementing rate increases in states and territories most impacted by catastrophe reinsurance cost. We did experience significant margin compression in 2012 due to the combination of the previously mentioned increased cat cost which became effective in January of 2012 and delays inherent in the rate approval process. Our cat reinsurance cost held steady in 2013 and as rate increases are implemented, we should experience some relief from catastrophe cost related margin compression.
Net investment income remained relatively unchanged ending 2012 at $4,227,000 compared to $4,261,000 in 2011; a decrease of 0.8%. A primary reason for comparable results for investment income was the minimal change in invested assets in the current year compared to the prior year. The Company ended 2012 with invested assets of $100,133,000 compared to $101,972,000 in 2011; a 1.8% or $1,839,000 decrease. In addition, cash flow from P&C segment operations was adversely impacted by claims incurred from Hurricane Isaac in 2012 which reduced operating cash flow available to grow investments. This outflow, coupled with a challenging interest rate environment, were primary reasons for the lack of growth in investment income in the current year compared to the same period last year.
Net realized investment gains totaled $2,790,000 in 2012 compared to $669,000 in 2011; an increase of $2,121,000. The $2,121,000 increase in realized investment gains in 2012 compared to 2011 was primarily in the life segment which ended the current year with an increase of $1,592,000 while the P&C segment increase totaled $417,000. The primary reason for the increase was a greater amount of selling activity during the current year compared to the same period last year. A primary focus during the current year was to moderately reduce the equity portfolio in the life segment in order to increase the allocation to fixed income. These efforts were made to improve duration matching of liabilities and strengthen regulatory cash flow testing results. The realization of capital gains in the investment portfolio is influenced by both market conditions and liquidity requirements of the insurance subsidiaries and therefore
The P&C segment is affected by storm systems classified as "catastrophes" by Property Claims Service (PCS) when a single storm system or other natural disaster causes in excess of $25 million in industry losses. The losses and loss adjustment expenses (LAE) incurred in the P&C segment from claims associated with storm systems classified as "catastrophic" (referred to as "cat events" hereafter), totaled $4,295,000 in 2012 compared to $14,040,000 ($7,455,000 net of reinsurance) in 2011. The current year claims were incurred from nine separate cat events and accounted for 11.7% of total claims during the year compared to 33.1% of claims (18.2% on a net basis) from eighteen cat events during the prior year.
The largest cat event during 2012 was Hurricane Issac from which we incurred 1,147 policyholder claims totaling $3,390,000. Hurricane Issac claims accounted for 78.9% of all incurred losses and incurred LAE related to cat events during 2012. The P&C segment maintains catastrophe reinsurance to reduce risk associated with losses from cat events. The reinsurance is structured with a $4,000,000 retention/deductible from a single cat event with 5% coinsurance retained on the first two layers of coverage. Any claim activity exceeding the first two layers is 100% reinsured up to $72,500,000 in ultimate incurred losses and LAE. Because the claims from Hurricane Issac did not exceed our deductible for 2012, they were not reinsured.
A cat event on April 25th-27th, 2011 (catastrophe 46) was the primary source of the overall losses and LAE incurred during 2011. The reported losses and LAE cat 46 totaled $10,432,000. The reinsurance deductible for 2011 was $3,500,000. Because the P&C segment losses and LAE reported from catastrophe 46 exceeded the 2011 reinsurancedeductible, the P&C segment recovered $6,585,000 from reinsurers during the prior year. The P&C segment retained $3,847,000 of the reported losses and LAE from catastrophe 46 during 2011.
General and administrative expenses decreased $44,000, ending 2012 at $8,790,000 compared to $8,834,000 for the same period last year. Although general and administrative expenses were down, management continues to focus on this area as we seek ways to maximize efficiency and reduce costs by streamlining processes and cross-training employees across both insurance segments of the Company.
Taxes, licenses and fees were comparable at $1,846,000 in 2012 compared to $1,885,000 for the same period last year. As a percent of premium revenue, taxes, license and fees for the year ended December 31, 2012 and 2011 were 3.6% and 3.4%, respectively. Premium taxes were moderately higher due to shifts in P&C gross written premium with declines in surplus lines states in which we incur no premium taxes and increases in gross written premium in states in which we typically incur higher premium taxes, principally Alabama and Georgia.
significant liquidity constraints in supporting a potentially long, expensive and arduous appeal process. Therefore, after careful consideration, management made a decision to reach a settlement agreement. Under the terms of the settlement agreement, the Company will pay a total of $13 million to the plaintiff. In order to manage the liquidity constraints, the settlement will be in the form of an interest-bearing note with amounts to be paid over nine years with the ability to defer payments in years in which the Company's P&C subsidiaries incur substantial catastrophe losses thus allowing capital management flexibility in the P&C subsidiaries. Under the terms of the agreement, the annual debt service on the note cannot be less than the dividends paid to our shareholders in the last twelve months. The Company made an initial installment payment of $2,500,000 in September 2012. The remaining principal will be repaid in nine annual installments of $1,167,000. Accrued and unpaid interest shall be payable with each installment of principal based on the prime rate published in the Wall Street Journal plus 1%. Additional information related to the settlement can be found in the liquidity and capital resources section of the Management Discussion and Analysis as well as in Note 15 to the consolidated financial statements.
Interest expense for the year ended December 31, 2012 was up $127,000 from the prior year at $1,280,000 compared to $1,153,000 in 2011. Interest expense related to litigation settlement (discussed above) in the holding company was the primary reason for the increase in 2012 compared to 2011.
The Company had an income tax benefit totaling $4,393,000 in 2012 compared to income tax benefit totaling $2,643,000 in 2011. Primary components of the income tax benefit for the year ended December 31, 2012 and 2011 included deferred tax benefits associated with the litigation settlement of $3,145,000 and $425,000, respectively and deferred tax benefits associated with NOL carryforward of $1,348,000 and $1,363,000, respectively. Deferred tax assets related to AMT credit in 2012 were $246,000 compared to $0 in 2011. The Company exhausted all net operating losses available for carry back to prior periods in 2011.
Stockholders equity for the year ended December 31, 2012 was $30,227,000 compared to $38,015,000 at December 31, 2011; a decrease of $7,788,000 or 20.5%. The change in stockholders equity is composed of dividends paid to shareholders of $802,000 and a net loss of $6,671,000 as well as accumulated other comprehensive income, primarily decreases in accumulated unrealized capital gains, totaling $101,000 and unrealized losses on interest rate swap totaling $214,000. Year-end book value per share, defined as stockholders equity divided by common shares outstanding of 2,466,600, was $12.25 at December 31, 2012 compared to $15.41 at December 31, 2011.
NSIC premium accounted for 12.8% of total consolidated premium revenue for 2012. Premium revenue in NSIC was $6,609,000 at December 31, 2012 compared to $6,870,000 for the same period last year; a decrease of 3.8%. The $261,000 decrease in gross premium revenue was primarily due to the $216,000 or 7.5% decline in ordinary business related to the independent agent distribution method. The home service distribution method also contributed to the overall decline in premium revenue ending 2012 down 2.1% compared to the same period last year. NSIC has faced challenges in growing life insurance revenue over the past two years due to new competitors in the market paying independent agent commission rates that we believe to be unprofitable long term and would contribute to short term surplus strain if we matched those commission rates. We intend to increase focus on niche areas and products in 2013 in order to reverse the declining revenue trend.
As mentioned previously, NSIC operates using two primary methods of distribution: home service employee agents and independent agents. While the Company has used the traditional home service distribution method since its founding in 1947, the independent agent distribution method has become the largest source of renewal business and new business production over the past decade. For 2012, the home service and independent agent distribution methods accounted for 32.8% and 62.4%, respectively of NSIC premium revenue.
Property and casualty segment premium revenue for 2012 was $45,206,000 compared to $49,373,000 for the same period last year; a decrease of 8.4%. The primary reasons for the decrease in premium revenue in 2012 compared to 2011 were the discontinuance of the automobile program in addition to increases in reinsurance cost and the addition of RPP coverage.
P&C segment premium revenue was down 8.4% in 2012 compared to 2011. One primary reason for the decrease in premium revenue was the termination of the private passenger non-standard and commercial automobile programs. Due to unprofitable underwriting results for multiple years, the decision was made by management to discontinue the automobile program in late 2011. The termination of the automobile programs led to a $2,882,000 or 85.9% decrease
Additional details regarding the structure of the current year agreement can be found in Note 10 to the consolidated financial statements.
A catastrophe event in late April 2011, which exceeded our single event retention, triggered additional ceded premium payments (reinstatement premium) in order to reinstate coverage under our catastrophe reinsurance agreement. This catastrophe reinstatement premium was $1,439,000 in 2012 compared to $1,621,000 in 2011.
Net investment income totaled $2,107,000 in 2012 compared to $2,246,000 in 2011; a decrease of $139,000. The decrease in investment income in the P&C segment was primarily attributable to a decline in invested assets in 2012 compared to 2011. For the year ended December 31, 2012 and 2011, P&C segment invested assets were $51,163,000 and $56,154,000, respectively; a decrease of 8.9%. Partially offsetting the decline was an increase in investment income related to the company owned life insurance (COLI) value which increased $131,000 in the current year compared to the same period last year.
The P&C segment ended 2012 with realized capital gains totaling $1,083,000 compared to $666,000 for the same period last year. The 62.6% increase in realized capital gains was primarily associated with an increase in selling activity during the current year compared to the the prior year. Realized capital gains from the sale of three securities during 2012 accounted for 66.8% of total realized capital gains for the current year. The realization of capital gains in the investment portfolio is influenced by both market conditions and liquidity requirements and therefore can vary significantly from year to year. Other activities, such as tax planning strategies, may also lead to significant variation in realized capital gains from year to year. The P&C segment was not impacted by the write-down of other-than-temporary impairments in 2012 or 2011.
Other income was $718,000 in 2012 compared to $916,000 for the same period last year; a $198,000 or 21.6% decrease. Other income consists primarily of fees related to the issuance of our property and automobile insurance policies as well as miscellaneous income. As a percent of net earned premium, other income was 1.6% in 2012 compared to 1.9% in 2011. Due to the termination of our automobile programs, billing, payment and policy fees declined, which triggered the overall reduction in other income for the current year.
A cat event on April 25th-27th, 2011 (catastrophe 46) was the primary source of the overall losses and LAE incurred during 2011. The reported losses and LAE from cat 46 totaled $10,432,000. The reinsurance deductible for 2011 was $3,500,000. Because the P&C segment losses and LAE reported from catastrophe 46 exceeded the 2011 reinsurance deductible, the P&C segment recovered $6,585,000 from reinsurers during the prior year. The P&C segment retained $3,847,000 of the reported losses and LAE from catastrophe 46 during 2011 after reinsurance. In our catastrophe reinsurance model results, which we utilize to establish reinsurance coverage limits, this tornado event exceeded a one in 250 year return period, which means that this event had a probability of occurrence in the models of less than four tenths of one percentage point in any given year.
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. The P&C companies incurred 1,424 claims from nine cat events in 2012 compared to 3,085 claims from seventeen cat events in 2011. The average severity per claim related to the 2012 cat events was $3,000 compared to $4,600 per claim ($1,200 net of reinsurance recoveries) in 2011. The average severity per claim related to the tornado outbreak on April 25th-27th, 2011, catastrophe 46, was $6,300 and contributed significantly to skewing 2011's average severity upward.
The personal lines automobile program ended 2012 with incurred losses and incurred LAE of $(177,000) compared to $4,492,000 for the same period last year. The primary reason for the decline in current year claims was reserve releases. The automobile programs were cumulatively unprofitable and produced year over year underwriting losses prior to program termination in 2012. Because of the continued lack of underwriting profits and significant claim activity associated with this program, the decision was made to terminate the program during the fourth quarter of 2011. The automobile policies are six month coverage periods; therefore, all policies have now expired. The discontinuance of the automobile program, while contributing to a further decline in premium revenue, is expected to positively impact overall underwriting results provided we do not experience any further adverse development on reported claims, many of which are liability coverage claims which tend to take longer to settle.
Commission expense for 2012 was $7,088,000 (15.7% of premium revenue) compared to $7,615,000 (15.4% of premium revenue) for the same period last year. The primary reason for the $527,000 or 6.9% decrease in commission expense during 2012 compared to 2011 was a decline in contingent commissions payments to our general agents.
Insurance taxes, licenses and fees were $1,628,000 in 2012 compared to $1,569,000 for the same period last year. Insurance taxes, licenses and fees were up slightly at 3.6% of premium revenue in 2012 compared to 3.2% in 2011. Although premium revenue in the P&C segment was down in 2012 compared to 2011, there was an up tick in premium revenue in a couple of states in which we write business. The increases led to higher premium taxes in the current year compared to the prior year for these states and was the primary reason for the overall increase in insurance taxes, licenses and fees.
During 2012, the P&C segment experienced a decrease of 14 percentage points in the combined ratio compared to 2011. The primary reason for the decrease was a $10,025,000 decline in incurred losses from catastrophe related tornado, wind and hail related claims. Cat events increased the current year combined ratio by 9.5 percentage points compared to 23.5 percentage points in 2011. While cat events are unpredictable and beyond the control of management, measures have been taken to improve underwriting results in the P&C segment. Management also continues to evaluate rate adequacy, exposure concentrations and risk management strategies in order to improve underwriting profitability and reduce earnings volatility.
The non-insurance operations of the Company consist of our parent company, The National Security Group, Inc. The National Security Group has no material sources of revenue and relies almost entirely on dividends from subsidiaries to pay expenses. Dividends from subsidiaries are subject to insurance department approval and are subject to statutory restrictions. Subsidiary dividends are eliminated upon consolidation of the subsidiaries in the audited financial statements included herein. General and administrative expenses totaled $519,000 compared to $431,000 for the same period last year; a 20.4% increase. The expenses of NSG are primarily associated with the public listing of our stock, taxes and fees, and directors' fees. The most significant item impacting the increase in general expenses were increases in interest costs related to deferred compensation and bank charges related to the line of credit obtained during the year.
The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. The types of assets in which the Company can invest are influenced by various state insurance laws which prescribe qualified investment assets. While working within the parameters of these prescribed regulatory requirements
*Due to the downgrade of United States Government bonds, AAA and AA+ are presented consolidated for comparability. Most of the securities within this combined category are United States Government and Agency bonds, which are now rated AA+.
The amortized cost and aggregate fair values of investments in securities at December 31, 2012 and December 31, 2011 are as follows (dollars in thousands):
As shown in the tables above, the Company experienced an overall increase in fixed income securities in 2012 compared to the portfolio composition at December 31, 2011. This shift was primarily into corporate debt securities in the life insurance subsidiary. As discussed previously the shift in the portfolio will allow for greater yields and provide a moderate increase in duration.
The insurance subsidiaries' fixed maturity securities include residential mortgage-backed securities (RMBS) of $17.5 million and $19.3 million at amortized value at December 31, 2012 and 2011, respectively. We own no commercial mortgage backed securities. We also have no material direct exposure in sub-prime mortgage loans in our private label RMBS portfolio.
As for the composition of the RMBS portfolio, agency mortgage backed securities compose 56% and 49% of the RMBS portfolio at December 31, 2012 and 2011, respectively. The remainder of the RMBS portfolio is composed of private label mortgage backed securities. These securities consist primarily of conventional 15 and 30 year loans with an average borrower FICO score at origination of 740. We own no mortgage backed securities with direct exposure to subprime loans and less than 1% of the RMBS portfolio is composed of loans subject to rate resets. Three securities in the private label mortgage backed security portfolio are rated below investment grade and compose less than 2% of total invested assets.
Investment returns with respect to the investment portfolio for the years ended December 31, 2012 and 2011 follows:
The Company's subsidiaries maintain repurchase agreements under which the policy requires 102% (100% minimum) of the fair value of the securities purchased to be maintained as collateral. Cash collateral received is invested in short-term investments. The repurchase investments are limited to government securities that are highly liquid. The Company does not have any reverse repurchase agreements.
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 effective maturities spread over periods usually not exceeding 10 years. The liabilities of the life insurance subsidiary are typically of a longer duration, and therefore, a higher percentage of securities in the life insurance subsidiary are invested for periods exceeding 10 years.
At December 31, 2012, the Company had aggregate equity capital, unrealized investment gains (net of income taxes) and retained earnings of $30,227,000, down $7,788,000 compared to $38,015,000 at December 31, 2011. Components of the change in equity were a net loss of $6,671,000, net unrealized loss on investments of $101,000, a net unrealized loss of $214,000 related to interest rate swaps and cash dividends paid totaling $802,000.
Net cash provided by investing activities totaled $4,111,000 for the year ended December 31, 2012, compared to cash provided of $9,888,000 for the same period last year. During the prior year, investment sales were necessary to increase liquidity in order to pay storm claims in the P&C segment during the second quarter as a result of losses from catastrophe 46.
Included in long-term debt held by the Company is the issuance of $9,279,000 in subordinated debentures completed on December 15, 2005. The proceeds from the debentures were used to make a $6,000,000 capital infusion in the P&C subsidiary National Security Fire and Casualty with the remainder to be held for general corporate purposes. The subordinated debentures mature December 15, 2035. It is anticipated that principal payments will not be made until the expiration of the fixed rate period on the debt in 2015. Also included in long-term debt is the issuance of $3,093,000 in subordinated debentures completed June 21, 2007. The proceeds from the debentures were used to fund general corporate expenses, thereby reducing the amount of dividends to the Group paid by the P&C subsidiary National Security Fire & Casualty in 2007 and 2008, thereby continuing to restore capital in the P&C subsidiary National Security Fire and Casualty to pre-hurricane levels. The second issue matures June 15, 2037 and may be redeemed following the fifth anniversary of issuance. Also included in long-term debt held by the Company is a line of credit in the amount of $4,000,000 obtained in September 2012. The line of credit is secured by timber property and had $3,634,000 drawn at December 31, 2012. In July 2012, the Company executed an installment note in the amount of $13,000,000 to finance the settlement obligation related to the Mobile Attic litigation. As of December 31, 2012, a total of $10,500,000 was outstanding, $1,167,000 included in notes payable.
Our P&C segment, incurred $3,390,000 in losses from Hurricane Isaac during the third quarter triggering current year underwriting losses in the P&C segment. These underwriting losses coupled with the transfer of timber property to the Holding company contributed to a decline in statutory capital levels in the P&C segment. These reduced capital levels, while adequate to operate our existing business, have reduced the subsidiary's ability to pay dividends upstream to the holding company in the near term.
In July of 2012, NSFC issued an extraordinary dividend of real estate to the holding company in order to secure a bank line of credit. The payment of this extraordinary dividend will limit NSFC's ability to pay further dividends to the parent company until August of 2013. The payment of any subsidiary dividend requires prior notice to the regulatory authorities who may disallow the dividend if, in their judgment, payment of the dividend would have an adverse effect on the surplus of the subsidiary.
Due to the erosion in capital levels in the P&C subsidiaries, we have made changes in order to reduce capital/surplus strain in the P&C subsidiaries and help protect capital levels from substantial further erosion resulting from a major catastrophic event. These changes include a combination of reduction in underwriting leverage and an increase in catastrophe reinsurance protection. A summary of each change follows:
As disclosed in Note 15 to these consolidated financial statements regarding contingencies, the Company was involved in litigation related to its divestiture of Mobile Attic, Inc. The Company's insurance subsidiaries were not involved in this litigation, and the Company has funded all costs associated with defending this action. The defense cost placed a strain on our liquidity in the holding company leading up to the date of the jury trial which was set for June of 2012. As was disclosed in our previous filings, the Company believed that the damages claimed in the litigation were excessive in amount and that a substantial portion of the claimed damages was unrelated to the Company's involvement in the Mobile Attic transaction. The Company believed that the damages should be limited to a diminished value of the purchaser's original investment in Mobile Attic resulting from the claimed breach of warranty in the stock purchase agreement. The Company had filed motions for summary judgment requesting a court ruling as to how damages should be measured as a matter of law. As was disclosed in our first quarter Form 10-Q, on April 24, 2012, the Court heard oral arguments on the motion for summary judgment and took the matter under advisement.
Immediately before the trial, settlement discussions with the plaintiff approached the amount of the financial benefit that NSG had received from the purchaser in the Mobile Attic transaction. After careful consideration of the aforementioned factors, management made a decision to reach a settlement agreement just as the trial was about to commence. Under the terms of the settlement agreement, the Company will pay a total of $13 million to the plaintiff. In order to manage the liquidity constraints, the settlement will be in the form of an interest-bearing note with amounts to be paid over nine years with the ability to defer payments in years in which the Company's P&C subsidiaries incur substantial catastrophe losses thus allowing capital management flexibility in the P&C subsidiaries. Under the terms of the agreement, the annual debt service on the note cannot be less than the dividends paid to our shareholders in the last twelve months. The Company made an initial payment of $2,500,000 in September 2012. The remaining principal will be repaid in nine annual installments of $1,167,000. Accrued and unpaid interest shall be payable with each installment of principal based on the prime rate published in the Wall Street Journal plus 1%.
We have taken and continue to take corrective action to improve our profitability and capital position. However, due to the adverse effects of six major hurricanes in the last eight years, the financial market meltdown in 2008, continued historically low interest rates, an unprecedented tornado outbreak in April of 2011 and the recently settled litigation, we have experienced significant reduction in equity capital. While we are beginning to see improvement and have put some major obstacles behind us, we are in a position where we have to preserve capital in the near term in order to put our Company in the best position to be successful moving forward. In order to improve our capital position, we will continue to monitor our dividend policy on a quarterly basis and could take action including the suspension of dividends should operating conditions warrant such action. Due to various factors discussed herein, we must remain flexible in our dividend policy until we achieve more consistent profitability and capital growth.
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 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 3.7 to 1 at December 31, 2012.
National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $24.1 million and $25.5 million at December 31, 2012 and 2011, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 3.7 and 3.8 at December 31, 2012 and 2011, respectively. Accordingly, National Security Fire & Casualty 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. Management does not anticipate any issues with recoverability of reinsurance balances based on current evaluations of collectability. For more information regarding reinsurance, see the Notes to our consolidated financial statements.
At December 31, 2012, 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 financial statements.
Property and casualty loss reserves are maintained to cover the estimated unpaid liability for losses and loss adjustment expenses with respect to reported and unreported incurred claims. Loss reserves are an estimation based on actuarial projection techniques common in the insurance industry. Reserves are management's expectations of what the settlement and administration of claims will cost. Management estimated reserves are based on historical settlement patterns, estimated salvage and subrogation, and an appraisal of the related facts and circumstances. Management's
reserve estimates are reviewed by consulting actuaries to determine their adequacy and reasonableness. The reserve analysis performed by management is reviewed by the actuaries during the third quarter each year with a final comprehensive review and actuarial sign off performed at year-end.
At December 31, 2012 and 2011, the recorded liability for loss and loss adjustment expense was $11,214,000 and $14,386,000, respectively, a $3,172,000 decrease. The primary reason for the decline was a reduction in losses from tornado, wind and hail related cat events as well as claims associated with the automobile line of business. We believe the estimate of unpaid losses and loss adjustment expenses 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 consolidated financial statements.
Liabilities for loss contingencies arising from, but not limited to, litigation, claims, assessments, fines and penalties are recorded when it is probable that a liability has been incurred and the amount of the assessment and/or remediation can be reasonably estimated. Additional details with respect to contingencies are disclosed in Note 15 to the accompanying consolidated financial statements.
In July 2012, the FASB issued guidance related to impairment of indefinite-lived intangible assets other than goodwill. The new guidance will allow an entity to first make a qualitative assessment of whether it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount before applying the quantitative
impairment test. An entity is required to perform the quantitative test only if it determines that it is more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount. We are currently evaluating the impact of this revised guidance on our financial statements. However, we do not expect a material effect on our results of operations or financial position upon adoption in 2013.
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. as of December 31, 2012 and 2011, 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. Also, in our opinion, the financial statement schedules listed in the accompanying index appearing under Item 8, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
Omega is licensed in the states of Alabama and Louisiana. Omega operates in property and casualty homeowners line of business.
The Company's life, accident and health insurance subsidiary, composing approximately 12% of consolidated revenues, is licensed in six states. However, over 75% of segment revenue is generated in the states of Alabama and Georgia. Consequently, changes in the legal, regulatory or economic environment could adversely impact the Company.
Interest on fixed income securities is credited to income as it accrues on the principal amounts outstanding adjusted for amortization of premiums and accretion of discounts computed utilizing the effective interest rate method. Premiums and discounts on mortgage backed securities are amortized or accreted using anticipated prepayments with changes in anticipated prepayments accounted for prospectively. The model used to determine anticipated prepayment assumptions for mortgage backed securities uses separate home sale, refinancing, curtailment and pay-off
assumptions derived from a variety of industry sources. Mortgage backed security valuations are subject to prospective adjustments in yield due to changes in prepayment assumptions. The utilization of the prospective method will result
in a recalculated effective 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.
The Company owns life insurance (COLI) contracts on certain management and supervisory employees each having a face amount of approximately $2,000,000. The Company's original investment in company owned life insurance was $5,000,000. The primary purpose of the program is to offset future employee benefit expenses through earnings on the cash value of the policies. The Company is the owner and principal beneficiary of these policies. The life insurance contracts are carried at their current cash surrender value. Cash surrender value at December 31, 2012 and 2011 was $5,931,000 and $5,660,000, respectively. Changes in cash surrender values are included in income in the current period. The change in surrender value included in earnings for the periods ended December 31, 2012 and 2011 was $271,000 and $140,000, respectively. Death proceeds from the contracts are recorded when the proceeds become payable under the terms of the policy. There were no proceeds received from the COLI during 2012 or 2011.
Mortality assumptions include various percentages of the 1955-60 and 1965-70 Select and Ultimate Basic Male Mortality Table. Withdrawal assumptions are based on the Company's experience.
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 bases of the Company's assets and liabilities and 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.
The Company expenses advertising costs as incurred. Advertising costs charged to expense were $128,000 for the year ended December 31, 2012 ($107,000 for the year ended December 31, 2011). Advertising cost consists primarily of agent convention expense and print media.
losses, are composed of balances due from independent agents. At December 31, 2012, the single largest balance due from one agent totaled $532,000.
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, 2012 and 2011, 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, 2012, management does not believe the Company is exposed to any significant credit risk related to its reinsurance program.
In December 2011, the FASB issued guidance requiring expanded disclosures, including both gross and net information, for financial instruments and derivative instruments that are either offset in the reporting entity's financial statements or those that are subject to an enforceable master netting arrangement or similar agreement. The guidance is effective
for reporting periods beginning on or after January 1, 2013 and is to be applied retrospectively. The new guidance affects disclosures only and will have no impact on the Company's results of operations or financial position.
The Company holds a passive interest in a limited partnership that is considered to be a Variable Interest Entity (VIE) under the provisions of FIN 46(R). The Company is not the primary beneficiary of the entity and is not required to consolidate under FIN 46(R). The entity is a private placement investment fund formed for the purpose of investing in private equity investments. The Company owns less than 1% of the limited partnership. The carrying value of the investment totals $325,000 and is included as a component of Other Invested Assets in the accompanying consolidated balance sheets.
The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2011 are as follows:
The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2011 are as follows:
A summary of securities available-for-sale with unrealized losses as of December 31, 2011, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows:
There were no securities held-to-maturity with unrealized losses as of December 31, 2012 and December 31, 2011.
temporary. If the impairment is determined to be other-than-temporary, the Company is required to separate the other-than-temporary impairments into two components: the amount representing the credit loss and the amount related to all other factors. The credit loss is the portion of the amortized book value in excess of the net present value of the projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment. The credit loss component of other-than-temporary impairments is reported in earnings, whereas the amount relating to factors other than credit losses are recorded in other comprehensive income, net of taxes.
Management has evaluated each security in a significant unrealized loss position. The Company has no material exposure to sub-prime mortgage loans and less than 4% of the fixed income investment portfolio is rated 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 at least two independent sources. Based on a review of the available financial information, the prospect for future earnings of each company and consideration of the Company’s intent and ability to hold the securities until market values recovered, it was determined that the securities in an accumulated loss position in the portfolio were temporary impairments.
Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2012 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):
For the year ended December 31, 2011, there were no assets or liabilities measured at fair values on a nonrecurring basis.
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 carrying amount and estimate fair value of the Company’s financial instruments as of December 31, 2012 and December 31, 2011 are as follows (in thousands):
The Company recognizes tax-related interest and penalties as a component of tax expense. The Company has not incurred any income tax related interest and penalties during December 31, 2012 and $1,000 during December 31, 2011. The Company files income tax returns in the U.S. federal jurisdiction and various states. The Company is not subject to examinations by authorities related to its U.S. federal or state income tax filings for years prior to 2006. Tax returns have been filed through the year 2011.
Net deferred tax liabilities are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax laws. Management believes that, based on its historical pattern of taxable income, the Company will produce sufficient income in the future to realize its deferred tax assets. The Company recognized net deferred tax asset position of $4,997,000 at December 31, 2012, and net deferred tax liability position of $86,000 at December 31, 2011.
Total income tax (benefit) expense varies from amounts computed by applying current federal income tax rates to income or loss before income taxes. The reason for these differences and the approximate tax effects are as follows:
The aggregate balance in this account, $2,520,000 at December 31, 2012, 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 $857,000 at December 31, 2012.
Short-term debt and current portion of long-term debt consisted of the following as of December 31, 2012 and December 31, 2011:
Long-term debt consisted of the following as of December 31, 2012 and December 31, 2011:
The swaps entered into in 2009 and 2010 have fair values of $471,000 (liability) and $1,050,000 (liability), respectively, for a total liability of $1,521,000 at December 31, 2012 ($1,196,000 at December 31, 2011). The swap liability is reported as a component of other liabilities on the condensed consolidated balance sheets. A net valuation loss of $214,000 is included in accumulated other comprehensive income related to the swap agreements for the current period. A net valuation loss of $640,000 was included in accumulated other comprehensive income related to the swap at December 31, 2011.
In September 2012, the Company obtained a secured line of credit in the amount of $4,000,000 with an interest rate equal to the WSJ prime (4.5% at December 31, 2012) and subject to a 4.5% floor. As of December 31, 2012, $3,634,000 was drawn on this line. The line of credit is secured by timber property investments of the Company.
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, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. The Company generally seeks to reduce its exposure to catastrophes through individual risk selection and the purchase of catastrophe reinsurance. At December 31, 2012, the Company's estimate of unpaid losses and adjustment expenses for claims incurred in prior years related to catastrophes that exceeded our retention totaled $958,000 before reinsurance ($1,793,000 in 2011). Because the Company has exhausted its catastrophe coverage limits available for Hurricane Katrina any additional development will not be covered by reinsurance. The Company maintains case reserves of $390,000 for losses in excess of catastrophe reinsurance ($266,000 in 2011).
The effect of reinsurance on premiums written and earned in the property and casualty segment is as follows (dollars in thousands):
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 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 2012 and 2011 amounted to $202,000 and $216,000, respectively. The Company contributes dollar-for-dollar matching contributions up to 5% of compensation subject to government limitations.
In January 2006, the Company established a non-qualified plan under which directors are allowed to defer all or a portion of directors' fees into various investment options.
The Company is dependent on dividends from its insurance subsidiaries to fund operations and payment of shareholder dividends. Dividend payments from the insurance subsidiaries are subject to regulatory review/approval and statutory limitations. The statutory limitations are outlined as follows:
The payment of any subsidiary dividend requires prior notice to the regulatory authorities who may disallow the dividend if, in their judgment, payment of the dividend would have an adverse effect on the surplus of the subsidiary.
At December 31, 2012, securities with market values of $3,785,000 ($3,786,000 at December 31, 2011) were deposited with various states pursuant to statutory requirements.
During the years ended December 31, 2012 and 2011, changes in shareholders' equity consisted of net losses of $6,671,000 and $4,956,000, respectively; dividends paid of $802,000 in 2012 and $1,357,000 in 2011; changes in accumulated other comprehensive loss, net of applicable taxes, of $315,000 in 2012 and other comprehensive income, net of applicable taxes, of $618,000 in 2011. Other comprehensive loss consists of accumulated unrealized gains and losses on securities and unrealized gains and losses on interest rate swaps.
The table below provides information regarding the Company's preferred and common stock as of December 31, 2012 and December 31, 2011:
The following table presents the Company’s gross and net premiums written for the property and casualty segment and the life and accident and health segment for the years ended December 31, 2012 and 2011, respectively:
The Company and its subsidiaries continue to be named individually as parties to litigation related to the conduct of their insurance operations. These suits involve alleged breaches of contracts, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of the Company's subsidiaries, and miscellaneous other causes of action.
As previously disclosed, the Company and the Purchaser have been involved in litigation regarding this transaction. The Purchaser asserted claims against the Company seeking indemnification of Purchaser's losses and damages as a result of the breach of representations and warranties regarding Mobile Attic's financial condition, as set forth in the Stock Purchase Agreement.
Cash paid for interest during 2012 was $1,163,000 ($1,144,000 in 2011). Cash received for income taxes in 2012 was $1,437,000 compared to cash paid for income taxes in 2011 of $316,000.
In 2012, cash dividends of $1.8 million were paid to the Registrant by its subsidiaries ($2.1 million in 2011). Also in 2012, timber property with a carrying value of $1.5 million was transferred to the Registrant from an insurance subsidiary.