The following discussion highlights significant factors influencing the consolidated financial position and results of operations of The National Security Group, Inc. (referred to in this document as we, our, us, the Company or NSEC) and its subsidiaries. We are a “smaller reporting company” under Securities and Exchange Commission (SEC) regulations and therefore qualify for the scaled disclosure of smaller reporting companies. In general, the same information is required to be disclosed in the management discussion and analysis by smaller reporting companies except that the discussion need only cover the latest two year period and disclosures relating to contractual obligations are not required. In accordance with the scaled disclosure requirements, this discussion covers the two year period ended December 31, 2014.
The National Security Group, Inc. is made up of two segments: the Life segment and the P&C segment. 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. The Company's property and casualty insurance business is conducted through National Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company
This discussion and analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data and Consolidated Financial Statements and related notes included in this Form 10-K. Please refer to our note regarding forward-looking statements on pages 4-5 of this report.
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 50.3% of total premium revenue generated in the states of Alabama and Mississippi. Property and casualty insurance is the most significant segment, accounting for 89.9% of gross premium revenue in 2014. Revenue generated from the life segment accounted for 10.1% of gross premium revenue in 2014.
All of our insurance companies have been assigned ratings by A.M. Best Co (Best). On November 13, 2014, Best affirmed the financial strength rating (FSR) of B++ (Good) and the issuer credit rating (ICR) of "bbb" of NSFC. Best revised the outlook on both of NSFC's ratings from negative to stable. In addition, Best affirmed the FSR of B+(Good) and ICR of "bbb-" of Omega and NSIC. The outlook for all of these ratings is stable. Best also affirmed the ICR of "bb" of the parent holding company, NSEC, with a revised outlook from negative to stable. The property and casualty subsidiaries have been assigned ratings by Demotech, Inc. On November 22, 2014, Demotech affirmed a Financial Stability Rating of A (Exceptional) for both NSFC and Omega.
The two primary segments in which we report insurance operations are the personal lines property and casualty segment (NSFC) and the life, accident and health insurance segment (NSIC). Due to Omega producing no earned premium revenue and the fact that Omega is a wholly owned subsidiary of NSFC authorized to underwrite similar lines of business, all references to NSFC in the remainder of this management discussion and analysis will include the insurance operations of both NSFC and Omega. Our income is principally derived from net underwriting profits and investment income. Net underwriting profit is principally derived from earned premiums received less claims paid, sales commissions to agents, costs of underwriting and insurance taxes and fees. Investment income includes interest and dividend income and gains and losses on investment holdings.
A primary non-GAAP financial measure used by management is pretax income from insurance operations. This measure consists of net income before income taxes adjusted for realized investment gains and losses and gain on company owned life insurance. This measure provides a means of comparing the results of our core insurance
operations without the impact of items that are more unpredictable and less consistent from year to year. A reconciliation of pretax income from insurance operations is presented in the table above.
For the year ended December 31, 2014, pretax income from insurance operations was $6,019,000 compared to $2,884,000 for the same period in 2013, an increase of $3,135,000. The primary factor contributing to an increase in pretax income from insurance operations was a significant improvement in the loss ratio of policyholder benefits as a percent of premium earned. Policyholder benefits were 54.5% of premium revenue in 2014 compared to 59.5% in 2013, a reduction of five percentage points. This reduction in incurred losses was primarily driven by reduced wind related property losses, a calmer spring storm season and a second consecutive year of no hurricane related losses.
Invested assets as of December 31, 2014 were $109,549,000 up $9,499,000, or 9.5%, compared to December 31, 2013. This increase in invested assets was primarily due to the the investment of positive cash flow from insurance operations coupled with increases in market values of available for sale securities. The increase in market value of available for sale securities also contributed to the increase in accumulated other comprehensive income to $2,772,000 as of December 31, 2014, up $1,836,000 compared to December 31, 2013.
The Company, primarily through its insurance subsidiaries, had $6,426,000 in cash and cash equivalents at December 31, 2014, compared to $4,987,000 at December 31, 2013. Significantly improved performance in our insurance operations for the year ended December 31, 2014, coupled with year over year growth in premium revenue, contributed to $11,867,000 in positive cash flow from operations for the year compared to cash provided by operations the same period in the prior year totaling $2,659,000. Cash flows from operations in the prior year were negatively impacted by insured losses from spring storms incurred during the first quarter.
Total assets as of December 31, 2014 were $144,865,000 compared to $133,980,000 at December 31, 2013. The increase in invested assets and cash during 2014 were the primary contributors to the increase in total assets.
Shareholders' equity as of December 31, 2014 was $42,757,000 up $9,285,000 compared to December 31, 2013 Shareholders' equity of $33,472,000. Book value per share was $17.05 per share at December 31, 2014 compared to $13.42 per share at December 31, 2013, an increase of $3.63. The primary factors contributing to the increase in Shareholders' equity were net income of $7,616,000 and other comprehensive income of $1,836,000. The increase in other comprehensive income was primarily driven by the declining interest rate environment, which increased the market value of our investments in fixed income securities, and an increase in value of our equity investments.
The property and casualty segment composed 88.7% of total premium revenue in 2014 compared to 87.4% in 2013. The P&C segment is primarily composed of dwelling fire and homeowners lines of business. The life segment composed 11.3% of premium revenue in 2014 compared to 12.6% in 2013 with revenue produced primarily from life, accident and supplemental health insurance products. While reading this discussion regarding segment information, reference is made to Note 15 to the Consolidated Financial Statements which provides additional segment related information.
Net premium revenue in NSIC was $6,374,000 at December 31, 2014 compared to $6,591,000 for the same period in 2013; a decrease of 3.3%. The $271,000 decrease in net premium revenue was primarily due to a decline in new business production in both the traditional life and supplemental accident and health insurance products offered in NSIC.
While NSIC composes only 11.3% of premium revenue, the segment makes up 39% of consolidated assets. The majority of these assets consist of fixed income investments. Due to the continued low interest rate environment, net investment income was down 5.3% at $1,925,000 for the year ended December 31, 2014 compared to $2,032,000 for the same period last year. Management believes the portfolio is well positioned to take advantage of a rising rate environment; however, continued low interest rates could lead to continued moderate declines in interest income.
NSIC ended 2014 with net realized investment gains of $455,000 compared to $111,000 for the same period in 2013. Realized investment gains are highly dependent on several factors including market conditions, tax position and liquidity needs of the Company and can vary significantly from period to period. The primary source of realized investment gains in both 2014 and 2013, were gains from the sale of fixed income and equity investments.
Deferred policy acquisition cost amortization and commission expenses decreased $81,000 for the year ended December 31, 2014 at $1,381,000 compared to $1,462,000 for the same period in 2013; a decline of 5.5%. The decline in commission expense was associated with the corresponding decrease in premium revenue of 3.3%.
General and administrative expenses were $1,893,000 in 2014 compared to $2,034,000 in 2013. Reduction of general and administrative expenses in NSIC is currently a major focus of management. Historically, general and administrative expenses in our life segment have run higher than industry averages due to the small size of the subsidiary. This disadvantage coupled with the persistent low interest rate environment has eroded earnings in the life segment. In the second half of 2014, management began the process of implementing significant operational changes that included the consolidation of P&C and life segment operations. This consolidation process is ongoing but is expected to continue to contribute to reductions in NSIC's general and administrative expenses as employees become cross trained and operational areas become more streamlined.
For the year ended December 31, 2014, the life segment had a pretax loss of $290,000 compared to pretax income of $7,000 for the same period in 2013. The increase in claims related expenses coupled with the reduction in investment income were the primary contributors to the decline in pretax income.
The reduction in ceded catastrophe reinsurance cost contributed significantly to the improvement in underwriting margins in our property and casualty segment. The Company maintains catastrophe reinsurance coverage to mitigate loss exposure from catastrophic events. Our catastrophe retention remained unchanged at $4 million and we maintain catastrophe reinsurance covering incurred claims of a single catastrophe event up to $72.5 million after exceeding the retention. Our catastrophe reinsurance also covers the cost of a second event up to the same $72.5 million upper limit. In our reinsurance structure, management attempts to limit the impact on pretax earnings of a single modeled 100 year cat event to no more than $4 million. It is noted, however, that hurricane models are subject to significant risk and are only a tool to estimate the impact of catastrophe events. The Company also has risk associated with multiple smaller catastrophe events that individually may not exceed our $4 million retention.
Additional details regarding the structure of our 2014 catastrophe reinsurance program can be found in Note 10 to the Consolidated Financial Statements.
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 of fixed income or equity investments in 2014 or 2013.
Other income was $550,000 in 2014 compared to $604,000 for the same period in 2013; a $54,000 decrease. Other income consists primarily of fees related to the issuance of our property insurance policies as well as other miscellaneous income. As a percent of net earned premium other income was 1.1% in 2014 compared to 1.3% in 2013.
Gain on company owned life insurance consists of proceeds in excess of cash surrender value on life insurance contracts. The Company owns life insurance (COLI) contracts on certain management and supervisory employees each having a face amount of approximately $2,000,000 (including accumulated cash surrender value). The Company's original investment in company owned life insurance was $5,000,000 made in 2006 and 2007. The primary purpose of the program is to offset future employee benefit expenses through earnings on the cash value of the policies with cash values ultimately returned tax free in the form of death benefits. The Company pays all premium and is the owner and principal beneficiary of these policies. The life insurance contracts are carried on the Consolidated Balance Sheet at their cash surrender value on the balance sheet date. Cash surrender value at December 31, 2014 and December 31, 2013 was $5,513,000 and $5,858,000, 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, 2014 and 2013 was an increase of $68,000 and a decline of $73,000, respectively. Death proceeds from the contracts are recorded when the proceeds become payable under the terms of the policy and proceeds in excess of cash surrender value are recognized as a gain on company owned life insurance. Gains on COLI in excess of cash surrender value of $3,256,000 were recognized in income in 2014. There were no gains on COLI recognized in income in 2013.
The table below provides a recap of P&C segment gross reported losses and LAE by catastrophe event and non-catastrophe wind and hail losses and LAE for the year ended December 31, 2014 and 2013 (dollars in thousands):
During 2014, the P&C segment had reported losses and LAE from seven catastrophe events totaling $2,628,000 from 842 claims compared to reported losses and LAE from ten cat events totaling $4,365,000 from 1,281 claims in 2013. During 2014, the spring storm season was relatively quiet leading to fewer storm related losses and loss adjustment expenses compared to the same period in 2013. In addition, 2014 was the second consecutive year of no hurricane related losses. All catastrophe events in 2014 and 2013 were below our catastrophe reinsurance retention of $4 million so no losses were recovered through our catastrophe reinsurance program during these loss years.
While overall policyholder benefit payments were down in the property and casualty segment due to fewer wind related losses, fire losses reported in 2014 were up $1,297,000 or 10.8% compared to fire losses reported during 2013. The P&C segment had 535 fire losses reported in 2014 totaling $13,299,000 compared to 518 claims reported in 2013 totaling $12,002,000. The average cost per claim was $24,900 for fire losses reported in 2014 compared to $23,200 for fire losses reported in 2013. Many factors can impact the frequency and severity of fire losses, but the primary factor we observe is the duration of cold weather in our coverage areas. House fires tend to be more frequent in winter months due to the use of supplemental heat sources.
Deferred policy acquisition costs totaled $2,565,000 in 2014 compared to $2,576,000 in 2013. Deferred policy acquisition costs were comparable at 5.1% of premium revenue for 2014; down 0.5 percentage points compared to 5.6% of premium revenue for the same period in 2013. Deferred policy acquisition costs consist of amortization of previously capitalized distribution costs, primarily commissions.
General and administrative expenses in the property and casualty segment totaled $6,966,000 in 2014 compared to $5,683,000 in 2013. General and administrative expenses tend to correlate with the change in premium revenue. General expenses were 13.9% of premium revenue in 2014 compared to 12.4% in 2013. The moderate increase in general expenses in 2014 compared to 2013 was primarily related to costs associated with an ongoing rate optimization project and an increase in incentive compensation associated with the improved financial results of the Company.
The P&C segment ended 2014 with pretax net income of $11,527,000 compared to pretax income of $6,266,000 for the same period in 2013. The $5,261,000 increase in pretax income was primarily due to the reduction in catastrophe related claims, improvement in underwriting margins and the gain on COLI.
During 2014, the P&C segment experienced a decrease of six percentage points in the combined ratio compared to 2013. The primary reason for the decrease was a $4,504,000 increase in net premium earned coupled with a $740,000 decline in claims in 2014 compared to 2013. Reported non-catastrophe wind and hail related claims added 11.7 percentage points to the 2014 loss ratio and 13.2 percentage points to the 2013 loss ratio. Catastrophe events increased the loss ratio by 5.2 percentage points in 2014 compared to 9.5 percentage points in 2013. While catastrophe 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 further improve underwriting profitability and reduce earnings volatility.
There has been no material shift in credit quality except for a moderate increase in securities rated AA+ or better. This increase is primarily due to an increase in investment allocation to government agency securities during 2014.
At December 31, 2014, 2.72% of total investments in the fixed income portfolio were classified as below investment grade. In evaluating whether or not the equity loss positions were other-than-temporary impairments, Management evaluated financial information on each company and, where available, reviewed analyst reports from 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. Management has evaluated each security in a significant unrealized loss position. For the year ended December 31, 2014, the Company realized no other-than-temporary impairments related to fixed maturities or equity securities.
Investment returns with respect to the investment portfolio for the years ended December 31, 2014 and 2013 follows:
The total return on investments in 2014 increased significantly compared to 2013. The increase was primarily driven by a decline in market interest rates which led to increases in market value of our fixed income investment holdings. Also, contributing to the increase was a 14.2% increase in equity security investments during the year.
While the increase in interest rates causes near term declines in the value of fixed income securities, we are able to reap the benefit of reinvesting at higher rates as current fixed income investments are called, amortized (mortgage backed securities) or reach contractual maturity. Over the next twelve months, based on cash flow projection modeling that considers such factors as anticipated principal payments on mortgage backed securities, likelihood of call provisions being enacted and regular contractual maturities, we expect approximately 10.2% of our current fixed income portfolio to be reinvested or otherwise available to meet Company obligations.
Net cash used in financing activities totaled $3,420,000 for the period ended December 31, 2014, compared to $4,094,000 for the same period last year. During the year ended December 31, 2014, the Company repaid a $700,000 short-term note payable which was renewed with a two-year term. Also during this period, the Company utilized $1,475,000 from long-term lines of credit and repaid $3,958,000 in long-term debt. As of December 31, 2014, a total of $6,000,000 remained outstanding on the note associated with the Mobile Attic settlement with the next installment due in November of 2015. This installment is $857,000 and is included in short-term notes payable. The Company maintains a $1,000,000 operating line of credit which matures in September 2017 as well as a $700,000 line of credit which matures in February of 2016, $500,000 of which was available at December 31, 2014.
The Company had a total of $18,715,000 of long-term debt outstanding as of December 31, 2014, compared to $20,889,000 at December 31, 2013, which includes $12,372,000 in trust preferred securities issued by the Company in addition to the installment note.
The following table reflects the anticipated cash flows associated with our short- and long-term contractual obligations and commitments as of December 31, 2014 (dollars in thousands):
Contractual obligations reflected in the table above include the issuance of $9,279,000 in subordinated debentures completed on December 15, 2005. The subordinated debentures mature December 15, 2035. It is anticipated that principal payments will not be made before maturity. Also included in long-term debt is the issuance of $3,093,000 in subordinated debentures on June 21, 2007. This issue matures June 15, 2037 and may be prepaid at any time. Also included in long-term debt held by the Company is a line of credit in the amount of $1,000,000 obtained in September 2012. The line of credit had $500,000 drawn at December 31, 2014. 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, 2014, a total of $6,000,000 was outstanding with $857,000 included in short-term notes payable.
The Company's liquidity requirements are primarily met by funds provided from operations of the insurance subsidiaries. The Company receives funds from its subsidiaries through payment of dividends, management fees, reimbursements for federal income taxes and reimbursement of expenses incurred at the corporate level for the subsidiaries. These funds are used to pay stockholder dividends, principal and interest on debt, corporate administrative expenses, federal income taxes, and for funding investments in the subsidiaries. The Company maintains minimal liquidity in order to maximize liquidity within the insurance subsidiaries in order to support ongoing insurance operations. The Company has no separate source of revenue other than dividends and fees from the insurance subsidiaries. Also, dividends from the insurance subsidiaries are subject to regulatory restrictions and, therefore, are limited depending on capital levels and earnings of the subsidiaries.
Our P&C segment is the primary source of dividends to the holding company. Due to a combination of growth opportunities and continued risk of capital exposure to weather related events, management is maintaining a conservative stance with regard to paying of dividends to the holding company. Strengthening capital levels in the insurance subsidiaries remains a priority. However, due to very strong operating results in 2014, the P&C segment was able to pay additional dividends to the holding company which was used to prepay long term debt.
Dividends paid from the insurance subsidiaries are subject to regulatory restrictions and prior approval of the Alabama Department of Insurance. As disclosed in Note 12 to the audited Consolidated Financial Statements, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company during 2015 is statutorily limited to $1,209,000 in the life insurance subsidiary and $6,591,000 in the property/casualty insurance subsidiary. Dividends are limited to the greater of net income (operating income for life subsidiary) or 10% of statutory capital, and regulators consider dividends paid within the preceding twelve months when calculating the available dividend capacity. Therefore, all of the above referenced dividend capacity will not be available for consideration of payment until dividends paid in the preceding twelve months have been considered on a rolling basis. The Company also has to continuously evaluate other factors such as subsidiary operating performance, subsidiary capital requirements and potential impact by rating agencies in making decisions on how much capital can be released from insurance subsidiaries for payment of dividends to NSG. These factors are considered along with the goal of growing year over year statutory surplus in the subsidiaries, and these considerations along with previous adverse impacts on regulatory surplus, will likely lead to dividend payments to NSG substantially below the above referenced regulatory maximums. The Company received $2,500,000 in dividends from its subsidiaries during the year ended December 31, 2014.
The Company continues to monitor liquidity and subsidiary capital closely. Improved underwriting results stemming from the discontinuation of unprofitable lines of business and streamlining of products offered combined with enhancements to the Company's rate development process and improvements in the Company's catastrophe reinsurance structure have reduced the pressure on subsidiary capital levels. However, due to modest levels of growth in premium revenue, it is still necessary to remain cautious and protect subsidiary capital.
The ratios of Total Adjusted Capital to Authorized Control Level RBC for The National Security Group's life/health and property/casualty insurance subsidiaries are all in excess of 4.9 to 1 at December 31, 2014.
National Security Insurance Company (life insurer) has regulatory adjusted capital of $12.9 million and $12.4 million at December 31, 2014 and 2013, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 17.4 and 16.8 at December 31, 2014 and 2013, respectively. Accordingly, National Security Insurance Company exceeds the minimum RBC requirements.
Omega One Insurance Company (property/casualty insurer), which began writing business in late 1995, has regulatory adjusted capital of $9.9 million and $9.0 million at December 31, 2014 and 2013, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 36.1 and 37.7 at December 31, 2014 and 2013, respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.
At December 31, 2014, the estimated reinsurance recoverable recorded was $939,000 compared to $1,501,000 for the same period last year. The Company does not anticipate any issues with collection of the recorded amount. In 2014, catastrophe reinsurance premiums ceded totaled $6,166,000 compared to $7,040,000 ceded in 2013. Catastrophe reinsurance premiums are based on a premium calculation applying the agreed upon rate to the earned premium of the covered lines of business. The decline in ceded premium in 2014 is attributable to a 18% decline in the rate applied. In addition to catastrophe reinsurance, the Company placed reinstatement premium protection (RPP) reinsurance during 2014 and 2013 totaling $1,077,000 and $1,367,000, respectively.
Investments are recorded at fair value based upon quoted prices when available. Quoted prices are available for most investment debt and equity securities included in the financial statements. Further discussion of fair value methodology is discussed in Note 5 to the Consolidated 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 the 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. We have very limited exposure to less liquid and difficult to value investments such as collateralized debt obligations.
terms of the policies. Unearned premiums represent that portion of direct premiums written that are applicable to the unexpired terms of policy contracts in force and is reported as a liability. Prepaid reinsurance premiums represent the unexpired portion of premiums ceded to reinsurers and are reported as an asset.