The Life segment accounted for 9.2% of gross premium revenue in 2017. The Life segment is licensed to underwrite life and accident and health insurance in Alabama, Florida, Georgia, Mississippi, South Carolina, Tennessee and Texas.
The Company's P&C segment is conducted through National Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of National Security Fire & Casualty Company organized in 1992. There is no material differentiation between the products underwritten by NSFC and Omega as both underwrite primarily dwelling personal lines coverage. Due to Omega producing no direct written premium and the fact that Omega is a wholly owned subsidiary of NSFC authorized to underwrite similar lines of business, all references to NSFC or P&C segment 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
All of our insurance companies have been assigned ratings by A.M. Best Co (Best). On March 7, 2017, Best affirmed the financial strength rating (FSR) of B++ (Good) and the issuer credit rating (ICR) of "bbb" of NSFC. 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 stable outlook.
Information in this discussion is presented in whole dollars rounded to the nearest thousand. Tabular amounts are presented in thousands.
Overview-Year Ended December 31, 2017 compared to Year Ended December 31, 2016
Results for 2016 were negatively impacted by Hurricane Matthew which made landfall on the coast of South Carolina during early October 2016. Net of tax, Hurricane Matthew reduced 2016 net income by $2,640,000.
For the year ended December 31, 2017, the Company had a net loss of $1,203,000, $0.48 loss per share, compared to net income of $3,063,000, $1.22 income per share, for the same period in 2016, a decrease of $4,266,000. The primary reason for the decline in 2017 year to date earnings compared to 2016 was the adverse impact of losses incurred from Hurricane Irma coupled with an increase in frequency and severity of catastrophe losses in early 2017 from a very active spring storm season. Net of tax, our reported losses and LAE from 26 catastrophe events in 2017 totaled $9,425,000 compared to 20 cat events in 2016 totaling $6,430,000 after reinsurance recoveries. Also adversely impacting 2017 year to date earnings was a fourth quarter charge to income tax expense of $803,000 from the net impact of recognition and revaluation of deferred tax assets and liabilities due to enactment of the TCJA.
A primary non-GAAP financial measure utilized by management is pretax income (loss) from operations. This measure consists of net income (loss) before income taxes adjusted for realized investment gains and losses. This measure provides a means of comparing the results of our core operations without the impact of items that are more unpredictable and less consistent from year to year. A reconciliation of pretax income (loss) from operations is presented in the table above.
For the year ended December 31, 2017, our pretax loss from operations was $1,348,000 compared to pretax income from operations of $3,096,000 for the year ended December 31, 2016, a decrease of $4,444,000. The primary reason for the pretax loss from operations in 2017 compared to the prior year was an increase in the frequency and severity of catastrophe related claims in the P&C segment. In addition to Hurricane Irma, which occurred in September of 2017, our property and casualty subsidiary was impacted by numerous tornado and severe thunderstorm related catastrophe events in the first half of 2017.
For the year ended December 31, 2017, the P&C segment had a GAAP combined ratio of 102.3%. Reported claims from Hurricane Irma coupled with 25 additional severe weather events in 2017 totaled $14,280,000 and increased the P&C segment combined ratio by 25.7 percentage points. In comparison, for the year ended December 31, 2016, the P&C segment had a GAAP combined ratio of 94.6%. Hurricane Matthew reported claims, net of reinsurance, along with non-hurricane cat event claims totaled $9,742,000 and increased the P&C segment combined ratio 17.5 percentage points. The P&C segment ended 2016 with reported claims from 20 catastrophe events.
Invested assets as of December 31, 2017 were $114,731,000 up $1,575,000, or 1.4%, compared to $113,156,000 as of December 31, 2016. Although invested assets increased in marginally 2017 compared to 2016, growth of invested assets was limited due to an increase in weather related claims in the P&C segment.
The Company, primarily through its insurance subsidiaries, had $6,644,000 in cash and cash equivalents at December 31, 2017, not materially different compared to $7,368,000 at December 31, 2016.
Total assets as of December 31, 2017 were $146,438,000 compared to $148,579,000 at December 31, 2016. Asset growth was hampered in 2017 by increased catastrophe losses in the P&C segment.
Policy liabilities were $76,674,000 at December 31, 2017 compared to $76,174,000 at December 31, 2016; an increase of $500,000 or 0.7%. The primary reason for the increase in policy liabilities in 2017 compared to the same period last year was a $839,000 increase in life segment accident and health and life loss reserves. Life segment loss reserves were up 2.3% in 2017 compared to 2016. While the property and casualty subsidiary had a significant increase in reported claims early in the fourth quarter of 2017 due to Hurricane Irma, over 95% of Hurricane Irma claims were settled by December 31, 2017.
Total debt at December 31, 2017 was $15,639,000 compared to $17,126,000 at December 31, 2016. Debt was reduced $1,487,000 during 2017. The improvement of balance sheet strength through both capital growth and reduction of debt continues to be a primary focus of management.
On December 22, 2017, the President signed the TCJA, a comprehensive tax legislation which, among other things, will reduce the Company's statutory federal income tax rate from 34% to 21% effective January 1, 2018. In addition to the reduction in tax rates, the TCJA makes broad and complex changes to the Internal Revenue Code that will introduce changes to many tax related exclusions, deductions and credits. Among the notable TCJA changes impacting tax expense in 2017, under pre-1984 life insurance company tax laws, a portion of NSIC's gain from operations was not subject to current income taxation, but was accumulated for tax purposes in a memorandum account designated "policyholder surplus". The Deficit Reduction Act of 1984 eliminated further additions to policyholder's surplus but under special rules, the aggregate balance in this account ($2,520,000 at December 31, 2017) would be taxed at current rates only if distributed to shareholders or if the account exceeded a prescribed minimum. Due to the special rules, the Company did not previously recognize the deferred tax liability on amounts designated as policyholder surplus. The TCJA repealed the previously enacted special rules and imposed tax at the 21% statutory rate on the remaining accumulated balance of the account as of December 31, 2017 to be paid over eight years beginning in 2018. Due to enactment of the TCJA the Company established a deferred tax liability at December 31, 2017 on the pre-1984 surplus account in the amount of $529,000.
Deferred tax assets and 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. Due to the enactment of the TCJA, the Company revalued its deferred tax assets and liabilities at December 31, 2017. As a result, the Company recognized $857,000 in income tax expense due to the repeal of a special provision on pre-1984 surplus and a $54,000 income tax benefit due to the change in corporate tax rate from 34% to 21%.
Net earned premium revenues for The National Security Group's two operating segments (Life segment, Property and Casualty segment) are summarized as follows (amounts in thousands):
The property and casualty segment composed 90.0% of total net earned premium revenue in 2017 compared to 89.8% in 2016. Through the P&C segment, we offer primarily dwelling fire and homeowners insurance coverage to our customers. The life segment composed 10.0% of net earned premium revenue in 2017 compared to 10.2% in 2016 with revenue produced 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 earned premium revenue in the life segment was $6,119,000 at December 31, 2017 compared to $6,234,000 at December 31, 2016; a decrease of 1.8%. The $115,000 decrease in net earned 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 10.0% of premium revenue, the segment makes up 41.5% of consolidated assets. The majority of these assets consist of fixed maturity investments. Net investment income was down $111,000 or 5.2% at $2,011,000 for the year ended December 31, 2017 compared to $2,122,000 for the same period last year. While the multi-year trend of low interest rates began to ease in 2017, investment portfolio book yield erosion persisted during the year as maturing investments were typically reinvested at interest rates that were below the rates of maturing investments.
Claims were $5,045,000 through December 31, 2017 compared to $5,285,000 through December 31, 2016; a decrease of $240,000 or 4.5%. NSIC experienced a moderate decrease in life insurance claims in 2017 compared to the same period last year.
Property and casualty segment net premium earned for 2017 was $55,044,000 compared to $55,164,000 for the same period in 2016. The primary reason for the moderate decline in 2017 compared to 2016 was a 3.2% decrease in gross premium revenue in our homeowners program. An increase in catastrophe reinsurance cost (ceded premium) of 7.6% also contributed to our 0.2% decrease in net premium earned.
Under the catastrophe reinsurance program in 2017, the Company retained the first $4,000,000 in losses from each event. Reinsurance coverage for 2017 was maintained in three layers as follows:
we have sought reinsurance coverage to reduce the impact of smaller serial events, it has been challenging to obtain cost effective coverage and structure. However, through improvement in our rate structure and implementation of more adequate risk adjusted rates over the past four years, we were able to limit the adverse impact of the record year for retained catastrophe losses in 2017 on our capital position and expect to achieve higher margins in future years with reduced storm activity.
Net investment income totaled $1,571,000 in 2017 compared to $1,706,000 in 2016; a decrease of $135,000. The primary reason for the decrease in net investment income was a $1,341,000 decrease in P&C segment invested assets in 2017, compared to the same period last year, along with moderate erosion in book yields. While overall market interest rates trended higher in 2017, reinvestment rates were still typically below the interest rates earned on maturing investments, leading to lower reinvestment rates on new investments.
Other income was $593,000 in 2017 compared to $603,000 for the same period in 2016; a $10,000 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 both 2017 and 2016.
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, 2017 and 2016 (dollars in thousands):
To add some perspective to our record year for retained catastrophe losses, on a countrywide basis in the United States, 2017 will go down as one of the costliest years on record. According to the National Oceanic and Atmospheric Administration (NOAA), in 2017, there were 16 weather and climate events with losses exceeding $1 billion each across the U.S. Cumulatively these events generated $306 billion in damages and shattered the previous CPI adjusted record set in 2005 in the aftermath of Hurricanes Dennis, Katrina, Rita and Wilma. Also notable, these 16 events significantly exceeded the 1980-2017 annual average of 5.8 events and the 11.6 annual event average of the last five years. (Source: NOAA National Centers for Environmental Information (2018). https://www.ncdc.noaa.gov/billions/ )
During 2017, we were impacted by 26 catastrophe events producing 3,216 policyholder claims totaling $14,280,000, a Company record for retained catastrophe losses. Net of tax, these losses reduced 2017 net income by $9,425,000 or $3.74 per share. In comparison, the P&C segment was impacted by 20 catastrophe events in 2016, from 3,405 claims totaling $14,128,000 ($9,742,000 net of reinsurance recoveries). Net of tax, 2016 catastrophe losses reduced net income by $6,430,000 or $2.55 per share.
Hurricane Matthew was the largest catastrophe event in 2016. Hurricane Matthew caused $8,386,000 in gross reported losses ($4,000,000 net of reinsurance) from 1,925 claims. This storm struck the Atlantic coast during early October 2016; primarily impacting our policyholders in the states of South Carolina and Georgia. In addition to Hurricane Matthew, 2016 also had an active spring storm season with reported non-hurricane catastrophe event losses totaling $5,742,000 from 1,480 claims.
Non-catastrophe wind and hail claims reported in 2017 totaled $5,649,000 compared to non-catastrophe wind and hail claims reported in 2016 totaling $5,575,000; an increase of $74,000 or 1.3%. During 2017, the P&C segment had 1,596 non-cat wind and hail claims reported (an average of $3,500 per claim) compared to 1,784 claims reported during 2016 (an average of $3,100 per claim). Non-cat wind and hail claims reported during 2017 accounted for 14.9% of total P&C segment incurred losses and LAE in the current year. Non-cat wind and hail claims reported during 2016 accounted for 16.6% of total P&C segment incurred losses and LAE in the prior year.
Year to date policyholder benefit payments were up in the property and casualty segment due to an increase in frequency of reported losses from catastrophe events; however, reported fire losses were down in 2017 compared to 2016. Reported fire losses were down $1,338,000 or 8.7% in 2017 compared to fire losses reported during 2016. The P&C segment had 486 fire losses reported for the year ended December 31, 2017, totaling $13,975,000 compared to 510 fire claims reported for the same period in 2016 totaling $15,313,000. The average cost per claim was $28,800 for fire losses reported in 2017 compared to $30,000 for fire losses reported in 2016.
Commission expense for 2017 was $7,380,000 (13.4% of premium revenue) compared to $7,584,000 (13.7% of premium revenue) for the same period in 2016. The primary reason for the $204,000 decrease in commission expense was a reduction in bonus commissions to agents in 2017 compared to 2016.
General and administrative expenses in the property and casualty segment totaled $6,670,000 in 2017 compared to $6,818,000 in 2016; a decrease of $148,000 or 2.2%. General and administrative expenses were comparable at $12.1% of premium revenue in 2017 and 12.4% of premium revenue in 2016. The $148,000 decline in general and administrative expenses is primarily due to a reduction in employee bonus payments in 2017 due to weather related underwriting losses in the P&C subsidiary.
Insurance taxes, licenses and fees were $2,237,000 through December 31, 2017 compared to $2,005,000 for the same period in 2016. Insurance taxes, licenses and fees were 4.1% of premium revenue in 2017 compared to 3.6% of premium in 2016. The primary reason for the increase in taxes, licenses and fees in 2017 compared to 2016 was a one time charge for state taxes in the P&C segment totaling $185,000.
During 2017, the P&C segment experienced an increase of 7.66 percentage points in the combined ratio compared to 2016. As noted in the table above, catastrophe loss is the primary source of variability in our combined ratio over the past two years and is generally the primary driver of variability in our earnings. While catastrophe events are unpredictable and often occur in cycles, management has sought to increase margins through efficiency measures and improved rate optimization. These efforts helped limit the impact of 2017 catastrophe events on our capital position. We believe that these efforts, while not eliminating earnings volatility, will improve our ability to better absorb the impact of a major catastrophe or increased frequency of smaller catastrophe events and improve our long term average returns on equity. Management also continues to improve rate adequacy, reduce significant exposure concentrations and implement other risk management strategies in order to further improve underwriting profitability and mitigate earnings volatility.
The non-insurance operations of the Company consist of our parent company, The National Security Group, Inc. (NSG). The National Security Group has no material sources of revenue and relies on dividends and management service fees from our insurance subsidiaries to pay expenses. Dividends from subsidiaries are subject to insurance department approval and are subject to statutory restrictions. Subsidiary dividends and service fees are eliminated upon consolidation of the subsidiaries in the audited financial statements included herein and thus are not included in the table below. Revenues and expense for non-insurance operations for the year ended December 31, 2017 and 2016 are summarized as follows (amounts in thousands):
Year Ended December 31, 2017 Compared to Year Ended December 31, 2016:
At December 31, 2017, the Company's holdings in debt securities amounted to 84.9% of total investments and 66.5% of total assets. The Company utilizes the ratings of various Nationally Recognized Statistical Rating Organizations when classifying fixed maturity investments by quality rating.
At December 31, 2017, 6.61% 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 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, 2017, the Company realized no other-than-temporary impairments related to fixed maturities or equity securities.
The amortized cost and aggregate fair value of debt securities at December 31, 2017, by contractual maturity, are as follows (dollars in thousands). 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.
The total return on investments in 2017 remained unchanged at 4.6%. Prior year total return was negatively impacted by a combination of interest rate driven declines in fixed income investments and declines in market value of our energy sector bond holdings. During 2017, market values of our energy sector bonds recovered and our equity investments increased in value leading to an increase in net unrealized capital gains. Also, realized capital gains were higher due to sales of both fixed income and equity investments.
Due to regulatory restrictions, the majority of the Company's cash is required to be invested in investment-grade securities to provide 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 with an average portfolio duration typically of less than 5 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.
Virtually all invested assets of the Company are held in the insurance subsidiaries. As of December 31, 2017, the contractual maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows (dollars in thousands):
At December 31, 2017, the Company had aggregate equity capital, unrealized investment gains (net of income taxes) and retained earnings of $47,625,000, down $427,000 compared to $48,052,000 at December 31, 2016. Components of the change in equity were a net loss of $1,203,000, increase in accumulated unrealized gains on investments of $926,000, a net unrealized gain of $278,000 related to interest rate swaps, common stock issued of $5,000, additional paid-in-capital of $71,000 and cash dividends paid totaling $504,000.
As discussed above, changing interest rates can have a significant impact on the market value of fixed maturity investments. Fixed maturity securities classified as available-for-sale increase the liquidity resources of the Company as they can be sold at any time to pay claims or meet other Company obligations. However, these securities are required to be carried at market value with net of tax accumulated unrealized gains and losses directly impacting shareholder's equity. 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 4% of our current fixed income portfolio to be reinvested or otherwise available to meet Company obligations.
The Company, primarily through its insurance subsidiaries, had $6,644,000 in cash and cash equivalents at December 31, 2017, compared to $7,368,000 at December 31, 2016. Cash provided by operating activities increased cash by $2,316,000 during the year ended December 31, 2017. The increase in cash from operating activities was primarily related to collections of reinsurance recoverable balances associated with Hurricane Matthew. Positive cash flow from operations in 2017 was primarily used to increase fixed maturity investments and reduce debt outstanding. Cash provided by operating activities increased cash by $1,148,000 for the year ended December 31, 2016. The increase in cash provided by operations in 2016 was primarily driven by net income from operations.
Net cash used in investing activities totaled $1,113,000 for the year ended December 31, 2017, compared to cash provided of $684,000 in 2016. Cash used in investing activities in 2017 primarily consisted of investment of positive cash flow from operations.
The following table reflects the anticipated cash flows associated with our short- and long-term contractual obligations and commitments as of December 31, 2017 (dollars in thousands):
Contractual obligations reflected in the table above include the issuance of $9,111,000 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 $3,028,000 in subordinated debentures on June 21, 2007. This issue matures June 15, 2037 and may be prepaid at any time. Also reflected in the table above is a $3,000,000 unsecured loan obtained in December 2016. The current portion of this loan is $800,000 and the long term portion is $2,200,000. The unsecured loan matures in November 2019. The Company drew down $500,000 on a line of credit which is Included in notes payable above.
In estimating the time interval for payment of property and casualty claim reserves, the Company utilized historical payment patterns. By the nature of the insurance contracts under which these liabilities exist, there can be no certainty that actual payments will fall in the periods indicated above. However, management believes that current liquidity and capital resources are sufficient to pay these obligations as they come due. Also, due to the relatively short-tail nature of the majority of the Company's property and casualty claim liabilities, management can conclude with a reasonable level of confidence that historical patterns indicate that approximately 97.2% of claim liabilities at the end of a given year are settled within the following two year period. See Note 9 for additional details on payout patterns.
Our P&C segment is the primary source of dividends to the holding company. Consideration of insurance subsidiary growth opportunities, regulatory capital adequacy, rating agency impact and holding company debt reduction, among other items, are factors that influence our subsidiary dividend requirements. While we have made significant progress over the past five years, continued strengthening capital levels in the insurance subsidiaries and reduction of debt remains a top priority.
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 included in our 2017 Annual Report on Form 10-K, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company during 2018 is statutorily limited to $1,646,000 in the life insurance subsidiary and $3,419,000 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 potential adverse impacts on regulatory surplus, will likely lead to dividend payments to NSG substantially below the above referenced regulatory maximums. The Company received $900,000 in dividends from its subsidiaries during the year ended December 31, 2017.
The Company continues to monitor liquidity and subsidiary capital closely. Improved underwriting results over the past five years stemming from the discontinuation of unprofitable lines of business, generally favorable tropical weather patterns over this period, 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, continuing to strengthen subsidiary capital continues to be a top priority for management.
National Security Insurance Company (life insurer) has regulatory adjusted capital of $15.7 million and $15.1 million at December 31, 2017 and 2016, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 17.6 and 15.2 at December 31, 2017 and 2016, respectively. Accordingly, National Security Insurance Company exceeds the minimum RBC requirements.
National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $34.2 million and $35.2 million at December 31, 2017 and 2016, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 4.7 and 5.1 at December 31, 2017 and 2016, respectively. Accordingly, National Security Fire & Casualty Company exceeds the minimum RBC requirements.
During 2017, the property and casualty segment maintained a catastrophe contract, which covered losses related to a catastrophic event with multiple policyholders affected. In the event a catastrophe exceeded the $4 million company retention stated in the contract, reinsurers would reimburse the company 100% of gross losses up to the upper limits of the reinsurance agreement, which was $72.5 million in 2017 and 2016. Any losses above the $72.5 million upper limit are the responsibility of our Company. The contract in place during 2017 also allowed one reinstatement for coverage under the contract for a second catastrophic event if needed.
The reinsurance related amounts recorded have been estimated based upon management's interpretation of the related reinsurance treaty. Areas in which judgment has been used regarding said estimates include: assessing the financial viability and credit quality of each reinsurer as well as the ability of each reinsurer to pay amounts owed.
Deferred policy acquisition costs (DAC) are those costs incurred in connection with acquiring new business or renewing existing business. DAC is primarily comprised of commissions, premium taxes, and underwriting costs associated
At December 31, 2017 and 2016, the Company recorded $8,124,000 and $8,351,000, respectively, as an asset for DAC in the Consolidated Financial Statements. We do not foresee any issues related to recoverability of these capitalized costs. For more information regarding deferred policy acquisition costs, see Note 1 to our Consolidated Financial Statements.
At December 31, 2017, 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 Consolidated Financial Statements.
At December 31, 2017 and 2016, the recorded liability for loss and loss adjustment expense was $7,075,000 and $7,531,000, respectively, a $456,000 decrease. The decrease in claim and claim adjustment expense reserves is primarily due to a reduction in non-catastrophe reported claims in the fourth quarter of 2017 compared to last year. 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.
The Company's property and casualty subsidiaries, composing 91% of consolidated direct written premium, produced business during 2017 in eight states. However, 55% of property and casualty segment direct written premium is generated in the states of Alabama, Mississippi and Louisiana, subjecting the Company to significant geographic concentration. Consequently, adverse weather conditions or changes in the legal, regulatory or economic environment could adversely impact the Company.
The Company's life, accident and health insurance subsidiary, composing approximately 9% of consolidated direct written premium, is licensed in seven states. However, over 79% of life segment direct premium is generated in the
Securities Held-to-Maturity - Bonds, notes and redeemable preferred stock for which the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts which are recognized in interest income using methods which approximate level yields over the period to maturity.
Securities Available-for-Sale - Bonds, notes, common stock and non-redeemable preferred stock, not classified as either held-to-maturity or trading, are reported at fair value and adjusted for other-than-temporary declines in fair value.
When a fixed maturity security has a decline in value, where fair value is below amortized cost, an other-than-temporary impairment (OTTI) is triggered in circumstances where:
Mortgage loans and policy loans are stated at the unpaid principal balance of such loans, net of any related allowance for loan losses.
Investment real estate is reported at cost, less allowances for depreciation computed on the straight-line basis. Investment real estate consists primarily of undeveloped commercial real estate.
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 basis of the Company's assets and liabilities and capital or 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.
Certain 2016 amounts have been reclassified from the prior year consolidated financial statements to conform to the 2017 presentation.
The Company maintains cash balances which are generally held in non-interest bearing demand deposit accounts subject to FDIC insured limits of $250,000 per entity. At December 31, 2017, the net amount exceeding FDIC insured limits was $5,683,000 at three financial institutions. The Company has not experienced any losses in such accounts. Management of the Company reviews financial information of financial institutions on a quarterly basis and believes the Company is not exposed to any significant credit risk on cash and cash equivalents.
Reinsurance contracts do not relieve the Company of its obligations to policyholders. A failure of a reinsurer to meet its obligation could result in losses to the insurance subsidiaries. Allowances for losses on reinsurance recoverables are established if amounts are believed to be uncollectible. At December 31, 2017 and December 31, 2016, 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, 2017, management does not believe the Company is exposed to any significant credit risk related to its reinsurance program.
In January 2016, the FASB issued guidance that requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. The guidance requires entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes and requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset. The guidance eliminates the requirement for public companies to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. This guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. The Company does not expect the adoption to have a material impact on its financial position, however, the Company does expect adoption of this guidance to increase variability in our results of operations as changes in unrealized gains and losses on equity investments will be reflected in consolidated statements of operations.
In February 2018, the FASB issued guidance to address certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years beginning after June 15, 2018. The Company does not expect the adoption to have a material impact on its financial position or results of operations.
In March 2017, the FASB issued guidance that shortens the amortization period for certain callable debt securities held at a premium and requires the premium to be amortized to the earliest call date. The guidance is effective for fiscal years beginning after December 15, 2018 and interim reporting periods within those fiscal years. The Company does not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows.
In May 2017, the FASB issued guidance to provide clarity and reduce diversity in practice as well as cost and complexity when there is a change in the terms or conditions of a share-based payment award. The guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. The Company does not expect adoption of this guidance to have a significant impact on our financial position, results of operations or cash flows.
In February 2018, the FASB issued guidance that allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. The guidance eliminates the stranded tax effects resulting from the Tax Cuts and Jobs Act and improves the usefulness of information reported to financial statement users. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those periods. Early adoption is permitted. The Company adopted this guidance as of December 31, 2017. The adoption of this guidance resulted in a $435,000 reclassification to accumulated other comprehensive income from retained earnings related to stranded tax effects resulting from the Tax Cuts and Jobs Act.
securities (TPS) and using the proceeds thereof, together with the equity proceeds received from the Company in the initial formation of the Trust, to purchase $9,279,000 of variable rate subordinated debentures issued by the Company. The Company owns all voting securities of the Trust and the subordinated debentures are the sole assets of the Trust. The Trust will meet the obligations of the TPS with the interest and principal paid on the subordinated debentures. The Company received net proceeds from the TPS transactions, after commissions and other costs of issuance, of $9,005,000. The Company also holds all the voting securities issued by the Trust and such trusts are considered to be VIE's. The Trust is not consolidated because the Company is not the primary beneficiary of the trust. The Subordinated Debentures, disclosed in Note 8, are reported in the accompanying consolidated balance sheets as a component of long-term debt. The Company's equity investments in the Trust total $279,000 and are included in Other Assets in the accompanying consolidated balance sheets.
The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2017 are as follows (dollars in thousands):
The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2017 are as follows (dollars in thousands):
The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2016 are as follows (dollars in thousands):
The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2016 are as follows (dollars in thousands):
There were no securities held-to-maturity with unrealized losses as of December 31, 2017.
Management has evaluated each security in a significant unrealized loss position in both the debt and equity investment portfolios. The Company has no material exposure to sub-prime mortgage loans and approximately 6.61% 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.
The Company categorizes assets and liabilities carried at their fair value based upon a fair value hierarchy:
Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2017 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):
As of December 31, 2017, Level 3 fair value measurements of assets include $1,073,000 of equity securities in a local community bank whose value is based on an evaluation of the financial statements of the entity. The Company does not develop the unobservable inputs used in measuring fair value.
As of December 31, 2017, Level 3 fair value measurements of liabilities include $608,000 net fair value of various interest rate swap agreements whose value is based on analysis provided by a third party that utilizes financial modeling tools and assumptions on interest and other factors. The Company does not develop the unobservable inputs used in measuring fair value. Additional information regarding the interest rate swap agreements is provided in Note 8.
The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the years ended December 31, 2017 (in thousands):
The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2016 (in thousands):
For the year ended December 31, 2016, there were no assets or liabilities measured at fair values on a nonrecurring basis.
The carrying amount and estimated fair value of the Company’s financial instruments as of December 31, 2017 and December 31, 2016 are as follows (in thousands):
Depreciation expense for the years ended December 31, 2017 was $121,000 ($159,000 for the year ended December 31, 2016).
Under pre-1984 life insurance company tax laws, a portion of NSIC's gain from operations was not subject to current income taxation, but was accumulated for tax purposes in a memorandum account designated "policyholder surplus". The Deficit Reduction Act of 1984 eliminated further additions to policyholder's surplus but under special rules, the aggregate balance in this account ($2,520,000 at December 31, 2017) would be taxed at current rates only if distributed to shareholders or if the account exceeded a prescribed minimum. Due to the special rules, the Company did not previously recognize the deferred tax liability on amounts designated as policyholder surplus. The TCJA repealed the previously enacted special rules and imposed tax on the remaining accumulated balance of the account as of December 31, 2017 to be paid over eight years at 21% beginning in 2018. Due to enactment of the TCJA the Company established a deferred tax liability at December 31, 2017 on the pre-1984 surplus account in the amount of $529,000.
Deferred tax assets and 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. Due to the enactment of the TCJA, the Company revalued its deferred tax assets and liabilities at December 31, 2017. As a result, the Company recognized $857,000 in income tax expense due to the repeal of a special provision on pre-1984 surplus and a $54,000 income tax benefit due to the change in corporate tax rate from 34% to 21%. 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 positions of $1,487,000 at December 31, 2017 and $2,402,000 at December 31, 2016.
The appropriate income tax effects of changes in temporary differences are as follows (at 34% with the exception of the impact of the change in tax rate which is calculated at 21%)(dollars in thousands):
The Company recognizes tax-related interest and penalties as a component of tax expense. 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 2011. Tax returns have been filed through the year 2016.
net valuation gain of $256,000 (net of tax) was included in accumulated other comprehensive income related to the swap at December 31, 2016.
The claim development table that follows present incurred and cumulative paid claims and adjustment expense by accident year. Information presented is undiscounted and net of reinsurance (dollars in thousands).
As shown in the table above depicting average annual payout of incurred claims, 87.7% of claims are settled within twelve months of the date of loss and cumulatively, 97.2% of claims are settled within two years of the date of loss. While reserves for reported but unpaid and incurred but not reported claims can ultimately prove to be excessive or deficient, the short duration of the Company's claim liabilities serves to lesson the uncertainty compared to longer tail lines of insurance. The Company has no material exposure to difficult to estimate long tail liabilities such as toxic waste cleanup, asbestos related illness or other environmental remediation exposures.
The Company's insurance operations utilize reinsurance in the risk management process in order to limit losses, minimize exposure to large risks, provide additional capacity for future growth and effect business-sharing arrangements. Life reinsurance is placed through yearly renewable term coverage. Property and casualty reinsurance is placed on an excess of loss basis to cover losses from catastrophe events. Reinsurance ceded arrangements do not discharge the insurance subsidiaries as the primary insurer, except for cases involving a novation. Failure of re-insurers to honor their obligations could result in losses to the insurance subsidiaries. The insurance subsidiaries evaluate the financial conditions of their reinsurance companies and monitor concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the companies to minimize their exposure to significant losses from reinsurance insolvencies.
The Company's catastrophe reinsurance contract allows for one reinstatement. The Company maintains reinstatement premium protection (RPP) to cover reinstatement premiums incurred. The RPP further reduces risk from a major catastrophe and serves to protect the Company's capital position by reducing the modeled 100 year event net cost.
In the normal course of business, NSIC seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to reinsurance companies under excess coverage contracts. NSIC retains a maximum of $50,000 of coverage per individual life. Cost is amortized over the reinsurance contract period.
At December 31, 2017, the largest reinsurance recoverable of a single reinsurer was $322,000 ($332,000 at December 31, 2016). Amounts reported as ceded incurred losses were related to development of losses from prior year catastrophes.
The Company and its subsidiaries established an Employee Stock Ownership Plan (ESOP) in January 2010, to enable eligible employees to acquire a proprietary interest in the Company's common stock and to provide retirement and other benefits to such employees. There were $268,000 costs incurred during the year ended December 31, 2017 and $250,000 costs incurred during the year ended December 31, 2016 related to ESOP plan contributions. All contributions were made in cash for purchase of Company shares in the open market. The Company has not allocated newly issued shares directly to the plan and the plan has no debt.
NSFC is similarly restricted in the amount of dividends payable to the Company; dividends may not exceed the greater of 10% of statutory surplus as of the end of the preceding year, or net income for the preceding year. At December 31, 2017, NSFC's retained earnings unrestricted for the payment of dividends in the next twelve months amounted to $3,419,000.
At December 31, 2017, securities with market values of $2,928,000 ($3,026,000 at December 31, 2016) were deposited with various states pursuant to statutory requirements.
During the years ended December 31, 2017 and December 31, 2016, changes in shareholders' equity consisted of net loss of $1,203,000 and net income of $3,063,000, respectively; dividends paid of $504,000 in 2017 and $452,000 in 2016; increases in accumulated other comprehensive income, net of applicable taxes, of $1,204,000 in 2017 and increases in accumulated other comprehensive income, net of applicable taxes, of $482,000 in 2016. Other comprehensive gains and losses consisted of accumulated unrealized gains and losses on securities available-for-sale and unrealized loss on interest rate swaps.
The following table presents the amounts reclassified out of AOCI for the years ended December 31, 2017 (dollars in thousands):
The following table presents the amounts reclassified out of AOCI for the years months ended December 31, 2016 (dollars in thousands):
Total assets by industry segment at December 31, 2017 and at December 31, 2016 are summarized below (dollars in thousands):
Premium revenues and operating income by business segment for the years ended December 31, 2017 and 2016 are summarized below (dollars in thousands):
The Company has reserves set up on litigated claims and the reserves are included in benefit and loss reserves.
Cash paid for interest during the years ended December 31, 2017 was $1,285,000 ($1,360,000 in 2016). The Company received refunds of $754,000 from income taxes during the year ended December 31, 2017. Cash paid for income taxes during the year ended December 31, 2016 was $750,000.