The Company’s subsidiaries own certain real estate investment properties. We own approximately 2,750 acres of undeveloped timberland in Pike, Coffee and Covington counties in Alabama. The only depreciable improvements on this land include a small pavilion with current accumulated depreciation of $18,000. The timber is accounted for as a natural resource and depleted in accordance with SFAS 19, which identifies 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.
Total revenues for the year decreased 11.97% to $61,233,000 compared to $69,563,000 for 2007. Leading the decrease in total revenue was a 9.62% decline in premium revenue to $56,264,000 in 2008 compared to $62,250,000 for the year 2007. The decline in revenue in the property and casualty subsidiaries combined with an increase in ceded premiums due to catastrophe reinsurance reinstatements were the primary contributors to the decline in premium revenue.
Results of Operations for Years Ended December 31, 2008 and 2007
Net premiums earned totaled $56,264,000 in 2008 compared to $62,250,000 in 2007, a decline of 9.6%. The most significant factors leading to the reduction in premium revenue were a decline in property and casualty premium in the dwelling fire and homeowners lines of business and an increase of $1,335,000 in ceded reinsurance premiums primarily due to the payment of catastrophe reinsurance reinstatement premium triggered by Hurricane Gustav.
Other expenses decreased $762,000 primarily due to declines in commission expense associated with agent bonus commissions and a reduction in deferred compensation expenses.
The life segment composed 12.36% of premium revenue compared to 11.29% in 2007. The life segment consists of the operations of National Security Insurance Company (NSIC).
The following discussion outlines more specific information with regard to the individual operating segments of the Company along with non-insurance related information (primarily administration expenses) associated with the insurance holding Company.
NSIC ended 2008 with premium revenue of $6,956,000 compared to $7,031,000 for the same period last year; a decrease of 1%. Although premium revenue was down slightly overall, revenue in the independent agent method of distribution was over $4,000,000 with premium revenue up 7.4% as compared to 2007. The home service method of distribution ended 2008 with a decline in premium revenue of 2.8% compared to the prior year.
Premium revenue in the life segment remained in a mode of moderate decline in 2008. The current economic downturn combined with the customer base we service with our products contributed to the overall negative impact on potential premium revenue growth. Our typical customer is in the middle income to lower income levels. This group tends to be most severely impacted by economic downturns and reduces our customer’s ability to purchase certain insurance products. Our customers also encounter competing alternatives for their spending dollars and sometimes are forced to reduce or eliminate certain insurance coverage when they have a reduction in household income.
NSIC ended 2008 with year to date net loss of $(859,000) compared to a year to date net loss of $(23,000) for the same period last year. The primary factor contributing to the increase in net losses was an increase in unrealized capital losses due to other than temporary impairments on investments securities.
Premium revenues for the property and casualty segment were down 12% compared to the same period last year. The primary reasons for the decline were the increase in ceded premium related to the reinstatement premium for the catastrophe reinsurance agreement as well as the overall decline the company has experienced in new business over the past 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 severity of claims related to the nineteen catastrophic storms affecting the P&C companies during 2008 totaled approximately $2,400 per claim while the average severity of claims related to Hurricanes Gustav and Ike totaled $2,900 and $3,400, respectively.
The P&C segment was also impacted by the write-down of other than temporary impairments. During 2008, other than temporary impairment losses totaled $1,254,000 in NSFC and $361,000 in Omega One. For information regarding management’s method of determining investment impairment, please see the other than temporary impairment and credit quality section under investments on page 30.
As discussed previously, catastrophe losses related to tornado and windstorm outbreaks in the first half of 2008 coupled with losses in September from Hurricane Gustav and Hurricane Ike were the primary factors contributing to the significant increase in the combined ratio. Tornado and windstorm losses totaling $4,903,000 incurred in the first half of 2008 added 9.9 percentage points to the combined ratio. Losses, net of reinsurance recoveries, from Hurricane Gustav totaled $4,032,000 and added 8.2 percentage points to the 2008 combined ratio. Losses, net of reinsurance recoveries, from Hurricane Ike totaled $3,539,000 and added 7.2 percentage points to the 2008 combined ratio.
A summary of debt and equity securities available for sale with unrealized losses as of December 31, 2008 along with related fair value, aggregated by length of time that the investments have been in a continuous unrealized loss position follows:
The amortized cost and aggregate fair values of investment securities are as follows:
Investment returns with respect to the investment portfolio for the years ended December 31, 2008 and 2007 follows:
The liquidity requirements for the Company are primarily met by funds generated from operations of the life insurance and property/casualty insurance subsidiaries. Premium and investment income as well as maturities and sales of invested assets provide the primary sources of cash for both the life and property/casualty businesses, while applications of cash are applied by both businesses to the payment of policy benefits, the cost of acquiring new business (principally commissions), operating expenses, purchases of new investments, and in the case of life insurance, policy loans.
As of December 31, 2008, the maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows:
It should be noted that the above table represents maturities based on stated maturity. Due to call and prepayment features inherent in some debt securities, actual repayment will differ from stated maturities. The Company routinely evaluates the impact of changing interest rates on the projected maturities of bonds in the portfolio and actively manages the portfolio in order to minimize the impact of interest rate risk.
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 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.
National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $26.8 million and $34.1 million at December 31, 2008 and 2007, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 4.0 and 5.3 at December 31, 2008 and 2007 respectively. Accordingly, National Security Fire & Casualty 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 $9.1 million and $9.6 million at December 31, 2008 and 2007, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 25.2 and 24.4 at December 31, 2008 and 2007, respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.
At December 31, 2008 and 2007, the Company recorded $9,825,000 and $8,993,000, respectively, as an asset for DAC in the financial statements. We do not foresee any issues related to recoverability of these capitalized costs. For more information regarding deferred policy acquisition costs, please see Note 1 to our financial statements.
At December 31, 2008, there is no evidence to suggest to management that any deferred tax asset is unrealizable. For more information regarding deferred income taxes, please see Note 8 to our financial statements.
Omega is licensed in the states of Alabama and Louisiana. Omega operates in property and casualty lines, the most significant of which are homeowners and nonstandard automobile physical damage and liability.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these financial statements are reserves for future policy benefits, liabilities for losses and loss adjustment expenses, reinsurance recoverable asset on associated loss and loss adjustment expense liabilities, deferred policy acquisition costs, deferred income tax assets and liabilities, and assessments of other than temporary impairments on investments. Actual results could differ from those estimates.
Generally, realized gains and losses on sales of other investments are recognized in net income using the specific identification method.
Mortgage loans and policy loans are stated at the unpaid principal balance of such loans. Investment real estate is reported at cost, less allowances for depreciation computed on the straight-line basis.
Other investments consist primarily of investments in notes and equity investments in limited liability companies and company owned life insurance. The Company has no influence or control over the operating or financial policies of the investee limited liability companies and consequently, these investments are accounted for using the cost method. The Company owns life insurance contracts on certain management employees. The life insurance contracts are carried at their current cash surrender value. Changes in cash surrender values are included in income in the current period. Death proceeds from the contracts are recorded when the proceeds become payable under the terms of the policy.
Multiple observable inputs are not available for certain of our investments, primarily private placements and limited partnerships. Management values these investments either using non-binding broker quotes or pricing models that utilize market based assumptions that have limited observable inputs.
Life insurance premiums are recognized as revenues when due. Property and casualty insurance premiums include direct writings plus reinsurance assumed less reinsurance ceded and are recognized on a pro rata basis over the terms of the policies. Unearned premiums represent that portion of direct premiums written that are applicable to the unexpired terms of policies in force and is reported as a liability. Prepaid reinsurance premiums represent the unexpired portion of premiums ceded to reinsurers and is reported as an asset.
The liability for unpaid claims represents the estimated liability for claims reported to the Company and its subsidiaries plus claims incurred but not yet reported and the related adjustment expenses. The liabilities for claims and related adjustment expenses are determined using case-basis evaluations and statistical analyses and represent estimates of the ultimate net cost of all losses incurred through December 31 of each year. Although considerable variability is inherent in such estimates, management believes that the liabilities for unpaid claims and related adjustment expenses are adequate. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in the period in which they are determined.
Earnings per share of common stock is based on the weighted average number of shares outstanding during each year. The adjusted weighted average shares outstanding were 2,466,600 (2,466,600 in 2007).
In the normal course of business, NSFC seeks to reduce the loss that may arise from catastrophes or other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various
areas of exposure with other insurance enterprises or reinsurers. In 2008, NSFC maintained a catastrophe reinsurance agreement to cover losses from catastrophic events, primarily hurricanes.
Layers 1-3 cover events occurring from January1-December 31 of the contract year. The Company placed the 4th layer in July allowing an interim review of exposure and projected storm patterns for the current contract
year. The 4th layer covers events occurring from July 1-June 30 of the contract year. All reinsurers under the program carry A.M. Best ratings of A- (Excellent) or higher.
Reclassifications have been made in the 2007 financial statements and notes to conform to the presentation of the 2008 financial statements.
SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities--requires entities to provide enhanced disclosures about (a) how and why an entity uses derivative instruments, (b) how derivative instruments and related hedged items are accounted for under SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities and its related interpretations and (c) how derivative instruments and related hedged items affect an entity’s financial position, results of operations and cash flows. SFAS 161 requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments and credit-risk related contingent features in derivative instruments. SFAS 161 is to be applied prospectively and is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. In years after initial adoption, SFAS 161 requires comparative disclosures only for periods subsequent to initial adoption. SFAS 161 is a disclosure standard and as such is not expected to impact the Company’s consolidated financial statements when adopted.
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 $250,000 and is included as a component of Other Invested Assets.
In December 2005, the Company formed National Security Capital Trust I, a statutory trust created under the Delaware Statutory Trust Act, for the sole purpose of issuing, in private placement transactions, $9 million of trust preferred 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 $9.3 million 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 million. 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 9, are reported in the accompanying Consolidated Balance Sheet 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 June 2007, the Company formed National Security Capital Trust II for the sole purpose of issuing, in private placement transactions, $3 million of trust preferred 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 $3.093 unsecured junior subordinated deferrable interest debentures. 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 $2.995 million. 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 9, are reported in the accompanying Consolidated Balance Sheet as a component of long-term debt. The Company’s equity investments in the Trust total $93,000 and are included in Other Assets.
The amortized cost and aggregate fair value of debt securities at December 31, 2008, by contractual maturity, are as follows. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
A summary of securities available-for-sale with unrealized losses as of December 31, 2008 and 2007 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:
In determining whether or not unrealized losses are other-than-temporary impairments, the Company does not use set thresholds as exclusive reliance on thresholds removes the ability of management to apply its judgment, a concept that is inherent to the analysis of impairments. All unrealized losses are reviewed to determine whether the losses are other than temporary. Management utilizes positive and negative information on an investment by investment basis to make the determination as to whether an unrealized loss is other-than-temporary. Items that are considered include: the nature of the investment, the cause or causes of the impairment, the number of investment positions that are in an unrealized loss position, the severity and duration of the impairment, industry analyst reports, credit ratings, volatility of the security’s fair value, whether the securities are backed by the U.S. Government or its agencies, the Company’s intent and ability to hold the security and other factors deemed relevant by management. Management has evaluated each security in a significant unrealized loss position. Most unrealized losses in the fixed income portfolio are interest rate driven as opposed to credit quality driven and management believes no ultimate loss will be realized. The Company has no material exposure to sub-prime mortgage loans and less than 2% of the fixed income investment portfolio is rated below investment grade.
SFAS No. 157 establishes a fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. A financial instrument’s categorization within the fair value hierarchy is based upon the lowest level of input that is significant to the fair value measurement. SFAS No. 157 establishes three levels of inputs that may be used to measure fair value:
Level 2 assets include certain of our marketable debt and equity instruments with quoted market prices that are traded in less active markets or priced using a quoted market price for similar instruments. Level 2 assets also include marketable equity instruments with security-specific restrictions that would transfer to the buyer, marketable debt instruments priced using indicator prices which represent non-binding market consensus prices that can be corroborated by observable market quotes, as well as derivative contracts and debt instruments priced using inputs that are observable in the market or can be derived principally from or corroborated by observable market data.
Level 3 assets and liabilities include marketable debt instruments, non-marketable equity investments, derivative contracts, and company issued debt whose values are determined using inputs that are both unobservable and significant to the values of the instruments being measured. Level 3 assets also include marketable debt instruments that are priced using indicator prices that we were unable to corroborate with observable market quotes. Marketable debt instruments in this category generally include asset-backed securities and certain of our floating-rate notes, corporate bonds, and municipal bonds.
For the year ended December 31, 2008, there were no assets or liabilities measured at fair values on a nonrecurring basis.
Effective January 1, 2008, the Company adopted SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities-including an amendment of FASB Statement No. 115, which allows measurement at fair value of eligible financial assets and liabilities that are not otherwise measured at fair value. The Company did not elect the fair value option for any eligible items.
Depreciation expense for the year ended December 31, 2008 was $454,000 ($538,000 for the year ended December 31, 2007).
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 changed from a net deferred tax liability position of $1,231,000 in 2007 to a net deferred tax asset position of $1,839,000 in 2008.
Short-term debt consisted of the following as of December 31, 2008 and December 31, 2007:
The subordinated debentures (debentures) have the same maturities and other applicable terms and features as the associated trust preferred securities (TPS). Payment of interest may be deferred for up to 20 consecutive quarters; however, stockholder dividends cannot be paid during any extended interest payment period or any time the debentures are in default. All have stated maturities of thirty years. None of the securities require the Company to maintain minimum financial covenants. The Company has guaranteed that amounts paid to the Trusts (discussed in Note 2) will be remitted to the holders of the associated TPS. This guarantee, when taken together with the obligations of the Company under the debentures, the Indentures pursuant to which the
The Company’s insurance operations participate in reinsurance in order to limit losses, minimize exposure to large risks, provide additional capacity for future growth and effect business-sharing arrangements. Life reinsurance is accomplished through yearly renewable term. Property and casualty reinsurance is placed on both a quota-share and excess of loss basis. Reinsurance ceded arrangements do not discharge the insurance subsidiaries as the primary insurer, except for cases involving a novation. Failure of reinsurers to honor their obligations could result in losses to the insurance subsidiaries. The insurance subsidiaries evaluate the financial conditions of their reinsurers and monitor concentrations
of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize their exposure to significant losses from reinsurance insolvencies. At December 31, 2008, the largest reinsurance recoverable of a single reinsurer was $607,000. Reinsurance receivables with a carrying value of $14,000 and prepaid reinsurance premiums of $3,000 at December 31, 2007 were associated with a single reinsurer. The amounts of recoveries pertaining to reinsurance contracts that were deducted from losses incurred during 2008 and 2007 were approximately $12,582,000 and $383,000, respectively. The Company incurred gross losses of $18,411,000 (ceded losses of $10,840,000) from covered events occurring in 2008. Amounts reported as ceded incurred losses in 2008 were related to Hurricanes Gustav and Ike as well as due to development of losses from prior year catastrophes.
The Company and its subsidiaries operate primarily in the insurance industry. Selected balance sheet information by industry segment for the years ended December 31, 2008 and 2007 is summarized below:
Premium revenues and operating income by industry segment for the years ended December 31, 2008 and 2007 are summarized below:
Cash paid for interest during 2008 was $1,085,000 ($1,080,000 in 2007). Cash paid for income taxes in 2008 was $500,000 ($2,330,000 in 2007). In 2007, significant noncash transactions included $1,781,000 reduction in accounts receivable of discontinued operations; $428,000 reduction of inventory of discontinued operations; $8,844,000 reduction in property and equipment of discontinued operations; and $9,409,000 reduction of notes payable of discontinued operations.