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 1-2 of this report.
The Company ended the year 2011 with a net loss totaling $4,956,000 compared to net income of $3,265,000 in 2010. The Company ended 2011 with a net loss per share of $2.01 compared to net income per share of $1.32 in 2010. A 12.8% increase in policyholder benefits was the primary factor contributing to the net loss in the current year. For the year 2011, policyholder benefits were 78.3% of earned premium compared to 63.7% in 2010, an increase of 14.6 percentage points. Losses and loss adjustment expenses incurred in the P&C segment from increased storm activity during 2011 combined with losses and adjustment expenses from an automobile program were the primary reasons for the increase compared to the same period last year.
Results of Operations for Years Ended December 31, 2011 and 2010
Other income was $919,000 for the period ended December 31, 2011 compared to $1,161,000 for the same period last year; a $242,000 decrease. Other income consists primarily of billing, payment and policy fees related to the issuance of our property and automobile insurance policies in the P&C segment as well as other, primarily non-recurring, miscellaneous income. The primary reason for the decrease was a decline in fee income related to a reduction in policy issuance in the automobile program in the P&C segment during 2011 compared to 2010.
Taxes, licenses and fees were $1,885,000 in 2011, down 9.4% compared to $2,081,000 for the same period last year. The primary reason for the decrease was the reduction in expenses paid in 2011 related to insurance examination
The Company had an income tax benefit totaling $2,643,000 in 2011 compared to income tax expense of $1,372,000 in 2010. Income tax benefit as a percent of net loss before taxes was 34.8% in 2011. The primary reason for the tax benefit in the current year was the operating losses incurred in the P&C segment, coupled with litigation cost in the holding company. The Company ended 2010 with an effective tax rate of 29.6%.
The Company ended 2011 with a net loss of $4,956,000 compared to net income of $3,265,000 for the same period last year. The claims incurred from cat events and adverse underwriting results in the automobile program were the primary contributing factor to the net loss in 2011 compared to net income in 2010. As mentioned previously, policyholder claims increased $4,994,000 compared to the same period last year. In addition, net premiums earned decreased $5,020,000 while net investment income declined $828,000 compared to 2010.
Stockholders equity for the year ended December 31, 2011 was $38,015,000 compared to $43,710,000 at December 31, 2010; a decrease of $5,695,000 or 13%. The change in stockholders equity is composed of dividends paid to shareholders of $1,357,000 and a net loss of $4,956,000 as well as accumulated other comprehensive income, primarily increases in accumulated unrealized capital gains, totaling $1,258,000 and unrealized losses on interest rate swap totaling $640,000. Year-end book value per share, defined as stockholders equity divided by common shares outstanding of 2,466,600, was $15.41 at December 31, 2011 compared to $17.72 at December 31, 2010.
Premium revenues for The National Security Group's two operating segments (Life segment, Property and Casualty segment) is summarized as follows (amounts in thousands):
Net investment income was $1,939,000 for the year ended December 31, 2011 compared to $2,116,000 for the same period last year. Investment income in NSIC is generated from securities held in our investment portfolio as well as mortgage and policy loan interest. The $177,000 or 8.4% decrease was primarily attributable to a decline in average portfolio yield due to historically low interest rates.
NSIC ended 2011 with net realized investment gains totaling $43,000 compared to $420,000 in 2010. Although NSIC recognized $398,000 in other-than-temporary impairment losses on two securities in the current year, we also had recoveries from previously recognized other-than-temporary impairments totaling $384,000. NSIC did not recognize any other-than-temporary impairment losses during 2010. The primary reason for the decline in net realized investment income in 2011 compared to 2010 was management's decision to sell fewer securities. This decision was based on an evaluation of current market conditions.
Policyholder claims decreased $97,000 ending 2011 at $5,189,000 compared to $5,286,000 for the same period last year. The primary reason for the decrease was a decline in claims incurred related to ordinary death and maturity benefits.
General and administrative expenses decreased $85,000 in 2011 compared to 2010. The primary reason for the decline was a decrease in professional and consulting fees in the current year compared to the same period last year.
Year Ended December 31, 2011 Compared to Year Ended December 31, 2010:
Property and casualty segment premium revenue for 2011 was $49,373,000 compared to $54,236,000 for the same period last year; a decrease of 9.0%. The primary reasons for the decrease in premium revenue in 2011 compared to 2010 were the discontinuance of the automobile program in addition to declines in new business writing in our property programs. Furthermore, the P&C segment incurred $1,621,000 in catastrophe reinstatement premium ceded during 2011, accounting for three percentage points of the 9% decrease compared to 2010.
Production of premium revenue in the P&C segment is primarily driven by our dwelling fire, allied lines and homeowner lines of business. The following table provides premiums earned by line of business:
The P&C segment ended 2011 with realized capital gains totaling $666,000 compared to $1,352,000 for the same period last year. The primary reason for the decline in realized capital gains was a reduction in selling activity in the current year compared to the same period last year. The P&C segment was not impacted by the write-down of other-than-temporary impairments in 2011 or 2010.
We routinely evaluate our claims frequency and severity statistics in order to better understand the nature of our risks and aid in the loss reserve liability evaluation process. Claims frequency is a measure of the number of claims incurred during a measurement period regardless of amount. Claims severity is a measure of the average dollar amount of claims during a measurement period. The P&C companies incurred 2,874 claims from seventeen cat events in 2011 compared to 485 claims from ten cat events in 2010. The average severity per claim related to the seventeen non-hurricane cat events affecting the P&C companies during 2011 was $4,900 compared to $3,500 per claim from the ten non-hurricane cat events in 2010. The magnitude of the 2011 cat events lead to the 40% increase in severity per claim compared to 2010. The average severity per claim related to the tornado outbreak on April 25th-27th, 2011, catastrophe 46, was $6,300 and contributed significantly to skewing 2011's average severity upward.
The personal lines automobile program ended 2011 with incurred losses and incurred loss adjustment expenses of $4,226,000 compared to $5,327,000 for the same period last year; a decrease of $1,101,000. Although incurred losses were down in 2011 compared to 2010, net premium earned was also down 34.0%. The loss ratio for the automobile program was 141.2% for the year ended December 31, 2011 compared to 118.8% for the same period last year and was the primary reason for incurred underwriting losses in excess of $2,000,000 in each year. Because of the year over year underwriting losses and significant claim activity associated with this program, the decision was made to terminate the program during the fourth quarter of 2011. The automobile policies are six month coverage periods; therefore, we expect the business to run off quickly. The discontinuance of the automobile program, while contributing to a further decline in premium revenue, is expected to positively impact overall underwriting results provided we do not experience any further adverse development on reported claims, many of which are liability coverage claims which tend to take longer to settle.
The P&C segment continued to be involved in litigation pertaining to claims from Hurricane Katrina which impacted our coverage areas in Louisiana and Mississippi in August 2005. The cumulative claims associated with Hurricane Katrina exceeded the $37,500,000 million upper limit of the reinsurance agreement in effect during 2005. As of December 31, 2011, cumulative claims incurred related to Hurricane Katrina exceeded the reinsurance upper limit by $1,550,000. Although the reinsurance for this catastrophe has been exhausted and the ultimate outcome of the remaining open claims is unknown, the company maintains adequate reserves for the remaining 13 open claims based
The P&C segment ended 2011 with a net loss of $2,125,000 compared to net income of $5,508,000 for the same period last year. The primary reason for the net loss in the current year was the $5,091,000 increase in claims which resulted from the seventeen cat events in 2011 combined with the automobile incurred losses. In addition, net premium revenue was down $4,863,000 in 2011 compared to 2010. The combination of declining revenue and increased claims led to the negative results in the current year compared to the prior year.
A measure used to analyze a property/casualty insurer's underwriting performance is the combined ratio. It is the sum of two ratios:
The results of these ratios for the past two years were:
Maintaining a combined ratio below 100%, which indicates that the company is making an underwriting profit, depends upon many factors including hurricane activity in the Gulf of Mexico and the southern Atlantic coast, strict underwriting of risks, and adequate and timely premium rates. A major hurricane hitting the coast of Alabama, Georgia, South Carolina, Mississippi, Louisiana, or Texas could cause the combined ratio to fluctuate materially from prior years. The property and casualty subsidiaries maintain catastrophe reinsurance to minimize the effect of a major catastrophe; however, prohibitive catastrophe reinsurance costs associated with maintaining lower deductibles prevent us from further mitigating hurricane risks.
During 2011, the P&C segment experienced an increase of 21 percentage points in the combined ratio compared to 2010. The primary reason for the increase was a $5,091,000 increase in incurred losses primarily from tornado, wind and hail related claims as well as incurred losses from the automobile program. The cat events and automobile losses increased the current year combined ratio by 23.5 and 8.9 percentage points, respectively, compared to 2.7 and 9.4 percentage points, respectively in 2010. While cat events are unpredictable and beyond the control of management, measures have been taken to improve underwriting results in the P&C segment. The discontinuance of the private passenger and commercial automobile programs is expected to improve overall P&C segment underwriting results pending no further adverse development related to currently reported claims. Management also continues to evaluate
rate adequacy, exposure concentrations and risk management strategies in order to improve underwriting profitability and reduce earnings volatility.
The non-insurance operations of the Company consist of our parent company, The National Security Group, Inc. The National Security Group has no material sources of revenue and relies almost entirely on dividends from subsidiaries to pay expenses. Dividends from subsidiaries are subject to insurance department approval and are subject to statutory restrictions. Subsidiary dividends are eliminated upon consolidation of the subsidiaries in the audited financial statements included herein. General and administrative expenses totaled $2,057,000 compared to $2,303,000 for the same period last year; a 10.7% decrease. The expenses of NSG are primarily associated with the public listing of our stock, taxes and fees, and directors' fees. The single most significant recurring expense of NSG is interest expense associated with $12,372,000 in debt. This debt is composed of two trust preferred securities offerings, the first being $9,279,000 issued in the December 2005 and the second being $3,093,000 issued in June 2007. The primary use for these proceeds was to add capital to the property and casualty subsidiaries following the hurricanes of 2004 and 2005. Total interest expense for the Group associated with these borrowings in both 2011 and 2010 was $1,091,000. The primary reason for the decline in general expenses in 2011 compared to 2010 was the change in director deferred compensation which reduced general expenses $346,000 in the current year compared to $162,000 in the prior year. Defense cost related to matters disclosed in Note 15 of the Consolidated Financial Statements, was the most significant factor impacting general expenses in both 2011 and 2010. Defense costs incurred in NSG for the year ended December 31, 2011 and 2010 totaled $1,626,000 (79% of total 2011 general expenses) and $1,542,000 (67% of total 2010 general expenses), respectively.
At December 31, 2011, the company's holdings in debt securities amounted to 74.9% of total investments and 57.7% of total assets. The Company utilizes the ratings of various Nationally Recognized Statistical Rating Organizations when classifying fixed maturity investments by quality rating. The most significant shift in quality ratings occurring in 2011 was the downgrade of US Government debt by S&P from their highest rating of AAA to AA+. Moody's and Fitch continued to carry US Government debt at their highest rating throughout 2011. Due to the split ratings of the major
At December 31, 2011, 3.65% of total investments in the fixed income portfolio were classified as below investment grade. Management has evaluated each security in a significant unrealized loss position. For the year ended December 31, 2011, the Company realized $398,000 in other-than-temporary impairments. Most of the remaining unrealized losses in the fixed income portfolio, for which no impairment has been realized, are interest rate driven as opposed to credit quality driven and management believes no ultimate loss will be realized. 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 remaining securities in an accumulated loss position in the portfolio were temporary impairments.
During 2011, recoveries on securities for a portion of which other-than-temporary impairments were realized totaled
The amortized cost and aggregate fair value of debt securities at December 31, 2011, 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 mortgage-backed bonds are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than were expected at the time of purchase. Securities that are purchased at a premium to par value and prepay faster than expected will incur a reduction in yield or loss. Securities that are purchased at a discount to par value and prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between amortized cost and par value, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. In order to minimize risk associated with prepayments on collateralized mortgage obligations, the Company typically invests primarily in more predictable planned amortization class (PAC) structures of CMO's and typically avoids investment in CMO's priced at significant premiums above par value.
Investment returns with respect to the investment portfolio for the years ended December 31, 2011 and 2010 follows:
The decrease in current yield on investments is primarily due to the reinvestment of proceeds received from investment
maturities at lower interest rates. Also impacting the decrease in net investment income was a reduction in float associated with the automobile program. Float in the insurance subsidiaries results from the investment of claim reserves and a portion of unearned premium reserves between the time insurance contract payments are received from the insured and claim obligations are settled.
The Company maintains a repurchase agreement under which the policy requires 102% (100% minimum) of the fair value of the securities purchased to be maintained as collateral. Cash collateral received is invested in short-term investments. The repurchase investments are limited to government securities that are highly liquid. The company does not have any reverse repurchase agreements.
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, or effective maturities, 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. Currently, for every 100 basis point change in interest rates the Company will incur a change in market price of the fixed income portfolio of approximately 4%.
The National Security Group's consolidated statement of cash flows indicates that cash flow used in operating activities was $6,752,000 in 2011 compared to net cash flows provided by operating activities of $2,793,000 in 2010. The primary reasons for the decline in operating cash flow was a reduction in net income related to declines in earned premium and increased losses in the auto program coupled with catastrophe losses and related reinstatement premium incurred during the second quarter. Also largely associated with the catastrophe losses and the decline in cash flow from operations were increases in reinsurance recoverable of $1,079,000 and a decline in accrued income taxes totaling $1,796,000.
requirements. In 2010, a decline in underwriting profits decreased cash from operations resulting in a reduction in the cash available to invest.
Included in long-term debt held by the Company is the issuance of $9,279,000 in subordinated debentures completed on December 15, 2005. The proceeds from the debentures were used to make a $6,000,000 capital infusion in the P&C subsidiary National Security Fire and Casualty with the remainder to be held for general corporate purposes. The subordinated debentures mature December 15, 2035. It is anticipated that principal payments will not be made until the expiration of the fixed rate period on the debt in 2015. Also included in long-term debt is the issuance of $3,093,000 in subordinated debentures completed June 21, 2007. The proceeds from the debentures were used to fund general corporate expenses thereby reducing the amount of dividends to the Group paid by the P&C subsidiary National Security Fire & Casualty in 2007 and 2008 thereby continuing to restore capital in the P&C subsidiary National Security Fire and Casualty to pre-hurricane levels. The second issue matures June 15, 2037 and may be redeemed following the fifth anniversary of issuance.
As disclosed in Note 15 to the Consolidated Financial Statements regarding contingencies, the Company is involved in litigation related to the sale of Mobile Attic, Inc. As is customarily discussed in the Management Discussion and Analysis, the Company's liquidity requirements are primarily met by funds provided from operations of the insurance 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, which composes the largest segment of our insurance operations, incurred substantial operating losses in 2011. These operating losses contributed to a decline of over 16% in capital levels in the segment. These reduced capital levels, while adequate to operate our existing business, have substantially reduced our ability to pay dividends upstream to the holding company in the near term. We have also paid over $1,600,000 in defense related cost associated with the Mobile Attic litigation over the past two years with ultimate defense cost expected to exceed $2,000,000 before trial, set for June of 2012. This litigation related defense cost has further reduced cash reserves in the holding company. In the event of a substantial adverse judgment related to the litigation against the Company, we could face limitations in our ability to fund shareholder dividends and service interest payments on outstanding debt.
The uncertainty related to the pending litigation could also temporarily impair our ability to raise new debt or equity capital until this matter is resolved. The Company is vigorously defending the allegations raised in this litigation and is unable to determine a potential liability at this time which limits our ability to predict the ultimate impact on our liquidity and capital resources.
The Company's business is concentrated primarily in the Southeastern United States. Accordingly, unusually severe storms or other disasters in the Southeastern United States might have a more significant effect on the Company than on a more geographically diversified insurance company. However, the Company's P&C subsidiaries maintain a catastrophe reinsurance program to limit the effect of such catastrophic events on the Company's financial condition. The Company's deductible under the terms of the reinsurance contract in place during 2011 totaled $3.5 million; however, the Company's P&C subsidiaries maintained cash and short-term investments in sufficient amounts to cover the deductible payment. In the event of a major storm impacting the P&C subsidiaries in 2012, similar to the spring storm occurrence in 2011, we could face further pressures and/or limitations in the subsidiaries ability to pay dividends to the Company which could force us to suspend dividend payments to shareholders and limit our ability to service interest payments on outstanding debt.
The Company maintains an operating line of credit to allow flexibility with respect to cash management at the holding company level. The outstanding balance at December 31, 2011 was $485,000.
National Security Insurance Company (life insurer) has regulatory adjusted capital of $11.5 million and $11.0 million at December 31, 2011 and 2010, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 14.6 and 12.4 at December 31, 2011 and 2010, respectively. Accordingly, National Security Insurance Company exceeds the minimum RBC requirements.
National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $25.5 million and $30.5 million at December 31, 2011 and 2010, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 3.8 and 5.1 at December 31, 2011 and 2010, 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 $7.4 million and $9.0 million at December 31, 2011 and 2010, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 11.3 and 12.8 at December 31, 2011 and 2010, respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.
NSFC and Omega generally reinsure with third parties any liability in excess of $225,000 on any single policy. During 2011, 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 $3.5 million retention stated in the contract, reinsurers would reimburse the company 95% (5% co-pay) of gross losses and loss adjustment expenses paid up to $17.5 million (layer one and layer two of the contract). If losses exceeded $ 17.5 million, the contract allowed for 100% reimbursement of losses and loss adjustment expenses up to $72.5 million. Any losses above the $72.5 million upper limit were the responsibility of our company. The contract in place during 2011 also allowed one reinstatement for coverage under the contract for a second catastrophic event if needed. The contract provided protection which exceeded a 100 year “near term” event as depicted in catastrophe modeling results. The “near term” catastrophe modeling results reflect a predicted increase in storm activity given the current weather pattern and various factors projected to impact our weather patterns in the near term.
A reduction in DAC is recognized if the sum of the expected loss and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and projected investment income. Management reviews DAC calculations throughout the year to establish and assess their recoverability. Changes in management's assumptions, estimates or judgment with respect to calculating DAC could materially impact our financial statements
Property and casualty loss reserves are maintained to cover the estimated unpaid liability for losses and loss adjustment expenses with respect to reported and unreported incurred claims. Loss reserves are an estimation based on actuarial projection techniques common in the insurance industry. Reserves are management's expectations of what the settlement and administration of claims will cost. Management estimated reserves are based on historical settlement patterns, estimated salvage and subrogation, and an appraisal of the related facts and circumstances. Management's reserve estimates are reviewed by consulting actuaries to determine their adequacy and reasonableness. The reserve analysis performed by management is reviewed by the actuaries during the third quarter each year with a final comprehensive review and actuarial sign off performed at year-end.
At December 31, 2011 and 2010, the recorded liability for loss and loss adjustment expense was $14,386,000 and $13,184,000, respectively, a $1,202,000 increase. Claim activity from catastrophe related losses combined with increased automobile claims were the primary factors contributing to the increase. We believe the estimate of unpaid losses and loss adjustment expenses to be sufficient based on currently available information and a review of our historical reserving practices. For more information regarding loss and loss adjustment expense, see Note 9 to our Consolidated Financial Statements.
Liabilities for loss contingencies arising from, but not limited to, litigation, claims, assessments, fines and penalties are recorded when it is probable that a liability has been incurred and the amount of the assessment and/or remediation can be reasonably estimated. Additional details with respect to contingencies are disclosed in Note 15 to the accompanying Consolidated Financial Statements.
Effective for interim and annual reporting periods beginning after December 15, 2010, the FASB revised guidance to require additional disclosure about purchases, sales, issuances, and settlements in the roll forward activity in Level 3 fair value measurements. We adopted the guidance on January 1, 2011; adoption did not have a material effect on our results of operations or financial position.
Effective for interim and annual reporting periods beginning after December 15, 2011, the FASB revised guidance related to fair value measurements and disclosures, all of which are to be applied prospectively. The new guidance increases disclosure requirements regarding valuation methods used to determine fair value measurements categorized as Level 3, as well as the sensitivity to change of those measurements, and requires additional disclosures regarding the consideration given to highest and best use in fair value measurements of nonfinancial assets. The guidance requires that when fair value measurements of items not carried at fair value are disclosed, the fair value measurements are to be categorized by level of fair value hierarchy. Additionally, the guidance also clarifies or revises certain fair value measurement principles related to the valuation of financial instruments managed within a portfolio, the valuation of instruments classified as a part of shareholders' equity, the appropriate application of the highest and best use valuation premise, and the consideration of premium and discounts in a fair value measurement. We are currently evaluating the impact of this revised guidance. However, we do not expect a material effect on our results of operations or financial position upon adoption in 2012.
Effective for fiscal years beginning after December 15, 2011, the FASB revised guidance regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. The guidance permits deferral of qualifying costs associated only with successful contract acquisitions. The portion of internal selling agent and underwriter salary and benefit costs allocated to unsuccessful contracts, as well as advertising costs, are excluded. The guidance should be applied prospectively, but may be applied retrospectively for all prior periods. We are currently evaluating the impact of this revised guidance on our financial statements. However, we do not expect a material effect on our results of operations or financial position upon adoption in 2012.
We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. as of December 31, 2011 and 2010, and the related consolidated statements of income (loss), shareholders' equity and cash flows for the years then ended. The Company's management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The National Security Group, Inc. as of December 31, 2011 and 2010, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the financial statement schedules listed in the accompanying index appearing under Item 8, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.
The accompanying condensed consolidated financial statements include the accounts of The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries: National Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and NATSCO, Inc. (NATSCO). NSFC includes a wholly-owned subsidiary - Omega One Insurance Company (Omega) . The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP). All significant intercompany transactions and accounts have been eliminated.
The significant accounting policies followed by the Company and subsidiaries that materially affect financial reporting are summarized below.
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, assessments of other-than-temporary impairments on investments and accruals for contingencies. Actual results could differ from these estimates.
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.
Trading Securities. Trading securities are classified as such on the balance sheet and reported at fair value.
Unrealized gains and losses on investments, net of tax, on securities available-for-sale are reflected directly in shareholders' equity as a component of accumulated other comprehensive income, and accordingly, have no effect on net income until realized.
Interest on fixed income securities is credited to income as it accrues on the principal amounts outstanding adjusted for amortization of premiums and accretion of discounts computed utilizing the effective interest rate method. Premiums and discounts on mortgage backed securities are amortized or accreted using anticipated prepayments with changes in anticipated prepayments accounted for prospectively. The model used to determine anticipated prepayment assumptions for mortgage backed securities uses separate home sale, refinancing, curtailment and pay-off assumptions derived from a variety of industry sources. Mortgage-backed security valuations are subject to prospective adjustments in yield due to changes in prepayment assumptions. The utilization of the prospective method will result
Investments with other-than-temporary impairment in value are written down to estimated realizable values and losses recognized in the determination of net income. The fair value of the investment becomes its new cost basis.
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 are reported as an asset.
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 in both 2011 and 2010.
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 2011, NSFC maintained a catastrophe reinsurance agreement to cover losses from catastrophic events, primarily hurricanes.
Liabilities for loss contingencies arising from, but not limited to, litigation, claims, assessments, fines and penalties are recorded when it is probable that a liability has been incurred and the amount of the assessment and/or remediation can be reasonably estimated. Significant attorney fees are estimated and recorded when incurred.
The Company maintains cash balances which are generally held in non interest bearing demand deposit accounts. Through December 31, 2012, these balances are insured by the FDIC with no balance limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.
Effective for interim and annual reporting periods beginning after December 15, 2010, the FASB revised guidance related to goodwill impairment testing. The revised guidance clarifies that when evaluating goodwill associated with a reporting unit that has a zero or negative carrying value, an initial determination should be made as to whether it is more likely than not that the goodwill is impaired. When impairment is more likely than not, the goodwill is required to be tested for impairment. We adopted the guidance on January 1, 2011. Adoption did not have a material effect on our results of operations or financial position.
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) which vary in certain respects from reporting practices prescribed or permitted by insurance regulatory authorities. The significant differences for statutory reporting include: (a) acquisition costs of acquiring new business are charged to operations as incurred, (b) life policy liabilities are established utilizing interest and mortality factors specified by regulatory authorities, (c) the Asset Valuation Reserve (AVR) and the Interest Maintenance Reserve (IMR) are recorded as liabilities, and (d) non-admitted assets (furniture and equipment, agents' debit balances and prepaid expenses) are charged directly to surplus.
The amortized cost and aggregate fair value of debt securities at December 31, 2011, by contractual maturity, are as follows (dollars in thousands):
There were no securities held-to-maturity with unrealized losses as of December 31, 2011. A summary of securities held-to-maturity with unrealized losses as of December 31, 2010 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 (dollars in thousands):
Management has evaluated each security in a significant unrealized loss position. For the year ended December 31, 2011, the Company realized $398,000 in other-than-temporary impairments. No impairments were recognized during 2010. Most of the remaining unrealized losses in the fixed income portfolio, for which no impairment has been realized, 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 4% of the fixed income investment portfolio is rated below investment grade. In evaluating whether or not the equity loss positions were other-than-temporary impairments, Management evaluated financial information on each company and where available reviewed analyst reports from at least two independent sources. Based on a review of the available financial information, the prospect for future earnings of each company and consideration of the Company’s intent and ability to hold the securities until market values recovered, it was determined that the remaining securities in an accumulated loss position in the portfolio were temporary impairments.
Our available-for-sale securities consists of fixed maturity and equity securities which are recorded at fair value in the accompanying condensed consolidated balance sheets. The change in the fair value of these investments, unless deemed to be other than temporarily impaired, is recorded as a component of other comprehensive income.
Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2011 are summarized in the following table by the type of inputs applicable to the fair value measurements (dollars in thousands):
For the year ended December 31, 2011, there were no assets or liabilities measured at fair values on a nonrecurring
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, 2010 (dollars in thousands):
Other invested assets-the carrying amount is a reasonable estimate of fair value.
The carrying amount and estimated fair value of the Company’s financial instruments as of December 31, 2011 and 2010 are as follows (dollars in thousands):
Net deferred tax liabilities are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax laws. Management believes that, based on its historical pattern of taxable income, the Company will produce sufficient income in the future to realize its deferred tax assets. The Company recognized net deferred tax liability positions of $86,000 at December 31, 2011 and $1,043,000 at December 31, 2010.
Total income tax expense varies from amounts computed by applying current federal income tax rates to income before income taxes. The reason for these differences and the approximate tax effects are as follows (dollars in thousands):
The aggregate balance in this account, $2,520,000 at December 31, 2011, would be taxed at current rates only if distributed to shareholders or if the account exceeded a prescribed minimum. The Deficit Reduction Act of 1984 eliminated additions to policyholders' surplus for 1984 and thereafter. Deferred taxes have not been provided on amounts designated as policyholders' surplus. The deferred income tax liability not recognized is approximately $857,000 at December 31, 2011.
Long-term debt consisted of the following as of December 31, 2011 and December 31, 2010 (dollars in thousands):
On March 19, 2009, the Company entered into a forward swap effective September 17, 2012, which will also hedge against changes in cash flows following the termination of the 5 year swap agreement discussed previously. Commencing September 17, 2012, under the terms of the forward swap, the Company will receive interest at the three-month LIBOR rate plus 3.4% and pay interest at the fixed rate of 7.02%. This forward swap will effectively fix the interest rate on $3,000,000 in debt until September of 2019.
The swaps entered into in 2007, 2009 and 2010 have fair values of $66,000 (liability), $373,000 (liability) and $757,000 (liability), respectively, for a total liability of $1,196,000 at December 31, 2011 ($227,000 at December 31, 2010). The swap liability is reported as a component of other liabilities on the consolidated balance sheets. A net valuation loss of $640,000 is included in accumulated other comprehensive income related to the swap agreements for the current period. A net valuation loss of $90,000 was included in accumulated other comprehensive income related to the swap at December 31, 2010.
The Company’s interest rate swaps include provisions requiring the Company to post collateral when the derivative is in a net liability position. The Company has cash collateral on deposit of $310,000 (none at December 31, 2010) in addition to securities on deposit with fair market values of $877,000, all of which is posted as collateral. At December 31, 2010, the Company had securities on deposit with fair market values of $822,000 ($660,000 of which was posted as collateral). See Note 5 for additional information about the interest rate swaps.
In December of 2010, the Company renewed an unsecured line of credit for $700,000, with an interest rate of 5%, to be made available for general corporate purposes. As of December 31, 2011, $485,000 was drawn on this line ($500,000 at December 31, 2010). The line of credit matured January 5, 2012 and was subsequently renewed under the same terms as disclosed in the table above.
The 2011 increase in the provision for claims and claim adjustment expenses arising from claims in the current year and the ending reinsurance recoverable on unpaid losses are attributable to the increase in claim activity related to spring storm losses including the tornado catastrophe in late April as well as an increase in claims related to the automobile program.
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, 2011, the largest reinsurance recoverable of a single reinsurer was $574,000 ($278,000 in 2010). The Company incurred losses in excess of its retention from tornado related losses in April 2011. Losses incurred by the Company from this covered event totaled $10,030,000. Amounts reported as ceded incurred losses in 2011 were primarily related to the spring catastrophe and included development of losses from prior year catastrophes. The Company incurred no losses from covered events occurring in 2010. Amounts reported as ceded incurred losses in 2010 were related to development of losses from prior year catastrophes.
In 1989, the Company and its subsidiaries established a retirement savings plan (401K Plan) and transferred the assets from the defined contribution profit sharing plan into the new plan. All full-time employees are eligible to participate, and all employer contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Company matching contributions for 2011 and 2010 amounted to $216,000 and $239,000, respectively. The Company contributes dollar-for-dollar matching contributions up to 5% of compensation subject to government limitations.
Contributions to the plan are fully vested upon the earlier of death, disability, change in control, or ten years of participation in the plan. Costs for amounts credited of the non-qualified deferred compensation plans for 2011 and 2010 amounted to approximately $68,000 and $254,000, respectively.
At December 31, 2011, securities with market values of $3,786,000 ($3,597,000 at December 31, 2010) were deposited with various states pursuant to statutory requirements.
Selected balance sheet information by industry segment for the years ended December 31, 2011 and 2010 is summarized below (dollars in thousands):
The Company has been sued in a putative class action in the State of Alabama. The Plaintiff alleges entitlement to, but did not receive, payment for general contractor overhead and profit (“GCOP”) in the proceeds received from the Company concerning the repair of the Plaintiff's home. Plaintiff alleges that said failure to include GCOP is a material breach by the Company of the terms of its contract of insurance with Plaintiff and seeks monetary damages in the form of contractual damages. A class certification hearing was held on March 1, 2010 with the trial court taking the Plaintiff's motion for class certification under advisement. On May 10, 2010, the trial court issued its ruling granting Plaintiff's motion to certify the class. The Company filed its Appellant Brief on October 5, 2010. The Company denies Plaintiff's allegations and intends to vigorously defend this lawsuit. On November 18, 2011, the Supreme Court of Alabama ruled the trial court exceeded its discretion in granting Plaintiff's motion for class certification. Accordingly, the Alabama Supreme Court vacated the trial court's order granting class certification and remanded this case for proceedings consistent with the opinion.
On August 13, 2009, the Court granted the Company's motion to intervene. At the request of the Court, each party filed an amended complaint on or before August 23, 2010. The Purchaser has asserted counterclaims against the Company for losses incurred as a result of failure to disclose material facts or alleged innocent, negligent or reckless false representations made to induce Purchaser to enter into the Stock Purchase Agreement, breach of the Stock Purchase Agreement and indemnification of Purchaser's losses and damages as a result of the breach of representations and warranties in the Stock Purchase Agreement.
The Company has denied the allegations supporting Purchaser's claims. The financial records of Mobile Attic have been in the possession of Purchaser since Purchaser acquired the stock of Mobile Attic in early 2007 and are only available to the Company through discovery in the litigation. The Company actively conducted discovery in defense of Purchaser's claims and has requested Purchaser to provide the financial information supporting the allegations made in its complaint. Fact-based and expert discovery has concluded, but pre-trial investigation continues with the case set for trial in June 2012. The Company believes that the Purchaser's claim for damages is unreasonable and excessive even if the Purchaser is able to prove the alleged misrepresentations in Mobile Attic's financial statements. The Company believes that if any damages are applicable due to any alleged breach of warranty in the Stock Purchase Agreement, those damages are limited to a diminished value of the stock price paid by the Purchaser. The Company has filed motions for summary judgment requesting a court ruling, among others, as to how damages should be measured as a matter of law. Given the difficulty in obtaining access to the Mobile Attic financial records, continuing pre-trial investigation, and the outstanding legal issues, the Company is unable to predict the amount of the ultimate liability that the Company may have if the Purchaser is successful in this litigation. Management has recorded an estimate of aggregate litigation related defense costs associated with these actions as of December 31, 2011 and December 31, 2010, and the amounts are included in other liabilities in the accompanying condensed consolidated financial statements.
Schedule I. Summary of Investments Other Than Investments in Related Parties