Our principal executive offices, owned by NSIC, are located at 661 East Davis Street, Elba, Alabama. The executive offices are shared by the insurance subsidiaries. The building was constructed in 1977 with an addition added in 2008. The Company expansion and renovation project completed in early 2008, added an additional 4,684 square feet and renovated 3,017 square feet of the existing structure. The executive offices total approximately 30,700 square feet. The Company believes this space to be adequate for our immediate needs.
The following discussion highlights significant factors influencing the consolidated financial position and results of operations of The National Security Group, Inc. (referred to in this document as we, our, us, the Company or NSEC) and its subsidiaries. We are a “smaller reporting company” under Securities and Exchange Commission (SEC) regulations and therefore qualify for the scaled disclosure of smaller reporting companies. In general, the same information is required to be disclosed in the management discussion and analysis by smaller reporting companies except that the discussion need only cover the latest two year period and disclosures relating to contractual obligations are not required. In accordance with the scaled disclosure requirements, this discussion covers the two year period ended December 31, 2013.
The National Security Group, Inc. is made up of two segments: the Life segment and the P&C segment. The Company's life, accident and health insurance business is conducted through National Security Insurance Company (NSIC), a wholly owned subsidiary of the Company organized in 1947. The Company's property and casualty insurance business is conducted through National Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of National Security Fire & Casualty Company organized in 1992.
The National Security Group operates in the property and casualty and life, accident and supplemental health insurance businesses and markets products primarily through independent agents. The Company operates in ten states with 50.4% of total premium revenue generated in the states of Alabama and Mississippi. Property and casualty insurance is the most significant segment, accounting for 89.0% of gross insurance premium revenue in 2013. Revenue generated from the life segment accounted for 11.0% of gross insurance premium revenue in 2013.
National Security Insurance Company (NSIC) is a life, accident and health insurance company founded in 1947. The premium revenue produced in NSIC from the traditional life products and accident and health products accounted for 7.8% and 3.2%, respectively, of total gross premium revenue. All references to NSIC in the remainder of this management discussion and analysis will refer to the combined life, accident and health insurance operations and will compose the life segment of the Company. NSIC is licensed to underwrite life and accident and health insurance in Alabama, Florida, Georgia, Mississippi, South Carolina, Tennessee and Texas.
The property and casualty subsidiaries have been assigned ratings by Demotech, Inc. On November 22, 2013, Demotech affirmed a Financial Stability Rating of A (Exceptional) for both NSFC and Omega.
For the year ended December 31, 2013, the Company had net income totaling $5,658,000, $2.28 per share, compared to a net loss of $6,671,000, $2.70 loss per share, for the year ended December 31, 2012. On a pretax basis, for the year ended December 31, 2013, we had income of $7,323,000 compared to a loss of $11,064,000 for the year in 2012. Our pretax income for the year ended December 31, 2013, consisted of income from operations of $2,884,000 and realized investment gains of $4,439,000. The pretax loss for the year ended December 31, 2012, consisted of a loss from operations of $526,000, realized investment gains of $2,790,000 and expenses associated with a non-insurance related litigation settlement (Mobile Attic Litigation) of $13,328,000.
For the year ended December 31, 2012, pretax income was adversely impacted by litigation related settlement expenses of $13,328,000. This settlement was associated with previously disclosed litigation stemming from the sale of a holding company investment, Mobile Attic Inc., and was not associated with either of our insurance segments. Since this action was settled in 2012, our 2013 results were not impacted by this litigation.
The significant improvement in income from operations in 2013 compared to the prior year was primarily associated with improved underwriting results in the property and casualty segment. Favorable weather patterns during 2013, particularly in the second half of the year, contributed to a $1,918,000 decrease in non-catastrophe related wind and hail claims. In addition, fire related losses were down $725,000 compared to 2012. Our 2012 results were adversely impacted by losses from Hurricane Isaac. Losses from Hurricane Isaac increased our incurred losses in 2012 by $3,390,000.
Results of Operations for Years Ended December 31, 2013 and 2012
Consolidated net earned premium revenue was $52,366,000 for the year ended December 31, 2013 compared to $51,815,000 for the same period last year; an increase of $551,000 or 1.1%. The P&C segment was the primary source of the increase in net earned premium ending December 31, 2013, at $45,775,000 compared to $45,206,000 for the same period last year; an increase of $569,000. With the termination of all automobile lines of business in 2012 and the discontinuation of our marine program in June 2013, we have streamlined our property and casualty operations to focus on the home insurance market. With a combination of rate adjustments and modest organic growth, we increased P&C segment net earned premium by 1.3% in 2013 compared to 2012.
While gross premium earned from our dwelling fire program increased 8.0% in 2013 compared to the same period last year, this was partially offset by a 2.0% decline from our homeowners programs as well as the reduction in premium from the discontinued automobile and ocean marine programs.
P&C segment gross earned premium was also impacted by a 2.4% increase in catastrophe reinsurance cost in 2013 compared to the same period last year. While our reinsurance structure remained unchanged, we did incur a slight increase in our reinsurance rate leading to the increase in reinsurance cost in 2013.
The life segment ended December 2013 with year-to-date net earned premium revenue (net of reinsurance ceded) of $6,591,000 compared to $6,609,000 for the same period last year; a decrease of $18,000 or 0.3%. A $100,000 decrease in net earned premium from our traditional life insurance products was the primary reason for the overall decline in 2013 life segment premium revenue. However, this decrease was mostly offset by growth in accident and health lines.
For the year ended December 31, 2013, net investment income was $3,746,000 compared to $4,191,000 for the same period last year; a decrease of $445,000 or 10.6%. The primary reason for the 2013 decline in year to date investment income was a decrease in value of company owned life insurance (COLI). The decrease in value of COLI was primarily driven by the rise in interest rates, particularly mortgage interest rates, as most of the cash value is invested in mortgage related investments.
Net realized investment gains totaled $4,439,000 in 2013 compared to $2,790,000 in 2012; an increase of $1,649,000. The $1,649,000 increase in realized investment gains in 2013 compared to 2012 was primarily related to net realized capital gains from the sale of 2,739 acres of investment real estate consisting of timber property in Alabama. The timber property sale contributed $3.3 million to pretax realized capital gains. The timber property, carried at historical cost of $1.3 million, was sold for $4.6 million.
Policyholder benefits and settlement expenses (claims) were $31,146,000 (59.5% of net premiums earned) for the year ended December 31, 2013, compared to $34,105,000 (65.8% of net premium earned) for the same period last year; a decrease of 8.7%. The primary reason for the decrease in claims in 2013 compared to 2012 was a reduction in reported non-catastrophe wind and hail claims as well as a decline in reported fire losses; both in the P&C segment.
Interest expense for the year ended December 31, 2013 was up $406,000 from the prior year at $1,686,000 compared to $1,280,000 in 2012. An increase in debt related to the litigation settlement (discussed above) in the holding company was the primary reason for the increase in interest expense in 2013 compared to 2012.
The property and casualty segment composed 87.4% of total premium revenue in 2013 compared to 87.2% in 2012. The P&C segment is primarily composed of dwelling fire and homeowners lines of business. The life segment composed 12.6% of premium revenue in 2013 compared to 12.8% in 2012 with revenue produced primarily from life, accident and supplemental health insurance products.
Our life segment is the smaller of our insurance segments contributing 12.6% of total insurance premium revenue in 2013 and 12.8% in 2012. Premium revenues and operating income for the life segment for the year ended December 31, 2013 and 2012 are summarized below (amounts in thousands):
NSIC ended 2013 with net realized investment gains totaling $111,000 compared to $1,635,000 for the same period last year. The primary reason for the $1,524,000 decrease in net realized investment gains was a decline in selling activity in 2013 compared to 2012. Realized investment gains in both 2013 and 2012 were primarily generated from the sale of equity securities. In an effort to lessen statutory capital volatility and reduce capital charges for equity investment holdings, we have reduced our equity investments over the past two years with the level of reductions in equity holdings in 2012 exceeding 2013. During the prior year, net realized capital gains were impacted by recognized other-than-temporary impairment losses on one security totaling $87,000; however, we had recoveries from previously recognized other-than-temporary impairments totaling $364,000.
Claims were $4,927,000 through December 31, 2013 compared to $5,294,000 through December 31, 2012; a decrease of $367,000. The primary reason for the reduction in claims in the current year compared to the prior year was a decrease in claims in both the ordinary and individual accident and health lines of business.
General and administrative expenses were $2,034,000 in 2013 compared to $1,973,000 in 2012. As a percent of earned premium, general and administrative expenses were comparable ending December 31, 2013 and 2012 at 30.9% and 29.9%, respectively. Historically, general and administrative expenses in our life segment have run higher than industry averages due to the small size of the subsidiary.
For the year ended December 31, 2013, the life segment had year-to-date pretax income of $7,000 compared to pretax income of $1,295,000 for the same period last year. The primary reason for the decline was the $1,524,000 decrease in realized capital gains.
Year Ended December 31, 2013 Compared to Year Ended December 31, 2012:
P&C segment net premium revenue was up 1.3% for the year ended December 31, 2013, at $45,775,000 compared to $45,206,000 through December 31, 2012. The primary reason for the increase was 8.0% growth in gross premium earned in the dwelling fire program in the current year compared to the same period last year. The 2013 increase in dwelling fire gross earned premium was partially offset by a 2.0% decrease in gross earned premium from our homeowners programs as well as the reduction in premium from the discontinued automobile and ocean marine programs.
P&C segment net earned premium was also impacted by a 2.6% increase in ceded premium associated with increased catastrophe reinsurance cost in 2013 compared to the same period last year. The Company maintains catastrophe reinsurance coverage to mitigate loss exposure from catastrophic events. Our catastrophe retention remained unchanged at $4 million and we maintain catastrophe reinsurance covering the cost of a single catastrophe event up to $72.5 million after exceeding the retention. The 2.6% increase included coverage related to our reinsurance premium protection (RPP) which was added in 2012. The decision to add and maintain the RPP coverage was made by management in an effort to reduce earnings volatility and strengthen our capital position in the P&C segment. In the event of a major catastrophe, the RPP coverage limits the pretax impact on earnings of a modeled 100 year cat event by approximately $4.5 million. A 100 year event is defined as an event that has approximately a 1% probability of occurring in a given year.
Under the catastrophe reinsurance program for 2013, the Company retains the first $4,000,000 in losses from each event. Reinsurance coverage is maintained in four layers as follows:
The P&C segment ended 2013 with realized capital gains totaling $1,020,000 compared to $1,083,000 for the same period last year. The $63,000 or 5.8% decrease in realized capital gains was primarily associated with a decline in selling activity during the current year compared to the the prior year. The realization of capital gains in the investment portfolio is influenced by both market conditions and liquidity requirements and therefore can vary significantly from
year to year. Other activities, such as tax planning strategies, may also lead to significant variation in realized capital gains from year to year. The P&C segment was not impacted by the write-down of other-than-temporary impairments in 2013 or 2012.
Other income was $604,000 in 2013 compared to $718,000 for the same period last year; a $114,000 or 15.9% decrease. Other income consists primarily of fees related to the issuance of our property and automobile insurance policies as well as miscellaneous income. As a percent of net earned premium, other income was 1.3% in 2013 compared to 1.6% in 2012. Due to the termination of our automobile programs in 2012, billing, payment and policy fees declined, which triggered the overall reduction in other income for the current year.
Claims were $26,219,000 in 2013 compared to $28,811,000 for the same period last year; a decrease of $2,592,000 or 9.0%. The primary reason for the decrease was a reduction in reported losses and loss adjustment expenses (LAE)from non-catastrophe wind and hail claims as well as a decline in losses and LAE reported from fire related claims in 2013 compared to 2012.
During 2013, the P&C segment had reported losses and LAE from ten cat events totaling $4,365,000 from 1,281 claims compared to reported losses and LAE from nine cat events totaling $4,295,000 from 1,424 claims in 2012. While the reported losses and LAE from cat events were comparable in 2013 compared to 2012, the pattern of losses was significantly different. During 2013, the majority of the cat events were the result of an active spring storm season. In contrast, Hurricane Isaac (cat 87), occurring in August of 2012, was the primary contributing factor to the 2012 cat events.
The largest cat event during 2013 was cat 93 which occurred in March 2013. This cat event, consisting primarily of straight line wind and isolated tornadoes, lead to reported losses and LAE totaling $3,054,000 from 915 claims. In comparison, Hurricane Isaac in 2012 lead to reported losses and LAE during the prior year totaling $3,390,000 from 1,147 policyholder claims. The P&C segment maintains catastrophe reinsurance to reduce risk associated with losses
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 estimation process. Claims frequency is a measure of the number of claims incurred during a measurement period regardless of amount. Claims severity is a measure of the average dollar amount of claims during a measurement period. The P&C companies incurred 1,281 claims from ten cat events in 2013 compared to 1,424 claims from nine cat events in 2012. The average cost per claim related to the 2013 cat events was $3,400 compared to $3,000 per claim in 2012. The largest cat events were cat 93 in 2013 and cat 87 (Hurricane Isaac) in 2012 with an average per claim of $3,300 and $3,000 per claim, respectively. Historically, spring time cat events primarily consisting of more costly tornado related damage, lead to higher average payments per claim. In contrast, claims in the second half of the year tend to be associated with tropical storm and hurricane related activity. These losses tend to be more widespread leading to more claims per event but with most of the claims resulting from less severe damage, usually from straight line winds, so average claim settlement tend to be slightly lower.
Fire losses reported in 2013 were down $725,000 or 5.7% compared to fire losses reported during 2012. The P&C segment had 518 fire losses reported in 2013 totaling $12,002,000 compared to 525 claims reported in 2012 totaling $12,727,000. The average cost per claim was $23,000 for fire losses reported in 2013 compared to $24,000 for fire losses reported in 2012.
Deferred policy acquisition costs totaled $2,576,000 in 2013 compared to $2,773,000 in 2012. Deferred policy acquisition costs were comparable at 5.6% of premium revenue for 2013; down 0.5 percentage points compared to 6.1% of premium revenue for the same period last year. Deferred policy acquisition costs consist of amortization of previously capitalized distribution costs, primarily commissions.
Commission expense for 2013 was $6,678,000 (14.6% of premium revenue) compared to $7,088,000 (15.7% of premium revenue) for the same period last year. The primary reason for the $410,000 or 5.8% decrease in commission expense during 2013 compared to 2012 was a decline in contingent commissions payments to our general agents.
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 are eliminated upon consolidation of the subsidiaries in the audited financial statements included herein. In July of 2012, NSG's wholly owned subsidiary National Security Fire and Casualty Company issued an extraordinary dividend of investment real estate, consisting of timber property, to the holding company which allowed NSG to secure a $4,000,000 bank line of credit for the primary purpose of paying final legal fees and making an initial settlement payment associated with the Mobile Attic litigation which was settled in June of 2013. In August of 2013, NSG sold substantially all of its timber property holdings and paid down the line of credit. Realized gains of $3,308,000 on the transaction account for the $3,236,000 increase over the prior year.
There has been no material shift in credit quality except for a moderate increase in securities rated AA+ or better. This increase is primarily due to an increase in investment allocation to government agency securities during 2013.
As shown in the tables above, the Company experienced an overall increase in fixed income securities in 2013 compared to the portfolio composition at December 31, 2012. Most of the increase within the fixed income portfolio was due to increase in investment in corporate debt securities and US Treasury and agency securities. These increases were partially offset by decreases in non-agency mortgage backed securities.
A number of factors influence portfolio allocation within each of the insurance subsidiaries. Within the property and casualty subsidiaries, due to the relatively short term nature of segment liabilities, fixed income investments tend to be of shorter duration, typically inside of seven years. Also due to higher levels of potential volatility of policy liabilities (severe weather related losses), a greater emphasis is placed upon overall liquidity of investments. In contrast, within the life insurance subsidiary, policy liabilities tend to be more stable and of significantly longer duration. In order to match the longer duration of liabilities, investments in the life insurance portfolio tend to have longer maturities and higher average book yields. Also, less emphasis is placed upon short term liquidity.
A downside of investing in longer duration securities in the life segment is that the portfolio is exposed to more significant price volatility as market interest rates change. This exposure to sudden interest rate changes can lead to declines in market value of fixed income securities in a rising interest rate environment. In the second quarter of 2013 we experienced some of the adverse impact of rising interest rates when the US Treasury yield curve on securities with maturities of five years and longer shifted 60+ basis points within a ninety day period. This market interest rate shift led to declines in market value of our intermediate and long duration fixed income investments. As shown in the table above, unrealized losses increased from $636,000 as of December 31, 2012 to $2,588,000 as of December 31, 2013. 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.
As discussed earlier, the majority of our longer duration securities are investments made to match longer duration liabilities in the life segment and are investments in mortgage backed securities, primarily government agency. Due to the amortizing nature and the ability to prepay mortgage backed securities, actual maturities tend to be significantly shorter than contractual maturities.
Average current yield on investments declined due to the maturity of investments at higher book yields reinvested at current historically low interest rates. With the recent increase in market interest rates, the erosion of average current yield on investments is expected to stabilize. However, in this persistent low interest rate environment, generation of investment income will remain challenging.
The total return on investments declined in 2013 compared to 2012 primarily due to increases in market interest rates which drove down the market value of our longer duration fixed income securities. Partially offsetting this decline was an increase in value of our equity investments. However, due to increased underwriting leverage and reduced capital positions in our property and casualty subsidiaries, we have reduced our allocation to equity investments in order to reduce volatility in our statutory capital and reduce capital charges in our statutory risk based capital.
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. 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.
The liquidity requirements for the Company are primarily met by funds generated from operations of the life insurance and property/casualty insurance subsidiaries. All operations and virtually all investments are maintained by the 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.
It should be noted that the above table represents maturities based on stated/contractual maturity. Due to call and prepayment features inherent in some debt securities and principal pay-downs on mortgage backed 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. However, due to other factors, both regulatory and those associated with good investment management practices associated with asset/liability matching, we do have exposure to changes in market values of securities due to changes in interest rates. Currently, a 100 basis point immediate increase in interest rates would generate approximately a $4,700,000 decline in the market value of fixed income investment. Alternatively, a 100 basis point decrease in interest rates will generate approximately $4,700,000 in increases in market value of fixed income investments.
At December 31, 2013, the Company had aggregate equity capital, unrealized investment gains (net of income taxes) and retained earnings of $33,472,000, up $3,245,000 compared to $30,227,000 at December 31, 2012. Components of the change in equity were a net income of $5,658,000, reduction in accumulated unrealized gains on investments of $2,801,000, a net unrealized gain of $412,000 related to interest rate swaps, common stock issued of $28,000, additional paid in capital of $196,000 and cash dividends paid totaling $248,000.
The Company, primarily through its insurance subsidiaries, had $4,987,000 in cash and cash equivalents at December 31, 2013, compared to $6,779,000 at December 31, 2012. Improved performance in our insurance operations coupled with the decline in litigation related expenses, for the period ended December 31, 2013 contributed to the $2,659,000 in cash provided by operations compared to cash used the same period last year totaling $13,706,000. Negative cash flows from operations in the prior year were related to the settlement of Mobile Attic litigation and losses from Hurricane Isaac.
Net cash used in investing activities totaled $357,000 for the period ended December 31, 2013, compared $4,111,000 provided by investing activities for the same period last year. At December 31, 2012, the Company had $6,779,000 in cash which was subsequently reduced by the purchase of available-for-sale securities, primarily fixed income investments. These purchases were partially offset by $4,847,000 in proceeds from the sale of investment real estate, of which the proceeds were used to pay expenses associated with the sale and to repay debt obligations.
Net cash used in financing activities totaled $4,094,000 for the period ended December 31, 2013 compared to net cash provided of $12,981,000 for the same period last year. During 2013, the Company paid the first installment on the note that financed the settlement obligation related to the Mobile Attic litigation. The installment due November 15, 2013 was $1,167,000. As of December 31, 2013, a total of $9,333,000 remained outstanding on the settlement obligation with the next installment due in November of 2014 ($1,166,000) included in short-term notes payable. The Company maintains a $1,000,000 operating line of credit which matures in September 2017 as well as a $700,000 line of credit which matures in February of 2014. The Company had $1,000,000 available on lines of credit at December 31, 2013. Also, the $700,000 short-term operating line of credit was renewed for a two year term in February of 2014.
The Company had a total of $20,889,000 of long-term debt outstanding as of December 31, 2013, compared to $25,339,000 at December 31, 2012, which includes $12,372,000 in trust preferred securities issued by the Company in addition to the installment note and operating line of credit. The company had $700,000 drawn on the operating line of credit included in short-term notes payable at December 31, 2013.
The following table reflects the anticipated cash flows associated with our short- and long-term contractual obligations and commitments as of December 31, 2013 (dollars in thousands):
1 Long-term debt, consisting of two separate issues of trust preferred securities, a line of credit and the long-term portion of an installment note is assumed to be settled at contractual maturity. Interest on long-term debt is calculated using the interest rates in effect at December 31, 2013 for each issue. Interest on long-term debt is accrued and settled quarterly on the trust preferred securities, monthly on the line of credit and annually on the installment note. Therefore, the timing and amount of interest payments may vary from the calculated value included in the table above. These calculations do not take into account any potential prepayments. For additional information regarding long-term debt and interest on long-term debt, please see Note 8, Notes Payable and Long-term Debt, in the notes to consolidated financial statements.
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 70% of claim liabilities at the end of a given year are settled within the following two year period.
The ability of the Company to meet its commitments for timely payment of claims and other expenses depends, in addition to current cash flow, on the liquidity of its investments. The Company has relatively little exposure to lower grade fixed income investments, which might be especially subject to liquidity problems due to thinly traded markets.
Our P&C segment is the primary source of dividends to the holding company. Due to a combination of growth opportunities and continued risk of capital exposure to weather related events, management is maintaining a
conservative stance with regard to paying of dividends to the holding company. Strengthening capital levels in the insurance subsidiaries remains a priority.
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, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company during 2014 is limited to $1,463,000 in the life insurance subsidiary and $2,632,000 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 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 recent adverse impacts on regulatory surplus, will likely lead to dividend payments to NSG substantially below the above referenced regulatory maximums.
In 2013, we discontinued our marine insurance program in order to increase underwriting capacity in our core dwelling fire line of business.
annual debt service on the note cannot be less than the dividends paid to our shareholders in the last twelve months. The Company made an initial payment of $2,500,000 in September 2012 and the first installment payment of $1,167,000 in November of 2013. The remaining principal will be repaid in eight annual installments. Accrued and unpaid interest shall be payable with each installment of principal based on the prime rate published in the Wall Street Journal plus 1%.
National Security Insurance Company (life insurer) has regulatory adjusted capital of $12.4 million and $11.1 million at December 31, 2013 and 2012, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 16.8 and 15.7 at December 31, 2013 and 2012, respectively. Accordingly, National Security Insurance Company exceeds the minimum RBC requirements.
National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $26.3 million and $24.1 million at December 31, 2013 and 2012, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 4.3 and 3.7 at December 31, 2013 and 2012, 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 $9.0 million and $8.0 million at December 31, 2013 and 2012, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 37.7 and 23.6 at December 31, 2013 and 2012, 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 2013, 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 2013 and 2012. Any losses above the $72.5 million upper limit are the responsibility of our Company. The contract in place during 2013 also allowed one reinstatement for coverage under the contract for a second catastrophic event if needed.
The property and casualty subsidiaries utilize our actual in force policy data modeled utilizing two different industry accepted catastrophe models to structure catastrophe reinsurance and determine upper limits of catastrophe reinsurance agreements. Based on modeling results utilized in 2013 and 2012, the Company was reinsured at approximately a 250 year event level. While this estimate is subject to some uncertainty and model risk, the models indicate that we maintain catastrophe reinsurance upper limits to cover an event that has less than a 0.5% probability of occurring in a given year.
Investments are recorded at fair value based upon quoted prices when available. Quoted prices are available for most investment debt and equity securities included in the financial statements. Further discussion of fair value methodology
We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. as of December 31, 2013 and 2012, and the related consolidated statements of income (loss), comprehensive 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, 2013 and 2012, and the results of their operations and their 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 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 United States generally accepted accounting principles (GAAP). All significant intercompany transactions and accounts have been eliminated. The financial information presented herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, which includes information and disclosures not presented herein.
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 consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these consolidated financial statements are reserves for future life insurance policy benefits, liabilities for losses and loss adjustment expenses, reinsurance recoverable associated with 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.
Changes in fair value of trading securities are recognized in net income.
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
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 sold substantially all timber land investments in 2013 with the gain reflected in realized capital gains in the statement of income. Real estate is carried at cost.
The Company owns life insurance (COLI) contracts on certain management and supervisory employees each having a face amount of approximately $2,000,000. The Company's original investment in company owned life insurance was $5,000,000. The primary purpose of the program is to offset future employee benefit expenses through earnings on the cash value of the policies. The Company is the owner and principal beneficiary of these policies. The life insurance contracts are carried at their current cash surrender value. Cash surrender value at December 31, 2013 and December 31, 2012 was $5,858,000 and $5,931,000, respectively. Changes in cash surrender values are included in investment income in the current period. The change in surrender value included in earnings for the periods ended December 31, 2013 and 2012 was a decline of $73,000 and an increase of $271,000, respectively. Death proceeds from the contracts are recorded when the proceeds become payable under the terms of the policy. There were no proceeds received from the COLI during 2013 or 2012.
Investments with other-than-temporary impairment in value are written down to estimated realizable values and losses recognized in the determination of operating results. The fair value of the investment becomes its new cost basis.
The Company uses the following methods and assumptions to estimate fair values:
Receivables and reinsurance recoverable - The carrying amounts reported approximate fair value.
For purposes of reporting cash flows, cash includes cash-on-hand, demand deposits with banks and overnight investments consisting primarily of repurchase agreement.
The Company files a consolidated federal income tax return. Tax related interest and penalties are reported as components of income tax expense.
losses, are composed of balances due from independent agents. At December 31, 2013, the single largest balance due from one agent totaled $546,000.
Investments-Equity Method and Joint Ventures-Accounting for Investments in Qualified Affordable Housing Projects
Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists
In July 2013, the FASB issued guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss ("NOL") carryforward, a similar tax loss, or a tax credit carryforward exists. This guidance applies to all entities with unrecognized tax benefits that also have tax loss or tax credit carryforwards in the same tax jurisdiction as of the reporting date. This guidance is effective for fiscal years beginning after December 15, 2013. The Company will adopt this standard on January 1, 2014. The Company anticipates that adoption of the standard will not have a material impact on its Consolidated Financial Statements.
In February 2013, the FASB issued an accounting standards update that requires additional disclosures for reclassification adjustments from accumulated other comprehensive income (AOCI). These additional disclosures include changes in AOCI balances by component and significant items reclassified out of AOCI. These disclosures must be presented either on the face of the affected financial statement or in the notes to the financial statements. The disclosures were effective beginning in the first quarter of 2013 and were to be provided on a prospective basis. These disclosures are presented in Note 14 to the consolidated financial statements.
investment totals $325,000 and is included as a component of Other Invested Assets in the accompanying consolidated balance sheets.
The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2013 are as follows:
The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2013 are as follows:
A summary of securities available-for-sale with unrealized losses as of December 31, 2012, 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:
Major categories of investment income are summarized as follows (dollars in thousands):
Other, principally real estate gain above reflects the third quarter sale of investment real estate with a carrying value of $1,300,000.
Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 are summarized in the following table by the type of inputs applicable to the fair value measurements (unaudited) (in thousands):
Depreciation expense for the year ended December 31, 2013 was $386,000 ($433,000 for the year ended December 31, 2012).
Net deferred tax liabilities are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax laws. Management believes that, based on its historical pattern of taxable income, the Company will produce sufficient income in the future to realize its deferred tax assets. The Company recognized net deferred tax asset positions of $4,654,000 at December 31, 2013 and $4,997,000 at December 31, 2012.
The appropriate income tax effects of changes in temporary differences are as follows (dollars in thousands):
Total income tax expense (benefit) varies from amounts computed by applying current federal income tax rates to income or loss before income taxes. The reasons for these differences and the approximate tax effects are as follows:
The aggregate balance in this account, $2,520,000 at December 31, 2013, 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, 2013.
Long-term debt consisted of the following as of December 31, 2013 and December 31, 2012 (dollars in thousands):
The swaps entered into in 2009 and 2010 have fair values of $278,000 (liability) and $619,000 (liability), respectively, for a total liability of $897,000 at December 31, 2013 ($1,521,000 at December 31, 2012). The swap liability is reported as a component of other liabilities on the condensed consolidated balance sheets. A net valuation gain of $412,000 (net of tax) is included in accumulated other comprehensive income related to the swap agreements for the current period. A net valuation loss of $214,000 (net of tax) was included in accumulated other comprehensive income related to the swap at December 31, 2012.
The Company’s interest rate swaps include provisions requiring the Company to post collateral when the derivative is in a net liability position. At December 31, 2013, the Company has securities on deposit with fair market values of $1,422,000 (all of which is posted as collateral). At December 31, 2012, the Company had securities on deposit with fair market values of $1,557,000, all of which is posted as collateral. See Note 5 for additional information about the interest rate swaps.
In July 2012, the Company executed a promissory note in the amount of $13,000,000 payable to the Bagley Family Revocable Trust with an interest rate of WSJ prime plus 1% (4.25% at December 31, 2013 and 2012). The purpose of this promissory note is to finance the settlement obligation related to the Mobile Attic litigation. As of December 31, 2013 a total of $9,333,000 ($10,500,000 at December 31, 2012) was outstanding with principal payments due in equal annual installments of $1,167,000 payable each November beginning in 2013. Installment payments due within 12 months of the balance sheet date are classified as current portion of long term debt. The promissory note allows for the Company to defer payments in years in which its P&C subsidiaries incur substantial catastrophe losses thus allowing capital management flexibility in the P&C subsidiaries. Under the terms of the promissory note, annual debt service payments on the note must equal or exceed any payment of dividends to shareholders in the preceding twelve months.
The Company has a geographic exposure to catastrophe losses in certain areas of the country. Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes, hail, severe winter weather, explosions and fires, and the incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophe losses are restricted to small geographic areas; however, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. The Company generally seeks to reduce its exposure to catastrophes through individual risk selection and the purchase of catastrophe reinsurance. At December 31, 2013, the Company's estimate of unpaid losses and adjustment expenses for claims incurred in prior years related to catastrophes that exceeded our retention totaled $476,000 before reinsurance ($958,000 in 2012). Because the Company has exhausted its catastrophe coverage limits available for Hurricane Katrina any additional development will not be covered by reinsurance. The Company maintains case reserves of $174,000 for losses in excess of catastrophe reinsurance ($390,000 in 2012).
In the normal course of business, NSFC seeks to reduce the loss that may arise from catastrophes or other individually significant large loss events that cause unfavorable underwriting results by re-insuring certain levels of risk in various
Each reinsurance layer covers events occurring from January 1-December 31 of the contract year. All significant reinsurance companies under the program carry A.M. Best ratings of A- (Excellent) or higher, or equivalent ratings.
At December 31, 2013, the largest reinsurance recoverable of a single reinsurer was $214,000 ($295,000 at December 31, 2012). Amounts reported as ceded incurred losses in both 2013 and 2012 were related to the development of losses from prior year catastrophes.
The Company and its subsidiaries established an Employee Stock Ownership Plan (ESOP) in January 2010, to enable its eligible employees to acquire a proprietary interest in the Company's common stock and to provide retirement and other benefits to such employees. Costs for amounts contributed to the ESOP for the period ended December 31, 2013 and 2012 amounted to $125,000 and $100,000, respectively. All contributions were made in cash for purchase of Company shares in the open market. The Company has not allocated shares directly to the plan and the plan has no debt.
The amount of dividends paid from NSIC to the Company in any year may not exceed, without prior approval of regulatory authorities, the greater of 10% of statutory surplus as of the end of the preceding year, or the statutory net gain from operations for the preceding year. At December 31, 2013, NSIC's retained earnings unrestricted for the payment of dividends in the next twelve months amounted to $1,463,000.
During the year ended December 31, 2013, and year ended December 31, 2012, changes in shareholders' equity consisted of a net income of $5,658,000 and net loss of $6,671,000, respectively; dividends paid of $248,000 in 2013 and $802,000 in 2012; changes in accumulated other comprehensive loss, net of applicable taxes, of $2,389,000 in 2013 and $315,000 in 2012. Other comprehensive loss consists of accumulated unrealized gains and losses on securities and unrealized gains and losses on interest rate swaps.
The holders of the Class A Common Stock will have one-twentieth of one vote per share, and the holders of the common stock will have one vote per share. There is currently no Class A Common Stock issued or outstanding.
The balance of and changes in each component of accumulated other comprehensive income (loss) (“AOCI”) for the period ended December 31, 2013, net of income taxes, are as follows (dollars in thousands):
Total assets by industry segment for the years ended December 31, 2013 and 2012 are summarized below (dollars in thousands):
Premium revenues and operating income by business segment for the years ended December 31, 2013 and 2012 are summarized below (dollars in thousands):
The following table presents the Company’s gross and net premiums earned for the property and casualty segment and the life and accident and health segment for the years ended December 31, 2013 and 2012, respectively:
The Company's property & casualty subsidiaries are defending a limited number of matters filed in the aftermath of Hurricanes Katrina in Mississippi and Louisiana as well as Gustav and Ike in Texas. These actions include individual lawsuits with allegations of underpayment of hurricane-related claims.
Note 2 - Cash Dividends and Asset Transfers from Insurance Subsidiaries