10-Q 1 nsec-6302012x10q.htm NSEC-6.30.2012-10Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 FORM 10-Q

 
 (Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For Quarterly Period Ended June 30, 2012
or      
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from           to          .

Commission File Number 0-18649

The National Security Group, Inc.
(Exact name of registrant as specified in its charter)

Delaware
 
63-1020300
(State or Other Jurisdiction of
Incorporation or Organization)
 
(IRS Employer
Identification No.)
 
 
 
661 East Davis Street
Elba, Alabama
 
36323
(Address of principal executive offices)
 
(Zip-Code)
 Registrant’s Telephone Number including Area Code (334) 897-2273

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  o 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    þ Yes    o No

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in rule 12b-2 of the Act).  (Check One) :    Large accelerated filer Accelerated filer  o Non-accelerated filer  o Smaller reporting company  þ

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  No  þ
As of August 6, 2012, there were 2,466,600 shares, $1.00 par value, of the registrant’s common stock outstanding.


1


THE NATIONAL SECURITY GROUP, INC.

INDEX

PART I. FINANCIAL INFORMATION
 
 
 
 
Page No.
 
Item 1.  Financial Statements (unaudited)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

2


Cautionary Statement Regarding Forward-Looking Statements

Any statement contained in this report which is not a historical fact, or which might otherwise be considered an opinion or projection concerning the Company or its business, whether expressed or implied, is meant as and should be considered a forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1995.  The following report contains forward-looking statements that are not strictly historical and that involve risks and uncertainties.  Such statements include any statements containing the words “expect,” “plan,” “estimate,” “anticipate” or other words of a similar nature. Management cautions investors about forward-looking statements.  Forward-looking statements involve certain evaluation criteria, such as risks, uncertainties, estimates, and/or assumptions made by individuals informed of the Company and industries in which we operate.  Any variation in the preceding evaluation criteria could cause actual results to differ materially from those expressed or implied by such forward-looking statements.  These risks and uncertainties include, without limitation, the following:

The insurance industry is highly competitive and the Company encounters significant competition in all lines of business from other insurance companies.  Many of the competing companies have more abundant financial resources than the Company.
Insurance is a highly regulated industry.  It is possible that legislation may be enacted which would have an adverse effect on the Company’s business.
The Company is subject to regulation by state governments for each of the states in which it conducts business.  The Company cannot predict the subject of any future regulatory initiative(s) or its (their) impact on the Company’s business.
The Company is rated by various insurance rating agencies.  If a rating is downgraded from its current level by one of these agencies, sales of the Company’s products and stock could be adversely impacted.
The Company’s financial results are adversely affected by increases in policy claims received by the Company.  While a manageable risk, this fluctuation is often unpredictable.
The Company’s investments are subject to a variety of risks.  Investments are subject to defaults and changes in market value.  Market value can be affected by changes in interest rates, market performance and the economy.
The Company mitigates risk associated with life policies through implementing effective underwriting and reinsurance strategies.  These factors mitigate, not eliminate, risk related to mortality and morbidity exposure.  The Company has established reserves for claims and future policy benefits based on amounts determined by independent actuaries.  There is no assurance that these estimated reserves will prove to be sufficient or that the Company will not incur claims exceeding reserves, which could result in operating losses.
The Company mitigates risk associated with property and casualty policies through implementing effective underwriting and reinsurance strategies.  The Company obtains reinsurance which increases underwriting capacity and limits the risk associated with policy claims.  The Company is subject to credit risk with regard to reinsurers as reinsurance does not alleviate the Company’s liability to its insured’s for the ceded risks.  The Company utilizes a third-party to develop a reinsurance treaty with reinsurers who are reliable and financially stable.  However, there is no guarantee that booked reinsurance recoverable will actually be recovered.  A reinsurer’s insolvency or inability to make payments due could have a material adverse impact on the financial condition of the Company.
The Company’s ability to continue to pay dividends to shareholders is contingent upon profitability and capital adequacy of the insurance subsidiaries.  The insurance subsidiaries operate under regulatory restrictions that could limit the ability to fund future dividend payments of the Company.  An adverse event or series of events could materially impact the ability of the insurance subsidiaries to fund future dividends and consequently the Board of Directors would have to suspend the declaration of dividends to shareholders.
The Company is subject to the risk of adverse settlements or judgments resulting from litigation.  It is difficult to predict or quantify the expected results of litigation because the outcome depends on decisions of the court and jury that are based on facts and legal arguments presented at the trial.


3


Part I.  FINANCIAL INFORMATION

Item 1.  Financial Statements

THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
 
 
June 30,
 
December 31,
 
 
2012
 
2011
ASSETS
 
(unaudited)
 
 
Investments
 
 
 
 
Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2012 - $2,501;
2011 - $3,497)
 
$
2,336

 
$
3,303

Fixed maturities available-for-sale, at estimated fair value (cost: 2012 - $68,936;
2011 -$69,980)
 
72,446

 
73,074

Equity securities available-for-sale, at estimated fair value (cost: 2012 - $4,559;
2011 - $4,931)
 
7,875

 
8,547

Trading securities
 
40

 
80

Mortgage loans on real estate, at cost
 
386

 
390

Investment real estate, at book value
 
5,774

 
5,745

Policy loans
 
1,241

 
1,244

Company owned life insurance
 
5,831

 
5,660

Other invested assets
 
3,848

 
3,929

Total Investments
 
99,777

 
101,972

Cash
 
6,345

 
3,393

Accrued investment income
 
776

 
706

Policy receivables and agents' balances, net
 
10,109

 
8,805

Reinsurance recoverable
 
1,960

 
2,778

Deferred policy acquisition costs
 
9,703

 
9,558

Property and equipment, net
 
2,482

 
2,528

Accrued income tax recoverable
 
1,496

 
1,669

Deferred income tax asset
 
4,282

 

Other assets
 
1,200

 
1,045

Total Assets
 
$
138,130

 
$
132,454

 
 
 
 
 
LIABILITIES AND SHAREHOLDERS' EQUITY
 
 

 
 

Property and casualty benefit and loss reserves
 
$
12,369

 
$
14,386

Accident and health benefit and loss reserves
 
2,172

 
2,122

Life and annuity benefit and loss reserves
 
29,813

 
29,605

Unearned premiums
 
26,906

 
25,232

Policy and contract claims
 
686

 
652

Other policyholder funds
 
1,429

 
1,408

Short-term notes payable
 
625

 
485

Litigation settlement
 
13,000

 

Long-term debt
 
12,372

 
12,372

Deferred income tax liability
 

 
86

Other liabilities
 
8,095

 
8,091

Total Liabilities
 
107,467

 
94,439

Contingencies
 


 


Shareholders' equity
 
 

 
 

Common stock
 
2,467

 
2,467

Additional paid-in capital
 
4,951

 
4,951

Accumulated other comprehensive income
 
3,557

 
3,640

Retained earnings
 
19,688

 
26,957

Total Shareholders' Equity
 
30,663

 
38,015

Total Liabilities and Shareholders' Equity
 
$
138,130

 
$
132,454


The Notes to Condensed Consolidated Financial Statements are an integral part of these statements.
THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)
(In thousands, except per share amounts)

 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2012
 
2011
 
2012
 
2011
REVENUES
 
 
 
 
 
 
 
Net premiums earned
$
12,533

 
$
13,321

 
$
26,029

 
$
28,191

Net investment income
1,066

 
1,171

 
2,201

 
2,228

Net realized investment gains
865

 
261

 
1,071

 
1,031

Other income
193

 
256

 
390

 
511

Total revenues
14,657

 
15,009

 
29,691

 
31,961

EXPENSES
 

 
 

 
 

 
 

Policyholder benefits paid
7,976

 
15,682

 
15,821

 
25,004

Policy acquisition costs
2,933

 
3,071

 
5,705

 
5,995

General expenses
1,835

 
2,418

 
4,323

 
4,589

Litigation settlement and defense costs
12,670

 
482

 
13,259

 
789

Taxes, licenses and fees
438

 
622

 
930

 
1,102

Interest expense
288

 
285

 
580

 
570

Total expenses
26,140

 
22,560

 
40,618

 
38,049

 
 
 
 
 
 
 
 
Loss Before Income Taxes
(11,483
)
 
(7,551
)
 
(10,927
)
 
(6,088
)
 
 
 
 
 
 
 
 
INCOME TAX (BENEFIT) EXPENSE
 

 
 

 
 

 
 

Current
145

 
(2,515
)
 
173

 
(2,165
)
Deferred
(4,322
)
 
(91
)
 
(4,325
)
 
27

 
(4,177
)
 
(2,606
)
 
(4,152
)
 
(2,138
)
 
 
 
 
 
 
 
 
Net Loss
$
(7,306
)
 
$
(4,945
)
 
$
(6,775
)

$
(3,950
)
 
 
 
 
 
 
 
 
LOSS PER COMMON SHARE
$
(2.96
)
 
$
(2.00
)
 
$
(2.75
)
 
$
(1.60
)
 
 
 
 
 
 
 
 
DIVIDENDS DECLARED PER SHARE
$
0.10

 
$
0.15

 
$
0.20

 
$
0.30


The Notes to Condensed Consolidated Financial Statements are an integral part of these statements.


4


THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (UNAUDITED)
(In thousands)

 
Three Months
 Ended June 30,
 
Six Months Ended
 June 30,
 
2012
 
2011
 
2012
 
2011
 
 
 
 
 
 
 
 
Net loss:
$
(7,306
)
 
$
(4,945
)
 
$
(6,775
)
 
$
(3,950
)
 
 
 
 
 
 
 
 
Other comprehensive income (loss), net of tax
 
 
 
 
 
 
 
Changes in:
 
 
 
 
 
 
 
Unrealized gains (losses) on securities
(201
)
 
465

 
76

 
285

Unrealized loss on interest rate swap
(244
)
 
(103
)
 
(159
)
 
(55
)
 
 
 
 
 
 
 
 
Other comprehensive income (loss), net of tax
(445
)
 
362

 
(83
)
 
230

 
 
 
 
 
 
 
 
Comprehensive loss
$
(7,751
)
 
$
(4,583
)
 
$
(6,858
)
 
$
(3,720
)


The Notes to Condensed Consolidated Financial Statements are an integral part of these statements.



5


THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY (UNAUDITED)
(In thousands)

 
 
Total
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Common
Stock
 
Additional
Paid-in
Capital
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2011
 
$
38,015

 
$
26,957

 
$
3,640

 
$
2,467

 
$
4,951

 
 
 
 
 
 
 
 
 
 
 
Comprehensive income
 
 

 
 

 
 

 
 

 
 

Net loss six months ended 6/30/2012
 
(6,775
)
 
(6,775
)
 
 

 
 

 
 

Other comprehensive income, net of tax:
 
 

 
 

 
 

 
 

 
 

Unrealized gain on securities, net of reclassification adjustment of $704
 
76

 
 

 
76

 
 

 
 

Unrealized gain on interest rate swap
 
(159
)
 
 

 
(159
)
 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
Total comprehensive loss
 
(6,858
)
 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
Cash dividends
 
(494
)
 
(494
)
 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2012 (Unaudited)
 
$
30,663

 
$
19,688

 
$
3,557

 
$
2,467

 
$
4,951


The Notes to the Condensed Consolidated Financial Statements are an integral part of these statements.

THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)

 
 
Six Months Ended
 
 
June 30,
 
 
2012
 
2011
Cash Flows from Operating Activities
 
 
 
 
Net loss
 
$
(6,775
)

$
(3,950
)
Adjustments to reconcile net loss to net cash (used in) provided by operating activities:
 
 

 
 

Change in accrued investment income
 
(70
)
 
109

Change in reinsurance recoverable
 
818

 
(1,832
)
Change in deferred policy acquisition costs
 
(145
)
 
(27
)
Change in accrued income tax recoverable
 
173

 
(2,604
)
Change in deferred income taxes
 
(4,325
)
 
(27
)
Depreciation expense
 
286

 
187

Change in policy liabilities and claims
 
(1,376
)
 
2,195

Change in litigation settlement
 
13,000

 

Other, net
 
(1,569
)
 
(1,660
)
Net cash provided (used) by operating activities
 
17

 
(7,609
)
 
 
 
 
 
Cash Flows from Investing Activities
 
 

 
 

Cost of investments acquired
 
(15,267
)
 
(11,777
)
Sale and maturity of investments
 
18,690

 
19,847

Purchase of property and equipment
 
(155
)
 
(31
)
Net cash provided by investing activities
 
3,268

 
8,039

 
 
 
 
 
Cash Flows from Financing Activities
 
 

 
 

Change in other policyholder funds
 
21

 
28

Change in short-term notes payable
 
140

 
(325
)
Dividends paid
 
(494
)
 
(740
)
Net cash used in financing activities
 
(333
)
 
(1,037
)
 
 
 
 
 
Net change in cash and cash equivalents
 
2,952

 
(607
)
 
 
 
 
 
Cash and cash equivalents, beginning of period
 
3,393

 
1,572

 
 
 
 
 
Cash and cash equivalents, end of period
 
$
6,345

 
$
965


The Notes to the Condensed Consolidated Financial Statements are an integral part of these statements.


6


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)


NOTE 1 – SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation
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 condensed 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 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, 2011, which includes information and disclosures not presented herein.

Use of Estimates
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 those estimates.

Recently Adopted Accounting Standards

Presentation of Comprehensive Income
In June and December 2011, the Financial Accounting Standards Board (FASB) issued guidance amending the presentation of comprehensive income and its components. Under the new guidance, a reporting entity has the option to present comprehensive income in a single continuous statement or in two separate but consecutive statements.  The Company adopted the new guidance in the first quarter of 2012.  The Company opted to present the total of comprehensive income, the components of net income, and the components of other comprehensive income in two separate but consecutive statements. The Unaudited Condensed Consolidated Financial Statements included herein reflect the adoption of this updated guidance. The new guidance affects presentation only and therefore had no impact on the Company's results of operations or financial position.

Accounting for Costs Associated with Acquiring or Renewing Insurance Contracts
In October 2010, the FASB issued guidance modifying the definition of the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal insurance contracts.  The guidance specifies that the costs must be directly related to the successful acquisition of insurance contracts.  The guidance also specifies that advertising costs should be included as deferred acquisition costs ("DAC") only when the direct-response advertising accounting criteria are met.  Under the new guidance, only acquisition costs associated with "successful sales" are allowed to be deferred. Successful sales ratios will be reviewed quarterly and the new guidance will reduce the amount of acquisition cost that can be deferred to future periods. The Company adopted the new guidance on a prospective basis as of January 1, 2012. 

Amendments to Fair Value Measurement and Disclosure Requirements
In May 2011, the FASB issued guidance that clarifies the application of existing fair value measurement and disclosure requirements and amends certain fair value measurement principles, requirements and disclosures.  The guidance is to be applied prospectively for reporting periods beginning after December 15, 2011.  The adoption of this guidance as of January 1, 2012 had no impact on the Company's results of operations or financial position. The expanded disclosures required by this guidance are included in Note 9.

Accounting Changes Not Yet Adopted

Disclosures about Offsetting Assets and Liabilities for Financial Instruments and Derivative Instruments
In December 2011, the FASB issued guidance requiring expanded disclosures, including both gross and net information, for financial instruments and derivative instruments that are either offset in the reporting entity's financial statements or those that are subject to an enforceable master netting arrangement or similar agreement.  The guidance is effective for reporting periods beginning on or after January 1, 2013 and is to be applied retrospectively.  The new guidance affects disclosures only and will have no impact on the Company's results of operations or financial position.

NOTE 2 – REINSURANCE

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.  NSFC maintains a catastrophe reinsurance agreement to cover losses from catastrophic events, primarily hurricanes.
 
Under the catastrophe reinsurance program, the Company retains the first $4,000,000 in losses from each event.  Reinsurance is maintained in four layers as follows:

Layer
Reinsurers' Limits of Liability
First Layer
95% of  $6,000,000 in excess of $4,000,000
Second Layer
95% of  $7,500,000 in excess of $10,000,000
Third Layer
100% of  $25,000,000 in excess of $17,500,000
Fourth Layer
100% of  $30,000,000 in excess of $42,500,000

Layers 1-4 cover events occurring from January 1-December 31 of the contract year.  All significant reinsurers under the program carry A.M. Best ratings of A- (Excellent) or higher, or equivalent ratings.

Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy.  Amounts paid for prospective reinsurance contracts are reported as prepaid reinsurance premiums and amortized over the remaining contract period.

In the normal course of business, NSIC seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage contracts.  NSIC retains a maximum of $50,000 of coverage per individual life.  The cost of reinsurance is amortized over the contract period of the reinsurance.

NOTE 3 – CALCULATION OF EARNINGS PER SHARE

Earnings per share were based on net income divided by the weighted average common shares outstanding.  The weighted average number of shares outstanding for the three-month and six-month periods ending June 30, 2012 and 2011 were 2,466,600.

NOTE 4 – CHANGES IN SHAREHOLDERS' EQUITY

During the six month periods ended June 30, 2012 and 2011, there were no changes in shareholders' equity except for a net loss of $6,775,000 and $3,950,000, respectively; dividends paid of $494,000 in 2012 and $740,000 in 2011; changes in accumulated other comprehensive loss, net of applicable taxes, $83,000 in 2012 and changes in accumulated other comprehensive income of $230,000 in 2011.  Other comprehensive income/loss consists of accumulated unrealized gains and losses on securities and unrealized gains and losses on interest rate swaps.


NOTE 5 – INVESTMENTS

The amortized cost and aggregate fair values of investments in available-for-sale securities as of June 30, 2012 are as follows:
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
30,876

 
$
1,703

 
$
233

 
$
32,346

Trust preferred securities
 
537

 

 
2

 
535

Mortgage backed securities
 
6,640

 
215

 
22

 
6,833

Private label mortgage backed securities
 
8,354

 
212

 
5

 
8,561

Obligations of states and political subdivisions
 
14,334

 
1,187

 

 
15,521

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
8,195

 
465

 
10

 
8,650

Total fixed maturities
 
68,936

 
3,782

 
272

 
72,446

Equity securities
 
4,559

 
3,859

 
543

 
7,875

Total
 
$
73,495

 
$
7,641

 
$
815

 
$
80,321


The amortized cost and aggregate fair values of investments in held-to-maturity securities as of June 30, 2012 are as follows:
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
1,619

 
$
121

 
$

 
$
1,740

Private label mortgage backed securities
 

 

 

 

Obligations of states and political subdivisions
 
515

 
27

 

 
542

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
202

 
17

 

 
219

Total
 
$
2,336

 
$
165

 
$

 
$
2,501


The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2011 are as follows:
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
19,907

 
$
1,340

 
$
267

 
$
20,980

Trust preferred securities
 
537

 

 
58

 
479

Mortgage backed securities
 
7,587

 
307

 
23

 
7,871

Private label mortgage backed securities
 
9,716

 
199

 
62

 
9,853

Obligations of states and political subdivisions
 
18,355

 
1,142

 
15

 
19,482

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
13,878

 
534

 
3

 
14,409

Total fixed maturities
 
69,980

 
3,522

 
428

 
73,074

Equity securities
 
4,931

 
4,206

 
590

 
8,547

Total
 
$
74,911

 
$
7,728

 
$
1,018

 
$
81,621


The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2011 are as follows:
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
2,026

 
$
125

 
$

 
$
2,151

Private label mortgage backed securities
 
55

 
1

 

 
56

Obligations of states and political subdivisions
 
996

 
50

 

 
1,046

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
226

 
18

 

 
244

Total
 
$
3,303

 
$
194

 
$

 
$
3,497

The amortized cost and aggregate fair value of debt securities at June 30, 2012, by contractual maturity, are presented in the following table.  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.
 
 
(Dollars in Thousands)
 
 
Amortized
Cost
 
Fair
Value
Available-for-sale securities:
 
 
 
 
Due in one year or less
 
$
1,115

 
$
1,134

Due after one year through five years
 
14,420

 
15,489

Due after five years through ten years
 
21,148

 
22,329

Due after ten years
 
32,253

 
33,494

 
 
 
 
 
Total
 
$
68,936

 
$
72,446

 
 
 
 
 
Held-to-maturity securities:
 
 

 
 

Due in one year or less
 
$

 
$

Due after one year through five years
 
516

 
544

Due after five years through ten years
 
473

 
507

Due after ten years
 
1,347

 
1,450

 
 
 
 
 
Total
 
$
2,336

 
$
2,501


A summary of securities available-for-sale with unrealized losses as of June 30, 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:

 
 
Less than 12 months
 
12 months or longer
 
Total
June 30, 2012
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in
a Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
8,368

 
$
81

 
$
2,647

 
$
152

 
$
11,015

 
$
233

 
27
Trust preferred securities
 

 

 
535

 
2

 
535

 
2

 
1
Mortgage backed securities
 
1,155

 
22

 

 

 
1,155

 
22

 
4
Private label mortgage backed securities
 

 

 
117

 
5

 
117

 
5

 
1
Obligations of state and political subdivisions
 

 

 

 

 

 

 
0
U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
608

 
2

 
254

 
8

 
862

 
10

 
3
Equity securities
 
184

 
8

 
1,050

 
535

 
1,234

 
543

 
5
 
 
$
10,315

 
$
113

 
$
4,603

 
$
702

 
$
14,918

 
$
815

 
41


A summary of securities available-for-sale with unrealized losses as of December 31, 2011, 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:

 
 
Less than 12 months
 
12 months or longer
 
Total
December 31, 2011
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
4,703

 
$
166

 
$
899

 
$
101

 
$
5,602

 
$
267

 
15
Trust preferred securities
 
479

 
58

 

 

 
479

 
58

 
1
Mortgage backed securities
 
883

 
21

 
198

 
2

 
1,081

 
23

 
3
Private label mortgage backed securities
 
1,860

 
15

 
1,094

 
47

 
2,954

 
62

 
9
Obligations of state and political subdivisions
 

 

 
1,803

 
15

 
1,803

 
15

 
5
U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
260

 
3

 

 

 
260

 
3

 
1
Equity securities
 
391

 
49

 
802

 
541

 
1,193

 
590

 
6
 
 
$
8,576

 
$
312

 
$
4,796

 
$
706

 
$
13,372

 
$
1,018

 
40

There were no securities held-to-maturity with unrealized losses as of June 30, 2012 and December 31, 2011.

The Company conducts periodic reviews to identify and evaluate securities in an unrealized loss position in order to identify other-than-temporary-impairments. For securities in an unrealized loss position, the Company assesses whether the Company has the intent to sell the security or more likely than not will be required to sell the security before the anticipated recovery.  If either of these conditions is met, the Company is required to recognize an other-than-temporary impairment with the entire unrealized loss reported in earnings.  For securities in an unrealized loss position that do not meet these conditions, the Company assesses whether the impairment of a security is other-than-temporary.  If the impairment is determined to be other-than-temporary, the Company is required to separate the other-than-temporary impairments into two components:  the amount representing the credit loss and the amount related to all other factors.  The credit loss is the portion of the amortized book value in excess of the net present value of the projected future cash flows discounted at the effective interest rate implicit in the debt security prior to impairment.  The credit loss component of other-than-temporary impairments is reported in earnings, whereas the amount relating to factors other than credit losses are recorded in other comprehensive income, net of taxes.

Management has evaluated each security in a significant unrealized loss position.  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 securities in an accumulated loss position in the portfolio were temporary impairments.

For the quarter ended June 30, 2012, the Company realized no additional other-than-temporary impairments.  The single largest accumulated loss was in the equity portfolio and totaled $498,000.  The second largest loss position was in the bond portfolio and totaled $75,000.  The third largest loss position was in the bond portfolio and totaled $25,000.  

For the year ended December 31, 2011, the Company realized $398,000 in other-than-temporary impairments.   The single largest accumulated loss was in the equity portfolio and totaled $501,000.  The second largest loss position was in the bond portfolio and totaled $70,000.  The third largest loss position was in the bond portfolio and totaled $58,000
 
An analysis of the net change in unrealized appreciation on available-for-sale securities follows:

 
 
(Dollars in thousands)
 
 
Six-month period ended June 30, 2012
 
Year Ended December 31, 2011
 
 
(unaudited)
 
 
Net change in unrealized appreciation on available-for-sale securities before deferred tax
 
$
115

 
$
1,792

Deferred income tax
 
(39
)
 
(534
)
Net change in unrealized appreciation on available-for-sale securities
 
$
76

 
$
1,258


NOTE 6 – INCOME TAXES

The Company recognizes tax-related interest and penalties as a component of tax expense.  The Company has not incurred any income tax related interest and penalties as of June 30, 2012 and $1,000 as of December 31, 2011. The Company files income tax returns in the U.S. federal jurisdiction and various states.  The Company is not subject to examinations by authorities related to its U.S. federal or state income tax filings for years prior to 2006. Tax returns have been filed through the year 2011.

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 position of $4,282,000 at June 30, 2012, and net deferred tax liability position of $86,000 at December 31, 2011.

The tax effect of significant differences representing deferred tax assets and liabilities are as follows (dollars in thousands):

 
 
June 30, 2012
 
December 31, 2011
 
 
(unaudited)
 
 
General expenses
 
$
1,211

 
$
1,576

Unearned premiums
 
1,827

 
1,714

Claims liabilities
 
249

 
271

Litigation settlement
 
4,420

 

NOL carry forward
 
1,594

 
1,363

Other-than-temporary impairments on securities owned
 
231

 
258

Unrealized loss on interest rate swaps
 
489

 
407

Deferred tax assets
 
10,021

 
5,589

 
 
 
 
 
Depreciation
 
(120
)
 
(144
)
Deferred policy acquisition costs
 
(3,299
)
 
(3,250
)
Unrealized gains on securities available-for-sale
 
(2,320
)
 
(2,281
)
Deferred tax liabilities
 
(5,739
)
 
(5,675
)
 
 
 
 
 
Net deferred tax asset (liability)
 
$
4,282

 
$
(86
)


7


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The appropriate income tax effects of changes in temporary differences are as follows (dollars in thousands):

 
 
Six Months Ended June 30,
 
 
2012
 
2011
Deferred policy acquisition costs
 
$
49

 
$
304

Other-than-temporary impairments
 
27

 
(69
)
Trading securities
 

 
10

Unearned premiums
 
(113
)
 
(102
)
General expenses
 
(61
)
 
(98
)
Depreciation
 
(24
)
 
(16
)
Claim liabilities
 
22

 
(2
)
Litigation settlement
 
(3,995
)
 

NOL carry forward
 
(230
)
 

 
 
 
 
 
Deferred income tax (benefit) expense
 
$
(4,325
)
 
$
27


Total income tax (benefit) expense varies from amounts computed by applying current federal income tax rates to income or loss before income taxes.  The reason for these differences and the approximate tax effects are as follows:

 
 
Six Months Ended June 30,
 
 
2012
 
2011
Federal income tax rate applied to pre-tax income/loss
 
34.00
%
 
34.00
 %
Dividends received deduction and tax-exempt interest
 
0.80
%
 
1.70
 %
Company owned life insurance
 
0.50
%
 
0.70
 %
Small life deduction
 
2.10
%
 
3.10
 %
Other, net
 
0.60
%
 
(4.40
)%
 
 
 
 
 
Effective federal income tax rate
 
38.00
%
 
35.10
 %

NOTE 7 –NOTES PAYABLE AND LONG-TERM DEBT

Short-term notes payable consisted of the following as of June 30, 2012 and December 31, 2011:

 
 
(Dollars in thousands)
 
 
2012
 
2011
Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 5.0% floor; maturity January 2013.  Interest payments due quarterly.  Unsecured.
 
$
625

 
$
485



8


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Long-term debt consisted of the following as of June 30, 2012 and December 31, 2011:

 
 
(Dollars in thousands)
 
 
2012
 
2011
 
 
 
 
 
Subordinated debentures issued on December 15, 2005 with fixed interest rate of 8.83% each distribution period thereafter until December 15, 2015 when the coupon rate shall equal the 3-Month LIBOR plus 3.75% applied to the outstanding principal; maturity December 2035.  Interest payments due quarterly.  All may be redeemed at any time following the tenth anniversary of issuance.  Unsecured.
 
$
9,279

 
$
9,279

 
 
 
 
 
Subordinated debentures issued on June 21, 2007 with a floating interest rate equal to the 3 Month LIBOR plus 3.40% applied to the outstanding principal; maturity June 15, 2037. Interest payments due quarterly.  All may be redeemed at any time following the fifth anniversary of issuance.  Unsecured.
 
3,093

 
3,093

 
 
$
12,372

 
$
12,372


The subordinated debentures (debentures) have the same maturities and other applicable terms and features as the associated trust preferred securities (TPS).  Payment of interest may be deferred for up to 20 consecutive quarters; however, stockholder dividends cannot be paid during any extended interest payment period or any time the debentures are in default.  All have stated maturities of thirty years.  None of the securities require the Company to maintain minimum financial covenants. The Company has guaranteed that amounts paid to the Trusts will be remitted to the holders of the associated TPS.  This guarantee, when taken together with the obligations of the Company under the debentures, the Indentures pursuant to which the debentures were issued, and the related trust agreement (including obligations to pay related trust fees, expenses, debt and other obligations with respect to the TPS), provides a full and unconditional guarantee of amounts due the Trusts.  The amount guaranteed is not expected to at any time exceed the obligations of the TPS, and no additional liability has been recorded related to the guarantee.

The Company has entered into various swap agreements related to the trust preferred securities. On March 19, 2009, the Company entered into a forward swap effective September 17, 2012, with a notional amount of $3,000,000 and designated the swap as a hedge against changes in cash flows attributable to changes in the benchmark interest rate (LIBOR) associated with the subordinated debentures issued June 21, 2007. 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.

On May 26, 2010, the Company entered into a forward swap with a notional amount of $9,000,000 effective December 15, 2015, which will hedge against changes in cash flows following the termination of the fixed rate period. Quarterly, commencing March 16, 2016 under the terms of the forward swap, the Company will pay interest at a fixed rate of 8.49% until March 15, 2020.

The swaps entered into in 2009 and 2010 have fair values $469,000 (liability) and $968,000 (liability), respectively, for a total liability of $1,437,000 at June 30, 2012 ($1,196,000 at December 31, 2011).  The swap liability is reported as a component of other liabilities on the condensed consolidated balance sheets.  A net valuation loss of $159,000 is included in accumulated other comprehensive income related to the swap agreements for the current period.  A net valuation loss of $640,000 was included in accumulated other comprehensive income related to the swap at December 31, 2011.

We use dollar offset at the hedge's inception and for each reporting period thereafter to assess whether the derivative used in a hedging transaction is expected to be, and has been, effective in offsetting changes in the fair value of the hedged item. Since inception, no portion of the hedged item has been deemed ineffective. For all hedges, we discontinue hedge accounting if it is determined that a derivative is not expected to be, or has ceased to be, effective as a hedge.

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 $100,000, in addition to securities on deposit with fair market values of $1,335,000 (all of which is posted as collateral). At December 31, 2011, the Company had cash collateral on deposit of $310,000 in addition to securities on deposit with fair market values of $877,000, all of which is posted as collateral. See Note

9


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

9 for additional information about the interest rate swaps.

In January 2012, 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 June 30, 2012, $625,000 was drawn on this line ($485,000 at December 31, 2011).

NOTE 8 – CONTINGENCIES

Litigation

The Company and its subsidiaries continue to be named individually as parties to litigation related to the conduct of their insurance operations.  These suits involve alleged breaches of contracts, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of the Company's subsidiaries, and miscellaneous other causes of action. 

The Company's property & casualty subsidiaries are defending a limited number of matters filed in the aftermath of Hurricanes Katrina and Rita in Mississippi, Louisiana and Alabama.  These actions include individual lawsuits with allegations of underpayment of hurricane-related claims, including allegations that the flood exclusion found in the Company's subsidiaries' policies, and in certain actions other insurance companies' policies, is either ambiguous, unenforceable as unconscionable or contrary to public policy, or inapplicable to the damage sustained. 

The various suits seek a variety of remedies, including actual and/or punitive damages in unspecified amounts and/or declaratory relief.  All of these matters are in various stages of development and the Company's subsidiaries intend to vigorously defend them.  The outcome of these disputes is currently uncertain. 

In April 2007, the Company sold substantially all of its 50% interest in Mobile Attic, Inc., to Bagley Family Revocable Trust (the "Purchaser"). The Company, Peter L. Cash and Russell L. Cash (collectively the "Sellers") sold to Purchaser 61% of the outstanding stock of Mobile Attic under the terms of a Stock Purchase Agreement dated April 5, 2007, executed by Sellers, Mobile Attic and Purchaser's assignor, James W. Bagley (the "Stock Purchase Agreement"). 

Under the terms of the Stock Purchase Agreement, the Purchaser paid the Company $2,700,000 for 45% of the total outstanding stock of Mobile Attic and paid the other Sellers $960,000 for an additional 16% of the total outstanding stock in Mobile Attic, thus obtaining a controlling interest of 61% of the outstanding stock.  The Stock Purchase Agreement provided that Purchaser was to use his best efforts to cause the Company to be released from its guaranty of a bank loan to Mobile Attic having an outstanding principal balance of approximately $9,400,000.  The bank loan was secured by portable storage containers of Mobile Attic. The Sellers made certain warranties to the Purchaser in the Stock Purchase Agreement regarding the financial condition of Mobile Attic and agreed to jointly and severally indemnify the Purchaser for any damages resulting from a breach of any of the warranties.

As previously disclosed , the Company and the Purchaser have been involved in litigation regarding this transaction The Purchaser asserted claims against the Company seeking indemnification of Purchaser's losses and damages as a result of the breach of representations and warranties regarding Mobile Attic's financial condition, as set forth in the Stock Purchase Agreement.
On June 20, 2012, the Company and Bagley Trust reached a settlement agreement to dispose of this action. Under the terms of the settlement the Company agreed to pay Bagley Trust $13,000,000 . The terms of the agreement are to be formalized in the form of a promissory note in accordance with the following payment schedule: $2.5 million on September 18, 2012, and the balance payable in 9 equal annual installments on November 15 each year beginning in 2013 with a final payment in 2021. The unpaid principal will bear interest at Wall Street Journal prime rate plus 1% per annum. The settlement will allow the ability to defer payments in years in which the Company's P&C subsidiaries incur substantial catastrophe losses thus allowing capital management flexibility in the P&C subsidiaries. Under the expected terms of the agreement, annual debt service payments on the note must equal or exceed any payment of dividends to shareholders in the preceding twelve months.

NOTE 9 – FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES

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.

We are permitted to elect to measure financial instruments and certain other items at fair value, with the change in fair value recorded in earnings.  We elected not to measure any eligible items using the fair value option.

Accounting standards define fair value as the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework to make the measurement of fair value more consistent and comparable.  In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets.

The Company categorizes assets and liabilities carried at their fair value based upon a fair value hierarchy:

Level 1 – Quoted prices in active markets for identical assets or liabilities that the Company has the ability to access at the measurement date.

Level 1 assets and liabilities consist of money market fund deposits and certain of our marketable debt and equity instruments, including equity instruments offsetting deferred compensation, that are traded in an active market with sufficient volume and frequency of transactions.

Level 2 - Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which all significant inputs are observable or can be derived principally from or corroborated by observable market data for substantially the full term of the assets or liabilities.

Level 2 assets include certain of our marketable debt and equity instruments with quoted market prices that are traded in less active markets or priced using a quoted market price for similar instruments. Level 2 assets also include marketable equity instruments with security-specific restrictions that would transfer to the buyer, marketable debt instruments priced using indicator prices which represent non-binding market consensus prices that can be corroborated by observable market quotes, as well as derivative contracts and debt instruments priced using inputs that are observable in the market or can be derived principally from or corroborated by observable market data.  Marketable debt instruments in this category generally include commercial paper, bank time deposits, repurchase agreements for fixed-income instruments, and a majority of floating-rate notes, corporate bonds, and municipal bonds.

Level 3 - Unobservable inputs to the valuation methodology that are significant to the measurement of fair value of assets or liabilities.

Level 3 assets and liabilities include marketable debt instruments, non-marketable equity investments, derivative contracts, and company issued debt whose values are determined using inputs that are both unobservable and significant to the values of the instruments being measured. Level 3 assets also include marketable debt instruments that are priced using indicator prices that we were unable to corroborate with observable market quotes.

Marketable debt instruments in this category generally include asset-backed securities and certain of our floating-rate notes, corporate bonds, and municipal bonds.

Assets/Liabilities Measured at Fair Value on a Recurring Basis
 
Financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2012 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):
 
 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
32,346

 
$

 
$
32,346

 
$

Trust preferred securities
 
535

 

 
535

 

Mortgage backed securities
 
6,833

 

 
6,833

 

Private label mortgage backed securities
 
8,561

 

 
8,561

 

Obligations of states and political subdivisions
 
15,521

 

 
15,521

 

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
8,650

 
8,650

 

 

Trading securities
 
40

 
40

 

 

Equity securities available-for-sale
 
7,875

 
7,087

 

 
788

Total Financial Assets
 
$
80,361

 
$
15,777

 
$
63,796

 
$
788

Financial Liabilities
 

 
 

 
 

 
 

Interest rate swap
 
$
1,437

 
$

 
$

 
$
1,437

Total Financial Liabilities
 
$
1,437

 
$

 
$

 
$
1,437


The methods and assumptions the Company uses to estimate the fair value of assets and liabilities measured at fair value on a recurring basis are summarized below.
Fixed maturities available-for-sale—The fair values of the Company’s public fixed maturity securities are generally based on prices obtained from independent pricing services. Consistent with the fair value hierarchy described above, securities with validated quotes from pricing services are generally reflected within Level 2, as they are primarily based on observable pricing for similar assets and/or other market observable inputs.
Trading securities—Trading securities consist primarily of mutual funds whose fair values are determined consistent with similar instruments described above under “Fixed Maturity Securities” and below under “Equity Securities” and “Derivative Instruments.”
Equity securities—Equity securities consist principally of investments in common and preferred stock of publicly traded companies and privately traded securities. The fair values of our publicly traded equity securities are based on quoted market prices in active markets for identical assets and are classified within Level 1 in the fair value hierarchy. Estimated fair values for our privately traded equity securities require a substantial level of judgment. Privately traded equity securities are classified within Level 3.
Interest rate swaps—Interest rate swaps are recorded at fair value either as assets, within other assets or as liabilities, within other liabilities. The fair values of our interest rate swaps are provided by a third party broker and are classified within Level 3.
As of June 30, 2012, Level 3 fair value measurements of assets include $788,000 of equity securities in a local community bank whose value is based on an evaluation of the financial statements of the entity. The Company does not develop the unobservable inputs used in measuring fair value.

As of June 30, 2012, Level 3 fair value measurements of liabilities include $1,437,000 net fair value of various interest rate swaps whose value is based on analysis provided by a third party broker. The Company does not develop the unobservable inputs used in measuring fair value. Additional information regarding the interest rate swaps is provided in Note 7.

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 quarter ended June 30, 2012 (in thousands):

For the quarter ended June 30, 2012
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
642

 
$
(1,196
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 

 

Included in other comprehensive income
 
3

 
(241
)
Purchases:
 
143

 

Sales:
 

 

Issuances:
 

 

Settlements
 

 

Transfers in/(out) of Level 3
 

 

Ending balance
 
$
788

 
$
(1,437
)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of June 30, 2012:
 
$

 
$


For the quarter ended June 30, 2012, there were no assets or liabilities measured at fair values on a nonrecurring basis.

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 (in thousands):

 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
20,980

 
$

 
$
20,980

 
$

Trust preferred securities
 
479

 

 
479

 

Mortgage backed securities
 
7,871

 

 
7,871

 

Private label mortgage backed securities
 
9,853

 

 
9,853

 

Obligations of states and political subdivisions
 
19,482

 

 
19,482

 

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
14,409

 
14,409

 

 

Trading securities
 
80

 
80

 

 

Equity securities available-for-sale
 
8,547

 
7,905

 

 
642

Total Financial Assets
 
$
81,701

 
$
22,394

 
$
58,665

 
$
642

Financial Liabilities
 
 

 
 

 
 

 
 

Interest rate swap
 
$
1,196

 
$

 
$

 
$
1,196

Total Financial Liabilities
 
$
1,196

 
$

 
$

 
$
1,196



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, 2011 (in thousands):
For the year ended December 31, 2011
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
787

 
$
(227
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 

 

Included in other comprehensive income
 
(145
)
 
(969
)
Purchases:
 

 

Sales:
 

 

Issuances:
 

 

Settlements
 

 

Transfers in/(out) of Level 3
 

 

Ending balance
 
$
642

 
$
(1,196
)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of December 31, 2011:
 
$

 
$


For the year ended December 31, 2011, there were no assets or liabilities measured at fair values on a nonrecurring basis.

The Company is exposed to certain risks in the normal course of its business operations.  The primary risk that is managed through the use of derivatives is interest rate risk on floating rate borrowings.  This risk is managed through the use of interest rate swaps which are designated as cash flow hedges.  For cash flow hedges, the effective portion of the gain or loss on the interest rate swap is included as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction is recognized in earnings.  The Company does not hold or issue derivatives that are not designated as hedging instruments.  See Note 7 for additional information about the interest rate swaps.

The following methods and assumptions were used to estimate fair value of each class of financial instrument for which it is practical to estimate that value:

Cash and cash equivalents—the carrying amount is a reasonable estimate of fair value.

Mortgage receivables—the carrying amount is a reasonable estimate of fair value due to the restrictive nature and limited marketability of the mortgage notes.

Other invested assets—the carrying amount is a reasonable estimate of fair value.

Other policyholder funds—the carrying amount is a reasonable estimate of fair value.

Debt—the carrying amount is a reasonable estimate of fair value.

The carrying amount and estimate fair value of the Company’s financial instruments as of June 30, 2012 and December 31, 2011 are as follows (in thousands):
 
 
June 30, 2012
 
December 31, 2011
 
 
Carrying
Value
 
Estimated
Fair Value
 
Carrying
Value
 
Estimated
Fair Value
Assets and related instruments
 
 
 
 
 
 
 
 
Mortgage loans
 
$
386

 
$
386

 
$
390

 
$
390

Policy loans
 
1,241

 
1,241

 
1,244

 
1,244

Company owned life insurance
 
5,831

 
5,831

 
5,660

 
5,660

Other invested assets
 
3,848

 
3,848

 
3,929

 
3,929

 
 
 
 
 
 
 
 
 
Liabilities and related instruments
 
 

 
 

 
 

 
 

Other policyholder funds
 
1,429

 
1,429

 
1,408

 
1,408

Short-term debt
 
625

 
625

 
485

 
485

Long-term debt
 
12,372

 
12,372

 
12,372

 
12,372


NOTE 10 – SEGMENTS

The Company’s property and casualty insurance operations comprise one business segment.  The property and casualty insurance segment consists of seven lines of business:  dwelling fire and extended coverage, homeowners (including mobile homeowners), ocean marine, other liability, private passenger auto liability, commercial auto liability and auto physical damage.  Management organizes the business utilizing a niche strategy focusing on lower valued dwellings as well as non-standard automobile products.  Our chief decision makers (President, Chief Financial Officer and Chief Executive Officer) review results and operating plans making decisions on resource allocations on a company-wide basis.  The Company’s products are primarily produced through agents within the states in which we operate.  The Company’s life and accident and health operations comprise the second business segment.  The life and accident and health insurance segment consists of two lines of business: traditional life insurance and accident and health insurance. Premium revenues and operating income by industry segment for the three and six-month periods ended June 30, 2012, and 2011 (unaudited) are summarized below (dollars in thousands):

Three-Month Period Ended June 30, 2012
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
REVENUE
 
 
 
 
 
 
 
Net premiums earned
$
12,533

 
$
10,814

 
$
1,719

 
$

Net investment income
1,066

 
529

 
520

 
17

Net realized investment gains
865

 
75

 
790

 

Other income
193

 
192

 
1

 

 
14,657

 
11,610

 
3,030

 
17

BENEFITS AND EXPENSES
 

 
 

 
 

 
 

Policyholder benefits paid
7,976

 
6,763

 
1,213

 

Policy acquisition costs
2,933

 
2,594

 
339

 

General and administrative expenses
1,835

 
1,111

 
644

 
80

Litigation settlement and defense costs
12,670

 

 

 
12,670

Taxes, licenses and fees
438

 
385

 
53

 

Interest expense
288

 

 
35

 
253

 
26,140

 
10,853

 
2,284

 
13,003

Income (Loss) Before Income Taxes
$
(11,483
)
 
$
757

 
$
746

 
$
(12,986
)




10


THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)



Three-Month Period Ended June 30, 2011
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
REVENUE
 
 
 
 
 
 
 
Net premiums earned
$
13,321

 
$
11,544

 
$
1,777

 
$

Net investment income
1,171

 
606

 
461

 
104

Net realized investment gains
261

 
257

 
4

 

Other income
256

 
254

 
2

 

 
15,009

 
12,661

 
2,244

 
104

BENEFITS AND EXPENSES
 

 
 

 
 

 
 

Policyholder benefits paid
15,682

 
14,386

 
1,296

 

Policy acquisition costs
3,071

 
2,751

 
320

 

General and administrative expenses
2,418

 
1,601

 
594

 
223

Litigation settlement and defense costs
482

 

 

 
482

Taxes, licenses and fees
622

 
516

 
106

 

Interest expense
285

 

 
16

 
269

 
22,560

 
19,254

 
2,332

 
974

Loss Before Income Taxes
$
(7,551
)
 
$
(6,593
)
 
$
(88
)
 
$
(870
)



Six-Month Period Ended June 30, 2012
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
REVENUE
 
 
 
 
 
 
 
Net premiums earned
$
26,029

 
$
22,558

 
$
3,471

 
$

Net investment income
2,201

 
1,140

 
1,028

 
33

Net realized investment gains
1,071

 
207

 
862

 
2

Other income
390

 
388

 
2

 

 
29,691

 
24,293

 
5,363

 
35

BENEFITS AND EXPENSES
 

 
 

 
 

 
 

Policyholder benefits paid
15,821

 
13,176

 
2,645

 

Policy acquisition costs
5,705

 
5,138

 
567

 

General and administrative expenses
4,323

 
2,940

 
1,092

 
291

Litigation settlement and defense costs
13,259

 

 

 
13,259

Taxes, licenses and fees
930

 
815

 
115

 

Interest expense
580

 

 
37