10-K 1 nsec-12312012x10k.htm 10-K NSEC-12.31.2012-10K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 
FORM 10-K

 
 (Mark One)
þ
ANNUAL REPORT PURSUANT TO SECTION 13 or 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
GE ACT OF 1934
For the fiscal Period Ended December 31, 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

Securities registered pursuant to Section 12 (b) of the Act:
 
None
 
Securities registered pursuant to Section 12 (g) of the Act:
 
Common Stock, par value $1.00 per share        The NASDAQ Global Market (EXCHANGE)

           
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes  o    No  þ

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o    No  þ

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).     Yes þ    No o

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filler,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer    o  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 o
    No  þ

The aggregate market value of the voting stock held by non-affiliates of the Registrant as of the last business day of the registrant's most recently completed second fiscal quarter, based upon the bid price of these shares on NASDAQ on such date, was $12,032,715

Indicate the number of shares outstanding of each of the issuer's classes of Common Stock, as of the close of the period covered by this report.



Class
 
Outstanding March 21, 2013
 
 
 
Common Stock $1.00 par value
 
2,466,600 shares




1


THE NATIONAL SECURITY GROUP, INC.

TABLE OF CONTENTS
 
Page No.
PART I
 
PART II
 
               Disclosure
PART III
 
PART IV
 
 
 
 
 
Certifications
 


DOCUMENTS INCORPORATED BY REFERENCE

1.
Definitive proxy statement for the 2013 Annual Meeting of Stockholders to be held May 17, 2013 is incorporated by reference into Part III of this report. The proxy statement will be filed no later than 120 days from December 31, 2012.

2.
Current Report on Form 8-K for event occurring on March 21, 2013 is incorporated into Part IV of this report.



2


PART I

Item 1. Business

Summary Description of The National Security Group, Inc.

The National Security Group, Inc. (the Company, NSG, we, us, our), an insurance holding company, was incorporated in Delaware on March 20, 1990. Our common stock is traded on the NASDAQ Global Market under the symbol NSEC.

Pursuant to regulations of the United States Securities and Exchange Commission (SEC), we are considered a “Smaller Reporting Company” as defined by SEC rules. We have elected to utilize an “a la carte” scaled disclosure which permits smaller reporting companies to elect to comply with scaled financial and non-financial disclosure requirements on an item by item basis. The most significant reporting difference permitted under the scaled disclosures, which we have utilized, is to include two years of audited financial statements.

The Company, through its three wholly owned subsidiaries, operates in two industry segments: property and casualty insurance and life insurance.

The property and casualty subsidiaries of the Company, National Security Fire and Casualty (NSFC), and Omega One Insurance Company (Omega), primarily write personal lines dwelling coverage including dwelling fire and windstorm, homeowners and mobile homeowners lines of insurance in eleven states. Property and casualty insurance is the most significant industry segment, accounting for 87% of total premium revenues.

The Company's life insurance subsidiary, National Security Insurance Company (NSIC), offers a basic line of life and health and accident insurance products in six states.

The majority of our assets and investments are held in the operating insurance companies.

The Company's website address is: www.nationalsecuritygroup.com. The “Investors” section of our website (http://www.nationalsecuritygroup.com/public/Investors/Investors.aspx) provides numerous resources for investors seeking additional information about us. Our annual reports on Form 10-K, our quarterly reports on Form 10-Q and our current reports on Form 8-K are made available on our website soon after filing with the SEC. Additionally, stock trades by insiders as filed on Forms 3, 4, and 5 are posted to the website after filing with the SEC. The website also provides information regarding corporate governance, stock quotes and press releases. Investors are encouraged to visit our website for additional information about the Company.

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.

3



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 price 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 and loss of capital.

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 of contested claims. 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.





4


Industry Segment and Geographical Area Information

Property and Casualty Insurance Segment
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. This segment will be referred to throughout this report as NSFC, property-casualty segment or P&C segment. NSFC is licensed to write insurance in Alabama, Arkansas, Florida, Georgia, Kentucky, Mississippi, Oklahoma, South Carolina, Tennessee and West Virginia, and operates on a surplus lines basis in the states of Louisiana, Missouri, and Texas. Omega is licensed to write insurance in Alabama and Louisiana.

The following table indicates allocation percentages of direct written premium by state for the two years ended December 31, 2012 and 2011:
State
 
Direct Written Premium

 
2012
 
2011
Alabama
 
$
15,858,000

 
29.62
%
 
$
15,689,000

 
28.13
%
Arkansas
 
2,711,000

 
5.06
%
 
3,538,000

 
6.34
%
Georgia
 
5,196,000

 
9.70
%
 
4,345,000

 
7.79
%
Louisiana
 
7,184,000

 
13.42
%
 
8,627,000

 
15.47
%
Mississippi
 
9,382,000

 
17.52
%
 
9,572,000

 
17.16
%
South Carolina
 
6,141,000

 
11.47
%
 
6,000,000

 
10.76
%
Florida
 
86,000

 
0.16
%
 
91,000

 
0.16
%
Missouri
 
6,000

 
0.01
%
 
363,000

 
0.65
%
Oklahoma
 
2,237,000

 
4.18
%
 
2,474,000

 
4.44
%
Tennessee
 
3,062,000

 
5.72
%
 
3,192,000

 
5.72
%
Texas
 
1,681,000

 
3.14
%
 
1,884,000

 
3.38
%
 
 
$
53,544,000

 
100.00
%
 
$
55,775,000

 
100.00
%
In general, the property-casualty insurance business involves the transfer by the insured, to an insurance company of all or a portion of certain risks for the payment, by the insured, of a premium to the insurance company. A portion of such risks is often retained by the insured in the form of deductibles, which vary from policy to policy, but are typically in the range of $500 to $1,000 on NSFC and Omega's primary dwelling property and homeowners lines of business.

The premiums or payments to be made by the insured for direct products of the property and casualty subsidiaries are based upon expected costs of providing benefits, writing and administering the policies. In determining the premium to be charged, the property and casualty subsidiaries utilize data from past claims experience, modeled catastrophe losses and anticipated claims estimates along with catastrophe reinsurance cost, commissions, taxes and general expenses.

The operating results of the property-casualty insurance industry are subject to significant fluctuations from quarter-to-quarter and from year-to-year. These fluctuations are often due to the effect of competition on pricing, unpredictable losses incurred in connection with weather-related and other catastrophic events, general economic conditions and other factors, such as changes in tax laws and the regulatory environment.


5


The following table sets forth the premiums earned and pre-tax income during the periods reported for the property and casualty insurance segment (dollars in thousands):

Year Ended December 31,

2012
 
2011
Net premiums earned:

 

Fire, allied lines and homeowners
$
43,962

 
$
45,165

Automobile
474

 
3,356

Other
770

 
850

Total net earned premium
$
45,206

 
$
49,371

Income (loss) before taxes
$
2,552

 
$
(4,389
)
Property and Casualty Loss Reserves
Our property and casualty insurance subsidiaries are required to maintain reserves to cover their ultimate liability for losses and adjustment expenses. Our staff periodically conducts reviews throughout the year of projected loss development information in order to adjust estimates. The liability for loss and adjustment expense reserves consists of an estimated liability for the ultimate settlement of claims that have been reported as well as an estimate of loss and adjustment expenses for incurred claims that have not yet been reported (IBNR). IBNR estimates are based primarily on historical development patterns using quantitative data generated from statistical information and qualitative analysis of legal developments, economic conditions and development caused by events deemed to be infrequent in occurrence. The reserves are based on an estimate made by management. Management estimates are based on an analysis of historical paid and incurred loss development patterns for the previous ten loss years. Prior year period-to-period loss development factors are applied to latest reported loss reserve estimates in order to estimate the ultimate incurred losses for each given loss year. The amount of loss reserves estimated in excess of current reported case losses are recorded as IBNR reserves.

In addition to loss and loss adjustment expense reserves for specific claims, both reported and unreported, we establish reserves for loss adjustment expenses that are not attributable to specific claims. These reserves consist of estimates for Defense and Cost Containment (DCC) and Adjusting and Other Expenses (AO). These reserves are established for the estimated expenses of internal claims staff and the cost of outside experts, such as attorneys representing our interest, in the final settlement of incurred claims that are still in process of settlement. We conduct annual and interim reviews over the course of each year in order to insure that no significant changes have occurred in our loss development that might adversely impact our loss reserving methodology.

The following Loss Reserve Re-estimates table illustrates the change over time of the net reserves established for property-liability insurance claims and claims expense at the end of the last 10 calendar years. The first section shows the reserves as originally reported at the end of the stated year. The second section, reading down, shows retroactive re-estimates of the original recorded reserve as of the end of each successive year. These re-estimates are the result of the Company's expanded awareness of additional facts and circumstances that pertain to the unsettled claims. The third section, reading down, shows the cumulative amounts paid as of the end of successive years with respect to that year's reserve liability. The last section compares the latest re-estimated reserve to the reserve originally established and indicates whether the original reserve was adequate to cover the estimated costs of unsettled claims. The Loss Reserve Re-estimates table is cumulative, and therefore, ending balances should not be added since the amount at the end of each calendar year includes activity for both the current and prior years.

While the information in the table provides a historical perspective on the adequacy of unpaid losses and loss adjustment expenses established in previous years, it should not be assumed to be predictive of redundancies or deficiencies on current year unpaid losses in future periods. Company management believes that the reserves established at the end of 2012 are adequate. However, due to inherent uncertainties in the loss reserve estimation process, management cannot guarantee that current year reserve balances will prove to be adequate. Due to the relatively short tail nature of the property and casualty subsidiaries' claim liabilities, the Company does not discount loss reserves for the time value of money. Dollar amounts are in thousands.





6


 
 
2002
 
2003
 
2004
 
2005
 
2006
 
2007
 
2008
 
2009
 
2010
 
2011
 
2012
Gross unpaid losses per
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
    Consolidated Balance Sheet
$
11,513

 
$
11,343

 
$
13,094

 
$
19,511

 
$
12,498

 
$
11,973

 
$
14,436

 
$
12,646

 
$
13,184

 
$
14,386

 
$
11,214

Ceded reserves
 
(1,555
)
 
(1,232
)
 
(2,611
)
 
(8,560
)
 
(1,783
)
 
(555
)
 
(2,421
)
 
(549
)
 
(1,329
)
 
(2,381
)
 
(1,229
)
Net unpaid losses
 
$
9,958

 
$
10,111

 
$
10,483

 
$
10,951

 
$
10,715

 
$
11,418

 
$
12,015

 
$
12,097

 
$
11,855

 
$
12,005

 
$
9,985

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Cumulative net payments:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1 year later
$
4,342

 
$
5,567

 
$
5,584

 
$
7,384

 
$
6,438

 
$
4,797

 
$
5,636

 
$
5,349

 
$
5,738

 
$
4,035

 

 
2 years later
5,520

 
6,765

 
7,006

 
9,063

 
8,103

 
6,496

 
6,350

 
6,305

 
7,239

 

 

 
3 years later
5,865

 
7,038

 
7,521

 
10,198

 
9,652

 
6,767

 
6,725

 
6,764

 

 

 

 
4 years later
5,945

 
7,274

 
7,811

 
11,439

 
10,094

 
6,976

 
6,980

 

 

 

 

 
5 years later
6,136

 
7,351

 
8,018

 
11,763

 
10,360

 
7,202

 

 

 

 

 

 
6 years later
6,167

 
7,390

 
8,006

 
11,900

 
10,662

 

 

 

 

 

 

 
7 years later
6,183

 
7,398

 
8,024

 
12,012

 

 

 

 

 

 

 

 
8 years later
6,192

 
7,400

 
8,056

 

 

 

 

 

 

 

 

 
9 years later
6,194

 
7,419

 

 

 

 

 

 

 

 

 

 
10 years later
6,194

 

 

 

 

 

 

 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net Liability re-estimated:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
1 year later
7,334

 
9,186

 
9,042

 
11,844

 
11,817

 
9,046

 
9,438

 
8,621

 
11,443

 
9,606

 

 
2 years later
7,165

 
8,607

 
9,118

 
11,827

 
11,061

 
8,739

 
7,916

 
8,869

 
11,064

 

 

 
3 years later
6,906

 
8,098

 
8,669

 
12,161

 
11,121

 
7,739

 
8,179

 
9,033

 

 

 

 
4 years later
6,509

 
7,863

 
8,404

 
12,337

 
10,792

 
7,792

 
8,514

 

 

 

 

 
5 years later
6,499

 
7,629

 
8,274

 
12,178

 
11,089

 
8,010

 

 

 

 

 

 
6 years later
6,313

 
7,570

 
8,135

 
12,372

 
11,413

 

 

 

 

 

 

 
7 years later
6,314

 
7,484

 
8,184

 
12,699

 

 

 

 

 

 

 

 
8 years later
6,278

 
7,500

 
8,093

 

 

 

 

 

 

 

 

 
9 years later
6,294

 
7,430

 

 

 

 

 

 

 

 

 

 
10 years later
6,201

 

 

 

 

 

 

 

 

 

 

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net cumulative redundancy (deficiency)
$
3,757

 
$
2,681

 
$
2,390

 
$
(1,748
)
 
$
(698
)
 
$
3,408

 
$
3,501

 
$
3,064

 
$
791

 
$
2,399

 

Our reported results, financial position and liquidity could be affected by changes in key assumptions that determine our loss reserves. The table below illustrates the change to equity that would occur as a result of a change in loss reserves and reserves for loss adjustment expense:
 
For The Years Ended December 31,
 
2012
 
2011
Change in Loss and LAE Reserves
Adjusted Loss and LAE Reserves
% Change in Equity
 
Adjusted Loss and LAE Reserves
% Change in Equity
*Loss and LAE reserves are in thousands
(10.0)%
$
10,093

3.71%
 
$
12,947

3.78%
(7.5)%
10,373

2.78%
 
13,307

2.84%
(5.0)%
10,653

1.86%
 
13,667

1.89%
(2.5)%
10,934

0.93%
 
14,026

0.95%
Reported
11,214

—%
 
14,386

—%
2.5%
11,494

(0.93)%
 
14,746

(0.95)%
5.0%
11,775

(1.86)%
 
15,105

(1.89)%
7.5%
12,055

(2.78)%
 
15,465

(2.84)%
10.0%
12,335

(3.71)%
 
15,825

(3.78)%

7


While our reserve estimates have had more significant variability in the past, we believe that the scenarios presented above are most reasonable as our methodology has become more seasoned, and we have maintained continuity of staff involved in the reserving process.

Life Insurance Segment
National Security Insurance Company (NSIC), a wholly owned subsidiary organized in 1947, conducts the Company's life insurance business. This segment will be referred to throughout this report as NSIC, Life Company, or Life segment. NSIC is licensed to write insurance in six states: Alabama, Florida, Georgia, Mississippi, South Carolina, and Texas.

The following table indicates NSIC's percentage of direct premiums collected by state for the two years ended December 31, 2012 and 2011:
State
 
Percentage of Total Direct Premiums

 
2012
 
2011
Alabama
 
3,959,000

 
58.17
%
 
4,044,000

 
58.20
%
Georgia
 
1,408,000

 
20.69
%
 
1,424,000

 
20.49
%
Mississippi
 
678,000

 
9.96
%
 
697,000

 
10.03
%
South Carolina
 
476,000

 
6.99
%
 
512,000

 
7.37
%
Texas
 
169,000

 
2.48
%
 
180,000

 
2.59
%
Florida
 
116,000

 
1.71
%
 
92,000

 
1.32
%

 
6,806,000

 
100.00
%
 
6,949,000

 
100.00
%
NSIC has two primary methods of distribution of insurance products: independent agents and home service (career) agents.  The independent agent distribution method accounts for 62.4% of total premium revenue in the life insurance segment. Approximately 212 agents of the Company's independent agents produced new business during 2012. The home service distribution method of life insurance products accounts for 32.8% of total premium revenue in the life insurance segment. Home service life products consist of products marketed directly at the home or other premises of the insured by an employee agent.  The Company employed nine career agents and one regional manager as of December 31, 2012. The remaining 4.8% of premium revenue consists of the following:  a book of business acquired from a state guaranty association in 2000 (1.6%), premium generated through direct sales of school accident insurance (1.4%), and other miscellaneous business serviced directly through the home office (1.8%).

NSIC's primary products are life insurance, both term and whole life, and health and accident insurance. NSIC does not sell annuities, interest sensitive whole life or universal life insurance products.  Term life insurance policies provide death benefits if the insured's death occurs during the specific premium paying term of the policy.  The policies generally do not provide a savings or investment element included as part of the policy premium.  Whole-life insurance policies demand a higher premium than term life, but provide death benefits which are payable under effective policies regardless of the time of the insured's death and have a savings and investment element which may result in the accumulation of a cash surrender value.  Our accident and health insurance policies provide coverage for losses sustained through sickness or accident and include individual hospitalization and accident policies, group supplementary health policies, and specialty products, such as cancer policies.  Our line of health and accident products feature specified fixed benefits, so rapidly rising health care costs do not have as great an impact on our health and accident line as they do on comparable products offered by other companies. 

The following table displays a schedule of 2012 life segment premium produced by product and distribution method (dollars in thousands):
Line of Business
 
Home Service Agent
 
Independent Agent
 
Other
Industrial
 
$
75

 
$

 
$
77

Ordinary
 
1,820

 
2,668

 
33

Group Life
 

 
9

 
63

A&H Group
 

 

 
106

A&H Other
 
276

 
1,444

 
38

Total Premium by Distribution Method
 
$
2,171

 
$
4,121

 
$
317



8


The following table sets forth certain information with respect to the development of the Life Company's business (dollars in thousands):

Year ended December 31,

2012
 
2011
Life insurance in force at end of period:

 

Ordinary-whole life
$
170,800

 
$
174,200

Term life
21,400

 
23,600

Industrial life
19,500

 
20,200


$
211,700

 
$
218,000

Life insurance issued:

 

Ordinary-whole life
$
24,800

 
$
31,400


$
24,800

 
$
31,400

Net premiums earned:

 

Life insurance
$
4,745

 
$
4,953

Accident and health insurance
1,864

 
1,917


$
6,609

 
$
6,870


Life Insurance Segment Reserves
We engage Wakely Actuarial Services of Palm Harbor, Florida as consulting actuary to calculate our reserves for traditional life insurance products. The methodology used requires that the present value of future benefits to be paid under life insurance policies less the present value of future net premiums be calculated. The calculation uses assumptions including estimates of any adverse deviation, investment yields and changes in investment yields, mortality, maintenance expenses and any non-forfeiture options or termination benefits. The assumptions determine the level and sufficiency of reserves which are calculated and reviewed by our consulting actuary at the end of each quarter. The independent consulting actuary also reviews our estimates for other insurance products including claims reserves under accident and health contracts. Management believes that the reserve amounts reflected in the accompanying consolidated financial statements are adequate.

Investments
A significant percentage of the total income for the Company is tied to the performance of its investments. Assets that will eventually be used to pay reserve liabilities and other policyholder obligations along with Company capital are invested to generate investment income while held by the Company. Our investment income is comprised primarily of interest and dividend income on debt and equity securities and realized capital gains and losses generated by debt and equity securities. At December 31, 2012, investments comprise 74% of total assets, and investment income (including realized gains) comprises almost 12% of total revenues evidencing the significant impact investments can have on financial results. Because the Company's insurance subsidiaries are regulated as to the types of investments they may make and the amount of funds they may maintain in any one type of investment, the Company has developed a conservative value oriented investment philosophy, in order to meet regulatory requirements. The Company's investment goals are to conserve capital resources and assets, obtain the necessary investment income threshold to meet reserves, and provide a reasonable return. Current yield from invested assets and capital appreciation of investments create this return.

Marketing and Distribution
As mentioned earlier in this report, NSIC products are marketed through a field force of agents who are employees of the Life Company and through a network of independent agents. The Company's use of independent agents is expected to be more cost effective in the long term and has become the fastest growing method of distribution over the past decade. In an effort to boost productivity and better educate agents on the products and services of NSIC, the Life Company marketing team travels extensively throughout our service areas holding training sessions for agents. We also offer our best agents the opportunity to periodically attend retreats to network with the home office staff that help serve them and our policyholders. In addition, the retreat provides agents with additional knowledge of the products we offer, and serves as a forum for feedback on how we can better serve our agency force and policyholders.

NSFC and Omega products are marketed through a network of independent agents and brokers, who are independent contractors and generally maintain relationships with one or more competing insurance companies. NSFC employs

9


three field marketing representatives who visit in the offices of our independent agent force regularly to give the agents opportunities for feedback. Our NSFC marketing representatives also host training seminars throughout our service areas. The goal of these seminars is to educate the independent agent sales force about our products and services.

Agents receive compensation for their sales efforts. In the case of life insurance agents, compensation is paid in the form of sales commissions plus a servicing commission. Commissions paid by NSIC in 2012 averaged approximately 7% of premiums. Commissions paid by NSFC in 2012 averaged approximately 15% of premiums. During 2012, one independent agent, accounted for more than 10% of total net earned premium of the property-casualty insurance subsidiaries. The net earned premium from this general agent totaled $4,622,000 or 10.22% of total P&C segment net earned premium. NSFC also offers a “profit sharing bonus plan” to independent agents in order to promote better field underwriting and encourage retention of profitable business. This plan not only rewards our agents but also enhances profitability by giving the agent a vested interest in our success and also aids in maintaining price stability for all our customers as agents have a financial incentive to use good field underwriting practices when completing an application for insurance.

At December 31, 2012, NSIC employed eight career agents and one regional manager. NSIC also had approximately 212 independent agents actively producing new business.

At December 31, 2012, NSFC had contracts with approximately 1,400 independent agencies in eleven states.

Competition
In both of our insurance segments, we operate in a very competitive environment. There are numerous insurance companies competing in the various states in which we offer our products. Many of the companies with which we compete are much larger, have significantly larger volumes of business, offer much broader ranges of products and have more significant financial resources than we do. We compete directly with many of these companies, not only in the sale of products to consumers, but also in the recruitment and retention of qualified agents. We believe the main areas in which a smaller company, like us, can compete is in the areas of providing niche products in under-served areas of the insurance market at competitive prices while providing excellent service to our agents and policyholders during the entire insurance product life cycle from policy issuance to final payment of a claim. We pride ourselves on being accessible to our independent agent force and maintain a presence through the efforts of a field marketing staff and easy access to home office staff. We believe we have made significant advancements in developing a competitive advantage, especially over the last decade. We also have longstanding relationships with many of our agents. We believe we compete effectively within the markets we serve and continue to evolve our processes and procedures in order to garner further competitive advantages.

NSFC and Omega's primary insurance products are dwelling fire and homeowners, including mobile homeowners. Dwelling fire and homeowners, collectively referred to as the dwelling property line of business, is the largest line of business in property and casualty operations, composing 94% of total property and casualty premium revenue. We focus on providing niche insurance products within the markets we serve. We are in the top twenty-five dwelling property insurance carriers in our two largest states, Alabama and Mississippi. However, due to the large concentration of business among the top five carriers, our total market share in the dwelling fire line of business is approximately 2% in Alabama and 1% in Mississippi. In the homeowners line of business, our market share in both Alabama and Mississippi is less than 1%. The homeowners markets are even more concentrated with the top three homeowners carriers in both Alabama and Mississippi controlling over 50% of the market share.

We have actively sought competitive advantages over the last decade in the area of technological advancement. We have replaced our primary policy administration systems in both our property and casualty and life insurance subsidiaries. We replaced our legacy policy administration system in our life subsidiary in 2002. In late 2006 and throughout 2007, we began the process in transitioning to a new policy administration system in our property and casualty subsidiary. In 2010, we converted to our current property and casualty claims administration system.

The property and casualty administration system is an internally developed end-to-end system that we believe enhances our ability to compete with larger carriers in the markets we serve. The system features a web based portal that allows our independent agents to rate, quote and issue policies directly in their office. The system streamlines the underwriting process with automation of many previous manual processes and enhances our agents' ability to provide excellent service to their clients. The system also enhances the efficiency of our underwriting process allowing for a more thorough evaluation of risks.


10


Our property and casualty claims administration system automates processes and workflows throughout the claims process and provides a single view of the activity that has occurred on a claim.  The system also has an adjuster web portal, which allows adjusters to view policy limits, see reserve history and policy information, and view prior claims and loss history.  Communications between adjusters and examiners are centralized on the web portal allowing for any messages to be viewed securely as part of the claims history.  Computerized issuance of field checks by staff adjusters was also implemented enforcing reserve and policy limits while reducing the error rates of the previously used hand written checks issued in the field.

Regulation
Our insurance subsidiaries are directly regulated by the insurance department in our state of domicile, Alabama. We are subject to the Alabama Insurance Holding Company System Regulatory Act and report to the Alabama Department of Insurance. Consequently, we are subject to periodic examination and regulation under Alabama Insurance Laws.

Our insurance subsidiaries are also subject to licensing and supervision by the various governmental agencies in the jurisdictions in which we do business. The nature and extent of such regulation varies, but generally has its source in state statutes which bestow regulatory, supervisory and administrative authority to State Insurance Commissioners and their respective insurance departments. The regulations may require the Company to meet and maintain standards of solvency, comply with licensing requirements, periodically examine market conditions and financial activities and report on the condition of operations and finances. In addition, most of our insurance rates are subject to regulation and approval by regulatory authorities within the respective states in which we offer our products.

Our insurance subsidiaries are subject to various statutory restrictions and limitations relating to the payment of dividends or distributions to stockholders. The restrictions are generally based on certain levels of surplus, net income or operating income as determined by statutory accounting practices. Alabama law permits dividends in any year which, together with other dividends made within the preceding 12 months, do not exceed the greater of (1) 10% of statutory surplus as of the end of the preceding year or (2) for property and casualty insurers, statutory net income for the preceding year or for life companies, statutory net gain from operations for the preceding year. Dividends in excess of the restricted amounts are payable only after obtaining expressed regulatory approval. Future dividends from the insurance subsidiaries may be limited by business or regulatory considerations. The Company relies on the ability of the insurance subsidiaries to pay dividends to fund stockholder dividends and for payment of most operating expenses of the group, including interest and principal payments on debt. Further discussion of dividend payment capacity of subsidiaries can be found in Note 12 of the Consolidated Financial Statements included herein.

Our insurance subsidiaries are subject to risk based capital requirements adopted by the National Association of Insurance Commissioners (NAIC). These requirements direct our insurance companies to calculate and report information according to a risk based formula which attempts to measure statutory capital and surplus needs based on the risk in our product mix and investment portfolio. The formula is designed to allow state insurance regulators to identify companies that are potentially inadequately capitalized. Under the formula, the Company calculates Risk Based Capital (RBC) by taking into account certain risks inherent in an insurer's assets, including investments and an insurer's liabilities. Risk based capital rules provide for different levels of action depending on the ratio of a company's total adjusted capital to its “authorized control level” RBC. Based on calculations made by each of our insurance subsidiaries at December 31, 2012, each subsidiary exceeds any levels that would require regulatory actions.

A.M. Best Rating
A.M. Best Company is a leading provider of insurance company financial strength ratings and insurance company issuer credit ratings. Best's financial strength ratings and issuer credit ratings provide an independent opinion based on comprehensive quantitative and qualitative evaluation of a company's balance sheet strength, operating performance and business profile. The Company currently has an issuer credit rating of “bb” with a negative outlook. The property and casualty companies currently carry an A.M. Best group financial strength rating of B++ (Good) with a negative outlook. This rating of B++ has remained the same for the past twelve years. The property and casualty group maintains an issuer credit rating of “bbb” with a negative outlook. The standalone financial strength rating for property and casualty subsidiary Omega One is currently B+ (Good) and Omega's issuer credit rating is “bbb-" with a stable outlook. National Security Insurance Company maintains a company specific financial strength rating of B+ (Good) with a stable outlook and an issuer credit rating of “bbb-” with a stable outlook. A.M. Best maintained a negative outlook on the property and casualty and group ratings citing underwriting volatility as a result of a trend of more frequent and severe weather-related events. For the latest ratings, you can access www.ambest.com.
  



11


Employees
The Company itself has no management or operational employees. Instead, all human resource activities are within the subsidiary National Security Insurance Company. NSIC employed 104 staff members as of December 31, 2012, none of which were represented by a labor union. The Company and its property and casualty subsidiary have a Management Service Agreement (“Agreement”) with National Security Insurance Company whereby the Company and the property and casualty subsidiaries reimburse NSIC for salaries and expenses of employees provided under the Agreement. Involved are employees in the areas of Underwriting, Customer Service, Policy Services, Accounting, Marketing, Administration, Document Management, Data Processing, Programming, Personnel, Claims, and Management. The Company, through NSIC, is represented by 8 employee agents in Alabama. The Company's property and casualty subsidiaries had approximately 1,400 independent (non-employee) agents producing business at December 31, 2012. We consider our employee relations to be good.

Additional information with respect to The National Security Group's Business
We maintain a website (www.nationalsecuritygroup.com). The National Security Group, Inc.'s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to such reports that we file or furnish pursuant to Section 13(a) of the Securities Exchange Act of 1934 are available through our website, free of charge, as soon as reasonably practical upon having been electronically filed or furnished to the Securities and Exchange Commission.

Our code of ethical conduct is also available on our website and in print to any stockholder who requests copies by contacting The National Security Group, Attn: Investor Relations, P. O. Box 703, Elba, AL 36323.

Any of the materials we file with the SEC may also be read and copied at the SEC's Public Reference Room at 100
F Street, NE, Washington, D.C. 20549. Information on the operation of the SEC's Public Reference Room may be
obtained by calling the SEC at 1.800.SEC.0330. Our periodic reports filed with the SEC, which include Forms 3, 4 and 5, Form 10-K, Form 10-Q, Form 8-K and any amendments thereto may also be accessed free of charge from the SEC's website at www.sec.gov.

Item 1A. Risk Factors

As a “Smaller Reporting Company,” we are not required to provide any disclosure under Item 1A. In providing these risk factors, we do not represent, and no inference should be drawn, that the disclosures so provided comply with all requirements of Item 1A if we were subject to them. Risk factors are events and uncertainties over which the Company has limited or no control and which can have a material adverse impact on our financial condition or results of operations. We are subject to a variety of risk factors. The following information sets forth our evaluation of the risk factors we deem to be most material. We work to actively manage these risks, but the reader should be cautioned that we are only able to mitigate the impact of most risk factors, not eliminate the risk. Also, there may be other risks which we do not presently deem material that may become material in the future.

Underwriting and product pricing
The insurance subsidiaries maintain underwriting departments that seek to evaluate the risks associated with the issuance of an insurance policy. NSIC accepts standard risks and, to an extent, substandard risks and engages medical doctors who review certain applications for insurance. In the case of the property and casualty subsidiaries, the underwriting staff attempts to assess, in light of the type of insurance sought by an applicant, the risks associated with a prospective insured or insurance situation. The underwriting assessment may involve various components in the risk evaluation process including, but not limited to, potential liability or fire hazards, age of dwelling, loss history, credit history of insured, employment status, location of fire department, home value, home heat source, and general maintenance of the property. In general, the property and casualty subsidiaries specialize in writing nonstandard risks.

The nonstandard market in which the property and casualty subsidiaries operate reacts to general economic conditions in much the same way as the standard market. When insurers' profits and equity are strong, companies sometimes cut rates or do not seek increases. Also, underwriting rules are less restrictive. As profit and/or capital fall, companies may tighten underwriting rules and seek rate increases. Premiums in the nonstandard market are higher than the standard market because of the increased risk, which generally comprises more frequent claims. Lower valued dwellings and mobile homes often warrant higher premiums because of the nature of the risk. The costs of placing such nonstandard policies and making risk determinations are similar to those of the standard market. The added costs due to more frequent claims servicing are reflected in the generally higher premiums that are charged.


12


Our ability to maintain profitability is contingent upon our ability to actively manage our rates and our underwriting procedures. Premium rate inadequacy may not become apparent quickly, and we will incur lag-time to correct. If our rates or underwriting processes become inadequate, our results of operations and financial condition could be adversely impacted.

Approval of rates
Most lines of business written by our property and casualty insurers are subject to prior approval of premium rates in the majority of the states in which we operate. The process of obtaining regulatory approval can be expensive and time consuming and can impair our ability to make necessary rate adjustments due to changes in loss experience, cost of reinsurance or other factors. If our requests to regulatory bodies for rate increases are not approved in an adequate or timely manner, our results of operations and financial condition may be adversely impacted.

Maintenance of profit margins and potential for margin compression
Our maximum long term average pretax profit margin on most of our insurance products is approximately five to six percent. In most states, we have limited ability to increase our margins beyond this level for higher risk, and we can incur significant delays in our ability to pass along higher cost that we may incur. Examples of this risk include:

Our catastrophe reinsurance cost is negotiated annually and effective January 1 of each year. The reinsurance market in which we operate is unregulated, and our reinsurance cost is based on negotiated rates that adjust annually. Due to increased frequency of storms over the past seven years and sometimes limited reinsurance market capacity, we often experience double digit rate increases and often cannot include these increases in our rates until the new reinsurance agreement is negotiated. Due to increased cat loads in more storm prone areas, significant year over year increases in cat cost can often temporarily eliminate our profit margins in some areas and significantly compress our overall profit margins priced into our insurance coverages.
We have a geographic concentration in the Southeastern U.S. which is exposed to significant hurricane risk. We believe that we are often not adequately compensated for certain heavily exposed risk through a combination of limits on allowable margin and delays in seeking rate increases. We often have to manage these exposures using alternatives to pricing, such as limits on new business production, to help us manage exposure concentrations and protect our capital position.
Due to increasing catastrophe reinsurance cost, we have incurred increases in our reinsurance retentions/deductibles over the past seven years. Again, due to limits to profit margins, we are often not adequately compensated for the increased risk associated with these higher reinsurance retentions due to overall limits on margins in some of the states in which we operate.

Reinsurance
Both insurance subsidiaries customarily reinsure with other insurers certain portions of the insurance risk. The primary purpose of such reinsurance arrangements is to enable the Company to limit its risk on individual policies, and in the case of property insurance, limit its risk in the event of a catastrophe in various geographic areas. A reinsurance arrangement does not discharge the issuing company from primary liability to the insured, and the issuing company is required to discharge its liability to the insured even if the reinsurer is unable to meet its obligations under the reinsurance arrangements. Reinsurance, however, does make the reinsurer liable to the issuing company to the extent of any reinsurance in force at the time of the loss. Reinsurance arrangements also decrease premiums retained by the issuing company since that company pays the reinsuring company a portion of total premiums based upon the amount of liability reinsured. NSIC generally reinsures all risks in excess of $50,000 with respect to any one insured. NSFC and Omega generally reinsure with third-parties any liability in excess of $225,000 on any single policy. In addition, the property and casualty subsidiaries have catastrophe excess reinsurance, which provided protection in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane.

In 2012, the property and casualty subsidiaries had catastrophe protection up to a $72.5 million aggregate loss. Under the property and casualty subsidiaries reinsurance arrangement in force during 2012, the Company retained the first $4 million of insured losses from any single catastrophic event. The next $13.5 million in insured losses from any single event was 95% reinsured with the Company's net retention being 5%. The third layer of reinsurance protection provided coverage for 100% of insured losses exceeding $17.5 million and up to $42.5 million. The fourth layer of reinsurance protection provided coverage for 100% of insured losses in excess of $42.5 million up to $72.5 million.

In the second quarter of 2012, we placed additional reinsurance cover in the form of reinsurance premium protection (RPP). The RPP cover will serve to reduce our risk from a major catastrophe and strengthen our capital position. The effect of adding this additional RPP cover is to reduce our modeled 100 year event net cost (net of reinsurance recoveries) from approximately $9 million (pretax) to an estimated $4.5 million (pretax).

13



Our inability to procure reinsurance, primarily catastrophe reinsurance, could adversely impact our ability to maintain our level of premium revenue. The increased frequency of catastrophic events also increases our cost of reinsurance pressuring the profit margins of our insurance products. It is generally cost prohibitive to maintain deductibles below levels currently in place. Our current $4.0 million catastrophe deductible will adversely impact underwriting results in years in which we incur losses from a major hurricane or tornado outbreak.

Risk of loss from catastrophic events and geographic concentration
As described above, we maintain catastrophe reinsurance in amounts that provides protection to the Company's financial condition in all but the most remote likelihood of occurrences. Our most critical catastrophe risk is from hurricanes due to our proximity to the Atlantic Ocean and the Gulf of Mexico. Our results of operations are very likely to be materially impacted in the event of the landfall of a major hurricane striking the Northern Gulf Coast or Southern Atlantic Coast in Georgia or South Carolina where we maintain significant concentrations of business. We are also exposed to the risk of significant tornado activity in many of the states in which we operate. Our most significant catastrophic event risk is the risk of a loss in excess of the Company's upper catastrophe limit which could adversely impact the Company's financial condition if such an event occurs. We are also subject to assessments from windstorm underwriting pools in various states. These risks are often difficult to measure and in the event of a major catastrophe, could exceed the upper limits of our available reinsurance protection. We also face risk from a high frequency of catastrophe events. While these events may not reach the lower limits of our catastrophe reinsurance protection, a large number of smaller events can materially impact our results of operations.

Catastrophe modeling results play a major role in our decision making process regarding the upper limits of our catastrophe reinsurance protection. While the level of sophistication has increased significantly in recent years in the design of computer generated catastrophe modeling, there are risks inherent in the modeling process, and the process continues to evolve. We believe the chance of a catastrophe event exceeding the upper limits of our reinsurance protection is remote; however, with the unpredictability of natural disasters, we are unable to eliminate all risk of exceeding the upper limits of our reinsurance protection. Hurricane Katrina exceeded the upper limits of our coverage in 2005. We have since increased the upper limits of our coverage, but should a future event exceed the upper limits of our reinsurance coverage by a material amount, our financial condition could be adversely impacted.

The amount of catastrophe reinsurance protection purchased by the Company was based on computer modeling of actual Company exposure. The Company generally seeks catastrophe protection for scenarios based on the computer modeling that mitigates losses up to at least a near term 1 in 100 year event, further described as an amount at which the probability of not exceeding is not less than 99%. NSFC and Omega had a provision for one reinstatement (coverage for two catastrophic events) during 2012.

Climate change
Scientific evidence supports that there have been and continue to be significant changes in climate including temperature, precipitation and wind resulting from various natural factors, processes, and human activities. Rising temperatures and changes in weather patterns could impact storm frequency and severity in our coverage areas. Increases in storm frequency and severity could negatively impact reinsurance costs impacting product pricing and the areas in which we offer our products. With respect to our property and casualty segment, climate change may impact the types of storms that impact our coverage areas as well as the frequency and severity of storms, thereby impacting reinsurance placement and rates. With respect to our life insurance segment, climate change may impact life expectancies, thereby influencing mortality assumptions used in pricing assumptions and reserve calculations. Climate change could impact future product offerings, exclusions and/or policy limitations.

The Company may be impacted by domestic legislation and regulation related to climate change. Governmental mandates could impede our ability to make a profit with our current product offerings, limit the products we can offer and/or impact the geographic locations in which we offer our products.

The impact of climate change cannot be quantified at this time.

Reserve liabilities
NSIC maintains life insurance reserves for future policy benefits to meet future obligations under outstanding policies. These reserves are calculated to be sufficient to meet policy and contract obligations as they arise. Liabilities for future policy benefits are calculated using assumptions for interest, mortality, morbidity, expense and withdrawals determined at the time the policies were issued. As of December 31, 2012, the total reserves of NSIC (including the reserves for accident and health insurance) were approximately $32.4 million. We believe, based on current available information,

14


reserves for future policy benefits are adequate. However, we are currently in a period of record low interest rates, and should this period of low rates be sustained over the long term, it can impair our ability to make sufficient returns to cover future policy liabilities. Also, should actual mortality, morbidity, expense or withdrawal assumption differ materially from assumptions, our operating results could be negatively impacted.

The property and casualty subsidiaries are also required to maintain loss reserves (claim liabilities) for all lines of insurance. Such reserves are intended to cover the probable ultimate cost of settling all claims, including those incurred but not yet reported. The reserves of the property and casualty subsidiaries reflect estimates of the liability with respect to incurred claims and are determined by evaluating reported claims on an ongoing basis and by estimating liabilities for incurred but not reported claims. Such reserves include adjustment expenses to cover the cost of investigating losses and defending lawsuits. The establishment of accurate reserves is complicated by the fact that claims in some lines of insurance are settled many years after the policies have been issued, thus raising the possibility that inflation may have a significant effect on the amount of ultimate loss payment, especially when compared to initial loss estimates. The subsidiaries, however, attempt to restrict their writing to risks that settle within one to four years of issuance of the policy. As of December 31, 2012, the property and casualty subsidiaries had reserves for unpaid claims of approximately $11.2 million before subtracting unpaid claims, due from reinsurers of $1,229,000 leaving net unpaid claims of
$10 million. The reserves are not discounted for the time value of money. No changes were made in the assumptions used in estimating the reserves during the years ending December 31, 2012 or 2011. The Company believes, based on current available information, such reserves are adequate to provide for settlement of claims.

We incur the risk that we may experience excessive losses due to unanticipated claims frequency, severity or both that may not be factored into our loss reserve liabilities. Unexpected frequency and severity can be adversely impacted by outcomes of claims litigation; adverse jury verdicts related to claims settlements and adverse interpretations of insurance policy provisions which result in increased liabilities. We are also subject to the risk of unanticipated assessments from state underwriting associations or windstorm pools related to losses in excess of the associations or pool's ability to pay. Such costs are often allocated to companies operating in the jurisdiction of the association or windstorm pool, and the likelihood and amount of such assessments are difficult to predict. These events could adversely impact our historical loss reserving methodology and cause financial adjustments that could materially impact our financial condition and results of operations.

Financial Ratings
The insurance subsidiaries are rated by A.M. Best Company, an insurance company-rating agency. NSFC is rated B++ (Good), Omega is rated B+ (Good) and NSIC is rated B+ (Good) by A.M. Best Company. The property and casualty and group ratings currently have a negative outlook and may be downgraded if earnings for 2013 fall below expectations or if capital is eroded by operating losses or dividends to the parent company. In order to stabilize the property and casualty and group ratings, the Company must show a positive earnings trend that leads to capital appreciation without excess growth. A downgrade in our A.M. Best ratings could adversely impact our ability to maintain existing business or generate new business. See page 12-13 of this Form 10-K for additional information on our current A.M. Best rating.

Regulation
The insurance subsidiaries are each subject to regulation by the insurance departments of those states in which they are licensed to conduct business. Although the extent of regulation varies from state to state, the insurance laws of the various states generally establish supervisory departments having broad administrative powers with respect to, among other matters: the granting and revocation of licenses to transact business, the licensing of agents, the establishment of standards of financial solvency (including reserves to be maintained), the nature of investments and in most cases premium rates, the approval of forms and policies, and the form and content of financial statements. The primary purpose of these regulations is the protection of policyholders. Compliance with regulations does not necessarily confer a benefit upon shareholders.

Many states in which the insurance subsidiaries operate, including Alabama, have laws requiring that insurers become members of guaranty associations. These associations guarantee that benefits due policyholders of insurance companies will continue to be provided even if the insurance company which wrote the business is financially unable to fulfill its obligations. To provide these benefits, the associations assess the insurance companies licensed in a state that write the line of insurance for which coverage is guaranteed. The amount of an insurer's assessment is generally based on the relationship between that company's premium volume in the state and the premium volume of all companies writing the particular line of insurance in the state. The Company has paid no material amounts to guaranty associations over the past three years. These payments, when made, are principally related to association costs

15


incurred due to the insolvency of various insurance companies. Future assessments depend on the number and magnitude of insurance company insolvencies, and such assessments are therefore difficult to predict.

Most states have enacted legislation or adopted administrative rules and regulations covering such matters as the acquisition of control of insurance companies, transactions between insurance companies and the persons controlling them. The National Association of Insurance Commissioners has recommended model legislation on these subjects, and all states where the Company's subsidiaries transact business have adopted, with some modifications, that model legislation. Among the matters regulated by such statutes are the payments of dividends. These regulations have a direct impact on the Company since its cash flow is substantially derived from dividends from its subsidiaries, and adverse operating results in the insurance subsidiaries or the development of significant additional obligations in the holding company could adversely impact liquidity at the holding company level. Statutory limitations of dividend payments by subsidiaries are disclosed in Note 12 of the accompanying Consolidated Financial Statements.

While most regulation is at the state level, the federal government has increasingly expressed an interest in regulating aspects of the insurance industry. All of these regulations at various levels of government increase the cost of conducting business through increased compliance expenses. Also, existing regulations are constantly evolving through administrative and court interpretations, and new regulations are often adopted. It is difficult to predict what impact changes in regulation may have on the Company in the future. Changes in regulations could occur that might adversely impact our ability to achieve acceptable levels of profitability and limit our growth.

Competition
The insurance subsidiaries are engaged in a highly competitive business and compete with many insurance companies of substantially greater financial resources, including stock and mutual insurance companies. Mutual insurance companies return profits, if any, to policyholders rather than shareholders; therefore, mutual insurance companies may be able to charge lower net premiums than those charged by stock insurers. Accordingly, stock insurers must attempt to achieve competitive premium rates through greater volume, efficiency of operations and control of expenses.

NSIC primarily markets its life and health insurance products through the home service system and independent producers. Direct competition comes from home service companies and other insurance companies that utilize independent producers to sell insurance products, of which there are many. NSIC's life and health products also compete with products sold by ordinary life companies. NSIC writes policies primarily in Alabama, Georgia and Mississippi. The market share of the total life and health premiums written is small because of the number of insurers in this highly competitive field. The primary methods of competition in the field are service and price.

Because of the increased costs associated with a home service company, premium rates are generally higher than ordinary products; as a result, competition from these ordinary insurers must be met through service. Initial costs of distribution through independent agents are generally more than through home service distribution methods, but lower commissions are paid in years subsequent to the first year of the policy so costs decline rapidly as policies renew after the first year. The primary factor in controlling cost under the independent agent distribution method is maintaining a high persistency rate. The persistency rate is the rate at which new business is maintained in renewal periods subsequent to the first year. If a high persistency rate can be maintained, the overall costs of distribution are lowered due to lower commission rate payments on policies in force subsequent to the first year.

The property and casualty subsidiaries market their products through independent agents and brokers, concentrating primarily on dwelling fire, homeowners and nonstandard auto coverage. NSFC, though one of the larger writers of lower value dwelling fire insurance in Alabama, nevertheless faces a number of competitors in this niche market. Moreover, larger general line insurers also compete with NSFC. The market share in states other than Alabama is small. Price is the primary method of competition. Because the Company utilizes independent agents, commission rates and service to the agent are also important factors in whether the independent agent agrees to offer NSFC products over those of its competitors. The Company primarily relies on an established independent agency force to market our insurance products. The loss of independent agents could adversely impact both the retention of existing business and production of new business.

Significant changes in the competitive environment in which we operate could materially impact our financial condition or results of operations.





16


Inflation
The Company shares the same risks from inflation as other companies. Inflation causes operating expenses to increase and erodes the purchasing power of the Company's assets. A large portion of the Company's assets is invested in fixed maturity investments. The purchasing power of these investments will be less at maturity because of inflation. This is generally offset by the reserves that are a fixed liability and will be paid with cheaper dollars. Also, inflation tends to increase investment yields, which may reduce the impact of the increased operating expenses caused by inflation.

Investment Risk and Liquidity
Our invested assets are managed by company personnel. The majority of these investments consist of fixed maturity securities. These securities are subject to price fluctuations due to changes in interest rates, and unfavorable changes could materially reduce the market value of the Company's investment portfolio and adversely impact our financial condition and results of operations. Fixed maturity investments are managed in light of anticipated liquidity needs. Should we experience a significant change in liquidity needs for any reason, we may be forced to sell fixed maturity securities at a loss to cover these liquidity needs. Changes in general economic conditions, the stock market and various other external factors could also adversely impact the value of our investments and consequently our results of operations and financial condition.

Impact of economic and credit market conditions on our investments
Our investment portfolio is exposed to economic and financial market risks, including changes in interest rates, credit markets and prices of marketable equity and fixed-income securities. Events that unfolded in the latest recession had a material impact on the valuations of our investments. Economic and credit market conditions during the recession adversely affected the ability of some issuers of investment securities to repay their obligations and may further affect the values of investment securities. If the carrying value of our investments exceeds the fair value, and the decline in fair value is deemed to be other-than-temporary, we will be required to write down the value of our investments, which could materially harm our results of operations and financial condition.

Litigation
We are routinely involved in litigation related to our insurance products. Litigation can involve claims for damages in excess of stated policy limits and include damages for bad faith. Defense of these claims can often be expensive adding to our loss adjustment expenses, and adverse jury verdicts could materially impact our results of operations and financial position.
Dependence of the Company on Dividends from Insurance Subsidiaries
The Company is an insurance holding company with no significant operations and limited outside sources of income. The primary asset of the Company is its stock in the insurance subsidiaries. The Company relies on dividends from the insurance subsidiaries in order to pay operating expenses, to service debt obligations and to provide liquidity for the payment of dividends to shareholders. The ability of the insurance subsidiaries to pay dividends is subject to regulatory restrictions discussed in detail in Note 12 of the Consolidated Financial Statements included herein. Should the insurance subsidiaries become subject to restrictions imposed by insurance regulations regarding the payment of dividends, the ability of the Company to pay expenses, meet debt service requirements and pay cash dividends to shareholders could be adversely impacted. Additionally, should business conditions deteriorate, we could be forced to further limit or suspend dividend payments in order to protect our capital position.

Low common stock trading volume and liquidity limitations
We are a small public company with a large percentage of common stock outstanding owned by founding family members, employees, officers and directors. Consequently, our average daily trading volume is very low with no shares traded on some days and only a few hundred shares trading in a typical day. This low trading volume can lead to significant volatility in our share price and limit a shareholders ability to dispose of large quantities of stock in a short period of time.

Debt covenants
Should we become unable to remain current on interest payments on our long term debt, under our debt covenants, we would be forced to suspend the payment of dividends to stockholders until interest payments are current.

Technology
Our insurance subsidiaries are dependent on computer technology and internet based platforms in the delivery of insurance products. Our ability to innovate and manage technological change is a key to remaining competitive in the insurance industry. A breakdown in major systems or failure to maintain up to date technology could adversely impact

17


our ability to write new business and service existing policyholders, which would adversely impact our results of operations and financial condition. The occurrence of computer viruses, information security breaches, disasters, or unanticipated events could affect the data processing systems of the Company or its service providers which could damage the Company's business and adversely affect our financial condition and results of operations.

Access to capital
We rely on debt and equity capital to operate. Due to a recent litigation settlement, our debt levels are higher than our historical norm. Adverse operating results, general market and economic conditions could impair our ability to raise new capital needed to support our operations.

Key Personnel
As a small company within the insurance industry, we could be adversely impacted by the loss of key personnel. Our ability to remain competitive is contingent upon our ability to attract and retain qualified personnel in all aspects of our operations.

Accounting Standards
Our financial statements are prepared based upon generally accepted accounting standards issued by the Financial Accounting Standards Board along with standards set by other regulatory organizations. We are required to adopt newly issued or revised accounting standards that are issued periodically. Future changes could impact accounting treatment applied to financial statements and could have a material adverse impact on the Company's results of operations and financial conditions. Potential changes in accounting standards that are currently expected to impact the Company are disclosed in the Notes to Financial Statements included herein.

Item 1B. Unresolved Staff Comments

As a smaller reporting company, the Company is not required to furnish the information required in Item 1B.

Item 2. Properties

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 Company and its subsidiaries own certain real estate investment properties. We own approximately 2,950 acres of undeveloped timberland in Pike, Coffee and Covington counties in Alabama. The timber is accounted for as a natural resource and depleted in accordance with applicable accounting standards, which identify total costs as including acquisition costs, exploration costs, development costs, production costs and support equipment and facilities cost.  We include in total costs timberland purchases and reforestation costs and other costs associated with the planting and growing of timber, such as site preparation, growing or purchases of seedlings, planting, fertilization, herbicide application and the thinning of tree stands to improve growth.  We allocate total cost of the timberland over periods benefited by means of depletion.  Timber revenue during 2012 totaled $87,000 compared to $14,000 during 2011. Gains on timber sales during 2012 totaled $71,000 compared to $12,000 in 2011.

We also own approximately 100 acres of undeveloped commercial real estate in Greenville, Alabama. We sell undeveloped lots from this development, and the development has no depreciable improvements.

Capitalized along with the cost of the timberland and the Greenville property are site preparation costs, including clearing, filling and leveling of land. There are no improvements such as paving, parking lots or fencing that would be recorded as land improvements and depreciated over the appropriate useful life.

Item 3. Legal Proceedings

As disclosed in Note 15 to these consolidated financial statements regarding contingencies, the Company was involved in litigation related to its divestiture of Mobile Attic, Inc. In June 2012, the matter was settled. Under the terms of the settlement agreement, the Company will pay a total of $13 million to the plaintiff. Further information regarding events leading to settlement and settlement details found within the Company's discussion of Liquidity and Capital Resources as well as in Note 15 to the consolidated financial statements.

18



The Company and its subsidiaries are named parties to litigation related to the conduct of their insurance operations. Further information regarding details of pending suits can be found in Note 15 to the consolidated financial statements.

Item 4. Mine Safety Disclosures

This section is not applicable.

PART II

Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

The capital stock of the Company is traded in the NASDAQ Global Market. Quotations are furnished by the National Association of Security Dealers Automated Quotations System (NASDAQ). The trade symbol is NSEC.

The following table sets forth the high and low sales prices per share, as reported by NASDAQ, during the period indicated:

Stock Closing Prices
 
2012
 
2011

High
 
Low
 
High
 
Low
 

 

 
 
 
 
  First Quarter
$
9.91

 
$
7.67

 
$
13.13

 
$
11.18

  Second Quarter
$
9.36

 
$
8.01

 
$
13.82

 
$
10.00

  Third Quarter
$
9.36

 
$
8.00

 
$
11.84

 
$
9.51

  Fourth Quarter
$
8.58

 
$
7.58

 
$
10.93

 
$
7.62

Shareholders
The number of shareholders of the Company's common stock was approximately 1,200, and the Company had 2,466,600 shares of common stock outstanding on March 26, 2013.

Dividends
The following table sets forth quarterly dividend payment information for the Company for the periods indicated:

Dividends Per Share
 
 
 
 
 
2012
 
2011
  First Quarter
$
0.10

 
$
0.15

  Second Quarter
$
0.10

 
$
0.15

  Third Quarter
$
0.10

 
$
0.15

  Fourth Quarter
$
0.025

 
$
0.10

Discussion regarding dividend restrictions may be found on page 41 of the Managements' Discussion and Analysis as well as in Note 12 of the Consolidated Financial Statements.

The payment of shareholder dividends is subject to the discretion of our Board of Directors and is dependent upon many factors including our operating results, financial condition, capital requirements and general economic conditions. Total shareholder dividends paid in 2012 totaled $802,000.

Future dividends are dependent on future earnings, the Company's financial condition and other factors evaluated periodically by management and the Board of Directors. The Company is an insurance holding company and depends upon the dividends from the insurance subsidiaries to pay operating expenses and to provide liquidity for the payment of shareholder dividends. The payment of shareholder dividends is subject to the profitability of the insurance subsidiaries and the ability of the insurance subsidiaries to pay dividends to the holding company. Dividends from the

19


insurance subsidiaries are subject to approval of the regulator in the state of domicile, the Alabama Department of Insurance.



Securities authorized for issuance under equity compensation plans
The Company currently only has one equity compensation plan which was approved by security holders at the 2009 Annual Shareholders Meeting. The following table sets forth securities authorized for issuance under the Company's equity compensations plans:

Plan category
Number of securities to be issued upon exercise of outstanding options, warrants and rights
(a)
 
Weighted-average exercise price of outstanding options, warrants and rights
(b)
 
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in column (a))
(c)
Equity compensation plans approved by security holders

 

 
200,000

Equity compensation plans not approved by security holders

 

 

Total

 

 
200,000




Item 6. Selected Financial Data

Under smaller reporting company rules we are not required to disclose information required under Item 6. However, in order to provide information to our investors, we have elected to provide certain selected financial data.

Five-Year Financial Information:
(Dollars in thousands, except per share)
Operating Results:
2012
 
2011
 
2010
 
2009
 
2008
Net premiums earned
$
51,815

 
$
56,243

 
$
61,263

 
$
59,594

 
$
56,264

Net investment income
4,227

 
4,261

 
5,089

 
5,289

 
4,368

Net realized investment gains (losses)
2,790

 
669

 
1,879

 
357

 
(1,049
)
Other income
720

 
919

 
1,161

 
764

 
1,107

Total revenues
$
59,552

 
$
62,092

 
$
69,392

 
$
66,004

 
$
60,690

Net (loss) income
$
(6,671
)
 
$
(4,956
)
 
$
3,265

 
$
4,224

 
$
(5,204
)
Net (loss) income per share
$
(2.70
)
 
$
(2.01
)
 
$
1.32

 
$
1.71

 
$
(2.11
)
Other Selected Financial Data:
2012
 
2011
 
2010
 
2009
 
2008
Total shareholders' equity
$
30,227

 
$
38,015

 
$
43,710

 
$
41,168

 
$
34,648

Book value per share
$
12.25

 
$
15.41

 
$
17.72

 
$
16.69

 
$
14.04

Dividends per share
$
0.325

 
$
0.550

 
$
0.600

 
$
0.600

 
$
0.900

Net change in unrealized

 

 

 

 

  capital gains (net of tax)
$
(101
)
 
$
1,258

 
$
847

 
$
3,520

 
$
(6,147
)
Total assets
$
135,716

 
$
132,951

 
$
136,867

 
$
131,396

 
$
124,890


20


Quarterly Information:
 Premiums
 
 Investment & Other Income
 
 Realized Investment Gains (Losses)
 
 Claims and Benefit Payments
 
 Net Income (Loss)
 
 Net Income (Loss) Per Share
2012

 

 

 

 

 

  First Quarter
$
13,496

 
$
1,332

 
$
206

 
$
7,845

 
$
531

 
$
0.21

  Second Quarter
12,533

 
1,259

 
865

 
7,976

 
(7,306
)
 
(2.96
)
  Third Quarter
12,904

 
1,398

 
1,703

 
11,564

 
(627
)
 
(0.25
)
  Fourth Quarter
12,882

 
958

 
16

 
6,720

 
731

 
0.30


$
51,815

 
$
4,947

 
$
2,790

 
$
34,105

 
$
(6,671
)
 
$
(2.70
)
2011

 

 

 

 

 

  First Quarter
$
14,870

 
$
1,397

 
$
770

 
$
9,322

 
$
995

 
$
0.40

  Second Quarter
13,321

 
1,513

 
261

 
15,682

 
(4,945
)
 
(2.00
)
  Third Quarter
14,340

 
982

 
(203
)
 
10,045

 
(650
)
 
(0.26
)
  Fourth Quarter
13,712

 
1,288

 
(159
)
 
8,976

 
(356
)
 
(0.15
)

$
56,243

 
$
5,180

 
$
669

 
$
44,025

 
$
(4,956
)
 
$
(2.01
)

Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview
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 NSG) 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, 2012.

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.

This discussion and analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data and Consolidated Financial Statements and related notes included in this Form 10-K. Please refer to our note regarding forward-looking statements on pages 4-5 of this report.

Information in this discussion is presented in whole dollars rounded to the nearest thousand.

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 49.5% of gross premium revenue generated in the states of Alabama and Mississippi.  Property and casualty insurance is the most significant segment, accounting for 87.2% of total insurance premium revenue for 2012.  Revenue generated from the life segment accounted for 12.8% of total insurance premium revenue for 2012.

National Security Insurance Company (NSIC) is a life, accident and health insurance company founded in 1947 and is the oldest subsidiary of the Company.  The premium revenue produced in NSIC from the traditional life products and accident and health products accounted for 9.4% and 3.5%, respectively, of total 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 and Texas.

Omega One Insurance Company (Omega) is a property and casualty insurance company incorporated in 1992.  Omega is a wholly owned subsidiary of National Security Fire and Casualty Company (NSFC) and is the smallest of the

21


insurance subsidiaries, accounting for approximately 2.3% of consolidated premium revenue.  Omega is licensed and underwrites property and casualty insurance in the states of Alabama and Louisiana.  There is no material product differentiation between those products underwritten by NSFC and Omega as both primarily underwrite personal lines of insurance.

National Security Fire and Casualty Company (NSFC) is a property and casualty insurance company and is the largest of the insurance subsidiaries, accounting for over 84.9% of total premium revenue of the Company.  NSFC operates primarily in the personal lines segment of the property and casualty insurance market.  NSFC has been in operation since 1959.  NSFC is licensed and underwrites property and casualty insurance in the states of Alabama, Arkansas, Florida, Georgia, Mississippi, Oklahoma, South Carolina and Tennessee.  NSFC is licensed, but does not currently underwrite any business, in the states of Kentucky and West Virginia.  NSFC also underwrites insurance on a non-admitted or surplus lines basis in the states of Louisiana, Missouri and Texas.

All of the insurance subsidiaries are Alabama domiciled insurance companies; therefore, the Alabama Department of Insurance is the primary insurance regulator.  However, each subsidiary is subject to regulation by the respective insurance regulators of each state in which it is licensed to transact business.  Insurance rates charged by each of the insurance subsidiaries are typically reviewed and approved by each insurance department for the respective state to which the rates will apply.

All of our insurance companies have been assigned ratings by A.M. Best.  The property and casualty group has been assigned a group rating of “B++” (Good) with a negative outlook.  In addition, A.M. Best has assigned an issuer credit rating of “bbb” with a negative outlook.  NSFC, the largest of the insurance subsidiaries, carries the same A.M. Best ratings as the group.  Omega carries an A.M. Best rating of “B+” (Good) with a stable outlook and an issuer credit rating of “bbb-” with a stable outlook.  The life insurance subsidiary, NSIC, has been assigned an upgraded rating of “B+” (Good) from "B" (Fair) with a stable outlook and an issuer credit ratio upgrade of "bbb-" up from “bb+” with a stable outlook.  All ratings are reviewed at least annually by A.M. Best with the latest ratings' effective date of November 30, 2012. AM Best is currently undergoing its annual review process of our ratings.

The two primary segments in which we report insurance operations are the personal lines property and casualty segment (NSFC) and the life, accident and health insurance segment (NSIC).  Due to the small amount of premium revenue produced by Omega and the fact that Omega is a wholly owned subsidiary of NSFC underwriting similar lines of business, all references to NSFC in the remainder of this management discussion and analysis will include the insurance operations of both NSFC and Omega.  Our income is principally derived from net underwriting profits and investment income.  Net underwriting profit is principally derived from earned premiums received less claims paid, sales commissions to agents, costs of underwriting and insurance taxes and fees.  Investment income includes interest and dividend income and gains and losses on investment holdings.
 
Summary of Consolidated Results of Operations
Condensed revenue and income information follows:


Year ended December 31,

2012
 
2011
Premium Earned
$
51,815,000

 
$
56,243,000

Investment Income
4,227,000

 
4,261,000

Realized Investment Gains
2,790,000

 
669,000

Other Income
720,000

 
919,000

Total Revenues
$
59,552,000

 
$
62,092,000

Net (Loss) Income
$
(6,671,000
)
 
$
(4,956,000
)


 

Net (Loss) Income Per Share
$
(2.70
)
 
$
(2.01
)

For the year-ended December 31, 2012, total revenues were $59,552,000 compared to $62,092,000 for the same period last year; a decrease of 4.1%. A decline in net premiums earned, primarily in the P&C segment, was the main contributing factor to the decrease in total revenue for 2012 over 2011. Partially offsetting the decline in revenue was a $2,121,000 increase in realized investment gains in the current year compared to the same period last year. The increase in realized capital gains was primarily from the sale of equity securities in the life segment.


22


Year-to-date net premiums earned were down 7.9% in 2012 compared to 2011. The decrease was composed of a $244,000 or 3.5% decline in total life, accident and health premium revenue and a $4,184,000 or 8.5% decrease in P&C net premiums earned. Primary drivers of the decline in net premiums earned were an increase in catastrophe reinsurance costs and a decline in automobile premium; both in the P&C segment. Catastrophe reinsurance cost was up approximately 19% in 2012 compared to 2011. In addition, we added reinsurance premium protection (RPP) coverage to our reinsurance coverage during 2012 to help reduce capital exposure in the event of a major catastrophe in the P&C segment. The RPP coverage cost increased reinsurance ceded and reduced premium revenue by $1,325,000. Furthermore, due to the termination of the automobile program in late 2011, P&C segment premium revenue was reduced $2,882,000 in the current year compared to the same period last year.

The Company ended 2012 with a net loss totaling $6,671,000 compared to a net loss of $4,956,000 in 2011. The Company ended 2012 with a net loss per share of $2.70 compared to net loss per share of $2.01 in 2011. The primary reasons for the net loss in 2012 were an increase of $11,702,000 in litigation settlement and defense costs and an increase in incurred losses from Hurricane Isaac claims. During 2012, we settled longstanding litigation related to the sale of The Mobile Attic, Inc. This settlement was the primary reason for the significant increase in litigation settlement and defense costs in the current year compared to the same period last year. The final settlement totaled $13,000,000, and the impact of the settlement and remaining legal fees are reflected in these consolidated financial statements. Additional information related to the settlement can be found below in the litigation settlement and defense costs discussion, liquidity and capital resources section of the Management Discussion and Analysis and in Note 15 to the consolidated financial statements. Also contributing to the net loss in 2012 were Hurricane Isaac reported losses and LAE which totaled $3,390,000 from 1,147 claims. The claims from this cat event increased the P&C segment loss ratio by 7.5 percentage points. Additional discussion regarding this catastrophe follows in the industry segment data section of the Management Discussion and Analysis.

As a percent of net premiums earned, claims were 65.8% through December 31, 2012 compared to 78.3% for the same period last year; a decrease of 12.5 percentage points. Although claims were down in 2012 compared to 2011, both years were negatively impacted by a higher frequency of reported losses due to cat events. As mentioned in the preceding paragraph, the P&C segment was negatively impacted by Hurricane Isaac in 2012. During 2011, the P&C segment was impacted by an extremely active spring storm season with April 2011 being ranked as the most active tornado month on record. The largest of these spring storms occurred on April 25th-27th, 2011 (referred to as catastrophe 46) and caused widespread damage from tornado, wind and hail damage throughout the Southeastern United States. This cat event led to 1,652 reported claims during 2011 totaling $10,432,000 ($3,847,000 net of reinsurance recoveries).

P&C segment incurred losses and LAE from the automobile program also contributed to the elevated claims levels in 2011. The automobile program was terminated in late 2011 due to continued unprofitable underwriting results. Year-to-date incurred losses and LAE were $(177,000) in 2012 compared to $4,492,000 for the same period last year. The primary reason for the decline in current year claims was reserve releases. The decision to discontinue the automobile programs was made by management in an effort to improve the profitability of P&C underwriting results and stabilize earnings.

Results of Operations for Years Ended December 31, 2012 and 2011
The Company ended 2012 with net premiums earned totaling $51,815,000 compared to $56,243,000 for the same period last year. Premium revenue is generated from our two operating segments: P&C segment and life segment. The P&C segment accounts for approximately 87% of total premium revenue while our life segment contributes the remaining 13%. The P&C segment operates in personal lines insurance products primarily generating premium revenue from dwelling fire and homeowners coverages. Our life segment produces premium revenue primarily from whole life, accident and critical illness insurance policies.

23


The table below provides a summary premium revenue by segment and line of business for the year ended December 31, 2012 and 2011:

 
 
Year-ended December 31,
 
Percent
 
 
2012
 
2011
 
increase (decrease)
Life, accident and health operations:
 
 
 
 
 
 
Traditional life insurance
 
$
4,818,000

 
$
5,008,000

 
(3.8
)%
Accident and health insurance
 
1,864,000

 
1,918,000

 
(2.8
)%
Total life, accident and health
 
6,682,000

 
6,926,000

 
(3.5
)%
 
 
 
 
 
 
 
Property and Casualty operations:
 
 
 
 
 
 
Dwelling fire & extended coverage
 
27,206,000

 
26,250,000

 
3.6
 %
Homeowners (Including mobile homeowners)
 
23,287,000

 
24,910,000

 
(6.5
)%
Ocean marine
 
1,090,000

 
1,205,000

 
(9.5
)%
Other liability
 
1,412,000

 
1,257,000

 
12.3
 %
Private passenger auto liability
 
319,000

 
2,154,000

 
(85.2
)%
Commercial auto liability
 
6,000

 
363,000

 
(98.3
)%
Auto physical damage
 
149,000

 
839,000

 
(82.2
)%
Total property and casualty
 
53,469,000

 
56,978,000

 
(6.2
)%
 
 
 
 
 
 
 
Reinsurance premium ceded
 
(8,336,000
)
 
(7,661,000
)
 
8.8
 %
 
 
 
 
 
 
 
 Total net earned premium revenue                              
 
$
51,815,000

 
$
56,243,000

 
(7.9
)%

A primary reason for the 7.9% decline in net premium revenue was an increase in catastrophe reinsurance cost in 2012. In addition to a 19% increase in catastrophe reinsurance cost related to our cat coverage, we also incurred $1,325,000 related to the cost of adding reinsurance premium protection (RPP) to our catastrophe reinsurance structure in 2012. The RPP coverage reduces our risk from a major catastrophe and helps strengthen our capital position. 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. Reinsurance ceded in the prior year was up $1,621,000 due to reinstatement premium related to catastrophe 46 discussed previously.

To offset the increase in catastrophe reinsurance cost in the P&C segment, we are implementing rate increases in states and territories most impacted by catastrophe reinsurance cost. We did experience significant margin compression in 2012 due to the combination of the previously mentioned increased cat cost which became effective in January of 2012 and delays inherent in the rate approval process. Our cat reinsurance cost held steady in 2013 and as rate increases are implemented, we should experience some relief from catastrophe cost related margin compression.

Net investment income remained relatively unchanged ending 2012 at $4,227,000 compared to $4,261,000 in 2011; a decrease of 0.8%. A primary reason for comparable results for investment income was the minimal change in invested assets in the current year compared to the prior year. The Company ended 2012 with invested assets of $100,133,000 compared to $101,972,000 in 2011; a 1.8% or $1,839,000 decrease. In addition, cash flow from P&C segment operations was adversely impacted by claims incurred from Hurricane Isaac in 2012 which reduced operating cash flow available to grow investments. This outflow, coupled with a challenging interest rate environment, were primary reasons for the lack of growth in investment income in the current year compared to the same period last year.

Net realized investment gains totaled $2,790,000 in 2012 compared to $669,000 in 2011; an increase of $2,121,000. The $2,121,000 increase in realized investment gains in 2012 compared to 2011 was primarily in the life segment which ended the current year with an increase of $1,592,000 while the P&C segment increase totaled $417,000. The primary reason for the increase was a greater amount of selling activity during the current year compared to the same period last year. A primary focus during the current year was to moderately reduce the equity portfolio in the life segment in order to increase the allocation to fixed income. These efforts were made to improve duration matching of liabilities and strengthen regulatory cash flow testing results. The realization of capital gains in the investment portfolio is influenced by both market conditions and liquidity requirements of the insurance subsidiaries and therefore

24


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.

Other income was $720,000 for the period ended December 31, 2012 compared to $919,000 for the same period last year; a $199,000 decrease. Other income consists primarily of billing, payment and policy fees related to the issuance of our property and automobile insurance policies in the P&C segment as well as other, primarily non-recurring, miscellaneous income. The primary reason for the decrease during 2012 compared to 2011 was a decline in fee income related to the discontinuance of our automobile program in the P&C segment.

Policyholder benefits paid (claims) decreased 22.5%, ending 2012 at $34,105,000 compared to $44,025,000 for the same period last year. Claims as a percentage of net premiums earned totaled 65.8% for 2012 compared to 78.3% in 2011. The primary reason for the $9,920,000 decrease was lower claims activity in the P&C segment primarily related to less storm activity during 2012 compared to 2011 coupled with decreased claims in the automobile line of business in 2012 compared to 2011. However, while comparatively better, claims were still elevated in the current year due to losses and LAE reported from Hurricane Isaac.
  
The P&C segment is affected by storm systems classified as "catastrophes" by Property Claims Service (PCS) when a single storm system or other natural disaster causes in excess of $25 million in industry losses. The losses and loss adjustment expenses (LAE) incurred in the P&C segment from claims associated with storm systems classified as "catastrophic" (referred to as "cat events" hereafter), totaled $4,295,000 in 2012 compared to $14,040,000 ($7,455,000 net of reinsurance) in 2011. The current year claims were incurred from nine separate cat events and accounted for 11.7% of total claims during the year compared to 33.1% of claims (18.2% on a net basis) from eighteen cat events during the prior year.

The largest cat event during 2012 was Hurricane Issac from which we incurred 1,147 policyholder claims totaling $3,390,000. Hurricane Issac claims accounted for 78.9% of all incurred losses and incurred LAE related to cat events during 2012. The P&C segment maintains catastrophe reinsurance to reduce risk associated with losses from cat events. The reinsurance is structured with a $4,000,000 retention/deductible from a single cat event with 5% coinsurance retained on the first two layers of coverage. Any claim activity exceeding the first two layers is 100% reinsured up to $72,500,000 in ultimate incurred losses and LAE. Because the claims from Hurricane Issac did not exceed our deductible for 2012, they were not reinsured.

A cat event on April 25th-27th, 2011 (catastrophe 46) was the primary source of the overall losses and LAE incurred during 2011. The reported losses and LAE cat 46 totaled $10,432,000. The reinsurance deductible for 2011 was $3,500,000. Because the P&C segment losses and LAE reported from catastrophe 46 exceeded the 2011 reinsurancedeductible, the P&C segment recovered $6,585,000 from reinsurers during the prior year. The P&C segment retained $3,847,000 of the reported losses and LAE from catastrophe 46 during 2011.

Amortization of deferred policy acquisition costs (DAC) and commissions totaled $11,267,000 compared to $12,168,000 for the same period last year; a decrease of $901,000. The primary reason for the decrease was a reduction in premium revenue in the P&C segment.

General and administrative expenses decreased $44,000, ending 2012 at $8,790,000 compared to $8,834,000 for the same period last year. Although general and administrative expenses were down, management continues to focus on this area as we seek ways to maximize efficiency and reduce costs by streamlining processes and cross-training employees across both insurance segments of the Company.

Taxes, licenses and fees were comparable at $1,846,000 in 2012 compared to $1,885,000 for the same period last year. As a percent of premium revenue, taxes, license and fees for the year ended December 31, 2012 and 2011 were 3.6% and 3.4%, respectively. Premium taxes were moderately higher due to shifts in P&C gross written premium with declines in surplus lines states in which we incur no premium taxes and increases in gross written premium in states in which we typically incur higher premium taxes, principally Alabama and Georgia.

Litigation settlement and defense costs were $13,328,000 for the year ended December 31, 2012 compared to $1,626,000 for the year ended December 31, 2011. On June 18, 2012, the Company settled longstanding litigation related to the Company's sale of Mobile Attic, Inc. which was the primary reason for the increase in the current year compared to the prior year. The Company believed that the damages claimed in the litigation were excessive in amount and that a substantial portion of the claimed damages was unrelated to the Company's involvement in the Mobile Attic transaction. However, with no guidance on damages, in the event of an excessive verdict we would have faced

25


significant liquidity constraints in supporting a potentially long, expensive and arduous appeal process. Therefore, after careful consideration, management made a decision to reach a settlement agreement. Under the terms of the settlement agreement, the Company will pay a total of $13 million to the plaintiff. In order to manage the liquidity constraints, the settlement will be in the form of an interest-bearing note with amounts to be paid over nine years with 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 terms of the agreement, the 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 installment payment of $2,500,000 in September 2012. The remaining principal will be repaid in nine annual installments of $1,167,000. 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%. Additional information related to the settlement can be found in the liquidity and capital resources section of the Management Discussion and Analysis as well as in Note 15 to the consolidated financial statements.

Interest expense for the year ended December 31, 2012 was up $127,000 from the prior year at $1,280,000 compared to $1,153,000 in 2011. Interest expense related to litigation settlement (discussed above) in the holding company was the primary reason for the increase in 2012 compared to 2011.

The Company had an income tax benefit totaling $4,393,000 in 2012 compared to income tax benefit totaling $2,643,000 in 2011. Primary components of the income tax benefit for the year ended December 31, 2012 and 2011 included deferred tax benefits associated with the litigation settlement of $3,145,000 and $425,000, respectively and deferred tax benefits associated with NOL carryforward of $1,348,000 and $1,363,000, respectively. Deferred tax assets related to AMT credit in 2012 were $246,000 compared to $0 in 2011. The Company exhausted all net operating losses available for carry back to prior periods in 2011.

The Company ended 2012 with a net loss of $6,671,000 compared to a net loss of $4,956,000 for the same period last year. The litigation settlement and $3.4 million in pretax Hurricane Isaac losses mentioned above were the primary reasons for the net loss in 2012. The claims incurred from cat events and adverse underwriting results in the automobile program were the primary contributing factors to the net loss in 2011.

Stockholder Equity and Book Value per Share
Stockholders equity for the year ended December 31, 2012 was $30,227,000 compared to $38,015,000 at December 31, 2011; a decrease of $7,788,000 or 20.5%. The change in stockholders equity is composed of dividends paid to shareholders of $802,000 and a net loss of $6,671,000 as well as accumulated other comprehensive income, primarily decreases in accumulated unrealized capital gains, totaling $101,000 and unrealized losses on interest rate swap totaling $214,000. Year-end book value per share, defined as stockholders equity divided by common shares outstanding of 2,466,600, was $12.25 at December 31, 2012 compared to $15.41 at December 31, 2011.

Industry Segment Data
Premium revenues for The National Security Group's two operating segments (Life segment, Property and Casualty segment) are summarized as follows (amounts in thousands):
Premium revenues:








2012

%

2011

%
Life, accident and health insurance
$
6,609


12.8
%

$
6,870


12.2
%
Property and casualty insurance
45,206


87.2
%

49,373


87.8
%

$
51,815


100.0
%

$
56,243


100.0
%
The property and casualty segment composed 87.2% of total premium revenue in 2012 compared to 87.8% in 2011. The P&C segment is primarily composed of dwelling fire and homeowners lines of business. The life segment composed 12.8% of premium revenue in 2012 compared to 12.2% in 2011 with revenue produced primarily from life, accident and supplemental health insurance products.

The following discussion outlines more specific information with regard to the individual operating segments of the Company along with non-insurance related information (primarily administration expenses) associated with the insurance holding company.


26


Life and Accident and Health Insurance Operations:
Our life segment is the smaller of our insurance segments contributing 12.8% of total insurance premium revenue in 2012 and 12.2% in 2011. Premium revenues and operating income for the life segment for the year ended December 31, 2012 and 2011 are summarized below (amounts in thousands):

 
2012
 
2011
REVENUE
 
 
 
      Net premiums earned
$
6,609

 
$
6,870

      Net investment income
2,029

 
1,939

      Net realized investment gains
1,635

 
43

      Other income
2

 
3

 
10,275

 
8,855

BENEFITS AND EXPENSES
 
 
 
      Policyholder benefits paid or provided
5,294

 
5,189

      Amortization of deferred policy acquisition costs
938

 
774

      Commissions
468

 
533

      General and administrative expenses
2,009

 
2,081

      Insurance taxes, licenses and fees
218

 
316

      Interest expense
53

 
60

 
8,980

 
8,953

 
 
 
 
INCOME BEFORE INCOME TAXES
$
1,295

 
$
(98
)

Year Ended December 31, 2012 Compared to Year Ended December 31, 2011:
NSIC premium accounted for 12.8% of total consolidated premium revenue for 2012.  Premium revenue in NSIC was $6,609,000 at December 31, 2012 compared to $6,870,000 for the same period last year; a decrease of 3.8%.  The $261,000 decrease in gross premium revenue was primarily due to the $216,000 or 7.5% decline in ordinary business related to the independent agent distribution method. The home service distribution method also contributed to the overall decline in premium revenue ending 2012 down 2.1% compared to the same period last year. NSIC has faced challenges in growing life insurance revenue over the past two years due to new competitors in the market paying independent agent commission rates that we believe to be unprofitable long term and would contribute to short term surplus strain if we matched those commission rates. We intend to increase focus on niche areas and products in 2013 in order to reverse the declining revenue trend.

As mentioned previously, NSIC operates using two primary methods of distribution: home service employee agents and independent agents.  While the Company has used the traditional home service distribution method since its founding in 1947, the independent agent distribution method has become the largest source of renewal business and new business production over the past decade. For 2012, the home service and independent agent distribution methods accounted for 32.8% and 62.4%, respectively of NSIC premium revenue.  

Net investment income was $2,029,000 for the year ended December 31, 2012 compared to $1,939,000 for the same period last year. Investment income in NSIC is generated from securities held in our investment portfolio as well as mortgage and policy loan interest. The $90,000 increase was primarily related to a 1% increase in invested assets in 2012 compared to 2011.

NSIC ended 2012 with net realized investment gains totaling $1,635,000 compared to $43,000 for the same period last year. The primary reason for the $1,592,000 increase in net realized investment gains was increased selling activity in 2012 compared to 2011. A primary focus during the current year was to moderately reduce the equity portfolio in order to increase the allocation to fixed income. These efforts were made to improve duration matching of liabilities and strengthen regulatory cash flow testing results. Net realized capital gains were also impacted during the current year 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. The life segment recognized other-than-temporary impairment losses totaling $398,000 during 2011 with recoveries of previously recognized other-than-temporary impairments of $384,000.

27



Policyholder claims were $5,294,000 through December 31, 2012 compared to $5,189,000 through December 31, 2011; an increase of $105,000. The primary reason for higher claims in the current year compared to the prior year was a 15% increase in death and maturity benefit incurred losses.

Deferred policy acquisition cost amortization and commission expenses increased $99,000 for the year ended December 31, 2012 at $1,406,000 compared to $1,307,000 for the same period last year; an increase of 7.6%. The increase in expense was primarily due to a reduction in cost capitalized in the current year to a change in accounting rules related to limitations on capitalization of costs associated with unsuccessful sales in life and A&H insurance products.

General and administrative expenses were $2,009,000 in 2012 compared to $2,081,000 in 2011. As a percent of earned premium, general and administrative expenses were virtually unchanged ending December 31, 2012 and 2011 at 30.4% and 30.3%, respectively. Although general and administrative expenses decreased in 2012 compared to 2011, as a percent of premium revenue, they were slightly higher. Historically, general and administrative expenses in our life segment have run higher than industry averages due to the small size of the subsidiary. Management continues to review processes to find ways to maximize efficiency and reduce costs and is currently looking into employee cross-training opportunities between insurance segments of the Company to help achieve this goal. However, due to the size of our life insurance subsidiary, reduction of general expenses will continue to be a challenge.

For the year ended December 31, 2012 and 2011, insurance taxes, licenses and fees were $218,000 and $316,000, respectively. As a percent of earned premium, insurance taxes, licenses and fees were 3.3% in 2012 compared to 4.6% in 2011. The primary reasons for the $98,000 decrease were the 3.8% decline in premium revenue combined with an increase in fees in the prior year associated with a periodic examination which concluded during the first half of 2011.

NSIC had interest expense of $53,000 in 2012 compared to $60,000 in 2011. As a percent of earned premium, interest expense was 0.8% at December 31, 2012 compared to 0.9% at December 31, 2011.

For the year ended December 31, 2012, the life segment had year-to-date pretax net income of $1,295,000 compared to a pre-tax net loss of $98,000 for the same period last year. Although the results were better in the current year compared to the prior year, the primary reason for the improvement was the $1,592,000 increase in realized capital gains. As mentioned previously, we will continue to face challenges due to the small size of our life insurance subsidiary due to scale; however, reduction of expenses will remain a primary focus area with the goal of improved operational results from the life segment.


28


Property & Casualty Operations:
Property and casualty operations constitute our largest segment composing 87.2% and 87.8% of our total premium revenue in 2012 and 2011, respectively. Premium revenues and operating income for the P&C segment for the year ended December 31, 2012 and 2011 are summarized below:


2012

2011
REVENUE



     Net premiums earned
$
45,206


$
49,373

     Net investment income
2,107


2,246

     Net realized investment gains
1,083


666

     Other income
718


916


49,114


53,201

BENEFITS AND EXPENSES



     Policyholder benefits paid or provided
28,811


38,836

     Amortization of deferred policy acquisition costs
2,773


3,246

     Commissions
7,088


7,615

     General and administrative expenses
6,262


6,322

     Insurance taxes, licenses and fees
1,628


1,569

     Interest expense


2


46,562


57,590





INCOME (LOSS) BEFORE INCOME TAXES
$
2,552


$
(4,389
)

Year Ended December 31, 2012 Compared to Year Ended December 31, 2011:
Property and casualty segment premium revenue for 2012 was $45,206,000 compared to $49,373,000 for the same period last year; a decrease of 8.4%. The primary reasons for the decrease in premium revenue in 2012 compared to 2011 were the discontinuance of the automobile program in addition to increases in reinsurance cost and the addition of RPP coverage.

Production of premium revenue in the P&C segment is primarily driven by our dwelling fire and homeowner lines of business. The following table provides premiums earned by line of business:

 
2012

2011
 

Line of Business
 
Premium Earned
 
%
of NPE
 
Premium Earned
 
%
of NPE
 
2012
Increase (Decrease) over 2011
Dwelling Fire/Allied Lines
 
$
28,618,000

 
63.3
 %
 
$
27,507,000

 
55.7
 %
 
4.0
 %
Homeowners
 
23,287,000

 
51.5
 %
 
24,910,000

 
50.5
 %
 
(6.5
)%
Ocean Marine
 
1,090,000

 
2.4
 %
 
1,205,000

 
2.4
 %
 
(9.5
)%
Private Passenger Automobile
 
468,000

 
1.0
 %
 
2,993,000

 
6.1
 %
 
(84.4
)%
Commercial Automobile
 
6,000

 
 %
 
363,000

 
0.7
 %
 
(98.3
)%
Reinsurance Ceded
 
(6,824,000
)
 
15.1
 %
 
(5,984,000
)
 
(12.1
)%
 
14.0
 %
Reinstatement Premium
 
(1,439,000
)
 
(3.2
)%
 
(1,621,000
)
 
(3.3
)%
 
(11.2
)%
Net Premium Earned
 
$
45,206,000

 
100.0
 %
 
$
49,373,000

 
100.0
 %
 
(8.4
)%

P&C segment premium revenue was down 8.4% in 2012 compared to 2011. One primary reason for the decrease in premium revenue was the termination of the private passenger non-standard and commercial automobile programs. Due to unprofitable underwriting results for multiple years, the decision was made by management to discontinue the automobile program in late 2011. The termination of the automobile programs led to a $2,882,000 or 85.9% decrease

29


in automobile premium revenue in the current year compared to the prior year. No auto policies were in-force at December 31, 2012.

Another contributing factor to the decline in P&C premium revenue was a slight decrease related to our property programs. For the year ended December 31, 2012, premium revenue from our property programs totaled $51,905,000 compared to $52,417,000 for the same period last year; a decrease of 1%. A re-underwriting project in the first half of 2012 led to a net decline in homeowners policies in-force contributing to the decline in homeowners premium but should help improve future underwriting profits.

An additional factor contributing to the decline in current year premium revenue was an increase in ceded premium; up 14% in 2012 compared to 2011. The Company maintains catastrophe reinsurance coverage to mitigate loss exposure from catastrophic events. The premium related to this coverage increased approximately 19% in 2012 with our deductible increasing to $4 million from $3.5 million in the prior year. In addition to the 19% increase in catastrophe reinsurance cost, we also incurred $1,325,000 related to reinsurance premium protection (RPP) in 2012. The decision to add the RPP coverage was made by management in an effort to reduce earnings volatility in the P&C segment. The RPP coverage reduces our risk from a major catastrophe and helps strengthen our capital position.

Under the catastrophe reinsurance program for 2012, the Company retains the first $4,000,000 in losses from each event.  Reinsurance coverage 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

Additional details regarding the structure of the current year agreement can be found in Note 10 to the consolidated financial statements.

A catastrophe event in late April 2011, which exceeded our single event retention, triggered additional ceded premium payments (reinstatement premium) in order to reinstate coverage under our catastrophe reinsurance agreement. This catastrophe reinstatement premium was $1,439,000 in 2012 compared to $1,621,000 in 2011.

Net investment income totaled $2,107,000 in 2012 compared to $2,246,000 in 2011; a decrease of $139,000. The decrease in investment income in the P&C segment was primarily attributable to a decline in invested assets in 2012 compared to 2011. For the year ended December 31, 2012 and 2011, P&C segment invested assets were $51,163,000 and $56,154,000, respectively; a decrease of 8.9%. Partially offsetting the decline was an increase in investment income related to the company owned life insurance (COLI) value which increased $131,000 in the current year compared to the same period last year.

The P&C segment ended 2012 with realized capital gains totaling $1,083,000 compared to $666,000 for the same period last year. The 62.6% increase in realized capital gains was primarily associated with an increase in selling activity during the current year compared to the the prior year. Realized capital gains from the sale of three securities during 2012 accounted for 66.8% of total realized capital gains for the current 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 2012 or 2011.

Other income was $718,000 in 2012 compared to $916,000 for the same period last year; a $198,000 or 21.6% 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 1.6% in 2012 compared to 1.9% in 2011. Due to the termination of our automobile programs, billing, payment and policy fees declined, which triggered the overall reduction in other income for the current year.

Claims were $28,811,000 in 2012 compared to $38,836,000 for the same period last year; a decrease of $10,025,000 or 25.8%. The primary reason for the decrease was a reduction in losses from tornado, wind and hail related cat

30


events as well as claims associated with our automobile line of business. However, partially offsetting this decrease was adverse claim activity related to Hurricane Isaac which predominantly impacted Louisiana and Mississippi in late August 2012.

The gross losses and adjustment expenses reported in the P&C segment from claims associated with cat events during 2012 totaled $4,295,000. These claims were incurred from nine separate cat events and accounted for 14.9% of P&C segment claims during the current year. In comparison, the P&C segment had gross losses and adjustment expenses reported from seventeen cat events during 2011 totaling $14,040,000 or 36.2% of P&C segment claims during the prior year.

Of the nine cat events during 2012, the most notable was Hurricane Issac which made landfall late in August 2012. Reported losses and LAE from this cat event totaled $3,390,000 and accounted for 78.9% of total claims related to 2012 cat events. The Company had 1,147 claims reported from Hurricane Isaac with an average severity per claim of $3,000. Because the losses and LAE from Hurricane Isaac did not exceed the 2012 catastrophe reinsurance retention of $4 million, the Company did not have any ceded losses or LAE related to this cat event.

A cat event on April 25th-27th, 2011 (catastrophe 46) was the primary source of the overall losses and LAE incurred during 2011. The reported losses and LAE from cat 46 totaled $10,432,000. The reinsurance deductible for 2011 was $3,500,000. Because the P&C segment losses and LAE reported from catastrophe 46 exceeded the 2011 reinsurance deductible, the P&C segment recovered $6,585,000 from reinsurers during the prior year. The P&C segment retained $3,847,000 of the reported losses and LAE from catastrophe 46 during 2011 after reinsurance. In our catastrophe reinsurance model results, which we utilize to establish reinsurance coverage limits, this tornado event exceeded a one in 250 year return period, which means that this event had a probability of occurrence in the models of less than four tenths of one percentage point in any given year.

We routinely evaluate our claims frequency and severity statistics in order to better understand the nature of our risks and aid in the loss reserve liability evaluation process. Claims frequency is a measure of the number of claims incurred during a measurement period regardless of amount. Claims severity is a measure of the average dollar amount of claims during a measurement period. The P&C companies incurred 1,424 claims from nine cat events in 2012 compared to 3,085 claims from seventeen cat events in 2011. The average severity per claim related to the 2012 cat events was $3,000 compared to $4,600 per claim ($1,200 net of reinsurance recoveries) in 2011. The average severity per claim related to the tornado outbreak on April 25th-27th, 2011, catastrophe 46, was $6,300 and contributed significantly to skewing 2011's average severity upward.

The personal lines automobile program ended 2012 with incurred losses and incurred LAE of $(177,000) compared to $4,492,000 for the same period last year. The primary reason for the decline in current year claims was reserve releases. The automobile programs were cumulatively unprofitable and produced year over year underwriting losses prior to program termination in 2012. Because of the continued lack of underwriting profits and significant claim activity associated with this program, the decision was made to terminate the program during the fourth quarter of 2011. The automobile policies are six month coverage periods; therefore, all policies have now expired. The discontinuance of the automobile program, while contributing to a further decline in premium revenue, is expected to positively impact overall underwriting results provided we do not experience any further adverse development on reported claims, many of which are liability coverage claims which tend to take longer to settle.

The P&C segment had fewer losses and LAE from fire related claims reported in 2012 compared to 2011. For 2012, the P&C segment had reported fire losses and LAE of $12,728,000 compared to $14,149,000 for the same period last year; a decrease of 10%. The P&C segment had 525 claims reported from fire losses and LAE in 2012 compared to 596 fire claims reported during 2011 with an average severity per claim of $24,000 for both years.

The P&C segment continued to be involved in litigation pertaining to claims from Hurricane Katrina which impacted our coverage areas in Louisiana and Mississippi in August 2005. The cumulative claims associated with Hurricane Katrina exceeded the $37,500,000 million upper limit of the reinsurance agreement in effect during 2005. For the year-ended December 31, 2012, claims exceeding the upper limits of our reinsurance related to Hurricane Katrina totaled $193,000. Nine claims remain open from Hurricane Katrina and based on presently available information, management believes reserves are adequate to cover the ultimate liability.

Deferred policy acquisition costs totaled $2,773,000 in 2012 compared to $3,246,000 in 2011. Deferred policy acquisition costs were comparable at 6.1% of premium revenue for 2012; down 0.5 percentage points compared to

31


6.6% of premium revenue for the same period last year. Deferred policy acquisition costs consist of amortization of previously capitalized distribution costs which are primarily commissions.

Commission expense for 2012 was $7,088,000 (15.7% of premium revenue) compared to $7,615,000 (15.4% of premium revenue) for the same period last year. The primary reason for the $527,000 or 6.9% decrease in commission expense during 2012 compared to 2011 was a decline in contingent commissions payments to our general agents.

General and administrative expenses totaled $6,262,000 in 2012 compared to $6,322,000 in 2011; a 0.9% decrease. The primary reason for the $60,000 decline in general and administrative expenses was a reduction in costs associated with the discontinued automobile programs along with continued company wide cost reduction efforts.

Insurance taxes, licenses and fees were $1,628,000 in 2012 compared to $1,569,000 for the same period last year. Insurance taxes, licenses and fees were up slightly at 3.6% of premium revenue in 2012 compared to 3.2% in 2011. Although premium revenue in the P&C segment was down in 2012 compared to 2011, there was an up tick in premium revenue in a couple of states in which we write business. The increases led to higher premium taxes in the current year compared to the prior year for these states and was the primary reason for the overall increase in insurance taxes, licenses and fees.

The P&C segment ended 2012 with pre-tax net income of $2,552,000 compared to a pre-tax net loss of $4,389,000 for the same period last year. The primary reason for the net income in the current year was the $10,025,000 decrease in claims in 2012 compared to 2011. However, partially offsetting the decrease in claims was $3,390,000 in reported losses and LAE related to Hurricane Isaac in 2012. In addition, decreases in deferred acquisition costs and commissions of $473,000 and $527,000, respectively, coupled with an increase of $417,000 in realized investment gains all contributed to the increase in net income in 2012 compared to 2011. The combination of declining revenue and increased claims led to the negative results in the prior year.

Property & Casualty Combined Ratio:
A measure used to analyze a property/casualty insurer's underwriting performance is the combined ratio. It is the sum of two ratios:

a.
The loss and loss expense ratio, which measures losses and loss adjustment expenses incurred as a percentage of premium revenue.
b.
The underwriting expense ratio, which measures underwriting expenses incurred (e.g., agents' commissions, premium taxes, and other administrative underwriting expenses) as a percentage of premium revenue.

The results of these ratios for the past two years were:

2012

2011
Loss and LAE Ratio
64
%

79
%
Underwriting Expense Ratio
39
%

38
%
Combined Ratio
103
%

117
%
Maintaining a combined ratio below 100%, which indicates that the company is making an underwriting profit, depends upon many factors including hurricane activity in the Gulf of Mexico and the southern Atlantic coast, strict underwriting of risks, and adequate and timely premium rates. A major hurricane hitting the coast of Alabama, Georgia, South Carolina, Mississippi, Louisiana, or Texas could cause the combined ratio to fluctuate materially from prior years. The property and casualty subsidiaries maintain catastrophe reinsurance to minimize the effect of a major catastrophe; however, prohibitive catastrophe reinsurance costs associated with maintaining lower deductibles prevent us from further mitigating hurricane risks.

During 2012, the P&C segment experienced a decrease of 14 percentage points in the combined ratio compared to 2011. The primary reason for the decrease was a $10,025,000 decline in incurred losses from catastrophe related tornado, wind and hail related claims. Cat events increased the current year combined ratio by 9.5 percentage points compared to 23.5 percentage points in 2011. While cat events are unpredictable and beyond the control of management, measures have been taken to improve underwriting results in the P&C segment. Management also continues to evaluate rate adequacy, exposure concentrations and risk management strategies in order to improve underwriting profitability and reduce earnings volatility.


32


Non-insurance Operations:

2012
 
2011
REVENUE

 

     Net investment income
91

 
76

     Net realized investment gains
72

 
(40
)

163

 
36



 

BENEFITS AND EXPENSES

 

     General and administrative expenses
519

 
431

     Litigation settlement and defense costs
13,328

 
1,626

     Interest expense
1,227

 
1,091


15,074

 
3,148



 

LOSS BEFORE INCOME TAXES
$
(14,911
)
 
$
(3,112
)

The non-insurance operations of the Company consist of our parent company, The National Security Group, Inc. The National Security Group has no material sources of revenue and relies almost entirely on dividends from subsidiaries to pay expenses. Dividends from subsidiaries are subject to insurance department approval and are subject to statutory restrictions. Subsidiary dividends are eliminated upon consolidation of the subsidiaries in the audited financial statements included herein. General and administrative expenses totaled $519,000 compared to $431,000 for the same period last year; a 20.4% increase. The expenses of NSG are primarily associated with the public listing of our stock, taxes and fees, and directors' fees. The most significant item impacting the increase in general expenses were increases in interest costs related to deferred compensation and bank charges related to the line of credit obtained during the year.

Litigation settlement and defense costs incurred by NSG for the year ended December 31, 2012 and 2011 totaled $13,328,000 and $1,626,000, respectively. The $11,826,000 increase is directly related to the settlement of the Mobile Attic litigation matter as discussed in detail in Note 15 to the consolidated financial statements with additional commentary included in Liquidity and Capital Resources. On June 20, 2012, the Company and The Bagley Family Revocable Trust (Bagley Trust) reached a settlement agreement to dispose of the Mobile Attic related action. Under terms of the settlement, the Company agreed to pay Bagley Trust $13,000,000. The Company paid $2,500,000 to the Bagley Trust on September 18, 2012, with the balance payable in nine equal annual installments beginning in November 2013 with a final payment in 2021. The settlement agreement contains an option for the Company to defer payments in years in which its P&C subsidiaries incur substantial catastrophe losses, providing some flexibility in regards to capital management. The settlement agreement also requires annual debt service payments to equal or exceed any payment of dividends to shareholders in the preceding twelve months.

Interest cost remains a significant expense for NSG. NSG's borrowings include $25,339,000 in long-term debt and $1,292,000 in short-term notes payable and current portion of long-term debt. Long-term debt is composed of subordinated debentures, an installment note and a secured line of credit. The $12,372,000 in subordinated debentures consists of two trust preferred security offerings. The first being $9,279,000 issued in December 2005 and the second being $3,093,000 issued in June 2007. The primary use for these proceeds was to add capital to the property and casualty subsidiaries following the hurricanes of 2004 and 2005. A $13,000,000 promissory note was executed to finance the Mobile Attic related settlement obligation. As of December 31, 2012, a total of $10,500,000 ($1,167,000 included in short-term debt) was outstanding with principal payments due in equal installments of $1,167,000 payable each November beginning in 2013. The Company also has a $4,000,000 secured line of credit obtained in September 2012. As of December 31, 2012, $3,634,000 was drawn on this line. The line of credit is secured by timber property. NSG maintains an unsecured line of credit in the amount of $700,000 ($125,000 drawn at December 31, 2012 and $485,000 drawn at December 31, 2011). Total interest expense for the Group associated with these borrowings in both 2012 and 2011 was $1,227,000 and $1,091,000, respectively.

Investments:
The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. The types of assets in which the Company can invest are influenced by various state insurance laws which prescribe qualified investment assets. While working within the parameters of these prescribed regulatory requirements

33


as well as liquidity and capital needs, the Company considers investment quality, investment return, asset/liability matching and composition of the investment portfolio when choosing investments.

At December 31, 2012, the Company's holdings in debt securities amounted to 77.7% of total investments and 57.3% of total assets. The Company utilizes the ratings of various Nationally Recognized Statistical Rating Organizations when classifying fixed maturity investments by quality rating. The most significant shift in quality ratings occurring in 2011 was the downgrade of US Government debt by S&P from their highest rating of AAA to AA+. Moody's and Fitch continued to carry US Government debt at their highest rating throughout 2012. Due to the split ratings of the major rating agencies, US Government and agency debt is shown in the table below in the category of AAA/AA+.

The following is a breakdown of the Company's fixed maturity investments by quality rating:

 
% of Total Bond Portfolio
S&P or Equivalent Ratings
 
2012
 
2011
AAA/AA+*
 
31.35%
 
47.26%
AA
 
3.32%
 
6.27%
AA-
 
11.90%
 
15.16%
A+
 
4.89%
 
4.39%
A
 
6.85%
 
4.63%
A-
 
8.30%
 
6.61%
BBB+
 
8.11%
 
3.89%
BBB
 
8.18%
 
5.33%
BBB-
 
12.82%
 
2.81%
Below Investment Grade
 
4.28%
 
3.65%
*Due to the downgrade of United States Government bonds, AAA and AA+ are presented consolidated for comparability. Most of the securities within this combined category are United States Government and Agency bonds, which are now rated AA+.
As depicted in the table above, the Company's investment allocation shifted slightly to lower quality investment grade securities. This shift occurred primarily in the life insurance subsidiary and resulted from an increased allocation in corporate bonds. Most of the shift was composed of purchases of intermediate term corporate bonds. While credit quality dropped moderately, the corporate bonds provided increased yield and improved cash flow predictability, better matching duration and crediting rate of insurance liabilities in what continues to be a challenging interest rate environment. The Company closely monitors its investment holdings and believes the slight reduction in credit quality will be offset by higher yields versus lower risk alternatives. The Company reviews investment allocations throughout the year and makes adjustments within the portfolio as needed.


34


A summary of debt and equity securities available-for-sale with unrealized losses as of December 31, 2012 along with related fair value, aggregated by length of time that the investments have been in a continuous unrealized loss position follows:
 
 
Less than 12 months
 
12 months or longer
 
Total
Fixed maturities
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a Loss Position
Corporate debt securities
 
$
2,226

 
$
31

 
$
963

 
$
49

 
$
3,189

 
$
80

 
7

Mortgage backed securities
 
2,904

 
77

 
165

 
8

 
3,069

 
85

 
8

Private label mortgage backed securities
 
206

 
8

 
65

 
1

 
271

 
9

 
2

Obligations of state and political subdivisions
 
356

 
3

 

 

 
356

 
3

 
1

U.S. Treasury securities and obligations of U.S. government corporations and agencies
 
495

 
2

 

 

 
495

 
2

 
1

Equity securities
 

 

 
829

 
457

 
829

 
457

 
1

 
 
$
6,187

 
$
121

 
$
2,022

 
$
515

 
$
8,209

 
$
636

 
20


Other-than-temporary impairments and credit quality
At December 31, 2012, 4.28% of total investments in the fixed income portfolio were classified as below investment grade. Management has evaluated each security in a significant unrealized loss position.  For the year ended December 31, 2012, the Company realized $87,000 in other-than-temporary impairments.  Most of the remaining unrealized losses in the fixed income portfolio, for which no impairment has been realized, are interest rate driven as opposed to credit quality driven and management believes no ultimate loss will be realized. In evaluating whether or not the equity loss positions were other-than-temporary impairments, Management evaluated financial information on each company and where available reviewed analyst reports from at least two independent sources.  Based on a review of the available financial information, the prospect for future earnings of each company and consideration of the Company’s intent and ability to hold the securities until market values recovered, it was determined that the remaining securities in an accumulated loss position in the portfolio were temporary impairments. There were no recoveries on securities for a portion of which other-than-temporary impairments were realized during 2012. During 2011, recoveries on securities for a portion of which other-than-temporary impairments were realized totaled $384,000.

The amortized cost and aggregate fair value of debt securities at December 31, 2012, by contractual maturity, are as follows (dollars in thousands). Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
 
Amortized Cost
 
Fair Value
Available-for-sale securities:
 
 
 
Due in one year or less
$
1,045

 
$
1,062

Due after one year through five years
15,410

 
16,825

Due after five years through ten years
23,364

 
24,813

Due after ten years
31,859

 
33,594

Total
$
71,678

 
$
76,294

Held-to-maturity securities:
 
 
 
D