10-Q 1 nsec6302014-10q.htm 10-Q NSEC 6.30.2014-10Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 FORM 10-Q

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

For Quarterly Period Ended June 30, 2014

or      
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from           to          .

Commission File Number 0-18649

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

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

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

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

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

As of August 13, 2014, there were 2,507,452 shares, $1.00 par value, of the registrant’s common stock outstanding.


1


THE NATIONAL SECURITY GROUP, INC.

INDEX

PART I. FINANCIAL INFORMATION
 
 
 
 
Page No.
 
Item 1.  Financial Statements
 
 
 
 
 
 
 
Condensed Consolidated Balance Sheets
 
 
Condensed Consolidated Statements of Income
 
 
Condensed Consolidated Statements of Comprehensive Income (Loss)
 
 
Condensed Consolidated Statements of Changes in Shareholders’ Equity
 
 
Condensed Consolidated Statements of Cash Flows
 
 
Notes to Condensed Consolidated Financial Statements
 
 
Review Report of Independent Registered Public Accounting Firm
 
 
 
 
 
Item 2.  Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 
 
 
 
Item 3.  Quantitative and Qualitative Disclosures about Market Risk
 
 
 
 
 
Item 4.  Controls and Procedures
 
 
 
 
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
 
 
Item 1.    Legal Proceedings
 
Item 1A. Risk Factors
 
Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds
 
Item 3.    Defaults Upon Senior Securities
 
Item 4. Mine Safety Disclosures
 
Item 5.    Other Information
 
Item 6.    Exhibits
 
 
 
 
 
 
 
 
SIGNATURE
 
 
 
 
 
 


2


Cautionary Statement Regarding Forward-Looking Statements

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

The insurance industry is highly competitive and the Company encounters significant competition in all lines of business from other insurance companies. Many of the competing companies have more abundant financial resources than the Company.

Insurance is a highly regulated industry. It is possible that legislation may be enacted which would have an adverse effect on the Company's business.

The Company is subject to regulation by state governments for each of the states in which it conducts business. The Company cannot predict the subject of any future regulatory initiative(s) or its (their) impact on the Company's business.

The Company is rated by various insurance rating agencies. If a rating is downgraded from its current level by one of these agencies, sales of the Company's products and stock 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.

3


Part I. Financial Information

Item 1.  Financial Statements

THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands)
 
 
June 30, 2014
 
December 31, 2013
 
 
(UNAUDITED)
 
 
ASSETS
 
 
 
 
Investments
 
 
 
 
Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2014 -
      $783; 2013 - $853)
 
$
728

 
$
812

Fixed maturities available-for-sale, at estimated fair value (cost: 2014 - $81,984;
2013 -$79,074)
 
85,092

 
79,434

Equity securities available-for-sale, at estimated fair value (cost: 2014 - $2,420;
2013 - $2,420)
 
4,888

 
4,374

Trading securities
 
19

 
19

Mortgage loans on real estate, at cost
 
229

 
333

Investment real estate, at book value
 
4,288

 
4,218

Policy loans
 
1,480

 
1,443

Company owned life insurance
 
5,996

 
5,858

Other invested assets
 
3,478

 
3,559

Total Investments
 
106,198

 
100,050

Cash
 
6,179

 
4,987

Accrued investment income
 
802

 
817

Policy receivables and agents' balances, net
 
12,176

 
10,276

Reinsurance recoverable
 
789

 
1,501

Deferred policy acquisition costs
 
8,960

 
8,776

Property and equipment, net
 
1,991

 
2,077

Accrued income tax recoverable
 

 
6

Deferred income tax asset, net
 
3,609

 
4,654

Other assets
 
2,563

 
836

Total Assets
 
$
143,267

 
$
133,980

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 

 
 

Property and casualty benefit and loss reserves
 
$
9,328

 
$
8,734

Accident and health benefit and loss reserves
 
2,694

 
2,651

Life and annuity benefit and loss reserves
 
31,163

 
30,696

Unearned premiums
 
30,512

 
27,301

Policy and contract claims
 
896

 
842

Other policyholder funds
 
1,483

 
1,447

Short-term notes payable and current portion of long-term debt
 
1,166

 
1,866

Long-term debt
 
21,164

 
20,889

Accrued income taxes
 
52

 

Other liabilities
 
6,441

 
6,082

Total Liabilities
 
104,899

 
100,508

Contingencies
 


 


Shareholders' equity
 
 

 
 

Common stock
 
2,508

 
2,495

Additional paid-in capital
 
5,267

 
5,147

Accumulated other comprehensive income
 
2,915

 
936

Retained earnings
 
27,678

 
24,894

Total Shareholders' Equity
 
38,368

 
33,472

Total Liabilities and Shareholders' Equity
 
$
143,267

 
$
133,980


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

4


THE NATIONAL SECURITY GROUP, INC.

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

 
Three months ended
June 30,
 
Six months ended June 30,
 
2014
 
2013
 
2014
 
2013
REVENUES
 
 
 
 
 
 
 
Net premiums earned
$
14,100

 
$
13,038

 
$
27,924

 
$
25,972

Net investment income
1,030

 
689

 
1,978

 
1,734

Net realized investment gains
312

 
1,030

 
400

 
1,057

Other income
1,713

 
145

 
1,867

 
317

Total Revenues
17,155

 
14,902

 
32,169

 
29,080

BENEFITS, LOSSES AND EXPENSES
 

 
 

 
 

 
 

Policyholder benefits and settlement expenses
9,155

 
8,260

 
17,019

 
17,811

Amortization of deferred policy acquisition costs
873

 
923

 
1,771

 
1,865

Commissions
1,967

 
1,486

 
3,994

 
3,468

General and administrative expenses
2,413

 
2,162

 
4,439

 
3,965

Taxes, licenses and fees
521

 
474

 
1,051

 
960

Interest expense
382

 
435

 
768

 
877

Total Benefits, Losses and Expenses
15,311

 
13,740

 
29,042

 
28,946

 
 
 
 
 
 
 
 
Income Before Income Taxes
1,844

 
1,162

 
3,127

 
134

 
 
 
 
 
 
 
 
INCOME TAX EXPENSE (BENEFIT)
 

 
 

 
 

 
 

Current
80

 
88

 
168

 
220

Deferred
(170
)
 
109

 
26

 
(642
)
 
(90
)
 
197

 
194

 
(422
)
 
 
 
 
 
 
 
 
Net Income
$
1,934

 
$
965

 
$
2,933

 
$
556

 
 
 
 
 
 
 
 
INCOME PER COMMON SHARE BASIC AND DILUTED
$
0.77

 
$
0.39

 
$
1.18

 
$
0.23

 
 
 
 
 
 
 
 
DIVIDENDS DECLARED PER SHARE
$
0.03

 
$
0.025

 
$
0.06

 
$
0.05



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


5


THE NATIONAL SECURITY GROUP, INC.

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

 
Three months ended June 30,
 
Six months ended
June 30,
 
2014
 
2013
 
2014
 
2013
 
 
 
 
 
 
 
 
Net income
$
1,934

 
$
965

 
$
2,933

 
$
556

 
 
 
 
 

 
 
Other comprehensive income (loss), net of tax
 
 
 
 
 
 
 
Changes in:
 
 
 
 
 
 
 
Unrealized gains (losses) on securities, net of reclassification adjustment of $264 and $698 for 2014 and 2013, respectively
1,080

 
(2,482
)
 
2,153

 
(1,956
)
Unrealized gain (loss) on interest rate swap
(98
)
 
302

 
(174
)
 
354

 
 
 
 
 
 
 
 
Other comprehensive income (loss), net of tax
982

 
(2,180
)
 
1,979

 
(1,602
)
 
 
 
 
 
 
 
 
Comprehensive income (loss)
$
2,916

 
$
(1,215
)
 
$
4,912

 
$
(1,046
)

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



6


THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)
(In thousands)

 
Total
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income
 
Common
Stock
 
Additional
Paid-in
Capital
Balance at December 31, 2013 (AUDITED)
$
33,472

 
$
24,894

 
$
936

 
$
2,495

 
$
5,147

 
 
 
 
 
 
 
 
 
 
Net income for the six months ended June 30, 2014
2,933

 
2,933

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Other comprehensive income (net of tax)
1,979

 
 

 
1,979

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Common stock issued
133

 
 
 
 
 
13

 
120

 
 
 
 
 
 
 
 
 
 
Cash dividends
(149
)
 
(149
)
 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2014
$
38,368

 
$
27,678

 
$
2,915

 
$
2,508

 
$
5,267


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






7


THE NATIONAL SECURITY GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED) (In thousands)
 
Six months ended
June 30,
 
2014
 
2013
Cash Flows from Operating Activities
 
 
 
Net income
$
2,933

 
$
556

Adjustments to reconcile net income to net cash provided by (used in) operating activities:
 
 
 

Depreciation expense and amortization/accretion, net
262

 
398

Increase (decrease) in cash surrender value of company owned life insurance
(138
)
 
148

Net realized gains on investments
(400
)
 
(1,057
)
Deferred income taxes
26

 
(642
)
Amortization of deferred policy acquisition costs
1,771

 
1,865

Changes in assets and liabilities:
 
 
 
Change in accrued investment income
15

 
(24
)
Change in reinsurance recoverable
712

 
8

Policy acquisition costs deferred
(1,955
)
 
(1,812
)
Change in accrued income taxes
58

 
120

Change in net policy liabilities and claims
2,459

 
(1,614
)
Change in other assets/liabilities, net
(1,459
)
 
(587
)
Other, net
13

 
233

Net cash provided by (used in) operating activities
4,297

 
(2,408
)
Cash Flows from Investing Activities
 
 
 

Purchase of:
 
 
 
Available-for-sale securities
(8,619
)
 
(9,619
)
Property and equipment
(123
)
 
(67
)
Proceeds from sale or maturities of:
 
 
 
Held-to-maturity securities
83

 
364

Available-for-sale securities
5,865

 
8,319

Real estate held for investment

 
207

Property and equipment
219

 
6

Other invested assets, net
8

 
3

Net cash used in investing activities
(2,567
)
 
(787
)
Cash Flows from Financing Activities
 

 
 

Change in other policyholder funds
36

 
5

Change in long-term debt
275

 
300

Change in short-term notes payable
(700
)
 
75

Dividends paid
(149
)
 
(123
)
Net cash (used in) provided by financing activities
(538
)
 
257

Net change in cash and cash equivalents
1,192

 
(2,938
)
Cash and cash equivalents, beginning of year
4,987

 
6,779

Cash and cash equivalents, end of year
$
6,179

 
$
3,841


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

8


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

NOTE 1 – SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation
The accompanying consolidated financial statements include the accounts of The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries:  National Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and NATSCO, Inc. (NATSCO).  NSFC includes a wholly-owned subsidiary, Omega One Insurance Company (Omega).  The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).  In the opinion of management, all adjustments, consisting of normal and recurring items, necessary for the fair presentation of the consolidated financial statements have been included. All significant intercompany transactions and accounts have been eliminated.  The financial information presented herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2013, which includes information and disclosures not presented herein.

Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these consolidated financial statements are reserves for future life insurance policy benefits, liabilities for losses and loss adjustment expenses, reinsurance recoverable associated with loss and loss adjustment expense liabilities, deferred policy acquisition costs, deferred income tax assets and liabilities, assessments of other-than-temporary impairments on investments and accruals for contingencies.  Actual results could differ from these estimates.

Earnings Per Share
Earnings per share of common stock is based on the weighted average number of shares outstanding during each year. The adjusted weighted average shares outstanding were 2,495,770 in 2014 and 2,467,062 in 2013.

Reclassifications
Certain 2013 amounts have been reclassified from the prior year consolidated financial statements to conform to the 2014 presentation.

Concentration of Credit Risk
The Company maintains cash balances which are generally held in non-interest bearing demand deposit accounts. Through December 31, 2012, these balances were insured by the FDIC with no balance limits. On January 1, 2013, $250,000 per entity account balance limits were reinstated. At June 30, 2014, the net amount exceeding FDIC insured limits was $3,769,000 at one financial institution. The Company has not experienced any losses in such accounts. Management of the Company reviews financial information of the financial institution on a quarterly basis and believes the Company is not exposed to any significant credit risk on cash and cash equivalents.

Policy receivables are reported at unpaid balances. Policy receivables are generally offset by associated unearned premium liabilities and are not subject to significant credit risk. Receivables from agents, less provision for credit losses, are composed of balances due from independent agents. At June 30, 2014, the single largest balance due from one agent totaled $1,407,000.

Reinsurance contracts do not relieve the Company of its obligations to policyholders. A failure of a reinsurer to meet their obligation could result in losses to the insurance subsidiaries. Allowances for losses are established if amounts are believed to be uncollectible. At June 30, 2014 and 2013, no amounts were deemed uncollectible. The Company, at least annually, evaluates the financial condition of all reinsurers and evaluates any potential concentrations of credit risk. At June 30, 2014, management does not believe the Company is exposed to any significant credit risk related to its reinsurance program.

9


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

Recently Adopted Accounting Standards
Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists
In July 2013, the FASB issued guidance on the financial statement presentation of an unrecognized tax benefit when a net operating loss ("NOL") carryforward, a similar tax loss, or a tax credit carryforward exists. This guidance applies to all entities with unrecognized tax benefits that also have tax loss or tax credit carryforwards in the same tax jurisdiction as of the reporting date. This guidance is effective for fiscal years beginning after December 15, 2013. The Company adopted this standard on January 1, 2014. This guidance did not have a material effect on results of operations or financial position.

Revenue from Contracts with Customers
In May 2014, the FASB issued guidance on a comprehensive new revenue recognition standard. This standard will not impact accounting for insurance contracts, leases, financial instruments and guarantees. For those contracts that are impacted by the new guidance, the guidance will require an entity to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to, in exchange for those goods or services. The guidance requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. This guidance is effective retrospectively for fiscal years beginning after December 15, 2016 and interim periods within those years. Early adoption of this standard is not permitted. The Company is currently evaluating the impact of this guidance on its consolidated financial statement.

NOTE 2 – VARIABLE INTEREST ENTITIES

The Company holds a passive interest in a limited partnership that is considered to be a Variable Interest Entity (VIE) under the provisions of ASC 810 Consolidation. The Company is not the primary beneficiary of the entity and is not required to consolidate under ASC 810. The entity is a private placement investment fund formed for the purpose of investing in private equity investments. The Company owns less than 1% of the limited partnership. The carrying value of the investment totals $325,000 and is included as a component of Other Invested Assets in the accompanying consolidated balance sheets.

In December 2005, the Company formed National Security Capital Trust I, a statutory trust created under the Delaware Statutory Trust Act, for the sole purpose of issuing, in private placement transactions, $9,000,000 of trust preferred securities (TPS) and using the proceeds thereof, together with the equity proceeds received from the Company in the initial formation of the Trust, to purchase $9,279,000 of variable rate subordinated debentures issued by the Company. The Company owns all voting securities of the Trust and the subordinated debentures are the sole assets of the Trust. The Trust will meet the obligations of the TPS with the interest and principal paid on the subordinated debentures. The Company received net proceeds from the TPS transactions, after commissions and other costs of issuance, of $9,005,000. The Company also holds all the voting securities issued by the Trust and such trusts are considered to be VIE's. The Trust is not consolidated because the Company is not the primary beneficiary of the trust. The Subordinated Debentures, disclosed in Note 7, are reported in the accompanying consolidated balance sheets as a component of long-term debt. The Company's equity investments in the Trust total $279,000 and are included in Other Assets in the accompanying consolidated balance sheets.

In June 2007, the Company formed National Security Capital Trust II for the sole purpose of issuing, in private placement transactions, $3,000,000 of trust preferred securities (TPS) and using the proceeds thereof, together with the equity proceeds received from the Company in the initial formation of the Trust, to purchase $3,093,000 unsecured junior subordinated deferrable interest debentures. The Company owns all voting securities of the Trust and the subordinated debentures are the sole assets of the Trust. The Trust will meet the obligations of the TPS with the interest and principal paid on the subordinated debentures. The Company received net proceeds from the TPS transactions, after commissions and other costs of issuance, of $2,995,000. The Company also holds all the voting securities issued by the Trust and such trusts are considered to be VIE's. The Trust is not consolidated because the Company is not the primary beneficiary of the Trust. The Subordinated Debentures, disclosed in Note 7, are reported in the accompanying consolidated balance sheets as a component of long-term debt. The Company's equity investments in the Trust total $93,000 and are included in Other Assets in the accompanying consolidated balance sheets.

10


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

NOTE 3 – INVESTMENTS

The amortized cost and aggregate fair values of investments in available-for-sale securities as of June 30, 2014 are as follows (dollars in thousands):
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
37,728

 
$
2,315

 
$
127

 
$
39,916

Mortgage backed securities
 
10,146

 
169

 
194

 
10,121

Private label mortgage backed securities
 
1,626

 
60

 
1

 
1,685

Obligations of states and political subdivisions
 
15,410

 
820

 
60

 
16,170

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
17,074

 
375

 
249

 
17,200

Total fixed maturities
 
81,984

 
3,739

 
631

 
85,092

Equity securities
 
2,420

 
2,688

 
220

 
4,888

Total
 
$
84,404

 
$
6,427

 
$
851

 
$
89,980


The amortized cost and aggregate fair values of investments in held-to-maturity securities as of June 30, 2014 are as follows (dollars in thousands):
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
648

 
$
51

 
$

 
$
699

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
80

 
4

 

 
84

Total
 
$
728

 
$
55

 
$

 
$
783


The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2013 are as follows (dollars in thousands):
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
35,831

 
$
1,698

 
$
713

 
$
36,816

Trust preferred securities
 
538

 
33

 

 
571

Mortgage backed securities
 
7,622

 
75

 
557

 
7,140

Private label mortgage backed securities
 
2,152

 
38

 
4

 
2,186

Obligations of states and political subdivisions
 
16,412

 
524

 
195

 
16,741

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
16,519

 
169

 
708

 
15,980

Total fixed maturities
 
79,074

 
2,537

 
2,177

 
79,434

Equity securities
 
2,420

 
2,365

 
411

 
4,374

Total
 
$
81,494

 
$
4,902

 
$
2,588

 
$
83,808

The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2013 are as follows (dollars in thousands):
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
706

 
$
34

 
$

 
$
740

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
106

 
7

 

 
113

Total
 
$
812

 
$
41

 
$

 
$
853



11


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The amortized cost and aggregate fair value of debt securities at June 30, 2014, by contractual maturity, are presented in the following table (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.
 
 
(Dollars in Thousands)
 
 
Amortized
Cost
 
Fair
Value
Available-for-sale securities:
 
 
 
 
Due in one year or less
 
$
1,379

 
$
1,421

Due after one year through five years
 
16,015

 
17,320

Due after five years through ten years
 
29,227

 
30,207

Due after ten years
 
35,363

 
36,144

Total
 
$
81,984

 
$
85,092

 
 
 
 
 
Held-to-maturity securities:
 
 

 
 

Due in one year or less
 
$

 
$

Due after one year through five years
 
201

 
212

Due after five years through ten years
 
154

 
167

Due after ten years
 
373

 
404

Total
 
$
728

 
$
783


A summary of securities available-for-sale with unrealized losses as of June 30, 2014, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows (dollars in thousands):
 
 
Less than 12 months
 
12 months or longer
 
Total
June 30, 2014
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
2,354

 
$
22

 
$
4,206

 
$
105

 
$
6,560

 
$
127

 
12

Mortgage backed securities
 
1,162

 
8

 
3,025

 
186

 
4,187

 
194

 
14

Private label mortgage backed securities
 

 

 
129

 
1

 
129

 
1

 
1

Obligations of state and political subdivisions
 
222

 
3

 
1,550

 
57

 
1,772

 
60

 
5

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
2,106

 
45

 
4,262

 
204

 
6,368

 
249

 
12

Equity securities
 

 

 
1,066

 
220

 
1,066

 
220

 
1

 
 
$
5,844

 
$
78

 
$
14,238

 
$
773

 
$
20,082

 
$
851

 
45


12


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

A summary of securities available-for-sale with unrealized losses as of December 31, 2013, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows (dollars in thousands):
 
 
Less than 12 months
 
12 months or longer
 
Total
December 31, 2013
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
10,589

 
$
600

 
$
1,548

 
$
113

 
$
12,137

 
$
713

 
26
Mortgage backed securities
 
3,215

 
427

 
1,796

 
130

 
5,011

 
557

 
18
Private label mortgage backed securities
 
472

 
4

 

 

 
472

 
4

 
3
Obligations of state and political subdivisions
 
3,545

 
165

 
325

 
30

 
3,870

 
195

 
11
U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
11,534

 
600

 
390

 
108

 
11,924

 
708

 
21
Equity securities
 

 

 
875

 
411

 
875

 
411

 
1
 
 
$
29,355

 
$
1,796

 
$
4,934

 
$
792

 
$
34,289

 
$
2,588

 
80

There were no securities held-to-maturity with unrealized losses as of June 30, 2014 and December 31, 2013.

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

Management has evaluated each security in a significant unrealized loss position.  The Company has no material exposure to sub-prime mortgage loans and less than 2.1% of the fixed income investment portfolio is rated below investment grade.  In evaluating whether or not the equity loss positions were other-than-temporary impairments, Management evaluated financial information on each company and where available, reviewed analyst reports from at least two independent sources.  Based on a review of the available financial information, the prospect for future earnings of each company and consideration of the Company’s intent and ability to hold the securities until market values recovered, it was determined that the securities in an accumulated loss position in the portfolio were temporary impairments.

For the six months ended June 30, 2014 and 2013, the Company realized no additional other-than-temporary impairments.

13


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

Major categories of investment income are summarized as follows (dollars in thousands):
 
Three months ended June 30,
 
Six months ended
June 30,
 
2014
 
2013
 
2014
 
2013
Fixed maturities
$
857

 
$
815

 
$
1,716

 
$
1,640

Equity securities
29

 
45

 
58

 
73

Mortgage loans on real estate
3

 
6

 
7

 
13

Investment real estate
1

 
2

 
3

 
3

Policy loans
28

 
26

 
55

 
50

Company owned life insurance change in surrender value
108

 
(198
)
 
138

 
(148
)
Other, principally short-term investments
74

 
50

 
128

 
208

 
1,100

 
746

 
2,105

 
1,839

Less: Investment expenses
70

 
57

 
127

 
105

Net investment income
$
1,030

 
$
689

 
$
1,978

 
$
1,734

Major categories of investment gains and losses are summarized as follows (dollars in thousands):
 
Three months ended June 30,
 
Six months ended
June 30,
 
2014
 
2013
 
2014
 
2013
Fixed maturities
$
159

 
$
104

 
$
249

 
$
127

Equity securities

 
928

 

 
928

Trading securities

 

 

 

Other, principally real estate
153

 
(2
)
 
151

 
2

Other-than-temporary impairments

 

 

 

Net realized investment gains
$
312

 
$
1,030

 
$
400

 
$
1,057


An analysis of the net change in unrealized appreciation on available-for-sale securities follows (dollars in thousands):

 
June 30, 2014
 
December 31, 2013
Net change in unrealized appreciation on available-for-sale securities before deferred tax
$
3,262

 
$
(4,243
)
Deferred income tax
(1,109
)
 
1,442

Net change in unrealized appreciation on available-for-sale securities
$
2,153

 
$
(2,801
)

NOTE 4 – FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES

Our available-for-sale securities consists of fixed maturity and equity securities which are recorded at fair value in the accompanying consolidated balance sheets.  The change in the fair value of these investments, unless deemed to be other-than-temporarily impaired, is recorded as a component of other comprehensive income.

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

Accounting standards define fair value as the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework

14


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

to make the measurement of fair value more consistent and comparable.  In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets.

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

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

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

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

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

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

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

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


15


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

Assets/Liabilities Measured at Fair Value on a Recurring Basis
 
Financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2014 are summarized in the following table by the type of inputs applicable to the fair value measurements (unaudited) (in thousands):
 
 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
39,916

 
$

 
$
39,916

 
$

Trust preferred securities
 

 

 

 

Mortgage backed securities
 
10,121

 

 
10,121

 

Private label mortgage backed securities
 
1,685

 

 
1,685

 

Obligations of states and political subdivisions
 
16,170

 

 
16,170

 

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
17,200

 
17,200

 

 

Trading securities
 
19

 
19

 

 

Equity securities available-for-sale
 
4,888

 
3,821

 

 
1,067

Total Financial Assets
 
$
89,999

 
$
21,040

 
$
67,892

 
$
1,067

Financial Liabilities
 

 
 

 
 

 
 

Interest rate swap
 
$
1,161

 
$

 
$

 
$
1,161

Total Financial Liabilities
 
$
1,161

 
$

 
$

 
$
1,161


The methods and assumptions the Company uses to estimate the fair value of assets and liabilities measured at fair value on a recurring basis are summarized below.

Fixed maturities available-for-sale — The fair values of the Company’s public fixed maturity securities are generally based on prices obtained from independent pricing services. Consistent with the fair value hierarchy described above, securities with validated quotes from pricing services are generally reflected within Level 2, as they are primarily based on observable pricing for similar assets and/or other market observable inputs.

Trading securities — Trading securities consist primarily of mutual funds whose fair values are determined consistent with similar instruments described above under “Fixed Maturities” and below under “Equity Securities.”

Equity securities — Equity securities consist principally of investments in common and preferred stock of publicly traded companies and privately traded securities. The fair values of our publicly traded equity securities are based on quoted market prices in active markets for identical assets and are classified within Level 1 in the fair value hierarchy.

Estimated fair values for our privately traded equity securities require a substantial level of judgment. Privately traded equity securities are classified within Level 3.

Interest rate swaps — Interest rate swaps are recorded at fair value either as assets, within other assets or as liabilities, within other liabilities. The fair values of our interest rate swaps are provided by a third-party broker and are classified within Level 3.

As of June 30, 2014, Level 3 fair value measurements of assets include $1,067,000 of equity securities in a local community bank whose value is based on an evaluation of the financial statements of the entity. The Company does not develop the unobservable inputs used in measuring fair value.

As of June 30, 2014, Level 3 fair value measurements of liabilities include $1,161,000 net fair value of various interest rate swap agreements whose value is based on analysis provided by a third party broker who utilizes financial modeling

16


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

tools and assumptions on interest and other factors. The Company does not develop the unobservable inputs used in measuring fair value. Additional information regarding the interest rate swap agreements is provided in Note 7.

The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the six months ended June 30, 2014 (in thousands):

For the six months ended June 30, 2014
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
875

 
$
(897
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 

 

Included in other comprehensive income
 
192

 
(264
)
Purchases:
 

 

Sales:
 

 

Issuances:
 

 

Settlements:
 

 

Transfers in/(out) of Level 3
 

 

Ending balance
 
$
1,067

 
$
(1,161
)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of June 30, 2014:
 
$

 
$


For the six months ended June 30, 2014, there were no assets or liabilities measured at fair values on a nonrecurring basis.

Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2013 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):
 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
36,816

 
$

 
$
36,816

 
$

Trust preferred securities
 
571

 

 
571

 

Mortgage backed securities
 
7,140

 

 
7,140

 

Private label mortgage backed securities
 
2,186

 

 
2,186

 

Obligations of states and political subdivisions
 
16,741

 

 
16,741

 

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
15,980

 
15,980

 

 

Trading securities
 
19

 
19

 

 

Equity securities available-for-sale
 
4,374

 
3,499

 

 
875

Total Financial Assets
 
$
83,827

 
$
19,498

 
$
63,454

 
$
875

Financial Liabilities
 
 

 
 

 
 

 
 

Interest rate swap
 
$
897

 
$

 
$

 
$
897

Total Financial Liabilities
 
$
897

 
$

 
$

 
$
897



17


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2013 (in thousands):
For the year ended December 31, 2013
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
829

 
$
(1,521
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 

 

Included in other comprehensive income
 
46

 
624

Purchases:
 

 

Sales:
 

 

Issuances:
 

 

Settlements:
 

 

Transfers in/(out) of Level 3
 

 

Ending balance
 
$
875

 
$
(897
)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of December 31, 2013:
 
$

 
$


For the year ended December 31, 2013, there were no assets or liabilities measured at fair values on a nonrecurring basis.

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

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

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

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

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

Company owned life insurance — the carrying amount is a reasonable estimate of fair value.

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

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

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


18


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The carrying amount and estimate fair value of the Company’s financial instruments as of June 30, 2014 and December 31, 2013 are as follows (in thousands):
 
 
June 30, 2014
 
December 31, 2013
 
 
Carrying
Value
 
Estimated
Fair Value
 
Carrying
Value
 
Estimated
Fair Value
Assets and related instruments
 
 
 
 
 
 
 
 
Mortgage loans
 
$
229

 
$
229

 
$
333

 
$
333

Policy loans
 
1,480

 
1,480

 
1,443

 
1,443

Company owned life insurance
 
5,996

 
5,996

 
5,858

 
5,858

Other invested assets
 
3,478

 
3,478

 
3,559

 
3,559

 
 
 
 
 
 
 
 
 
Liabilities and related instruments
 
 

 
 

 
 

 
 

Other policyholder funds
 
1,483

 
1,483

 
1,447

 
1,447

Short-term notes payable and current portion of long-term debt
 
1,166

 
1,166

 
1,866

 
1,866

Long-term debt
 
21,164

 
21,164

 
20,889

 
20,889


NOTE 5 – PROPERTY AND EQUIPMENT

Major categories of property and equipment are summarized as follows (dollars in thousands):

 
June 30, 2014
 
December 31, 2013
 
 
 
 
Building and improvements
$
3,207

 
$
3,185

Electronic data processing equipment
1,869

 
1,822

Furniture and fixtures
831

 
874

 
5,907

 
5,881

Less accumulated depreciation
3,916

 
3,804

Property and equipment, net
$
1,991

 
$
2,077



Depreciation expense for the six months ended June 30, 2014 was $170,000 ($386,000 for the year ended December 31, 2013).

NOTE 6 – INCOME TAXES

The Company recognizes tax-related interest and penalties as a component of tax expense.  The Company files income tax returns in the U.S. federal jurisdiction and various states.  The Company is not subject to examinations by authorities related to its U.S. federal or state income tax filings for years prior to 2010. Tax returns have been filed through the year 2012. Extensions have been filed for 2013.

Net deferred tax liabilities are determined based on the estimated future tax effects of differences between the financial statement and tax basis of assets and liabilities given the provisions of the enacted tax laws.  Management believes that, based on its historical pattern of taxable income, the Company will produce sufficient income in the future to realize its deferred tax assets.  The Company recognized net deferred tax asset positions of $3,609,000 at June 30, 2014 and $4,654,000 at December 31, 2013.


19


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The tax effect of significant differences representing deferred tax assets and liabilities are as follows (dollars in thousands):
 
 
As of
June 30, 2014
 
As of
December 31, 2013
General expenses
 
$
1,359

 
$
1,326

Unearned premiums
 
2,074

 
1,855

Claims liabilities
 
887

 
700

Litigation settlement
 
3,173

 
3,173

AMT credit
 
335

 
335

NOL carryforward
 
436

 
849

Unrealized loss on interest rate swaps
 
395

 
305

Deferred tax assets
 
8,659

 
8,543

 
 
 
 
 
Depreciation
 
(108
)
 
(119
)
Deferred policy acquisition costs
 
(3,047
)
 
(2,984
)
Unrealized gains on securities available-for-sale
 
(1,895
)
 
(786
)
Deferred tax liabilities
 
(5,050
)
 
(3,889
)
Net deferred tax asset
 
$
3,609

 
$
4,654


The appropriate income tax effects of changes in temporary differences are as follows (dollars in thousands):
 
 
Six months ended June 30,
 
 
2014
 
2013
Deferred policy acquisition costs
 
$
63

 
$
(19
)
Trading securities
 

 
(1
)
Unearned premiums
 
(219
)
 
(164
)
General expenses
 
(33
)
 
(82
)
Depreciation
 
(11
)
 
(17
)
Claim liabilities
 
(187
)
 
(197
)
NOL carryforward
 
413

 
(162
)
Deferred income tax expense (benefit)
 
$
26

 
$
(642
)

Total income tax expense (benefit) varies from amounts computed by applying current federal income tax rates to income or loss before income taxes.  The reasons for these differences and the approximate tax effects are as follows:
 
 
Six months ended June 30,
 
 
2014
 
2013
Federal income tax rate applied to pre-tax income/loss
 
34.0
 %
 
34.0
 %
Dividends received deduction and tax-exempt interest
 
(2.0
)%
 
(48.2
)%
Company owned life insurance
 
(19.1
)%
 
37.7
 %
Small life deduction
 
(8.9
)%
 
(197.3
)%
Life reserve tax adjustment
 
 %
 
(147.4
)%
Other, net
 
2.2
 %
 
6.2
 %
Effective federal income tax rate
 
6.2
 %
 
(315.0
)%


20


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

At June 30, 2014, the Company has approximately $1,283,000 of net operating loss carryforwards available ($436,000 tax benefit) to be applied to future periods.  These carryforwards expire in 2031 and 2032.

NOTE 7 – NOTES PAYABLE AND LONG-TERM DEBT

Short-term debt and current portion of long-term debt consisted of the following as of June 30, 2014 and December 31, 2013 (dollars in thousands):

 
 
2014
 
2013
Line of credit with variable interest rate equal to the Wall Street Journal (WSJ) prime rate, subject to a 5.0% floor; maturity February 2014.  Interest payments due quarterly.  Unsecured.
 
$

 
$
700

Current portion of installment note payable due November 2014 with variable interest rate equal to the WSJ prime rate plus 1%; Unsecured
 
1,166

 
1,166

 
 
$
1,166

 
$
1,866


Long-term debt consisted of the following as of June 30, 2014 and December 31, 2013 (dollars in thousands):

 
 
2014
 
2013
Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 5.0% floor; maturity February 2016.  Interest payments due quarterly.  Unsecured.
 
$
275

 
$

 
 
 
 
 
Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 4.5% floor; maturity September 2017.  Interest payments due monthly.  Secured.
 
350

 
350

 
 
 
 
 
Long term portion of installment note with variable interest rate equal to the WSJ prime rate plus 1% and adjustable each November; maturity November 2021. Interest payable annually with principal payable in equal annual installments. Next principal installment on long term portion due November 2015. Unsecured.
 
8,167

 
8,167

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

 
9,279

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

 
3,093

 
 
$
21,164

 
$
20,889


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

The swaps entered into in 2009 and 2010 have fair values of $289,000 (liability) and $872,000 (liability), respectively, for a total liability of $1,161,000 at June 30, 2014 ($897,000 at December 31, 2013).  The swap liability is reported as a component of other liabilities on the consolidated balance sheets.  A net valuation loss of $174,000 (net of tax) is included in accumulated other comprehensive income related to the swap agreements for the current period.  A net valuation gain of $412,000 (net of tax) was included in accumulated other comprehensive income related to the swap at December 31, 2013.

We use dollar offset at the hedge's inception and for each reporting period thereafter to assess whether the derivative used in a hedging transaction is expected to be, and has been, effective in offsetting changes in the fair value of the

21


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

hedged item. Since inception, no portion of the hedged item has been deemed ineffective. For all hedges, we discontinue hedge accounting if it is determined that a derivative is not expected to be, or has ceased to be, effective as a hedge.

The Company’s interest rate swaps include provisions requiring the Company to post collateral when the derivative is in a net liability position.  At June 30, 2014, the Company has securities on deposit with fair market values of $1,469,000 (all of which is posted as collateral). At December 31, 2013, the Company had securities on deposit with fair market values of $1,422,000 (all of which is posted as collateral). See Note 4 for additional information about the interest rate swaps.

NOTE 8 – REINSURANCE

The Company's insurance operations utilize reinsurance in order to limit losses, minimize exposure to large risks, provide additional capacity for future growth and effect business-sharing arrangements. Life reinsurance is accomplished through yearly renewable term coverage. Property and casualty reinsurance is placed on both a quota-share and excess of loss basis. Reinsurance ceded arrangements do not discharge the insurance subsidiaries as the primary insurer, except for cases involving a novation. Failure of re-insurers to honor their obligations could result in losses to the insurance subsidiaries. The insurance subsidiaries evaluate the financial conditions of their reinsurance companies and monitor concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the companies to minimize their exposure to significant losses from reinsurance insolvencies.

In the normal course of business, NSFC seeks to reduce the loss that may arise from catastrophes or other individually significant large loss events that cause unfavorable underwriting results by re-insuring certain levels of risk in various areas of exposure with reinsurance companies.  NSFC maintains a catastrophe reinsurance agreement to cover losses from catastrophic events, primarily hurricanes.
 
Under the catastrophe reinsurance program, the Company retains the first $4,000,000 in losses from each catastrophe event.  Catastrophe reinsurance coverage is maintained in four layers as follows:

Layer
Reinsurers' Limits of Liability
First Layer
100% of $6,000,000 in excess of $4,000,000
Second Layer
100% 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

Each reinsurance layer covers events occurring from January 1 through December 31 of the contract year.  All significant reinsurance companies under the program carry A.M. Best ratings of A- (Excellent) or higher, or equivalent ratings.

The Company's catastrophe reinsurance contract allows for one reinstatement. The Company maintains reinstatement premium protection (RPP) to cover reinstatement premiums incurred. The RPP further reduces risk from a major catastrophe and serves to strengthen the Company's capital position by reducing the modeled 100 year event net cost.

Amounts recoverable from re-insurers are estimated in a manner consistent with the claim liability associated with the underlying insurance policies.  Amounts paid for prospective reinsurance contracts are reported as prepaid reinsurance premiums and amortized over the remaining contract period.

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


22


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

At June 30, 2014, the largest reinsurance recoverable of a single reinsurer was $22,000 ($214,000 at December 31, 2013). Amounts reported as ceded incurred losses in both 2014 and 2013 were related to the development of losses from prior year catastrophes.

NOTE 9 – EMPLOYEE BENEFIT PLANS

The Company and its subsidiaries have an established retirement savings plan (401K Plan). All full-time employees are eligible to participate, and all employer contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Company matching contributions for the six months ended June 30, 2014 and 2013 amounted to $104,000 and $97,000, respectively. The Company contributes dollar-for-dollar matching contributions up to 5% of compensation subject to government limitations.

In January 2006, the Company established a non-qualified plan under which directors are allowed to defer all or a portion of directors' fees into various investment options.

The supplemental executive retirement plan (SERP) became effective March 1, 2008 and covers named executive officers with the Company contributing 15% of executive compensation to the plan. Contributions to the plan are fully vested upon the earlier of death, disability, change in control, or ten years of participation in the plan. Costs for amounts credited of the non-qualified deferred compensation plans for the six months ended June 30, 2014 and 2013 amounted to approximately $102,000 and $113,000, respectively.

The Company and its subsidiaries established an Employee Stock Ownership Plan (ESOP) in January 2010, to enable its eligible employees to acquire a proprietary interest in the Company's common stock and to provide retirement and other benefits to such employees. There were $100,000 in costs incurred during the first six months of 2014 and $50,000 costs incurred for the first six months of 2013 related to the ESOP. All contributions were made in cash for purchase of Company shares in the open market. The Company has not allocated shares directly to the plan and the plan has no debt.

NOTE 10 – SHAREHOLDERS' EQUITY

During the six months ended June 30, 2014, and year ended December 31, 2013, changes in shareholders' equity consisted of net income of $2,933,000 and $5,658,000, respectively; dividends paid of $149,000 in 2014 and $248,000 in 2013; changes in accumulated other comprehensive income, net of applicable taxes, of $1,979,000 in 2014 and other comprehensive loss, net of applicable taxes, of $2,389,000 in 2013.  Other comprehensive loss consists of accumulated unrealized gains and losses on securities and unrealized gains and losses on interest rate swaps.

The table below provides information regarding the Company's preferred and common stock as of June 30, 2014 and December 31, 2013:

 
Authorized
 
Issued
 
Outstanding
 
Authorized
 
Issued
 
Outstanding
Preferred Stock, $1 par value
500,000

 

 

 
500,000

 

 

Class A Common Stock, $1 par value
2,000,000

 

 

 
2,000,000

 

 

Common Stock, $1 par value
3,000,000

 
2,507,452

 
2,507,452

 
3,000,000

 
2,494,480

 
2,494,480


On June 13, 2014, 12,972 shares of common stock were issued to directors as compensation under the 2009 Equity Incentive Plan previously approved by shareholders.







23


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

NOTE 11 – ACCUMULATED OTHER COMPREHENSIVE INCOME

Accumulated other comprehensive income (loss) ("AOCI") includes certain items that are reported directly within a separate component of shareholders' equity. The following table presents changes in AOCI balances (dollars in thousands):
 
 
Six Months Ended
June 30,
 
 
2014
 
2013
Gains and Losses on Cash Flow Hedges
 
 
 
 
Balance at beginning of period
 
$
(591
)
 
$
(1,003
)
Other comprehensive income (loss) for period:
 
 
 
 
Other comprehensive income (loss) before reclassifications
 
(174
)
 
354

Amounts reclassified from accumulated other comprehensive income
 

 

Net current period other comprehensive income (loss)
 
(174
)
 
354

Balance at end of period
 
$
(765
)
 
$
(649
)
 
 
 
 
 
Unrealized Gains and Losses on Available-for-Sale Securities
 
 
 
 
Balance at beginning of period

 
$
1,527

 
$
4,328

Other comprehensive income (loss) for period:
 
 
 
 
Other comprehensive income before reclassifications
 
2,417

 
(1,258
)
Amounts reclassified from accumulated other comprehensive income
 
(264
)
 
(698
)
Net current period other comprehensive income
 
2,153

 
(1,956
)
Balance at end of period
 
$
3,680

 
$
2,372

Total Accumulated Other Comprehensive Income (loss) at end of period
 
$
2,915

 
$
1,723


The following table presents the amounts reclassified out of AOCI for the six months ended June 30, 2014 (dollars in thousands):
Details about Accumulated Other Comprehensive Income Components
 
Amounts Reclassified from Accumulated Other Comprehensive Income
 
Affected Line Item in the Statement Where Net Income is Presented
Unrealized Gains and Losses on
Available-for-Sale Securities
 
$
400

 
Net realized investment gains
 
 
400

 
Total before tax
 
 
 
 
 
 
 
(136
)
 
Tax (expense) or benefit
 
 
$
264

 
Net of Tax
 
 
 
 
 


24


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED EXCEPT FOR DECEMBER 31, 2013 AMOUNTS)

The following table presents the amounts reclassified out of AOCI for the six months ended June 30, 2013 (dollars in thousands):
Details about Accumulated Other Comprehensive Income Components
 
Amounts Reclassified from Accumulated Other Comprehensive Income
 
Affected Line Item in the Statement Where Net Income is Presented
Unrealized Gains and Losses on
Available-for-Sale Securities
 
$
1,057

 
Net realized investment gains
 
 
1,057

 
Total before tax
 
 
 
 
 
 
 
(359
)
 
Tax (expense) or benefit
 
 
$
698

 
Net of Tax
 
 
 
 
 


NOTE 12 – SEGMENTS

The Company’s property and casualty insurance operations comprise one business segment. The property and casualty insurance segment primarily underwrites home insurance coverage with primary lines of business consisting of:  dwelling fire and extended coverage, homeowners (including mobile homeowners) and other liability. The Company has ceased writing ocean marine, private passenger auto liability, commercial auto liability and auto physical damage coverages over the past two years with no policies remaining in-force at December 31, 2013 in the lines of business.  

Management organizes the business utilizing a niche strategy focusing on lower valued dwellings.  Our chief decision makers (Chief Executive Officer, Chief Financial Officer and President) review results and operating plans making decisions on resource allocations on a company-wide basis.  The Company’s products are primarily produced through agents within the states in which we operate.  

The Company’s life and accident and health operations comprise the second business segment.  The life and accident and health insurance segment consists of two lines of business: traditional life insurance and accident and health insurance.

Total assets by industry segment at June 30, 2014 and at December 31, 2013 are summarized below (dollars in thousands):

 
 
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
June 30, 2014
 
 
 
 
 
 
 
 
 
 
$
143,267

 
$
79,722

 
$
56,420

 
$
7,125

December 31, 2013
 


 
 
 
 
 
 
 
 
$
133,980

 
$
71,003

 
$
53,831

 
$
9,146



25