10-Q 1 nsec6302016-10q.htm 10-Q Document

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, 2016

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 12, 2016, there were 2,517,339 shares, $1.00 par value, of the registrant’s common stock outstanding.


1


THE NATIONAL SECURITY GROUP, INC.

TABLE OF CONTENTS

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
 
 
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, 2016
 
December 31, 2015
 
 
(UNAUDITED)
 
 
ASSETS
 
 
 
 
Investments
 
 
 
 
Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2016 -
      $2,357; 2015 - $2,504)
 
$
2,236

 
$
2,439

Fixed maturities available-for-sale, at estimated fair value (cost: 2016 - $96,219;
2015 - $92,077)
 
99,044

 
91,812

Equity securities available-for-sale, at estimated fair value (cost: 2016 - $2,420;
2015 - $2,420)
 
5,273

 
4,897

Trading securities
 
107

 
107

Mortgage loans on real estate, at cost
 
188

 
202

Investment real estate, at book value
 
3,291

 
3,291

Policy loans
 
1,689

 
1,655

Company owned life insurance
 
4,951

 
4,898

Other invested assets
 
3,105

 
3,256

Total Investments
 
119,884

 
112,557

Cash
 
4,063

 
6,763

Accrued investment income
 
803

 
797

Policy receivables and agents' balances, net
 
12,786

 
11,296

Reinsurance recoverable
 
544

 
1,660

Deferred policy acquisition costs
 
8,690

 
8,485

Property and equipment, net
 
1,950

 
1,946

Deferred income tax asset, net
 
2,545

 
3,824

Other assets
 
756

 
513

Total Assets
 
$
152,021

 
$
147,841

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 

 
 

Property and casualty benefit and loss reserves
 
$
7,007

 
$
9,645

Accident and health benefit and loss reserves
 
3,161

 
3,197

Life and annuity benefit and loss reserves
 
32,281

 
31,962

Unearned premiums
 
32,241

 
29,852

Policy and contract claims
 
970

 
826

Other policyholder funds
 
1,589

 
1,561

Short-term notes payable and current portion of long-term debt
 
857

 
857

Long-term debt
 
17,106

 
17,100

Accrued income taxes
 
71

 
101

Other liabilities
 
7,561

 
7,857

Total Liabilities
 
102,844

 
102,958

Contingencies
 


 


Shareholders' equity
 
 

 
 

Common stock
 
2,517

 
2,512

Additional paid-in capital
 
5,412

 
5,341

Accumulated other comprehensive income
 
2,732

 
525

Retained earnings
 
38,516

 
36,505

Total Shareholders' Equity
 
49,177

 
44,883

Total Liabilities and Shareholders' Equity
 
$
152,021

 
$
147,841


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,
 
2016
 
2015
 
2016
 
2015
REVENUES
 
 
 
 
 
 
 
Net premiums earned
$
15,227

 
$
14,880

 
$
30,392

 
$
29,586

Net investment income
1,029

 
813

 
2,020

 
1,815

Net realized investment gains
242

 
245

 
249

 
387

Other income
150

 
156

 
304

 
314

Total Revenues
16,648

 
16,094

 
32,965

 
32,102

BENEFITS, LOSSES AND EXPENSES
 

 
 

 
 

 
 

Policyholder benefits and settlement expenses
8,862

 
9,435

 
17,909

 
17,697

Amortization of deferred policy acquisition costs
906

 
918

 
1,693

 
1,817

Commissions
2,117

 
2,089

 
4,225

 
4,144

General and administrative expenses
2,158

 
2,119

 
4,287

 
4,150

Taxes, licenses and fees
574

 
518

 
1,174

 
1,173

Interest expense
333

 
348

 
678

 
668

Total Benefits, Losses and Expenses
14,950

 
15,427

 
29,966

 
29,649

 
 
 
 
 
 
 
 
Income Before Income Taxes
1,698

 
667

 
2,999

 
2,453

 
 
 
 
 
 
 
 
INCOME TAX EXPENSE
 

 
 

 
 

 
 

Current
399

 
161

 
620

 
632

Deferred
3

 
(117
)
 
142

 
(110
)
 
402

 
44

 
762

 
522

 
 
 
 
 
 
 
 
Net Income
$
1,296

 
$
623

 
$
2,237

 
$
1,931

 
 
 
 
 
 
 
 
INCOME PER COMMON SHARE BASIC AND DILUTED
$
0.52

 
$
0.25

 
$
0.89

 
$
0.77

 
 
 
 
 
 
 
 
DIVIDENDS DECLARED PER SHARE
$
0.045

 
$
0.04

 
$
0.09

 
$
0.08



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,
 
2016
 
2015
 
2016
 
2015
 
 
 
 
 
 
 
 
Net income
$
1,296

 
$
623

 
$
2,237

 
$
1,931

 
 
 
 
 

 
 
Other comprehensive income (loss), net of tax
 
 
 
 
 
 
 
Changes in:
 
 
 
 
 
 
 
Unrealized gains (losses) on securities, net of reclassification adjustment of $172 and $257 for 2016 and 2015, respectively
1,130

 
(1,240
)
 
2,288

 
(875
)
Unrealized gain (loss) on interest rate swap
21

 
56

 
(81
)
 
(61
)
 
 
 
 
 
 
 
 
Other comprehensive income (loss), net of tax
1,151

 
(1,184
)
 
2,207

 
(936
)
 
 
 
 
 
 
 
 
Comprehensive income (loss)
$
2,447

 
$
(561
)
 
$
4,444

 
$
995


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, 2015 (AUDITED)
$
44,883

 
$
36,505

 
$
525

 
$
2,512

 
$
5,341

 
 
 
 
 
 
 
 
 
 
Net income for June 30, 2016
2,237

 
2,237

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Other comprehensive income (net of tax)
2,207

 
 

 
2,207

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Common stock issued
76

 
 
 
 
 
5

 
71

 
 
 
 
 
 
 
 
 
 
Cash dividends
(226
)
 
(226
)
 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Balance at June 30, 2016
$
49,177

 
$
38,516

 
$
2,732

 
$
2,517

 
$
5,412


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,
 
2016
 
2015
Cash Flows from Operating Activities
 
 
 
Net income
$
2,237

 
$
1,931

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

Depreciation expense and amortization/accretion, net
154

 
165

Increase in cash surrender value of company owned life insurance
(53
)
 
52

Net realized gains on investments
(249
)
 
(387
)
Deferred income taxes
142

 
(110
)
Amortization of deferred policy acquisition costs
1,693

 
1,817

Changes in assets and liabilities:
 
 
 
Change in accrued investment income
(6
)
 
(4
)
Change in reinsurance recoverable
1,116

 
(471
)
Policy acquisition costs deferred
(1,898
)
 
(1,937
)
Change in accrued income taxes
(30
)
 
(334
)
Change in net policy liabilities and claims
(1,319
)
 
1,438

Change in other assets/liabilities, net
(436
)
 
929

Other, net
8

 
8

Net cash provided by operating activities
1,359

 
3,097

Cash Flows from Investing Activities
 
 
 

Purchase of:
 
 
 
Available-for-sale securities
(14,278
)
 
(14,290
)
Trading securities and short-term investments

 
(88
)
Property and equipment
(84
)
 
(103
)
Proceeds from sale or maturities of:
 
 
 
Held-to-maturity securities
213

 
470

Available-for-sale securities
10,317

 
13,668

Real estate held for investment

 
201

Property and equipment

 
5

Other invested assets, net
(29
)
 
371

Net cash provided by (used in) investing activities
(3,861
)
 
234

Cash Flows from Financing Activities
 

 
 

Change in other policyholder funds
28

 
22

Repayments of long-term debt

 
(500
)
Change in short-term notes payable

 
(700
)
Dividends paid
(226
)
 
(201
)
Net cash used in financing activities
(198
)
 
(1,379
)
Net change in cash and cash equivalents
(2,700
)
 
1,952

Cash and cash equivalents, beginning of year
6,763

 
6,426

Cash and cash equivalents, end of period
$
4,063

 
$
8,378

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

8


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)


NOTE 1 – SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation
The accompanying condensed consolidated financial statements include the accounts of The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries:  National Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and NATSCO, Inc. (NATSCO).  NSFC includes a wholly-owned subsidiary, Omega One Insurance Company (Omega).  The accompanying condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).  In the opinion of management, all adjustments, consisting of normal and recurring items, necessary for the fair presentation of the condensed 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, 2015, 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 condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Among the more significant estimates included in these condensed 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 2,513,559 at June 30, 2016 and 2,508,551 at June 30, 2015. The Company did not have any dilutive securities as of June 30, 2016 and 2015.

Reclassifications
Certain 2015 amounts have been reclassified from the prior year condensed consolidated financial statements to conform to the 2016 presentation.

Concentration of Credit Risk
The Company maintains cash balances which are generally held in non-interest bearing demand deposit accounts subject to FDIC insured limits of $250,000 per entity. At June 30, 2016, the net amount exceeding FDIC insured limits was $3,242,000 at two financial institutions. The Company has not experienced any losses in such accounts. Management of the Company reviews financial information of financial institutions 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, 2016, the single largest balance due from one agent totaled $1,284,000.

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, 2016 and December 31, 2015, 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, 2016, 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 AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

Change in Accounting Principle:

Effective January 1, 2016, the Company elected to change its method of presentation relating to placement fees associated with the issuance of trust preferred securities in accordance with FASB ASU 2015-03. Prior to 2016, the Company’s policy was to present these fees in Other Assets on the balance sheet, net of accumulated amortization. Beginning in 2016, the Company has presented these fees as a direct reduction in the related note payable.

Accounting Changes Not Yet Adopted

Revenue from Contracts with Customers
In May 2014, the Financial Accounting Standards Board (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. In August 2015, the FASB issued a deferral of the effective date by one year. This guidance is effective retrospectively for fiscal years beginning after December 15, 2017 and interim periods within those years. Early adoption of this standard is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. Although insurance contracts are specifically scoped out of this new guidance, the Company has minor services that may be subject to the new revenue recognition guidance and are still in the process of evaluating the impact, if any, the guidance may have on its condensed consolidated financial statements.

Presentation of Financial Statements - Going Concern
In August 2014, the FASB issued guidance on determining when and how to disclose going concern uncertainties in the financial statements, and requires management to perform interim and annual assessments of an entity’s ability to continue as a going concern within one year of the date the financial statements are issued. The updated guidance is effective for annual periods ending after December 15, 2016 and interim periods thereafter. Early adoption is permitted. The Company does not expect the adoption to have a material impact on its financial position, results of operations or disclosures.

Recognition and Measurement of Financial Assets and Financial Liabilities
In January 2016, the FASB issued guidance that requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. The guidance requires entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes and requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset. The guidance eliminates the requirement for public companies to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. This guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

Leases
In February 2016, the FASB issued guidance that requires lessees (for capital and operating leases) to recognize the lease liability and right-of-use asset at the commencement date of the lease. This guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

Contingent Put and Call Options in Debt Instruments
In March 2016, the FASB issued guidance that clarifies the requirements for assessing whether contingent call (put) options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts. This guidance is effective for fiscal years beginning after December 15, 2019, including interim periods within

10


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

those years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

Financial Instruments - Credit Losses
In June 2016, the FASB issued guidance that replaces the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. This guidance is effective for fiscal years beginning after December 15, 2016, including interim periods within those years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

Recently Adopted Accounting Standards

Simplifying Income Statement Presentation by Eliminating the Concept of Extraordinary Items
In January 2015, the FASB issued guidance that eliminates from GAAP the concept of extraordinary items. The Company adopted this standard on January 1, 2016. This guidance did not have a material effect on results of operations or financial position.

Amendments to the Consolidation Analysis
In February 2015, the FASB issued additional guidance regarding the consolidation of certain legal entities. The guidance modifies the evaluation of whether or not limited partnerships and similar legal entities are variable interest entities (VIEs) and the consolidation analysis of entities involved with VIEs, particularly those that have fee arrangements and related party relationships. The Company adopted this standard on January 1, 2016. This guidance did not have a material effect on results of operations or financial position.

Interest - Imputation of Interest: Simplifying the Presentation of Debt Issuance Costs.
In April 2015, the FASB issued guidance to simplify the presentation of debt issuance costs. This ASU requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of the debt liability. The Company adopted this standard retrospectively on January 1, 2016, which resulted in the reclassification of $258,000 of unamortized debt issuance costs related to Company borrowings from other assets to long-term debt within our condensed consolidated balance sheet as of December 31, 2015. The adoption also resulted in the reclassification of $6,000 from general expenses to interest expense for the six months ended June 30, 2015.

Disclosure about Short-Duration Contracts
In May 2015, the FASB issued guidance that enhances disclosure about short-duration insurance liabilities to help users understand the nature, amount, timing and uncertainty of future cash flows related to insurance liabilities and the effect of those cash flows on the statement of comprehensive income. The Company adopted this standard on January 1, 2016. Required disclosures will be included in the notes to consolidated financial statements included in the Company's 2016 Annual Report on Form 10-K and in interim reports beginning in 2017.

Simplifying the Accounting for Measurement-Period Adjustments
In September 2015, the FASB issued guidance that requires an acquirer to recognize adjustments to provisional amounts that are identified during the measurement period in the reporting period in which the adjustment amounts are determined. The acquirer must record, in the same period's financial statements, the effect on earnings of changes in depreciation, amortization, or other income effects, if any, as a result of the change to the provisional amounts, calculated as if the accounting had been completed at the acquisition date. The guidance requires an entity to present on the face of the income statement or to disclose in the notes the portion of the amount recorded in current-period earnings by line item that would have been recorded in previous reporting periods if the adjustment to the provisional amounts had been recognized as of the acquisition date. The Company adopted this standard on January 1, 2016. This guidance did not have a material effect on results of operations or financial position.

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

11


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

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 $228,000 and is included as a component of Other Invested Assets in the accompanying condensed 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 condensed 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 condensed 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 condensed consolidated balance sheets.

NOTE 3 – INVESTMENTS

The amortized cost and aggregate fair values of investments in available-for-sale securities as of June 30, 2016 are as follows (dollars in thousands):
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
40,660

 
$
1,571

 
$
482

 
$
41,749

Mortgage backed securities
 
12,379

 
368

 
62

 
12,685

Private label asset backed securities
 
8,765

 
44

 
507

 
8,302

Obligations of states and political subdivisions
 
14,612

 
951

 
1

 
15,562

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
19,803

 
953

 
10

 
20,746

Total fixed maturities
 
96,219

 
3,887

 
1,062

 
99,044

Equity securities
 
2,420

 
2,919

 
66

 
5,273

Total
 
$
98,639

 
$
6,806

 
$
1,128

 
$
104,317



12


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

The amortized cost and aggregate fair values of investments in held-to-maturity securities as of June 30, 2016 are as follows (dollars in thousands):
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
2,201

 
$
119

 
$

 
$
2,320

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
35

 
2

 

 
37

Total
 
$
2,236

 
$
121

 
$

 
$
2,357



The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2015 are as follows (dollars in thousands):
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
38,245

 
$
747

 
$
1,728

 
$
37,264

Mortgage backed securities
 
15,324

 
157

 
224

 
15,257

Private label asset backed securities
 
6,029

 
24

 
380

 
5,673

Obligations of states and political subdivisions
 
14,654

 
869

 
47

 
15,476

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
17,825

 
413

 
96

 
18,142

Total fixed maturities
 
92,077

 
2,210

 
2,475

 
91,812

Equity securities
 
2,420

 
2,590

 
113

 
4,897

Total
 
$
94,497

 
$
4,800

 
$
2,588

 
$
96,709


The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2015 are as follows (dollars in thousands):
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
2,395

 
$
62

 
$

 
$
2,457

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
44

 
3

 

 
47

Total
 
$
2,439

 
$
65

 
$

 
$
2,504


The amortized cost and aggregate fair value of debt securities at June 30, 2016, 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
 
$
3,533

 
$
3,622

Due after one year through five years
 
14,967

 
15,451

Due after five years through ten years
 
35,639

 
36,295

Due after ten years
 
42,080

 
43,676

Total
 
$
96,219

 
$
99,044

 
 
 
 
 
Held-to-maturity securities:
 
 

 
 

Due in one year or less
 
$

 
$

Due after one year through five years
 
53

 
54

Due after five years through ten years
 
93

 
102

Due after ten years
 
2,090

 
2,201

Total
 
$
2,236

 
$
2,357


13


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

A summary of securities available-for-sale with unrealized losses as of June 30, 2016, 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, 2016
 
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
 
$
3,313

 
$
39

 
$
5,048

 
$
443

 
$
8,361

 
$
482

 
15

Mortgage backed securities
 
927

 
60

 
316

 
2

 
1,243

 
62

 
6

Private label asset backed securities
 
3,477

 
264

 
2,386

 
243

 
5,863

 
507

 
9

Obligations of state and political subdivisions
 
1,089

 
1

 

 

 
1,089

 
1

 
2

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
1,550

 
5

 
331

 
5

 
1,881

 
10

 
2

Equity securities
 

 

 
1,220

 
66

 
1,220

 
66

 
1

 
 
$
10,356

 
$
369

 
$
9,301

 
$
759

 
$
19,657

 
$
1,128

 
35


There were no securities held-to-maturity with unrealized losses as of June 30, 2016.

A summary of securities available-for-sale with unrealized losses as of December 31, 2015, 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, 2015
 
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
 
$
18,205

 
$
821

 
$
3,783

 
$
907

 
$
21,988

 
$
1,728

 
44
Mortgage backed securities
 
9,069

 
161

 
675

 
63

 
9,744

 
224

 
20
Private label asset backed securities
 
4,962

 
379

 
84

 
1

 
5,046

 
380

 
10
Obligations of state and political subdivisions
 
1,920

 
36

 
331

 
11

 
2,251

 
47

 
5
U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
6,131

 
70

 
1,452

 
26

 
7,583

 
96

 
12
Equity securities
 

 

 
1,173

 
113

 
1,173

 
113

 
1
 
 
$
40,287

 
$
1,467

 
$
7,498

 
$
1,121

 
$
47,785

 
$
2,588

 
92

There were no securities held-to-maturity with unrealized losses as of December 31, 2015.

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

14


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

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 approximately 5.6% 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, 2016 and year ended December 31, 2015, the Company realized no other-than-temporary impairments. At June 30, 2016, the single largest loss not realized as an impairment was in the bond portfolio and totaled $186,000. The second largest loss position was in the bond portfolio and totaled $155,000. The third largest loss position was in the bond portfolio and totaled $148,000. At December 31, 2015, the single largest loss not realized as an impairment was in the bond portfolio and totaled $252,000. The second largest loss position was in the bond portfolio and totaled $211,000. The third largest loss position was in the bond portfolio and totaled $186,000.

Major categories of investment income are summarized as follows (dollars in thousands):
 
Three months ended
June 30,
 
Six months ended
June 30,
 
2016

2015
 
2016

2015
Fixed maturities
$
948

 
$
868

 
$
1,849

 
$
1,762

Equity securities
26

 
30

 
54

 
60

Mortgage loans on real estate
6

 
4

 
7

 
8

Investment real estate
2

 
2

 
4

 
4

Policy loans
32

 
30

 
64

 
59

Company owned life insurance change in surrender value
19

 
(96
)
 
53

 
(52
)
Other
26

 
33

 
75

 
75

 
1,059

 
871

 
2,106

 
1,916

Less: Investment expenses
30

 
58

 
86

 
101

Net investment income
$
1,029

 
$
813

 
$
2,020

 
$
1,815


Major categories of realized investment gains and losses are summarized as follows (dollars in thousands):
 
Three months ended
June 30,
 
Six months ended
June 30,
 
2016

2015
 
2016
 
2015
Fixed maturities
$
243

 
$
250

 
$
260

 
$
392

Other, principally real estate
(1
)
 
(5
)
 
(11
)
 
(5
)
Net realized investment gains
$
242

 
$
245

 
$
249

 
$
387


15


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)


An analysis of the net change in unrealized appreciation on available-for-sale securities follows (dollars in thousands):
 
June 30, 2016
 
December 31, 2015
Net change in unrealized appreciation on available-for-sale securities before deferred tax
$
3,466

 
$
(3,225
)
Deferred income tax
(1,178
)
 
1,097

Net change in unrealized appreciation on available-for-sale securities
$
2,288

 
$
(2,128
)

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 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.


16


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

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

Assets/Liabilities Measured at Fair Value on a Recurring Basis
 
Financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2016 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
 
$
41,749

 
$

 
$
41,749

 
$

Mortgage backed securities
 
12,685

 

 
12,685

 

Private label asset backed securities
 
8,302

 

 
8,302

 

Obligations of states and political subdivisions
 
15,562

 

 
15,562

 

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
20,746

 
20,746

 

 

Trading securities
 
107

 
107

 

 

Equity securities available-for-sale
 
5,273

 
4,052

 

 
1,221

Total Financial Assets
 
$
104,424

 
$
24,905

 
$
78,298

 
$
1,221

Financial Liabilities
 

 
 

 
 

 
 

Interest rate swap
 
$
(1,541
)
 
$

 
$

 
$
(1,541
)
Total Financial Liabilities
 
$
(1,541
)
 
$

 
$

 
$
(1,541
)

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, 2016, Level 3 fair value measurements of assets include $1,221,000 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.


17


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

As of June 30, 2016, Level 3 fair value measurements of liabilities include $1,541,000 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 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, 2016 (in thousands):

For the six months ended June 30, 2016
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
1,173

 
$
(1,419
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 

 

Included in other comprehensive income
 
48

 
(122
)
Purchases:
 

 

Sales:
 

 

Issuances:
 

 

Settlements:
 

 

Transfers in/(out) of Level 3
 

 

Ending balance
 
$
1,221

 
$
(1,541
)
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, 2016:
 
$

 
$


For the six months ended June 30, 2016, 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, 2015 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
 
$
37,264

 
$

 
$
37,264

 
$

Mortgage backed securities
 
15,257

 

 
15,257

 

Private label asset backed securities
 
5,673

 

 
5,673

 

Obligations of states and political subdivisions
 
15,476

 

 
15,476

 

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
18,142

 
18,142

 

 

Trading securities
 
107

 
107

 

 

Equity securities available-for-sale
 
4,897

 
3,724

 

 
1,173

Total Financial Assets
 
$
96,816

 
$
21,973

 
$
73,670

 
$
1,173

Financial Liabilities
 
 

 
 

 
 

 
 

Interest rate swap
 
$
(1,419
)
 
$

 
$

 
$
(1,419
)
Total Financial Liabilities
 
$
(1,419
)
 
$

 
$

 
$
(1,419
)


18


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 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, 2015 (in thousands):
For the year ended December 31, 2015
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
1,116

 
$
(1,238
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 

 

Included in other comprehensive income
 
57

 
(181
)
Purchases:
 

 

Sales:
 

 

Issuances:
 

 

Settlements:
 

 

Transfers in/(out) of Level 3
 

 

Ending balance
 
$
1,173

 
$
(1,419
)
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, 2015:
 
$

 
$


For the year ended December 31, 2015, 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.

Fixed maturities held-to-maturity — the carrying amount is amortized cost; the fair values of the Company’s public fixed maturity securities that are classified as held-to-maturity are generally based on prices obtained from independent pricing services.

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.


19


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

The carrying amount and estimated fair value of the Company’s financial instruments as of June 30, 2016 and December 31, 2015 are as follows (in thousands):
 
 
June 30, 2016
 
December 31, 2015
Assets and related instruments
 
Carrying
Value
 
Estimated
Fair Value
 
Carrying
Value
 
Estimated
Fair Value
Held-to-maturity securities
 
$
2,236

 
$
2,357

 
$
2,439

 
$
2,504

Mortgage loans
 
188

 
188

 
202

 
202

Policy loans
 
1,689

 
1,689

 
1,655

 
1,655

Company owned life insurance
 
4,951

 
4,951

 
4,898

 
4,898

Other invested assets
 
3,105

 
3,105

 
3,256

 
3,256

Liabilities and related instruments
 
 

 
 

 
 

 
 

Other policyholder funds
 
1,589

 
1,589

 
1,561

 
1,561

Short-term notes payable and current portion of long-term debt
 
857

 
857

 
857

 
857

Long-term debt
 
17,106

 
17,106

 
17,100

 
17,100


NOTE 5 – PROPERTY AND EQUIPMENT

Major categories of property and equipment are summarized as follows (dollars in thousands):
 
June 30, 2016
 
December 31, 2015
Building and improvements
$
3,348

 
$
3,350

Electronic data processing equipment
1,560

 
1,631

Furniture and fixtures
533

 
529

 
5,441

 
5,510

Less accumulated depreciation
3,491

 
3,564

Property and equipment, net
$
1,950

 
$
1,946

Depreciation expense for the six months ended June 30, 2016 was $79,000 ($168,000 for the year ended December 31, 2015).

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 2014.

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 $2,545,000 at June 30, 2016 and $3,824,000 at December 31, 2015.


20


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

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

 
 
As of June 30,
2016
 
As of December 31, 2015
General expenses
 
$
1,544

 
$
1,569

Unearned premiums
 
2,193

 
2,039

Claims liabilities
 
805

 
730

Litigation settlement
 
1,748

 
1,748

AMT credit
 
543

 
816

Impairment on real estate owned
 
187

 
187

Unrealized loss on interest rate swaps
 
524

 
483

Deferred tax assets
 
7,544

 
7,572

 
 
 
 
 
Depreciation
 
(115
)
 
(111
)
Deferred policy acquisition costs
 
(2,954
)
 
(2,885
)
Unrealized gains on securities available-for-sale
 
(1,930
)
 
(752
)
Deferred tax liabilities
 
(4,999
)
 
(3,748
)
Net deferred tax asset
 
$
2,545

 
$
3,824


The appropriate income tax effects of changes in temporary differences are as follows (dollars in thousands):
 
 
Six months ended
June 30,
 
 
2016
 
2015
Deferred policy acquisition costs
 
$
69

 
$
41

Unearned premiums
 
(154
)
 
(169
)
General expenses
 
25

 
(96
)
Depreciation
 
4

 
(9
)
Claims liabilities
 
(75
)
 
4

AMT credit
 
273

 
119

Deferred income tax expense (benefit)
 
$
142

 
$
(110
)

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,
 
 
2016
 
2015
Federal income tax rate applied to pre-tax income/loss
 
34.0
 %
 
34.0
 %
Dividends received deduction and tax-exempt interest
 
(1.5
)%
 
(2.1
)%
Company owned life insurance
 
(0.6
)%
 
0.7
 %
Small life deduction
 
(5.4
)%
 
(7.7
)%
Other, net
 
(1.1
)%
 
(3.6
)%
Effective federal income tax rate
 
25.4
 %
 
21.3
 %


21


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

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, 2016 and December 31, 2015 (dollars in thousands):
 
 
June 30,
 
December 31,
 
 
2016
 
2015
Current portion of installment note payable due November 2016 with variable interest rate equal to the WSJ prime rate plus 1%. Unsecured.
 
$
857

 
$
857

 
 
$
857

 
$
857

Long-term debt consisted of the following as of June 30, 2016 and December 31, 2015 (dollars in thousands):
 
 
June 30,
 
December 31,
 
 
2016
 
2015
Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 5.0% floor; maturity March 2018.  Interest payments due quarterly.  Unsecured.
 
$
700

 
$
700

 
 
 
 
 
Line of credit, $1,000,000 available, with variable interest rate equal to the WSJ prime rate, subject to a 4.5% floor; maturity September 2017.  Interest payments due monthly.  Secured.
 

 

 
 
 
 
 
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 2016. Unsecured.
 
4,286

 
4,286

 
 
 
 
 
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; net of $183,000 in debt issuance cost ($187,000 in 2015); maturity December 2035.  Interest payments due quarterly.  All may be redeemed at any time following the tenth anniversary of issuance.  Unsecured.
 
9,096

 
9,092

 
 
 
 
 
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; applied to the outstanding principal; net of $70,000 in debt issuance cost ($71,000 in 2015); maturity June 15, 2037. Interest payments due quarterly.  All may be redeemed at any time following the fifth anniversary of issuance.  Unsecured.
 
3,024

 
3,022

 
 
$
17,106

 
$
17,100


The Company has entered into various swap agreements related to the trust preferred securities. On March 19, 2009, the Company entered into a forward swap effective September 17, 2012, with a notional amount of $3,000,000 and designated the swap as a hedge against changes in cash flows attributable to changes in the benchmark interest rate (LIBOR) associated with the subordinated debentures issued June 21, 2007. Quarterly, commencing September 17, 2012, under the terms of the forward swap, the Company will pay interest at a fixed rate of 7.02% until March 15, 2019. On May 26, 2010, the Company entered into a forward swap with a notional amount of $9,000,000 effective December 15, 2015, which hedges 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 pays interest at a fixed rate of 8.49% until March 15, 2020.

The swaps entered into in 2009 and 2010 have fair values of $235,000 (liability) and $1,306,000 (liability), respectively, for a total liability of $1,541,000 at June 30, 2016 ($1,419,000 at December 31, 2015).  The swap liability is reported as a component of other liabilities on the consolidated balance sheets.  A net valuation loss of $81,000 (net of tax) is

22


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

included in accumulated other comprehensive income related to the swap agreements at June 30, 2016.  A net valuation loss of $119,000 (net of tax) was included in accumulated other comprehensive income related to the swap at December 31, 2015.

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

The Company’s interest rate swaps include provisions requiring the Company to post collateral when the derivative is in a net liability position.  At June 30, 2016, the Company has securities on deposit with fair market values of $1,536,000 and cash of $230,000 (all of which is posted as collateral). At December 31, 2015, the Company had securities on deposit with fair market values of $1,482,000 and cash of $130,000 (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 an excess of loss basis to cover losses from catastrophe events. 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 three layers as follows:
Layer
Reinsurers' Limits of Liability
First Layer
100% of $13,500,000 in excess of $4,000,000 retention
Second Layer
100% of $25,000,000 in excess of $17,500,000
Third 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.


23


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

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.

At June 30, 2016, the largest reinsurance recoverable of a single reinsurer was $10,000 ($12,000 at December 31, 2015). Amounts reported as ceded incurred losses in both 2016 and 2015 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, 2016 and 2015 amounted to $113,000 and $115,000, 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 to the non-qualified deferred compensation plans for the six months ended June 30, 2016 and 2015 amounted to approximately $107,000 and $89,000, 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 $150,000 costs incurred during the first six months of 2016 and $158,000 costs incurred during the first six months of 2015 related to ESOP plan contributions. 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, 2016 and year ended December 31, 2015, changes in shareholders' equity consisted of net income of $2,237,000 and $4,697,000, respectively; dividends paid of $226,000 in 2016 and $402,000 in 2015; increases in accumulated other comprehensive income, net of applicable taxes, of $2,207,000 in 2016 and decreases in accumulated other comprehensive income, net of applicable taxes, of $2,247,000 in 2015.  Other comprehensive gains and loss consisted of accumulated unrealized gains and losses on securities available for sale and unrealized loss on interest rate swaps.

Preferred Stock
Preferred Stock may be issued in one or more series as shall from time to time be determined and authorized by the Board of Directors. The directors may make specific provisions regarding (a) the voting rights, if any (b) whether such dividends are to be cumulative or noncumulative (c) the redemption provisions, if any (d) participating rights, if any (e) any sinking fund or other retirement provisions (f) dividend rates (g) the number of shares of such series and (h) liquidation preference.

Common Stock
The holders of the Class A Common Stock will have one-twentieth of one vote per share, and the holders of the common stock will have one vote per share. There is currently no Class A Common Stock issued or outstanding.

In the event of any liquidation, dissolution or distribution of the assets of the Company remaining after the payments to the holders of the Preferred Stock of the full preferential amounts to which they may be entitled as provided in the resolution or resolutions creating any series thereof, the remaining assets of the Company shall be divided and

24


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

distributed among the holders of both classes of common stock, except as may otherwise be provided in any such resolution or resolutions.
The table below provides information regarding the Company's preferred and common stock as of June 30, 2016 and December 31, 2015:

 
June 30, 2016
December 31, 2015
 
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

 
2,517,339

 
2,517,339

3,000,000

 
2,512,425

 
2,512,425


On May 20, 2016, 4,914 shares of common stock were issued to directors as compensation under the 2009 Equity
Incentive Plan previously approved by shareholders.

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,
 
 
2016
 
2015
Gains and Losses on Cash Flow Hedges
 
 
 
 
Balance at beginning of period
 
$
(935
)
 
$
(816
)
Other comprehensive loss for period:
 
 
 
 
Other comprehensive loss before reclassifications
 
(81
)
 
(61
)
Amounts reclassified from accumulated other comprehensive income
 

 

Net current period other comprehensive loss
 
(81
)
 
(61
)
Balance at end of period
 
$
(1,016
)
 
$
(877
)
Unrealized Gains and Losses on Available-for-Sale Securities
 
 
 
 
Balance at beginning of period
 
$
1,460

 
$
3,588

Other comprehensive income for period:
 
 
 
 
Other comprehensive income (loss) before reclassifications
 
2,460

 
(618
)
Amounts reclassified from accumulated other comprehensive income
 
(172
)
 
(257
)
Net current period other comprehensive income (loss)
 
2,288

 
(875
)
Balance at end of period
 
$
3,748

 
$
2,713

Total Accumulated Other Comprehensive Income at end of period
 
$
2,732

 
$
1,836



25


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

The following table presents the amounts reclassified out of AOCI for the six months ended June 30, 2016 (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
 
$
260

 
Net realized investment gains
 
 
260

 
Total before tax
 
 
(88
)
 
Tax (expense) or benefit
 
 
$
172

 
Net of Tax

The following table presents the amounts reclassified out of AOCI for the six months ended June 30, 2015 (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
 
$
390

 
Net realized investment gains
 
 
390

 
Total before tax
 
 
(133
)
 
Tax (expense) or benefit
 
 
$
257

 
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. 

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 independent 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, 2016 and at December 31, 2015 are summarized below (dollars in thousands):

 
 
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
 
 
 
 
 
 
 
 
 
June 30, 2016
 
$
152,021

 
$
86,167

 
$
59,199

 
$
6,655

 
 


 
 
 
 
 
 
December 31, 2015
 
$
147,841

 
$
84,435

 
$
57,067

 
$
6,339



26


THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2015 AMOUNTS)

Premium revenues and operating income by business segment for the three and six months ended June 30, 2016 and 2015 are summarized below (dollars in thousands):

Three months ended June 30, 2016
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
REVENUE
 
 
 
 
 
 
 
Net premiums earned
$
15,227

 
$
13,646