-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, FzhudVBRsH0WLo7idDKIa2bH6LoiCcy/nGHHxkmAUwBKVPUWGUR7sNTjJ/mXv40a KmBNLSPgDS6outag+ZiO7g== 0000865058-02-000004.txt : 20020814 0000865058-02-000004.hdr.sgml : 20020814 20020814152821 ACCESSION NUMBER: 0000865058-02-000004 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20020630 FILED AS OF DATE: 20020814 FILER: COMPANY DATA: COMPANY CONFORMED NAME: NATIONAL SECURITY GROUP INC CENTRAL INDEX KEY: 0000865058 STANDARD INDUSTRIAL CLASSIFICATION: LIFE INSURANCE [6311] IRS NUMBER: 631020300 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-18649 FILM NUMBER: 02735799 BUSINESS ADDRESS: STREET 1: 661 E DAVIS ST CITY: ELBA STATE: AL ZIP: 36323 BUSINESS PHONE: 2058972273 10-Q 1 form10q_june2002txt.txt FORM 10-Q JUNE 30, 2002 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 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 (IRS Employer incorporation or organization) Identification No.) 661 East Davis Street, Elba, Alabama 36323 (Address and Zip code of principal executive offices) Registrant's telephone number, including area code (334) 897-2273 -------------- Not Applicable (Former name, address, and former fiscal year, if changed since last report) 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 (X) No ( ) Number of Shares of Common Stock outstanding as of August 8, 2002: 2,466,600 Exhibit index is located on page 18. Page 1 of 18 pages 1 THE NATIONAL SECURITY GROUP, INC INDEX Page No. PART I. FINANCIAL INFORMATION Item 1. Financial Statements Consolidated Statements of Income .............................. 3 Consolidated Balance Sheets .................................... 4 Consolidated Statements of Shareholders' Equity ................ 5 Consolidated Statements of Cash Flow ........................... 6 Notes to Financial Statements .................................. 7 Accountants Review Report ...................................... 10 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .................................... 11 Item 3. Market Risk Disclosures ........................................ 16 PART II OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K ............................... 16 SIGNATURE ............................................................... 17 EXHIBIT INDEX ........................................................... 18 2 Part I. FINANCIAL INFORMATION Item 1. Financial Statements THE NATIONAL SECURITY GROUP, INC. CONSOLIDATED UNAUDITED STATEMENTS OF INCOME (In thousands, except per share amounts)
Three Months Six Months Ended June 30 Ended June 30 2002 2001 2002 2001 ---- ---- ---- ---- Revenues Net insurance premiums earned ............... $ 8,063 $ 6,142 $ 15,306 $ 12,304 Net investment income ....................... 1,152 1,114 2,212 2,162 Realized investment gains ................... 454 116 678 544 Other income ................................ 272 187 520 886 -------- -------- -------- -------- Total revenues ............................ 9,941 7,559 18,716 15,896 -------- -------- -------- -------- Benefits and Expenses Policyholder benefits and settlement expenses 6,180 2,936 11,004 7,537 Policy acquisition costs 1,904 1,280 3,487 2,526 General insurance expenses 1,513 1,618 3,002 2,935 Insurance taxes, licenses and fees .......... 369 268 712 678 -------- -------- -------- -------- Total benefits and expense .............. 9,966 6,102 18,205 13,676 -------- -------- -------- -------- Income Before Income Taxes and Equity in Income of Affiliate ........... (25) 1,457 511 2,220 Income Taxes (Current and deferred) (114) 463 105 675 -------- -------- -------- -------- Income Before Equity in Income to Affiliate . 89 $ 994 406 $ 1,545 Equity in Income of Affiliate ............... 9 0 36 0 Net Income ............................. $ 98 $ 994 $ 442 $ 1,545 $ ======== ======== ======== ======== Earnings per share .......................... $ .04 $ .41 $ 0.18 $ 0.63 ======== ======== ======== ======== Dividends Declared per Share ................ $ .20 $ .19 $ 0.40 $ 0.38 ======== ======== ======== ========
The Notes to Financial Statements are an integral part of these statements. 3 THE NATIONAL SECURITY GROUP, INC. CONSOLIDATED BALANCE SHEETS (In thousands, except per share amounts) As of As of June 30, December 31, 2002 2001 ---- ---- (Unaudited) Assets Investments: Debt Securities held-to-maturity at amortized cost (estimated fair value: 2002 - $24,127; 2001 - $26,381) $23,296 $23,135 Debt Securities available-for-sale, at estimated fair value (cost: 2002 - $35,935; 2001 - $29,765) 37,701 35,145 Equity Securities, at market (cost: 2002 --$10,568; 2001 -- $11,673) 20,206 22,503 Receivable for securities sold 0 50 Note receivable from affiliate 1,000 250 Mortgage loans 269 275 Investment real estate, at cost 1,594 1,563 Policy loans 699 726 Investment in affiliate 89 53 ------ ------ Total investments 84,854 83,700 ------ ------ Cash and cash equivalents 802 3,391 Accrued investment income 1,066 938 Reinsurance recoverable 2,325 3,524 Deferred policy acquisition costs 5,259 4,615 Prepaid reinsurance premiums 244 291 Other assets 4,067 3,025 ------ ------ Total assets $98,617 $99,484 ======= ======= Liabilities Policy liabilities-Life Insurance $23,353 $22,734 Policy liabilities-Property and Casualty Insurance 12,173 11,890 Unearned premiums 9,069 7,115 Other policyholder funds 1,500 1,503 Notes payable 3,514 2,108 Current income tax payable 58 593 Deferred income tax 2,819 3,083 Other liabilities 2,788 5,574 ------ ------ Total liabilities $55,274 $54,600 ------ ------ Shareholders' Equity Common stock, $1 par value, 2,466,600 shares outstanding 2,467 2,467 Additional paid in capital 4,951 4,951 Accumulated comprehensive income: Net unrealized appreciation on investment securities 7,622 8,618 Retained earnings 28,303 28,848 ------ ------ Total shareholders' equity 43,343 44,884 ------ ------ Total liabilities and shareholder's equity $98,617 $99,484 ====== ====== Shareholders' Equity per Share $ 17.57 $18.20 ====== ====== The Notes to Financial Statements are an integral part of these statements 4 THE NATIONAL SECURITY GROUP, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY (In thousands, except per share amounts)
Accumulated Other Retained Comprehensive Common Paid-in Treasury Total Earnings Income Stock Capital Stock Balance at December 31, 2000 $ 43,780 $ 35,225 $ 9,779 $ 2,340 $ 17 $ (3,581) Comprehensive Income Net Income for 2001 4,130 4,130 Other comprehensive income (net of tax) Unrealized loss on securities, net of reclassification adjustment (1,161) (1,161) -------- Total Comprehensive Income 2,969 -------- Retirement of treasury stock ( 3,297) (284) 3,581 Stock dividend (20%) ( 5,345) 411 4,934 Cash dividends ( 1,865) ( 1,865) ------- ------- ------- ------ ----- ------ Balance at December 31, 2001 $ 44,884 $28,848 $ 8,618 $ 2,467 $4,951 $ 0 Comprehensive Income Net Income three months ended 6/30/2002 442 442 Other comprehensive income (net of tax) Unrealized loss on securities, net of reclassification adjustment ( 996) ( 996) ------ Total Comprehensive Income ( 554) ------ Cash dividends ( 987) ( 987) ------- ------- ------- ------ ------ --------- Balance at March 31, 2002 (Unaudited) $ 43,343 $28,303 $ 7,622 $ 2,467 $4,951 $ 0 ======== ======= ======== ======= ===== =========
The Notes to the Financial Statements are an integral part of these statements. 5 THE NATIONAL SECURITY GROUP. INC. CONSOLIDATED UNAUDITED STATEMENTS OF CASH FLOWS (In thousands) Six Months Ended June 30 2002 2001 ----- ---- Cash Flows from Operating Activities Income from continuing operations $ 442 $ 1,545 Adjustments to reconcile income from continuing operations to net cash provided by (used in) operating activities: Accrued investment income (128) (45) Reinsurance receivables 1,199 163 Deferred Policy acquisition costs (644) (292) Income Taxes (799) 522 Depreciation expense (73) (73) Policy liabilities and claims 2,856 1,516 Other, net (3,618) (1,650) ------- ------- Net cash used in operating activities (765) 1,686 ------- ------- Cash Flows from Investing Activities Cost of investments acquired (7,545) (6,758) Sale and maturity of investments 5,396 6,509 Purchase of property and equipment (91) (80) ------- ------ Net cash used in investing activities (2,240) (329) ------- ------ Cash Flows from Financing Activities Change in other policyholder funds (3) (53) Change in notes payable 1,406 (163) Dividends paid (987) (906) ------- ------ Net cash used in financing activities 416 (1,122) ------- ------ Net decrease in cash and cash equivalents (2,589) 235 Cash and cash equivalents, beginning of period 3,391 2,629 ------- ------- Cash and cash equivalents, end of period $ 802 $2,864 ======= ======= The Notes to the Financial Statements are an integral part of these statements. 6 THE NATIONAL SECURITY GROUP, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1-Basis of Presentation The consolidated unaudited financial statements have been prepared in conformity with generally accepted accounting principles. The interim financial statements include all adjustments necessary, in the opinion of management, for fair statement of financial position, results of operations and cash flows for the periods reported. These adjustments are all normal recurring adjustments. A summary of the more significant accounting policies are set forth in the notes to the audited consolidated financial statements for the year ended December 31, 2001. The accompanying consolidated unaudited 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. The accompanying consolidated unaudited financial statements also include an investment in affiliate, which consists of a fifty percent interest in The Mobile Attic, Inc. The Mobile Attic, Inc. is a portable storage leasing company which began operations in 2001. The Company accounts for this investment using the equity method. Note 2-Reinsurance National Security Fire and Casualty Company ("NSFC"), Omega One Insurance Company ("OMEGA"), and National Security Insurance Company ("NSIC") wholly owned subsidiaries of the Company, reinsure certain portions of insurance risk, which exceed various retention limits. NSFC, OMEGA, and NSIC are liable for these amounts in the event assuming companies are unable to meet their obligations. Note 3-Calculation of Earnings Per Share Earnings per share were based on net income divided by the weighted average common shares outstanding. The weighted average number of shares outstanding for the period ending June 30, 2002 was 2,466,600 and for the period ending June 30, 2001 was 2,466,600. Note 4-Changes in Shareholder's Equity (in thousands) During the three months ended June 30, 2002 and 2001, there were no changes in shareholders' equity except for net income of $442 and $1,545 respectively; dividends paid of $987 and $906 respectively; and unrealized investment gains (losses), net of applicable taxes, of $(996) and $179 respectively. 7 THE NATIONAL SECURITY GROUP, INC. NOTES TO FINANCIAL STATEMENTS (Continued) Note 5 - Deferred Taxes The tax effect of significant temporary differences representing deferred tax assets and liabilities are as follows: (in thousands) June 30, January 1, 2002 2002 ------ ------- Deferred policy acquisition costs ...................... (1,788) (1,569) Policy liabilities ..................................... 314 349 Unearned premiums ...................................... 600 464 Claims liabilities ..................................... 344 310 General insurance expenses ............................. 758 757 Alternative minimum tax credit carry forward ........... 45 0 Unrealized gains on securities available-for-sale ...... (3,092) (3,394) ------ ------ Net deferred tax liability ............................. (2,819) (3,083) ====== ====== Deferred taxes are determined based on the estimated future tax effects of differences between the financial statement and tax bases of assets and liabilities given the provisions of the enacted tax laws. Note 6-Commitments and Contingencies Commitments The Company is obligated under a commitment to extend credit to a 50% owned subsidiary, The Mobile Attic, Inc. in the form of a $1,000,000 credit line. The credit line is secured by inventory and matures on September 18, 2002. Interest is due on the unpaid principal at the rate of 8% per annum. The Company may, at its option anytime on or before the payment by The Mobile Attic, Inc. of all principal and interest, elect to convert the outstanding principal and accrued interest to a proportionate share of common stock in The Mobile Attic, Inc. Management currently expects to convert a portion of the outstanding balance on the note to common stock on or before the maturity date. The remaining balance on the note is expected to be converted to a term note to be repaid over a term not less than five years. In April of 2002 the Company agreed to guarantee a $5,000,000 credit line of its 50% owned subsidiary, The Mobile Attic, Inc. The Mobile Attic will use the proceeds from this borrowing to acquire portable storage units which are leased to building contractors, retail establishments, and individual consumers through a network of independently operated dealerships currently located in Alabama and Florida. With the additional borrowing The Mobile Attic will be able to further expand operations by granting additional independently operated dealerships throughout the Southeastern United States. Under the terms of the guarantee agreement, The Company will receive compensation from Mobile Attic of 150 basis points on the average outstanding monthly balance of the credit line. Mobile Attic will pay interest to the lender quarterly and convert the credit line to a term note at the end of the two year draw down period. 8 THE NATIONAL SECURITY GROUP, INC. NOTES TO FINANCIAL STATEMENTS (Continued) Contingencies The Company and its subsidiaries continue to be named as parties to litigation related to the conduct of their insurance operations. These suits involve alleged breaches of contracts, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of agents of the Company's subsidiaries, and miscellaneous other causes of action. Most of these lawsuits include claims for punitive damages in addition to other specified relief. In two separately filed actions, NSIC is named as a defendant in purported class actions relating to the past sale of industrial burial insurance. The actions address whether the premiums charged were "excessive" relative to the benefit provided and whether the premiums charged were in any manner discriminatory relative to the race of the person insured. In addition, several individual actions on behalf of specifically named persons have been filed with similar allegations. These actions are in the initial phases and little discovery has been undertaken and no class has been certified. While the cases entail separate and distinguishable facts, the legal issues are similar to the issues pending in numerous other actions currently pending nationwide against numerous insurers. While NSIC did at one time sell industrial burial insurance, no such plans have been sold for several decades. The company establishes and maintains reserves on contingent liabilities to the extent losses are probable and amounts are estimable. In many instances, however, it is not feasible to predict the ultimate outcome with any degree of accuracy. While a resolution of these matters may significantly impact consolidated earnings and the Company's consolidated financial position, it remains management's opinion, based on information presently available, that the ultimate resolution of these matters will not have a material impact on the Company's consolidated financial position. However, it should be noted that instances of class action lawsuits against insurance companies appear to be increasing in several states in which insurance subsidiaries of the company operate. Note 7-Long-Term Debt In the first quarter of 2002 the Company refinanced long term debt totaling $2.1 million dollars. In conjunction with the refinancing of existing long term debt the Company borrowed an additional $1.5 million. The primary use of the proceeds from the additional borrowing will be to upgrade information systems, the most significant of which involves the installation of a new policy administration system in the life insurance subsidiary. The refinancing and additional borrowing consists of a note payable to a local bank with a variable interest rate of LIBOR plus 275 basis points (currently 4.49%). The interest rate is adjusted quarterly. Repayment of the note is to be made in quarterly installments of $112,953.40 with a final payment of $2,114,610.46 due March 28, 2007. 9 ACCOUNTANTS REVIEW REPORT Board of Directors The National Security Group, Inc. Elba, Alabama We have reviewed the accompanying balance sheet of The National Security Group, Inc. as of June 30, 2002, and the related statements of income and cash flows for the period then ended in accordance with Statements on Standards for Accounting and Review Services issued by the American Institute of Certified Public Accountants. All information included in these financial statements is the representation of the management of The National Security Group, Inc. A review consists principally of inquiries of Company personnel and analytical procedures applied to financial data. It is substantially less in scope than an audit in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying financial statements in order for them to be in conformity with generally accepted accounting principles. Barfield, Murphy, Shank & Smith, PC August 12, 2002 10 Item 2. MANAGEMENTS' DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS INTRODUCTION The following discussion addresses the financial condition of The National Security Group, Inc. as of June 30, 2002, compared with December 31, 2001 and its results of operations and cash flows for the quarter ending June 30, 2002, compared with the same period last year. The reader is assumed to have access to the Company's 2001 Annual Report. This discussion should be read in conjunction with the Annual Report and with consolidated financial statements on pages 3 through 6 of this form 10-Q. Information is presented in whole dollars. CONSOLIDATED RESULTS OF OPERATIONS Premium revenues: Premium revenue of the Company is generated by three wholly owned subsidiaries, National Security Insurance Company (NSIC), National Security Fire & Casualty Company (NSFC), and Omega One Insurance Company (Omega). NSIC is a life, accident and health insurance company. NSFC and Omega write property and casualty lines of insurance, primarily dwelling fire, homeowners, and private passenger auto. The following table sets forth premium revenue by major line of business for the six months ended June 30, 2002 compared to the same period last year: Six months ended June 30, Percent 2002 2001 increase(decrease) Life, accident and health operations: Traditional life insurance $2,171,353 $2,056,190 5.60% Accident and health insurance 555,229 441,749 25.69% Other 772 895 (13.75%) ---------- --------- Total life, accident and health 2,727,354 2,498,834 9.15% Property and Casualty operations: Dwelling fire & extended coverage 6,025,095 5,381,114 11.97% Homeowners (Including mobile homeowners) 2,955,637 1,968,581 50.14% Ocean marine 752,562 593,982 26.70% Other liability 281,651 236,668 19.01% Private passenger auto liability 1,666,756 1,188,100 40.29% Commercial auto liability 323,031 537,900 (39.95%) Auto physical damage 1,396,371 718,000 94.48% Reinsurance premium ceded (822,434) (819,042) 0.41% ---------- --------- Total property and casualty 12,578,669 9,805,303 28.28% ---------- --------- Total earned premium revenue $15,306,023 $12,304,137 24.40% ========== ========== 11 Premium revenue in the life insurance subsidiary, NSIC accounts for 18% of total premium income of the Company. NSIC has two primary methods of distribution of insurance products, employee agents and independent agents. Employee agents primarily consist of home service agents that sell policies and collect premium primarily in the insured's home. Premium production from home service agents is down less than 1% compared to last year. In an effort to increase production of new business and penetrate markets in states outside of Alabama, NSIC began appointing independent agents in 1998. Independent agents now account for over 90% of all new business production in NSIC. Premium revenue in NSIC consists of traditional life insurance products and supplemental accident and health products. As set forth in the preceding table, traditional life insurance premium revenue increased 5.6% in the first six months of 2002 compared to the same period last year. Accident and health insurance premium revenue increased 25.7%. Increased sales of simplified and guaranteed issue whole life products and lump sum cancer and critical illness health products through independent agents are the primary factors contributing to the increase in NSIC premium revenue. Premium revenue in the property/casualty insurance subsidiaries increased 24.4% in the first six months of 2002 compared to the same period last year. Dwelling fire insurance premium, which accounts for 47.9% of total property/casualty premium revenue, increased 11.97%. Homeowners insurance premium increased 50.14%. Increased marketing efforts, modernization of product line including increases in policy limits and decreased competition in several markets are the primary contributing factors to the increase in dwelling property premium revenue. The remaining primary lines of insurance contributing to the increased growth in property/casualty premium revenue are automobile liability and physical damage. In the year 2000 the property/casualty subsidiaries began a non-standard auto program in Alabama with a monthly premium payment option. The program was expanded into Mississippi in the fourth quarter of 2001. This program was acquired through the acquisition on Liberty Southern Insurance Company of Mobile, Alabama. This non-standard auto program is the primary contributor to the increase in automobile premium revenue. Net investment income: Net investment income increased 2.3% in the first six months of 2002 compared to the same period last year. The Company has significantly reduced holdings of equity securities over the last three years and proceeds from disposals of equity securities were reinvested in debt securities which typically produce more current income. However, the potential increase in investment income has been diminished due to the current record low interest rate environment. Realized capital gains and losses: Realized capital gains are generated primarily by the sale of common stock investments from the insurance subsidiaries investment portfolio. However, the Company has experienced an increase in capital gains in 2002 from investments in debt securities. With the declining interest rate environment the insurance subsidiaries have had debt securities called. The majority of these bonds were originally bought at a discount to par value and the early calls of the bonds produced realized capital gains. Securities being periodically sold or called can produce significant fluctuations in realized capital gains from period to period. Realized capital gains were $678,000 for the first six months of 2002 compared to $544,000 in the same period last year, an increase of 24.6%. 12 Other income: Other income is down 366,000 in the first six months of 2002 compared to the same period last year. In the first quarter of 2001 a subsidiary of the Company, NSFC, recovered $580,000 from a third party in connection with a previously settled lawsuit. Other income was $272,000 for the three months ended June 30, 2002 compared to the same period last year, an increase of 45.5%. Increased billing fees associated with the monthly billed private passenger auto insurance program is the primary factor contributing to the increase in other income for the quarter. Policyholder benefits and settlement expenses: Policyholder benefits and settlement expenses are up significantly for the quarter and year to date compared to last year. Two primary factors contributed to the sharp increase in policyholder benefits in the second quarter. In June of 2002 a property/casualty subsidiary, NSFC settled a longstanding lawsuit in connection with a claim that incurred in 1989. NSFC set up reserves for the anticipated cost of settling the claim, but the final settlement exceeded reserves by over $400,000. The second factor contributing to the increase in policyholder benefits is related to the large increase in premium revenue. Historically, in the product lines that property/casualty subsidiaries underwrite, new business has carried a much higher frequency and severity of claims than business that has been renewed for several years. With earned premium up nearly 25% for the year to date, the new business has brought a significant increase in severity of losses, particularly total fire losses to dwellings. In order to bring down loss ratios on dwelling lines of business, NSFC is currently implementing more stringent underwriting procedures, terminating independent agents with poor loss experience, and has temporarily put a moratorium on appointments of new agents in NSFC's largest state, Alabama. In addition, the overall market for dwelling insurance products is hardening, which allows the property/casualty subsidiaries to more easily implement rate increase in unprofitable programs. Some of the more significant rate increase currently being implemented include an overall 13% rate increase in comprehensive mobile homeowners in Alabama, an overall 3.2% rate increase in NSFC's traditional auto program in Alabama, an overall 9.8% rate increase in Omega's non-standard monthly bill auto program in Alabama, an overall 6% to 7% rate increase on homeowners rates in Arkansas and Mississippi, and an overall 8.7% rate increase in mobile homeowners in Mississippi. These rate increases are all currently scheduled to take affect during the third quarter of 2002. Policy acquisition costs: Policy acquisition costs are up $961,000 in the first six months of 2002 compared to the same period last year. Policy acquisition cost primarily consists of salaries and commissions paid to employee and independent insurance agents and generally rise and fall in relation to premium revenue. Policy acquisition cost as a percent of earned premium totaled 22.8% in the first six months of 2002 compared to 20.5%in the first six months of 2001. Increased production of monthly billed auto premium coupled with a new employee agent contract in the life insurance subsidiary were the primary contributing factors in the increased policy acquisition cost. Some reductions were made in the employee agent field force late in the second quarter with a few more reductions possible by year end, which should help reduce the acquisition cost of the life insurance subsidiary. Also, the commission paid to the general agent on the monthly bill auto program will reduce in phases over the next two years by 20%. General insurance expenses: General insurance expenses are up only 2% for the year to date compared to last year. Even though premium revenue has increased nearly 25% over last year, the Company has not had to add significant staff or greatly increase general overhead to achieve this level of growth. 13 Insurance taxes, licenses, and fees: Insurance taxes, licenses and fees as a percent of earned premium are down significantly compared to last year. Insurance fees were adversely impacted in 2001 due to the cost of a routine statutory financial examination conducted by the Alabama Department of Insurance. Equity in income of Affiliate: Equity in the income of a 50% owned affiliate, The Mobile Attic, Inc., contributed $36,000 to net income for the quarter. The Mobile Attic, Inc. began operations in the fourth quarter of 2001. The Mobile Attic is in the business of leasing portable storage units to construction companies, retail establishments, and household customers. Summary: The Company has a year to date net income of $442,000 versus net income of $1,545,000 in 2001. As discussed in previous sections of this Management Discussion and Analysis, the insurance subsidiaries have achieved significant top line growth, with premium revenue increasing nearly 25%. However, an increase in incurred losses in the property/casualty subsidiaries had an adverse impact on underwriting results. Investments: Invested assets are up $1.1 million at June 30, 2002 compared to December 31, 2001. The increase in invested assets is primarily the result of the reinvestment of cash held at December 31, 2001. The Company considers any fixed income investment with a Standard & Poor's rating of BB+ or lower to be below investment grade (Commonly referred to as "Junk Bonds"). At June 30, 2002 less than 1% of the Company's investment portfolio was invested in fixed income investments rated below investment grade. The Company currently has no bonds in the investment portfolio in default. The Company monitors its level of investments in debt and equity securities held in issuers of below investment grade debt securities. Management believes the level of such investments is not significant to the Company's financial condition. Income taxes: The effective tax rate in the first six months of 2002 was 20.5% compared to 30.4% for the first six months of 2001. Capital resources: At June 30, 2002, the Company had aggregate equity capital, unrealized investment gains (net of income taxes) and retained earnings of $43.3 million, down $1,541,000 compared to December 31, 2001. The decrease reflects net income of $442,000, a decrease in accumulated unrealized investment gains of $995,000, and dividends paid of $986,000. The Company has $3.5 million in notes from local banks. 14 Liquidity: The liquidity requirements of the Company are primarily met by funds provided from operations of the life insurance and property/casualty insurance subsidiaries. Premium and investment income, as well as maturities, calls, and sales of invested assets, provide the primary sources of cash for both subsidiaries. Cash is used by subsidiaries for payments of policy benefits, the acquisition of new business (principally commissions), operating expenses, and purchases of new investments. The Company had $802,000 in cash and cash equivalents at June 30, 2002. Net cash used by operating activities was $765,000 for the current period, compared to net cash provided of $1,686,000 for the period ended June 30, 2001. Cash used in investing activities was $2,240,000. Cash dividends paid to stockholders' of $987,000 and an increase in notes payable of $1,406,000 were the primary uses of cash in financing activities. The liquidity requirements of the Company are primarily met by funds provided from operations of the life insurance and property/casualty subsidiaries. The Company receives funds from its subsidiaries consisting of dividends, payments for federal income taxes, and reimbursement of expenses incurred at the corporate level for the subsidiaries. These funds are used to pay stockholder dividends, corporate interest, corporate administrative expenses, federal income taxes, and for funding investments in subsidiaries. The Company's subsidiaries require cash in order to fund policy acquisition costs, claims, other policy benefits, interest expense, general expenses, and dividends to the Company. Premium and investment income, as well as maturities, calls, and sales of invested assets, provide the primary sources of cash for both subsidiaries. A significant portion of the Company's investment portfolio consists of readily marketable securities which can be sold for cash. The Company's business is concentrated primarily in the Southeastern United States. Accordingly, unusually severe storms or other disasters in the Southeastern United States might have a more significant effect on the Company than on a more geographically diversified insurance company. Unusually severe storms, other natural disasters and other events could have an adverse impact on the Company's financial condition and operating results. However, the Company maintains a catastrophe reinsurance program to limit the effect on such catastrophic events on the Company's financial condition. Information about 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. Forward-looking statements are based on assumptions and opinions concerning a variety of known and unknown risks, including but not limited to changes in market conditions, natural disasters and other catastrophic events, increased competition, changes in availability and cost of reinsurance, changes in governmental regulations, technological changes, political and legal contingencies and general economic conditions, as well as other risks and uncertainties more completely described in the Company's filings with the Securities and Exchange Commission. If any of these assumptions or opinions prove incorrect, any forward-looking statements made on the basis of such assumptions or opinions may also prove materially incorrect in one or more respects and may cause future results to differ materially from those contemplated, projected, estimated or budgeted in such forward-looking statements. 15 Item 3. Market Risk Disclosures The Company's primary objectives in managing its investment portfolio are to maximize investment income and total investment returns while minimizing overall credit risk. Investment strategies are developed based on many factors including changes in interest rates, overall market conditions, underwriting results, regulatory requirements, and tax position. Investment decisions are made by management and reviewed and approved by the Board of Directors. Market risk represents the potential for loss due to adverse changes in fair value of securities. The three potential risks related to the Company's fixed maturity portfolio are interest rate risk, prepayment risk, and default risk. The primary risk related to the Company's equity portfolio is equity price risk. There have been no material changes to the Company's market risk for the six months ended June 30, 2002. For further information reference is made to the Company's Form 10-K for the year ended December 31, 2001. Part II. OTHER INFORMATION Item 6. Exhibits and Reports on Form 8-K See Exhibit Index 16 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed by the undersigned duly authorized officer, on its behalf and in the capacity indicated. The National Security Group, Inc. By /s/ William L. Brunson Jr. By /s/ Brian R. McLeod ----------------------------- -------------------------- William L. Brunson, Jr. Brian R. McLeod President and Chief Executive Officer Treasurer and Chief Financial Officer Dated: August 12, 2002 17 EXHIBIT INDEX Exhibit Description Page (a)11 Statement Regarding Computation of Per Share Earnings Filed Herewith; See Note 3 to Financial (b) Form 8-K None. 18 -----END PRIVACY-ENHANCED MESSAGE-----