UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 or 15(D) OF

THE SECURITIES EXCHANGE ACT OF 1934

For Fiscal Year Ended December 31, 2005 Commission File Number 0-18649  

The National Security Group, Inc.

(Exact name of registrant as specified in its charter)

Delaware	63-1020300
(State or Other Jurisdiction of Incorporation or Organization)	(IRS Employer Identification No.)
661 East Davis Street Elba, Alabama	36323
(Address of principal executive offices)	(Zip-Code)

Registrant’s Telephone Number including Area Code (334) 897-2273

Securities registered pursuant to Section 12 (b) of the Act:

None

Securities registered pursuant to Section 12 (g) of the Act:

Common Stock, par value $1.00 per shareThe NASDAQ Stock Market (EXCHANGE)

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

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

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  o

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in rule 12b-2 of the Exchange Act. (Check one): Non-accelerated filer Yes  x    No  o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  o    No x

The aggregate market value of the voting stock held by nonaffiliates of the Registrant as of February 28, 2006, (based upon the bid price of these shares on NASDAQ on such date) was $21,570,514.

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

Class	Outstanding December 31, 2005
Common Stock, $1.00 par value	2,466,600 shares

Table of Contents

Part I			Page
	Item 1.	Business	4
	Item 1A.	Risk Factors	10
	Item 1B.	Unresolved Staff Comments	13
	Item 2.	Properties	13
	Item 3.	Legal Proceedings	13
	Item 4.	Submission of Matters to a Vote of Security Holders	13
Part II
	Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases	14
	Item 6.	Selected Financial Data	15
	Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
	Item 7A.	Quantitative and Qualitative Disclosures About Market Risk	30
	Item 8.	Consolidated Financial Statements and Supplementary Data	31
	Item 9.	Changes in and Disagreements with Accountants on Financial Disclosure	66
	Item 9A.	Controls and Procedures	66
	Item 9B.	Other Information	66
Part III
	Item 10.	Directors and Executive Officers of the Registrant	66
	Item 11.	Executive Compensation	66
	Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	66
	Item 13.	Certain Relationships and Related Transactions	66
	Item 14.	Principal Accountant Fees and Services	67
Part IV.
	Item 15.	Exhibits, Financial Statement Schedules and Reports of Form 8-K	68
		Signature Page	70
		Certifications	71

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Note Regarding Forward-Looking Statements

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

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

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

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

• The Company is rated by various insurance rating agencies. If a rating is downgraded from its current level by one of these agencies, sales of the Company’s products and stock could be adversely impacted.

• The Company’s financial results are adversely affected by increases in policy claims received by the Company. While a manageable risk, this fluctuation is often unpredictable.

• The Company’s investments are subject to a variety of risks. Investments are subject to defaults and changes in market value. Market value can be affected by changes in interest rates, market performance and the economy.

• The Company mitigates risk associated with life policies through implementing effective underwriting and reinsurance strategies. These factors mitigate, not control, risk related to mortality and morbidity exposure. The Company has established reserves for claims and future policy benefits based on amounts determined by independent actuaries. There is no assurance that these estimated reserves will prove to be sufficient or that the Company will not incur claims exceeding reserves, which could result in operating losses.

• The Company mitigates risk associated with property and casualty policies through implementing effective underwriting and reinsurance strategies. The Company obtains reinsurance, which increases underwriting capacity and limits the risk associated with policy claims. The Company is subject to credit risk with regard to reinsurers as reinsurance does not alleviate the Company’s liability to its insureds 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 recoverables 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.

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PART I

Item 1. Business

Summary Description of The National Security Group, Inc.

The National Security Group, Inc. (the Company), an insurance holding company, was incorporated in Delaware on March 20, 1990. The Company, through its property and casualty subsidiaries, writes primarily dwelling fire and windstorm, homeowners, mobile homeowners, and personal non-standard automobile lines of insurance in eleven states. The Company, through its life insurance subsidiary, offers a basic line of life and health and accident insurance products in six states. Property-casualty insurance is the most significant segment accounting for 88% of total premium revenues.

The Company’s common stock is traded on the NASDAQ National Market under the symbol NSEC.

Industry Segment and Geographical Area Information

Property and Casualty Insurance Segment

The Company’s property and casualty insurance business is conducted through National Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of National Security Fire & Casualty Company organized in 1992. This segment will be referred to throughout this report as NSFC, Omega, property and casualty segment or P&C segment. NSFC is licensed to write insurance in the states of Alabama, Arkansas, Florida, Georgia, Mississippi, Oklahoma, South Carolina, and Tennessee, and operates on a surplus lines basis in the states of Louisiana, Missouri, and Texas. Omega is licensed to write insurance in Alabama and Louisiana. The following table indicates allocation percentages of direct written premium by state for the three years ended December 31, 2005, 2004 and 2003:

State	Percent of direct written premium
	2005	2004	2003
Alabama	35.46%	39.62%	44.88%
Arkansas	9.74%	8.25%	7.69%
Georgia	6.42%	6.42%	5.36%
Louisiana	5.29%	7.48%	7.87%
Mississippi	21.38%	20.23%	19.11%
South Carolina	8.68%	7.88%	6.72%
Florida	0.34%	0.43%	0.46%
Missouri	2.20%	1.64%	1.88%
Oklahoma	4.15%	2.77%	1.98%
Tennessee	4.98%	3.71%	1.96%
Texas	1.36%	1.57%	2.09%
	100.00%	100.00%	100.00%

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In general, the property-casualty insurance business involves the transfer by the insured, to an insurance company of all or a portion of certain risks for the payment, by the insured, of a premium to the insurance company. A portion of such risks is often retained by the insured in the form of deductibles, which vary from policy to policy, but are typically in the range of $250 to $500 on NSFC and Omega’s primary dwelling and automobile lines of business.

The premiums or payments to be made by the insured for direct products of the property-casualty subsidiaries are based upon expected cost of providing benefits, writing, and administering the policies. In determining the premium to be charged, the property-casualty subsidiaries utilize data from past claims experience and anticipated claims estimates along with commissions and general expenses. Historically, there has been more price competition among property-casualty insurers than other types of insurers.

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

The following table sets forth the premiums earned and income during the periods reported for the property and casualty insurance segment:

		Year Ended December 31
		(Amounts In Thousands)
		2005	2004		2003
Net premiums earned:
Fire, Allied lines, and Homeowners	$	38,670	$	37,642	$	32,669
Automobile		6,990		7,468		7,453
Other		1,668		1,702		1,615
	$	47,328	$	46,812	$	41,737
Income before taxes	$	2,698	$	4,224	$	5,720

Property and Casualty Loss Reserves

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

While the information in the table provides a historical perspective on the adequacy of unpaid losses and loss adjustment expenses established in previous years, it should not be assumed to be predictive of redundancies or deficiencies on current year unpaid losses in future periods. Company management believes that the reserves established at the end of 2005 are adequate. However, due to inherent uncertainties in the loss reserve estimation process, management cannot assert that current year reserve balances will prove to be adequate. Due to the short tail nature of the property and casualty subsidiaries claim liabilities, the Company does not discount loss reserves for the time value of money. Dollar amounts are in thousands.

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			1995		1996		1997		1998		1999		2000		2001		2002		2003		2004	2005
Gross unpaid losses per
Consolidated Balance Sheet			16,037		19,088		21,869		21,528		18,463		15,409		11,489		11,513		11,343		13,094	19,511
Ceded reserves			(8,737)		(9,967)		(7,148)		(5,889)		(3,899)		(3,092)		(2,396)		(1,555)		(1,232)		(2,611)	(8,560)
Net unpaid losses			7,300		9,121		14,721		15,639		14,564		12,317		9,093		9,958		10,111		10,483	10,951
Liability re-estimated:	1 year later		9,161		11,091		14,158		14,637		11,067		8,847		6,805		7,334		9,186		9,042
	2 years later		9,833		10,691		14,570		12,067		9,261		7,863		6,017		7,165		8,607
	3 years later		9,657		10,940		13,161		11,350		8,931		7,460		5,856		6,906
	4 years later		9,706		10,295		12,936		11,496		8,556		7,236		5,699
	5 years later		9,613		10,310		13,271		11,121		8,422		7,240
	6 years later		9,733		10,862		13,034		11,087		8,519
	7 years later		10,373		10,724		13,104		11,202
	8 years later		10,285		10,785		13,193
	9 years later		10,356		10,930
	10 years later		10,513
Net deficiency (redundancy)		$	3,213	$	1,809	$	(1,528)	$	(4,437)	$	(6,045)	$	(5,077)	$	(3,394)	$	(3,052)	$	(1,504)	$	(1,441)
Cumulative payments:	1 year later		5,449		5,227		7,176		5,997		4,423		3,907		3,362		4,342		5,567		5,584
	2 years later		7,298		7,660		9,961		8,079		5,758		5,643		4,416		5,520		6,765
	3 years later		8,215		8,848		10,887		8,997		7,266		6,359		5,076		5,865
	4 years later		8,818		9,117		11,566		10,371		7,744		6,737		5,221
	5 years later		8,988		9,479		12,522		10,557		8,039		6,837
	6 years later		9,213		10,367		12,657		10,779		8,139
	7 years later		10,069		10,473		12,892		10,874
	8 years later		10,104		10,631		12,972
	9 years later		10,262		10,712
	10 years later		10,343
Net deficiency (redundancy) above		$	3,213	$	1,809	$	(1,528)	$	(4,437)	$	(6,142)	$	(5,077)	$	(3,394)	$	(3,052)	$	(1,504)	$	(1,441)

6

Life Insurance Segment

National Security Insurance Company (NSIC), a wholly owned subsidiary organized in 1947, conducts the Company’s life insurance business. This segment will be referred to throughout this report as NSIC, Life Company, or Life segment. NSIC is licensed to write insurance in six states: Alabama, Florida, Georgia, Mississippi, South Carolina, and Texas. The following table indicates NSIC’s percentage of direct premiums collected by state for the three years ended December 31, 2005, 2004 and 2003.

State	Percentage of Total Direct Premiums
	2005	2004	2003
Alabama	62.07%	65.23%	70.59%
Georgia	20.56%	18.80%	16.70%
Mississippi	10.13%	8.76%	6.89%
South Carolina	4.17%	3.18%	1.49%
Florida	2.35%	2.17%	3.05%
Texas	2.49%	1.86%	1.28%

NSIC has two primary methods of distribution of insurance products, home service agents and independent agents. The home service distribution method of life insurance products accounts for 46.3% of total premium revenues in the life insurance segment. Home service life products consist of products marketed directly at the home or other premises of the insured by an employee agent. The Company employed 15 home service agents at December 31, 2005. The independent agent distribution method accounts for 46.3% of total premium revenue in the life insurance segment. Since NSIC began marketing life, accident and health products through independent agents in 1999 the distribution channel has become the fastest growing method of distribution. The Company had approximately 300 agents that had new business production during 2005. The remaining 7.4% of premium revenue consists of the following: an acquired book of premium from a state guaranty association in 2000 (2.9%), premium generated through direct sales of school accident insurance (1.3%), and other miscellaneous business serviced directly through the home office (3.2%).

The products offered by NSIC primarily consist of term and whole life insurance and supplemental accident and health insurance. NSIC does not sell annuities, interest sensitive whole life or universal life insurance products. Term life insurance policies provide death benefits if the insured’s death occurs during the specific premium paying term of the policy and generally do not include a savings or investment element in the policy premium. Whole-life insurance policies demand a higher premium than term life, but provide death benefits which are payable under effective policies regardless of the time of the insured’s death and have a savings and investment element which may result in the accumulation of a cash surrender value. Accident and health insurance provides coverage for losses sustained through sickness or accident and includes individual hospitalization and accident policies, group supplementary health policies and specialty products, such as cancer policies. These policies generally provide a specified fixed benefit and therefore have not experienced the escalating health care costs, which many health and accident insurance policies have experienced in recent years.

The following table displays a break down of 2005 life segment premium produced by product and distribution method (dollars in thousands):

Line of Business		Home Service Agent		Independent Agent		Other
Industrial	$	153	$	-	$	112
Ordinary		2,227		1,956		263
Group Life		9		53		46
A&H Group		-		-		91
A&H Other		438		821		65
Total Premium by Distribution Method	$	2,827	$	2,830	$	577

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The following table sets forth certain information respecting the development of the Life Company’s business:

			Year Ended December 31
			(Amounts In Thousands)
			2005		2004		2003
Life insurance in force at end of period:
	Ordinary-whole Life	$	137,100	$	112,400	$	111,500
	Term Life		38,400		36,500		37,000
	Industrial life		28,100		29,100		30,500
	Other		-		-		-
		$	203,600	$	178,000	$	179,000
Life insurance issued:
	Ordinary-whole life	$	35,600	$	46,150	$	56,200
	Term Life		3,500		3,400		9,100
	Industrial		-		-		-
	Other		-		100		100
		$	39,100	$	49,650	$	65,400
	Net premiums earned:
	Life insurance	$	4,819	$	4,798	$	4,496
	Accident and health insurance		1,415		1,375		1,303
		$	6,234	$	6,173	$	5,799

Investments

Investment income is a significant portion of the Company’s total income. Assets that will eventually be used to pay reserve liabilities and other policyholder obligations along with Company capital are invested to generate investment income while held by the Company. Investment income is comprised primarily of interest and dividend income on debt and equity securities and realized capital gains and losses generated by debt and equity securities. For 2005, investments comprise 71% of total assets and investment income (including realized gains) comprises 12% of total revenues evidencing the significant impact investments can have on financial results. As the Company’s insurance subsidiaries are regulated as to the types of investments that they may make and the amount of funds they may maintain in any one type of investment, the Company has developed a conservative value oriented investment philosophy, which meets regulatory requirements. The central theme of the Company’s investment philosophy is to conserve capital resources and assets while meeting the investment requirements of its reserves and providing a reasonable return on investments. This return is generated through current yield from invested assets as well as capital appreciation of investments.

The single most significant investment for the Company is The Mobile Attic, Inc. (Mobile Attic), a joint venture with a local manufacturing firm established in the fourth quarter of 2001. Mobile Attic, through a network of franchises, leases portable storage units in locations across Southeastern United States. During January of 2004, Mobile Attic established Mobile Attic Franchising Company (MAFCO), a wholly owned subsidiary. The primary focus of MAFCO will be to market Mobile Attic portable storage leasing franchises in the continental United States. The primary customers of Mobile Attic are building contractors, retail establishments, and residential consumers.

When established in 2001, the investment in Mobile Attic was accounted for under the equity method of accounting as management of the Company does not participate in the day-to-day management of Mobile Attic nor does the Company own a controlling interest in Mobile Attic. As discussed in note 2 to the Consolidated Financial Statements, due to preexisting guarantees of Mobile Attic debt, The Financial Accounting Standards Board’s adoption of FIN 46R dictated that the Company consolidates the results of Mobile Attic beginning in the first quarter of 2004.

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The Company guarantees Mobile Attic debt totaling $11.2 million. Additional details of investments, including further discussion on the operations of Mobile Attic are discussed in detail in the accompanying management’s discussion and analysis.

Marketing and Distribution

NSIC products are marketed through a field force of agents and service representatives who are employees of the Life Company and through a network of independent agents. The independent agent method of distribution is expected to be more cost effective in the long term and has become the fastest growing method of distribution. In an effort to boost productivity and better educate agents on the products and services of NSIC, our marketing team routinely holds training meetings across the various regions we serve. We also offer our best agents opportunities to attend retreats, usually over a weekend, at least twice a year to network with the home office staff that helps serve them and our policyholders, gain broader knowledge of the products we offer, and offer feedback on how we can better serve our agency force and policyholders.

NSFC and Omega products are marketed through a network of independent agents and brokers, who are independent contractors and who generally maintain relationships with one or more competing insurance companies. Like NSIC, NSFC also routinely visits with agents both in their office and at training sessions throughout the regions we serve with a primary objective of educating agents about our products and services.

Agents receive compensation for their sales efforts. In the case of life insurance agents, compensation is paid in the form of sales commissions plus a servicing commission. Commissions paid by NSIC in 2005 averaged approximately 22% of premiums. Commissions paid by the NSFC in 2005 averaged approximately 16% of premiums. During 2005, no one independent agent accounted for more than 10% of total net earned premium of the property-casualty insurance subsidiaries. NSFC also offers a “profit sharing bonus plan” to independent agents in order to promote better field underwriting and encourage retention of profitable business. This plan not only rewards our agents but also enhances profitability by giving the agent a vested interest in our success and also aids in maintaining price stability for all our customers as agents have a financial incentive to use good field underwriting practices when completing an application for insurance.

At December 31, 2005, NSIC employed 15 home service agents and one manager. NSIC also had approximately 1,379 independent agents actively producing new business.

At December 31, 2005, NSFC had contracts with approximately 1,354 independent agencies in twelve states.

Employees

The Company has no management or operational employees. Subsidiary National Security Insurance Company employs all employees which totaled 158 at December 31, 2005. The Company and its property and casualty subsidiary have a Management Service Agreement (“Agreement”) with the National Security Insurance Company whereby the Company and the property and casualty subsidiary reimburse NSIC for salaries and expenses of employees provided under the Agreement. Involved are employees in the areas of Underwriting, Customer Service, Policy Services, Accounting, Marketing, Administration, Imaging, Data Processing, Programming, Personnel, Claims, and Management. The Company, through NSIC, was represented by 15 employee agents in Alabama. The Company’s property and casualty subsidiaries had over 1300 independent agencies at December 31, 2005. The Company believes its employee relations are good.

Additional information with respect to The National Security Group’s business

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

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Company’s code of ethical conduct is also available on our website and in print to any stockholder who requests copies by contacting The National Security Group, Attn: Investor Relations, P. O. Box 703, Elba, AL 36323. The Company’s periodic reports filed with the SEC, which include Forms 3, 4 and 5, Form 10-K, Form 10-Q, Form 8-K and any amendments thereto may also be accessed free of charge from the SEC’s website at www.sec.gov. Additional information about the Company’s 50% owned subsidiary, The Mobile Attic, Inc., can be found on its website www.mobileattic.com.

Item 1A. Risk Factors

Underwriting

Underwriting is the first step in the Company’s risk management process. The insurance subsidiaries maintain underwriting departments that seek to evaluate the risks associated with the issuance of an insurance policy. NSIC accepts standard risks and, to an extent, substandard risks and engages medical doctors who review certain applications for insurance. In the case of the property-casualty subsidiaries, the underwriting staff attempts to assess, in light of the type of insurance sought by an applicant, the risks associated with a prospective insured or insurance situation. Depending upon the type of insurance involved, the process by which the risks are assessed will vary. In the case of automobile liability insurance, the underwriting staff assesses the risks involved in insuring a particular driver, and in the case of dwelling insurance, the underwriting staff assesses the risks involved in insuring a particular dwelling. Where possible, the underwriting staff of the property-casualty insurance subsidiary utilizes standard procedures as guides that quantify the hazards associated with a particular occupancy. In general, the property-casualty subsidiaries specialize in writing nonstandard risks.

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

Reinsurance

Reinsurance is the second step in the Company’s risk management process. Both insurance subsidiaries customarily reinsure with other insurers certain portions of the insurance risk. The primary purpose of such reinsurance arrangements is to enable the Company to limit its risk on individual policies, and in the case of property insurance, limit its risk in the event of a catastrophe in various geographic areas. A reinsurance arrangement does not discharge the issuing company from primary liability to the insured, and the issuing company is required to discharge its liability to the insured even if the reinsurer is unable to meet its obligations under the reinsurance arrangements. Reinsurance, however, does make the reinsurer liable to the issuing company to the extent of any reinsurance in force at the time of the loss. Reinsurance arrangements also decrease premiums retained by the issuing company since that company pays the reinsuring company a portion of total premiums based upon the amount of liability reinsured.

NSIC generally reinsures all risks in excess of $50,000 with respect to any one insured. NSFC and Omega generally reinsure with third parties any liability in excess of $150,000 on any single policy. In addition, the property-casualty subsidiaries have catastrophe excess reinsurance, which provided protection in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane. In 2005, the property-casualty subsidiaries had catastrophe protection up to a $37.5 million loss. Under the property and casualty subsidiaries reinsurance arrangement in force during 2005, the Company retained the first $2 million of insured losses from any single catastrophic event. The next $17.5 million in insured losses from any single event was 95% reinsured with the Company’s net retention being 5%. The final layer of reinsurance protection provided coverage for 100% of insured losses exceeding

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$17.5 million and up to $37.5 million. The amount of catastrophe reinsurance protection purchased by the Company was based on computer modeling of actual Company exposure. The Company generally seeks protection for worst case scenarios based on the computer modeling that mitigates losses up to a 1 in 250 year event, that is a loss that has less than a ½ of 1% chance of occurring in any given year. NSFC and Omega had a provision for one reinstatement (coverage for two catastrophic events) during 2005. In addition to catastrophe reinsurance, NSFC also had a 60% quota share reinsurance agreement on ocean marine exposure with additional excess of loss coverage.

Reserve liabilities

NSIC maintains life insurance reserves for future policy benefits to meet future obligations under outstanding policies. These reserves are calculated to be sufficient to meet policy and contract obligations as they arise. Liabilities for future policy benefits are calculated using assumptions for interest, mortality, morbidity, expense, and withdrawals determined at the time the policies were issued. As of December 31, 2005, the total reserves of NSIC (including the reserves for accident and health insurance) were approximately $25 million. NSIC believes that such reserves for future policy benefits were calculated in accordance with generally accepted actuarial methods and that such reserves are adequate to provide for future policy benefits. Wakely Actuarial, consulting actuaries, provided actuarial services in calculating reserves.

The property-casualty subsidiaries are also required to maintain loss reserves (claim liabilities) for all lines of insurance. Such reserves are intended to cover the probable ultimate cost of settling all claims, including those incurred but not yet reported. The reserves of the property-casualty subsidiaries reflect estimates of the liability with respect to incurred claims and are determined by evaluating reported claims on an ongoing basis and by estimating liabilities for incurred but not reported claims. Such reserves include adjustment expenses to cover the cost of investigating losses and defending lawsuits. The establishment of accurate reserves is complicated by the fact that claims in some lines of insurance are settled many years after the policies have been issued, thus raising the possibility that inflation may have a significant effect on the amount of ultimate loss payment, especially when compared to initial loss estimates. The subsidiaries, however, attempt to restrict their writing to risks that settle within one to four years of issuance of the policy. As of December 31, 2005, the property-casualty subsidiaries had reserves for unpaid claims of approximately $19.5 million before subtracting unpaid claims, which will be due from reinsurers of $8.6 million leaving net unpaid claims of $10.9 million. The reserves are not discounted for the time value of money. No changes were made in the assumptions used in estimating the reserves during the years ending December 31, 2005, 2004 or 2003. The Company believes such reserves are adequate to provide for settlement of claims. Employees of the Company calculate NSFC and Omega loss reserves. Milliman, Inc., an independent actuarial consulting firm, reviews loss reserve estimates and issues a Statement of Actuarial Opinion regarding the adequacy of reserves.

Financial Ratings

The insurance subsidiaries are rated by AM Best Company, an insurance company-rating agency. NSFC is rated B++ (Very Good), Omega is rated B+ (Good) and NSIC is rated B (Fair) by AM Best Company.

Regulation

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

Many states in which the insurance subsidiaries operate, including Alabama, have laws which require that insurers become members of guaranty associations. These associations guarantee that benefits due

11

policyholders of insurance companies will continue to be provided even if the insurance company which wrote the business is financially unable to fulfill its obligations. To provide these benefits, the associations assess the insurance companies licensed in a state that write the line of insurance for which coverage is guaranteed. The amount of an insurer’s assessment is generally based on the relationship between that company’s premium volume in the state and the premium volume of all companies writing the particular line of insurance in the state. The Company has paid no material amounts to guaranty associations over the past three years. These payments, when made, are principally related to association costs incurred due to the insolvency of various insurance companies. Future assessments depend on the number and magnitude of insurance company insolvencies and such assessments are therefore difficult to predict.

Most states have enacted legislation or adopted administrative rules and regulations covering such matters as the acquisition of control of insurance companies, transactions between insurance companies and the persons controlling them. The National Association of Insurance Commissioners has recommended model legislation on these subjects and all states where the Company’s subsidiaries transact business have adopted, with some modifications, that model legislation. Among the matters regulated by such statutes are the payments of dividends. These regulations have a direct impact on the Company since its cash flow is substantially derived from dividends from its subsidiaries. However, the Company has not had nor does it foresee a problem obtaining the necessary funds to operate because of the regulation. Statutory limitations of dividend payments by subsidiaries are disclosed in Note 12 to the accompanying Consolidated Financial Statements.

Competition

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

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

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

The property-casualty subsidiaries market their products through independent agents and brokers, concentrating primarily on dwelling fire, homeowners and nonstandard auto coverage. NSFC, though one of the larger writers of lower value dwelling fire insurance in Alabama, nevertheless faces a number of competitors in this niche. Moreover, larger general line insurers also compete with NSFC. The market share in states other than Alabama is small. Price is the primary method of competition. Due to the method of marketing through independent agents, commission rates and service to the agent are also important factors in whether the independent agent agrees to offer NSFC products over its competitors.

Inflation

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

Item 1B. Unresolved Staff Comments

None

Item 2. Properties

The Company owns no property. The Life insurance subsidiary owns its principal executive offices located at 661 East Davis Street, Elba, Alabama. The executive offices are shared by the insurance subsidiaries. The building was constructed in 1977 and consists of approximately 26,000 square feet. The Company believes this space to be adequate for its foreseeable future needs. The Company’s subsidiaries own certain real estate properties, including approximately 2,700 acres of timberland in Alabama.

Item 3. Legal Proceedings

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

Item 4. Submission of Matters to a vote of Security Holders

There were no matters submitted to a vote of security holders during the three months ended December 31, 2005.

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PART II

Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters

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

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

		Stock Closing Prices
		High		Low
2005
First Quarter	$	23.91	$	18.23
Second Quarter		24.29		20.65
Third Quarter		22.25		18.10
Fourth Quarter		19.03		15.05
2004
First Quarter	$	26.00	$	19.03
Second Quarter		23.60		21.51
Third Quarter		25.20		20.26
Fourth Quarter		22.98		21.00

Shareholders

The number of shareholders of the Company’s capital stock as of January 31, 2006, was approximately 1,100.

Dividends

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

	Dividends
	Per Share
2005
First Quarter	0.215
Second Quarter	0.215
Third Quarter	0.215
Fourth Quarter	0.220
2004
First Quarter	0.210
Second Quarter	0.210
Third Quarter	0.210
Fourth Quarter	0.215

Discussion regarding dividend restrictions may be found on page 26 of the Managements’ Discussion and Analysis as well as in Note 12 of the consolidated financial statements.

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Item 6. Selected Financial Data

Five-Year Financial Information:

(Amounts in thousands, except per share)

Operating results		2005		2004		2003		2002		2001
Net premiums earned	$	53,563.00	$	52,985.00	$	47,536.00	$	32,631.00	$	25,357.00
Net investment income		3,964.00		4,230.00		4,023.00		4,235.00		4,506.00
Net realized investment gains		3,727.00		2,162.00		1,416.00		1,168.00		1,640.00
Net revenues from leasing operations		3,360.00		2,459.00		1,433.00		942.00
Other income		1,416.00		1,312.00		1,395.00		1,051.00		1,280.00
Total revenues	$	66,030.00	$	63,148.00	$	55,803.00	$	40,027.00	$	32,783.00
Net Income	$	1,558.00	$	3,113.00	$	4,090.00	$	908.00	$	4,130.00
Net income per share	$	0.63	$	1.26	$	1.66	$	0.37	$	1.67

Other Selected Financial Data		2005		2004		2003		2002		2001
Total shareholders’ equity	$	43,556	$	46,676	$	45,872	$	42,159	$	44,8844
Book value per share		17.66		18.92		18.60		17.09		18.18
Dividends per share		0.865		0.845		0.825		0.805		0.760
Net change in unrealized
capital gains (net of tax)		(2,544)		(225)		1,658		(1,647)		(1,161)
Total assets	$	139,226	$	128,631	$	127,236	$	101,602	$	99,484

Quarterly information:

		Premiums		Leasing Revenues		Investment & Other Income		Realized Investment Gains or Losses		Benefits		Net Income		Net Income Per Share
2005
1st QTR	$	13,664	$	602	$	1,451	$	198	$	8,113	$	1,292	$	0.52
2nd QTR		13,696		988		1,560		683		8,496		1,346		0.55
3rd QTR		11,969		700		1,273		1,394		15,161		(3,896)		(1.58)
4th QTR		14,234		1,070		1,096		1,452		6,471		2,816		1.14
	$	53,563	$	3,360	$	5,380	$	3,727	$	38,241	$	1,558	$	0.63
2004
1st QTR	$	13,795	$	374	$	1,396	$	387	$	7,912	$	1,053	$	0.43
2nd QTR		14,105		529		1,520		699		7,697		2,444		0.99
3rd QTR		11,972		989		1,391		569		11,924		(1,622)		(0.66)
4th QTR		13,113		567		1,235		507		7,534		1,238		0.50
	$	52,985	$	2,459	$	5,542	$	2,162	$	35,067	$	3,113	$	1.26

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

OVERVIEW

The following discussion highlights significant factors influencing the consolidated financial position and results of operations of The National Security Group, Inc. (referred to in this document as we, our, us, the Company or NSEC) and its subsidiaries for the three years ended December 31, 2005. This discussion and analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data and Consolidated Financial Statements and related notes included elsewhere herein. Please refer to our note regarding forward-looking statements on page 3 of this report.

Similar to last year, except for the increase in number, the term hurricane will be prominent throughout management’s discussion. During the third quarter of 2005 three hurricanes affected the Company’s Property and Casualty coverage areas: Hurricanes Dennis, Katrina and Rita. Losses resulting from the impact of these third quarter hurricanes significantly influenced the financial results for the year ended December 31, 2005. While total losses, just as with Hurricane Ivan, were mitigated through risk management using catastrophe excess of loss reinsurance; the Company’s share of total losses and catastrophe reinsurance reinstatement premium reduced net income by over $7,400,000.

RESULTS OF OPERATIONS

The following analysis of the Results of Operations should be read in conjunction with the Consolidated Financial Statements, which begin on Page 31 of this Form 10-K. Primary reference is made to the Consolidated Statements of Income on page 33 and segment information provided in Note 14 to the Consolidated Financial Statements.

Consolidated Results of Operations:

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004

For the fourth consecutive year, 2005 premium revenue reached a new Company record high despite reductions for reinstatement premiums related to Hurricane Katrina. Total premium revenue was $53,563,000, an increase of just over 1% over 2004 premium revenue of $52,985,000. Premium revenue in 2005 included reductions for catastrophe reinsurance reinstatement premium triggered by Hurricane Katrina of $2,400,000 and premium revenue in 2004 included reductions for catastrophe reinsurance reinstatement premium triggered by Hurricane Ivan of $1,400,000. Life segment revenue accounted for 11.6% of consolidated premium revenue while property and casualty segment revenue accounted for 88.4% of consolidated premium, virtually no change from the same period last year.

Consolidated income before income taxes declined 37.5% in 2005 to $2,400,000 compared to $3,853,000 in 2004. Third quarter hurricanes Dennis, Katrina and Rita were the primary factors contributing to the decline in income before taxes in 2005 compared to the same period last year. Gross incurred losses, before reinsurance recoveries, from the third quarter hurricanes totaled $38,949,000.

After reinsurance recoveries, pre-tax losses and expenses from third quarter hurricanes totaled over $7,909,000 and a catastrophe reinsurance reinstatement premium of $2,400,000 was also incurred in the third and fourth quarters of 2005. Third quarter losses from Hurricanes Dennis, Katrina and Rita were the primary reason for the decline in net income. Losses and related expenses from 2005 hurricanes reduced 2005 net income by approximately $6,804,000 or $2.76 per share.

Consolidated net income for 2005 was $1,558,000 compared to $3,113,000 in 2004, a decline of 49.95%. On a per share basis earnings were $0.63 in 2005 compared to $1.26 in 2004.

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

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For the third consecutive year, 2004 premium revenue reached a new Company record high. Total premium revenue was $52,985,000, an increase of 11.5% over 2003 premium revenue of $47,536,000. Life segment revenue accounted for 11.7% of consolidated premium revenue and increased 6.5% over 2003. Property and casualty segment revenue accounted for 88.5% of consolidated premium revenue and increased 12.2% over 2003. Continued strong growth in the dwelling property lines of business, particularly the homeowners line of business, were the major contributor to increases in property and casualty premium revenue.

Consolidated income before income taxes declined 31.5% in 2005 to $3,853,000 compared to $5,628,000 in 2003. Hurricane Ivan, which struck the Alabama Gulf coast in September of 2004, is the primary factor leading to the decline in consolidated income before income taxes. Gross incurred losses, before reinsurance recoveries, from Hurricane Ivan totaled $14,577,000 including paid losses of $12,806,000, case unpaid losses and adjustment expenses of $1,077,000 and incurred but not reported reserve (IBNR) estimates of $694,000. After reinsurance recoveries, pre-tax losses from Hurricane Ivan totaled over $4,100,000 and a catastrophe reinsurance reinstatement premium of $1,400,000 was also incurred in the third quarter of 2004. As for the bottom line impact from Hurricane Ivan, consolidated net income declined by over $3,600,000 due to losses and expenses related to Hurricane Ivan. As a result of Hurricane Ivan earnings per share, for 2004, declined by $1.46.

Consolidated net income for 2004 was $3,113,000 compared to $4,090,000 in 2003, a decline of 23.9%. Again, Hurricane Ivan was the primary factor contributing to the decline in consolidated net income. On a per share basis earnings were $1.26 in 2004 compared to $1.66 in 2003.

Additional details on the sources of premium revenue growth and the impact of individual segments on consolidated income will be discussed in the respective Segment Results of Operations sections that follow.

Industry Segment Data

Certain financial information for The National Security Group’s three segments (Life segment, property and casualty segment, and other (non-insurance)) is summarized as follows (amounts in thousands):

Premium revenues:
		2005	%		2004	%		2003	%
Life, accident and health insurance	$	6,234	11.64%	$	6,173	11.65%	$	5,799	12.20%
Property and casualty insurance		47,329	88.36%		46,812	88.35%		41,737	87.80%
	$	53,563	100.00%	$	52,985	100.00%	$	47,536	100.00%
Income before taxes and minority interest:
		2005	%		2004	%		2003	%
Life, accident and health insurance	$	(271)	-11.29%	$	216	5.61%	$	563	10.00%
Property and casualty insurance		2,698	112.42%		4,224	109.63%		5,720	101.63%
Other		1,113	46.38%		140	3.63%		(23)	-0.41%
Interest expense		(1,140)	-47.50%		(727)	-18.87%		(632)	-11.23%
	$	2,400	100.00%	$	3,853	100.00%	$	5,628	100.00%

In addition to the preceding table, reference is made to Note 14 of the Consolidated Financial Statements contained in this report for the segment information that follows.

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Life and Accident and Health Insurance Operations:

The Company’s life, accident and health insurance business is conducted through National Security Insurance Company (NSIC), a wholly owned subsidiary of the Company organized in 1947.

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004:

NSIC had a loss before income taxes in 2005 of $(271,000) compared to income before tax of $216,000 in 2004. Expenses related to ongoing litigation totaled over $375,000 and $250,000 in 2005 and 2004. The litigation expenses are primarily related to an ongoing class action lawsuit which is further discussed in Note 15 of the Consolidated Financial Statements and Form 8-K filed December 15, 2005 and incorporated herein by reference. Based on currently available information, we remain optimistic that this ongoing multi-year litigation will reach final settlement during 2006. This litigation is periodically reevaluated and estimates are adjusted to reflect total estimated cost. While we believe that, based on currently available information, our reserves are adequate to cover the total ultimate cost of this settlement, until a final settlement is approved; it is possible that our litigation reserve may have to be adjusted.

Premium revenue increased to $6,234,000 in 2005 compared to $6,173,000 in 2004, an increase of 1%. As we have discussed over the last few years, we have began a shift to the independent agent method of distribution of

NSIC’s products. In 2005, for the first time in Company history, we had more business in-force that was produced by independent agents than was in-force and produced by our traditional home service method of distribution. Independent agent premium revenue grew by 11.5% year over year in 2005 while home service premium revenue declined by 5.5%. Unfortunately, the shift to the independent agent method of distribution is expensive as commissions paid to independent agents are front loaded, meaning that higher commission rates are paid early in the life of the policy and decline as the policy ages. This front loading significantly increases our cost of producing new business and until a more substantial book of renewal business is built, this method of distribution will hamper short term earnings. As discussed last year, NSIC has had a primary focus on the production of new business in the independent agent method of distribution over the last five years. In the process of establishing this position, NSIC has had very low thresholds for business production and persistency. NSIC has appointments with approximately 300 that activilely produce new business. During 2005 we did begin the process of implementing new performance standards that will require minimum amounts of premium production and persistency in order to retain a contract with our Company. As a result of these standards, we will become more selective in the appointment of new agents and will discontinue appointments with many current agents. In undertaking this exercise, we plan to get to a point that we can offer more exceptional service to fewer agents and produce higher quality business in the process. This process will take a couple of years to implement but will help improve profitability of NSIC in the future.

Commission expense, including field servicing cost from the home service method of distribution, as a percent of premium revenue increased 2 percentage points in 2005 compared to 2004. This increase was primarily due to increased separation cost associated in reducing home service management personnel. Independent agent commission expense and other cost of distribution decline 3.7 percentage points in 2005 compared to 2004. These costs are expected to continue to decline 3 to 5 percentage points per year for the next couple of years until the renewal book of business reaches a point of maturity to support short term profitability. Life insurance commission rates for independent agents are typically front loaded meaning that higher commissions are paid in the early years of a policy and commission rates decline as the policy ages. Because the independent agent method of distribution is a relatively new method of distribution, overall commission rates are skewed higher because the majority of in force policies are still paying the higher commission rates of the early years. Management is continuing to focus on reducing commissions through improving the rate of retention of new and existing business.

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Year Ended December 31, 2004 Compared to Year Ended December 31, 2003:

Income before income taxes in 2004 was $186,000 compared to $529,000 in 2003. A decline in realized capital gains of $680,000 in the Life segment was the primary factor contributing to the decline in income before income taxes. Also, litigation related expenses continued to be a drain on the bottom line. Litigation expenses exceeded $250,000 in 2004 compared to $565,000 in 2003. Litigation expenses for 2004 and 2003 are related to items discussed in Note 15 to the Consolidated Financial Statements.

Premium revenue increased to $6,173,000 in 2004 compared to $5,799,000 in 2003, an increase of 6.5%. Premium revenue produced by independent agents totaled $2,537,000 in 2004 compared to $2,186,000 in 2003, a 16% increase. While NSIC is continuing to focus on growth through the independent agent method of distribution, we will begin to shift focus to an increased focus on quality. Premium revenue produced by NSIC home service agency force increased slightly in 2004 to $2,996,000 from $2,970,000 in 2003. Due to changing market conditions, the home service market is not considered to be a growth market, but the Company intends to maintain a niche in this market to serve our current policyholders that prefer this method of service. At December 31, 2004 NSIC had 17 home service agents that serviced this book of business.

Commission expense, including field servicing cost from the home service method of distribution, as a percent of premium revenue declined 3.4 percentage points in 2004 compared to 2003. Commission expense totaled 37% of revenue in 2004 compared to over 40% in 2003.

Property & Casualty Operations:

The Company’s property and casualty insurance business is conducted through National Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of National Security Fire & Casualty Company organized in 1992.

Year Ended December 31, 2005 Compared to Year Ended December 31, 2004:

Property and casualty premium revenues totaled $47,329,000 in 2005 compared to $46,812,000 in 2004, an increase of just over 1%. The property and casualty subsidiaries have generated significant growth in revenue over the last four years. While growth has slowed, 2005 premium revenue was reduced 5% due to additional ceded reinsurance premium paid under the reinstatement provisions of our catastrophe reinsurance contracts triggered by Hurricane Katrina. Premium revenue for 2004 was reduced by 3% due to similar provisions triggered by Hurricane Ivan.

While overall premium revenue growth moderated significantly in 2005 compared to 2004, the property and casualty subsidiaries continued to grow the primary dwelling property lines of dwelling fire, homeowners and mobile homeowners with growth rates of 11.7%, 7.9% and 13.4% respectively. Offsetting these gains were declines in non-standard private passenger automobile and ocean marine lines of business. We expect the trend of more moderate premium revenue growth to continue in 2006 with premium revenue growth expected to be in the range of 5%.

As the discussed on the Consolidated Results of Operations section of this report, the 2005 hurricane season was the overriding event that led to a decline in earnings for the year and of course property and casualty operations was the operating segment that bore the full brunt of the 2005 hurricane season. Income before income tax in the segment declined to $2,698,000 in 2005 compared to $4,220,000 in 2004, a decrease of 36.07%.

Claims frequency increased significantly in 2005 compared to 2004 with claims on dwelling lines of business (homeowners and dwelling fire) exceeding 15,800 claims compared to 12,500 claims in 2004. Approximately 8,450 claims were reported from Hurricane Katrina in 2005, very close to the 8,500 claims were reported from Hurricane Ivan in 2004. However, the average severity of claims from Hurricane Katrina was much higher with losses averaging over $3,500 each compared to less than $2,000 per occurrence from Hurricane Ivan. The increase in the average loss per claim is due to the widespread

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impact of this huge storm causing severe damage in coastal areas of Alabama, Louisiana and the most heavily impacted coastal area, Mississippi. The most heavily impacted coastal area for us from Hurricane Ivan was concentrated in Baldwin County, Alabama. Additionally, we paid nearly $3.5 million in underwriting association assessments due to losses from Hurricane Katrina. In addition to Katrina, we incurred over 1,600 claims from Hurricane Rita with an average severity of $3,000 and Hurricane Dennis with over 500 claims and an average severity of $1,300. Non-hurricane related dwelling property claims totaled 5,200 in 2005 which remained consistent with 2004 non-hurricane related claims of just over 5,000. Average severity for all dwelling property claims was $4,000 per occurrence in 2005 compared to $2,900 in 2004. As discussed earlier, 2004 average severity was skewed downward due to lower average claims from Hurricane Ivan. Hurricanes typically cause higher number of claims (frequency) and a lower average cost per claim (severity) than tornado related losses. Tornadoes tend to affect a more isolated area and therefore have a lower frequency but typically cause more structural damage including a higher proportion of total losses therefore severity is greater from tornado losses. Non-catastrophe related dwelling losses typically have an average per loss severity in the $3,500 to $4,000 range for the P&C subsidiaries.

To help add a little perspective to the magnitude of the 2005 hurricane season, we thought it may be useful to give a few statistics. Total insured losses from Hurricane Katrina alone totaled more than the cumulative amount of hurricane losses paid in previous Company history dating back to 1959. Hurricane Katrina was the most expensive Hurricane in Company history, exceeding the previous most costly storm, Hurricane Ivan, by over 200%. Hurricane Rita, which was a bit of an afterthought in the media, was the fourth most costly hurricane in Company history with losses of $5,093,000. Our property and casualty subsidiaries had previously never incurred two major hurricanes in a major season until Hurricanes Katrina and Rita in 2005. We had also never incurred consecutive hurricane seasons with a major hurricane until 2004 and 2005 with Ivan (2004), Katrina (2005) and Rita (2005).

While we would like to think that the events of the last two years are statistical anomalies, we are taking a critical look at our hurricane risk mitigation program with a goal of better managing this risk should we actually be entering an era of more frequent and severe Atlantic and Gulf Coast hurricanes. This is especially challenging for us as a regional carrier with a large percentage of total business concentrated primarily in the Southeastern United States. Because of our geographic concentration of risk, we will be unable to totally eliminate the impact of future storms, but we do believe that the events of the last two years will allow some changes in the markets we serve to help mitigate the impact of future storms on short term profits.

We are in the process of making several changes to help reduce future storm exposure. We will be reviewing rates and minimum deductibles on over 20 of our programs during 2006. Obviously the risk/reward paradigm for writing in coastal areas of the Southeastern US has shifted in the last two years. While we do not want to abandon areas that we have served successfully for many years, we are going to have to seek higher margins on our insurance products in certain coastal areas to justify the economic feasibility of continuing to write in these areas. We are increasing marketing efforts in the non-coastal states that we serve in order to gain greater geographic diversity. Of course this opens us up to more significant exposure to other types of risk such as more frequent tornados, hail storms, and ice storms but these types of events are generally more geographically concentrated and help mitigate the risk of the widespread exposure posed by Atlantic and Gulf Coast hurricanes.

Another challenge posed by the events of 2005 that will have an impact on future earnings of the property and casualty subsidiaries is the cost that we pay for catastrophe reinsurance. We incurred an increase in catastrophe reinsurance in 2006 of 18% as a result the frequency of storm related losses over the last two years. In addition, we had to increase our catastrophe deductible by 50% to $3,000,000 in order to keep the increase in catastrophe reinsurance rates to only 18%. This has necessitated that we increase rates in many of the areas we serve. Our reinsurance rate increase took effect January 1, 2006. Unfortunately, due to regulatory hurdles and backlogs created from a large number of other insurers filing revised rates in the affected states as well, we will be unable to reflect the increased reinsurance rates we pay in rates charged to our insured for up to a year. This will result in a drag on 2006 earnings of approximately $500,000 pre-tax. However, we believe that the short term earnings drag will be offset by increased pricing power and less competition in many of the areas impacted by the 2005 hurricane season.

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003:

Property and casualty premium revenues totaled $46,812,000 in 2004 compared to $41,737,000 in 2003, an increase of 12.2%. The significant growth in premium revenue over the past four years has been achieved through several different methods including an acquisition in 2000, increased marketing efforts in states outside of Alabama, and careful monitoring and increasing of rates in order to achieve underwriting profitability. The homeowners line of business was the largest contributor to the increase in premium revenue. Gross written premium from the homeowners market for the P&C subsidiaries totaled $3,067,000 in 2000 and has grown to $18,872,000 in written premium in 2004, a 57.5% compound growth rate over four years. Several factors have contributed to this growth including, the development of a new homeowners product launched in 2001, an upgrade to an existing homeowners product that made the product more competitive, and favorable market conditions that have allowed pricing of the product to achieve more attractive margins. Significant premium growth has also been achieved in NSFC’s traditional dwelling fire market. Dwelling fire written premium totaled $22,183,000 in 2004 compared to $19,890,000 in 2003, an increase of 11.5%. This line of business has also enjoyed robust growth over the last four years and has grown at a 19.4% compound growth rate since 2000. This growth is primarily attributable to favorable market conditions, as many larger carriers do not focus on the dwelling fire market with insured values typically less than $80,000 per dwelling.

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Income before income tax declined considerably in 2004 to $4.22 million compared to $ 5.72 million in 2003. As discussed earlier, results for 2004 were negatively impacted by losses and adverse claims experience related to hurricane losses in the third quarter of 2004. Claims frequency increased significantly in 2004 compared to 2003 with claims on dwelling lines of business (homeowners and dwelling fire) exceeding 12,500 claims compared to 5,100 claims in 2003. Over 7,500 claims were reported from Hurricane Ivan so without the impact of Ivan, claims frequency was in line with 2003 total of around 5,000 claims. Average severity on dwelling claims in 2004 declined to an average of $2,900 compared to $3,600 in 2003. Average severity declined primarily due to the large volume of Hurricane Ivan claims. Because most of the losses from Hurricane Ivan were inland and limited primarily to minor wind damage, claims from Ivan averaged less than $2,000 per occurrence, which skewed 2004 average severity downward.

Claim adjustment expenses averaged 6.4% of earned premium in 2004 compared to 5.6% in 2003. The slight increase was primarily due to the increase in cost associated with settling claims from Hurricane Ivan. The Company employs claims adjusters, which work approximately 50% of reported dwelling claims in a typical year with independently contracted adjusters working remaining claims. In areas with large concentrations of business, it is typically less expensive to use employee adjusters compared to independent adjusters. Due to the large number of claims from Hurricane Ivan, the Company utilized more independent adjusters to handle the increased workload in order to expedite the payment of claims to our policyholders.

P&C segment revenue before income taxes was $4,224,000 in 2004 compared to $5,720,000 in 2003. The decline in pretax earnings was due to losses incurred from Hurricane Ivan. Pretax losses from Ivan, including catastrophe reinstatement premium of $1,400,000 reduced P&C segment income before taxes by over $5,500,000. As shown in the combined ratio comparison that follows, the P&C companies still managed to achieve a combined ratio below 100% even after the impact of Hurricane Ivan.

Property & Casualty Combined Ratio:

A measure used to analyze a property/casualty insurer’s underwriting performance is the combined ratio. It is the sum of two ratios:

a. The loss and loss expense ratio, which measures losses and loss adjustment expenses incurred as a percentage of premium revenue.

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

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

	2005	2004	2003
Loss and LAE Ratio	74.4%	68.2%	60.0%
Underwriting Expense Ratio	32.2%	31.4%	30.8%
Combined Ratio	106.6%	99.6%	90.8%

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

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The combined ratio for 2005 compared to 2004 increased 7.02 percentage points. This increase was entirely due to losses incurred from Hurricanes Dennis, Katrina and Rita which each added 1.4, 10.7 and 4.6 percentage points to the combined ratio respectively. Hurricane Ivan added 8.9 percentage points to the combined ratio for 2004.

Leasing operations:

The Company’s leasing operations are conducted through its 50% owned subsidiary, Mobile Attic, Inc. Mobile Attic was incorporated in August of 2001 and is a joint venture with a manufacturing partner, Cash Brothers Leasing of Elba, Alabama. As detailed in Note 1 (a) of the consolidated financial statements on page 37, the Company consolidated its investment in the subsidiary Mobile Attic, Inc.

Mobile Attic is in the business of leasing portable storage containers to individual and commercial customers primarily through franchise locations covering Alabama and expanding throughout the Southeastern United States. At December 31, 2005 there were 33 franchise locations throughout the Southeast and 4 dealerships. At December 31, 2005 Mobile Attic had over 5,000 storage containers available for lease through franchise and dealer locations. The portable storage containers are eight feet wide and eight feet tall and are available in lengths of 8, 16, 20, and 40 feet. Independent dealers market these portable storage containers primarily to household customers in need of a convenient alternative to fixed location mini-storage, commercial customers in need of secure storage facilities at job sites, and retail customers for storage of seasonal inventory.

Mobile Attic began the steps to change its business model during 2004 with the goal of future growth to come through expansion of independently owned franchise locations. Expansion through this new avenue will allow Mobile Attic to venture more rapidly into new areas and expand into larger cities while significantly reducing future capital requirements. Mobile Attic began selling franchised locations in the first quarter of 2004 with 33 locations in operation or beginning operations as of December 31, 2005.

In 2005, Mobile Attic generated net income of $275,000 primarily due to franchise fees generated on the strength of sales of new franchise locations. As individual franchise locations begin to mature over the next five years, the Company expects a shift in revenue away from one time franchise fees to more stable continuing royalty fees which are based on a percentage of individual franchisee rental revenues.

In 2004, Mobile Attic generated a net loss of $211,000 which was primarily related to a decrease in revenues from dealership sales fees and utilization fees below expected ultimate levels coupled with the cost of shifting to a franchise method of establishing new locations.

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Asset Portfolio Review:

The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. At December 31, 2005, the company’s holdings in debt securities amounted to 75.6% of total investments and 53.8% of total assets. The following is a breakdown of the bond portfolio quality according to National Association of Insurance Commissioners (NAIC) Securities Valuation Office (SVO) rating standards, and the nationally recognized rating organization equivalents of Moody’s and Standard and Poor’s:

SVO Equivalents
SVO Class	Moody’s	Standard and Poor’s	% of Total Bond Portfolio
1	Aaa to A3	AAA to A-	98.53%
2	Baa to Baa3	BBB+ to BBB-	1.20%
3	Ba1 to Ba3	BB+ to BB-	0.27%
4	B1 to B3	B+ to B-	0.00%
5	Caa to Ca	CCC to C	0.00%
6	Caa to Ca	C1 to D	0.00%

As of January 1, 1994, the Company adopted Financial Accounting Standards Board Statement 115 and reclassified a portion of its fixed maturity securities portfolio as “available-for-sale,” with the remainder being classified as “held-to-maturity.” With that reclassification, the fixed maturity securities classified as “available-for-sale” are carried at fair value and changes in fair values, net of related income taxes, are charged or credited to shareholders’ equity (see Note 4 to the consolidated financial statements).

The insurance subsidiaries’ fixed maturity securities include mortgage-backed bonds, primarily collateralized mortgage obligations (CMO’s), of $13.1 million and $8.7 million at December 31, 2005 and 2004 respectively. The mortgage-backed bonds are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than that expected at the time of purchase. Securities that are purchased at a premium to par value and prepay faster than expected will incur a reduction in yield or loss. Securities that are purchased at a discount to par value and prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between amortized cost and par value, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure. In order to minimize risk associated with prepayments on collateralized mortgage obligations, the Company typically invests primarily in more predictable planned amortization class (PAC) structures of CMO’s and typically avoids investment in CMO’s priced at significant premiums above par value.

The results with respect to the foregoing investments are as follows:

		Year Ended December 31
		2005		2004		2003
Net investment income	$	3,964	$	4,230	$	4,023
Average current yield on investments		4.0%		4.4%		4.2%
Total return on investments		4.1%		6.2%		5.9%
Net realized gains on investments (before taxes)		3,727		2,162		1,416
Changes in net unrealized gains on investments
(before income taxes)	$	(3,688)	$	(339)	$	2,520

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As of December 31, 2005, the maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows:

Maturity Schedule (Amounts in thousands)

Maturity		Available for sale		Held to Maturity		Total	Percentage of Total
Maturity in less than 1 year	$	583	$	0	$	583	0.8%
Maturity in 1-5 years		19,207		2,425		21,632	28.6%
Maturity in 5-10 years		15,989		6,761		22,750	30.1%
Maturity after 10 years		20,925		9,645		30,570	40.5%
	$	56,704	$	18,831	$	75,535	100.0%

Liquidity and Capital Resources: Due to increased claims from Hurricanes Dennis, Katrina and Rita, the Company established a $2 million revolving credit facility with a local bank. The establishment of the credit facility allowed the Company to better manage the timing differences associated with the payment of catastrophe claims to policyholders and subsequent reimbursement of paid claims from reinsurance companies. The establishment of the credit facility also prevented the insurance subsidiaries from having to liquidate investments for the payment of claims and reinvest proceeds upon reimbursement from reinsurance companies.

Due to regulatory restrictions, the majority of the Company’s cash is required to be invested in investment-grade securities to provide ample protection for policyholders. The liabilities of the property and casualty insurance subsidiaries are of various terms and, therefore, those subsidiaries invest in securities with various maturities spread over periods usually not exceeding 10 years. The liabilities of the life insurance subsidiaries are typically of a longer duration and therefore, a higher percentage of securities in the life insurance subsidiaries are invested for periods exceeding 10 years.

The liquidity requirements for the Company are primarily met by funds generated from operations of the life insurance and property/casualty insurance subsidiaries. Premium and investment income as well as maturities and sales of invested assets provide the primary sources of cash for both the life and property/casualty businesses, while applications of cash are applied by both businesses to the payment of policy benefits, the cost of acquiring new business (principally commissions), operating expenses, purchases of new investment, and in the case of life insurance, policy loans.

The National Security Group’s consolidated statement of cash flows indicate that operating activities (used) provided cash of $(5,449,000), $886,000, and $11,398,000 in 2005, 2004, and 2003 respectively. The significant decline in cash flow from operating activities in 2005 compared to 2004 was primarily due to the significant increase in claims associated with Hurricanes Dennis, Katrina and Rita. Cash flow in 2004 compared to 2003 declined primarily due to the increase in claims associated with Hurricane Ivan.

The consolidated statement of cash flows also reflects an increase (decrease) in cash from financing activities of $4,934,000, $(2,274,000) and $4,770,000 respectively. The increase in cash flow from financing activities in 2005 reflects proceeds from the issuance of long term debt of $9,279,000, the reduction of debt held by Mobile Attic of $2.2 million, and the payment of shareholder dividends of $2,134,000.

In December of 2005, The National Security Group completed the issuance of debt through a trust preferred securities offering. Specific details of the offering are discussed on Form 8-K filed December 12, 2005 and are incorporated herein by reference. The primary purpose of the offering was to increase regulatory capital of the primary property and casualty subsidiary, NSFC. Upon receipt of the proceeds of the $9.2 million debt issuance, the Company made an additional capital contribution to NSFC of $6,000,000. Over the past five years, NSFC has generated significant growth in premium revenue. Due to losses incurred from four hurricanes over the past two years, regulatory surplus had not kept pace with the rate of premium growth. In order to put NSFC in a better position to react to opportunities for continued growth going forward, we felt it prudent to boost the regulatory capital of NSFC via the proceeds of the long term debt issuance.

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Also in December of 2005, the consolidated joint venture, Mobile Attic paid down debt of approximately $2,000,000 through the sale of portable storage units to new franchisees. As discussed previously, we do not own a controlling interest in Mobile Attic but through the existence of certain debt guarantees established in 2001 and the subsequent issuance of Financial Interpretation 46R by the Financial Accounting Standards Board in December of 2003, we are obligated to consolidate Mobile Attic Financial Statements. It is a primary focus of management to continue to reduce Mobile Attic debt; to remove the impact of the debt guarantees and return the presentation Mobile Attic Financial Statements of the Company to the equity method.

The Company has standby letters of credit of $25,000. These letters are used to guarantee obligations of the property/casualty subsidiary under assumed reinsurance contracts. Certain invested assets of the Company secure the letters of credit. The Company also routinely incurs a liability for declared but unpaid dividends. Long-term liquidity needs of the Company constitute only those items which are directly related to the principal business operations of the Company.

		Payments due by period
		($ in thousands)
Contractual Obligations		Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Long-Term Debt Obligations	$	22,906	$	280	$	13,347	$	-	$	9,279
Property and casualty claim reserves	$	19,511	$	11,900	$	6,242	$	976	$	393

Long-term debt obligations include $11,718,000 in debt held directly by the Company. It is anticipated that $2,439,000 will be retired in 2007. Included in long term debt held directly by the Company is the issuance of $9,279,000 in subordinated debentures on December 15, 2005. The proceeds from the debentures were used to make a $6,000,000 capital infusion in the P&C subsidiary National Security Fire and Casualty with the remainder to be held for general corporate purposes. The subordinated debentures mature December 15, 2035. It is anticipated that principal payments will not be made until the expiration of the fixed rate period on the debt in 2015. For further discussion of the subordinated debentures please review Note 8 to the consolidated financial statements and Form 8-K filed December 12, 2005 which is incorporated herein by reference. Long-term debt obligations also include $11,188,000 in debt held by a 50% owned subsidiary, The Mobile Attic. The current debt obligation of Mobile Attic matures in 2007, but it is currently anticipated that Mobile Attic will seek to refinance approximately 50% of this debt under a longer term financing prior to maturity.

In estimating the time interval for payment of property and casualty claim reserves, the Company utilized historical payment patterns. By the nature of the insurance contracts under which these liabilities exist, there can be no certainty that actual payments will fall in the periods indicated above. However, management feels that current liquidity and capital resources are sufficient to pay these obligations as they come due. Also, due to the relatively short-tail nature of the majority of the Company’s claim liabilities, management can conclude with a reasonable level of confidence that historical patterns indicate that approximately 70% of claim liabilities at the end of a given year are settled within the following two year period.

The ability of the Company to meet its commitments for timely payment of claims and other expenses depends, in addition to current cash flow, on the liquidity of its investments. On December 31, 2005, the Company had no known impairments of assets or changes in operation, which would have a material adverse effect upon liquidity. Approximately 81% of the Company’s insurance subsidiary assets are invested in cash; investment grade fixed income securities, short-term investments and broadly traded equity securities, which are highly liquid. The values of these investments are subject to the conditions of the markets in which they are traded. Past fluctuations in these markets have had little effect on the liquidity of the Company. The Company has relatively little exposure to lower grade fixed income investments which might be especially subject to liquidity problems due to thinly traded markets.

Except as discussed in Note 15 to the consolidated financial statements, the Company is aware of no known trends, events, or uncertainties reasonably likely to have a material effect on its liquidity, capital resources, or operations. Additionally, the Company has not been made aware of any recommendations of regulatory authorities, which if implemented, would have such an effect.

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As disclosed in Note 12 to the consolidated financial statements, in 2005, the amount that The National Security Group’s insurance subsidiaries can transfer in the form of dividends to the parent company is limited to $993,000 in the life insurance subsidiary and $2,721,000 in the property/casualty insurance subsidiary. However, that condition poses no short-term or long-term liquidity concerns for the parent company.

Off-Balance Sheet Arrangements: With the consolidation of 50% owned subsidiary, The Mobile Attic, Inc. triggered by preexisting debt guarantees and the adoption of Financial Accounting Standards Board Interpretation 46 (FIN 46R), the Company has no off balance sheet arrangements.

Statutory Risk-Based Capital of Insurance Subsidiaries: The NAIC has adopted Risk-Based Capital (RBC) requirements for life/health and property/casualty insurance companies to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks such as asset quality, mortality and morbidity, asset and liability matching, benefit and loss reserve adequacy, and other business factors. State insurance regulators will use the RBC formula as an early warning tool to identify, for the purpose of initiating regulatory action, insurance companies that potentially are inadequately capitalized. In addition, the formula defines new minimum capital standards that will supplement the current system of low fixed minimum capital and surplus requirements on a state-by-state basis. Regulatory compliance is determined by a ratio of the company’s regulatory total adjusted capital, as defined by the NAIC, to its authorized control level RBC, as defined by the NAIC. Companies below specific trigger points or ratios are classified within levels, each of which requires corrective action.

The levels and ratios are as follows:

	Ratio of Total Adjusted Capital to
		Authorized Control Level RBC
Regulatory Event			(Less Than or Equal to)
Company action level				2.0
Regulatory action level				1.5
Authorized control level				1.0
Mandatory control level				0.7

The ratios of Total Adjusted Capital to Authorized Control Level RBC for The National Security Group’s life/health and property/casualty insurance subsidiaries are all in excess of 4.4 to 1 at December 31, 2005.

National Security Insurance Company (life insurer) has regulatory adjusted capital of $10.78 and $11.45 million at December 31, 2005 and 2004, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 13.3 and 14.0 at December 31, 2005 and 2004 respectively. Accordingly, National Security Insurance Company exceeds the minimum RBC requirements.

National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $27.2 million and $23.9 million at December 31, 2005 and 2004, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 4.4 and 3.6 at December 31, 2005 and 2004 respectively. Accordingly, National Security Fire & Casualty Company exceeds the minimum RBC requirements.

Omega One Insurance Company (property/casualty insurer), which began writing business in late 1995, has regulatory adjusted capital of $8.0 million and $7.6 million at December 31, 2005 and 2004, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 17.4 and 12.3 at December 31, 2005 and 2004 respectively. Accordingly, Omega One Insurance Company exceeds the minimum RBC requirements.

Application of Critical Accounting Policies: Our consolidated financial statements are based upon the development and application of accounting policies that require management to make significant estimates and assumptions. Accounting policies may be based on (including but not limited to) GAAP authoritative literature, statutory authoritative literature, regulations, and industry standards. The Company’s financial results would be directly impacted by changes in assumptions and judgments used to select and apply our accounting policies. It is management’s opinion that the following are some of the more critical judgment areas in regards to the application of our accounting policies and their affect on our financial condition and results of operations.

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• Reinsurance Receivables

• Deferred Policy Acquisition Costs

• Deferred Taxes

• Valuation of Investments

• Reserves for losses and loss adjustment expense

• Recognition of Revenue

• Evaluation of Litigation

Reinsurance

As part our risk management strategy we routinely cede risks associated with insurance policies we underwrite to reinsurers pursuant to contractual agreements. Reinsurance provides protection for individual loss occurrences, including catastrophes, to alleviate fluctuation in the results of our underwriting activities and to limit our net liability for individual risks. The estimated reinsurance recoverable on paid losses, including an estimate for losses incurred but not reported, and amounts paid to reinsurers applicable to unexpired terms of policies in force are reported as assets.

A reinsurance arrangement does not discharge the issuing company from primary liability to the insured, and the issuing company is required to discharge its liability to the insured even if the reinsurer is unable to meet its obligations under the reinsurance arrangements. Reinsurance, however, does make the reinsurer liable to the issuing company to the extent of any reinsurance in force at the time of the loss. Reinsurance arrangements also decrease premiums retained by the issuing company since that company pays the reinsuring company a portion of total premiums based upon the amount of liability reinsured.

When a claim is made under a policy we have reinsured, we initially pay the full amount owed to the policyholder or claimant. Subsequently, we initiate the process to recover any amounts due from reinsurers in accordance with the terms of applicable reinsurance treaties. The estimated recoverable is recorded as an asset on the financial statements.

At December 31, 2005, the estimated reinsurance recoverable recorded was $10,193,000. The Company does not anticipate any issues with collection of the recorded amount.

The reinsurance related amounts recorded have been estimated based upon management’s interpretation of the related reinsurance treaty. Areas in which judgment has been used regarding said estimates include: assessing the financial viability and credit quality of each reinsurer as well as the ability of each reinsurer to pay amounts owed.

There is a possibility that the actual amounts recovered from reinsurers could be materially less than the estimates recorded. This possibility could result in a material adverse impact on our financial condition and results of operations. Reinsurers may dispute claims under reinsurance treaties, such as the calculated amount of reinsurance recoverable. Management does not anticipate any issues with recoverability of reinsurance balances based on current evaluations of collectibility.

NSIC generally reinsures all risks in excess of $50,000 with respect to any one insured.

NSFC and Omega generally reinsure with third parties any liability in excess of $150,000 on any single policy. In addition, the property-casualty subsidiaries have catastrophe excess reinsurance, which protects it in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane. In 2005, the property-casualty subsidiaries had catastrophe protection up to a $37.5 million loss. Based on an evaluation using actual NSFC and Omega exposures and catastrophe modeling based on a 250 year loss, that is a loss that has a less than ½ of 1% chance of occurring in any given year, the property and casualty subsidiaries would pay (pre-tax) $6.9 million in losses and reinstatement and reinsurers would pay (pre-tax) $39.1 million.

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It should be noted that, due to an increase in reinsurance rates, effective January 1, 2006 the property and casualty insurance subsidiaries incurred an 18% increase in the cost of reinsurance coverage. Also, due to the level of rate increases on the first layer of coverage, which began at $2,000,000 in 2005, we increased our deductible to $3,000,000 for 2006. However, management also placed coverage on a book of run-off business that was previously not insured under the catastrophe reinsurance arrangement. Catastrophe losses on this book of business exceeded $1,000,000 in each of the last two years. So, we believe the increase in deductible coupled with the addition of catastrophe coverage to this book of business does not materially change our catastrophe reinsurance profile and is the most cost effective risk management solution in the current rate environment. Also in light of the magnitude of Hurricane Katrina in 2005, we felt it prudent to increase the top end of our catastrophe reinsurance coverage for 2006. For 2006, we will have in place catastrophe reinsurance protection for a single event of up to $42.5 million in excess of $3,000,000 with one reinstatement.

For more information regarding reinsurance please see Note 10 to our consolidated financial statements.

Deferred Policy Acquisition Costs

Deferred policy acquisition costs (DAC) are those costs incurred in connection with acquiring new business or renewing existing business. DAC is primarily comprised of commissions and other costs related to issuing insurance policies, net of amounts ceded to reinsurers. In accordance with generally accepted accounting principles, these costs are not expensed in their entirety, rather they are recorded as an asset and amortized over the lives of the policies.

A reduction in DAC is recognized if the sum of the expected loss and loss adjustment expenses, unamortized acquisition costs, and maintenance costs exceeds related unearned premiums and projected investment income. Management reviews DAC calculations throughout the year to establish and assess their recoverability. Changes in management’s assumptions, estimates or judgment with respect to calculating DAC could materially impact our financial statements and financial condition. Changes in loss ratios, projected investment income, premium rates or overall expense levels could negatively impact the recoverability of DAC.

At December 31, 2005, we had recorded $6,567,000 as an asset for DAC in our financial statements. For more information regarding deferred policy acquisition costs, please see Note 1 to our financial statements.

Deferred Income Taxes

Deferred income taxes are created when there are differences between assets and liabilities for tax and financial reporting purposes, as well as tax credits, net operating losses and other carryforwards. SFAS 109 “Accounting for Income Taxes,” requires that deferred tax assets be reduced by a valuation allowance if, based on the available evidence, it is more likely than not that all of the recorded deferred

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tax assets will not be realized in future periods. This standard requires management to exercise judgment in determining whether or not the deferred tax asset is realizable.

At December 31, 2005 there is no evidence to suggest to management that the deferred tax asset is unrealizable. For more information regarding deferred income taxes, please see Note 7 to our financial statements.

Valuation of Investments

Investments are recorded at fair value based upon quoted prices when available. Quoted prices are available for every investment debt and equity security included in the financial statements. Periodically, the carrying values of an individual investment may become temporarily impaired because of time value, volatility, credit quality and existing market conditions. Management evaluates investments to determine whether the impairment is other-than-temporary. Evaluation criteria include credit quality of security, severity of decrease between cost and market value, length of time of the impairment and likelihood that the impairment will reverse in the near future. This evaluation requires significant assumptions, estimates and judgments by management. If the impairment is determined to be other-than-temporary, the investment is written down to the current fair value and a realized loss is recorded on the income statement.

At December 31, 2005 there were no other-than-temporary impairments. For more information regarding valuation of investments, see Note 1 to our financial statements.

Loss and Loss Adjustment Expense

Property and casualty loss reserves are maintained to cover the estimated unpaid liability for losses and loss adjustment expenses with respect to reported and unreported incurred claims. Loss reserves are an estimation based on actuarial projection techniques common in the insurance industry. Reserves are management’s expectations of what the settlement and administration of claims will cost. Management estimated reserves are based on historical settlement patterns, estimated salvage and subrogation, and an appraisal of the related facts and circumstances. Management’s reserve estimates are reviewed by independent actuaries to determine their adequacy and reasonableness.

At December 31, 2005 the recorded liability for loss and loss and adjustment expense was $19,511,000. For more information regarding loss and loss adjustment expense, see Note 9 to our financial statements.

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Item 7A. Quantitative and Qualitative Disclosures About Market Risk

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.

Since the Company’s assets and liabilities are largely monetary in nature, the Company’s financial position and earnings are subject to risks resulting from changes in interest rates at varying maturities, changes in spreads over U.S. Treasuries on new investment opportunities, changes in the yield curve and equity pricing risks.

The Company is exposed to equity price risk on its equity securities. The Company holds common stock with a fair value of $15.2 million. If the market value of the S & P 500 Index decreased 10% from its December 31, 2005 value, the fair value of the Company’s common stock would decrease by approximately $1.5 million.

Certain fixed interest rate market risk sensitive instruments may not give rise to incremental income or loss during the period illustrated but may be subject to changes in fair values. Note 1 in the consolidated financial statements presents additional disclosures concerning fair values of Financial Assets and Financial Liabilities, and is incorporated by reference herein.

The Company limits the extent of its market risk by purchasing securities that are backed by stable collateral, the majority of the assets are issued by U.S. government sponsored entities. Also, the majority of all of the subsidiaries’ CMO’s are Planned Amortization Class (PAC) bonds. PAC bonds are typically the lowest risk CMO’s, and provide greater cash flow predictability. Such securities with reduced risk typically have a lower yield, but higher liquidity, than higher-risk mortgage backed bonds. To reduce the risk of loss of principal should prepayments exceed expectations, the Company does not purchase mortgage backed securities at significant premiums over par value.

The Company’s investment approach in the equity markets is based primarily on a fundamental analysis of value. This approach requires the investment committee to invest in well managed, primarily dividend paying companies, which have a low debt to capital ratio, above average return on net worth for a sustained period of time, and low price to book value or low volatility rating (beta) relative to the market. The dividends provide a steady cash flow to help pay current claim liabilities, and it has been the Company’s experience that by following this investment strategy, long term investment results have been superior to those offered by bonds, while keeping the risk of loss of capital to a minimum relative to the overall equity market.

As for shifts in investment allocations, the major shift has been a move away from corporate bonds and into government agency issues. Corporate spreads have remained extremely tight relative to agency securities. Due to the tight interest rate spreads, the investment committee has not felt compelled from a risk/reward standpoint to increase or maintain the allocation to corporate bonds. Corporate bonds now compose just 11.8% of bond investments compared to over 15.3% last year. In contrast, government securities, primarily agency issues, compose 58.5% of bond investments compared to 67.5% last year. Collateralized mortgage obligations, which primarily consist of planned amortization class structures, now compose 17.4% of bond investment compared to 12.1% last year. The Company does not anticipate any further major shifts in fixed income investment allocations in the near future.

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Item 8. Consolidated Financial Statements and Supplementary Data

Index to Financial Statements
Consolidated Financial Statements:
Report of Independent Registered Public Accounting Firm	32
Consolidated Statements of Income –
Years Ended December 31, 2005, 2004, and 2003	33
Consolidated Balance Sheets –
December 31, 2005 and 2004	34
Consolidated Statements of Shareholders’ Equity –
Years Ended December 31, 2005, 2004, and 2003	35
Consolidated Statements of Cash Flows –
Years Ended December 31, 2005, 2004, and 2003	36
Notes to Consolidated Financial Statements –
December 31, 2005	37
Financial Statement Schedules:
Schedule I. Summary of Investments –
December 31, 2005 and 2004	59
Schedule II. Condensed Financial Information of Registrant –
December 31, 2005 and 2004	60
Schedule III. Supplementary Insurance Information –
December 31, 2005, 2004, and 2003	64
Schedule IV. Reinsurance –
Years Ended December 31, 2005, 2004, and 2003	65
All other Schedules are not required under related instructions or are
inapplicable and therefore have been omitted.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders

The National Security Group, Inc.

Elba, Alabama

We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. and subsidiaries as of December 31, 2005 and 2004 and the related consolidated statements of income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2005.Our audits also included the financial statement schedules listed in the Index at page 31. These consolidated financial statements and schedules are the responsibility of the company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement. The company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of The National Security Group, Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

\s\ Barfield, Murphy, Shank & Smith, P.C.

Birmingham, Alabama

February 23, 2006

32

THE NATIONAL SECURITY GROUP, INC.
CONSOLIDATED STATEMENTS OF INCOME
		(Dollars in thousands
		except per share amounts)
		Year Ended December 31,
			2005		2004		2003
REVENUES
	Net premiums earned	$	53,563	$	52,985	$	47,536
	Net investment income		3,964		4,230		4,023
	Net realized investment gains		3,727		2,162		1,416
	Net revenues from leasing operations		3,360		2,459		1,433
	Other income		1,416		1,312		1,395
			66,030		63,148		55,803
BENEFITS AND EXPENSES
	Policyholder benefits paid or provided		38,241		35,067		27,545
	Amortization of deferred policy acquisition costs		2,704		2,221		1,825
	Commissions		8,987		8,646		8,901
	General insurance expenses		7,911		8,608		8,566
	Expenses from leasing operations		2,404		2,008		988
	Insurance taxes, licenses and fees		2,243		2,018		1,718
	Interest expense		1,140		727		632
			63,630		59,295		50,175
Income Before Income Taxes and Minority Interest			2,400		3,853		5,628
INCOME TAX EXPENSE (BENEFIT)
	Current		531		482		1,703
	Deferred		174		364		(138)
			705		846		1,565
	Income Before Minority Interest		1,695		3,007		4,063
	(Income) Loss of Minority Interest		(137)		106		27
	Net Income	$	1,558	$	3,113	$	4,090
	EARNINGS PER COMMON SHARE
	Net Income	$	0.63	$	1.26	$	1.66

See accompanying notes to consolidated financial statements

33

The National Security Group, Inc.
CONSOLIDATED BALANCE SHEETS
			(Dollars in thousands)
			December 31,
ASSETS						2005	2004
Investments
	Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2005 - $18,204;
		2004 - $19,967)	$			18,831	$	20,280
	Fixed maturities available-for-sale, at estimated fair value (cost: 2005 - $56,704;
		2004- $50,164)				56,124	50,889
	Equity securities available-for-sale, at estimated fair value (cost: 2005 - $6,374;
		2004 - $8,995)				15,169	20,173
	Receivable for securities					677	-
	Mortgage loans on real estate, at cost					387	238
	Investment real estate, at book value (accumulated depreciation: 2005 - $18; 2004 - $17)					3,842	1,463
	Policy loans					793	771
	Other invested assets					2,605	2,973
	Short-term investments					699			250
Total Investments				$		99,127	$		97,037
Cash						2,350	360
Accrued investment income						701	744
Receivable from agents, less allowance for credit losses (2005 - $110; 2004 - $110)						2,663	2,465
Accounts receivable, less allowance for credit losses (2005 - $48; 2004 - $40)						2,848	745
Inventory						1,238	222
Reinsurance recoverable						10,193	3,318
Deferred policy acquisition costs						6,567	6,217
Property and equipment, net						12,393	16,907
Other assets						1,146			616
Total Assets			$			139,226	$		128,631
LIABILITIES AND SHAREHOLDERS' EQUITY
Property and casualty benefit and loss reserves			$			19,511	$		13,094
Accident and health benefit and loss reserves						575	480
Life and annuity benefit and loss reserves						24,552	23,935
Unearned premiums						15,791	14,779
Policy and contract claims						351	419
Other policyholder funds						1,309	1,311
Long-term debt						22,906	15,836
Accrued income taxes						99	-
Other liabilities						7,185	7,876
Deferred income tax						2,502			3,473
Total Liabilities				$		94,781	$		81,203
Contingencies						-	-
Minority interest						889	752
Shareholders' Equity
	Preferred stock, $1 par value, 500,000 shares authorized, none issued or outstanding					-	-
	Class A common stock, $1 par value, 2,000,000 shares authorized, none issued or outstanding					-	-
	Common stock, $1 par value, 10,000,000 shares authorized
		2,466,600 shares issued and outstanding				2,467	2,467
	Additional paid-in capital					4,951	4,951
	Accumulated other comprehensive income					5,860	8,404
	Retained earnings					30,278			30,854
Total Shareholders' Equity						43,556			46,676
Total Liabilities and Shareholders’ Equity					$	139,226	$		128,631

See accompanying notes to consolidated financial statements

34

THE NATIONAL SECURITY GROUP, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
(Dollars in thousands)
										Accumulated
										Other
						Comprehensive	Retained			Comprehensive		Common	Paid-in
				Total	Income (Loss)		Earnings			Income		Stock	Capital
Balance at December 31, 2002			$	42,159			$	27,770	$	6,971	$	2,467	$	4,951
Comprehensive income:
	Net income for 2003			4,090		4,090		4,090		-		-		-
	Other comprehensive income, net of tax
		Unrealized gain on securities, net
		of reclassification adjustment of $1,130		1,658		1,658		-		1,658		-		-
Comprehensive income						5,748
	Cash dividends ($0.825 per share)			(2,035)				(2,035)		-		-		-
Balance at December 31, 2003				45,872				29,825		8,629		2,467		4,951
Comprehensive income:
	Net income for 2004			3,113		3,113		3,113		-		-		-
	Other comprehensive loss, net of tax
		Unrealized loss on securities, net
		of reclassification adjustment of $1,483		(225)		(225)		-		(225)		-		-
Comprehensive income						2,888
	Cash dividends ($0.845 per share)			(2,084)				(2,084)		-		-		-
Balance at December 31, 2004				46,676				30,854		8,404		2,467		4,951
Comprehensive loss:
	Net income for 2005			1,558		1,558		1,558		-		-		-
	Other comprehensive loss, net of tax
		Unrealized loss on securities, net
		of reclassification adjustment of $2,504		(2,544)		(2,544)		-		(2,544)		-		-
Comprehensive loss						(986)
	Cash dividends ($0.865 per share)			(2,134)				(2,134)		-		-		-
Balance at December 31, 2005			$	43,556			$	30,278	$	5,860	$	2,467	$	4,951

See accompanying notes to consolidated financial statements.

35

THE NATIONAL SECURITY GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
			(Dollars in thousands)
			Year ended December 31,
				2005		2004		2003
Cash flows from operating activities:
Net income			$	1,558	$	3,113	$	4,090
Adjustments to reconcile net income to net cash provided by
	operating activities:
		Change in accrued investment income		43		186		80
		Change in reinsurance recoverable		(6,875)		(1,519)		(100)
		Amortization of deferred policy acquisition costs		2,704		2,221		1,825
		Change in receivable for securities		(677)		-		-
		Net realized gains on investments		(3,727)		(2,162)		(1,416)
		Change in accounts receivable		(2,103)		(265)		(251)
		Change in inventory		(1,016)		(178)		2
		Policy acquisition costs deferred		(3,054)		(2,621)		(2,399)
		Change in prepaid reinsurance premiums		271		29		(153)
		Depreciation expense and amortization/accretion		944		700		808
		Change in policy liabilities and claims		8,073		3,396		4,257
		Change in income tax payable		99		(1,486)		1,253
		Change in deferred income taxes		174		362		(260)
		Change in other liabilities		(691)		(1,246)		3,991
		(Gain) loss of minority interest		(137)		106		29
		Other, net		(1,035)		250		(358)
		Net cash (used in) provided by operating activities		(5,449)		886		11,398
Cash flows from investing activities:
	Purchases of held-to-maturity securities			(1,193)		(19,379)		(17,694)
	Purchases of available-for-sale securities			(23,037)		(4,933)		(22,455)
	Proceeds from maturities of held-to-maturity securities			2,770		3,176		13,271
	Proceeds from sales of available-for-sale securities			22,576		25,687		17,379
	Proceeds from sales of real estate held for investment			189		124		24
	Purchases of real estate held for investment			(2,451)		-		-
	Purchase of other invested assets			-		(3,358)		-
	Proceeds from sales of other invested assets			368		385		-
	Net (purchases) proceeds from sale of short-term investments			(449)		50		1,152
	(Advances on) repayment of policy loans, net			(22)		(41)		641
	Purchase of property and equipment			(457)		(1,327)		(8,078)
	Proceeds from sale of property and equipment			4,211		69		5
		Net cash provided by (used in) investing activities		2,505		453		(15,755)
Cash flows from financing activities:
	Proceeds from debt			9,279		243		7,862
	Payments on debt			(2,209)		(328)		(946)
	Change in other policyholder funds			(2)		(105)		(111)
	Dividends paid			(2,134)		(2,084)		(2,035)
		Net cash provided by (used in) financing activities		4,934		(2,274)		4,770
		Net increase (decrease) in cash		1,990		(935)		413
Cash at beginning of year				360		1,295		882
Cash at end of year			$	2,350	$	360	$	1,295

See accompanying notes to consolidated financial statements.

36

Note 1 - SIGNIFICANT ACCOUNTING POLICIES

(a) Principles of Consolidation

The accompanying consolidated financial statements include the accounts of The National

Security Group, Inc. (the Company) and its wholly-owned subsidiaries: National Security

Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and

NATSCO, Inc. (NATSCO). NSFC includes a wholly-owned subsidiary - Omega One Insurance

Company (Omega). All significant intercompany transactions and accounts have been

eliminated.

The accompanying consolidated financial statements also include an investment in affiliate,

which consists of a fifty percent interest in The Mobile Attic, Inc and its wholly owned subsidiary established in January of 2004, Mobile Attic Franchising Company (MAFCO). The Mobile Attic, Inc. is a portable storage leasing company that began operations in 2001. MAFCO was established in the first quarter of 2004 to conduct the business of selling Mobile Attic portable storage leasing franchises. Effective in the first quarter of 2004 the Company consolidated the accounts of Mobile Attic, Inc. and subsidiary MAFCO according to guidance in Financial Accounting Standards Board Interpretation 46 as revised December 2003 (FIN 46R).

Changes in financial statement presentation as a result of the adoption of recently issued accounting standards:

As disclosed in the notes to the audited consolidated financial statements for the year ended

December 31, 2003, the Company adopted Financial Accounting Standards Board Interpretation 46 as revised December 2003 (FIN 46R), in the first quarter of 2004. As a result of the adoption of FIN 46R, triggered by previously existing and disclosed guarantees of Mobile Attic debt by the Company, the Company consolidated an investment in a subsidiary Mobile Attic, Inc. Further details of the debt guarantees are discussed in Note 2 to these consolidated financial statements.

Mobile Attic was previously reported using the equity method of accounting. For comparative

purposes, the Company made adjustments to the December 31, 2003 Balance Sheet and the Income Statement and Statement of Cash Flows for the period ended December 31, 2003. These adjustments increased December 31, 2003 assets by $15,109,000 and liabilities by $13,394,000. The adjustment had no effect on consolidated stockholders’ equity. Certain accounts in the Income Statement for the period ended December 31, 2003 were adjusted as a result of the consolidation of Mobile Attic, but because the results of Mobile Attic were previously reported under the equity method, the adjustments had no effect on the consolidated results of operations for the period ended December 31, 2003. Cash flow, for the year ended December 31, 2003 from operating activities increased $79,000; from investing activities decreased $7,224,000; and from financing activities increased $7,862,000. Total cash increased $169,000.

(b) Description of Major Products

NSIC is licensed in the states of Alabama, Florida, Georgia, Mississippi, South Carolina and

Texas and was organized in 1947 to provide life and burial insurance policies to the home

service market. Business is now produced by both company and independent agents.

Primary products include ordinary life, accident and health, supplemental hospital, and cancer insurance products.

NSFC is licensed in Alabama, Arkansas, Florida, Georgia, Mississippi, Oklahoma, South

Carolina, and Tennessee. In addition NSFC operates on a surplus lines basis in Louisiana,

Missouri, and Texas. NSFC operates in various property and casualty lines, the most

37

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

significant of which are dwelling property fire and extended coverage, homeowners, mobile

homeowners, ocean marine, nonstandard automobile physical damage and liability and

nonstandard commercial auto liability.

Omega is licensed in the states of Alabama and Louisiana. Omega operates in property and

casualty lines, the most significant of which are homeowners and nonstandard automobile

physical damage and liability.

(c) Basis of Presentation

The significant accounting policies followed by the Company and subsidiaries that materially

affect financial reporting are summarized below. The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) which, as to the subsidiary insurance companies, differ from statutory accounting practices permitted by regulatory authorities.

(d) Use of Estimates

The preparation of financial statements in conformity with generally accepted accounting

principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

(e) Investments

The Company’s securities are classified in two categories and accounted for as follows:

•     Securities Held-to-Maturity. Bonds, notes and redeemable preferred stock for which

the Company has the positive intent and ability to hold to maturity are reported at cost, adjusted for amortization of premiums and accretion of discounts which are

recognized in interest income using methods which approximate level yields over the period to maturity.

•     Securities Available-for-Sale. Bonds, notes, common stock and non-redeemable

preferred stock not classified as either held-to-maturity, or trading are reported at fair value, adjusted for other-than-temporary declines in fair value. The Company and its subsidiaries have no trading securities.

Unrealized holding gains and losses, net of tax, on securities available-for-sale are reported as

a net amount in a separate component of shareholders’ equity until realized.

Realized gains and losses on the sale of securities available-for-sale are determined using the

specific-identification method.

Mortgage loans and policy loans are stated at the unpaid principal balance of such loans.

Investment real estate is reported at cost, less allowances for depreciation computed on the straight-line basis. Short-term investments are carried at cost, which approximates market value. Investments with other than temporary impairment in value are written down to estimated realizable values.

Other invested assets consist principally of state sponsored investments with a portion of the
	investment yield derived from insurance premium tax credits. These investments are
	reported at the unpaid principal balance.

38

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES - CONTINUED

(f) Receivable from Agents

Agent balances are reported at unpaid balances, less a provision for credit losses.

(g) Accounts Receivable

Accounts receivable are reported at net realizable value. Management determines the

allowance for doubtful accounts based on historical losses and current economic conditions. On a continuing basis, management analyzes delinquent receivables and, once these receivables are determined to be uncollectible, they are written off through a charge against an existing allowance account or against earnings.

(h) Inventory

Inventory consists of finished goods inventory and is carried at the lower of cost (first-in, first-out

method) or market.

(i) Property and Equipment

Property and equipment is carried at cost less accumulated depreciation and includes

expenditures that substantially increase the useful lives of existing property and equipment. Maintenance, repairs, and minor renovations are charged to expense as incurred. Upon sale or retirement of property and equipment, the cost and related accumulated depreciation are eliminated from the respective account and the resulting gain or loss is included in the results of operations. The Company provides for depreciation of property and equipment using the straight-line method designed to amortize costs over estimated useful lives. Estimated useful lives range up to 40 years for buildings and from 3-8 years for electronic data processing equipment and furniture and fixtures.

(j) Fair Value of Financial Instruments

The table below presents the carrying value and fair value of the Company’s financial

instruments, as defined in accordance with applicable requirements. Fair values of the Company’s financial instruments are estimated by reference to quoted prices from market sources and financial institutions, as well as other valuation techniques. In cases where quoted market prices are not available, fair values are estimated using present value or other valuation techniques. The fair value estimates are made at a specific point in time, based on available market information and judgments about the financial instrument, such as estimates of timing and amount of expected future cash flows. Such estimates do not reflect any premium or discount that could result from offering for sale at one time the Company’s entire holdings of a particular financial instrument, nor do they consider the tax impact of the realization of unrealized gains or losses. In many cases, the fair value estimates cannot be substantiated by comparison to independent markets, nor can the disclosed value be realized in immediate settlement of the instrument.

Certain financial instruments, particularly insurance liabilities other than financial guarantees

and investment contracts are excluded from the disclosures. In evaluating the Company’s management of interest rate and liquidity risk, the fair values of all assets and liabilities should be taken into consideration.

The fair values of cash, cash equivalents, short-term investments and balances due on

accounts from agents, reinsurers and others approximate their carrying amounts as reflected in the consolidated balance sheet due to their short-term availability or maturity.

39

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

		In Thousands of Dollars at December 31,
		2005				2004
		Carrying		Estimated		Carrying		Estimated
		Value		Fair Value		Value		Fair Value
Assets and related instruments
Debt and equity securities	$	90,124	$	89,497	$	91,342	$	91,029
Mortgage loans		387		387		238		238
Policy loans		793		793		771		771
Liabilities and related instruments
Other policyholder funds		1,309		1,309		1,311		1,311
Long-term debt		22,906		22,906		15,836		15,836

(K) Statement of Cash Flows

For purposes of reporting cash flows, cash includes cash-on-hand, demand deposits with banks and overnight investments.

(l) Revenue Recognition

Life insurance premiums are recognized as revenues when due. Property and casualty

insurance premiums, less amounts ceded to reinsurers, are recognized on a pro rata basis over the terms of the policies. Reinsurance premiums assumed are recognized as reported by the ceding company.

Mobile Attic, Inc. recognizes leasing revenues from royalties, storage unit rentals and sales on a

monthly basis. Revenues from delivery charges are recognized when these services are billed. Mobile Attic executes franchise agreements that set the terms of its arrangement with each franchisee. The franchisee agreement requires the franchisee to pay an initial, non-refundable fee ranging from $35,000 to $55,000 and continuing fees based on percentage of rents. The initial term of the franchise is 20 years and, subject to Mobile Attic’s approval and payment of a renewal fee, a franchise may generally renew its agreement upon its expiration for an additional 10 years.

When an individual franchise is sold, Mobile Attic agrees to provide certain services to the

Franchisee, including training on the operations of the business as well as training on the loading and unloading of the storage containers. Mobile Attic recognizes initial fees as revenue when substantially all initial services required by the franchise agreement are performed, which is generally upon opening of a franchise location.

Mobile Attic sold 15 individual franchise licenses during 2005 and 13 during 2004. Initial fees

included in revenues for the years ended December 31, 2005 and 2004 were $625,000 and $350,000, respectively. Deferred revenue at December 31, 2005 and 2004 was $175,000 and $122,500, respectively, and represents that portion of total revenues from franchises not yet open. There were two company-owned locations in operation during the years ended December 31, 2005 and 2004.

As territory is assigned to each franchise sold, Mobile Attic may reach the point where existing

markets become saturated and initial franchising revenue declines. Unless new markets are entered, franchise revenues after market saturation will come primarily from renewal fees for existing franchises.

40

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

(m) Deferred Policy Acquisition Costs

The costs of acquiring new insurance business are deferred and amortized over the lives of the

policies. Deferred costs include commissions, other agency compensation and expenses, and other underwriting expenses directly related to the level of new business produced.

Acquisition costs relating to life contracts are amortized over the premium paying period of the

contracts, or the first renewal period of term policies, if earlier. Assumptions utilized in amortization are consistent with those utilized in computing policy liabilities.

The method of computing the deferred policy acquisition costs for property and casualty policies

limits the amount deferred to a percentage of related unearned premiums.

(n) Policy Liabilities

The liability for future life insurance policy benefits is computed using a net level premium

method including the following assumptions:

Years of Issue	Interest Rate
1947 - 1968	4%
1969 - 1978	6% graded to 5%
1979 - 2005	7% graded to 6%

Mortality assumptions include various percentages of the 1955-60 and 1965-70 Select and

Ultimate Basic Male Mortality Table. Withdrawal assumptions are based on the Company’s experience.

(o) Claim Liabilities

The liability for unpaid claims represents the estimated liability for claims reported to the

Company and its subsidiaries plus claims incurred but not yet reported and the related adjustment expenses. The liabilities for claims and related adjustment expenses are determined using case-basis evaluations and statistical analyses and represent estimates of the ultimate net cost of all losses incurred through December 31 of each year. Although considerable variability is inherent in such estimates, management believes that the liabilities for unpaid claims and related adjustment expenses are adequate. The estimates are continually reviewed and adjusted as necessary; such adjustments are included in current operations.

(p) 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 2,466,600 (2,466,600 in 2004 and 2003).

(q) Reinsurance

In the normal course of business, NSFC seeks to reduce the loss that may arise from catastrophes or

other events that cause unfavorable underwriting results by reinsuring certain levels of risk in various areas of exposure with other insurance enterprises or reinsurers. Amounts recoverable from reinsurers are estimated in a manner consistent with the claim liability associated with the reinsured policy. Amounts paid for prospective reinsurance contracts are reported as prepaid reinsurance premiums and amortized over the remaining contract period.

In the normal course of business, NSIC seeks to limit its exposure to loss on any single insured

41

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage contracts. NSIC retains a maximum of $50,000 of

coverage per individual life. The cost of reinsurance is amortized over the contract period of the reinsurance.

(r) Reclassifications

Certain reclassifications have been made in the previously reported financial statements to

make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on the previously reported net income or shareholders’ equity.

(s) Advertising

The Company expenses advertising costs as incurred except for nondirect-response advertising

costs, which are expensed the first time the advertising takes place. Advertising costs charged to expense were $250,000 for the year ended December 31, 2005 ($142,000 and $118,000 for the years ended December 31, 2004 and 2003, respectively). Advertising costs capitalized at December 31, 2005 were $192,000.

(t) Concentration of Credit Risk

The Company maintains cash depository accounts which, at times, may exceed federally insured

limits. These amounts represent actual account balances held by financial institutions at the end of the period, and unlike the balance reported in the financial statements, the account balances do not reflect timing delays inherent in reconciling items such as outstanding checks and deposits in transit. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.

(u) Recently Issued Accounting Standards

During 2005, the Financial Accounting Standards Board (FASB) issued the following pronouncements:

SFAS No. 154, Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3, changes the requirements for accounting and reporting of a change in accounting principle. The statement requires retrospective application to prior periods’ financial statements of changes in accounting principle, unless it is impractical to determine either the period-specific effects or the cumulative effect of the change. The adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.

FIN No. 47, Accounting for Conditional Asset Retirement Obligations—an interpretation of FASB Statement No. 143, clarifies that the term conditional asset retirement obligation as used in SFAS No. 143 refers to a legal obligation to perform an asset retirement activity in which the timing and (or) method of settlement are conditional on a future event that may or may not be within the control of the entity. The interpretation also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement

obligation. The adoption of this statement did not have a material impact on the Company’s financial position or results of operation.

SOP 05-01, Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection

With Modifications or Exchanges of Insurance Contracts, provides guidance on accounting for deferred acquisition costs on internal replacements of insurance and investment contracts other than those specifically described in SFAS No. 97. The SOP defines an internal replacement as a modification in product benefits, features, rights, or coverages that occurs by the exchange of a contract for a new contract, or by amendment, endorsement, or rider to a contract, or by the election of a feature or coverage within a contract. This SOP is effective for internal replacements occurring in fiscal years beginning after December 15, 2006, with earlier

42

NOTE 1 - SIGNIFICANT ACCOUNTING POLICIES – CONTINUED

adoption encouraged. The adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.

NOTE 2 – VARIABLE INTEREST ENTITIES

In December 2003, the FASB issued Revised FIN 46 (FIN 46R) to clarify certain aspects of

FIN 46 including the determination of who is the primary beneficiary of a variable interest entity (VIE). FIN 46R postponed the effective date as to when companies are required to apply the provisions prospectively for all variable interest entities in existence prior to January 31, 2003 until the first financial reporting period that ends after March 15, 2004. However, for entities that are considered to be special purpose entities, the effective date of FIN 46R is financial reporting periods after December 15, 2003. The Company does not have an interest in any special purpose entities. The Company consolidated its affiliate, Mobile Attic, Inc., upon adoption of FIN 46R in the first quarter 2004 due to the Company’s guarantee of Mobile Attic’s line of credit. The consolidation of Mobile Attic increased total assets by approximately $15 million and total liabilities by approximately $13 million. There was no effect on total shareholders’ equity. The consolidation of Mobile Attic did not have a material impact on the results of operations as the Company previously accounted for the investment under the equity method. See Note 17 for additional information related to the VIE.

In December 2005, the Company formed National Security Capital Trust I (the Trust), a statutory trust created under the Delaware Statutory Trust Act, for the sole purpose of issuing, in private placement transactions, $9 million 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 $9.3 million 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 million. 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 8 are reported in the accompanying Consolidated Balance Sheet as a component of long-term debt. The Company’s equity investments in the Trusts total $279,000 and are included in Other Assets.

NOTE 3 - STATUTORY ACCOUNTING PRACTICES

The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles (GAAP) which vary in certain respects from reporting practices prescribed or permitted by insurance regulatory authorities. The significant differences for statutory reporting include: (a) acquisition costs of acquiring new business are charged to operations as incurred, (b) life policy liabilities are established utilizing interest and mortality factors specified by regulatory authorities, (c) the Asset Valuation Reserve (AVR) and the Interest Maintenance Reserve (IMR) are recorded as liabilities, and (d) non-admitted assets (furniture and equipment, agents’ debit balances and prepaid expenses) are charged directly to surplus.

Statutory net gains from operations and capital and surplus, excluding intercompany transactions, are summarized as follows:

43

NOTE 3 - STATUTORY ACCOUNTING PRACTICES – CONTINUED

			2005		2004		2003
	NSIC - including realized capital (losses) gains of $129, $(56), and $287, respectively	$	(101)	$	291	$	7
	NSFC - including realized capital gains of $3,098, $1,847, and $203, respectively	$	729	$	2,164	$	2,526
	Omega - including realized capital gains of $180, $35, and $257, respectively	$	645	$	667	$	779
Statutory risk-based adjusted capital:
	NSIC - including AVR of $845, $1,153, and $1,180, respectively	$	10,776	$	11,451	$	11,375
	NSFC	$	27,209	$	23,766	$	23,104
	Omega	$	8,016	$	7,573	$	6,691

The above amounts exclude allocation of overhead from the Company. NSIC, NSFC and Omega are in compliance with statutory restrictions with regard to minimum amounts of surplus and capital.

44

NOTE 4 - INVESTMENT SECURITIES

The amortized cost and aggregate fair values of investments in securities are as follows:

				(Dollars in thousands)
				December 31, 2005
						Gross		Gross
				Amortized		Unrealized		Unrealized		Fair
				Cost		Gains		Losses		Value
Available-for-sale securities:
	Corporate debt securities		$	8,958	$	148	$	121	$	8,985
	Obligations of states and political subdivisions			6,519		134		101		6,552
	U.S. Treasury securities and obligations of
		U.S. government corporations and agencies		41,227		114		754		40,587
Total fixed maturities				56,704		396		976		56,124
Equity securities				6,374		9,192		397		15,169
		Total	$	63,078	$	9,588	$	1,373	$	71,293
Held-to-maturity securities:
	Corporate debt securities		$	244	$	-	$	47	$	197
	Obligations of states and political subdivisions			2,280		7		66		2,221
	U.S. Treasury securities and obligations of
		U.S. government corporations and agencies		16,307		9		530		15,786
		Total	$	18,831	$	16	$	643	$	18,204
				December 31, 2004
						Gross		Gross
				Amortized		Unrealized		Unrealized		Fair
				Cost		Gains		Losses		Value
Available-for-sale securities:
	Corporate debt securities		$	10,379	$	473	$	23	$	10,829
	Obligations of states and political subdivisions			9,609		446		93		9,962
	U.S. Treasury securities and obligations of
		U.S. government corporations and agencies		30,176		155		233		30,098
Total fixed maturities				50,164		1,074		349		50,889
Equity securities				8,995		11,590		412		20,173
		Total	$	59,159	$	12,664	$	761	$	71,062
Held-to-maturity securities:
	Obligations of states and political subdivisions		$	2,279	$	18	$	33	$	2,264
	U.S. Treasury securities and obligations of
		U.S. government corporations and agencies		18,001		53		351		17,703
		Total	$	20,280	$	71	$	384	$	19,967

45

NOTE 4 - INVESTMENT SECURITIES – CONTINUED

The amortized cost and aggregate fair value of debt securities at December 31, 2005, by contractual maturity, are as follows. 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	Fair
Available-for-sale securities:			Cost	Value
	Due in one year or less	$	583	585
	Due after one year through five years		19,207	19,182
	Due after five years through ten years		15,989	15,781
	Due after ten years		20,925	20,576

	Total	$	56,704	$	56,124
Held-to-maturity securities:
	Due in one year or less	$	-		-
	Due after one year through five years		2,425		2,323
	Due after five years through ten years		6,761		6,498
	Due after ten years		9,645		9,383
	Total	$	18,831	$	18,204

For 2005, gross gains of $3,793,000 ($2,219,000 for 2004 and $2,266,000 for 2003) and gross losses of $66,000 ($130,000 for 2004 and $858,000 for 2003) were realized on sales of available-for-sale-securities.

A summary of securities available-for-sale with unrealized losses as of December 31, 2005 and 2004 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)								December 31, 2005
			Less than 12 months				12 months or longer				Total
					Gross				Gross				Gross	Total
			Fair		Unrealized		Fair		Unrealized		Fair		Unrealized	Securities in a
			Value		Losses		Value		Losses		Value		Losses	Loss Position
Fixed maturities
	Corporate	$	-	$	-	$	3,562	$	121	$	3,562	$	121	16
	Obligations of state and
	political subdivisions		-		-		3,424		101		3,424		101	17
	U.S. Treasury securities and
	obligations of U.S. government
	corporations and agencies		-		-		33,426		754		33,426		754	78
Equity securities			-		-		998		397		998		397	7
		$	-	$	-	$	41,410	$	1,373	$	41,410	$	1,373	118

46

NOTE 4 - INVESTMENT SECURITIES – CONTINUED

			(Dollars in thousands)								December 31, 2004
			Less than 12 months				12 months or longer					Total
					Gross				Gross					Gross	Total
			Fair		Unrealized		Fair		Unrealized			Fair		Unrealized	Securities in a
			Value		Losses		Value		Losses			Value		Losses	Loss Position
Fixed maturities
	Corporate	$	542	$	11	$	542	$	11	$		1,084	$	22	6
	Obligations of state and
	political subdivisions		1,457		20		3,489		74			4,946		94	9
	U.S. Treasury securities and
	obligations of U.S. government
	corporations and agencies		6,561		78		9,533		154			16,094		232	52
Equity securities			576		23		774		390			1,350		413	8
		$	9,136	$	132	$	14,338	$	629	$		23,474	$	761	75

A summary of securities held-to-maturity with unrealized losses as of December 31, 2005 and 2004 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)							December 31, 2005
			Less than 12 months				12 months or longer					Total
					Gross				Gross					Gross	Total
			Fair		Unrealized		Fair		Unrealized			Fair		Unrealized	Securities in a
			Value		Losses		Value		Losses			Value		Losses	Loss Position
Fixed maturities
	Corporate	$	-	$	-	$	244	$	47		$	244	$	47	1
	Obligations of state and
	political subdivisions		-		-		2,078		66			2,078		66	8
	U.S. Treasury securities and
	obligations of U.S. government
	corporations and agencies		-		-		15,203		530			15,203		530	43
		$	-	$	-	$	17,525	$	643		$	17,525	$	643	52
			(Dollars in thousands) December 31, 2004
			Less than 12 months				12 months or longer					Total
					Gross				Gross					Gross	Total
			Fair		Unrealized		Fair		Unrealized			Fair		Unrealized	Securities in a
			Value		Losses		Value		Losses			Value		Losses	Loss Position
Fixed maturities
	Corporate	$	-	$	-	$	-	$	-		$	-	$	-	-
	Obligations of state and
	political subdivisions		-		-		789		33			789		33	3
	U.S. Treasury securities and
	obligations of U.S. government
	corporations and agencies		-		-		14,718		351			14,718		351	33
		$	-	$	-	$	15,507	$	384		$	15,507	$	384	36

47

NOTE 4 - INVESTMENT SECURITIES – CONTINUED

All unrealized losses are reviewed to determine whether the losses are other than temporary. Factors considered include whether the securities are backed by the U.S. Government or its agencies and concerns surrounding the recovery of full principal. Management believes the unrealized losses are market driven and no ultimate loss will occur.

NOTE 5 - NET INVESTMENT INCOME

Major categories of investment income are summarized as follows:

		(Dollars in thousands)
		Year ended December 31,
			2005		2004		2003
Fixed maturities		$	3,505	$	3,704	$	3,618
Equity securities			408		503		528
Mortgage loans on real estate			22		18		19
Investment real estate			23		15		103
Policy loans			56		2		32
Other, principally short-term investments			95		223		(16)
			4,109		4,465		4,284
Less: Investment expenses			145		235		261
Net investment income		$	3,964	$	4,230	$	4,023
An analysis of investment gains follows:		Year ended December 31,
			2005		2004		2003
Net realized investment gains (losses):
	Fixed maturities	$	132	$	431	$	627
	Other, principally equity securities		3,595		1,731		789
		$	3,727	$	2,162	$	1,416

An analysis of the net (decrease) increase in unrealized appreciation on available-for-sale securities follows:

		Year ended December 31,
			2005		2004		2003
Net (decrease) increase in unrealized appreciation on available-
	for-sale securities before deferred tax	$	(3,689)	$	(339)	$	2,520
Deferred income tax			1,145		114		(862)
Net (decrease) increase in unrealized appreciation on available-
	for-sale securities	$	(2,544)	$	(225)	$	1,658

48

NOTE 6 - PROPERTY AND EQUIPMENT

At December 31, property and equipment consisted of the following:

		(Dollars in Thousands)
		2005		2004
Building and improvements	$	1,945	$	1,876
Electronic data processing equipment		2,027		1,936
Leasing equipment		10,955		15,077
Furniture and fixtures		1,098		1,076
		16,025		19,965
Less accumulated depreciation		3,632		3,058
	$	12,393	$	16,907

Depreciation expense for the year ended December 31, 2005 was $905,000 ($805,000 for the year ended December 31, 2004 and $686,000 for the year ended December 31, 2003).

NOTE 7 - INCOME TAXES

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

	(Dollars in thousands)
	Year ended December 31,
		2005		2004		2003
Federal income tax rate applied to pre-tax income	$	816	$	1,310	$	1,927
Dividends received deduction and tax-exempt interest		(183)		(196)		(176)
Small life insurance company deduction		-		-		(18)
Other, net		72		(268)		(168)
Federal income tax expense	$	705	$	846	$	1,565

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.

49

NOTE 7 - INCOME TAXES – CONTINUED

The tax effect of significant differences representing deferred tax assets and liabilities are as follows:

		(Dollars in Thousands)
		December 31,
		2005			2004
General insurance expenses			$	1,233		$	1,178
Unearned premiums				1,061			973
Claim liabilities				255			299
Policy liabilities				70			140
	Deferred tax assets			2,619			2,590
Depreciation				(534)			(448)
Deferred policy acquisition costs				(2,233)			(2,116)
Unrealized gains on securities available-for-sale				(2,354)			(3,499)
	Deferred tax liabilities			(5,121)			(6,063)
Net deferred tax liability			$	(2,502)		$	(3,473)

The appropriate income tax effects of changes in temporary differences are as follows:

	Year ended December 31,
		2005		2004		2003
Deferred policy acquisition costs	$	117	$	138	$	196
Policy liabilities		70		69		70
Unearned premiums		(88)		(65)		(263)
General insurance expenses		(55)		(71)		(306)
Alternative minimum tax credit carryforwards		-		-		-
Depreciation		86		313		135
Claim liabilities		44		(20)		30
	$	174	$	364	$	(138)

Under pre-1984 life insurance company tax laws, a portion of NSIC’s gain from operations was not subject to current income taxation, but was accumulated for tax purposes in a memorandum account designated “policyholders’ surplus”. The aggregate balance in this account, $3,720,000 at December 31, 2005, would be taxed at current rates only if distributed to shareholders or if the account exceeded a prescribed minimum. The Deficit Reduction Act of 1984 eliminated additions to policyholders’ surplus for 1984 and thereafter. Deferred taxes have not been provided on amounts designated as policyholders’ surplus. The deferred income tax liability not recognized is approximately $1,270,000 at December 31, 2005.

50

NOTE 8 –LONG-TERM DEBT

Long-term debt consisted of the following as of December 31:

		(Dollars in thousands)
		2005		2004
Subordinated debentures issued on December 15, 2005 with fixed interest rate of 8.83% each distribution period thereafter until December 15, 2015 when the coupon rate shall equal the 3-month LIBOR plus 3.75% applied to the outstanding principal;
maturity December, 2035. Interest payments due quarterly. Unsecured	$	9,279	$	-
Note payable to bank with an interest rate based on LIBOR
(7.12% at December 31, 2005 and 5.15% at December 31, 2004)
dated March, 2002; maturity March, 2007. Payments of $112,953
due quarterly with balloon payment at maturity. Unsecured		2,439		2,731
Note payable to bank with an interest rate based on prime minus 25
basis points (7.00% at December 31, 2005 and 5.00% at December 31, 2004)
dated June, 2004; maturity June, 2007. Interest payments due quarterly.
Secured by $11,920 of leasing equipment.		11,188		13,105
	$	22,906	$	15,836

Aggregate maturities of long-term debt for each of the five years subsequent to December 31, 2005 are as follows (dollars in thousands): 2006-$280; 2007-$13,347; 2008-$0; 2009-$0; 2010-$0. The remaining $9,279 is due in 2035.

The subordinated debentures (debentures) have the same maturities and other applicable terms and features as the associated trust preferred securities (TPS). The debentures bear a fixed interest rate until December 15, 2015. Payment of interest may be deferred for up to 20 consecutive quarters; however, stockholder dividends cannot be paid during any extended interest payment period or any time the debentures are in default. All have stated maturities of thirty years but may be redeemed at any time following the tenth anniversary of issuance. None of the securities require the Company to maintain minimum financial covenants. The Company has guaranteed that amounts paid to the Trust (discussed in Note 2) will be remitted to the holders of the associated TPS. This guarantee, when taken together with the obligations of the Company under the debentures, the Indentures pursuant to which the debentures were issued, and the related trust agreement (including obligations to pay related trust fees, expenses, debt and other obligations with respect to the TPS), provides a full and unconditional guarantee of amounts due the Trust. The amount guaranteed is not expected to at any time exceed the obligations of the TPS, and no additional liability has been recorded related to the guarantee.

51

NOTE 9 - POLICY AND CLAIM RESERVES

The following table is a reconciliation of beginning and ending property and casualty reserve balances for claims and claim adjustment expense for the years ended December 31:

		(Dollars in thousands)
		2005		2004		2003
Claims and claim adjustment expense
reserves at beginning of year	$	13,094	$	11,343	$	11,513
Less reinsurance recoverables on
unpaid losses		2,611		1,232		1,555
Net balances at beginning of year		10,483		10,111		9,958
Provision for claims and claim adjustment
expenses for claims arising in current year		36,660		32,702		27,066
Estimated claims and claim adjustment
expenses for claims arising in prior years		(1,599)		(1,091)		(1,928)
Total increases		35,061		31,611		25,138
Claims and claim adjustment expense
payments for claims arising in:
Current year		29,168		25,837		19,892
Prior years		5,425		5,402		5,093
Total payments		34,593		31,239		24,985
Net balance at end of year		10,951		10,483		10,111
Plus reinsurance recoverables on
unpaid losses		8,560		2,611		1,232
Claims and claim adjustment expense
reserves at end of year	$	19,511	$	13,094	$	11,343

The provision for claims and claim adjustment expenses for prior years (net of reinsurance recoveries) decreased in 2005, 2004 and 2003 because of lower-than-anticipated losses primarily in homeowners and dwelling fire lines of business. As a result of changes in estimates of insured events in prior years, the provision for claims and claim adjustment expenses (net of reinsurance recoveries) decreased in 2005 by an additional $500,000.

The Company has a geographic exposure to catastrophe losses in certain areas of the country. Catastrophes can be caused by various events including hurricanes, windstorms, earthquakes, hail, severe winter weather, explosions and fires, and the incidence and severity of catastrophes are inherently unpredictable. The extent of losses from a catastrophe is a function of both the total amount of insured exposure in the area affected by the event and the severity of the event. Most catastrophe losses are restricted to small geographic areas; however, hurricanes and earthquakes may produce significant damage in large, heavily populated areas. The Company generally seeks to reduce its exposure to catastrophes through individual risk selection and the purchase of catastrophe reinsurance. At December 31, 2005, the Company’s estimate of unpaid losses and adjustment expenses for hurricane related claims incurred in 2005 totaled $11.7 million. Net of anticipated reinsurance recoveries, the estimate of unpaid loss and loss adjustment reserves for claims incurred in 2005 totaled $1.1 million at December 31, 2005.

NOTE 10 – REINSURANCE

The Company’s insurance operations participate in 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. Property and casualty reinsurance is placed on both a quota-share and excess of loss basis. Reinsurance ceded arrangements do not discharge the insurance subsidiaries as the primary insurer, except for cases involving a novation. Failure of reinsurers to honor their obligations could result in losses to the insurance subsidiaries. The

52

NOTE 10 – REINSURANCE – CONTINUED

insurance subsidiaries evaluate the financial conditions of their reinsurers and monitor concentrations of credit risk arising from similar geographic regions, activities, or economic characteristics of the reinsurers to minimize their exposure to significant losses from reinsurance insolvencies. At December 31, 2005, reinsurance receivables with a carrying value of $233,000 ($326,000 at December 31, 2004) and prepaid reinsurance premiums of $196,000 ($467,000 at December 31, 2004) were associated with a single reinsurer. The amounts of recoveries pertaining to reinsurance contracts that were deducted from losses incurred during 2005, 2004 and 2003 were approximately $32,613,000, $11,284,000, and $580,000, respectively. The significant increase in recoveries pertaining to reinsurance contracts in 2005 compared to prior years was due to reinsurance associated with losses incurred from hurricanes Katrina and Rita. The effect of reinsurance on premiums written and earned was as follows:

	(Dollars in Thousands)
	2005
	Life				Property & Casualty
	Written		Earned		Written			Earned
Direct	$	6,148	$	6,280	$	-	$	53,718
Assumed		-		-		-
Ceded		(46)		(46)		(6,117)		(6,389)
Net	$	6,102	$	6,234	$	(6,117)	$	47,329
	2004
	Life				Property & Casualty
	Written		Earned		Written			Earned
Direct	$	6,176	$	6,200	$	-	$	51,618
Assumed		-		-		-		-
Ceded		(27)		(27)		-		(4,806)
Net	$	6,149	$	6,173	$	-	$	46,812
	2003
	Life				Property & Casualty
		Written		Earned		Written		Earned
Direct	$	5,719	$	5,843	$	-	$	44,666
Assumed		-		-		-		500
Ceded		(44)		(44)		-		(3,429)
Net	$	5,675	$	5,799	$	-	$	41,737

53

NOTE 11 - EMPLOYEE BENEFIT PLAN

In 1989, the Company and its subsidiaries established a retirement savings plan (401K Plan) and transferred the assets from the defined contribution profit sharing plan into the new plan. All full-time employees who have completed one year of service at January 1 or July 1 are eligible to participate and all employee contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Company matching contributions for 2005, 2004, and 2003 amounted to $217,000, $189,000, and $228,000, respectively. The Company contributes matching contributions up to 5% of compensation subject to government limitations.

In 1987, the Company established a non-qualified deferred compensation plan for its Board of Directors. The Board members had an option of deferring their fees to a cash account or to a stock account and all share deferrals are recorded at the fair market value on the date of the award. Costs of the deferred compensation plan for 2005, 2004, and 2003 amounted to approximately ($259,000), $208,000, and $421,000, respectively. The directors’ non-qualified deferred compensation plan was frozen on December 31, 2004 and deferrals are no longer allowed. No deferrals of directors’ fees were allowed in 2005 prior to adoption of a new non-qualified plan. A new non-qualified plan became effective January 1, 2006 under which directors are allowed to defer all or a portion of directors’ fees into various investment options. Unlike the previous non-qualified plan, the Company is not exposed to any market risk for investment in the new non-qualified deferred compensation plan for directors. All directors fees for 2005 were paid in cash.

NOTE 12 - REGULATORY REQUIREMENTS AND DIVIDEND RESTRICTIONS

The amount of dividends paid from NSIC to the Company in any year may not exceed, without prior approval of regulatory authorities, the greater of 10% of statutory surplus as of the end of the preceding year, or the statutory net gain from operations for the preceding year. At December 31, 2005, NSIC’s retained earnings unrestricted for the payment of dividends in 2006 amounted to $993,000.

NSFC is similarly restricted in the amount of dividends payable to the Company; dividends may not exceed the greater of 10% of statutory surplus as of the end of the preceding year, or net income for the preceding year. At December 31, 2005, NSFC’s retained earnings unrestricted for the payment of dividends in 2006 amounted to $2,721,000.

At December 31, 2005, securities with market values of $3,780,000 ($3,655,000 at December 31, 2004) were deposited with various states pursuant to statutory requirements.

Under applicable Alabama insurance laws and regulations, NSFC is required to maintain a minimum total surplus (to include both paid-in and contributed and unassigned surplus) of $100,000.

Under applicable Alabama insurance laws and regulations, NSIC is required to maintain a minimum total surplus (to include both paid-in and contributed and unassigned surplus) of $200,000.

Under applicable Alabama insurance laws and regulations, Omega is required to maintain a minimum total surplus (to include both paid-in and contributed and unassigned surplus) of $600,000.

NOTE 13 - SHAREHOLDERS’ EQUITY

Preferred Stock

The 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.

54

NOTE 13 - SHAREHOLDERS’ EQUITY – CONTINUED

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.

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 distributed among the holders of both classes of common stock, except as may otherwise be provided in any such resolution or resolutions.

NOTE 14 - INDUSTRY SEGMENTS

The Company and its subsidiaries operate primarily in the insurance industry. Premium revenues and operating income by industry segment for the years ended December 31, 2005, 2004 and 2003 are summarized below:

(Dollars in thousands)
			Total		P&C Operations		Life Insurance Operations		Non-Insurance Operations
Year ended December 31, 2005
Revenues
	Net premiums earned	$	53,563	$	47,329	$	6,234	$	-
	Net investment income		3,964		2,323		1,619		22
	Net realized investment gains		3,727		3,278		215		234
	Net revenues from leasing operations		3,360		-		-		3,360
	Other income (loss)		1,416		1,364		52		-
		$	66,030	$	54,294	$	8,120	$	3,616
Income (loss) before income taxes:		$	3,540	$	2,698	$	(271)	$	1,113
Interest expense			1,140		15		114		1,011
		$	2,400	$	2,683	$	(385)	$	102
Assets		$	139,226	$	74,967	$	45,565	$	18,694
Amortization of deferred policy aquisition costs		$	2,704	$	2,256	$	448	$	-
Depreciation expense		$	905	$	100	$	347	$	458
Capital expenditures		$	457	$	18	$	321	$	118

55

NOTE 14 - INDUSTRY SEGMENTS – CONTINUED

(Dollars in thousands)
			Total		P&C Operations		Life Insurance Operations		Non-Insurance Operations
Year ended December 31, 2004
Revenues
	Net premiums earned	$	52,985	$	46,812	$	6,173	$	-
	Net investment income		4,230		2,315		2,013		(98)
	Net realized investment gains		2,162		1,881		276		5
	Net revenues from leasing operations		2,459		-		-		2,459
	Other income (loss)		1,312		1,325		9		(22)
		$	63,148	$	52,333	$	8,471	$	2,344
Income (loss) before income taxes:		$	4,580	$	4,224	$	216	$	140
Interest expense			727		-		30		697
		$	3,853	$	4,224	$	186	$	(557)
Assets		$	128,631	$	65,462	$	45,947	$	17,222
Amortization of deferred policy acquisition costs		$	2,221	$	2,115	$	106	$	-
Depreciation expense		$	805	$	188	$	173	$	444
Capital expenditures		$	1,327	$	130	$	663	$	534
Year ended December 31, 2003
Revenues
	Net premiums earned	$	47,536	$	41,737	$	5,799	$	-
	Net investment income		4,023		2,131		1,865		27
	Net realized investment gains		1,416		460		956
	Net revenues from leasing operations		1,433		-		-		1,433
	Other income		1,395		1,383		12		-
		$	55,803	$	45,711	$	8,632	$	1,460
Income (loss) before income taxes:		$	6,260	$	5,720	$	563	$	(23)
Interest expense			632		-		34		598
		$	5,628	$	5,720	$	529	$	(621)
Assets		$	127,236	$	65,225	$	45,796	$	16,215
Amortization of deferred policy acquisition costs		$	1,825	$	1,727	$	98	$	-
Depreciation expense		$	686	$	74	$	312	$	300
Capital expenditures		$	8,079	$	118	$	645	$	7,316

56

NOTE 15 - CONTINGENCIES

Litigation

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.

On December 12, 2005, the United States District court for the Middle District of Alabama (the “Court”) entered an order preliminarily approving a proposed settlement of a case pending against a subsidiary of the Company styled Mary W. Williams, et al v. National Security Insurance Company (“Williams Litigation”) and preliminarily certifying such case as a class action. The Williams Litigation relates primarily to claims that a subsidiary of the Company sold industrial burial insurance policies to racial minorities on which it charged higher premiums or provided inferior benefits than premiums charged to or policy benefits provided to similarly situated non-minority policyholders. The Company’s subsidiary has not sold industrial burial insurance for more than 20 years. The proposed settlement provides for the Company’s subsidiary to, among other matters, provide additional policyholder benefits, including premiums adjustments and benefits enhancements on existing policies and additional benefits on matured policies and pay attorneys fees. The Company has previously established litigation reserves with respect to this matter and has taken a policy reserve charge with respect to adjustments to the subject policies that were voluntarily made in 2000. The costs associated with prospective enhancements will be based on actuarial analysis not yet completed and accordingly, no provision has yet been made for them. However, based on preliminary discussions with the Company’s independent consulting actuary and the Alabama Department of Insurance, it is believed that the necessary reserve adjustments in the subsidiary will not have a material adverse impact on the Company’s consolidated financial position.

The class, as preliminarily certified, would not permit any class members to opt out of the settlement and preliminarily enjoins all similar litigation against the Company’s subsidiary. In the settlement, the Company’s subsidiary denied all claims and allegations made in the lawsuit. The proposed settlement is subject to final approval by the Court following a fairness hearing which is presently scheduled to be held on May 11, 2006.

NSFC was named a defendant in a Washington County, Alabama action alleging fraud and bad faith in connection with a claim for wind damage to a mobile home. This action was settled in January 2004 under terms which required that the amount be kept confidential. The amount of this settlement has been reflected in the financial statements for the period ending December 31, 2003.

The company establishes and maintains reserves on contingent liabilities. 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.

NOTE 16 - SUPPLEMENTAL CASH FLOW INFORMATION

Cash paid for interest during 2005 was $1,139,000 ($645,000 in 2004, and $611,000 in 2003). Cash paid for income taxes in 2005 was $400,000 ($2,000,000 in 2004, and $400,000 in 2003). In 2003, Mobile Attic acquired $7,134,950 of assets through debt.

NOTE 17 - RELATED PARTY TRANSACTIONS

During the years ended December 31, 2005, 2004 and 2003 the Company’s affiliate Mobile Attic acquired $2,632,000; $1,389,000; and $7,200,000, respectively, of equipment from Cash Brothers Leasing, Inc. (Cash Brothers). The principal owners of Cash Brothers are also stockholders in Mobile Attic. Cash Brothers is also a distributor of the mobile storage units. During 2005, 2004 and 2003 Mobile Attic paid $103,000; $100,000; and

57

NOTE 17 - RELATED PARTY TRANSACTIONS – CONTINUED

$83,000, respectively, in commissions to Cash Brothers. At December 31, 2005 and 2004, Mobile Attic had accrued expenses due Cash Brothers of $16,000 and $22,000, respectively.

Mobile Attic also acquired $4,977,000 of equipment from Bridgeville Trailers during the year ended December 31, 2005. Two of the majority shareholders of Bridgeville Trailers each own 25% of Mobile Attic.

58

THE NATIONAL SECURITY GROUP, INC.
SCHEDULE I. SUMMARY OF INVESTMENTS (CONSOLIDATED)
(Dollars in Thousands)
				December 31, 2005						December 31, 2004
								Amount per						Amount per
						Fair		the Balance				Fair		the Balance
				Cost		Value		Sheet		Cost		Value		Sheet
Securities Held to Maturity:
	United States government		$	16,307	$	15,788	$	16,307	$	18,001	$	17,703	$	18,001
	States, municipalities and
		political subdivisions		2,280		2,220		2,280		2,279		2,264		2,279
	Public Utilities			-		-		-		-		-		-
	Industrial and Miscellaneous			244		196		244		-		-		-
	Total Securities Held to Maturity		$	18,831	$	18,204	$	18,831	$	20,280	$	19,967	$	20,280
Securities Available for Sale:
Equity Securities:
	Public utilities		$	314	$	724	$	724	$	368	$	818	$	818
	Banks and insurance companies			911		2,942		2,942		1,236		4,114		4,114
	Industrial and all other			5,150		11,503		11,503		7,391		15,241		15,241
	Total equity securities		$	6,375	$	15,169	$	15,169	$	8,995	$	20,173	$	20,173
Debt Securities:
	United States government		$	41,227	$	40,587	$	40,587	$	29,926	$	29,847	$	29,847
	States, municipalities and
		political subdivisions		6,519		6,552		6,552		9,608		9,962		9,962
	Public Utilities			398		405		405		707		728		728
	Industrial and Miscellaneous			8,560		8,580		8,580		9,923		10,352		10,352
	Total Debt Securities		$	56,704	$	56,124	$	56,124	$	50,164	$	50,889	$	50,889
	Total Available for Sale		$	63,079	$	71,293	$	71,293	$	59,159	$	71,062	$	71,062
	Total Securities			81,910		89,497		90,124		79,439		91,029		91,342
Receivable for securities				677		-		677		-		-		-
Note Receivable From Affiliate				-		-		-		-		-		-
Mortgage loans on real estate				387		-		387		238		-		238
Investment real estate				3,842		-		3,842		1,463		-		1,463
Policy loans				793		-		793		771		-		771
Other invested assets				2,605		-		2,605		2,973		-		2,973
Short term investments				699		-		699		250		-		250
		Total investments .	$	90,913	$	89,497	$	99,127	$	85,134	$	91,029	$	97,037

59

THE NATIONAL SECURITY GROUP, INC. (PARENT COMPANY)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
BALANCE SHEETS
(Amounts in thousands)
			December 31,
			2005		2004
Assets
	Cash	$	2,952	$	663
	Investment in subsidiaries (equity method)
	eliminated upon consolidation		51,470		48,739
	Other assets		2,025		1,425
	Total Assets	$	56,447	$	50,827
Liabilities and Shareholders’ Equity
	Accrued general expenses	$	1,174	$	1,420
	Notes Payable		11,717		2,731
	Total Liabilities	$	12,891	$	4,151
	Total Shareholders’ Equity	$	43,556	$	46,676
	Total Liabilities and Shareholders’ Equity	$	56,447	$	50,827

60

THE NATIONAL SECURITY GROUP, INC. (PARENT COMPANY)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF INCOME
(Amounts in thousands)
			For the Years Ended December 31,
			2005		2004		2003
Income
	From subsidiaries-eliminated upon consolidation
	Dividends	$	2,500	$	2,800	$	2,300
	Other Income		395		381		142
			2,895		3,181		2,442
Expenses
	State taxes		24		7		19
	Other expenses		483		722		1,003
			507		729		1,022
Income before income taxes and equity in
	undistributed earnings of subsidiaries		2,388		2,452		1,420
Income tax expense (benefit)			105		(357)		(214)
Income before equity in undistributed earnings
	of subsidiaries		2,283		2,809		1,634
Equity in undistributed (losses) earnings of subsidiaries			(725)		304		2,456
	Net Income	$	1,558	$	3,113	$	4,090

61

THE NATIONAL SECURITY GROUP, INC. (PARENT COMPANY)
SCHEDULE II - CONDENSED FINANCIAL INFORMATION OF REGISTRANT
STATEMENTS OF CASH FLOWS
(Amounts in thousands)
			For the Years Ended December 31,
			2005		2004		2003
Cash flows from operating activities:
Net income		$	1,558	$	3,113	$	4,090
Adjustments to reconcile net income to net
cash provided by operating activities:
Equity in undistributed (income) loss of subsidiaries			725		(304)		(2,456)
Change in other assets			(321)		(24)		339
Change in other liabilities			(246)		105		275
	Net cash provided by
	operating activities		1,716		2,890		2,248
Cash flows from investing activities:
Capital contribution to subsidiary			(6,000)		-		-
	Net cash (used in)
	investing activities		(6,000)		-		-
Cash flows from financing activities:
Proceeds from notes payable			9,279		-		-
Payments on notes payable			(572)		(328)		(321)
Cash dividends			(2,134)		(2,084)		(2,035)
	Net cash provided by (used in)
	financing activities		6,573		(2,412)		(2,356)
Net increase (decrease) in cash and cash equivalents			2,289		478		(108)
Cash at beginning of year			663		185		293
Cash at end of year		$	2,952	$	663	$	185

62

THE NATIONAL SECURITY GROUP, INC. (PARENT COMPANY)
Notes to Condensed Financial Information of Registrant
Note 1-Basis of Presentation
	Pursuant to the rules and regulations of the Securities and Exchange Commission, the Condensed
	Financial Information of the Registrant does not include all of the information and notes normally
	included with financial statements prepared in accordance with generally accepted accounting
	principles. It is, therefore, suggested that this Condensed Financial Information be read in
	conjunction with the Consolidated Financial Statements and Notes thereto included in the
	Registrant’s Annual Report as referenced in Form 10-K, Part II, Item 8, page 31.
Note 2-Cash Dividends from Subsidiaries
	Dividends of $2.5 million in 2005, $2.8 million in 2004 and $2.3 million in 2003 were paid to the
	Registrant by its subsidiaries.

63

THE NATIONAL SECURITY GROUP, INC.
SCHEDULE III SUPPLEMENTARY INSURANCE INFORMATION (CONSOLIDATED)
(Amounts in thousands)
									Deferred		Future
									Acquisition		Policy		Unearned
									Costs		Benefits		Premiums
At December 31, 2005:
	Life and accident and health insurance							$	4,089	$	25,478	$	-
	Property and casualty insurance								2,478		-		15,791
	Total							$	6,567	$	25,478	$	15,791
At December 31, 2004:
	Life and accident and health insurance							$	3,961	$	24,834	$	-
	Property and casualty insurance								2,256		-		14,779
	Total							$	6,217	$	24,834	$	14,779
At December 31, 2003:
	Life and accident and health insurance							$	3,702	$	23,742	$	-
	Property and casualty insurance								2,115		-		13,750
	Total							$	5,817	$	23,742	$	13,750
											Commissions,
									Benefits,		Amortization		General
									Claims,		of Deferred		Expenses,
					Net				Losses and		Policy		Taxes,
			Premium		Investment		Other		Settlement		Acquisition		Licenses
			Revenue		Income		Income		Expenses		Costs		and Fees
For the year ended December 31, 2005:
	Life and accident and health insurance	$	6,234	$	1,619	$	52	$	3,904	$	1,833	$	3,525
	Property and casualty insurance		47,329		2,323		1,364		34,337		9,858		6,657
	Other		-		22		-		-		-		3,516
	Total	$	53,563	$	3,964	$	1,416	$	38,241	$	11,691	$	13,698
For the year ended December 31, 2004:
	Life and accident and health insurance	$	6,173	$	2,013	$	9	$	4,130	$	1,578	$	3,268
	Property and casualty insurance		46,812		2,315		1,325		30,937		9,289		6,909
	Other		-		(98)		(22)		-		-		3,184
	Total	$	52,985	$	4,230	$	1,312	$	35,067	$	10,867	$	13,361
For the year ended December 31, 2003:
	Life and accident and health insurance	$	5,799	$	1,865	$	11	$	2,952	$	1,948	$	3,040
	Property and casualty insurance		41,737		2,131		1,384		24,593		8,778		6,482
	Other		-		27		-		-		-		1,022
	Total	$	47,536	$	4,023	$	1,395	$	27,545	$	10,726	$	11,904

64

THE NATIONAL SECURITY GROUP, INC.
SCHEDULE IV. REINSURANCE (CONSOLIDATED)
(Amounts in thousands)
										Percentage
					Ceded		Assumed			of Amount
			Gross		to Other		from Other		Net	Assumed
			Amount		Companies		Companies		Amount	to Net
For the year ended December 31, 2005:
Life insurance in force		$	217,152	$	13,541	$	-	$	203,611	0.00%
Premiums:
	Life insurance and accident and health insurance		6,280		46		-		6,234	0.00%
	Property and casualty insurance		53,718		6,389		-		47,329	-
	Total premiums	$	59,998	$	6,435	$	-	$	53,563	0.00%
For the year ended December 31, 2004:
Life insurance in force		$	186,474	$	8,441	$	-	$	178,033	0.00%
Premiums:
	Life insurance and accident and health insurance		6,200		27		-		6,173	0.00%
	Property and casualty insurance.		51,676		4,864		-		46,812	-
	Total premiums	$	57,876	$	4,891	$	-	$	52,985	0.00%
For the year ended December 31, 2003:
Life insurance in force		$	186,555	$	7,803	$	-	$	178,752	0.00%
Premiums:
	Life insurance and accident and health insurance		5,844		45		-		5,799	0.00%
	Property and casualty insurance		44,360		3,123		500		41,737	1.20%
	Total premiums	$	50,204	$	3,168	$	500	$	47,536	1.20%

65

Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

None.

Item 9A. Controls and Procedures

Company management, including the Chief Executive Officer and Chief Financial Officer, have conducted an evaluation of the effectiveness of disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures are effective in ensuring that all material information required to be filed in this quarterly report has been made known to them in a timely fashion. There have been no significant changes in internal controls, or in factors that could significantly affect internal controls, subsequent to the date the Chief Executive Officer and Chief Financial Officer completed their evaluation.

The National Security Group, Inc., as a non-accelerated filer, must be in compliance with Section 404 of The Sarbanes-Oxley Act for yearend 2007. Management is currently performing documentation procedures in preliminary assessment on internal controls over financial reporting in order to document and evaluate the current controls in place in order to form a basis for future testing required for compliance with Section 404 of the Sarbanes-Oxley Act. In the past, management has relied on existing controls although said controls may not have been in unabridged written form.

Item 9B. Other Information

None

PART III

Item 10. Directors and Executive Officers of the Registrant

The information contained on pages 4-5 of The National Security Group’s Proxy Statement dated April 4, 2006, with respect to directors and executive officers of the Company, is incorporated herein by reference in response to this item.

Item 11. Executive Compensation

The information contained on pages 9 and 10 of The National Security Group’s Proxy Statement dated April 4, 2006, with respect to executive compensation and transactions, is incorporated herein by reference in response to this item.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The information contained on page 12 of The National Security Group’s Proxy Statement dated April 4, 2006, with respect to security ownership of certain beneficial owners and management, is incorporated herein by reference to this item.

Item 13. Certain Relationships and Related Transactions

The information contained on page 7 of The National Security Group’s Proxy Statement dated April 4, 2006, with respect to certain relationships and related transactions, is incorporated herein by reference in response to this item.

66

Item 14. Principal Accountant Fees and Services

The information contained on page 8 of The National Security Group’s Proxy Statement dated April 4, 2006, with respect to principal accountant fees and services, is incorporated herein by reference in response to this item.

67

68

PART IV

Item 15 (a) (1) Exhibits and Financial Statement Schedules

The following consolidated financial statements, notes thereto and related information of The National Security Group, Inc. (the “Company”) are included in Item 8 beginning on page 31.

Report of Independent Registered Public Accounting Firm

Consolidated Statements of Income

Consolidated Balance Sheets

Consolidated Statements of Shareholders’ Equity

Consolidated Statements of Cash Flows

Consolidated Notes to the Financial Statements

Item 15 (a) (2)

The following additional financial statement schedules and report of independent registered accounting firm are furnished herewith pursuant to the requirements of Form 10-K.

The National Security Group, Inc.		Page
Schedule I	Summary of Investments	59
Schedule II	Condensed Financial Information of the Registrant	60
Schedule III	Supplementary Insurance Information (Consolidated)	64
Schedule IV	Reinsurance (Consolidated)	65

Item 15 (a) (3)

The following is a list of the exhibits filed as part of this Form 10-K:

3. Amended Certificate of Incorporation filed with the Secretary of State of Delaware on August 2, 2004 and By-Laws.

11.	Computation of Earnings Per Share Filed Herewith, See Note 1 to Consolidated Financial
		Statements

14. Code of Ethics, see additional information on page 9 of this report.

21. Subsidiaries of the registrant.

31.1      Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 302 of the

Sarbanes-Oxley Act of 2002

31.2      Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 302 of the

Sarbanes-Oxley Act of 2002

32.1      Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 906 of the

Sarbanes-Oxley Act of 2002

32.1.1Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 906 of the

Sarbanes Oxley Act of 2002

68

Item 15 (b)

During the last fiscal quarter of the period covered by this Report, the Company filed the following Current Reports on Form 8-K:

Date of Report	Date Filed	Description
November 11, 2005	November 14, 2005	Press release, dated November 11, 2005, issued by The National Security Group, Inc.
November 14, 2005	November 15, 2005	Press release, dated November 14, 2005, issued by The National Security Group, Inc.
December 6, 2005	December 12, 2005	Entry into a material definitive agreement.
December 12, 2005	December 15, 2005	Other Events

69

SIGNATURE

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

THE NATIONAL SECURITY GROUP, INC.

/s/ Brian R. McLeod	/s/ William L. Brunson, Jr.
Brian R. McLeod	William L. Brunson, Jr.
Chief Financial Officer and Treasurer	President, Chief Executive Officer and Director

Date: March 24, 2006

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in their capacity as a Director of The National Security Group, Inc. on March 31, 2006.

SIGNATURE

/s/ Winfield Baird	/s/ Mickey L. Murdock
/s/ Carolyn Brunson	/s/ Donald Pittman
/s/ Jack E. Brunson	/s/ Fleming Brooks
/s/ William L. Brunson, Jr.	/s/ Paul C. Wesch
/s/ Fred D. Clark, Jr.	/s/ L. Brunson White
/s/ Frank B. O’Neil	/s/ Walter P. Wilkerson

70

Certification Chief Executive Officer The National Security Group, Inc.

Exhibit 31.1

CERTIFICATION

I, William L. Brunson, Jr. certify that:

1. I have reviewed this annual report on Form 10-K of The National Security Group, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 24, 2006

/S/ William L. Brunson Jr.

William L. Brunson, Jr.

Chief Executive Officer

71

Certification Chief Financial Officer The National Security Group, Inc.

Exhibit 31.2

CERTIFICATION

I, Brian R. McLeod, certify that:

1. I have reviewed this annual report on Form 10-K of The National Security Group, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(c) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 24, 2006

/S/ Brian R. McLeod

Brian R. McLeod, CPA

Chief Financial Officer

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Certification Chief Executive Officer The National Security Group, Inc.

EXHIBIT 32.1

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

Exhibit 32.1 Certification of Chief Executive Officer

Pursuant to 18 U.S.C. § 1350, the undersigned officer of the National Security Group, Inc. (the “Company”), hereby certifies, to such officer’s knowledge, that the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005 (the “Report”) fully complies with the requirements of Section 13(a) or 15 (d), as applicable, of the Securities Exchange Act of 1934 and the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: March 24, 2006	/S/ William L. Brunson Jr.
	Name: William L. Brunson, Jr. Title: Chief Executive Officer

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Certification of Chief Financial Officer The National Security Group, Inc.

EXHIBIT 32.2

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

Exhibit 32.2 Certification of Chief Financial Officer

Pursuant to 18 U.S.C. § 1350, the undersigned officer of The National Security Group, Inc. (the “Company”), hereby certifies, to such officer’s knowledge, that the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2005 (the “Report”) fully complies with the requirements of Section 13(a) or 15 (d), as applicable, of the Securities Exchange Act of 1934 and the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Date: March 24, 2006	/S/ Brian R. McLeod
	Name: Brian R. McLeod, CPA Title: Chief Financial Officer

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