NATIONAL SECURITY GROUP INC – 10-Q – Management’s Discussion and Analysis of Financial Condition and Results of Operations

Overview

 The following discussion addresses the financial condition of The National Security Group, Inc. (referred to in this document as we, our, us, the Company or NSEC) as of March 31, 2013, compared with December 31, 2012 and its results of operations and cash flows for the three months ended March 31, 2013, compared with the same period last year. This discussion and analysis should be read in conjunction with the unaudited consolidated financial statements and related notes thereto included in Part I, Item 1 of this report and with our audited consolidated financial statements and related notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2012. This discussion will primarily consist of an analysis of the two segments of our operations. The life segment consists of the operations of our life insurance subsidiary, National Security Insurance Company (NSIC). The property and casualty (P&C) segment consists of the operations of our two property and casualty insurance subsidiaries, National Security Fire & Casualty Company (NSFC) and Omega One Insurance Company (Omega). This discussion contains forward-looking statements that are not historical facts, including statements about our beliefs and expectations. These statements are based upon current plans, estimates and projections. Our actual results may differ materially from those projected in these forward-looking statements as a result of various factors. See "Cautionary Statement Regarding Forward-Looking Statements" contained on Page 3 of this report. The reader is assumed to have access to the Company's 2012 Annual Report. This discussion should be read in conjunction with the Annual Report and with the condensed consolidated financial information on pages 4 through 34 of this Form 10-Q.  

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

The National Security Group operates in the property and casualty and life, accident and supplemental health insurance businesses and markets products primarily through independent agents. The Company operates in eleven states with 49.3% of total premium revenue generated in the states of Alabama and Mississippi. Property and casualty insurance is the most significant segment, accounting for 86.5% of total insurance premium revenue for the first three months of 2013. Revenue generated from the life segment accounted for 13.5% of total insurance premium revenue for the first three months of 2013.  National Security Insurance Company (NSIC) is a life, accident and health insurance company founded in 1947. The premium revenue produced in NSIC from the traditional life products and accident and health products accounted for 10.0% and 3.5%, respectively, of total premium revenue. All references to NSIC in the remainder of this management discussion and analysis will refer to the combined life, accident and health insurance operations and will compose the life segment of the Company. NSIC is licensed to underwrite life and accident and health insurance in Alabama, Florida, Georgia, Mississippi, South Carolina, Tennessee and Texas.  The property and casualty segment consists of the consolidated operations of two subsidiaries, National Security Fire and Casualty Company and its wholly owned subsidiary, Omega One Insurance Company. There is no material product differentiation between the products underwritten by NSFC and Omega as both underwrite primarily dwelling personal lines coverage. The Property and Casualty segment has premium in-force in the states of Alabama, Arkansas, Florida (ocean marine only), Georgia, Louisiana, Mississippi, Oklahoma, South Carolina, Tennessee and Texas.  All of the insurance subsidiaries are Alabama domiciled insurance companies; therefore, the Alabama Department of Insurance is the primary insurance regulator. However, each subsidiary is subject to regulation by the respective insurance regulators of each state in which it is licensed to transact business. Insurance rates charged by each of the insurance subsidiaries are typically reviewed and approved by each insurance department for the respective state in which the rates will apply.  All of our insurance companies have been assigned ratings by A.M. Best. The property and casualty group has been assigned a group rating of "B++" (Good) with a negative outlook. In addition, A.M. Best has assigned an issuer credit rating of "bbb" with a negative outlook. NSFC, the largest of the insurance subsidiaries, carries the same A.M. Best ratings as the group. Omega carries an A.M. Best rating of "B+" (Good) with a stable outlook and an issuer credit rating of "bbb-" with a stable outlook. The life insurance subsidiary, NSIC, has been assigned a rating of "B+" (Good) with a stable outlook and an issuer credit rating upgrade of "bbb-" with a stable outlook. All ratings are reviewed at least annually by A.M. Best with the latest ratings' effective date of November 30, 2012.                                          36

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  The two primary segments in which we report insurance operations are the personal lines property and casualty segment (NSFC) and the life, accident and health insurance segment (NSIC). Due to the small amount of premium revenue produced by Omega and the fact that Omega is a wholly owned subsidiary of NSFC underwriting similar lines of business, all references to NSFC in the remainder of this management discussion and analysis will include the insurance operations of both NSFC and Omega. Our income is principally derived from net underwriting profits and investment income. Net underwriting profit is principally derived from earned premiums received less claims paid, sales commissions to agents, costs of underwriting and insurance taxes and fees. Investment income includes interest and dividend income and gains and losses on investment holdings.  The property and casualty segment can be impacted by severe storm activity resulting in incurred losses and loss adjustment expenses primarily from wind and hail related damage. These storm systems or other natural disasters are classified as catastrophes (referred to as "cat events" or "catastrophe events" throughout the remainder of this document) by Property Claim Service (PCS) when these events cause $25 million or more in industry wide direct insured losses and affect a significant number of policyholders and insurers.  

CONSOLIDATED RESULTS OF OPERATIONS

Summary:

 The Company ended the first quarter of 2013 with a net loss of $409,000 compared to net income of $531,000 for the same period last year; a decrease of $940,000. For the three months ended March 31, 2013, the Company had a net loss per share of $0.17 compared to net income per share of $0.22 for the three months ended March 31, 2012. The primary reason for the net loss in the current year compared to net income in the prior year was a $1,706,000 or 21.7% increase in claims in the first three months of 2013 compared to the same period last year. The increase in claims was primarily associated with an increase in losses and loss adjustment expenses reported in the P&C segment from catastrophe events (cat events) and non-catastrophe wind and hail claims compared to the same period last year. In addition, for the three months ended March 31, 2013, realized investment gains decreased 86.9%. Year to date net realized investment gains were $27,000 compared to $206,000 for the same period last year. The decrease in realized investment gains was primarily associated with a decline in trading activity in the investment portfolios during the first quarter of 2013 compared to the first quarter of 2012.  Claims were $9,551,000 for the three months ended March 31, 2013, compared to $7,845,000 for the same period last year, an increase of $1,706,000 or 21.7%. The loss ratio (claims as a percent of net earned premium) was 73.8% for the first three months of 2013 compared to 58.1% for the same period last year. The primary reason for the 15.7 percentage point increase in the loss ratio was an increase in incurred losses and incurred loss adjustment expenses in the P&C segment from cat events in 2013 compared to 2012. The P&C segment was impacted by three cat events during the first quarter of 2013 totaling $1,578,000 compared to $480,000 from two cat events in 2012. The cat events in 2013 added 12.1 percentage points to the current year loss ratio while the cat events in 2012 added 3.5 percentage points to the prior year loss ratio. In addition to the increase in claims from cat events, the P&C segment had an increase in claims resulting from non-catastrophe wind and hail losses and LAE in the first quarter of 2013 compared to the same period last year. The non-cat wind and hail losses totaled $2,142,000 in 2013 compared to $1,499,000 for the same period last year. These claims added 16.5 and 11.1 percentage points, respectively, to the 2013 and 2012 loss ratio.  Shareholders' equity as of March 31, 2013 was $30,334,000, up $107,000 compared to $30,227,000 as of December 31, 2012. Book value per share increased $0.05 per share for the period ended March 31, 2013 to $12.30 per share compared to $12.25 per share at December 31, 2012. Factors contributing to the change in equity were a year to date net loss of $409,000, increase in market values of fixed maturities and equity securities of $526,000, a net gain on interest rate swaps of $52,000 and dividends paid of $62,000.                                                    37

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  Premium Revenue: The table below provides earned premium revenue by segment for the for the three months ended March 31, 2013 and 2012:                                                    Three months ended                                                        March 31,                      Percent                                                  2013              2012         increase (decrease) Life, accident and health operations: Traditional life insurance                  $       1,316$      1,308                 0.6  % Accident and health insurance                         449              464                (3.2 )% Total life, accident and health                     1,765            1,772                (0.4 )%  Property and Casualty operations: Dwelling fire & extended coverage                   7,018            6,547                 7.2  % Homeowners (Including mobile homeowners)            5,681            5,904                (3.8 )% Ocean marine                                          256              268                (4.5 )% Other liability                                       373              340                 9.7  % Private passenger auto liability                        -              235              (100.0 )% Commercial auto liability                               -                6              (100.0 )% Auto physical damage                                    -              107              (100.0 )% Total property and casualty                        13,328           13,407                (0.6 )%  Gross premiums earned                              15,093           15,179               (0.57 )%  Reinsurance premium ceded                          (2,159 )         (1,683 )             28.28  %  Net premiums earned                         $      12,934$     13,496               (4.16 )%    Consolidated premium revenue was $12,934,000 for the three months ended March 31, 2013 compared to $13,496,000 for the same period last year; a decrease of $562,000 or 4.2%. There were two primary factors contributing to the decline in premium revenue:  

• We had no premium revenue from the automobile lines of business in 2013.

Due to adverse underwriting results, we made the decision to exit the auto

       insurance business and ceased writing new business during 2011 with        remaining in-force policies expiring in 2012.   

• We bought additional catastrophe reinsurance coverage in the second

quarter of 2012 which increased our annualized cat reinsurance cost by

approximately $1.3 million. The coverage was in the form of reinstatement

premium protection (RPP). We have historically bought catastrophe

reinsurance subject to a reinstatement provision which requires us to pay

the reinsurance premium again, to cover a second event, to the extent

reinsurance coverage layers are utilized. In 2012, we made the decision to

purchase RPP which, in substance, is a prepayment of the reinstatement

premium triggered by a second event. While this decision will increase our

catastrophe cost in years in which we have no catastrophe losses impacting

the cover, it will significantly reduce the uncertainty of reinstatement

cost in years in which we have major storms and help reduce earnings

volatility due to major catastrophes. The purchase of the RPP coverage

will allow us to better reflect the true cost of our reinsurance coverage

in our rates, and under a modeled 100 year catastrophe event, will reduce

the adverse impact on capital of the event by approximately $4,000,000.

    Investment income: Investment income decreased $51,000 to $1,084,000 for the three months ended March 31, 2013 from $1,135,000 for the same period last year. While invested assets increased moderately during the quarter, the continued record low interest rate environment is reducing the yield on new investments leading to the reduction in interest income.                                           38

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  Realized investment gains and losses: For the three months ended March 31, 2013, realized investment gains totaled $27,000 compared to $206,000 for the same period last year; a decrease of $179,000. Realized investment gains and losses in the life and P&C segments are primarily related to the sale of bonds and common stock investments. The decline in realized capital gains was primarily associated with a decline in trading activity in the investment portfolios.  Other income: Other income was $172,000 for the period ended March 31, 2013 compared to $197,000 for the period ended March 31, 2012; a decrease of 12.7%. Other income is primarily composed of billing, payment and policy fees associated with residential property and automobile policies issued in the P&C segment. Due to the discontinuation of the automobile program, billing, payment and policy fees decreased $26,000 in the P&C segment and was the primary reason for the overall reduction in other income for the current year.  Policyholder benefits paid: Policyholder benefits paid (claims) as a percent of net premiums earned were 73.8% for the three-months ended March 31, 2013 compared to 58.1% for the three months ended March 31, 2012. Policyholder benefits for the three months ended March 31, 2013 were $9,551,000 compared to $7,845,000 for the same period last year; an increase of 21.7%. The $1,706,000 increase in claims was primarily associated with increases in losses and LAE incurred in the P&C segment. Year-to-date incurred losses and LAE in the P&C segment increased $2,140,000 in 2013 compared to 2012 with claims incurred from current year cat events and non-catastrophe wind and hail losses and LAE being the primary drivers of the increase.  

The table below provides P&C segment reported losses and LAE by catastrophe event and non-catastrophe wind and hail losses and loss adjustment expenses (LAE) for the three months ended March 31, 2013 and 2012:

                          2013                                                      2012                           Reported                                                   Reported                         Losses & LAE      Claim Count                              Losses & LAE     Claim Count

Cat event                                                  Cat event Cat 91                $      228,000                44     Cat 65                $      154,000              44 Cat 92                        89,000                20     Cat 67                       326,000              97 Cat 93                     1,261,000               320                       $    1,578,000             384                             $      480,000             141  Non-cat wind & hail   $    2,142,000               756     Non-cat wind & hail   $    1,499,000             568     The P&C segment incurred claims from three storm systems categorized as catastrophes during the first quarter of 2013 compared to two cat events during the first quarter of 2012. The claims reported in 2013 from the three current year cat events totaled $1,578,000, resulted in 384 claims and added 12.1 percentage points to the loss ratio. The largest cat event in 2013 occurred in March and accounted for 80% of the total losses and LAE from first quarter 2013 cat events. This storm system impacted four states in which we write business in the P&C segment leading to over $1,261,000 in losses and LAE from 320 claims. Claims reported from the two 2012 cat events totaled $480,000, resulted in 141 claims and increased the loss ratio 3.5 percentage points. The average cost per claim from the 2013 cat events was $4,100 while the average cost per claim for 2012 was $3,400.  In addition to the cat events mentioned above, the P&C segment had increases in reported losses and LAE from non-catastrophe wind and hail losses and LAE during the first quarter of 2013 compared to the same period last year. During 2013, the P&C segment had 756 non-cat wind and hail claims reported totaling $2,142,000 compared to 568 claims totaling $1,499,000 during 2012. The current year non-cat wind and hail average cost per claim was approximately $2,800 compared to $2,600 for the same period last year. In addition, these claims added 16.5 percentage points to the current year loss ratio compared to 11.1 percentage points to the prior year loss ratio.                                          39

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  Policy acquisition cost (commissions and amortization of deferred acquisition cost): For the three months ended March 31, 2013, policy acquisition costs were $2,924,000 compared to $2,772,000 for the same period last year. Policy acquisition costs were 22.6% of premium revenue for the first quarter of 2013 compared to 20.5% for the same period last year. A reduction in capitalized cost, primarily in the life segment, was the primary factor contributing to the increase in policy acquisition cost in 2013 compared to 2012.  General Expenses: General expenses were down $646,000 for the three months ended March 31, 2013 at $1,842,000 compared to $2,488,000 for the same period last year. While general expenses were down in both segments, the P&C segment accounted for approximately 90% of the decline. The primary reason for the lower general expenses in the P&C segment in 2013 compared to 2012 was a $156,000 reduction in legal fees, a $77,000 decrease in salary expenses and a $38,000 reduction in inspection report fees. In addition, a $66,000 refund of guaranty association fees paid for previous year's assessments, further reduced current year general expenses. These decreases, combined with declines in various other general expense accounts, were the primary source of the overall reduction in P&C general expenses in 2013 compared to 2012. Management continues to focus on the reduction of general expenses through the utilization of various cost savings measures coupled with continued efforts to improve efficiency through the use of technology.  Litigation settlement and defense costs: Litigation costs were $0 for the three months ended March 31, 2013 compared to $589,000 for the same period last year. This line items isolates cost associated with Mobile Attic litigation which was settled in 2012. The primary reason for the decrease was that during the second quarter of 2012, the Company settled longstanding litigation related to the Company's sale of Mobile Attic, Inc. [See Note 14 to the condensed consolidated financial statements for further discussion regarding litigation].  Taxes, licenses and fees: Taxes, licenses and fees for the three months ended March 31, 2013 and 2012 were comparable at $486,000 and $492,000, respectively. Taxes, licenses and fees as a percentage of earned premiums were 3.8% for the three months ended March 31, 2013 and 3.6% for the same period last year.  Interest expense: Interest expense was up $150,000 or 51.4% at $442,000 through March 31, 2013 compared to $292,000 for the same period last year. The primary reason for the increase was the addition of $10.5 million in debt related to the Mobile Attic litigation settlement.  Income taxes: For the period ended March 31, 2013, income tax benefit was $619,000 compared to income tax expense of $25,000 for the same period last year. Income tax was composed of current income tax expense totaling $132,000 for the three months ended March 31, 2013 compared to a current income tax expense of $28,000 for the three months ended March 31, 2012. Deferred tax benefit totaled $751,000 for 2013 and $3,000 for 2012. A higher frequency of claims from cat events and non-catastrophe wind and hail losses and LAE in the P&C segment during the first quarter was the primary contributor to the 2013 tax benefit.  Net income (loss): The Company ended the first three months of 2013 with a year to date net loss of $409,000 compared to net income of $531,000 for the same period last year. As mentioned previously, the primary reasons for the net loss in 2013 compared to net income in 2012 were an 86.9% decrease in net realized investment gains and a 21.7% increase in claims. Realized investment gains were down due to a reduction in sales in the current year compared to the same period last year. In addition, claims were up $1,706,000 primarily due to an increase in P&C segment losses and LAE incurred during the first quarter of 2013 from cat events and non-catastrophe wind and hail claims compared to the same period last year.  Liquidity and capital resources: 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 effective maturities spread over periods usually not exceeding 10 years. The liabilities of the life insurance subsidiary are typically of a longer duration, and therefore, a higher percentage of securities in the life insurance subsidiary are invested for periods exceeding 10 years.                                         40

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   The liquidity requirements for the Company are primarily met by funds generated from operations of the life insurance and property/casualty insurance subsidiaries. All operations and virtually all investments are maintained by the 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 investments, and in the case of life insurance, policy loans.  

Virtually all invested assets of the Company are held in the insurance subsidiaries. As of March 31, 2013, the maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows (dollars in thousands):

                                 Available-                                               Percentage of           Maturity               for-Sale         Held-to-Maturity         Total             Total Maturity in less than 1 year $          581     $                -     $        581            0.76 % Maturity in 1-5 years                16,278                    384           16,662           21.82 % Maturity in 5-10 years               24,896                    109           25,005           32.75 % Maturity after 10 years              33,288                    821           34,109           44.67 %                              $       75,043     $            1,314     $     76,357          100.00 %   It should be noted that the above table represents maturities based on stated maturity. Due to call and prepayment features inherent in some debt securities, actual repayment, or effective maturities, will differ from stated maturities. The Company routinely evaluates the impact of changing interest rates on the projected maturities of bonds in the portfolio and actively manages the portfolio in order to minimize the impact of interest rate risk. However, if the current pattern of sustained period of record low interest rates persist, our investment income will be negatively impacted. Currently, for every 100 basis point change in interest rates, the Company will incur a change in market price of the fixed income portfolio of approximately 4.5%.  At March 31, 2013, the Company had aggregate equity capital, unrealized investment gains (net of income taxes) and retained earnings of $30,334,000, up $107,000 compared to $30,227,000 at December 31, 2012. Components of the change in equity were a net loss of $409,000, net unrealized gain on investments of $526,000</money>, a net unrealized gain of $52,000 related to interest rate swaps and cash dividends paid totaling $62,000.  The Company has $25,639,000 of long-term debt outstanding. Included in long-term debt held by the Company is the issuance of $9,279,000 in subordinated debentures completed 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. Also included in long-term debt is the issuance of $3,093,000 in subordinated debentures completed June 21, 2007. The proceeds from the debentures were used to fund general corporate purposes, thereby reducing the amount of dividends to the Group paid by the P&C subsidiary National Security Fire & Casualty in 2007 and 2008, thereby helping to restore capital in the P&C subsidiary National Security Fire and Casualty to pre-hurricane levels. The second issue matures June 15, 2037 and may be redeemed following the fifth anniversary of issuance. Also included in long-term debt held by the Company is a line of credit in the amount of $4,000,000 obtained in September 2012. The line of credit is secured by timber property and had $3,934,000 drawn at March 31, 2013. In July 2012, the Company executed an installment note in the amount of $13,000,000 to finance the settlement obligation related to the Mobile Attic litigation. As of March 31, 2013, a total of $10,500,000 was outstanding including a current installment due in November of 2013 of $1,167,000 included in notes payable.  The Company has $1,292,000 in short-term notes payable and current portion of long-term debt. This debt includes a $125,000 outstanding balance on a $700,000 operating line of credit to allow flexibility with respect to cash management at the holding company level. We had $575,000 available at March 31, 2013, under the operating credit line. Also included in short-term debt is the current amount due on long term notes payable of $1,167,000.  The Company, primarily through its insurance subsidiaries, had $2,725,000 in cash and cash equivalents at March 31, 2013, compared to $2,243,000 at March 31, 2012. Cash used in operations for the three months ended March 31, 2013 totaled $1,244,000, compared to cash used in the same period last year totaling $801,000.                                          41

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  At December 31, 2012, the Company had $6,779,000 in cash which was subsequently reduced by the purchase of available-for-sale securities, primarily fixed income investments. Net cash used in investing activities totaled $3,043,000 for the three months ended March 31, 2013, compared to $333,000 for the same period last year.  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. 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.  The Company's liquidity requirements are primarily met by funds provided from operations of the insurance subsidiaries. The Company receives funds from its subsidiaries through payments for federal income taxes and reimbursement of expenses incurred at the corporate level for the subsidiaries. These funds are used to pay stockholder dividends, interest on debt, corporate administrative expenses, federal income taxes, and for funding investments in the subsidiaries. The Company maintains minimal liquidity in order to maximize liquidity within the insurance subsidiaries in order to support ongoing insurance operations. The Company has no separate source of revenue other than dividends and fees from the insurance subsidiaries. Also, dividends from the insurance subsidiaries are subject to regulatory restrictions and, therefore, are limited depending on capital levels and earnings of the subsidiaries.  Our P&C segment, incurred $1,578,000 in losses from spring catastrophes during the first quarter of 2013 triggering current year underwriting losses in the P&C segment. These underwriting losses further reduced capital levels; and while capital levels remain adequate to operate our existing business, the subsidiary's ability to pay dividends upstream to the holding company in the near term has not improved.  Dividends paid from the insurance subsidiaries are subject to regulatory restrictions and prior approval of the Alabama Department of Insurance. As disclosed in Note 10, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company during 2013 is limited to $1,034,000 in the life insurance subsidiary and $2,468,000 in the property/casualty insurance subsidiary. Dividends are limited to the greater of net income (operating income for life subsidiary) or 10% of statutory capital, and regulators consider dividends paid within the preceding twelve months when calculating the available dividend capacity. Therefore, all of the above referenced dividend capacity will not be available for consideration of payment until dividends paid in the preceding twelve months have been considered on a rolling basis. The Company also has to continuously evaluate other factors such as subsidiary operating performance, subsidiary capital requirements and potential impact by rating agencies in making decisions on how much capital can be released for payment of dividends to NSG. These factors are considered along with the goal of growing year over year statutory surplus in the subsidiaries, and these considerations along with recent adverse impacts on regulatory surplus, will likely lead to dividend payments to NSG substantially below the above referenced regulatory maximums.  In July of 2012, NSFC issued an extraordinary dividend of real estate to the holding company in order to secure a bank line of credit. The payment of this extraordinary dividend will limit NSFC's ability to pay further dividends to the parent company until August of 2013. The payment of any subsidiary dividend requires prior notice to the regulatory authorities who may disallow the dividend if, in their judgment, payment of the dividend would have an adverse effect on the surplus of the subsidiary.  The Company's subsidiaries require cash in order to fund policy acquisition costs, claims, other policy benefits, interest expense, general expenses, and dividends to the Company. Premium and investment income, as well as maturities, calls, and sales of invested assets, provide the primary sources of cash for both subsidiaries. A significant portion of the Company's investment portfolio, which is held by the insurance subsidiaries, consists of readily marketable securities, which can be sold for cash.  Due to the erosion in capital levels in the P&C subsidiaries, we have made changes in order to reduce capital/surplus strain in the P&C subsidiaries and help protect capital levels from substantial further erosion resulting from a major catastrophic event. These changes include a combination of reduction in underwriting leverage and an increase in catastrophe reinsurance protection. A summary of each change follows:  

• In late 2011, we discontinued both our private passenger and commercial

automobile programs. These two programs accounted for approximately 6% of

net written premium in 2011, down from nearly 10% in 2010 but had produced

       significant underwriting losses over the last five years. Due to a        combination of reduced capital levels and a view that it would take some        time to achieve underwriting profitability, we made the decision to

discontinue the program in order to reduce surplus strain and underwriting

       leverage in the P&C subsidiaries. The final in-force policies in this        program expired in mid 2012.                                           42

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• We have incurred substantial losses from catastrophe events over the past

seven years. These events have driven up catastrophe reinsurance cost and

forced our catastrophe reinsurance deductible up from $2 million in 2005

to $4 million in our 2013 renewal. As our cat retention has increased, we

have attempted to achieve higher margins in our insurance rate structure

in order to compensate for the additional risk of the higher catastrophe

reinsurance retention but with limited success due to regulatory

constraints primarily because this additional retention was not a "hard

dollar" cost in our rate structure. So, since we were limited in our

ability to increase margins for this additional retained risk and due to

the capital erosion incurred in 2011, in the second quarter of 2012, we

placed additional reinsurance cover in the form of reinsurance premium

protection (RPP). The RPP cover will serve to reduce our risk from a major

catastrophe and strengthen our capital position. The effect of adding this

additional RPP cover is to reduce our modeled 100 year event net cost (net

of reinsurance recoveries) from approximately $9 million (pretax) to an

estimated $4.5 million (pretax). A 100 year event is defined as an event

that has approximately a 1% probability of occurring in a given year. This

additional cover added $350,000 to our cat reinsurance cost in the first

        quarter of 2013.    As disclosed in Note 14 to the condensed consolidated financial statements regarding contingencies, the Company reached settlement in litigation related to its divestiture of Mobile Attic, Inc. in June 2012. Under the terms of the settlement agreement, the Company will pay a total of $13 million to the plaintiff. In order to manage the liquidity constraints, the settlement will be in the form of an interest-bearing note with amounts to be paid over nine years with the ability to defer payments in years in which the Company's P&C subsidiaries incur substantial catastrophe losses thus allowing capital management flexibility in the P&C subsidiaries. Under the terms of the agreement, the annual debt service on the note cannot be less than the dividends paid to our shareholders in the last twelve months. The Company made an initial payment of $2,500,000 in September 2012. The remaining principal will be repaid in nine annual installments of $1,167,000. Accrued and unpaid interest shall be payable with each installment of principal based on the prime rate published in the Wall Street Journal plus 1%.  Cash to fund the litigation settlement will come from three primary sources. First, the Company owns 3,000 acres of timber property with a carrying value of approximately $1.4 million and an estimated fair market value of $5 million. As previously discussed, this property was used as collateral to obtain a $4,000,000 operating line of credit through a regional bank to aid in restoring short-term liquidity and allow flexibility in managing holding company liquidity. Ultimately, the Company will seek to sell the property or use the proceeds from timber sales on the property to retire the debt. Second, the holding Company has significant deferred tax assets associated with a net operating loss (NOL) carryforward generated by a combination of this settlement and defense costs incurred over the prior two years. This NOL carryforward will generate tax benefits that will offset a portion of future tax liabilities of the P&C insurance subsidiaries in our consolidated tax returns. It is expected that this NOL carryforward will generate approximately $5 million in tax benefits over the term of the settlement. Finally, dividends and management fees paid by the insurance subsidiaries will provide an additional source of proceeds to pay this obligation. Although not a preferred source of flexibility, the Company can also defer interest payments on the trust preferred securities to provide additional operating cash flow. In the event that the Company elects to defer interest payments, shareholder dividends will be suspended until interest payments are current.  Except as discussed above, the Company is unaware of any 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.  The Company maintains an unsecured operating line of credit, with a $700,000 limit, to allow flexibility with respect to cash management at the holding company level. The outstanding balance at March 31, 2013 was $125,000. The Company obtained a $4,000,000 secured line of credit in September 2012 to provide additional operating flexibility to the holding company. The outstanding balance at March 31, 2013 was $3,934,000.  We have taken and continue to take corrective action to improve our profitability and capital position. However, due to the adverse effects of six major hurricanes in the last eight years, the financial market meltdown in 2008, continued historically low interest rates, an unprecedented tornado outbreak in April of 2011 and the recently settled litigation, we have experienced significant reduction in equity capital. While we are beginning to see improvement and have put some major obstacles behind us, we are in a position where we have to preserve capital in the near term in order to put our Company in the best position to be successful moving forward. In order to improve our capital position, we will continue to monitor our dividend policy on a quarterly basis and could take action including the suspension of dividends should operating conditions warrant such action. Due to various factors discussed herein, we must remain flexible in our dividend policy until we achieve more consistent profitability and capital growth.                                         43

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