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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 FORM 10-Q
  (Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For Quarterly Period Ended March 31, 2018

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

Commission File Number 0-18649
image1a01a08.jpg
The National Security Group, Inc.
(Exact name of registrant as specified in its charter)

Delaware
 
63-1020300
(State or Other Jurisdiction of
Incorporation or Organization)
 
(IRS Employer
Identification No.)
 
 
 
661 East Davis Street
Elba, Alabama
 
36323
(Address of principal executive offices)
 
(Zip-Code)
 
Registrant’s Telephone Number including Area Code (334) 897-2273
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  þ    No  o

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

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

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

As of May 14, 2018, there were 2,522,312 shares, $1.00 par value, of the registrant’s common stock outstanding.


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THE NATIONAL SECURITY GROUP, INC.

TABLE OF CONTENTS

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


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

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

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

▪
The Company is subject to regulation by state governments for each of the states in which it conducts business. The Company cannot predict the subject of any future regulatory initiative(s) or its (their) impact on the Company's business. Company insurance rates are also subject to approval by state insurance departments in each of these states. We are often limited in the level of rate increases we can obtain.

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

▪
The Company's financial results are adversely affected by increases in policy claims received by the Company. While a manageable risk, this fluctuation is often unpredictable.
  
▪
The Company's investments are subject to a variety of risks. Investments are subject to defaults and changes in market value. Market value can be affected by changes in interest rates, market performance and the economy.

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

▪
The Company mitigates risk associated with property and casualty policies through implementing effective underwriting and reinsurance strategies. The Company obtains reinsurance which increases underwriting capacity and limits the risk associated with policy claims. The Company is subject to credit risk with regard to reinsurers as reinsurance does not alleviate the Company's liability to its insured's for the ceded risks. The Company utilizes a third-party to develop a reinsurance treaty with reinsurers who are reliable and financially stable. However, there is no guarantee that booked reinsurance recoverable will actually be recovered. A reinsurer's insolvency or inability to make payments due could have a material adverse impact on the financial condition of the Company.

▪
The Company's ability to continue to pay dividends to shareholders is contingent upon profitability and capital adequacy of the insurance subsidiaries. The insurance subsidiaries operate under regulatory restrictions that could limit the ability to fund future dividend payments of the Company. An adverse event or series of events could materially impact the ability of the insurance subsidiaries to fund future dividends, and consequently, the Board of Directors would have to suspend the declaration of dividends to shareholders.

▪
The Company is subject to the risk of adverse settlements or judgments resulting from litigation of contested claims. It is difficult to predict or quantify the expected results of litigation because the outcome depends on decisions of the court and jury that are based on facts and legal arguments presented at the trial.

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PART I. Financial Information
Item 1. Financial Statements

THE NATIONAL SECURITY GROUP, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands)
 
 
March 31, 2018
 
December 31, 2017
 
 
(UNAUDITED)
 
 
ASSETS
 
 
 
 
Investments
 
 
 
 
Fixed maturities held-to-maturity, at amortized cost (estimated fair value: 2018 -
      $1,575; 2017 - $1,645)
 
$
1,573

 
$
1,616

Fixed maturities available-for-sale, at estimated fair value (cost: 2018 - $96,277;
2017 - $94,467)
 
95,825

 
95,758

Equity securities, at estimated fair value (cost: 2018 - $1,842; 2017 - $1,842)
 
4,303

 
4,509

Trading securities
 
107

 
107

Mortgage loans on real estate, at cost
 
161

 
162

Investment real estate, at book value
 
3,221

 
3,221

Policy loans
 
1,842

 
1,810

Company owned life insurance
 
4,835

 
4,974

Other invested assets
 
2,451

 
2,574

Total Investments
 
114,318

 
114,731

Cash and cash equivalents
 
5,586

 
6,644

Accrued investment income
 
826

 
768

Policy receivables and agents' balances, net
 
11,985

 
11,653

Reinsurance recoverable
 
771

 
366

Deferred policy acquisition costs
 
8,031

 
8,124

Property and equipment, net
 
1,743

 
1,781

Income tax recoverable
 
926

 
393

Deferred income tax asset, net
 
1,123

 
1,487

Other assets
 
765

 
491

Total Assets
 
$
146,074

 
$
146,438

LIABILITIES AND SHAREHOLDERS' EQUITY
 
 

 
 

Property and casualty benefit and loss reserves
 
$
6,927

 
$
7,075

Accident and health benefit and loss reserves
 
3,603

 
3,595

Life and annuity benefit and loss reserves
 
33,329

 
33,283

Unearned premiums
 
30,773

 
30,112

Policy and contract claims
 
913

 
903

Other policyholder funds
 
1,705

 
1,706

Short-term notes payable and current portion of long-term debt
 
800

 
1,300

Long-term debt
 
14,342

 
14,339

Other liabilities
 
6,956

 
6,500

Total Liabilities
 
99,348

 
98,813

Contingencies
 


 


Shareholders' equity
 
 

 
 

Common stock
 
2,522

 
2,522

Additional paid-in capital
 
5,483

 
5,483

Accumulated other comprehensive income (loss)
 
(705
)
 
2,646

Retained earnings
 
39,426

 
36,974

Total Shareholders' Equity
 
46,726

 
47,625

Total Liabilities and Shareholders' Equity
 
$
146,074

 
$
146,438


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

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THE NATIONAL SECURITY GROUP, INC.

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

 
 
Three months ended
March 31,
 
 
2018
 
2017
REVENUES
 
 
 
 
Net premiums earned
 
$
15,059

 
$
15,040

Net investment income
 
781

 
926

Net realized investment gains (losses)
 
(125
)
 
160

Other income
 
161

 
152

Total Revenues
 
15,876

 
16,278

BENEFITS, LOSSES AND EXPENSES
 
 

 
 

Policyholder benefits and settlement expenses
 
9,427

 
11,146

Amortization of deferred policy acquisition costs
 
803

 
945

Commissions
 
2,060

 
2,093

General and administrative expenses
 
2,003

 
1,797

Taxes, licenses and fees
 
649

 
689

Interest expense
 
302

 
323

Total Benefits, Losses and Expenses
 
15,244

 
16,993

 
 
 
 
 
Income (Loss) Before Income Taxes
 
632

 
(715
)
 
 
 
 
 
INCOME TAX EXPENSE (BENEFIT)
 
 

 
 

Current
 
(534
)
 
(325
)
Deferred
 
695

 
(74
)
 
 
161

 
(399
)
 
 
 
 
 
Net Income (Loss)
 
$
471

 
$
(316
)
 
 
 
 
 
INCOME (LOSS) PER COMMON SHARE BASIC AND DILUTED
 
$
0.19

 
$
(0.13
)
 
 
 
 
 
DIVIDENDS DECLARED PER SHARE
 
$
0.05

 
$
0.05


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


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THE NATIONAL SECURITY GROUP, INC.

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

 
 
Three months ended
March 31,
 
 
2018
 
2017
 
 
 
 
 
Net income (loss)
 
$
471

 
$
(316
)
 
 

 
 
Other comprehensive income (loss), net of tax
 
 
 
 
Changes in:
 
 
 
 
Unrealized gains (losses) on securities, net of reclassification adjustment of $68 and $106 for 2018 and 2017, respectively
 
(1,376
)
 
344

Unrealized gain on interest rate swap
 
132

 
70

 
 
 
 
 
Other comprehensive income (loss), net of tax
 
(1,244
)
 
414

 
 
 
 
 
Comprehensive income (loss)
 
$
(773
)
 
$
98


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



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THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (UNAUDITED)
(In thousands)
 
Total
 
Retained
Earnings
 
Accumulated
Other
Comprehensive
Income (Loss)
 
Common
Stock
 
Additional
Paid-in
Capital
Balance at December 31, 2017
$
47,625

 
$
36,974

 
$
2,646

 
$
2,522

 
$
5,483

 
 
 
 
 
 
 
 
 
 
Cumulative effect of change in accounting principle
—

 
2,107

 
(2,107
)
 
—

 
—

 
 
 
 
 
 
 
 
 
 
Comprehensive income (loss):
 

 
 

 
 

 
 

 
 

 
 
 
 
 
 
 
 
 
 
Net income for March 31, 2018
471

 
471

 
—

 
—

 
—

 
 
 
 
 
 
 
 
 
 
Other comprehensive loss (net of tax)
(1,244
)
 
—

 
(1,244
)
 
—

 
—

 
 
 
 
 
 
 
 
 
 
Cash dividends
(126
)
 
(126
)
 
—

 
—

 
—

 
 
 
 
 
 
 
 
 
 
Balance at March 31, 2018
$
46,726

 
$
39,426

 
$
(705
)
 
$
2,522

 
$
5,483


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






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THE NATIONAL SECURITY GROUP, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
(In thousands)
 
Three months ended
March 31,
 
2018
 
2017
Cash Flows from Operating Activities
 
 
 
Net income (loss)
$
471

 
$
(316
)
Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 

Depreciation expense and amortization/accretion, net
100

 
146

(Increase) decrease in cash surrender value of company owned life insurance
139

 
(42
)
Net realized gains on investments
125

 
(160
)
Deferred income taxes
695

 
(74
)
Amortization of deferred policy acquisition costs
803

 
945

Changes in assets and liabilities:
 
 
 
Change in receivable for securities sold
—

 
499

Change in accrued investment income
(58
)
 
(26
)
Change in reinsurance recoverable
(405
)
 
776

Policy acquisition costs deferred
(710
)
 
(935
)
Change in accrued income taxes
(533
)
 
(325
)
Change in net policy liabilities and claims
240

 
698

Change in other assets/liabilities, net
472

 
(520
)
Other, net
6

 
5

Net cash provided by operating activities
1,345

 
671

Cash Flows from Investing Activities
 
 
 

Purchase of:
 
 
 
Available-for-sale securities
(5,601
)
 
(3,324
)
Property and equipment
—

 
(8
)
Proceeds from sale or maturities of:
 
 
 
Held-to-maturity securities
43

 
92

Available-for-sale securities
3,813

 
3,939

Property and equipment
—

 
2

Other invested assets, net
(31
)
 
(13
)
Net cash provided by (used in) investing activities
(1,776
)
 
688

Cash Flows from Financing Activities
 

 
 

Change in other policyholder funds
(1
)
 
22

Change in short-term notes payable
(500
)
 
(500
)
Dividends paid
(126
)
 
(126
)
Net cash used in financing activities
(627
)
 
(604
)
Net change in cash and cash equivalents
(1,058
)
 
755

Cash and cash equivalents, beginning of year
6,644

 
7,368

Cash and cash equivalents, end of period
$
5,586

 
$
8,123

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

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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)


NOTE 1 – SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation and Basis of Presentation
The accompanying consolidated financial statements include the accounts of The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries:  National Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and NATSCO, Inc. (NATSCO).  NSFC includes a wholly-owned subsidiary, Omega One Insurance Company (Omega).  The accompanying consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP).  In the opinion of management, all adjustments, consisting of normal and recurring items, necessary for the fair presentation of the consolidated financial statements have been included. All significant intercompany transactions and accounts have been eliminated. The financial information presented herein should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, which includes information and disclosures not presented herein.

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

Earnings Per Share
Earnings per share of common stock is based on the weighted average number of shares outstanding during each year. The adjusted weighted average shares outstanding were 2,522,312 at March 31, 2018 and 2,517,339 at March 31, 2017. The Company did not have any dilutive securities as of March 31, 2018 and 2017.

Reclassifications
Certain 2017 amounts have been reclassified from the prior year consolidated financial statements to conform to the 2018 presentation.

Concentration of Credit Risk
The Company maintains cash balances which are generally held in non-interest bearing demand deposit accounts subject to FDIC insured limits of $250,000 per entity. At March 31, 2018, the net amount exceeding FDIC insured limits was $3,654,000 at three financial institutions. The Company has not experienced any losses in such accounts. Management of the Company reviews financial information of financial institutions on a quarterly basis and believes the Company is not exposed to any significant credit risk on cash and cash equivalents.

Policy receivables are reported at unpaid balances. Policy receivables are generally offset by associated unearned premium liabilities and are not subject to significant credit risk. Receivables from agents, less provision for credit losses, are composed of balances due from independent agents. At March 31, 2018, the single largest balance due from one agent totaled $729,000.

Reinsurance contracts do not relieve the Company of its obligations to policyholders. A failure of a reinsurer to meet its obligation could result in losses to the insurance subsidiaries. Allowances for losses on reinsurance recoverables are established if amounts are believed to be uncollectible. At March 31, 2018 and December 31, 2017, no amounts were deemed uncollectible. The Company, at least annually, evaluates the financial condition of all reinsurers and evaluates any potential concentrations of credit risk. At March 31, 2018, management does not believe the Company is exposed to any significant credit risk related to its reinsurance program.


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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

Accounting Changes Not Yet Adopted

Recognition and Measurement of Financial Assets and Financial Liabilities
In February 2018, the Financial Accounting Standards Board (FASB) issued guidance to address certain aspects of recognition, measurement, presentation and disclosure of financial instruments. The guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years beginning after June 15, 2018. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

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

Contingent Put and Call Options in Debt Instruments
In March 2016, the FASB issued guidance that clarifies the requirements for assessing whether contingent call (put) options that can accelerate the payment of principal on debt instruments are clearly and closely related to their debt hosts. This guidance is effective for fiscal years beginning after December 15, 2019, including interim periods within those years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

Financial Instruments - Credit Losses
In June 2016, the FASB issued guidance that replaces the incurred loss impairment methodology in current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. This guidance is effective for fiscal years beginning after December 15, 2019, including interim periods within those years. The Company does not expect the adoption to have a material impact on its financial position or results of operations.

Receivables - Nonrefundable Fees and Other Costs
In March 2017, the FASB issued guidance that shortens the amortization period for certain callable debt securities held at a premium and requires the premium to be amortized to the earliest call date. The guidance is effective for fiscal years beginning after December 15, 2018 and interim reporting periods within those fiscal years. The Company does not expect the adoption of this new guidance to have a significant impact on our financial position, results of operations or cash flows.

Derivatives and Hedging
In August 2017, the FASB issued guidance that amends and simplifies hedge accounting guidance in order to enable entities to better portray the economic results of their risk management activities. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those periods. Early adoption is permitted. The Company is currently evaluating the impact of the standard on its consolidated financial statements and related disclosures.

Recently Adopted Accounting Standards

Income Statement - Reporting Comprehensive Income
In February 2018, the Financial Accounting Standards Board (FASB) issued guidance that allows a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act. The guidance eliminates the stranded tax effects resulting from the Tax Cuts and Jobs Act and improves the usefulness of information reported to financial statement users. The guidance is effective for fiscal years beginning after December 15, 2018, including interim periods within those periods. Early adoption is permitted. The Company adopted this guidance as of December 31, 2017. The adoption of this guidance resulted in a $435,000 reclassification to accumulated other comprehensive income from retained earnings related to stranded tax effects resulting from the Tax Cuts and Jobs Act.


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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

Revenue from Contracts with Customers
In May 2014, FASB issued guidance on a comprehensive new revenue recognition standard. This standard will not impact accounting for insurance contracts, leases, financial instruments and guarantees. For those contracts that are impacted by the new guidance, the guidance will require an entity to recognize revenue upon the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled to, in exchange for those goods or services. The guidance requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. In August 2015, the FASB issued a deferral of the effective date by one year. This guidance is effective retrospectively for fiscal years beginning after December 15, 2017 and interim periods within those years. Early adoption of this standard is permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that reporting period. Insurance contracts are specifically scoped out of this new guidance.

The Company does not have policy fees or any material services that may be subject to the new revenue recognition guidance. The Company adopted this guidance as of January 1, 2018. The adoption of this guidance did not have an impact on its condensed consolidated financial statements.

Recognition and Measurement of Financial Assets and Financial Liabilities
In January 2016, the FASB issued guidance that requires equity investments (except those accounted for under the equity method of accounting or those that result in consolidation of the investee) to be measured at fair value with changes in fair value recognized in net income. The guidance requires entities to use the exit price notion when measuring the fair value of financial instruments for disclosure purposes and requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset. The guidance eliminates the requirement for public companies to disclose the method(s) and significant assumptions used to estimate the fair value that is required to be disclosed for financial instruments measured at amortized cost. This guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. The Company adopted this guidance as of January 1, 2018. The adoption of this guidance resulted in a $2,107,000 reclassification to retained earnings from accumulated other comprehensive income related to accumulated unrealized gains on equity securities as well as recognition of a $162,000 loss, net of tax, related to the change in value of equity securities.

Classification of Certain Cash Receipts and Cash Payments
In August 2016, the FASB issued guidance that clarifies how certain cash receipts and cash payments shall be presented and classified in the statement of cash flows. This guidance addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The guidance is effective for annual and interim reporting periods beginning after December 15, 2017. The Company adopted this guidance as of January 1, 2018. The adoption of this guidance did not have a significant impact on our financial position, results of operations or cash flows.
 
Compensation - Stock Compensation
In May 2017, the FASB issued guidance to provide clarity and reduce diversity in practice as well as cost and complexity when there is a change in the terms or conditions of a share-based payment award. The guidance is effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. The Company adopted this guidance as of January 1, 2018. The adoption of this guidance did not have a significant impact on our financial position, results of operations or cash flows.

NOTE 2 – VARIABLE INTEREST ENTITIES

The Company holds a passive interest in a limited partnership that is considered to be a Variable Interest Entity (VIE) under the provisions of ASC 810 Consolidation. The Company is not the primary beneficiary of the entity and is not required to consolidate under ASC 810. The entity is a private placement investment fund formed for the purpose of investing in private equity investments. The Company owns less than 1% of the limited partnership. The carrying value of the investment totals $142,000 and is included as a component of Other Invested Assets in the accompanying consolidated balance sheets.

In December 2005, the Company formed National Security Capital Trust I, a statutory trust created under the Delaware Statutory Trust Act, for the sole purpose of issuing, in private placement transactions, $9,000,000 of trust preferred

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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

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

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

NOTE 3 – INVESTMENTS

Our investment in available-for-sale securities, which are reported at fair value, includes fixed maturity securities and prior to January 1, 2018, equity securities. Net unrealized gains or losses on equity securities prior to January 1, 2018, and on fixed maturities are reported after-tax as a component of other comprehensive income. As of January 1, 2018, changes in fair value of equity securities are recognized through net income.

The amortized cost and aggregate fair values of investments in available-for-sale securities as of March 31, 2018 are as follows (dollars in thousands):
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
38,963

 
$
625

 
$
748

 
$
38,840

Mortgage backed securities
 
11,979

 
101

 
456

 
11,624

Private label asset backed securities
 
12,637

 
294

 
3

 
12,928

Obligations of states and political subdivisions
 
13,422

 
299

 
124

 
13,597

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
19,276

 
63

 
503

 
18,836

Total
 
$
96,277

 
$
1,382

 
$
1,834

 
$
95,825


The amortized cost and aggregate fair values of investments in held-to-maturity securities as of March 31, 2018 are as follows (dollars in thousands):
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
1,573

 
$
16

 
$
14

 
$
1,575

Total
 
$
1,573

 
$
16

 
$
14

 
$
1,575



12
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The amortized cost and aggregate fair values of investments in available-for-sale securities as of December 31, 2017 are as follows (dollars in thousands):
Available-for-sale securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Corporate debt securities
 
$
39,127

 
$
1,103

 
$
321

 
$
39,909

Mortgage backed securities
 
12,892

 
177

 
274

 
12,795

Private label asset backed securities
 
10,128

 
382

 
—

 
10,510

Obligations of states and political subdivisions
 
13,758

 
389

 
54

 
14,093

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
18,562

 
206

 
317

 
18,451

Total fixed maturities
 
94,467

 
2,257

 
966

 
95,758

Equity securities
 
1,842

 
2,667

 
—

 
4,509

Total
 
$
96,309

 
$
4,924

 
$
966

 
$
100,267


The amortized cost and aggregate fair values of investments in held-to-maturity securities as of December 31, 2017 are as follows (dollars in thousands):
Held-to-maturity securities:
 
Amortized
Cost
 
Gross
Unrealized
Gains
 
Gross
Unrealized
Losses
 
Fair
Value
Mortgage backed securities
 
$
1,615

 
$
29

 
$
—

 
$
1,644

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

 
—

 
—

 
1

Total
 
$
1,616

 
$
29

 
$
—

 
$
1,645


The amortized cost and aggregate fair value of debt securities at March 31, 2018, by contractual maturity, are presented in the following table (dollars in thousands).  Expected maturities will differ from contractual maturities because issuers may have the right to call or prepay obligations with or without call or prepayment penalties.
(Dollars in Thousands)
 
Amortized
Cost
 
Fair
Value
Available-for-sale securities:
 
 
 
 
Due in one year or less
 
$
1,284

 
$
1,284

Due after one year through five years
 
16,803

 
16,854

Due after five years through ten years
 
29,218

 
29,206

Due after ten years
 
48,972

 
48,481

Total
 
$
96,277

 
$
95,825

 
 
 
 
 
Held-to-maturity securities:
 
 

 
 

Due in one year or less
 
$
—

 
$
—

Due after one year through five years
 
—

 
—

Due after five years through ten years
 
57

 
61

Due after ten years
 
1,516

 
1,514

Total
 
$
1,573

 
$
1,575



13
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

A summary of securities available-for-sale with unrealized losses as of March 31, 2018, along with the related fair value, aggregated by the length of time that investments have been in a continuous unrealized loss position, is as follows (dollars in thousands):
 
 
Less than 12 months
 
12 months or longer
 
Total
March 31, 2018
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
17,812

 
$
471

 
$
5,950

 
$
277

 
$
23,762

 
$
748

 
40

Mortgage backed securities
 
7,180

 
257

 
2,124

 
199

 
9,304

 
456

 
21

Private asset backed securities
 
1,163

 
3

 
—

 
—

 
1,163

 
3

 
2

Obligations of state and political subdivisions
 
3,928

 
43

 
2,528

 
81

 
6,456

 
124

 
13

U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
8,188

 
223

 
6,349

 
280

 
14,537

 
503

 
22

 
 
$
38,271

 
$
997

 
$
16,951

 
$
837

 
$
55,222

 
$
1,834

 
98


A summary of securities held-to-maturity with unrealized losses as of March 31, 2018 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:

 
 
Less than 12 months
 
12 months or longer
 
Total
March 31, 2018
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a Loss Position
Fixed maturities:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Mortgage backed securities
 
$
1,145


$
14


$
—


$
—


$
1,145


$
14


1
 
 
$
1,145

 
$
14

 
$
—

 
$
—

 
$
1,145

 
$
14

 
1

A summary of securities available-for-sale with unrealized losses as of December 31, 2017, 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):

14
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

 
 
Less than 12 months
 
12 months or longer
 
Total
December 31, 2017
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Fair
Value
 
Gross
Unrealized
Losses
 
Total
Securities in a Loss Position
Fixed maturities
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
6,567

 
$
166

 
$
5,607

 
$
155

 
$
12,174

 
$
321

 
20
Mortgage backed securities
 
5,872

 
124

 
2,281

 
150

 
8,153

 
274

 
17
Obligations of state and political subdivisions
 
2,176

 
7

 
2,574

 
47

 
4,750

 
54

 
9
U.S. Treasury securities and obligations of U.S. Government corporations and agencies
 
4,878

 
111

 
6,667

 
206

 
11,545

 
317

 
18
 
 
$
19,493

 
$
408

 
$
17,129

 
$
558

 
$
36,622

 
$
966

 
64

There were no equity securities or securities held-to-maturity with unrealized losses as of December 31, 2017.

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

Management has evaluated each security in a significant unrealized loss position in both the debt and equity investment portfolios.  The Company has no material exposure to sub-prime mortgage loans and approximately 5.94% of the fixed income investment portfolio is rated below investment grade.  In evaluating whether or not the equity loss positions were other-than-temporary impairments, Management evaluated financial information on each company and where available, reviewed analyst reports from at least two independent sources.  Based on a review of the available financial information, the prospect for future earnings of each company and consideration of the Company’s intent and ability to hold the securities until market values recovered, it was determined that the securities in an accumulated loss position in the portfolio were temporary impairments.

For the three months ended March 31, 2018 and year ended December 31, 2017, the Company realized no other-than-temporary impairments. At March 31, 2018, the single largest loss not realized as an impairment was in the bond portfolio and totaled $88,000. The second largest loss position was in the bond portfolio and totaled $87,000. The third largest loss position was in the bond portfolio and totaled $81,000. At December 31, 2017, the single largest loss not realized as an impairment was in the bond portfolio and totaled $75,000. The second largest loss position was in the bond portfolio and totaled $60,000. The third largest loss position was in the bond portfolio and totaled $53,000.


15
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

Major categories of investment income are summarized as follows (dollars in thousands):

 
Three months ended
March 31,
 
2018
 
2017
Fixed maturities
$
891

 
$
817

Equity securities
20

 
24

Mortgage loans on real estate
2

 
2

Investment real estate
1

 
2

Policy loans
35

 
33

Company owned life insurance change in surrender value
(139
)
 
43

Other
8

 
45

 
818

 
966

Less: Investment expenses
37

 
40

Net investment income
$
781

 
$
926


Major categories of realized investment gains and losses are summarized as follows (dollars in thousands):

 
Three months ended
March 31,
 
2018
 
2017
Fixed maturities
$
81

 
$
160

Change in fair value of equity securities
(206
)
 
—

Net realized investment gains (losses)
$
(125
)
 
$
160


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

 
March 31,
2018
 
December 31, 2017
Net change in unrealized gains (losses) on available-for-sale securities before deferred tax
$
(1,742
)
 
$
1,402

Deferred income tax
366

 
(476
)
Net change in unrealized gains (losses) on available-for-sale securities
$
(1,376
)
 
$
926



16
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

NOTE 4 – FAIR VALUE OF FINANCIAL ASSETS AND FINANCIAL LIABILITIES
 
Our available-for-sale securities consists of fixed maturity and equity securities which are recorded at fair value in the accompanying consolidated balance sheets.  The change in the fair value of these investments, unless deemed to be other-than-temporarily impaired, is recorded as a component of other comprehensive income.

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

Accounting standards define fair value as the price that would be received to sell an asset or would be paid to transfer a liability in an orderly transaction between market participants at the measurement date, and establishes a framework to make the measurement of fair value more consistent and comparable.  In determining fair value, we primarily use prices and other relevant information generated by market transactions involving identical or comparable assets.

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

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

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

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

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

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

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

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


17
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

Assets/Liabilities Measured at Fair Value on a Recurring Basis

Financial assets and liabilities measured at fair value on a recurring basis as of March 31, 2018 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):
 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
38,840

 
$
—

 
$
38,840

 
$
—

Mortgage backed securities
 
11,624

 
—

 
11,624

 
—

Private label asset backed securities
 
12,928

 
—

 
12,928

 
—

Obligations of states and political subdivisions
 
13,597

 
—

 
13,597

 
—

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
18,836

 
18,836

 
—

 
—

Trading securities
 
107

 
107

 
—

 
—

Equity securities
 
4,303

 
3,201

 
—

 
1,102

Total Financial Assets
 
$
100,235

 
$
22,144

 
$
76,989

 
$
1,102

Financial Liabilities
 

 
 

 
 

 
 

Interest rate swap
 
$
(441
)
 
$
—

 
$
—

 
$
(441
)
Total Financial Liabilities
 
$
(441
)
 
$
—

 
$
—

 
$
(441
)

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

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

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

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

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

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

As of March 31, 2018, Level 3 fair value measurements of assets include $1,102,000 of equity securities in a local community bank whose value is based on an evaluation of the financial statements of the entity. The Company does not develop the unobservable inputs used in measuring fair value.

As of March 31, 2018, Level 3 fair value measurements of liabilities include $441,000 net fair value of various interest rate swap agreements whose value is based on analysis provided by a third party that utilizes financial modeling tools and assumptions on interest and other factors. The Company does not develop the unobservable inputs used in measuring fair value. Additional information regarding the interest rate swap agreements is provided in Note 7.

18
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the three months ended March 31, 2018 (in thousands):

For the three months ended March 31, 2018
 
Equity Securities
 
Interest Rate Swap
Beginning balance
 
$
1,073

 
$
(608
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 
29

 
—

Included in other comprehensive income
 
—

 
167

Purchases:
 
—

 
—

Sales:
 
—

 
—

Issuances:
 
—

 
—

Settlements:
 
—

 
—

Transfers in/(out) of Level 3
 
—

 
—

Ending balance
 
$
1,102

 
$
(441
)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of March 31, 2018:
 
$
—

 
$
—


For the three months ended ended March 31, 2018, there were no assets or liabilities measured at fair values on a nonrecurring basis.

Financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2017 are summarized in the following table by the type of inputs applicable to the fair value measurements (in thousands):

 
 
Fair Value Measurements at Reporting Date Using
Description
 
Total
 
Level 1
 
Level 2
 
Level 3
Financial Assets
 
 
 
 
 
 
 
 
Fixed maturities available-for-sale
 
 
 
 
 
 
 
 
Corporate debt securities
 
$
39,909

 
$
—

 
$
39,909

 
$
—

Mortgage backed securities
 
12,795

 
—

 
12,795

 
—

Private label asset backed securities
 
10,510

 
—

 
10,510

 
—

Obligations of states and political subdivisions
 
14,093

 
—

 
14,093

 
—

U.S. Treasury securities and obligations of U.S.
   Government corporations and agencies
 
18,451

 
18,451

 
—

 
—

Trading securities
 
107

 
107

 
—

 
—

Equity securities available-for-sale
 
4,509

 
3,436

 
—

 
1,073

Total Financial Assets
 
$
100,374

 
$
21,994

 
$
77,307

 
$
1,073

Financial Liabilities
 
 

 
 

 
 

 
 

Interest rate swap
 
$
(608
)
 
$
—

 
$
—

 
$
(608
)
Total Financial Liabilities
 
$
(608
)
 
$
—

 
$
—

 
$
(608
)


19
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The table below presents a reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) for the year ended December 31, 2017 (in thousands):
For the year ended December 31, 2017
 
Equity Securities Available-for-Sale
 
Interest Rate Swap
Beginning balance
 
$
1,258

 
$
(1,030
)
Total gains or losses (realized and unrealized):
 
 

 
 

Included in earnings
 
—

 
—

Included in other comprehensive income
 
114

 
422

Purchases:
 
46

 
—

Sales:
 
(345
)
 
—

Issuances:
 
—

 
—

Settlements:
 
—

 
—

Transfers in/(out) of Level 3
 
—

 
—

Ending balance
 
$
1,073

 
$
(608
)
The amount of total gains or losses for the period included in earnings attributable to the change in unrealized gains or losses relating to assets and liabilities still held as of December 31, 2017:
 
$
—

 
$
—


For the year ended December 31, 2017, there were no assets or liabilities measured at fair values on a nonrecurring basis.

The Company is exposed to certain risks in the normal course of its business operations.  The primary risk that is managed through the use of derivatives is interest rate risk on floating rate borrowings.  This risk is managed through the use of interest rate swap agreements which are designated as cash flow hedges.  For cash flow hedges, the effective portion of the gain or loss on the interest rate swap is included as a component of other comprehensive income and reclassified into earnings in the same period during which the hedged transaction is recognized in earnings.  The Company does not hold or issue derivatives that are not designated as hedging instruments.  See Note 8 for additional information about the interest rate swap agreements.

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

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

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

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

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

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

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

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

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


20
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The carrying amount and estimated fair value of the Company’s financial instruments as of March 31, 2018 and December 31, 2017 are as follows (in thousands):
 
 
March 31, 2018
 
December 31, 2017
Assets and related instruments
 
Carrying
Value
 
Estimated
Fair Value
 
Carrying
Value
 
Estimated
Fair Value
Held-to-maturity securities
 
$
1,573

 
$
1,575

 
$
1,616

 
$
1,645

Mortgage loans
 
161

 
161

 
162

 
162

Policy loans
 
1,842

 
1,842

 
1,810

 
1,810

Company owned life insurance
 
4,835

 
4,835

 
4,974

 
4,974

Other invested assets
 
2,451

 
2,451

 
2,574

 
2,574

Liabilities and related instruments
 
 

 
 

 
 

 
 

Other policyholder funds
 
1,705

 
1,705

 
1,706

 
1,706

Short-term notes payable and current portion of long-term debt
 
800

 
800

 
1,300

 
1,300

Long-term debt
 
14,342

 
14,342

 
14,339

 
14,339


NOTE 5 – PROPERTY AND EQUIPMENT

Major categories of property and equipment are summarized as follows (dollars in thousands):
 
March 31, 2018
 
December 31, 2017
Building and improvements
$
3,378

 
$
3,378

Electronic data processing equipment
1,511

 
1,512

Furniture and fixtures
486

 
486

 
5,375

 
5,376

Less accumulated depreciation
3,632

 
3,595

Property and equipment, net
$
1,743

 
$
1,781

Depreciation expense for the three months ended March 31, 2018 was $38,000 ($121,000 for the year ended December 31, 2017).

NOTE 6 – INCOME TAXES

On December 22, 2017, the President signed the Tax Cuts and Jobs Act (TCJA), a comprehensive tax legislation which, among other things, reduced the Company's statutory federal income tax rate from 34% to 21% effective January 1, 2018. In addition to the reduction in tax rates, the TCJA makes broad and complex changes to the Internal Revenue Code that will introduce changes to many tax related exclusions, deductions and credits. Management believes that, based on its historical pattern of taxable income, the Company will produce sufficient income in the future to realize its deferred tax assets.  The Company recognized net deferred tax asset positions of $1,123,000 at March 31, 2018 and $1,487,000 at December 31, 2017.


21
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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The tax effect of significant differences representing deferred tax assets and liabilities are as follows (dollars in thousands):
 
 
As of March 31,
 2018
 
As of December 31, 2017
General expenses
 
$
1,068

 
$
1,069

Unearned premiums
 
1,295

 
1,269

Claims liabilities
 
469

 
484

AMT credit
 
788

 
1,575

Impairment on real estate owned
 
116

 
116

Unrealized losses on securities available-for-sale
 
95

 
—

Unrealized loss on interest rate swaps
 
93

 
128

Deferred tax assets
 
3,924

 
4,641

 
 
 
 
 
Depreciation
 
(85
)
 
(88
)
Deferred policy acquisition costs
 
(1,686
)
 
(1,706
)
Pre-1984 policyholder surplus account
 
(513
)
 
(529
)
Unrealized gains on securities available-for-sale
 
—

 
(831
)
Unrealized gains on equity securities
 
(517
)
 
—

Deferred tax liabilities
 
(2,801
)
 
(3,154
)
Net deferred tax asset
 
$
1,123

 
$
1,487

The appropriate income tax effects of changes in temporary differences are as follows (dollars in thousands):
 
 
Three months ended
March 31,
 
 
2018
 
2017
Deferred policy acquisition costs
 
$
(20
)
 
$
(3
)
Unearned premiums
 
(26
)
 
(62
)
General expenses
 
1

 
62

Depreciation
 
(3
)
 
(4
)
Claims liabilities
 
15

 
(44
)
AMT credit
 
787

 
(23
)
Impact of repeal of special provision on pre-1984 policyholder surplus
 
(16
)
 
—

Unrealized gains on equity securities
 
(43
)
 
—

Deferred income tax expense (benefit)
 
$
695

 
$
(74
)
Total income tax expense (benefit) varies from amounts computed by applying current federal income tax rates to income or loss before income taxes.  The reasons for these differences and the approximate tax effects are as follows:
 
 
Three months ended
March 31,
 
 
2018
 
2017
Federal income tax rate applied to pre-tax income/loss
 
21.0
 %
 
34.0
 %
Dividends received deduction and tax-exempt interest
 
(1.2
)%
 
2.6
 %
Company owned life insurance
 
4.6
 %
 
2.0
 %
Small life deduction
 
—
 %
 
19.3
 %
Other, net
 
1.1
 %
 
(2.1
)%
Effective federal income tax rate
 
25.5
 %
 
55.8
 %

22
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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The Company recognizes tax-related interest and penalties as a component of tax expense.  The Company files income tax returns in the U.S. federal jurisdiction and various states.  The Company is not subject to examinations by authorities related to its U.S. federal or state income tax filings for years prior to 2011. Tax returns have been filed through the year 2016.

NOTE 7 – NOTES PAYABLE AND LONG-TERM DEBT

Short-term debt and current portion of long-term debt consisted of the following as of March 31, 2018 and December 31, 2017 (dollars in thousands):
 
 
March 31,
 
December 31,
 
 
2018
 
2017
Current portion of installment note payable due in November with variable interest rate equal to the WSJ prime rate plus 0.5%. Unsecured.
 
$
800

 
$
800

Line of credit with variable interest rate equal to the WSJ prime rate, subject to a 5.0% floor; maturity March 2018.  Interest payments due quarterly.  Unsecured.
 
—

 
500

 
 
$
800

 
$
1,300

Long-term debt consisted of the following as of March 31, 2018 and December 31, 2017 (dollars in thousands):
 
 
March 31,
 
December 31,
 
 
2018
 
2017
 
 
 
 
 
Promissory note with variable interest rate equal to the WSJ prime rate plus 0.5%; maturity November 2019. Annual installment payments beginning November 2017 with final balloon payment due November 30, 2019. Unsecured.
 
$
2,200

 
$
2,200

 
 
 
 
 
Subordinated debentures issued on December 15, 2005 with floating rate interest equal to 3-Month LIBOR plus 375 basis points; net of $168,000 in debt issuance cost ($178,000 in 2016); maturity December 2035.  Interest payable quarterly.  Redeemable prior to maturity. Unsecured.
 
9,113

 
9,111

 
 
 
 
 
Subordinated debentures issued on June 21, 2007 with floating rate interest equal to 3-Month LIBOR plus 340 basis points; net of $65,000 in debt issuance cost ($68,000 in 2016); maturity June 15, 2037. Interest payable quarterly.  Redeemable prior to maturity. Unsecured.
 
3,029

 
3,028

 
 
$
14,342

 
$
14,339


The Company has entered into various swap agreements related to the trust preferred securities. On March 19, 2009, the Company entered into a forward swap effective September 17, 2012, with a notional amount of $3,000,000 and designated the swap as a hedge against changes in cash flows attributable to changes in the benchmark interest rate (LIBOR) associated with the subordinated debentures issued June 21, 2007. Quarterly, commencing September 17, 2012, under the terms of the forward swap, the Company will pay interest at a fixed rate of 7.02% until March 15, 2019. On May 26, 2010, the Company entered into a forward swap with a notional amount of $9,000,000 effective December 15, 2015, which hedges against changes in cash flows following the termination of the fixed rate period. Quarterly, commencing March 16, 2016 under the terms of the forward swap, the Company pays interest at a fixed rate of 8.49% until March 15, 2020.

The swaps entered into in 2009 and 2010 have fair values of $39,000 (liability) and $402,000 (liability), respectively, for a total liability of $441,000 at March 31, 2018 ($608,000 at December 31, 2017).  The swap liability is reported as a component of other liabilities on the consolidated balance sheets.  A net valuation gain of $132,000 (net of tax) is included in accumulated other comprehensive income related to the swap agreements at March 31, 2018.  A net valuation gain of $278,000 (net of tax) was included in accumulated other comprehensive income related to the swap at December 31, 2017.

23
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

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

The Company’s interest rate swaps include provisions requiring the Company to post collateral when the derivative is in a net liability position.  At March 31, 2018, the Company has securities on deposit with fair market values of $1,425,000 ($926,000 of which is posted as collateral). At December 31, 2017, the Company had securities on deposit with fair market values of $1,446,000 (all of which is posted as collateral). See Note 4 for additional information about the interest rate swaps.

NOTE 8 – POLICY AND CLAIM RESERVES

The Company regularly updates its reserve estimates as new information becomes available and events occur that may impact the resolution of unsettled claims. Reserve estimation can be an inherently uncertain process and reserves estimates can be revised up or down depending on changes in circumstances. Changes in prior years' reserve estimates are reflected in the results of operations in the year such changes are determined.

The following table is a reconciliation of beginning and ending property and casualty reserve balances for claims and claim adjustment expense (dollars in thousands):
 
 
Three months ended
March 31,
 
 
2018
 
2017
Summary of claims and claim adjustment expense reserves
 
 
 
 
Balance, beginning of year
 
$
7,075

 
$
7,531

Less reinsurance recoverable on unpaid losses
 
327

 
1,184

Net balances at beginning of year
 
6,748

 
6,347

Net losses:
 
 
 
 
Provision for claims and claim adjustment expenses for claims arising in current year
 
9,185

 
10,786

Estimated claims and claim adjustment expenses for claims arising in prior years
 
(1,097
)
 
(751
)
Total increases
 
8,088

 
10,035

Claims and claim adjustment expense payments for claims arising in:
 
 
 
 
Current year
 
5,527

 
7,090

Prior years
 
2,567

 
2,006

Total payments
 
8,094

 
9,096

Net balance at end of period
 
6,742

 
7,286

Plus reinsurance recoverable on unpaid losses
 
185

 
526

Claims and claim adjustment expense reserves at end of period
 
$
6,927

 
$
7,812


The decline in claim and claim adjustment expense reserves before reinsurance recoverable is primarily due to the decrease in catastrophe losses during the period. The estimate for claims arising in prior years was reduced $1,097,000 in 2018 (reduced $751,000 in 2017) due to favorable loss development during the year on claims arising in prior years.

Accident and Health Claim Reserves

The Company, through its life insurance subsidiary, underwrites a limited number of short duration accident and health contracts. These claims are typically settled in three years or less and the reserve for unpaid claims totaled $430,000 at March 31, 2018 ($367,000 at December 31, 2017). These claims are a component of policy and contract claims which totaled $913,000 at March 31, 2018 ($903,000 at December 31, 2017).

24
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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

NOTE 9 – REINSURANCE

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

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

Layer
Reinsurers' Limits of Liability
First Layer
100% of $13,500,000 in excess of $4,000,000 retention
Second Layer
100% of $25,000,000 in excess of $17,500,000
Third Layer
100% of $30,000,000 in excess of $42,500,000

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

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

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

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

At March 31, 2018, the largest reinsurance recoverable of a single reinsurer was $340,000 ($322,000 at December 31, 2017). Amounts reported as ceded incurred losses were related to development of losses from prior year catastrophes.

NOTE 10 – EMPLOYEE BENEFIT PLANS

The Company and its subsidiaries have an established retirement savings plan (401K Plan). All full-time employees are eligible to participate, and all employer contributions are fully vested for employees who have completed 1,000 hours of service in the year of contribution. Company matching contributions for the three months ended March 31, 2018 and 2017 amounted to $45,000 and $57,000, respectively. The Company contributes dollar-for-dollar matching contributions up to 5% of compensation subject to government limits.


25
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The Company established a non-qualified plan under which Company directors are allowed to defer all or a portion of directors' fees into various investment options. A supplemental executive retirement plan (SERP) covers named executive officers, with the Company contributing 15% of executive compensation to the plan. Contributions to the plan are fully vested upon the earlier of death, disability, change in control, or ten years of participation in the plan. Costs for amounts related to the non-qualified deferred compensation plans for the three months ended March 31, 2018 and 2017 amounted to an approximate $48,000 decrease and $83,000 increase in employee benefit related expenses, respectively.

The Company and its subsidiaries established an Employee Stock Ownership Plan (ESOP) in January 2010, to enable eligible employees to acquire a proprietary interest in the Company's common stock and to provide retirement and other benefits to such employees. There were $232,000 costs incurred during the three months ended March 31, 2018 and $268,000 costs incurred during the three months ended March 31, 2017 related to ESOP plan contributions. All contributions were made in cash for purchase of Company shares in the open market. The Company has not allocated newly issued shares directly to the plan and the plan has no debt.

NOTE 11 – SHAREHOLDERS' EQUITY

During the three months ended March 31, 2018 and year ended December 31, 2017, changes in shareholders' equity consisted of net income of $471,000 and net loss of $1,203,000, respectively; dividends paid of $126,000 in 2018 and $504,000 in 2017; decreases in accumulated other comprehensive income, net of applicable taxes, of $1,244,000 in 2018 and increases in accumulated other comprehensive income, net of applicable taxes, of $1,204,000 in 2017.  Other comprehensive gains and losses consisted of accumulated unrealized gains and losses on securities available-for-sale and unrealized loss on interest rate swaps.

Preferred Stock
Preferred Stock may be issued in one or more series as shall from time to time be determined and authorized by the Board of Directors. The directors may make specific provisions regarding (a) the voting rights, if any (b) whether such dividends are to be cumulative or noncumulative (c) the redemption provisions, if any (d) participating rights, if any (e) any sinking fund or other retirement provisions (f) dividend rates (g) the number of shares of such series and (h) liquidation preference. There is currently no Preferred Stock issued or outstanding.

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

In the event of any liquidation, dissolution or distribution of the assets of the Company remaining after the payments to the holders of the Preferred Stock of the full preferential amounts to which they may be entitled as provided in the resolution or resolutions creating any series thereof, the remaining assets of the Company shall be divided and distributed among the holders of both classes of common stock, except as may otherwise be provided in any such resolution or resolutions.

The table below provides information regarding the Company's preferred and common stock as of March 31, 2018 and December 31, 2017:

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

 
—

 
—

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

 
—

 
—

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

 
2,522,312

 
2,522,312



26
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

NOTE 12 – ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

Accumulated other comprehensive income (loss) ("AOCI") includes certain items that are reported directly within a separate component of shareholders' equity. The following table presents changes in AOCI balances (dollars in thousands):
 
 
Three months ended
March 31,
 
 
2018
 
2017
Gains and Losses on Cash Flow Hedges
 
 
 
 
Balance at beginning of period
 
$
(480
)
 
$
(679
)
Other comprehensive income for period:
 
 
 
 
Other comprehensive gain before reclassifications
 
132

 
70

Net current period other comprehensive income
 
132

 
70

Balance at end of period
 
$
(348
)
 
$
(609
)
 
 
 
 
 
Unrealized Gains and Losses on Available-for-Sale Securities
 
 
 
 
Balance at beginning of period
 
$
3,126

 
$
1,686

Other comprehensive income (loss) for period:
 
 
 
 
Other comprehensive income (loss) before reclassifications
 
(1,308
)
 
450

Reclassification adjustment - gains on equity securities
 
(2,107
)
 
—

Amounts reclassified from accumulated other comprehensive income
 
(68
)
 
(106
)
Net current period other comprehensive income (loss)
 
(3,483
)
 
344

Balance at end of period
 
$
(357
)
 
$
2,030

 
 
 
 
 
Total Accumulated Other Comprehensive Income (Loss) at end of period
 
$
(705
)
 
$
1,421


The following table presents the amounts reclassified out of AOCI for the three months ended March 31, 2018 (dollars in thousands):
Details about Accumulated Other Comprehensive Income Components
 
Amounts Reclassified from Accumulated Other Comprehensive Income
 
Affected Line Item in the Statement Where Net Income is Presented
Unrealized Gains and Losses on
Available-for-Sale Securities
 
$
86

 
Net realized investment gains
 
 
86

 
Total before tax
 
 
(18
)
 
Tax (expense) or benefit
 
 
$
68

 
Net of Tax


27
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The following table presents the amounts reclassified out of AOCI for the three months ended March 31, 2017 (dollars in thousands):
Details about Accumulated Other Comprehensive Income Components
 
Amounts Reclassified from Accumulated Other Comprehensive Income
 
Affected Line Item in the Statement Where Net Income is Presented
Unrealized Gains and Losses on
Available-for-Sale Securities
 
$
160

 
Net realized investment gains
 
 
160

 
Total before tax
 
 
(54
)
 
Tax (expense) or benefit
 
 
$
106

 
Net of Tax

NOTE 13 – SEGMENTS

The Company’s property and casualty insurance operations comprise one business segment. The property and casualty insurance segment primarily underwrites home insurance coverage with primary lines of business consisting of dwelling fire and extended coverage, homeowners (including mobile homeowners) and other liability. 

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

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

Total assets by industry segment at March 31, 2018 and at December 31, 2017 are summarized below (dollars in thousands):

Assets by industry segment
 
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
 
 
 
 
 
 
 
 
 
March 31, 2018
 
$
146,074

 
$
81,397

 
$
59,972

 
$
4,705

 
 


 
 
 
 
 
 
December 31, 2017
 
$
146,438

 
$
80,241

 
$
60,709

 
$
5,488


28
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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

Premium revenues and operating income by business segment for the three months ended March 31, 2018 and 2017 are summarized below (dollars in thousands):

Three months ended March 31, 2018
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
REVENUE
 
 
 
 
 
 
 
Net premiums earned
$
15,059

 
$
13,531

 
$
1,528

 
$
—

Net investment income
781

 
251

 
516

 
14

Net realized investment gains (losses)
(125
)
 
(174
)
 
49

 
—

Other income
161

 
160

 
1

 
—

 
15,876

 
13,768

 
2,094

 
14

BENEFITS AND EXPENSES
 

 
 

 
 

 
 

Policyholder benefits paid
9,427

 
7,978

 
1,449

 
—

Amortization of deferred policy acquisition costs
803

 
690

 
113

 
—

Commissions
2,060

 
2,012

 
48

 
—

General and administrative expenses
2,003

 
1,452

 
507

 
44

Taxes, licenses and fees
649

 
553

 
96

 
—

Interest expense
302

 
—

 
12

 
290

 
15,244

 
12,685

 
2,225

 
334

Income (Loss) Before Income Taxes
$
632

 
$
1,083

 
$
(131
)
 
$
(320
)



Three months ended March 31, 2017
Total
 
P&C Insurance Operations
 
Life Insurance Operations
 
Non-Insurance Operations
REVENUE
 
 
 
 
 
 
 
Net premiums earned
$
15,040

 
$
13,489

 
$
1,551

 
$
—

Net investment income
926

 
392

 
519

 
15

Net realized investment gains
160

 
—

 
160

 
—

Other income
152

 
150

 
2

 
—

 
16,278

 
14,031

 
2,232

 
15

BENEFITS AND EXPENSES
 

 
 

 
 

 
 

Policyholder benefits paid
11,146

 
9,918

 
1,228

 
—

Amortization of deferred policy acquisition costs
945

 
694

 
251

 
—

Commissions
2,093

 
2,024

 
69

 
—

General and administrative expenses
1,797

 
1,275

 
279

 
243

Taxes, licenses and fees
689

 
592

 
97

 
—

Interest expense
323

 
—

 
19

 
304

 
16,993

 
14,503

 
1,943

 
547

Income (Loss) Before Income Taxes
$
(715
)
 
$
(472
)
 
$
289

 
$
(532
)


29
Table of Contents

THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

The following table presents the Company’s gross and net premiums written for the property and casualty segment and the life and accident and health segment for the three months ended March 31, 2018 and 2017, respectively:
 
 
Three months ended
March 31,
 
 
2018

2017
Life, accident and health operations premiums written:
 
 

Traditional life insurance
 
$
1,120

 
$
1,145

Accident and health insurance
 
415

 
423

Gross life, accident and health
 
1,535

 
1,568

Reinsurance premium ceded
 
(31
)
 
(29
)
Net life, accident and health premiums written
 
$
1,504

 
$
1,539

Property and Casualty operations premiums written:
 
 

Dwelling fire & extended coverage
 
$
9,553

 
$
9,431

Homeowners (Including mobile homeowners)
 
5,312

 
5,627

Other liability
 
565

 
543

Gross property and casualty
 
15,430

 
15,601

Reinsurance premium ceded
 
(1,154
)
 
(1,102
)
Net property and casualty written
 
$
14,276

 
$
14,499

Consolidated gross premiums written
 
$
16,965

 
$
17,169

Reinsurance premium ceded
 
(1,185
)
 
(1,131
)
Consolidated net premiums written
 
$
15,780

 
$
16,038


The following table presents the Company’s gross and net premiums earned for the property and casualty segment and the life and accident and health segment for the three months ended March 31, 2018 and 2017, respectively:



Three months ended
March 31,
 

2018

2017
Life, accident and health operations premiums earned:

 
Traditional life insurance

$
1,144

 
$
1,158

Accident and health insurance

415

 
422

Gross life, accident and health

1,559

 
1,580

Reinsurance premium ceded

(31
)
 
(29
)
Net life, accident and health premiums earned

$
1,528

 
$
1,551

Property and Casualty operations premiums earned:



Dwelling fire & extended coverage

$
9,116

 
$
8,816

Homeowners (Including mobile homeowners)

5,497

 
5,720

Other liability

530

 
513

Gross property and casualty

15,143

 
15,049

Reinsurance premium ceded

(1,612
)

(1,560
)
Net property and casualty earned

$
13,531


$
13,489

Consolidated gross premiums earned

$
16,702


$
16,629

Reinsurance premium ceded

(1,643
)

(1,589
)
Consolidated net premiums earned

$
15,059


$
15,040


30
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THE NATIONAL SECURITY GROUP, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED AMOUNTS EXCEPT FOR DECEMBER 31, 2017 AMOUNTS)

NOTE 14 – CONTINGENCIES

In the ordinary course of business, the Company and its subsidiaries are routinely a defendant in or party to pending or threatened legal actions and proceedings related to the conduct of their insurance operations. These suits can involve alleged breaches of contracts, torts, including bad faith and fraud claims based on alleged wrongful or fraudulent acts of the Company's subsidiaries, and other miscellaneous causes of action. It is inherently difficult to predict the outcome of such matters, particularly when the claimant seeks very large or indeterminate damages or when the matters present novel legal theories or involve multiple parties. An accrued liability is established when loss contingencies are both probably and estimable. However, there is potential loss exposure in excess of any accrued amounts. The Company monitors pending matters for further development that could affect the amount of the accrued liability.

The Company's property & casualty subsidiaries had two actions remaining in Texas filed in the aftermath of Hurricane Ike at December 31, 2017. These actions include individual lawsuits with allegations of underpayment of hurricane-related claims. The suits seek a variety of remedies, including actual and/or punitive damages in unspecified amounts and/or declaratory relief. In March of 2018 the Company was notified that the Texas Supreme Court denied a Writ of Application to review an unfavorable decision handed down by the Court of Appeals on one of the two remaining Ike claims. This claim was 95% reinsured by the Company's catastrophe reinsurance coverage and the amount of the settlement, net of reinsurance, did not have a material impact on these consolidated financial statements.  

The Company has reserves set up on litigated claims and the reserves are included in benefit and loss reserves.

NOTE 15 – SUPPLEMENTAL CASH FLOW INFORMATION

Cash paid for interest during the three months ended March 31, 2018 was $266,000 ($269,000 in 2017). There was no cash paid for income taxes during the three months ended March 31, 2018 or 2017.

NOTE 16 – SUBSEQUENT EVENTS

Management has evaluated subsequent events and their potential effects on these consolidated financial statements through the filing date of this Form 10-Q.

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REVIEW OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM


To the Board of Directors and Shareholders
The National Security Group, Inc.

We have reviewed the condensed consolidated balance sheet of The National Security Group, Inc. as of March 31, 2018, and the related condensed consolidated statements of operations and comprehensive income (loss) for the three-month periods ended March 31, 2018 and 2017 and the condensed consolidated statement of changes in shareholders’ equity for the three-month period ended March 31, 2018 and the statement of cash flows for the three-month periods ended March 31, 2018 and 2017. These condensed consolidated financial statements are the responsibility of the company’s management.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the consolidated financial statements taken as a whole. Accordingly, we do not express such an opinion.

Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed consolidated financial statements referred to above for them to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with auditing standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of The National Security Group, Inc. as of December 31, 2017, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 16, 2018, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2017, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/ Warren Averett, LLC
 
Birmingham, Alabama
May 14, 2018






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Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

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. We are a “smaller reporting company” under Securities and Exchange Commission (SEC) regulations and therefore qualify for the scaled disclosure of smaller reporting companies. In general, the same information is required to be disclosed in the management discussion and analysis by smaller reporting companies except that the discussion need only cover the latest two year period and disclosures relating to contractual obligations are not required. In accordance with the scaled disclosure requirements, this discussion covers the three month periods ended March 31, 2018 and 2017.

The National Security Group, Inc. operates in ten states with 46.9% of total premium revenue generated in the states of Alabama and Mississippi.  The Company is made up of the following two segments:

•
The Property and Casualty (P&C) segment is the most significant segment, accounting for 90.7% of gross earned premium in 2018.  The P&C segment has insurance in-force in the states of Alabama, Arkansas, Georgia, Louisiana, Mississippi, Oklahoma, South Carolina, and Tennessee.  

•
The Life segment accounted for 9.3% of gross premium revenue in 2018. The Life segment is licensed to underwrite life and accident and health insurance in Alabama, Florida, Georgia, Mississippi, South Carolina, Tennessee and Texas.
 
The Company's P&C segment 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. There is no material differentiation between the products underwritten by NSFC and Omega as both underwrite primarily dwelling personal lines coverage. Due to Omega producing no direct written premium and the fact that Omega is a wholly owned subsidiary of NSFC authorized to underwrite similar lines of business, all references to NSFC or P&C segment in the remainder of this management discussion and analysis will include the insurance operations of both NSFC and Omega.

Life segment business is conducted through National Security Insurance Company (NSIC), a wholly owned subsidiary of the Company organized in 1947. All references to NSIC or life segment in the remainder of this management discussion and analysis will refer to the combined life, accident and health insurance operations.

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.

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 Co (Best).  On April 12, 2018, Best affirmed the financial strength rating (FSR) of B++ (Good) and the issuer credit rating (ICR) of "bbb" of NSFC. In addition, Best affirmed the FSR of B+(Good) and ICR of "bbb-" of Omega and NSIC. The A.M. Best outlook for all of the ratings is "stable" for NSFC and Omega. Best upgraded the outlook from "stable" to "positive" for NSIC. Best also affirmed the ICR of "bb" of the parent holding company, NSEC, with a "stable" outlook.

The property and casualty subsidiaries have been assigned ratings by Demotech, Inc. On March 8, 2018, Demotech affirmed a Financial Stability Rating of A (Exceptional) for both NSFC and Omega.

The property and casualty segment can be impacted by severe storm activity resulting in incurred losses and loss adjustment expenses primarily from tornado, 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.

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Overview-Three Months Ended March 31, 2018 compared to Three Months Ended March 31, 2017

Summary:

For the three months ended March 31, 2018, the Company had net income of $471,000, $0.19 income per share, compared to a net loss of $316,000, $0.13 loss per share, for the three months ended March 31, 2017. The pretax income from operations in the first quarter of 2018 totaled $757,000 compared to pretax loss from operations of $875,000 in the first quarter of 2017. During the first quarter of 2018, claim activity related to catastrophe events was significantly less compared to the same period last year. For the three months ended March 31, 2018, the P&C segment had $758,000 in reported losses and loss adjustment expenses (LAE) from cat events. Results for the first quarter of 2017 were negatively impacted by an increased frequency of severe thunderstorm activity which generated widespread wind, hail and tornado damage to insured property across the southeastern United States. This increased frequency of severe thunderstorm activity led to $3,521,000 in reported losses and LAE from cat events during the first quarter of 2017.

Financial results for the three months ended March 31, 2018 and 2017 were as follows:

Consolidated Financial Summary
 
Three months ended March 31,
     (dollars in thousands, except per share)
 
2018
 
2017
Gross premiums written
 
$
16,965

 
$
17,169

Net premiums written
 
$
15,780

 
$
16,038

 
 
 
 
 
Net premiums earned
 
$
15,059

 
$
15,040

Net investment income
 
781

 
926

Net realized investment (losses) gains
 
(125
)
 
160

Other income
 
161

 
152

Total Revenues
 
15,876

 
16,278

Policyholder benefits and settlement expenses
 
9,427

 
11,146

Amortization of deferred policy acquisition costs
 
803

 
945

Commissions
 
2,060

 
2,093

General and administrative expenses
 
2,003

 
1,797

Taxes, licenses and fees
 
649

 
689

Interest expense
 
302

 
323

Total Benefits, Losses and Expenses
 
15,244

 
16,993

Income (Loss) Before Income Taxes
 
632

 
(715
)
Income tax expense (benefit)
 
161

 
(399
)
Net Income (Loss)
 
$
471

 
$
(316
)
Income (Loss) Per Common Share
 
$
0.19

 
$
(0.13
)
Reconciliation of Net Income (Loss) to non-GAAP Measurement
 
 
 
 
Net income (loss)
 
$
471

 
$
(316
)
Income tax expense (benefit)
 
161

 
(399
)
Realized investment losses (gains), net
 
125

 
(160
)
Pretax Income (Loss) From Operations
 
$
757

 
$
(875
)

Three-month period ended March 31, 2018 compared to three-month period ended March 31, 2017

Premium Revenue:
For the three month period ended March 31, 2018, net premiums earned were up $19,000 at $15,059,000 compared to $15,040,000 during the same period in 2017. The increase in premium revenue was primarily attributable to a slight 0.3% increase in net premiums earned in the P&C segment.

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Net Income (Loss):
For the quarter ended March 31, 2018, the Company had net income of $471,000, $0.19 income per share, compared to a net loss of $316,000, $0.13 loss per share, for the same period in 2017, an increase of $787,000. As discussed above, a decrease in storm losses was the primary factor contributing to the increase in net income in the current year compared to the same period last year.

Pretax Income (Loss) from Operations:
A primary non-GAAP financial measure utilized by management is pretax income (loss) from operations. This measure consists of net income (loss) before income taxes adjusted for realized investment gains and losses. This measure provides a means of comparing the results of our core operations without the impact of items that are more unpredictable and less consistent from year to year. A reconciliation of pretax income (loss) from operations is presented in the table above.

For the three months ended March 31, 2018, our pretax income from operations was $757,000 compared to a pretax loss from operations of $875,000 for the three months ended March 31, 2017, an increase of $1,632,000. A decrease in severe thunderstorm activity during the first quarter of 2018 compared to the same period last year was the primary factor contributing to the improvement in pretax income from operations. The first quarter of 2017 was plagued with an unusually high frequency of severe thunderstorm activity due to much warmer temperatures in the early part of the year.

P&C Segment Combined Ratio:
The P&C segment ended the first three months of 2018 with a GAAP basis combined ratio of 92.7%. Reported catastrophe losses totaled $758,000 for the quarter and added 5.5 percentage points to the combined ratio. In comparison, the P&C segment ended the first quarter of 2017 with a GAAP basis combined ratio of 106.3% with catastrophe losses increasing the combined ratio by 25.8 percentage points. Partially offsetting the reduction in catastrophe losses in the first quarter; fire losses were up $1,210,000 in 2018 compared to last year. This increase in fire losses added 8.8 percentage points to the 2018 combined ratio. While the colder temperatures in January and February of 2018 reduced outbreaks of severe weather compared to last year, the colder temperatures tend to increase the frequency of fire losses in the nonstandard markets in which we operate due to increased use of supplemental home heating sources such as space heaters and wood burning stoves.

Overview - Balance Sheet highlights at March 31, 2018 compared to December 31, 2017
Selected Balance Sheet Highlights
 
March 31, 2018
 
December 31, 2017
     (dollars in thousands)
 
 
 
 
Invested Assets
 
$
114,318

 
$
114,731

Cash
 
$
5,586

 
$
6,644

Total Assets
 
$
146,074

 
$
146,438

Policy Liabilities
 
$
77,250

 
$
76,674

Total Debt
 
$
15,142

 
$
15,639

Accumulated Other Comprehensive Income (Loss)
 
$
(705
)
 
$
2,646

Shareholders' Equity
 
$
46,726

 
$
47,625

Book Value Per Share
 
$
18.53

 
$
18.88


Invested Assets:
Invested assets as of March 31, 2018 were $114,318,000 down $413,000, or 0.4%, compared to $114,731,000 as of December 31, 2017. Positive cash flow from operations lead to an increase in investment purchases during the first quarter of 2018, but this increase in new investment was offset by an increase in market interest rates which reduced the market value of our bond investment portfolio.

Cash:
The Company, primarily through its insurance subsidiaries, had $5,586,000 in cash and cash equivalents at March 31, 2018, not materially different compared to $6,644,000 at December 31, 2017. The decrease in cash was primarily due to an increase in investments in fixed income securities and debt reduction.


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Total Assets:
The Company had no material change in total assets as of March 31, 2018 compared to December 31, 2017. Total assets as of March 31, 2018 were $146,074,000 compared to $146,438,000 at December 31, 2017.

Policy Liabilities:
Policy liabilities were $77,250,000 at March 31, 2018 compared to $76,674,000 at December 31, 2017; an increase of $576,000 or 0.8%. The primary reason for the increase in policy liabilities in the first quarter of 2018 compared to 2017 was an increase in unearned premium. This increase in unearned premium is seasonal as we typically issue and renew a larger number of annual insurance contracts during the first and second quarters of each year compared to the remainder of the year.

Debt Outstanding:
Total debt at March 31, 2018 was $15,142,000 compared to $15,639,000 at December 31, 2017. The pay down of a bank credit line was the primary reason for the $497,000 or 3.2% decrease in total debt.

Shareholders' Equity:
Shareholders' equity as of March 31, 2018 was $46,726,000, down $899,000 compared to December 31, 2017 Shareholders' equity of $47,625,000. Book value per share was $18.53 at March 31, 2018, compared to $18.88 per share at December 31, 2017, a decrease of $0.35. The primary reason for the decrease in Shareholders' Equity was the decrease in market value of fixed income securities as well as the decrease in market value of equity securities. Partially offsetting these factors was net income of $471,000.

Three Months Ended March 31, 2018 compared to Three Months Ended March 31, 2017

Premium Revenue:
The table below provides earned premium revenue by segment for the three months ended March 31, 2018 and 2017:

 
 
Three months ended
March 31,
 
Percent
(dollars in thousands)
 
2018
 
2017
 
increase (decrease)
Life, accident and health operations premiums earned:
 
 
 
 
 
 
Traditional life insurance
 
$
1,144

 
$
1,158

 
(1.2
)%
Accident and health insurance
 
415

 
422

 
(1.7
)%
Gross life, accident and health
 
1,559

 
1,580

 
(1.3
)%
     Reinsurance premium ceded
 
(31
)
 
(29
)
 
6.9
 %
Net life, accident and health premiums earned
 
$
1,528

 
$
1,551

 
(1.5
)%
 
 
 
 
 
 
 
Property and Casualty operations premiums earned:
 
 
 
 
 
 

Dwelling fire & extended coverage
 
$
9,116

 
$
8,816

 
3.4
 %
Homeowners (Including mobile homeowners)
 
5,497

 
5,720

 
(3.9
)%
Other liability
 
530

 
513

 
3.3
 %
Gross property and casualty
 
15,143

 
15,049

 
0.6
 %
     Reinsurance premium ceded
 
(1,612
)
 
(1,560
)
 
3.3
 %
Net property and casualty premiums earned
 
$
13,531

 
$
13,489

 
0.3
 %
 
 
 
 
 
 
 
Consolidated gross premiums earned
 
$
16,702

 
$
16,629

 
0.4
 %
     Reinsurance premium ceded
 
(1,643
)
 
(1,589
)
 
3.4
 %
Consolidated net premiums earned
 
$
15,059

 
$
15,040

 
0.1
 %

Consolidated net premium earned was up 0.1% for the quarter ended March 31, 2018, at $15,059,000 compared to $15,040,000 for the quarter ended March 31, 2017. The slight increase in net premium earned was due to a 0.3%

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increase in net premium earned in the P&C segment. Premium growth has slowed due to a combination of competitive pressures and the smaller size of the non-standard market in which we operate.

The Company maintains catastrophe reinsurance coverage to mitigate loss exposure from catastrophic events. With our 2018 catastrophe contract placement, our catastrophe retention remained unchanged from last year at $4 million and, also unchanged from last year, we maintain catastrophe reinsurance covering incurred claims of a single catastrophe event up to $72.5 million. Our catastrophe reinsurance has a reinstatement provision for one event and covers the cost of a second event up to the same $72.5 million upper limit. In our reinsurance structure, management attempts to limit the impact on pretax earnings of a single modeled 100 year cat event to no more than $4 million (net of reinsurance). It is noted, however, that hurricane models are subject to significant risk and are only a tool to estimate the impact of catastrophe events. The Company also has risk associated with multiple smaller catastrophe events that individually may not exceed our $4 million retention and would not be covered under our catastrophe reinsurance contract. While the first quarter of 2018 had catastrophe related losses, no single event approached the upper limit of our $4 million retention under our catastrophe reinsurance coverage.

Under the catastrophe reinsurance program in 2018, the Company retains the first $4,000,000 in losses from each event.  Reinsurance coverage is maintained in three layers as follows:
Layer
Reinsurers' Limits of Liability
First Layer
100% of $13,500,000 in excess of $4,000,000 retention
Second Layer
100% of $25,000,000 in excess of $17,500,000
Third Layer
100% of $30,000,000 in excess of $42,500,000

Investment Income:
For the three months ended March 31, 2018, net investment income was $781,000 compared to $926,000 for the same period in 2017; a decrease of $145,000 or 15.7%. The primary reason for the decrease was a decline in value of investments in the cash value of our company owned life insurance in first quarter 2018 compared to first quarter 2017.

Realized Investment Gains and Losses:
Realized investment losses, for the three months ended March 31, 2018, were $125,000 compared to realized investment gains of $160,000 for the same period in 2017, a decline of $285,000. In January of 2016, the FASB issued guidance that requires equity investments to be measured at fair value with changes in fair value recognized in net income through investment gains and losses. For us, this guidance became effective January 1, 2018. A decrease in market value of our equity securities was the primary reason for the $285,000 decline and was primarily associated with the adoption of the guidance described above.

Other Income:
Other income was comparable at $161,000 for the three months ended March 31, 2018, compared to $152,000 for the same period in 2017; a decrease of $9,000. Other income consists primarily of fees related to the issuance of our property insurance policies as well as other miscellaneous income.

Policyholder Benefits:
Policyholder claims were $9,427,000 for the three months ended March 31, 2018, compared to $11,146,000 for the three months ended March 31, 2017; a decrease of $1,719,000 or 15.4%. Claims as a percentage of premium earned was 62.6% in the first quarter of 2018 compared to 74.1% in the first quarter of 2017. An active spring storm season in the first quarter of 2017 lead to higher windstorm related claims which negatively impacted underwriting results in the prior year.










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The table below provides a recap of P&C segment gross reported losses and LAE by catastrophe event and non-catastrophe wind and hail losses and LAE for the three months ended March 31, 2018 and 2017 (dollars in thousands):
For the three months ended March 31, 2018
 
For the three months ended March 31, 2017
Cat event
 
Reported
Losses & LAE
 
Claim Count
 
Cat event
 
Reported
Losses & LAE
 
Claim Count
Cat 1814 (Feb 24-26)
 
$
148

 
48

 
Cat 1711 (Jan 1-3)
 
$
777

 
178

Cat 1817 (Mar 18-20)
 
584

 
145

 
Cat 1713 (Jan 18-22)
 
2,034

 
352


 

 

 
Cat 1719 (Feb 28-Mar 2)
 
330

 
88


 

 

 
Cat 1720 (Mar 6-9)
 
106

 
35


 

 

 
Cat 1721 (Mar 21-22)
 
115

 
32

Misc cats less than $100k
 
26

 
8

 
Misc cats less than $100k
 
159

 
46

Total Cat losses
 
$
758

 
201

 
Total Cat losses
 
$
3,521

 
731

 
 
 
 
 
 
 
 
 
 
 
Non-cat wind & hail
 
$
1,159

 
372

 
Non-cat wind & hail
 
$
1,153

 
300


During the first quarter of 2018, the P&C segment was impacted by three catastrophe events which produced 201 claims with reported losses (including loss adjustment expenses) totaling $758,000. In comparison, the P&C segment was impacted by eight catastrophe events during the first quarter of 2017 from 731 claims totaling $3,521,000. The prior year had higher than average temperatures in January, which lead to an early start to the traditional "spring storm season" and a higher frequency of tornado and thunderstorm activity and was the primary reason for the increase in storm losses in 2017. During 2018, the P&C segment had reported losses from Cat 1817 totaling $584,000 from 145 claims. This cat event accounted for 77.0% of total reported losses from cat events during the first quarter of 2018 and added 4.3 percentage points to the first quarter 2018 P&C segment loss ratio. Claims reported from all first quarter 2018 cat events contributed 5.5 percentage points to the first quarter 2018 P&C segment loss ratio. During 2017, reported claims from cat events were primarily from Cat 1713 which impacted our policyholders in January 2017, predominantly in the state of Georgia. This cat event accounted for 57.8% of all losses reported from cat events during the first three months of 2017. In addition, Cat 1713 added 14.9 percentage points to the first quarter 2017 P&C segment loss ratio. Claims reported from all first quarter 2017 cat events contributed 25.8 percentage points to the first quarter 2017 P&C segment loss ratio.

Non-catastrophe wind and hail claims reported in the first quarter of 2018 totaled $1,159,000 compared to non-catastrophe wind and hail claims reported in the first quarter of 2017 totaling $1,153,000; an increase of $6,000. During the first three months of 2018, the P&C segment had 372 non-cat wind and hail claims reported (an average of $3,100 per claim) compared to 300 claims reported during the first three months of 2017 (an average of $3,800 per claim). Non-cat wind and hail claims reported during the first quarter of 2018 accounted for 14.5% of total P&C segment incurred losses in the current year. Non-cat wind and hail claims reported during the first quarter of 2017 accounted for 11.6% of total P&C segment incurred losses in 2017.

While overall policyholder benefit payments were down in the property and casualty segment due to a lower frequency of cat event losses, fire losses reported in the first quarter of 2018 were up $,1,210,000 or 34.4% compared to fire losses reported during the first quarter of 2017. The P&C segment had 145 fire losses reported in the first three months of 2018 totaling $4,731,000 compared to 135 claims reported in the first three months of 2017 totaling $3,521,000. The average cost per claim was $32,600 for fire losses reported in the first quarter of 2018 compared to $26,100 for fire losses reported in the first quarter of 2017. Many factors can impact the frequency and severity of fire losses, but the primary factor we observe is the duration of cold weather in our coverage areas. The first quarter of 2018, particularly in January and February, had colder average temperatures compared to 2017. While these colder temperatures reduce the impact of severe thunderstorm activity, the colder temperatures typically lead to an increase in fire related losses due to increased use of supplemental heat such as space heaters and wood burning stoves.

Policy Acquisition Cost (Commissions and Amortization of Deferred Acquisition Cost):
For the three months ended March 31, 2018, policy acquisition costs were $2,863,000 compared to $3,038,000 for the same period in 2017; a decrease of $175,000 or 5.8%. Policy acquisition costs consist of amortization of previously capitalized distribution costs and current commission payments to agents. As a percentage of premium revenue, policy

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acquisition costs were comparable at 19.0% in the first quarter of 2018 compared to 20.2% for the same period in 2017.

General Expenses:
General and administrative expenses totaled $2,003,000 in the first quarter of 2018 compared to $1,797,000 in the first quarter of 2017; a 11.5% increase. The primary factors contributing to the $206,000 increase in general expenses, in the first quarter of 2018, compared to the same period in 2017, was an increase in professional fees for product development and actuarial consulting.

Taxes, Licenses and Fees:
Insurance taxes, licenses and fees were $649,000 for the three months ended March 31, 2018, compared to $689,000 for the same period in 2017. As a percentage of net premiums earned, insurance taxes, licenses and fees were comparable at 4.3% for the three months ended March 31, 2018 compared to 4.6% for the three months ended March 31, 2017.

Interest Expense:
Interest expense for the first quarter of 2018 was $302,000 compared to $323,000 for the same period in 2017. A reduction in total debt outstanding over the past twelve months was the primary factor contributing to the $21,000 decrease.

Income Taxes:
On December 22, 2017, the President signed the TCJA, a comprehensive tax legislation which, among other things, reduced the Company's statutory federal income tax rate from 34% to 21% effective January 1, 2018. For the three month period ended March 31, 2018, the Company had pretax income of $632,000 compared to a pretax loss of $715,000 for the same period in 2017. The $161,000 tax expense for the first quarter of 2018 consisted of current tax benefit of $534,000 and deferred tax expense of $695,000. Tax benefit for the first quarter of 2017 consisted of current tax benefit of $325,000 and deferred tax benefit of $74,000.

Net Income (Loss):
The Company ended the first quarter of 2018 with net income of $471,000 compared to a net loss of $316,000 for the same period in 2017. As discussed in detail above, the primary reason for the first quarter 2018 net income compared to the first quarter 2017 net loss was a decrease in storm related losses in the current year compared to the same period in 2017.

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 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 with an average portfolio duration typically of less than 5 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.

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.
                  

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Virtually all invested assets of the Company are held in the insurance subsidiaries. As of March 31, 2018, the contractual maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows (dollars in thousands):
Maturity
Available- for-Sale
 
Held-to-Maturity
 
Total
 
Percentage of Total
Maturity in less than 1 year
$
1,284

 
$
—

 
$
1,284

 
1.31
%
Maturity in 1-5 years
16,803

 
—

 
16,803

 
17.17
%
Maturity in 5-10 years
29,218

 
57

 
29,275

 
29.92
%
Maturity after 10 years
48,972

 
1,516

 
50,488

 
51.60
%
 
$
96,277

 
$
1,573

 
$
97,850

 
100.00
%

It should be noted that the above table represents maturities based on stated/contractual maturity. Due to call and prepayment features inherent in some debt securities and principal pay-downs on mortgage backed 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, due to other factors, both regulatory and those associated with good investment management practices associated with asset/liability matching, we do have exposure to changes in market values of securities due to changes in interest rates. Currently, a 100 basis point immediate increase in interest rates would generate approximately a $5,436,000, or 5.7%, decline in the market value of fixed maturity investments. Alternatively, a 100 basis point decrease in interest rates will generate approximately $5,342,000, or 5.6%, increase in market value of fixed income investments. Management has attempted, to the extent possible, to reduce risk in a rising rate environment. However, due to asset liability matching requirements, particularly in the life subsidiary portfolio, interest rate risk can not be eliminated and exposure to market volatility can cause some variability in our accumulated other comprehensive income, total return on investments, total shareholders' equity and book value per share.

At March 31, 2018, the Company had aggregate equity capital, unrealized investment gains (net of income taxes) and retained earnings of $46,726,000, down $899,000 compared to $47,625,000 at December 31, 2017.  Components of the change in equity were net income of $471,000, a decrease in accumulated unrealized gains on fixed maturities of $1,376,000, a net unrealized gain of $132,000 related to interest rate swaps and cash dividends paid totaling $126,000.

As discussed above, changing interest rates can have a significant impact on the market value of fixed maturity investments. Fixed maturity securities classified as available-for-sale increase the liquidity resources of the Company as they can be sold at any time to pay claims or meet other Company obligations. However, these securities are required to be carried at market value with net of tax accumulated unrealized gains and losses directly impacting shareholder's equity. While the increase in interest rates causes near term declines in the value of fixed income securities, we are able to reap the benefit of reinvesting at higher rates as current fixed income investments are called, amortized (mortgage backed securities) or reach contractual maturity. Over the next twelve months, based on cash flow projection modeling that considers such factors as anticipated principal payments on mortgage backed securities, likelihood of call provisions being enacted and regular contractual maturities, we expect approximately 4% of our current fixed income portfolio to be reinvested or otherwise available to meet Company obligations.

The Company, primarily through its insurance subsidiaries, had $5,586,000 in cash and cash equivalents at March 31, 2018, compared to $8,123,000 at March 31, 2017. Cash provided by operating activities increased cash by $1,345,000 during the three months ended March 31, 2018. The increase in cash from operating activities was primarily driven by net income from operations. Cash provided by operating activities increased cash by $671,000 for the three months ended March 31, 2017. The increase in cash provided by operations in 2017 was primarily due to collection of receivable balances.

Net cash used in investing activities totaled $1,776,000 for the three months ended March 31, 2018, compared to cash provided of $688,000 in 2017. Cash used in investing activities in 2018 primarily consisted of investment of positive cash flow from operations.

Net cash used in financing activities totaled $627,000 for the three ended March 31, 2018, compared to $604,000 for the same period last year. During the three months ended March 31, 2018, the Company repaid $500,000 in short-term debt. The Company maintains a $1,000,000 operating line of credit which matures in September 2018, as well as a $700,000 line of credit which matures in March of 2020. We had $1,700,000 available on revolving line of credit at March 31, 2018.

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The Company had a total of $14,342,000 of long-term debt outstanding as of March 31, 2018, compared to $14,339,000 at December 31, 2017, which includes $12,372,000 in trust preferred securities issued by the Company in addition to the installment note. Current year and prior year amounts were reduced by the unamortized portion of the placement fees associated with the issuance of the trust preferred securities, $230,000 and $233,000, respectively.

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 below investment 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 payment of dividends, management fees, reimbursements for federal income taxes and reimbursement of expenses incurred at the corporate level for the subsidiaries.  These funds are used to pay stockholder dividends, principal and 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 is the primary source of dividends to the holding company. Consideration of insurance subsidiary growth opportunities, regulatory capital adequacy, rating agency impact and holding company debt reduction, among other items, are factors that influence our subsidiary dividend requirements. While we have made significant progress in recent years, continued strengthening capital levels in the insurance subsidiaries and reduction of debt remains a top priority.

Dividends paid from the insurance subsidiaries are subject to regulatory restrictions and prior approval of the Alabama Department of Insurance. As disclosed in Note 12 to the audited consolidated financial statements included in our 2017 Annual Report on Form 10-K, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company during 2018 is statutorily limited to $1,646,000 in the life insurance subsidiary and $3,419,000 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 from insurance subsidiaries 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 potential adverse impacts on regulatory surplus, will likely lead to dividend payments to NSG substantially below the above referenced regulatory maximums. The Company received no dividends from its subsidiaries during the three months ended March 31, 2018.
 
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.

The Company continues to monitor liquidity and subsidiary capital closely. Improved underwriting results over the past five years stemming from the discontinuation of unprofitable lines of business, generally favorable tropical weather patterns over this period, streamlining of products offered combined with enhancements to the Company's rate development process and improvements in the Company's catastrophe reinsurance structure have reduced the pressure on subsidiary capital levels. However, continuing to strengthen subsidiary capital continues to be a top priority for management.

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.

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Item 3. Quantitative and Qualitative Disclosures About Market Risk

Under smaller reporting company rules we are not required to disclose information required under Item 3. However, in order to provide information to our investors, we have elected to provide information related to 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 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 and 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 $4,303,000. Our portfolio has historically been highly correlated to the S&P 500 with regard to market risk. Based on an evaluation of the historical risk measure of our portfolio relative to the S&P 500, if the market value of the S&P 500 Index decreased 10% from its March 31, 2018 value, the fair value of the Company's common stock investments would decrease by approximately $430,000.

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 4 in the consolidated financial statements present additional disclosures concerning fair values of Financial Assets and Financial Liabilities and are incorporated by reference herein.

The Company limits the extent of its market risk by purchasing securities that are backed by entities considered to be financially stable, the majority of the assets are issued by U.S. government sponsored entities or corporate entities with debt considered to be "investment grade". 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 losing principal should prepayments exceed expectations, the Company generally 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 capital for a sustained period of time, and 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 Company has used improved cash flows from insurance operations to increase allocations to corporate and US Government bonds.

Item 4. Controls and Procedures

Our management carried out an evaluation, with the participation of our chief executive officer and chief financial officer, of the effectiveness of our disclosure controls and procedures as of March 31, 2018. Based upon that evaluation, our chief executive officer and chief financial officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the rules and forms of the Securities and Exchange Commission.

There has not been any change in our internal control over financial reporting in connection with the evaluation required by Rule 13A-15(d) under the Exchange Act that occurred during the three months ended March 31, 2018, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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Part II

Item 1.  Legal Proceedings
Please refer to Note 13 to the condensed consolidated financial statements included herein, and the 2017
Annual Report filed on Form 10-K.

Item 1A. Risk Factors
There has been no material change in risk factors previously disclosed under Item 1A. of the Company’s
Annual Report for 2017 on Form 10-K.

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None

Item 3.  Defaults Upon Senior Securities
None

Item 4. Mine Safety Disclosures
None

Item 5. Other Information    
None

Item 6.   Exhibits
a.  Exhibits
Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
Certification Pursuant to 18 U. S. C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS
XBRL Instance Document
101.SCH
XBRL Taxonomy Extension Schema Document
101.CAL
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF
XBRL Taxonomy Extension Definition Linkbase Document
101.LAB
XBRL Taxonomy Extension Label Linkbase Document
101.PRE
XBRL Taxonomy Extension Presentation Linkbase Document

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
January 19, 2018
 
January 20, 2018
 
February 28, 2018
 
February 28, 2018
 


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SIGNATURE

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed by the undersigned duly authorized officer, on its behalf and in the capacity indicated.

The National Security Group, Inc.
/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: May 14, 2018



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