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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2002
Commission File Number 0-18649

The National Security Group, Inc.
(Exact name of registrant as specified in its charter)

661 East Davis Street Elba, Alabama           36323
(Address of principal executive offices)      (Zip code)

        Registrant’s telephone number, including area code (334) 897-2273

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

None

        Securities registered pursuant to Section 12(g) of the Act:
Common stock par value $1.00 per share
Title of Each Class

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. (X) Yes ( )No

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act) ( ) Yes (X) No

Aggregate market value of the voting stock held by nonaffiliates of the Registrant as of February 28, 2003 (based upon the bid price of these shares on NASDAQ on such date) — $16,497,437.

Number of Shares of Common Stock outstanding as of February 28, 2003 - 2,466,600

Portions of the Annual Proxy Statement incorporated by reference into Part III.

Total Number of Sequentially Numbered Pages: 64

THE NATIONAL SECURITY GROUP, INC.
INDEX TO THE ANNUAL REPORT ON FORM 10-K
FOR THE YEAR ENDED DECEMBER 31, 2002

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PART I

Item 1. Business

Summary Description of The National Security Group, Inc.

The National Security Group, Inc. (the Company), an insurance holding company, was incorporated in Delaware on March 20, 1990. The Company, through its property and casualty subsidiaries, writes primarily dwelling fire and windstorm, homeowners, mobile homeowners, and personal non-standard automobile lines of insurance. The Company, through its life insurance subsidiary, offers a basic line of life, and health and accident insurance products. Property-casualty insurance is the most significant segment, accounting for 84% of total premium revenues.

Industry Segment and Geographical Area Information

Property and Casualty Insurance Segment

The Company’s property and casualty insurance business is conducted through National Security Fire & Casualty Company (NSFC), a wholly owned subsidiary of the Company organized in 1959, and Omega One Insurance Company (Omega), a wholly owned subsidiary of National Security Fire & Casualty Company organized in 1992. NSFC is licensed to write insurance in the states of Alabama, Arkansas, Florida, Georgia, Mississippi, Oklahoma, South Carolina, and Tennessee, and operates on a surplus lines basis in the states of Kentucky, Louisiana, Missouri, and Texas. Omega is licensed to write insurance in Alabama and Louisiana. The following table indicates those states, which accounted for more than five percent of direct written premium during 2002:

In general, the property-casualty insurance business involves the transfer by the insured, to an insurance company of all or a portion of certain risks for the payment, by the insured, of a premium to the insurance company. A portion of such risks is often retained by the insured in the form of deductibles, which may vary greatly from policy to policy.

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

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

The following table sets forth the premiums earned and income during the periods reported:

Life Insurance Segment

National Security Insurance Company (NSIC), a wholly owned subsidiary organized in 1947, conducts the Company’s life insurance business. NSIC is licensed to write insurance in six states: Alabama, Florida, Georgia, Mississippi, South Carolina, and Texas. The following table indicates NSIC direct premiums collected by state in 2002:

NSIC has two primary methods of distribution of insurance products, home service agents and independent agents. The home service distribution method of life insurance products accounts for 59% of total premium revenues in the life insurance segment. Home service life products consist of products marketed directly at the home or other premises of the insured by an employee agent of the Company. The independent agent distribution method accounts for 31% of total premium revenue in the life insurance segment. Since NSIC began marketing life, accident and health products through independent agents in 1999 the distribution channel has become the fastest growing method of distribution. The products offered by NSIC primarily consist of term and whole life insurance and supplemental accident and health insurance. NSIC does not sell annuities.

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Term life insurance policies provide death benefits if the insured’s death occurs during the specific premium paying term of the policy and generally do not include a savings or investment element in the policy premium. Whole-life insurance policies demand a higher premium than term life, but provide death benefits which are payable under effective policies regardless of the time of the insured’s death and have a savings and investment element which may result in the accumulation of a cash surrender value.

Accident and health business is primarily accident policies sold through schools, though NSIC is beginning to experience an increase in accident sales through its independent and captive agency force. Accident and health insurance provides coverage for losses sustained through sickness or accident and includes individual hospitalization and accident policies, group supplementary health policies and specialty products, such as cancer policies. These policies generally provide a stated benefit and have not experienced the escalating health care costs, which many health and accident insurance policies have experienced in recent years.

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

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Investments

The insurance subsidiaries are regulated as to the types of investments that they may make and the amount of funds they may maintain in any one type of investment. Through its investment policy, the Company seeks to conserve its capital resources and assets, meet the investment requirements of its reserves and provide a reasonable return on investments.

The following table sets forth certain information respecting the Company’s investments at the date shown:

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

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As of December 31, 2002, the maturity schedule for all bonds and notes held by the Company, stated at amortized cost, was as follows:

Maturity Schedule (Amounts in thousands)

In the fourth quarter of 2001 The Company entered into a joint investment with a local manufacturing firm, Cash Brothers Leasing, Inc and formed a new company, The Mobile Attic, Inc. The Mobile Attic, Inc, through a network of dealers, leases portable storage units. The primary customers of The Mobile Attic are building contractors, retail establishments, and residential consumers.

At 12/31/2002 the Company held a 50% equity investment in The Mobile Attic. The investment was accounted for in the financial statements on the equity basis. Further details of the financial results of The Mobile Attic, Inc. are discussed in the Management Discussion and Analysis Section of Form 10-K.

Certain Information Regarding Insurance Activities

Marketing and Distribution

NSIC products are marketed through a field force of agents and service representatives who are employees of the Life Company and through a network of independent agents. The independent agent method of distribution is expected to be more cost effective in the long term and has become the fastest growing method of distribution. NSFC's products are marketed through a network of independent agents and brokers, who are independent contractors and who generally maintain relationships with one or more competing insurance companies.

Agents receive compensation for their sales efforts. In the case of life insurance agents, compensation is paid in the form of sales commissions plus a servicing commission. Commissions incurred by NSIC in 2002 averaged approximately 44% of premiums. Commissions incurred by the NSFC in 2001 averaged approximately 22% of premiums and ranged from 12.5% to 27.5% depending on the type and amount of insurance sold. During 2002, no one independent agent accounted for more than 10% of total net earned premium of the property-casualty insurance subsidiaries.

At December 31, 2002 NSIC employed 19 home service agents and three managers. NSIC also had approximately 325 independent agents actively producing new business.

At December 31, 2002 NSFC had contracts with approximately 1,300 independent agents in twelve states.

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Reinsurance

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

NSIC generally reinsures all risks in excess of $50,000 with respect to any one insured. NSFC and Omega generally reinsure with third parties any liability in excess of $100,000 on any single policy. In addition, the property-casualty subsidiaries have catastrophe excess reinsurance, which protects it in part with respect to aggregate property losses arising out of a single catastrophe, such as a hurricane. In 2002, the property-casualty subsidiaries had catastrophe protection up to a $21 million loss. On a 1 in 200 year loss, that is a loss that has only a1/2of 1% chance of occurring in any given year, the property and casualty subsidiaries would pay $2.7 million in losses and reinsurers would pay $17.9 million.

In addition to catastrophe reinsurance, NSFC also had a 50% quota share reinsurance agreement on ocean marine exposure with additional excess of loss coverage.

Reserve liabilities

NSIC maintains life insurance reserves for future policy benefits to meet future obligations under outstanding policies. These reserves are calculated to be sufficient to meet policy and contract obligations as they arise. Liabilities for future policy benefits are calculated using assumptions for interest, mortality, morbidity, expense, and withdrawals determined at the time the policies were issued. As of December 31, 2002, the total reserves of NSIC (including the reserves for accident and health insurance) were approximately $23 million. NSIC believes that such reserves for future policy benefits were calculated in accordance with generally accepted actuarial methods and that such reserves are adequate to provide for future policy benefits. Wakely & Associates, consulting actuaries, provided actuarial services in calculating reserves.

The property-casualty subsidiaries are also required to maintain loss reserves (claim liabilities) for all lines of insurance. Such reserves are intended to cover the probable ultimate cost of settling all claims, including those incurred but not yet reported. The reserves of the property-casualty subsidiaries reflect estimates of the liability with respect to incurred claims and are determined by evaluating reported claims on an ongoing basis and by estimating liabilities for incurred but not reported claims. Such reserves include adjustment expenses to cover the cost of investigating losses and defending lawsuits. The establishment of accurate reserves is complicated by the fact that claims in some lines of insurance are settled many years after the policies have been issued, thus raising the possibility that inflation may have a significant effect on the amount of ultimate loss payment, especially when compared to initial loss estimates. The subsidiaries, however, attempt to restrict their writing to risks that settle within one to four years of issuance of the policy. As of December 31, 2002, the property-casualty subsidiaries had

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reserves for unpaid claims of approximately $11.5 million before subtracting unpaid claims which will be due from reinsurers of $1.56 million leaving net unpaid claims of $9.94 million. The reserves are not discounted for the time value of money. No changes were made in the assumptions used in estimating the reserves during the years ending December 31, 2002, 2001 or 2000. The Company believes such reserves are adequate to provide for settlement of claims. Employees of the Company calculate NSFC and Omega loss reserves. Milliman & Robertson, an independent actuarial consulting firm, issues a Statement of Actuarial Opinion regarding the adequacy of reserves.

Underwriting Activities

The insurance subsidiaries maintain underwriting departments that seek to evaluate the risks associated with the issuance of an insurance policy. NSIC accepts standard risks and, to an extent, substandard risks and engages medical doctors who review certain applications for insurance.

In the case of the property-casualty subsidiaries, the underwriting staff attempts to assess, in light of the type of insurance sought by an applicant, the risks associated with a prospective insured or insurance situation. Depending upon the type of insurance involved, the process by which the risks are assessed will vary. In the case of automobile liability insurance, the underwriting staff assesses the risks involved in insuring a particular driver, and in the case of fire insurance, the underwriting staff assesses the risks involved in insuring a particular dwelling. Where possible, the underwriting staff of the property-casualty insurance subsidiary utilizes standard procedures as guides that quantify the hazards associated with a particular business activity. In general, the property-casualty subsidiaries specialize in writing nonstandard risks.

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

Regulation

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

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

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

Competition

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

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

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

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

Inflation

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

Item 2. Properties

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

Item 3. Legal Proceedings

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

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

There were no matters submitted to a vote of security holders during the three months ended December 31, 2002.

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PART II

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

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

The number of shareholders of the Company's capital stock as of January 31, 2003, was approximately 1,100.

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Item 6. Selected Financial Data
        (Amounts in thousands, except per share)

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The following analysis of the consolidated results of operations and financial condition of the Company should be read in conjunction with the Selected Financial Data and Consolidated Financial Statements and related notes included elsewhere herein.

Results of Operations
Consolidated Results of Operations:

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001

Consolidated net income for The National Security Group (The Company) was $908,000 in 2002 compared to $4.13 million in 2001. On a per share basis earnings were $0.37 in 2002 compared to $1.67 in 2001. Realized capital gains were $1.168 million in 2002 compared to $1.640 million in 2001. Consolidated revenues were $39.085 million in 2002 compared to $32.783 million in 2001. Increased insurance premium production in the property/casualty insurance subsidiaries was the primary factor contributing to the increase in revenues in 2002. However, adverse underwriting results in the property/casualty insurance segment were the primary factor contributing to the decline in earnings for 2002 compared to 2001.

A 50% owned subsidiary contributed $136,000 to net income in 2002. This subsidiary, The Mobile Attic, Inc., is in the business of leasing portable storage containers through independent dealers in Alabama, Florida, and Tennessee.

The operating results of the subsidiaries are discussed in further detail in the sections that follow.

Year Ended December 31, 2001 Compared to Year Ended December 31, 2000

Consolidated net income for The National Security Group (The Company) was $4.130 million in 2001 compared to $3.776 million in 2000. On a per share basis earnings were 1.67 in 2001 compared to 1.53 in 2000. A second consecutive year of underwriting profits in the property/casualty insurance subsidiaries boosted earnings to the highest levels in more than a decade. Realized capital gains in 2001 were 1.64 million and 1.72 million in 2000. Consolidated revenues were $32.8 million in 2001 compared to $29.7 million in 2000.

Industry Segment Data
Certain financial information for The National Security Group’s three segments (life and accident and health insurance, property and casualty insurance, and other) is summarized as follows (amounts in thousands):

Premium revenues:

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Income before taxes and equity in income of affiliate:

Life and Accident and Health Insurance Operations:

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

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001:

Income before income taxes in 2002 was $1,186,000 compared to $586,000 in 2001. A decrease in litigation related expenses boosted income before income tax by over $200,000. A decline in general expenses is the other significant item contributing to the increase in income before income taxes in 2002 compared to 2001.

Premium revenue increased to $5,396,000 in 2002 compared to $5,161,000 in 2001, an increase of 4.6%. Insurance sales through independent agent distribution channels increased over 40% in 2002 over prior year; while sales through NSIC’s traditional home service distribution channel declined by 4%. While management is pleased with new business production from the independent agents distribution channel, an increased focus is now being placed on increasing retention of new business. Increased retention and persistency will not only further increase premium growth in the independent agent distribution channel, but also reduce commission expense as a percent of premium because most commission paid on an insurance contract sold through independent agents is paid in the first two years the policy is in force.

Commission expense increased 16% in 2002 compared to 2001. The continuing increases in new sales through independent agents and a change in the home service agents commission contract were the primary factors contributing to the increase in commission. Independent agents typically receive much higher commission rates in the early years of a policy compared to employee agents in the home service market, which typically receive a lower and more level commission over a longer number of years. With premium growth generated exclusively through independent agents, commission expense will rise at a faster rate than premium growth until a more significant block of insurance business rolls into subsequent years at lower commission rates. The second factor contributing to the increase in commission expense was a change in employee home service agents’ contract in 2002. Under the new contract agents received an increase in base salary and could achieve bonuses upon obtaining varying levels of persistency. To offset the increase in salaries, management reduced the number of agents and combined sales territories. Because the salary increases were implemented early in 2002 and efficiency efforts were not fully implemented until later in 2002, no cost savings were realized and in fact total field cost in the home service program increased. However, as a result of these efforts, home service field cost are expected to stabilize in 2003 and subsequent years.

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Year Ended December 31, 2001 Compared to Year Ended December 31, 2000:

Income before income taxes in 2001 was $586,000 compared to $1,667,000 in 2000. Increased field cost and general expenses and a decrease in realized capital gains were the primary factors contributing to the decrease in income in the life insurance subsidiary.

NSIC increased premium income 12.3% to $5,161,000 in 2001 compared to $4,594,000 in 2000. Life insurance premium income increased 10.5% in 2001, and accident and health insurance also had an increase of 20.5% in 2001. The life insurance sales through independent agents were the source of premium growth in NSIC in 2001.

Commission expenses increased due to the continued increase in new business production. Life insurance commissions are front loaded, meaning that significantly higher commission rates are paid in the early years of a policy and decrease significantly particularly after the first two years of the policy.

Property & Casualty Operations:

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

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001:

Property and casualty premium revenues increased $7,039,000 for the year ended December 31, 2002 compared to the same period in 2001, an increase of over 35%. Increased marketing efforts certainly had a significant impact on the increase in premium revenue, but market changes also significantly influenced the influx of new business. Over the last two years many companies have become much more restrictive in their underwriting guidelines, or have completely exited some markets that we serve. As a result of these market changes we have seen a decrease in competition and an opportunity to significantly increase market share. However, as will be discussed in the paragraphs that follow, we will have to strictly monitor underwriting results and proactively manage growth in order to improve underwriting profitability.

Net income before income tax was $518,000 in 2002 compared to $5,440,000 in 2001. Adverse claims experience from hurricane losses in the fourth quarter of 2002 and an increased severity of losses on new business issued were the primary reasons for the significant decrease in income. In October of 2002 Hurricane Lili swept across Louisiana causing over $1,300,000 in insured losses in NSFC and Omega. However, the most significant impact on property/casualty net income for the year was poor underwriting results on new business issued. Historically, new property insurance business issued has carried a higher loss ratio than renewal business. In 2002 the property/casualty subsidiaries issued more new business than has been issued in recent history with an increase in premium revenue of over 35%.

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NSFC incurred numerous total losses on business in force less than one year, mostly fire losses. 33% of all dwelling property losses incurred in 2002 were attributable to fire losses of over $25,000 per occurrence. Historically, fire losses are more numerous in the winter months of December and January, but a higher frequency of fire losses was experienced throughout the year. It is difficult to prove that these higher frequency losses were connected to any single cause, such as a colder than normal winter or lightning strikes, but with the overall economy in a downturn and personal bankruptcy at record highs in some of the states in which NSFC and Omega writes business, management believes that at least some of the losses could be attributable to arson, which is most cases is virtually impossible to prove. In an effort to stem the frequency of total fire losses, we have instituted additional underwriting standards in some states, such as providing proof of prior insurance coverage and closer evaluation of prior claims history. We will closely monitor underwriting results in 2003 and make further improvements and adjustments as deemed necessary to improve underwriting profitability.

Year Ended December 31, 2001 Compared to Year Ended December 31, 2000:

Net income before income tax was $5,440,000 in 2001 compared to $3,917,000 in 2000. Improved underwriting results continued to be the primary factor contributing to the improvement in income before taxes.

Earned premium for 2001 was $20,196,000 compared to $18,326,000 in 2000. The property/casualty subsidiaries experienced premium growth in dwelling fire, homeowners, and private passenger auto lines of business.

The improved underwriting results in 2001 compared to 2000 were primarily attributable to the completion of the runoff period for several general agent programs that were started through out the 1990‘s. Adverse loss development on these programs led to higher underwriting losses in the late 1990‘s. These programs, primarily commercial and private passenger auto programs, were discontinued in 1999 and 2000.

Property & Casualty Combined Ratio:

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

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

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

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

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

The combined ratio for 2002 compared to 2001 increased seventeen percentage points. The loss and LAE component of the combined ratio increased over twenty percentage points. The previously discussed hurricane related losses and a higher loss ratio on new business is the primary reason for the significant increase in the combined ratio. On a positive note, the expense ratio declined over four percentage points in 2002 compared to 2001. While the large influx of new business had an adverse impact on the loss and LAE ratio, the increase in new business did enable us to begin to achieve some economies of scale and reduce the expense ratio significantly. A primary objective for us in 2003 will be to focus on maintaining a manageable level of growth while reducing the loss and LAE ratio. As discussed earlier in the Property and Casualty operations section of this report, we are proactively managing our risk to mitigate the continuing negative impact of adverse underwriting results on the Company.

Leasing operations:

The Company's leasing operations are conducted through its 50% owned subsidiary, Mobile Attic, Inc. The investment in Mobile Attic is accounted for under the Equity Method in the Consolidated Financial Statements of the Company. Mobile Attic was incorporated in August of 2001 and is a joint venture with a manufacturing partner, Cash Brothers Leasing of Elba, Alabama.

Mobile Attic is in the business of leasing portable storage containers to individual and commercial customers through an independent dealer network primarily in Alabama, but also operating in Florida and Tennessee. At December 31, 2003 Mobile Attic had available approximately 1,800 storage containers for lease and thirteen independent dealers. The portable storage containers are eight feet wide and eight feet tall and are available in lengths of 8, 16, 20, and 40 feet. Independent dealers market these portable storage containers primarily to household customers in need of a convenient alternative to fixed location mini-storage, commercial customers in need of secure storage facilities at job sites, and retail customers for storage of seasonal inventory.

In 2002 Mobile Attic contributed $136,000 in net income to the Company compared to net income of $52,000 in 2001. In 2001, the year in which operations began, gross rental revenues were $87,000. In 2002 gross rental revenues were $557,000. It is anticipated that Mobile Attic will produce rental revenue of over $2,000,000 in 2003 with over 3,000 storage containers available for lease by year-end 2003.

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Asset Portfolio Review:

The life insurance and property/casualty subsidiaries primarily invest in highly liquid investment grade debt and equity securities. At December 31, 2002, the company's holdings in debt securities amounted to 71% of total investments and 62% of total assets. The following is a breakdown of the bond portfolio quality according to National Association of Insurance Commissioners (NAIC) Securities Valuation Office (SVO) rating standards, and the nationally recognized rating organization equivalents of Moody's and Standard and Poor's:

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

The insurance subsidiaries' fixed maturity securities include mortgage-backed bonds, primarily collateralized mortgage obligations (CMO's), of $5.4 million and $9.2 million at December 31, 2002 and 2001 respectively. The mortgage-backed bonds are subject to risks associated with variable prepayments of the underlying mortgage loans. Prepayments cause those securities to have different actual maturities than that expected at the time of purchase. Securities that are purchased at a premium to par value and prepay faster than expected will incur a reduction in yield or loss. Securities that are purchased at a discount to par value and prepay faster than expected will generate an increase in yield or gain. The degree to which a security is susceptible to either gains or losses is influenced by the difference between amortized cost and par value, the relative sensitivity of the underlying mortgages backing the assets to prepayments in a changing interest rate environment and the repayment priority of the securities in the overall securitization structure.

Liquidity and Capital Resources: Due to regulatory restrictions, the majority of the Company's cash is required to be invested in investment-grade securities to provide ample protection for policyholders. The liabilities of the insurance subsidiaries are of various terms and, therefore, those subsidiaries invest in securities with various maturities spread over periods usually not exceeding 10 years.

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

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The National Security Group's consolidated statement of cash flows indicate that operating activities provided (used) cash of $4,321,000, $2,913,000, $(442,000) in 2002, 2001, and 2000 respectively. Those statements also classify the other sources and uses of cash by investing activities, and financing activities and disclose the amount of cash available at the end of the year to meet the Company's obligations.

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

The Company has notes payable of $3.4 million at December 31, 2002. The notes payable are to be repaid in quarterly installments over five years.

The ability of the Company to meet its commitments for timely payment of claims and other expenses depends, in addition to current cash flow, on the liquidity of its investments. On December 31, 2002, the Company had no known impairments of assets or changes in operation, which would have a material adverse effect upon liquidity. Approximately 81% of the Company's assets are invested in cash, investment grade fixed income securities, short-term investments and broadly traded equity securities which are highly liquid. The values of these investments are subject to the conditions of the markets in which they are traded. Past fluctuations in these markets have had little effect on the liquidity of the Company. The Company has relatively little exposure to lower grade fixed income investments which might be especially subject to liquidity problems due to thinly traded markets.

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

As disclosed in note M to the consolidated financial statements, in 2003, the amount that The National Security Group's insurance subsidiaries can transfer in the form of dividends to the parent company is limited to $1.1 million in the life insurance subsidiary and $2.0 million in the property/casualty insurance subsidiary. However, that condition poses no short-term or long-term liquidity concerns for the parent company.

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

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The levels and ratios are as follows:

The ratios of Total Adjusted Capital to Authorized Control Level RBC for The National Security Group’s life/health and property/casualty insurance subsidiaries are all in excess of five to one at December 31, 2002.

National Security Insurance Company (life insurer) has regulatory adjusted capital of $11.47 million and $13 million at December 31, 2002 and 2001, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 17.1 and 15.75 at December 31, 2002 and 2001 respectively. Accordingly, National Security Insurance Company meets the minimum RBC requirements.

National Security Fire & Casualty Company (property/casualty insurer) has regulatory adjusted capital of $20.2 million and $23.6 million at December 31, 2002 and 2001, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 5.3 and 7.0 at December 31, 2002 and 2001 respectively. Accordingly, National Security Fire & Casualty Company meets the minimum RBC requirements.

Omega One Insurance Company (property/casualty insurer), which began writing business in late 1995, has regulatory adjusted capital of $5.7 million and $5.0 million at December 31, 2002 and 2001, respectively, and a ratio of regulatory total adjusted capital to authorized control level RBC of 8.7 and 8.4 at December 31, 2002 and 2001 respectively. Accordingly, Omega One Insurance Company meets the minimum RBC requirements.

Information about Forward-Looking Statements

Any statement contained in this report which is not a historical fact, or which might otherwise be considered an opinion or projection concerning the Company or its business, whether expressed or implied, is meant as and should be considered a forward-looking statement as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based on assumptions and opinions concerning a variety of known and unknown risks, including but not limited to changes in market conditions, natural disasters and other catastrophic events, increased competition, changes in availability and cost of reinsurance, changes in governmental regulations, technological changes, political and legal contingencies and general economic conditions, as well as other risks and uncertainties more completely described in the Company’s filings with the Securities and Exchange Commission. If any of these assumptions or opinions prove incorrect, any forward-looking statements made on the basis of such assumptions or opinions may also prove materially incorrect in one or more respects and may cause future results to differ materially from those contemplated, projected, estimated or budgeted in such forward-looking statements.

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Item 7A.                                                    Quantitative and Qualitative Disclosures About Market Risk

The Company’s primary objectives in managing its investment portfolio are to maximize investment income and total investment returns while minimizing overall credit risk. Investment strategies are developed based on many factors including changes in interest rates, overall market conditions, underwriting results, regulatory requirements, and tax position. Investment decisions are made by management and reviewed and approved by the Board of Directors. Market risk represents the potential for loss due to adverse changes in fair value of securities. The three potential risks related to the Company’s fixed maturity portfolio are interest rate risk, prepayment risk, and default risk. The primary risk related to the Company’s equity portfolio is equity price risk

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

The Company is exposed to equity price risk on its equity securities. The Company holds common stock with a fair value of $16.7 million. If the market value of the S & P 500 Index decreased 10% from its December 31, 2002 value, the fair value of the Company’s common stock would decrease by approximately $1.7 million.

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

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

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

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Item 8. Consolidated Financial Statements and Supplementary Data

All other Schedules are not required under related instructions or are inapplicable and therefore have been omitted.

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INDEPENDENT AUDITORS’ REPORT

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

We have audited the accompanying consolidated balance sheets of The National Security Group, Inc. and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2002. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the consolidated financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall consolidated financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of The National Security Group, Inc. and subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America.

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

Birmingham, Alabama
February 26, 2003

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THE NATIONAL SECURITY GROUP, INC.

CONSOLIDATED STATEMENTS OF INCOME

See notes to consolidated financial statements.

25

THE NATIONAL SECURITY GROUP, INC.

CONSOLIDATED BALANCE SHEETS

See notes to consolidated financial statements.

26

THE NATIONAL SECURITY GROUP, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

See notes to consolidated financial statements.

27

THE NATIONAL SECURITY GROUP, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

See notes to consolidated financial statements.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE A — SIGNIFICANT ACCOUNTING POLICIES

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of The National Security Group, Inc. (the Company) and its wholly-owned subsidiaries: National Security Insurance Company (NSIC), National Security Fire and Casualty Company (NSFC) and NATSCO, Inc. (NATSCO). NSFC includes a wholly-owned subsidiary — Omega One Insurance Company (Omega). Omega included a wholly-owned subsidiary — Liberty Southern Insurance Company (LSIC) through September 30, 2001. LSIC was liquidated on September 30, 2001. All significant intercompany transactions and accounts have been eliminated.

Investment in Affiliate

The company’s investment in affiliate consists of a 50% interest in Mobile Attic, Inc., a portable storage leasing company. The company accounts for this investment using the equity method (see Notes B, P and R).

Description of Major Products

NSIC is licensed in the states of Alabama, Georgia, Mississippi, Texas, South Carolina and Florida and was organized in 1947 to provide life and burial insurance policies to the home service market. Premiums sold and serviced by company agents primarily include industrial life, larger ordinary life, accident and health, limited hospital, cancer and low valued life insurance. NSFC operates in various property and casualty lines, the most significant of which are low valued dwelling property, home service fire, nonstandard automobile physical damage and liability, nonstandard commercial, and ocean marine. Omega operates in property and casualty lines, the most significant of which are nonstandard personal lines and automobile liability.

Basis of Presentation

The significant accounting policies followed by The National Security Group, Inc. and subsidiaries that materially affect financial reporting are summarized below. The accompanying consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) which, as to the subsidiary insurance companies, differ from statutory accounting practices permitted by regulatory authorities.

Investments

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

The Company and its subsidiaries have no trading securities.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

NOTE A — SIGNIFICANT ACCOUNTING POLICIES — CONTINUED

Investments — continued

Unrealized holding gains and losses, net of tax, on securities available-for-sale are reported as a net amount in a separate component of shareholders’ equity until realized.

Realized gains and losses on the sale of securities available-for-sale are determined using the specific-identification method.

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

Receivable from Agents

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

Property and Equipment

Property and equipment is carried at cost less accumulated depreciation and includes expenditures that substantially increase the useful lives of existing property and equipment. Maintenance, repairs, and minor renovations are charged to expense as incurred. Upon sale or retirement of property and equipment, the cost and related accumulated depreciation are eliminated from the respective account and the resulting gain or loss is included in the results of operations. The Company provides for depreciation of property and equipment using the straight-line method designed to amortize costs over estimated useful lives. Estimated useful lives range up to 40 years for buildings and from 3-20 years for electronic data processing equipment and furniture and fixtures.

Fair Value of Financial Instruments

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

Certain financial instruments, particularly insurance liabilities other than financial guarantees and investment contracts, leases and affiliate investments, are excluded from the disclosures. In evaluating the Company’s management of interest rate and liquidity risk, the fair values of all assets and liabilities should be taken into consideration.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

NOTE A — SIGNIFICANT ACCOUNTING POLICIES — CONTINUED

Fair Value of Financial Instruments — continued

The fair values of cash, cash equivalents, short-term investments and balances due on accounts from agents, reinsurers and others approximate their carrying amounts as reflected in the consolidated balance sheets due to their short-term availability or maturity.

Statement of Cash Flows

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

Premium Revenues

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

Deferred Policy Acquisition Costs

The costs of acquiring new insurance business are deferred and amortized over the lives of the policies. Deferred costs include commissions, other agency compensation and expenses, and other underwriting expenses directly related to the level of new business produced.

Acquisition costs relating to life contracts are amortized over the premium paying period of the contracts, or the first renewal period of term policies, if earlier. Assumptions utilized in amortization are consistent with those utilized in computing policy liabilities.

The method of computing the deferred policy acquisition costs for property and casualty policies limits the amount deferred to a percentage of related unearned premiums.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

NOTE A — SIGNIFICANT ACCOUNTING POLICIES — CONTINUED

Policy Liabilities

The liability for future life insurance policy benefits is computed using a net level premium method including the following assumptions:

Mortality assumptions include various percentages of the 1955-60 and 1965-70 Select and Ultimate Basic Male Mortality Table. Withdrawal assumptions are based on the Company’s experience.

Claim Liabilities

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

Earnings Per Share

Earnings per share of common stock is based on the weighted average number of shares outstanding during each year. The adjusted weighted average shares outstanding were 2,466,600 (2,466,600 in 2001 and 2000).

Reinsurance

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

In the normal course of business, NSIC seeks to limit its exposure to loss on any single insured and to recover a portion of benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage contracts. NSIC retains a maximum of $30,000 of coverage per individual life. The cost of reinsurance is amortized over the contract period of the reinsurance.

Reclassifications

Certain reclassifications have been made in the previously reported financial statements to make the prior year amounts comparable to those of the current year. Such reclassifications had no effect on the previously reported net income or shareholders’ equity.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

NOTE A — SIGNIFICANT ACCOUNTING POLICIES — CONTINUED

Use of Estimates

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

Advertising

The Company expenses advertising costs as incurred. Advertising costs were $101,000 for the year ended December 31, 2002 ($110,000 and $83,000 for the years ended December 31, 2001 and 2000, respectively).

Concentration of Credit Risk

The Company maintains cash depository accounts, which at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts. The Company believes it is not exposed to any significant credit risk on cash and cash equivalents.

Recently Issued Accounting Standards

On January 1, 2001, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 133, “Accounting for Derivative Instruments and Hedging Activities”. SFAS No. 133, as amended by SFAS Nos. 137 and 138, requires the Company to record all derivative financial instruments at fair value on the balance sheet. Changes in fair value of a derivative instrument are reported in net income or other comprehensive income, depending on the designated use of the derivative instrument. The adoption of SFAS No. 133 did not have a material effect on the Company’s financial position or results of operations. Prospectively, the adoption of No. 133 may introduce volatility into the Company’s reported net income and other comprehensive income depending on future market conditions and the Company’s hedging activities.

In September 2000, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, a replacement of SFAS No. 125". SFAS No. 140 revises the standards for accounting for securitizations and other transfers of financial assets. This Statement is effective for transfers and servicing of financial assets and extinguishments of liabilities occurring after March 31, 2001. The adoption of this statement is not expected to have a material effect on the Company’s financial position or results of operations.

In June 2001, the FASB issued SFAS Nos. 141, “Business Combinations”, and 142, “Goodwill and Other Intangible Assets”. SFAS No. 141 requires that business combinations initiated after June 30, 2001, be accounted for using the purchase method. SFAS No. 142 revises the standards for accounting for acquired goodwill and other intangible assets. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001, and effective for any goodwill or intangible asset acquired after June 30, 2001. The adoption of this accounting standard did not have a material effect on the Company’s financial position or results of operations.

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THE NATIONAL SECURITY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — CONTINUED

NOTE A — SIGNIFICANT ACCOUNTING POLICIES — CONTINUED

Recently Issued Accounting Standards — continued

In July 2001, the FASB issued SFAS No. 143, “Accounting for Asset Retirement Obligations”. SFAS No. 143 requires that companies record the fair value of a liability for an asset retirement obligation in the period in which the liability is incurred. The Statement is effective for fiscal years beginning after June 15, 2002. The Company does not expect the adoption of SFAS No. 143 to have a material effect on the Company’s financial position or results of operations.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”. SFAS No. 144 revises SFAS No. 121 by requiring that one accounting model be used for long-lived assets to be disposed of by sale, whether previously held and used or newly acquired, and by broadening the presentation of discontinued operations to include more disposal transactions. SFAS No. 144 is effective for fiscal years beginning after December 15, 2001. The adoption of this accounting standard did not have a material effect on the Company’s financial position or results of operations.

In July 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses financial accounting and reporting for costs associated with exit or disposal activities, and must be applied prospectively to exit or disposal activities initiated after December 31, 2002. The adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.

NOTE B — INVESTMENT IN AFFILIATE

Summarized financial information for the Company's investment in Mobile Attic, Inc., accounted for by the equity method, follows: